8.2. Conversion of Financial Data (financial cash flows) into Economic Flows: Opportunity Costs, Shadow Prices and Tax Adjustments

In general terms, cost and revenue cash flows need to be adjusted in order to reflect the real value or cost for society. The current market prices for many costs (but also revenues) usually reflect the real costs for the society as they appropriately provide opportunity costs. However, some cost estimations may not reflect an appropriate cost for society, since they may be biased for several reasons or because a market simply does not exist for them (externalities). When this occurs, it may be necessary to make some adjustments. See box 3.10 and figure 3.3.

Market Imperfections

A particular item’s current market price may not reflect its real price when the specific market has imperfections, especially when it is a regulated market or item (currencies, oil, energy, and other commodities, as well as labour and others). When this occurs, the concept of “shadow prices” should be introduced. These shadow prices shall be estimated and used instead of the market price being included in the financial analysis. The ‘shadow prices’ is an attempt to value a benefit or a cost where no competitive or explicit market price exists.

As an example, one of the most typical adjustments relates to the labour costs (wages).

• In the context of a high unemployment level, the salary is usually above the real price of the item (due to legal regulations on minimum salary). Therefore, an adjustment decreasing the value of this item must be made; and
• In a context of high employment, wages tend to reflect the real market price of the labour factor (so no adjustment has to be made).

Another example, especially relevant for emerging and developing economies (EMDEs), would be as follows.

• Electricity prices are often below economic levels. A commercial NPV of an energy efficiency project would tend to reject good projects because the energy savings measured at official tariffs will be depressed; valuing energy savings at the economic cost of electricity would give the correct CBA outcome.

Other opportunity cost adjustments

There may be some costs that are not a direct cash cost of the project, but should be considered within the socio-economic analysis. The most typical example is public land or public properties. When there is no cost for the land or the site, or a building or other asset is being provided by a public entity for the project, its cost should be included in the analysis — valuing the land at its market price so as to reflect the opportunity cost for the authority. However, in cases in which there is no alternative use for the asset, the cost is deemed to be zero since it is a sunk cost. The ‘sunk cost’ is Investments previously made in a program or project—such as original research and development costs that cannot be recouped—compared to ongoing costs.

Taxes

The price of an item (in cash terms) generally includes taxes that are in fact public revenue. Therefore, the tax effect has to be removed from the calculations; for example, corporate taxes, value-added tax (VAT) (not only for costs, but also for revenues) and other taxes, and social charges within labour costs — as they transfer price payments to individuals.

There may be some indirect taxes and subsidies that could be used as corrections for externalities, for example, taxes on energy to discourage negative environmental externalities. In these cases, including the tax may be justified, while also adding an adjustment for the externality in order to avoid double counting.

Another case of tax adjustment is related to imported products where the effect of the respective duty should be removed.