Environmental Externalities

Environmental externalities are a particular form of externalities that economic

analysis should take into account. They should be identified and

quantified where possible and included in the economic analysis as project

costs (as might be the case for a decreased fish catch or increased illness) or

benefits (as might be the case with the reduction in pollution of coastal

areas). After assigning a monetary value to the costs and benefits, the analyst

should treat them as any other cost and benefit and enter them into the

cash flow tables.

Project Boundaries and Time Horizon

Analysts must make two major decisions when assessing environmental

impacts. First, they must decide how far to look for environmental impacts,

that is, they must determine the boundary of the economic analysis.

By assessing the internal benefits and costs of a project, the boundaries

of the analysis become clear. If the benefits accrue to the project

entity or if the costs are borne by the project entity, they enter into the

analysis. When we attempt to assess the externalities of a project to determine

its impact on society, the boundaries become blurred. Identifying

externalities implies expanding the conceptual and physical boundaries

of the analysis. A mill that generates wastewater will adversely affect

downstream uses of water for drinking, irrigation, and fishing. The analyst

can easily identify, and maybe even measure, these impacts. Other

impacts on the environment, such as the effects of emissions from a power

plant on creation of acid rain, may be more distant or more difficult to identify. How far to expand the analysis is a matter of judgment and depends

on each individual project.

The second decision concerns the time horizon. Like the project’s physical

boundaries, its time horizon also becomes blurred when we go from

financial to economic analysis. A project’s environmental impact may not

last as long as the project, or it may outlive it. If the environmental impact

lasts less time than the expected economic life of the project, the effects can

be included in the standard economic analysis. If the analyst expects the

effects to last beyond the lifetime of the project, the time horizon must be

extended. This can be done in two ways, either by extending the cash flow

analysis a number of years, or by adding the capitalized value of that part

of the environmental impact that extends beyond the project’s life to the

last year of the project. The latter technique treats the environmental impact

much as one would treat a project’s capital good whose life extends

beyond the project’s lifetime by giving it a salvage value.

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Valuing Environmental Externalities

Sometimes an entity uses resources for a project without paying for them.

For example, a factory may emit soot into the air, dirtying surrounding

buildings and thereby increasing their maintenance costs. The higher

maintenance costs are a direct result of the factory’s use of a resource, air,

that from the factory’s viewpoint is free, but from society’s viewpoint

has a cost. Likewise, a new irrigation project may lead to reduced fish

catch or the spread of a disease. Sometimes a project benefits certain

groups in a way such that the project entity cannot extract a monetary

payment for them.

If a forest lowers the level of carbon dioxide in the world, the forest

owners cannot charge for the benefit. Or a sewage and water supply

project may not only improve water quality and yield direct health benefits,

but may also produce benefits from decreased pollution of coastal

areas, in turn increasing recreational use and property values. These

side effects of projects, known as externalities, are real costs and benefits

that should be included in the economic analysis as project costs or

as project benefits.

Externalities are easier to conceptualize than to measure. They occur in

production and consumption and in almost every walk of life. Involuntarily

inhaling another person’s smoke is an example of an externality. The

smoker’s pleasure produces displeasure in another person. To assess the

total pleasure derived from smoking, it would be necessary to reduce the

smoker’s pleasure by the displeasure of the person who involuntarily inhales

the smoke. Although it is easy to understand how smoking may produce

an externality, it is not as easy to assign a value to the smoker’s pleasure

or to the inhaler’s displeasure.

Externalities are easy to depict. Consider the production of a good, say,

electricity. Suppose that in producing electricity the plant emits soot that increases the maintenance costs of adjacent buildings. The utility company’s

costs would not reflect the costs to the neighbors of cleaning up the adjacent

buildings—unless the law requires it. Yet, the costs to society include

not only those that appear on the article of the utility company, but also the

additional maintenance costs of the adjacent buildings. MPC

is the marginal cost of producing electricity as reflected in the books of the

utility company, and MSC is the marginal cost of producing electricity and

cleaning up the buildings. MSC is the marginal social cost of producing

electricity. This cost would be higher than the private cost, which is the

cost to the utility company.

For any given level of output, q*, the area under the MSC curve gives the

total social cost of producing that level of output, while the area under the

MPC curve gives the perceived private cost. The difference between the areas

under the two curves gives the difference between the private and the social

cost. The financial costs of the project will not include the costs of the

externality, and, hence, an evaluation of the project based on MPC will

understate the social costs of the project and overstate its net benefits. In

principle, all we need to do to account for the externality is to work with

social rather than private costs. In practice, the shape of the MSC curve and

hence its relationship to the MPC curve is unknown, making measurement

difficult. Also, tracing and measuring all external effects is not always feasible. appear significant, to measure them. When externalities cannot be quantified,

they should be discussed in qualitative terms.

In some cases it is helpful to internalize externalities by considering a

package of closely related activities as one project, that is, to draw the project

boundary to include them. In the case of the soot-emitting factory, the externality

could be internalized by treating the factory and the neighboring buildings

as if they belonged to the project entity. In such a case, the additional

maintenance costs become part of the maintenance costs of the project entity

and are internalized. If the factory pays for the additional maintenance costs,

or if the factory is forced to install a stack that does not emit soot, the externality

also becomes internalized. In these cases, the formerly external cost

becomes an internal cost reflected in the accounts of the factory.

Nevertheless, analysts should always attempt to identify them and, if they

Quantity per

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Valuation of Nontradable Goods and Services

Domestic distortions drive a wedge between economic and financial prices

of nontradable goods. Consequently, it is necessary to adjust financial

prices to reflect economic opportunity costs. The calculation of shadow

prices for nontradables, however, can be extremely time-consuming, and

project analysts must determine whether the refinement is worth the additional

effort. For example, domestic sales taxes are a common distortion;

the prices consumers pay for the good (demand price) will differ

from the price suppliers receive (supply price) by the amount of the tax.

As discussed in the technical appendix, the economic opportunity cost of

this good would depend on the elasticities of supply of and demand for

the good. Because gathering information about elasticities can be timeconsuming,

it is advisable to proceed cautiously. If the NPV of a project is

not sensitive to variations in the economic price of the input, estimating

its economic price with great accuracy is not worth the cost and an educated

guess will suffice.

Material Inputs

The first step in valuing nontradable material inputs is assessing whether

there are serious distortions in the market for the good or service. The

second step is to estimate upper and lower bounds for the economic price of the good. The final step is to decide whether to estimate the economic

opportunity cost of the good in question with a great degree of accuracy,

or simply use an educated guess.

Suppose that a project uses quarry stones that are subject to a 15

percent excise tax and that each quarry stone costs one U.S. dollar. The

project unit, therefore, pays US$1.15 for each stone, producers receive

US$1.00, and the government receives US$0.15. As shown in the technical

appendix, the economic opportunity cost of quarry stones will lie

between US$1.00 and US$1.15. As a first approximation, analysts can

estimate the project’s NPV using the two extreme values. If the project’s

NPV does not change materially as a function of the economic price of

quarry stones, it would not be worthwhile conducting time-consuming

studies to calculate the elasticities of supply and demand. A rough, educated

guess will suffice.

If, however, the project’s NPV changes from positive to negative, depending

on whether the economic price is US$1.15 or US$1.00, then it behooves

the analyst to estimate the elasticities as thoroughly as the budget

allows. These considerations are applicable to all nontradable material inputs,

and the technical appendix provides further guidance on estimating

the shadow prices of such goods.

Land

Land is a prime example of a nontradable good. In this respect its valuation

is, in principle, no different from that of any other nontradable good.

Land differs from other tradable goods, however, in that its supply is completely

inelastic: any land diverted to the project is necessarily taken away

from some other use, even if that use is speculation. Therefore, the valuation

of land for project use may have to rely on indirect methods, rather

than on straightforward use of market prices, adjusted for distortions.

If an active land market exists, land purchased specifically for project use

may be costed as a capital value using the price paid adjusted for distortions.

This is so if the analyst thinks that the market is sufficiently representative of

alternative use values for the land. If a capital value is used in costing the

land in the project accounts, then a residual value should be included at the

end of the project life. If the annual rental or lease charge is used in costing

the land, then no residual value should be shown for the land at the end of

the project life. If a lessor rents the land, then the rental value adjusted for

distortions should be considered in the project analysis.

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Tradable and Nontradable Goods

Typically, a project’s inputs include material inputs, public utilities, labor,

land, and services. Some of these goods and services are tradable,

some are nontradable, and others are potentially tradable. These distinctions

are important, because the valuation of each type of good is different.

Traded goods include those that are either imported or exported by

the country. Tradable goods include all traded goods and goods that the

country could import or export under conditions of free trade, but does

not because of trade barriers such as import duties. Material inputs, however,

are normally tradable goods.

Nontradable goods are those that by their nature either cannot be traded

or are uneconomical to trade internationally. Real estate, hotel accommodations,

haircuts, and other services are typically nontradable. Nontradable

goods also include goods for which the costs of production and transportation

are so high as to preclude trade, even under conditions of free trade.

In principle, a good falls into this category if its CIF cost or landed price is

greater than the local cost. This condition precludes importation, and at

the same time, its local cost being greater than the FOB price, precludes

exportation. In some cases electric energy and transportation might be

nontradable. Land, however, is always a nontradable good.

To determine whether a good is tradable or nontradable, the first

step is to ascertain whether the good trades internationally. If no international

trade exists, then it is safe to assume that the good is

nontradable. If international trade takes place, but not in the country

where the project is to take place, the second step is to estimate the

relevant CIF and FOB prices, then compare them to the domestic price.

If the CIF price—net of import duties and subsidies—of the good is

higher than its domestic price, then the good is clearly not importable.

If its FOB price—net of export duties and subsidies—is lower than the

domestic price, then the good is clearly not exportable. Of course, the

exchange rate is crucial in this calculation. A nontradable may become

an export if the real exchange rate falls. If, by contrast, imports do not

come into the country, because, for example, import duties render the

import price higher than the domestic price, international trade does

not take place because of distortions. The good, however, is potentially

a traded good. Likewise, if duties make exports uncompetitive, the good

is potentially a traded good. All such potentially traded, but nontraded

goods, should be treated as nontradable goods.

Valuation of Tradable Goods

For various reasons, domestic market prices typically do not reflect the opportunity

costs to the country. In many countries, import duties, for example,

increase the price of domestic goods above the level that would prevail

under conditions of free trade. If the domestic price of inputs is far

higher than under conditions of free trade, a project that uses the protected

input may have a low, financial, expected NPV. Likewise, if a project produces

a good that enjoys protection, the project’s financial NPV may be

higher than under conditions of free trade. To approximate the opportunity

costs to the country, the valuation of tradable inputs and outputs in economic

analysis relies on border, rather than on domestic, market prices. The

technical annex provides a theoretical justification for using border prices

as the prices that reflect the opportunity costs to the country.

Border prices are either CIF or FOB prices suitably adjusted for internal

transport and other costs, but net of taxes and subsidies. If the country is a

net exporter of the good in question, the appropriate border price is the

FOB price of exports—also known as the export parity price. If the country

is a net importer, the appropriate border price is the CIF price of imports

plus internal transport costs—or the import parity price.

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Market Prices versus Economic Costs

We now return to the main theme of this site: getting the prices right.

Once analysts have identified and measured the costs and benefits of the

project, they must price them. Financial analysts use the market price of

the goods and services paid or received by the project entity. As noted earlier,

financial analyses are conducted in the currency of the country at the

domestic price level. This means that financial costs and benefits are valued

at the prices that the project entity is expected to pay for them. Usually

these are prices set by the market, although in some cases the government

may control them. Neither market nor government-controlled prices necessarily

reflect economic costs to society.

The economic values of both inputs and outputs may differ from their

financial values because of market distortions created by either the government

or the private sector. Tariffs, export taxes and subsidies, excise

and sales taxes, production subsidies, and quantitative restrictions are

common distortions created by governments. Monopolies are a market

phenomenon that can be created by either private or public sector actions.

Some market distortions are created by the nature of the good or

service. The values to society of common public services, such as clean

water, transportation, road services, and electricity, are often significantly

greater than the financial prices people pay for them. A project that sells

electricity below its economic cost implicitly subsidizes the users of the

service. Similarly, a project that employs labor at a wage rate that is higher

than its economic cost implicitly subsidizes labor. The differences between

financial and economic prices are rents that accrue to some group in the

society and convey important information about the distribution of costs

and benefits.

Valuation of Inputs and Outputs

In economies where distortions are few, market prices provide a reasonably

good approximation of the opportunity costs of inputs and outputs.

In economies characterized by price distortions, however, market prices are a poor reflection of those costs. The financial assessment of the project

usually differs markedly from the economic assessment. An economic

analysis should assess the project’s contribution to the society’s welfare.

This evaluation requires that the analyst compensate for price distortions

by using shadow prices that reflect more closely the opportunity costs

and benefits of the project, instead of market prices. In principle, if we

adjust all prices to reflect opportunity costs, these calculations would be

extremely time-consuming and expensive. In practice, analysts undertake

few adjustments and concern themselves primarily with adjustments

of the prices of tradable goods, the exchange rate, and the wage rate.

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Numeraire and Price Level

One of the earliest decisions that an analyst confronts is the choice of currency

and price level in which to conduct the analysis. In principle, analysts

can evaluate a project in any currency and at any price level. In practice,

they usually evaluate projects in the domestic currency of the country

implementing the project at prevailing market prices adjusted for distortions,

that is, at the domestic price level. These are not the only possible

choices. The two most frequently used alternatives are domestic currency

at the border price level and foreign currency at the border price level.

When analysts use domestic currency at the border price level, they calculate

the prices of all imports by taking the corresponding cost in the imports’

country of origin, adding insurance and freight (CIF) in foreign currency,

and converting it into domestic currency at the prevailing market or official exchange rate, whichever exchange rate the project entity uses to buy

foreign currency. Analysts must then adjust CIF prices for internal transport

costs. The prices of exports are calculated by taking their free on board (FOB)

prices in foreign currency, converting them into domestic currency at the

prevailing market or official exchange rate, and adjusting them for transport

costs within the country. A market exchange rate is used in this context to

mean the price at which the project entity actually gets its foreign exchange.

The prices of nontraded goods, such as services, are converted to their

border price equivalent by means of conversion factors. If the analysis is

done in foreign currency at the border price level, the prices of imports and

exports remain in foreign currency. The prices of such things as cleaning

services, however, are first converted to their border price equivalent by

means of a conversion factor, and then to their foreign currency equivalent

by means of the prevailing market or official exchange rate.

If the analysis is carried out in domestic currency at the domestic price

level, the analyst calculates the prices of imports and exports at their respective

border prices, but converts them to their domestic currency equivalent

using a shadow exchange rate that reflects the opportunity cost of foreign

exchange to the country. The analyst takes the prices of nontraded

goods and services, such as cleaning services, at their prevailing market

prices adjusted for distortions.

The price of the service (and in general of all nontraded goods whose

market prices reflect the true economic costs) would be converted as follows.

If we use domestic prices at the domestic price level, the price of the

service would be taken as given. If we use domestic currency at the border

price level, we would need to calculate the border price of the service by

using a conversion factor. In this case, the appropriate conversion factor

would be the ratio of the official to the shadow exchange rate, 0.88. If the

numeraire is foreign currency at the border price level, the border price in

domestic currency would have to be further converted to dollars using the

market exchange rate.

The choice of currency and price level is largely a matter of convenience

and will have no impact on relative prices or on the decision to

accept or reject a project. for example, the price of the imported

good relative to the price of cleaning services is 2.5:1 in all cases. As

long as relative prices are unaffected, if the NPV of a project is positive in

one case, it will be positive in all cases. Moreover, the NPV measured in

domestic currency at the domestic price level will differ from the NPV

measured in domestic currency at the border price level by the ratio of the

market exchange rate to the shadow exchange rate, that is. Therefore, one can quickly convert the NPV from one numeraire to another. The internal rate of return (IRR) remains the same, regardless of numeraire.

In most countries, the domestic price level is the price level used to

keep national accounts, the price level used by the government to reckon

its taxes and expenditures, and also the price level used by business. One

usually conducts financial analysis in domestic currency at prevailing market

prices. To integrate financial, fiscal, and economic analyses; to assess

risk and sustainability; and to identify gainers and losers, the analyst must

express the financial and economic analyses in the same unit of account.

When the financial analysis is performed in one unit of account and the

economic analysis in another, the differences between the financial and the

economic values have no meaning. Because we generally conduct financial

and fiscal analyses in domestic prices at the domestic price level, it is most convenient to carry out the economic analysis in the same unit of

account. If we use the border price level for the economic analysis, the

fiscal impact of the project would need to be calculated twice, first at the

border price level and then at the domestic price level. Moreover, for the

evaluation of projects with nontradable benefits, for example, projects in

education, health, and transportation, it is much easier to evaluate the benefits in domestic currency at the domestic price level than in some other

numeraire.

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Getting the Flows Right: Identifying Costsand Benefits

Identifying costs and benefits is the first and most important step in economic

analysis. Often project costs and benefits are difficult to identify and

measure, especially if the project generates side effects that are not reflected

in the financial analysis, such as air or water pollution. Identifying the costs

and benefits of a project is one of the most important steps in economic

analysis. A second important step is to quantify them. The final step is to

value them in monetary terms.

The projected financial revenues and costs are often a good starting

point for identifying economic benefits and costs, but two types of adjustments

are necessary. First, we need to include or exclude some costs and

benefits. Second, we need to revalue inputs and outputs at their economic

opportunity costs. Financial analysis looks at the project from the perspective

of the implementing agency. It identifies the project’s net money flows

to the implementing entity and assesses the entity’s ability to meet its financial

obligations and to finance future investments. Economic analysis,

by contrast, looks at a project from the perspective of the entire country, or

society, and measures the effects of the project on the economy as a whole.

These different points of view require that analysts take different items

into consideration when looking at the costs of a project, use different valuations

for the items considered, and in some cases, even use different rates

to discount the streams of costs and benefits.

Financial analysis assesses items that entail monetary outlays. Economic

analysis assesses the opportunity costs for the country. Just because the

project entity does not pay for the use of a resource, does not mean that the

resource is a free good. If a project diverts resources from other activities that produce goods or services, the value of what is given up represents an

opportunity cost of the project to society. Many projects involve economic

costs that do not necessarily involve a corresponding money flow from the

project’s financial account. For example, an adverse environmental effect

not reflected in the project accounts may represent major economic costs.

Likewise, a money payment made by the project entity—say the payment

of a tax—is a financial but not an economic cost. It does not involve the use

of resources, only a transfer from the project entity to the government. Finally,

some inputs—say the services of volunteer workers—may be donated,

entailing no money flows from the project entity. Analysts must also

consider such inputs in estimating the economic cost of projects.

Another important difference between financial and economic analysis

concerns the prices the project entity uses to value the inputs and outputs.

Financial analysis is based on the actual prices that the project entity pays

for inputs and receives for outputs. The prices used for economic analysis

are based on the opportunity costs to the country. The economic values of

both inputs and outputs differ from their financial values because of market

distortions created either by the government or by the private sector.

Tariffs, export taxes, and subsidies; excise and sales taxes; production subsidies;

and quantitative restrictions are common distortions created by governments.

Monopolies are a market phenomenon that can either be created

by government or the private sector. Some market distortions are

created by the public nature of the good or service. The values to society of

common public services, such as clean water, transportation, road services,

and electricity, are often significantly greater than the financial prices people

are required to pay for them. Such factors create divergence between the

financial and the economic prices of a project.

Economic and financial costs are always closely intertwined, but they

rarely coincide. The divergence between financial and economic prices

and flows shows the extent to which someone in society, other than the

project entity, enjoys a benefit or pays a cost of the project. Sometimes

such payments are in the form of explicit taxes and subsidies, as in a

sales tax; sometimes they are implicit, as in price controls. The magnitudes

and incidence of transfers are important pieces of information that

shed light on the project’s fiscal impact, on the distribution of its costs

and benefits, and, hence, on its likely opponents and supporters. By identifying

the groups benefiting from the project and the groups paying for

its costs, the analyst can extract valuable information about incentives

for these groups to implement the project as designed, or to support it

or oppose it.

A thorough evaluation should summarize all the relevant information

about the project. To look at the project from society’s and the implementing

agency’s viewpoint, to identify gainers and losers, and ultimately to

decide whether the project can be implemented and sustained, it is necessary

to integrate the financial, fiscal, and economic analyses and identify

the sources of the differences.

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Separable Components

Sometimes a project consists of several interrelated subprojects or components.

When the components are independent, each component must be

treated as if it were a separate project. The analyst then must determine

whether each component increases or decreases the project’s total NPV.

Any component with negative NPV should be dropped, even if the total

NPV of all the components is positive. Each separable component must

justify itself as a marginal part of the overall project.

Suppose a project provides three benefits: hydroelectric power, irrigation

water, and recreational facilities. If the benefits and costs of each component

are independent of each other, then the components are separable and can

be treated as independent projects. In this case, the decision to include each

component in the final design will depend solely on whether the NPV of the component is positive. But if the water is needed early in the year for irrigation

and only later in the year to meet peak demand for electricity, and if the

tourist season occurs at the end of the year, the three uses might conflict. For

example, maximizing the use for electricity generation might result in an

empty reservoir when the tourist season begins. If maximizing the NPV of

the whole package entails reducing the efficiency of one component, then

dropping one or more components might result in an overall package with a

higher NPV. In this case, the components are not mutually exclusive and,

hence, not separable.

Appraising such a project requires three steps:

• The analyst must appraise each component independently.

• The analyst must appraise each possible combination of components.

• The analyst must appraise the entire project, including all the components, as a package.

Thus, the analyst must appraise the hydroelectric component separately,

considering the most appropriate technology for generating electricity and

disregarding its uses for irrigation or recreation. Similarly, the analyst must

appraise the irrigation component as an irrigation project, choosing the

most appropriate design for irrigation and disregarding its potential use

for electricity generation or recreation. Finally, the analyst must appraise

the recreation component independently using the same general approach.

The second step would involve appraising three combinations, hydroirrigation,

hydro-recreation, and irrigation-recreation. In each case, the most

appropriate technology for the combination would be used, and the NPV

of each combination would be assessed.

The final step would be to evaluate the design that combines all three

components. This design would also be predicated on a technology that

maximizes the NPV from the combined facilities. We would thus have seven

alternatives: hydroelectricity, irrigation, recreation, hydro-irrigation, hydrorecreation,

irrigation-recreation, and hydro-irrigation-recreation. The preferred

alternative would be the one that yields the highest NPV without

exceeding the budget.

If the components are separable, then the NPV of the combinations is

equal to the sum of the NPVs of each separable component. If the components

are not separable, then the NPV of the combinations is not equal to

the sum of the NPVs of each component. In this table the NPVs of the

combinations are greater than the NPVs of the sums of the individual components.

This, however, does not need to be the case. If the components

are not separable, then choosing the combination with the highest NPV

entails assessing the NPV of each combination and choosing the one with

the highest NPV.

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