Guidelines for the Economic Analysis of Projects
The Asian Development Bank has revised its guidelines for project economic analysis, which help ensure investment decisions are based on economic and efficiency considerations.
The economic analysis of development projects helps to ensure that scarce resources are allocated efficiently, and investment brings benefits to a country and raises the welfare of its citizens. It is a tool used by the Asian Development Bank (ADB) to ensure that its operations comply with the ADB Charter and contribute to the broad objectives of poverty reduction, inclusive economic growth, environmental sustainability, and regional integration.
The guidelines in this publication are a revised version of the 1997 edition. The revision responds to the changing development context and ADB operational priorities, and aims to address the recommendations of the ADB Quality-at-Entry Assessments for more methodological work on project economic analysis.
The revised guidelines provide general principles for the conduct of project economic analysis. The appendices provide illustrations of their application.
Changes in the guidelines from the 1997 edition include
- revised minimum required economic internal rate of return for investment decisions;
- several issues that have emerged or become more important since the adoption of the 1997 edition, including economic analysis under various financing modalities, the treatment of the social cost of carbon, and economic analysis of regional economic cooperation projects; and
- a new chapter on benefit valuation by sector, which details the method for valuing project, benefits in major sectors of ADB operations.
These guidelines should be read together with handbooks, technical reports, and other reference materials published by ADB, which discuss sector-specific project economic analysis in detail.
The Agreement Establishing the Asian Development Bank (ADB Charter) requires staff to “take the necessary measures to ensure that the proceeds of any loan made, guaranteed or participated in by the Bank are used only for the purposes for which the loan was granted and with due attention to considerations of economy and efficiency” (Article 14.11). It also states that “only economic considerations shall be relevant to their decisions” (Article 36.2).1 Project economic analysis is a key tool to ensure that ADB operations comply with the mandate of the ADB Charter and contribute to the broad objectives of poverty reduction, inclusive economic growth, environmental sustainability, and regional integration. Read more.
A well-conducted economic analysis should show that
- a project is in line with the development context of a borrowing country and ADB’s country partnership strategy;
- there is strong rationale for the public sector and ADB to finance the project; and
- the selected project represents the most efficient or least-cost option among all the feasible alternatives for achieving the intended project benefits and, when benefit can be valued, it will generate a positive economic net present value (ENPV) using the minimum required economic internal rate of return (EIRR) as the discount rate, i.e., the project has an EIRR higher than the discount rate.
With and Without Project Scenarios, Constant Prices, and Project Life
There are four broad steps in project economic analysis:
- Identify gross project benefits and costs;
- Quantify and value the benefits and costs, initially in market or financial prices;
- Adjust the costs and benefits to reflect their economic values; and
- Compare gross economic benefits with economic costs..
Economic valuation of project benefits and costs involves converting their financial values into economic values, also known as “shadow pricing.” This conversion requires economic prices of project outputs and inputs to be estimated. Economic prices reflect values of goods, services, and other project effects on the national economy. The basis for estimating economic prices differs between internationally traded and nontraded goods and services, between project outputs and inputs, and between incremental and non-incremental outputs and inputs. Read more.
Unless otherwise indicated, benefit valuation as discussed below refers to gross benefit of a project, rather than its net benefit that is the difference between gross benefit and cost. While the general principles of benefit valuation—distinguishing between non-incremental benefits that are measured at cost savings and incremental benefits that are measured at market prices (where there is no consumer surplus) or willingness to pay—apply to all sectors, detailed applications differ among sectors. Read more.
Discounting and Indicators of Economic Viability
After identifying and valuing project benefit and cost flows accrued in different years of a project’s life that normally spans over 20–30 years, the future flows should be converted to their present value (or the value of a base year) by discounting at a required economic discount rate. The discounting allows calculating aggregated indicators of economic viability of a project for making investment decisions. The most commonly used indicators to determine economic viability are economic net present value (ENPV) and economic internal rate of return (EIRR). Other commonly used indicators are the benefit–cost ratio (BCR) and cost-effectiveness ratio (CER). Read more.
Project economic analysis uses the most likely forecast values of economic benefits and costs. However, streams of benefits and costs are influenced by a wide range of factors and they may deviate from the forecasts. Sensitivity analysis aims to assess the effect of adverse changes in key variables upon the project ENPV and EIRR and the implications of these changes for the project investment decision. Risk analysis incorporates the probabilities that the key variables will deviate from their forecast values and the associated risk to the project arising when these key variables vary simultaneously. These techniques can be used to assess the implications of uncertainty for investment decisions, and should be used to inform the design of mitigating actions. Appendix 19 provides more details and examples of sensitivity and risk analyses. Read more.
Economic viability depends on the sustainability of project effects over the project’s life. Hence, project economic analysis should ensure that an adequate analysis of the financial and institutional sustainability of the sponsoring agency and of the environmental sustainability of the project itself has been carried out. Read more.
Distribution analysis is an important component of project economic analysis. First, a project must be financially sustainable and, hence, financial incentives must be adequate for each of the main project stakeholders. Second, where the government is involved it will be important to know how far the project will add to or reduce future government financial commitments. Third, where parties from different countries are involved, it will be important to establish the distribution of net gains and costs between these countries. Finally, where projects are intended to contribute to the goal of inclusive growth, it will be important to establish how target groups are affected. Read more.
Appendix 3: Method for Constructing a Project Statement
Appendix 5: Methods for Valuing Nonmarket Impacts
Appendix 6: Treatment of Working Capital
Appendix 7: Examples of Deriving Economic Prices
Appendix 8: Illustrations of Estimating the Shadow Wage Rate
Appendix 10: Depletion Premium
Appendix 11: Use of Domestic Price Numeraire
Appendix 12: Illustration of Estimating the Shadow Exchange Rate
Appendix 13: Using Conversion Factors: A Water Project Example
Appendix 14: Examples of Benefit Transfer Method
Appendix 18: Estimating the National Economic Discount Rate
Appendix 20: Distribution of Project Effects
Asian Development Bank (ADB). 2017. Guidelines for the Economic Analysis of Projects. Manila.
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The views expressed in these articles are those of the authors and do not necessarily reflect the views of the Asian Development Bank, its management, its Board of Directors, or its members.