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The Methods For Evaluating Public Investments The Methods For Evaluating Public Investments Israel Fainboim International Monetary Fund International Seminar.

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Presentation on theme: "The Methods For Evaluating Public Investments The Methods For Evaluating Public Investments Israel Fainboim International Monetary Fund International Seminar."— Presentation transcript:

1 The Methods For Evaluating Public Investments The Methods For Evaluating Public Investments Israel Fainboim International Monetary Fund International Seminar on Improving the Quality of Public Investments and Public-Private Partnerships April 25-27, 2005

2 I. Brief History II. Objectives of CBA and Similar Methods III. Institutional Design for Program (Project) Evaluation IV. Main Steps of the Evaluation Process V. Main Critics to CBA VI. Conclusions Content

3 I. Brief History United States The New Deal government initiated the use of CBA in 1936, where Congress ordered agencies to weigh the costs and benefits of projects designed for flood control. It enjoyed a brief period of popularity in the 1960’s, but in the 1970’s many begun to doubt its utility. Progress in the valuation techniques, the spread of computerization and a sense that regulation had gone too far, account for the re- emergence of CBA in the 1980s and 1990s. Executive orders issued by the Reagan and Clinton administrations have since made the use of CBA by agencies common, and Congress has enacted numerous statutes requiring agencies to perform CBA. ( EPA alone has spent tens of millions of dollars on CBA over the last twenty years).

4 Developing Countries In the late 1960s there was considerable development of methods for applying CBA to investment in developing countries. In the late 1960s there was considerable development of methods for applying CBA to investment in developing countries. Dasgupta, Marglin, and Sen (UNIDO, 1972), Harberger (1972), Little and Mirrlees (1974) and others developed the methodology of shadow pricing. Dasgupta, Marglin, and Sen (UNIDO, 1972), Harberger (1972), Little and Mirrlees (1974) and others developed the methodology of shadow pricing. The methods were used and further developed by the World Bank in the 1970’s, but its use declined in the 1980’s and the Central Projects Department of the WB was closed. The methods were used and further developed by the World Bank in the 1970’s, but its use declined in the 1980’s and the Central Projects Department of the WB was closed. The IDB was very active in the 1970’s and 1980’s in calculating national parameters using input-output methods. The IDB was very active in the 1970’s and 1980’s in calculating national parameters using input-output methods. I. Brief History

5 Chile A Technical Assistance Program (TAP) on Social Project Evaluation and Public Investment Programming was offered by OAS between 1970 and 1976, and delivered in some 20 countries. A Technical Assistance Program (TAP) on Social Project Evaluation and Public Investment Programming was offered by OAS between 1970 and 1976, and delivered in some 20 countries. In 1976 a TAP financed by the IDB and headed by Mr. Fontaine (Economics Institute of the Catholic University of Chile) started. In 1976 a TAP financed by the IDB and headed by Mr. Fontaine (Economics Institute of the Catholic University of Chile) started. IDB funding stopped in The Chilean government took charge of its financing and agreed to open the course to public officials of Latin America and the Caribbean. IDB funding stopped in The Chilean government took charge of its financing and agreed to open the course to public officials of Latin America and the Caribbean. In the 28 long courses given, close to 1,000 Chilean public officials have been trained. More than 180 Latin American public officials have graduated from the course In the 28 long courses given, close to 1,000 Chilean public officials have been trained. More than 180 Latin American public officials have graduated from the course For over 35 years the Economics Institute has had a Master’s Program on Applied Economics, with a specialization in Social Project Evaluation. For over 35 years the Economics Institute has had a Master’s Program on Applied Economics, with a specialization in Social Project Evaluation. I. Brief History

6 Colombia Since the beginning of the 1980s, courses on project appraisal were offered as part of the Master on Economics. Since the beginning of the 1980s, courses on project appraisal were offered as part of the Master on Economics. In 1987, the Universidad de los Andes started offering a specialization on Social Project Evaluation within the Masters in Economics with support of the IDB. In 1987, the Universidad de los Andes started offering a specialization on Social Project Evaluation within the Masters in Economics with support of the IDB. A Masters program in Environmental and Natural Resource Economics was created in 1993; it includes project evaluation courses and has graduated 179 people. A Masters program in Environmental and Natural Resource Economics was created in 1993; it includes project evaluation courses and has graduated 179 people. An additional program in Project Evaluation graduated 192 students. An additional program in Project Evaluation graduated 192 students. Also 12 summer courses on Project Evaluation for University professors from Latin America have been delivered, and 285 professors attended Also 12 summer courses on Project Evaluation for University professors from Latin America have been delivered, and 285 professors attended A total of 250 government officials from Latin American Countries have been trained in 10 international courses. A total of 250 government officials from Latin American Countries have been trained in 10 international courses. I. Brief History

7 II. Objectives of CBA and Similar Methods CBA is useful for: Increasing the efficiency of the allocations of resources (screening “white elephants”), and making room for additional investments. Increasing the efficiency of the allocations of resources (screening “white elephants”), and making room for additional investments. Supporting “performance budgeting” and strengthening transparency and accountability. Supporting “performance budgeting” and strengthening transparency and accountability.

8 Need to move from public investment programming (common in Latin American countries) to medium-term expenditure framework and performance budgeting, which imply additional technical and institutional requirements. Need to move from public investment programming (common in Latin American countries) to medium-term expenditure framework and performance budgeting, which imply additional technical and institutional requirements. Should balance the three different perspectives and incentives that public officials bring to project evaluation in government: “analysts”, “spenders”, (line ministries and spending units) and “guardians” (Ministries of Finance). Should balance the three different perspectives and incentives that public officials bring to project evaluation in government: “analysts”, “spenders”, (line ministries and spending units) and “guardians” (Ministries of Finance). Strong coordination between Ministries of Planning and Finance is required for implementing a MTEF. Strong coordination between Ministries of Planning and Finance is required for implementing a MTEF. Who should evaluate? Who screens the proposals? (Chilean model; Colombian model). Who should evaluate? Who screens the proposals? (Chilean model; Colombian model). Restrict politician’s incentives to propose projects that benefit their constituencies or to favor new investments instead of rehabilitation and maintenance projects. Restrict politician’s incentives to propose projects that benefit their constituencies or to favor new investments instead of rehabilitation and maintenance projects. III. Institutional Design for Program (Project) Evaluation

9 Implementation of the CBA: the Chilean Model Each project must have a study at the profile level and pre-feasibility and feasibility studies Each project must have a study at the profile level and pre-feasibility and feasibility studies Appraisal studies performed by consultants Appraisal studies performed by consultants MIDEPLAN regularly publishes a decree establishing the social prices for foreign exchange, wages and discount rates (updated at least once a year), that must be used by all consultants. Those prices are calculated by contract to universities on a tender basis once every four or five years. MIDEPLAN regularly publishes a decree establishing the social prices for foreign exchange, wages and discount rates (updated at least once a year), that must be used by all consultants. Those prices are calculated by contract to universities on a tender basis once every four or five years. III. Institutional Design for Program (Project) Evaluation

10 1. Specify the set of alternative projects. 2. Decide whose benefits and costs count (standing). 3. Catalogue the impacts and select measurement indicators. 4. Predict the impacts quantitatively over the life of the project. 5. Monetize (attach dollar values to) all impacts (if possible). 6. Estimate the Social Discount Rate and discount benefits and costs to obtain the net present value (NPV) of each alternative. 7. Perform sensitivity analysis. 8. Make recommendations based on NPVs and sensitivity analysis. IV. Main Steps of the Evaluation Process

11 CBA compares the net social benefits of investing resources in a particular project with the benefits of a hypothetical project that would be displaced if the project under evaluation were to proceed (“counterfactual”). CBA compares the net social benefits of investing resources in a particular project with the benefits of a hypothetical project that would be displaced if the project under evaluation were to proceed (“counterfactual”). Status-quo: no change in government policy Status-quo: no change in government policy If it would displace a specific alternative, it should be evaluated relative to that alternative If it would displace a specific alternative, it should be evaluated relative to that alternative The alternatives to be compared should be of a similar scale. The alternatives to be compared should be of a similar scale. As a practical matter, full optimization is impossible. As a theoretical issue, only maximization (not optimization) is required As a practical matter, full optimization is impossible. As a theoretical issue, only maximization (not optimization) is required CBA can be carried out ex-ante, ex-post or in media res. Comparisons between ex-ante and ex-post CBA’s are not common but very useful for assessing the predictive accuracy of the CBA. CBA can be carried out ex-ante, ex-post or in media res. Comparisons between ex-ante and ex-post CBA’s are not common but very useful for assessing the predictive accuracy of the CBA. 1. Specify the set of alternative projects

12 Global, national, state, or local perspectives? Global, national, state, or local perspectives? It depends, for instance, on the relative importance of externalities Inclusion of the preferences of future generations Inclusion of the preferences of future generations 2. Decide whose benefits and costs count (standing)

13 3. Catalogue the impacts and select measurement indicators From a CBA perspective, what matters is only the project impacts that affect the utility of individuals with standing. From a CBA perspective, what matters is only the project impacts that affect the utility of individuals with standing.

14 Predictions are difficult when projects are unique, have long time horizons, or relationships among variables are complex. Predictions are difficult when projects are unique, have long time horizons, or relationships among variables are complex. Mathematical models have been applied frequently (micro simulation models; models of the spread of epidemics; queuing models, etc.) Mathematical models have been applied frequently (micro simulation models; models of the spread of epidemics; queuing models, etc.) 4. Predict the impacts quantitatively over the life of the project

15 Benefits are measured based on the concept of Willingness to Pay (WTP); costs are opportunity costs Benefits are measured based on the concept of Willingness to Pay (WTP); costs are opportunity costs WTP should be measured through “Hicksian” demand schedules (unaffected by income effects), but “Marshallian” demand schedules (which incorporate substitution and income effects) that are more often available. WTP should be measured through “Hicksian” demand schedules (unaffected by income effects), but “Marshallian” demand schedules (which incorporate substitution and income effects) that are more often available. The bias is important for policies that result in large price changes in consumption goods such as housing or big changes in wage rates. The bias is important for policies that result in large price changes in consumption goods such as housing or big changes in wage rates. 5. Monetize all impacts (if possible)

16 Impacts on goods traded in well functioning, competitive markets Impacts on goods traded in markets with important distortions (externalities, monopoly power, information asymmetries, etc) Impacts on goods rarely traded on markets, or markets do not exist Estimation of demand and supply curves to measure changes in social surplus using econometric techniques Shadow Prices Demonstrations or pilot programs: limited to programs that provide services, such as health, education, training, and housing; numerous evaluation designs Revealed preference methods 1. Market analogy 2. Intermediate good 3. Asset valuation 4. Hedonic prices 5. Travel cost 6. Defensive expenditures Contingent valuations (CV) surveys 1. Direct elicitation 2. Dichotomous-choice Type of Market Valuation Method 5. Monetize all impacts (if possible)

17 Rationale: Markets are much more distorted in developing countries than in developed countries: Rationale: Markets are much more distorted in developing countries than in developed countries: Price of goods exchanged in international markets is distorted by trade taxes, import controls, and high tariffs. Price of goods exchanged in international markets is distorted by trade taxes, import controls, and high tariffs. Segmented labor markets; minimum-wage legislation. Segmented labor markets; minimum-wage legislation. Official exchange rates do not reflect the values of the national currency (black markets). Official exchange rates do not reflect the values of the national currency (black markets). Credit markets divided between formal and informal sectors. Credit markets divided between formal and informal sectors. Adjust market prices of project outputs and inputs to reflect more accurately their value to society (shadow prices or accounting prices) SHADOW PRICES IN DEVELOPING COUNTRIES 5. Monetize all impacts (if possible)

18 The Little-Mirrlees methodology makes a basic distinction between tradable goods and non-tradable goods. The Little-Mirrlees methodology makes a basic distinction between tradable goods and non-tradable goods. uses world prices to shadow-price all project inputs and outputs that are exported or imported (and for products for which there might potentially be an international market). For tradable goods: uses world prices to shadow-price all project inputs and outputs that are exported or imported (and for products for which there might potentially be an international market). Non-tradable goods are often produced with inputs that are tradable, so that world prices can also be used to value them. Even the labor for a project may be drawn from other sectors of the economy in which it was previously producing tradable goods. Non-tradable goods are often produced with inputs that are tradable, so that world prices can also be used to value them. Even the labor for a project may be drawn from other sectors of the economy in which it was previously producing tradable goods. SHADOW PRICES IN DEVELOPING COUNTRIES 5. Monetize all impacts (if possible)

19 APPROACHDECISION CRITERIAMEASURES OF OUTCOMES STRENGTHSWEAKNESSESSECTOR FOCUS Cost-benefit Select the alternativeMonetary value Can be used to judgeOften difficult toAll that yields the highestthe absolute worth ofassign monetary level of net benefitsa single projectvalues to all relevant Can compare cost-benefits benefit results across sectors Cost- Select the alternativeUnits ofExistence of standard Difficult to applyHealth, effectiveness that yields a giveneffectivenessevaluations ofwhere there areEducation, and Defense level of effectiveness ateffectiveness formultiple measures the lowest cost (or themany sectors of effectiveness highest level of Unable to judge the effectiveness for a givenoverall worth of a cost)single project Cost-utility Select the alternativeUnits of utility Incorporates Sometimes difficultHealth, that yields a given levelindividual preferencesto arrive atEducation, and Defense of utility at the lowestfor units ofconsistent and cost (or the highest leveleffectivenessaccurate measures of of utility for a given cost) Can condenseindividual preferences multiple measures of Unable to judge the effectiveness into aoverall worth of a single measure ofsingle project utility Promotes stake- holder participation in decision making A COMPARISON BETWEEN THREE COMMON EVALUATION APPROACHES

20 In perfect markets: MSRTP=MRRI= i In perfect markets: MSRTP=MRRI= i In the absence of perfect markets (in an economy with taxes, risk, and transaction costs), different individuals and different corporations face different tax rates in practice, and the risk and transaction costs associated with loans vary across investment projects; numerous values exist for both the MRTP and the MRRI, and there is no obvious choice for the SDR. The main options are: In the absence of perfect markets (in an economy with taxes, risk, and transaction costs), different individuals and different corporations face different tax rates in practice, and the risk and transaction costs associated with loans vary across investment projects; numerous values exist for both the MRTP and the MRRI, and there is no obvious choice for the SDR. The main options are: MRRPI (Harberger) MRRPI (Harberger) MSRTP MSRTP The Weighted Social Opportunity Cost of Capital (WSOC) The Weighted Social Opportunity Cost of Capital (WSOC) The Shadow Price of Capital The Shadow Price of Capital 6. Estimate the Social Discount Rate

21 There may be considerable uncertainty about: 7. Sensitivity Analysis The predicted impacts and the appropriate monetary valuation of each unit of the impact The appropriate social discount rate The level of standing Perform sensitivity analysis

22 Or, alternatively, structure a CBA explicitly in terms of contingencies and their probabilities 7. Sensitivity Analysis Sensitivity analysis investigates the robustness of new benefit estimates to different resolutions of uncertainty: Partial sensitivity analysis Worst and best-case analysis Monte-Carlo sensitivity analysis

23 The VPN rule provides the adequate criteria for prioritizing. The VPN rule provides the adequate criteria for prioritizing. Other criteria such as the IRR are subject to errors (two or more optimal solutions, etc) Other criteria such as the IRR are subject to errors (two or more optimal solutions, etc) 8. Make recommendations based on NPVs

24 1. Arrow’s General Possibility Theorem. 2. Dependence of WTP on the Distribution of Wealth. 3. Dependence of Net Benefits on Assumptions of Standing. 4. Relevance of CBA when goals other than efficiency matter. 5. Sufficiency of Potential Compensations. V. Main Critics to CBA V. Main Critics to CBA

25 DISTRIBUTIONALLY WEIGHTED CBA Policies, programs, and projects typically affect individuals differently Policies, programs, and projects typically affect individuals differently The way in which benefits and costs are distributed among various groups can have a major influence over whether a policy is politically acceptable. The way in which benefits and costs are distributed among various groups can have a major influence over whether a policy is politically acceptable. Distributionally weighted CBA has been proposed based in arguments such as: Distributionally weighted CBA has been proposed based in arguments such as: Income has diminishing marginal utility Income has diminishing marginal utility The income distribution should be more equal The income distribution should be more equal The “one person-one vote” principle should apply The “one person-one vote” principle should apply Many difficulties in deriving distributional weights Many difficulties in deriving distributional weights Alternative I: compensate the low-income people affected by each individual project – difficult and costly to administrate. Alternative I: compensate the low-income people affected by each individual project – difficult and costly to administrate. Alternative II: implement a unique redistributive program after all projects have been considered; it should require less transfers than redistributing on an individual-project basis. Alternative II: implement a unique redistributive program after all projects have been considered; it should require less transfers than redistributing on an individual-project basis. Alternative III: basic-needs approach (Harberger) Alternative III: basic-needs approach (Harberger) V. Main Critics to CBA V. Main Critics to CBA

26 CBA helps in increasing the efficiency of the allocation of resources (screening “white elephants”) and strengthening accountability and transparency when implemented in an appropriate institutional setting. CBA helps in increasing the efficiency of the allocation of resources (screening “white elephants”) and strengthening accountability and transparency when implemented in an appropriate institutional setting. Improvement in valuation techniques and the extension of computerization makes CBA more accurate and less costly to apply. Improvement in valuation techniques and the extension of computerization makes CBA more accurate and less costly to apply. CBA is a “must” to adequately manage investments and very important when facing very tight fiscal constraints. CBA is a “must” to adequately manage investments and very important when facing very tight fiscal constraints. VI. Conclusions VI. Conclusions


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