Cost Cost - - Benefit Analysis Benefit Analysis
Jan Melichar jan.melichar@czp.cuni.cz
May 7th, 2009 IES FSV UK
• Describe the basic methodological
fundamentals and the principles of Cost- Benefit Analysis
• Explain a step-by-step procedure how to
conduct Cost-Benefit Analysis in consistent and transparent way
• Show how to take account external costs from energy production in Cost-Benefit Analysis
• Illustrate CBA on particular application linked to energy investment project
Intent of the presentation
• New energy investments and preparing new sectoral concepts and policies should not be approved without answering:
– What are the main outcomes of intended projects?
– Are there better ways to achieve these outcomes?
– Are there better uses for available resources?
• Provide valuable information to decision makers and helps them in answering these questions
CBA in the decision-making process
• CBA as a widely accepted economic assessment tool
• The broad purpose is to help social decision making
THE AIM OF CBA
• to compare costs and benefits induced by any projects, programs or policies, both
private and public actions
• to determine whether the entire society will be better off if the project is realized
What is Cost-Benefit Analysis and how
can it help?
FEATURES OF CBA
• All consequences (all positive and negative impacts) to all individuals of society ⇒
social costs and benefits
• Costs and benefits quantified in monetary terms
• Net social benefit of the project is
determined relative to the status quo ⇒ project goes ahead if NSB are positive
The basic methodology of CBA
Net social benefits (NSB) =
= social benefits (SB) – social costs (SC)
• Project evaluation ⇒ to determine the economically efficient alternative
– single project if provides net social economic benefit – several projects compared simultaneously ⇒ the best
option which provides the greatest NSB
• Class of analysis
– ex ante → before implementation of the project (based on predictions, high uncertainty)
– ex post → at the end of the project, cost are sunk (based on observation, few errors)
– in medias res → during the course of the life of project (reduced uncertainty)
– ex ante with ex post → for the same project
When to use of CBA
1. Specify the set of alternative projects 2. Decide whose benefits and costs count
3. Catalogue the impacts and select measurement indicators 4. Predict the impacts over time horizon
5. Monetize all impacts (social costs and benefits)
6. Discount benefits and costs to obtain present values 7. Compute the net present value of each alternative
8. Perform sensitivity analysis and deal with uncertainties 9. Make a policy recommendation
Source: Boardman, A.E., Greenberg, D.H., Vining, A.R., Weimer, D.L. (2006): Cost- Benefit Analysis: Concept and Practice. Pearson: USA.
The major steps in CBA
Project objectives
Example 1: Modernization of the existing power plants in order to increase energy efficiency and lower CO2 emissions.
Example 2: Change in the mix of energy sources in order to increase the share of natural gas and renewables in the energy balance.
Targets
Ad 1: Improving energy efficiency by 20 % and decreasing CO2 emissions by 10 % compared to 1995.
Ad 2: Increasing the share of renewable energy and natural gas in energy production of local heating plant (30 %
renewables and 50 % natural gas).
STEP 1
Specify the main alternatives of a project
• Establish the status quo option
– Represents no change from the current situation
– It is the benchmark against which all other options are compared
NOTE!
• If status quo option is not a viable alternative ⇒ compare the project options relative to the specific
displaced alternative
STEP 1
Status quo option
Different electricity generating technologies: coal-fired, gas-fired, nuclear, combining heat and power, biomass, others.
Type of generating system according to fuel used: pulverised bed, fluidised bed, supercritical steam cycle, integrated gasification combined cycle, combined cycle gas turbine, water-cooled nuclear power plants, internal-combustion engines, etc.
Sulphur dioxide control system: wet scrubber, spray dryer systems, dry sorbent injection and regenerable systems.
Nitrogen oxides control system: low-NOX burners, staging air within the combustion zone, selective catalytic reduction systems.
Control of particulate matters: electrostatic precipitators, fabric filters.
Feasible and realistic options that will solve the problem and meet the proposed objectives and targets
Shorten a wide range of option up to 3 – 7
STEP 1
Creating project options
• Project objective: Replacing coal fired units of existing power plant that are near to the end of service life
• Reference scenario: coal-fired unit with powdered coal burners
• Alternative scenario: FBC, IGCC, CHP
• Using of the available infrastructure and grid connection
• Not extend areas used for energy production
• Ex-ante CBA
STEP 1
Creating the status quo and project options CZECH CASE
Technology Fuel
Cleaning control system
Net capacity (MWe)
Net thermal efficiency (%) Reference powdered fuel
burners
brown coal /pulverised/
FGD, de NOX,
dust 1x300 37
Coal_2 fluidised bed
combustion brown coal de SOX 2x150 37
Coal_3
integrated gasification combined cycle
hard coal de SOX, de
NOX 1x300 43
Coal_4 fluidised bed combustion
brown coal &
biomass de SOX 2x150 37
CHP coal boiler+steam
turbine brown coal
FGD, de NOx, Electrostatic
precipitator
300 (MWe)
120 (MWth) 37*
Note: * electricity only
• Lifetime of the plant ⇒ 40 years
• Full load hours per year ⇒ 5 000
Czech coal plant specifications
• Decide about the geographical scope
– Local, national, regional or global perspective
• Make a list of groups and sub-groups of society affected
– consumers – firms
– government – environment
• Point out who accrue the benefits
(beneficiaries) and who bear the costs (losers)
STEP 2
Decide whose benefits and costs count
• Identify and list the physical impacts and the measurement indicator
• Consider all relevant impacts
– economic impacts
– impacts on human health – environmental impacts
• Distinguish between beneficial impacts
(benefits) and cost impacts (costs) for each project option
STEP 3
Catalogue the impacts and select measurement indicators
STEP 3 What is a benefit?
• Monetary
– Revenues - direct or indirect revenues – Avoided costs - costs if action is taken
– Cost savings - reduction in existing expenditures if the project option proceeds
– Residual value
• Non-monetary
– Quantitative - external costs avoided: human health and environmental impact
– Qualitative - other benefits not monetized or expressed in the physical terms
STEP 3 What is a cost?
• Monetary
– Investment costs - the expenditure
accumulated until the start-up of a power plant – Fixed costs - remain constant over different
volumes of energy production
– Variable costs - vary according to the volume of energy production
• Non-monetary
– Quantitative - particularly external costs linked to the adverse effects on human health and
environment
– Qualitative - other costs not monetized or expressed in the physical terms
• Set down the time horizon of the project
• Consider the physical or economic life of the project
• Quantify a magnitude of the impacts (on benefit and cost side) using appropriate data and tools for each project option over the proposed lifetime period
• Externalities defined as the impacts included in EcoSenseWeb 1.2
• Estimate the impact’s magnitude for each year of lifetime period
STEP 4
Predict the impacts quantitatively over the life of the project
BOX 5: RELEVANT DATA SOURCES AND TOOLS
Impact category Ex post Ex ante In medias res Economic data
Type of data Based on observation
Based on prediction Observation &
Prediction Precision of
estimates
Low uncertainty High uncertainty Reduced uncertainty Data sources Technical and
financial audits Databases
Official projections Research studies Databases
Feasibility studies Expert opinion
Same as in ex post and ex ante
Tools Financial analysis Financial analysis Econometric
analysis
Simulation models
Same as in ex post and ex ante
Human health &
Environment Common for all classes of CBA Data sources Environment database, Research reports
Tools EcoSenseWeb V1.2, Air quality models
• Assign monetary value to each of the relevant
quantitative impact, both on beneficial and cost side
• Benefits and costs must be valued either in real terms (constant prices) or in nominal terms (current prices
• To obtain real values you must adjust these measures for inflation, i.e. you deflate values to account for higher
prices ⇒ as deflator use the consumer price index (use e.g. OECD statistics database
http://webnet.oecd.org)
• Express all benefits and costs in a common currency, with a stated base year
STEP 5
Valuing relevant costs and benefits
• Project inputs should be valued at their opportunity cost and project outputs at consumer willingness to pay
• Conversion of market prices to social values in order to reflect true economic value ⇒ some market price are distorted because of monopoly, oligopoly markets, and government interventions
• Fiscal corrections: indirect taxes, subsidies and pure transfer payments should be deducted
• Correction for externalities: those project costs and benefits for which market values are not
available, like impacts on human health and
environment. Physical impacts are monetized using current ExternE values
STEP 5
Corrections of benefits and costs
• All values specified for the year 2005
• Investments are considered as overnight construction costs
Reference Coal_2 Coal_3 Coal_4 CHP COSTS
Investment 300 318 494 340 339
O&M 5.36 5.48 5.48 5.48 5.87
Fuel 18.74 18.74 24.10 25.63 18.74
Variable costs in total 24.10 24.23 29.58 31.11 24.61
Human Health 41.48 71.92 10.79 70.40 34.89
Crops 0.83 0.35 0.28 0.57 0.33
Buildings 1.58 3.98 0.34 3.35 1.72
Biodiversity Loss 6.39 7.38 1.87 4.84 4.05
Climate Change 33.21 34.22 32.67 37.17 39.33
External cost in total 83.49 117.85 45.94 116.32 80.32 BENEFITS
Heat credit_private 0.89
Heat credit_external 9.64
Revenues_electricity 129.03 129.03 129.03 129.03 129.03
Revenues_heat 18.55
Private and external costs (Mill. € of 2005
• Future benefits and cost are discounted relative to present benefits and costs
• To discount the impacts use social discount
rate ⇒ 5.5 % as proposed by EU for Cohesion countries and 3.5 % for the others
• NAC use national discount rates
( )
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B B PV ( )
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STEP 6
Discount benefits and costs to obtain present values
DECISION RULE
• Single alternative: adopt the project if its NPV is positive
• More than one alternative: select the project with the largest NPV
) ( )
( B PV C
PV
NPV = −
0 C
PV B
PV
NPV = ( ) − ( ) >
STEP 7
Compute the net present value of each alternative
• For large number of options may not be enough financial resources available to undertake them all, even if they all have high net present values
OPTIONAL
• pick the project with the highest BC ratio
) (
) (
C PV
B BC = PV
STEP 7
Benefit-Cost ratio
514 365
-527 -635
737
1 891 1 867
44
1 340 1 289
-1 000 -500 0 500 1 000 1 500 2 000
CHP Coal_3 Reference Coal_2 Coal_4
Reference Coal_2 Coal_3 Coal_4 CHP
Investment 300 318 494 340 339
Variable costs 387 389 475 499 395
External costs 1 340 1 891 737 1 867 1 289
Benefits 2 070 2 070 2 070 2 070 2 537
Net Present Value 44 -527 365 -635 514
Ranking NPV 3 4 2 5 1
Ranking External costs 3 5 1 4 2
NPV in the Czech Case Study (Mill. € of 2005)
• There may be considerable uncertainty about both the predicted impacts and monetary values
– Uncertainty about the magnitude of the impacts we predict and their monetary value
• Three approaches:
– Sensitivity (elasticity) analysis: how do NPV change as we vary a single variable while others are constant /discount rate, fuel costs, investment costs, monetary values of external costs/
– Scenario analysis: propose base-case assumptions that are most representative ⇒ calculate for them lower bound and upper bound, NPV lower will represent pessimistic prediction /worst case/ and upper will cover optimistic prediction /best case/
– Monte Carlo sensitivity analysis: tackle the riskiness of the project conveying distribution of NPV, i.e. mean and variance, display by histogram
STEP 8 Perform sensitivity analysis
STEP 8
Sensitivity analysis diagram
• Summarize the results ⇒ sum up
– objective, project options
– all assumptions including discount rate, project lifetime, etc.
– the results of sensitivity analysis
– report also any qualitative benefits or costs, particularly these that could affect the decision
• Provide appropriate recommendations ⇒ it must be clear whether the decision maker should proceed
with the project and, if so, which option should be approved
• Generally, the analyst should recommend adoption of the project with the largest NPV
STEP 9
Make a recommendation
