Guide to COST-BENEFIT ANALYSIS of investment projects - Ramiri

ANNEX EAFFORDABILITY AND EVALUATION OFDISTRIBUTIVE IMPACTA key aspect of the financial sustainability of public services is tariff setting. Under a ‘full-cost recovery’ approach 113 ,not only direct costs but also the relevant portion of overheads is included, such as premises, office costs,governance and direction costs, finance, human resources, IT, etc.Full cost recovery avoids chronic underinvestment in an organisation’s capacity, avoids funding gaps and allows anoverall improvement in cost management. This approach is advantageous also for funders as long as it providesenhanced accuracy, transparency and efficiency.In some countries, however, a cost-reflective tariff reform in industries such as water, electricity or waste disposalmay determine sizeable regressive redistribution effects. In fact, tariff setting must also consider social affordability.Obviously, the concern for equity is greater where the local circumstances reveal serious social imbalances, whichmay be exacerbated by some project features.Broadly speaking there are three possible methods of analysing distributional issues.- a more general formula for shadow prices could be used, plugging in the welfare weights in the shadow prices,and thus avoiding further distribution calculations;- explicit welfare weights derived from social inequality aversion estimates can be attached to the project winnersand losers, when shadow prices do not include welfare weights;- the last approach is to focus on the impact of the projects on the poor, and particularly on the share of incomenecessary to pay for the service.In principle, the general shadow pricing formula already includes a social welfare weight called ‘distributionalcharacteristic’ and so it combines efficiency gain and equity loss. In principle it could be properly used as an ex-anteweight of the net benefits of the public project, but this approach is relatively demanding in terms of informationrequirements. In order to give the reader an idea of the structure of such distributional characteristics, the box belowshows relevant values for some goods in two countries.DISTRIBUTIONAL CHARACTERISTIC FOR SHADOW PRICESShadow prices are inversely related to the distributional characteristic r, which is defined as the weighted average of thedistribution weights (the share of expenditure on good x in total consumption X by the specific household i).r =∑i⎛ xi⎜⎝ Xi⎞⎟ a⎠iThe weight used to calculate the average (a) is the social marginal utility of income, and under some conditions becomes simplythe inverse of income.Here are some examples of distribution characteristics (r) for various products in the UK:Phone Rail Bus Electricity Gas Water Coal0.875 0.573 0.756 0.893 0.9 0.938 0.992Source: Brau and Florio (2004)Brau and Florio (2004) discuss realistic assumptions for price elasticities and the average of distribution weights in order to allowfor simple empirical estimation.113Defined as: Operational & Management Costs + Depreciation + Return on capital215