Economic and Financial Analysis:

Demand for water depends on the price charged, a function of the cost of water supply which, in
turn, depends on demand. This interdependence requires careful analysis in all water supply
operations. Safe water should be generally provided at an affordable price and using an
appropriate level of service matching the beneficiaries’ preferences and their willingness to pay.

Purpose:
The purpose of the economic analysis of projects is to bring about a better allocation of scarce
resources. Projects must relate to the sectoral strategy and also to the overall development
strategy of the country.
In a water supply project, the goal may be “improved health and living conditions, reduction of
poverty, increased productivity and economic growth, etc.”.

Procedures for Economic Analysis

The economic analysis of a Water Supply Project has to follow a Sequence of interrelated steps:
(i) Defining the project objectives and economic rationale as mentioned above.
(ii) Demand analysis and forecasting effective demand for project outputs.
(iii) Establishing the gap between future demand and supply from existing
facilities after ensuring their optimum use.
(iv) Identifying project alternatives to meet the above gap in terms of
technology, process, scale and location through a least-cost and/or cost effectiveness
analysis using economic prices for all inputs.
(v) Identifying benefits, both quantifiable and no quantifiable, and
determining whether economic benefits exceed economic costs.
(vi) Assessing whether the project’s net benefits will be sustainable
throughout the life of the project through cost-recovery, tariff and subsidy (if any) based on
financial (liquidity) analysis and financial benefit-cost analysis.
(vii) Testing for risks associated with the project through sensitivity and risk analyses.

Financial and Economic Analyses

With- and Without-Project Cases
After choosing the best among alternatives, the next step will be to test the financial and
economic viability of the project, which is the chosen, least-cost alternative. The initial step in
testing the financial and economic viability of a project is to identify and quantify the costs and
benefits.
To identify project costs and benefits and to compare the net benefit
flows, the without-project situation should be compared with the with-project situation.
The without-project situation is different from the before-project situation. The without-project
situation is that one which would prevail without the project vis-à-vis factors like population
increase. As water is getting more scarce, the water use pattern and the cost are also likely to
change.

Financial vs. Economic Analysis

 Financial and economic analyses have similar features. Both estimate the net benefits of an
investment project based on the difference between the with-project and the without-project
situations.
However, the concept of financial net benefit is not the same as economic net benefit. While
financial net benefit provides a measure of the commercial (financial) viability of the project on
the project-operating entity, economic net benefit indicates the real worth of a project to the
country.
Financial and economic analyses are also complementary. For a project to be economically
viable, it must be financially sustainable. If a project is not financially sustainable, there will be
no adequate funds to properly operate, maintain and replace assets; thus the quality of the water
service will deteriorate, eventually affecting demand and the realization of financial revenues
and economic benefits.

The basic difference between the financial and economic benefit-cost analyses of the project is
that the former compares benefits and costs to the enterprise in constant financial prices, while
the latter compares the benefits and costs to the whole economy measured in constant economic
prices. Financial prices are market prices of goods and services that include the effects of
government intervention and distortions in the market structure. Economic prices reflect the true
cost and value to the economy of goods and services after adjustment for the effects of
government intervention and distortions in the market structure through shadow pricing of the
financial prices. In such analyses, depreciation charges, sunk costs and expected change in the
general price should not be included. In financial analysis, the taxes and subsidies included in the
price of goods and services are integral parts of financial prices, but they are treated differently
in economic analysis. Financial and economic analyses also differ in their treatment of external
effects (benefits and costs), favorable effects on health etc. Economic analysis attempts to value
such externalities, health effects and nontechnical losses.

Financial vs. Economic Viability

The steps in determining the financial viability of the proposed project will include:
(i) Identifying and quantifying the costs and revenues;
(ii) Calculating the project net benefits;
(iii) Estimating the average incremental financial cost, financial net present value and financial
internal rate of return (FIRR).
The FIRR is the rate of return at which the present value of the stream of incremental net flows
in financial prices is zero. If the FIRR is equal to or greater than the financial opportunity cost of
capital, the project is considered financially viable. Thus, financial benefit-cost analysis covers
the profitability aspect of the project.
The steps in determining the economic viability of the project will include the following:
(i) Identifying and quantifying (in physical terms) the costs and benefits;
(ii) Valuing the costs and benefits, to the extent feasible, in monetary terms;
and
(iii) Estimating the EIRR or economic net present value (NPV) discounted at 12 percent by
comparing benefits with the costs.
The EIRR is the rate of return for which the present value of the net benefit stream becomes
zero, or at which the present value of the benefit stream is equal to the present value of the cost
stream. For a project to be acceptable, the EIRR should be greater than the economic opportunity
cost of capital.
Financial Analysis:

The financial benefit-cost analysis will includes the following eight steps:
(i) determine annual project revenues;
(ii) Determine project costs;
(iii) Calculate annual project net benefits;
(iv)Determine the appropriate discount rate (i.e., weighted average cost of capital serving as
proxy for the financial opportunity cost of capital);
(v) Calculate the average incremental financial cost;
(vi)Calculate the financial net present value;
(vii) Calculate the financial internal rate of return; and
(viii) Risk and sensitivity analysis.
4. Project revenues, costs and net benefits are determined on a with-project and without-project
basis. They are estimated in constant prices for a selected year typically using the official
exchange rate at appraisal. The revenues of the project comprise of entirely user charges, that is,
no government subsidies are included.

Financial Revenues
The focus of the financial benefit-cost analysis is on the financial benefits and costs of the
project intervention. Hence, the project’s water sales revenues are determined on a with-project
and without-project basis. In this way, the contribution of the project to the total revenues of the
utility is estimated.
The project revenues are usually determined for different groups of users, such as households,
government institutions and private commercial/industrial establishments. Each may have a
different consumption pattern, may be charged a different tariff and may respond differently to
tariff increases.
Project Costs
Project cost estimates are typically will be worked out in detail. The following
main categories are distinguished:
(i) Investments;
(ii) Operation and maintenance; and
(iii) Re-investments during the life cycle.
Again, the costs should be attributed to the project on a with-project and without- project basis.
Only the additional costs due to the project should be taken into account. The basis to attribute
costs to the project should be the formulated with project and without-project scenarios.
. Investments
The breakdown of an investment cost into foreign and local currency components will
distinguished to establish the foreign exchange implications of the project and counterpart
financing requirements. Following the general principles of discounting according to which costs
and benefits are entered in the analysis in the year in which they occur, interest during
construction (IDC) is excluded from the costs used in the financial benefit-cost analysis.
Operation and maintenance
15. The elements of O&M costs may include:
labor;
electricity;
chemicals;
materials;
overhead;
raw water charges;
insurance;
other.
Reinvestments
Different project investment assets have different lifetimes and need replacement within the
project lifetime. The cost of those reinvestments needs to be included in the project’s benefit-cost
calculation.

Net Financial Benefits

The project net benefit is the difference between the project revenues
And project costs. Sometimes, the net benefit stream is called the (net) cash flow.

Financial IRR and NPV

The profitability of a project to the entity is indicated by the project’s financial internal rate of
return (FIRR). The FIRR is also the discount rate at which the present value of the net benefit
stream in financial terms becomes zero. The FIRR wil be compared with minimum acceptable
rate of return at which investor will be willing to invest/finance the project.

ECONOMIC BENEFIT-COST ANALYSIS

Identification of Economic Benefits and Costs

The next step is to test the economic viability of that option. The initial step in testing the
economic viability of a project is to identify, quantify and value the economic costs and benefits.
Two important principles to be followed are:
(i) Comparison between with- and without-project situations; and
(ii) Distinction between nonincremental and incremental inputs (costs) and
outputs (benefits).

With- and Without-cases: Comparison

The comparison between “with” and “without” the project is often different from the
comparison between “before” and “after” the project. The without project situation is that which
would prevail if the project is not undertaken. For example, population in the project area will
grow leading to an increase in the use of water; and water sources will become increasingly
scarce and remote, contributing to a higher cost of water to the consumers. The situation,
therefore, will not remain static at the level just “before” the project.
The project inputs and outputs should be identified, quantified and valued by comparing the
without-project situation with that of the with-project to cover the relevant project benefits and
costs.

Nonincremental and Incremental Inputs and Outputs

Nonincremental Inputs
In some cases, water supply to a user of water, say an industrial plant, is to be met (partly or
fully) by an existing stock of available water without expansion of overall supply. For example,
such supply is met by withdrawing water from existing users in, say, agriculture. Such water is
defined as nonincremental water input.
Incremental Inputs
If a water demand is to be met by an expansion of the water supply system, the water supply
input should be considered as incremental supply of water.
Nonincremental Output
If the output of a Water Supply Project replaces the existing supply to the users, that output is
defined as nonincremental output. For example, if the present source of water to the consumers is
from vendors or from wells, a canal and or a river (with time and effort spent on such use of
water), the supply of water from the project which replaces this is to be considered
nonincremental.
Incremental Output
The supply of water from a project that meets additional or induced demand (possibly as a result
of availability of higher quality of water at lower cost) is to be considered as incremental output.
Demand and Supply Prices
In economic analysis, the market prices of inputs and outputs are adjusted to consider the effects
of government intervention and market failures. Shadow prices based either on the supply price
or the demand price, or a weighted average of the two, are used. Different shadow prices are
used for incremental output, nonincremental output, incremental input and nonincremental input.
Incremental outputs and nonincremental inputs are valued in the same manner, i.e., in terms of
their adjusted demand price or willingness to pay. Nonincremental outputs and incremental
inputs are valued in terms of their adjusted supply price or opportunity costs.

Quantification of Economic Costs

In estimating the economic costs, some items of the financial costs are to
be excluded while some items not considered in the financial costs are to be included.
This is to reflect costs from the viewpoint of the economy as a whole rather than from
the viewpoint of the individual entity.
Quantification of Economic Benefits
Benefits from a Water Supply Project
Gross benefits from a water supply project can be estimated conveniently by apportioning the
supply of water into nonincremental output and incremental output.
Measuring Other Benefits of a Water Supply Project
Health Benefits
Water supply projects have been justified on the basis of expected public and private
health benefits, which are likely to occur with the project due to the overall improvement
in the quality of drinking water. Such benefits are likely to occur provided the adverse
health impacts of an increased volume of wastewater can be eliminated or minimized.
Drinking unsafe water may cause water-related diseases, such as
Diarrhoea, Roundworm, Guinea Worm and Schistosomiasis. People affected by these
diseases may have to purchase medicines, consult a doctor or lose a day’s wage.
Accordingly, health benefits due to the provision of safe water have two dimensions:
avoided private/public health expenditures; and economic value of days of sickness saved.

Time Cost Saving Benefit

In the without-project situation, time spent in collecting water from the nearest source of water
supply (e.g., wells, tank, river, standposts on the road) may be considerable, especially during the
dry season. An important benefit from a piped water supply and provision of public taps is that it
brings the source of water very near to the households. Time saved in with- and without-project
situations can be estimated. What is difficult, however, is how to value time in monetary terms.
Different approaches have been used by different agencies and authorities.
Valuation of Economic Benefits and Costs
Once the costs and benefits, including external effects, have been
Identified and quantified, they should be valued. Decisions by the producers and users of project
output are based on financial prices. To appraise the consequences of their decisions on the
national economy, benefits and costs are to be valued at economic prices. Therefore, the
(financial) market prices are to be adjusted to account for the effects of government interventions
and market structures.
(i) transfer payments - taxes, duties and subsidies incorporated in market
prices of goods and services;
(ii) official price of foreign exchange where government controls foreign
exchange markets;
(iii) wage rates of labor where minimum wage legislation affects wage rates;
and,
(iv) commercial cost of capital where government controls the capital market.
30. Hence, as market rates in those cases are poor indicators of the economic
worth of resources concerned, they need to be converted into their shadow prices for
economic analysis.
Net Economic Benefits
The project net benefit will be calculated the difference between the Economic benefits and
economic costs.
Economic IRR and NPV.
The profitability of a project to the entity is indicated by the project’s economic internal rate of
return (EIRR). The EIRR is also the discount rate at which the present value(NPV) of the net
benefit stream in financial terms becomes zero. The FIRR wil be compared with minimum
acceptable rate of return at which it will be beneficial for society.
SENSITIVITY AND RISK ANALYSES
The financial and economic benefit-cost analysis of water supply projects
is based on forecasts of quantifiable variables such as demand, costs, water availability and
benefits. The values of these variables are estimated based on the most probable forecasts,
which cover a long period of time. The values of these variables for the most probable outcome
scenario are influenced by a great number of factors, and the actual values may differ
considerably from the forecasted values, depending on future developments. It is therefore useful
to consider the effects of likely changes in the key variables on the viability (EIRR and FIRR) of
a project. Performing sensitivity and risk analysis does this.

Sensitivity Analysis shows to what extent the viability of a project is influenced by

variations in major quantifiable variables.
Risk Analysis considers the probability that changes in major quantifiable variables will
actually occur.
The viability of projects is evaluated based on a comparison of its internal rate of return (FIRR
and EIRR) to the financial or economic opportunity cost of capital. Alternatively, the project is
considered to be viable when the Net PresentValue (NPV) is positive, using the selected EOCC
or FOCC as discount rate. Sensitivity and risk analyses, therefore, focus on analyzing the effects
of changes in key variables on the project’s IRR or NPV, the two most widely used measures of
project worth. Sensitivity and risk analyses are particularly concerned with factors, and
combinations of factors, that may lead to unfavourable consequences