Economic assessment is a tool that calculates the potential costs and assigns values to the anticipated benefits of a proposed project, programme or policy. This way, it helps to understand the economic trade-offs between different alternatives and to select the best and most appropriate projects – within the water sector and in comparison to projects in other sectors as well. In some countries, economic assessments are required by law when planning water projects (see for instance the EU Water Framework Directive, 2000).
There is a basic distinction between cost-effectiveness analysis (CEA) and cost-benefit analysis (CBA). CEA aims to select the cheapest (most cost-effective) method of attaining given objectives, while CBA selects the project with the highest ratio of benefits to costs or benefits surplus (difference between total gains and total expenditures). Economic assessment techniques take account of all costs and benefits on a year-by-year basis over the life of the project or programme. This sort of analysis evaluates the total value of a project using the current and future cash flows which are then discounted according to given rates. Discount rates are normally estimated based on the interest rates that would otherwise apply if the capital for the proposed project was to be invested elsewhere.
Good economic assessment demands a clear understanding of the direct and indirect impacts of proposed projects and thus includes environmental costs and benefits. It can further be linked to participatory approaches and demand assessment, and can focus on women’s issues and broader health/livelihood effects of water use. Economic assessments also identify external impacts and equity (i.e. who pays and who reaps the benefits) as well as efficiency. If carefully carried out and put into the right hands, economic assessments can be used to increase public awareness on the integrated aspects that are advocated by the IWRM strategy.
When used seriously and consistently, economic assessments provide an objective way of recommending the most suitable water project. Depending on the type of assessment, results are expressed as: discounted cost per unit (e.g. of water saved or of treated effluent); Net Present Value (of the surplus of benefits over costs at a specified discount rate); or Internal Rate of Return (discount rate at which benefits and costs are equalised). Financial and economic values are usually differentiated (e.g. taxes and subsidies would be disregarded for economic analysis). Financial analysis only considers the costs and benefits that are directly carried by the body undertaking the development. Economic analysis considers the costs and benefits of a project or intervention for the economy as a whole.
Economic assessments need to follow a systematic and step by step methodology for it to serve its purpose, otherwise it can also be used cynically, e.g. to satisfy external funders, or to window-dress a pre-chosen project. In designing and performing the economic analysis special attention should be given to appropriately defining the geographic unit of analysis, properly assessing the time and duration of the water project, and objectively evaluating the key outputs by using recognized discounting rates. One of the common challenges of making good economic assessments is to measure the specific impacts of costs that are difficult to monetise. Consulting with local stakeholders provides support in estimating most accurately the economic value of natural resources, which are to be affected by a water project.
- The technocratic nature of CBA or CEA, and the use of a single criterion to choose among complex projects can be problematic.
- It is important that practitioners agree on technical specifications, such as which discount rate to use, the life span of the project, the inclusion of environmental costs and benefits, and on the definition of the "without case scenario”.
- The use of economic assessments is not compulsory and their findings are not upheld by any legal requirements (in contrast with environmental impact assessment), which can be problematic.
- Economic assessment can be promoted through a suitable guidance manual for sector professionals, responsible officials and consultants employed (Capacity Building, see B4).
- It works best if a range of options exists, sufficiently different to give a real choice, and compared consistently. Assumptions and the “without project scenario” should be realistic, to avoid casting the project in an artificially favourable light.
- Spurious accuracy should be avoided: “it is better to be approximately right than precisely wrong.”