The Economics Of Road Investment

1. The Economics Of Road Investment John Hine ETWTR SE197

2. Questions and Decisions 1. • Is the project justified ?- Are benefits greater than costs? • Which is the best investment if we have a set of mutually exclusive alternatives? • If funds are limited, how should different schemes be ranked? • When should the road be built?

3. Questions and Decisions 2. • Are complementary investments required? • Should stage construction be used? • What standards should be applied ?

4. Appraisal Framework • All appraisals need a framework or model for: a) Forecasting changes b) Evaluating those changes

5. These include: • Supervision • Management • Manpower • Machinery • Materials • Land • Environmental Mitigation (e.g. Resettlement) The Costs of Road Investment SE697

6. Primary Effects 1. • Reduced vehicle operating costs fuel and lubricants vehicle maintenance depreciation and interest overheads • Reduced journey time drivers, passengers and goods

7. Primary Effects 2. • Changes in road maintenance costs • Changes in accident rates • Increased travel • Environmental effects • Change in value of goods moved

8. Secondary Effects • Changes in agricultural output • Changes in services • Changes in industrial output • Changes in consumers behaviour • Changes in land values

9. Coverage and Double Counting • Any economic analysis should be designed to give maximum coverage of benefits. • But we must avoid double counting. Do not add primary and secondary benefits (e.g changes in land values added to changes in transport costs) • In a competitive economy the consumers’ surplus approach (used in HDM) should be adequate.

10. The Economic Comparison • An economic analysis involves a comparison of “With” and “Without” cases. • Traffic forecasts are made for BOTH scenarios - The analysis should not be based on “before and after”. • An unrealistic “Without” case can give a false result. • A range of “with investment” cases should be analysed to find the best solution. A minimum investment approach often gives the best economic results and should be tested.

11. Economic and Financial Prices The cost to the economy of road rehabilitation and maintenance may differ from the financial cost because of : • taxes and duties • shortage of foreign exchange • under-employment The Government will usually be concerned with ECONOMIC costs. Contractors will usually be concerned with FINANCIAL costs. SE897

12. In an Economic Appraisal we use ECONOMIC (or SHADOW) prices NOT FINANCIAL prices Use of Economic Prices • Adjust financial prices as follows: • Exclude all taxes and duties and subsidies • Use the planning discount rate not the financial market rate • If overvalued exchange rate then value • imports and exports more highly • Use the opportunity cost of labour • Standard Conversion Factors are now widely used for • road construction costs SE797

13. Benefits From Road Investment Changes in transport costs occur because of : • Lower road roughness • Shorter trip distance • Faster speeds • Reduced chance of impassability • Reduced traffickability problems • Change in mode

14. Traffic Categories • Normal traffic: Existing traffic and growth that would occur on the same road, with and without the investment • Diverted traffic: Traffic diverted from another road to the project road as a result of the investment • Generated traffic: New traffic induced by the investment

15. Transport cost savings for existing (or normal ) traffic = Traffic x Change in Transport Costs per km x distance Main changes in cost from: a) change in transport MODE b) reduced journey TIME c) reduced VOCs Benefits from Road Investment SE297

16. Generated Traffic Benefits Traffic induced by the road investment are traditionally valued at: Half the difference in transport costs Hence total generated transport cost benefits = Generated traffic volume x change in costs per km x distance x 1/2

17. Estimating Benefits Normal traffic benefits:tripsN * d1 * (VOC1- VOC2) Diverted traffic benefits: tripsD * ((d1 * VOC1)-(d2*VOC2)) Generated traffic benefits: tripsG * d2 * (VOC1- VOC2)/2 d1 = existing road length d2 new road length VOC1 = vehicle operating costs per km “without”investment VOC2 = vehicle operating costs per km “with” investment VOC data relates to each road section and its condition at the time

18. The Consumers’ Surplus Approach Transport Cost Savings to existing traffic and normal growth Total Benefits = Cost + Additional benefits from new traffic and production induced by new investment C1 C2 T1 T2 Traffic SE497

19. Development Benefits • Development benefits arise from a combination of increased traffic and reduced transport costs. • Benefits may also include : • Increased agricultural production • Increased service provision • Increased industrial activity SE397

20. Ethiopian Statistical Analysis

21. Illustration of Benefits Headloading C1 Track Costs Improved road C2 C3 T1 T2 T3 Traffic

22. Different Types of Benefit • Normal traffic benefits = traffic x change in transport costs • Development benefits - A function of (change in transport costs)2 • Social benefits - A function of population x change in transport costs

23. Consumer’s Surplus Approach: • Advantages: Simple, cost based, traffic approach dependent on predicting changes in traffic • Disadvantages: May not address critical factors promoting either rural development or social access

24. Producers Surplus Approach • Advantages: Draws attention to changes in agricultural output (key economic activity in rural areas) • Disadvantages: No reliable way of predicting response - impact studies give widely different answers –it could be based on agricultural supply price elasticities but this is almost never done; it requires very careful examination to use. • For most projects benefits are just invented !

25. Producers’ Surplus Price & Costs per unit Of output p2Increased farmgate price p1 lower input costs O1 O2 Output

26. Indicies and Ranking • Widely used for feeder road planning; there are many different approaches e.g. i) cost of improvement / population ii) estimated trips / cost Adavantages: Speed , simplicity, transparency, many factors can be incorporated Disadvantages: How do we value widely different factors ? (adding up apples and pears); weightings are not stable ; cannot easily address questions of road standards, timing etc, ; possible double counting

27. Community Priorities • Community priorities now often form an important part of feeder road appraisal. It is possible just to ask communities to rank the investments they prefer- both within the road sector or between roads and other investments. • Advantages: Community acceptability, use of community knowledge • Disadvantages: Sectional interest groups may dominate voting, community knowledge of area or road impact may be poor

28. 1. Net Present Value:NPV = (B1- C1) + (B2- C2) + ….. (Bn- Cn) (1 + r) (1 + r)2 (1 + r )n2. Internal Rate of Return : solve for i, (IRR) 0 = (B1- C1) + (B2- C2) + ….. (Bn- Cn) (1 + i) (1 + i)2 (1 + i )n B1, B2 … Bn : Benefits in years 1, 2 … n C1 C2 Cn : Costs in years 1, 2 …. n r : Planning discount rate , n : planning time horizon

29. 3. Net Present Value/ Investment Cost NPV/ C = NPV/Ci 4. First Year Rate of Return FYRR = (B1- C1) Ci B1, C1 : Benefits and Costs in year 1. Ci : Road investment costs

30. Internal Rate of Return

31. Economic Comparison of Alternatives • When comparing project-alternatives, the Net Present Value (NPV) is used to select the optimal project-alternative (alternative with highest NPV) • The Internal Rate of Return (IRR) or the B/C ratio are not recommended to compare alternatives of a given project Alternatives NPV0.03.76.75.5 Optimal Alternative:Highest NPV Project

32. Ranking Projects by Economic Priority • When comparing the economic priority of different projects, a recommended economic indicator is the NPV per Investment ratio Projects Selected Alternative OverlayReseal Overlay NPV/Investment 8.45.2 2.1 PRIORITY

33. Economic Decision Criteria NPV IRR NPV/C FYRR Economic validity v. good v. good v. good poor Mutually exclusive v. good poor good# poor projects Project timing fair## poor poor good Project screening poor v. good good poor /robustness Use with budget fair ## poor v. good poor constraint # Need incremental analysis ## Needs continuous recalculations

34. Appraisals & Post Evaluations 1. • An Appraisal is carried out before an investment is made. Everything is uncertain. • A Post evaluation may be made say 5 years after the investment. The investment is known and 5yrs of with case are known. The without case is unknown as is the remainder of the with case.

35. Appraisals & Post Evaluations 2 • In Both Cases forecasting and evaluation models are required to come to an answer. • Hence we can never be certain about the viability of an investment !