COST BENEFIT ANALYSIS OECS ENGINEERING WORKSHOP
OBJECTIVES Why Cost Benefits Analysis CBA Methodology CBA Exercise CBA Limitation Application in the Context of Disaster Risk Reduction
Why YOU, the Engineer? • Those who generate solutions are most intimate with the details and best suited to analyze them financially. • To be heard, engineers must be able to speak financially: • It is generally assumed that the engineering solution will work -- must justify financially
Engineering • Engineers provide answers. • Ability to solve problems or take advantage of opportunities through the application of science. • Must meet certain criteria. • Technical feasibility/efficiency: meet or exceed specifications. • Economic feasibility/efficiency: meet budgets and return.
The Role of engineering Economic analysis • Engineering economic analysis is most suitable for intermediate problems and economic aspects of complex problem, they have those qualities : 1) the problem is important enough to justify our giving it serious thought and effort. 2) careful analysis requires that we recognize the problem and all various consequences, and this is just too much to be done all at once. 3) the problem has economic aspects important in reaching a decision.
CBA Terms & Concepts • Interest and equivalence • Present Value Analysis • Cash Flow Analysis • Rate of Return • Deprecation • Cost benefit analysis • Risk, and uncertainly • Sensitivity analysis
Engineering Economy • Every technical solution has financial consequences. • Engineering economic analysis determines whether a proposed solution is financially viable. • Will it pay? • Is this the minimum cost solution? • Will it generate an acceptable return?
Making an Economic Decision The steps: • Problem or opportunity recognition and definition • Generation of Solution Alternatives • Development of Feasible Solution Alternative Cash Flows and Information Gathering • Evaluation of Solution Alternatives • Selection and Implementation of Best Alternative • Post-implementation Analysis and Evaluation
Decisions in Design • The design process is generally embedded in the second step of the decision-making process. • Designs = Solution Alternatives • Design decisions are generally discipline specific. • But the economics surrounding design decisions are for all engineers
Engineering Economic Decision Analysis Difficulty • Investments carry risk. • Money spent now for expected savings or returns in the future. • As future is uncertain, so are returns or savings. • Money spent can be lost. If too often, could lead to bankruptcy. • While economics are paramount, many other factors influence decision.
Evaluation Techniques • Payback Period • Net Present Value • Internal Rate of return • Cost Benefit Ratio
CBA Example A country is considering installing a water treatment system in a rural community that is expected to cause environmental and direct benefits of $ 1,000,000 per year for its inhabitants. The system would require an investment of $ 9,000,000 and have operating and maintenance costs of $ 300,000 per year for an expected life of 20 years, after which it would have no value. If money for this type of project costs the county 6%, is the project justified on an economic basis? Suppose an AID Agency is willing to pay $ 4,000,000 of the investment. Now is it justified?
Evaluation based on NPV Method Thus, it is not justified in total. Based only on benefit and costs to the county
B > (I + C’’) B – (I+ C’’) > 0 PW(i) = B – C’ > 0
FOCUS ON THE DIFFERENCES • Only the differences in expected future outcomes among the alternatives are relevant to their comparison and should be considered in the decision
Summary • A benefit-cost analysis is commonly used to evaluate public projects; • Difficulties involved in public project analysis include the following: • Identifying all the users who can benefit from the project; • Identifying all the benefits and disbenefits of the project; • Quantifying all benefits and disbenefits in some money unit of measure; • Selecting an appropriate interest rate at which to discount benefits and costs to a present value;
CBA AND DISASTER RISK REDUCTION An important aspect in risk evaluation is also: How much do we need to spend in order to reduce the risk
Risk reduction strategies • Structural measures: refer to any physical construction to reduce or avoid possible impacts of hazards, which include engineering measures and construction of hazard-resistant and protective structures and infrastructure • Non-Structural measures: refer to policies, awareness, knowledge development, public commitment, and methods and operating practices, including participatory mechanisms and the provision of information, which can reduce risk and related impacts.
Tools to evaluate best risk reduction measures • Cost Benefit Analysis (CBA) is used to compare costs and benefits of a one specific measures or a set of alternative measures over a period of time for a. CBA assesses the measure(s) mainly on the basis of the efficiency criterion. It requires the monetization of all the effects. The effects that cannot be expressed in monetary terms will be usually described in their original unit of measurement. • Cost Effectiveness Analysis: (CEA) has most of the features of CBA, but does not require the monetization of either the benefits or the costs (usually the benefits). CEA does not show whether the benefits outweigh the costs, but shows which alternative has the lowest costs (with the same level of benefits). CEA is often applied when the norm for a certain level of safety has been set. CEA analyzes which types of solution is the ‘cheapest’ given a certain level of safety standard. • Multi Criteria Analysis (MCE) is a tool that allows comparing alternative measures on multiple criteria. In contrast to CBA, MCE allows the treatment of more than one criterion and does not require the monetization of all the impacts. MCE results in a ranking of Alternatives
Which alternative is economically the most attractive? • If all alternatives are all as effective in terms of risk reduction the cheapest alternative (Cost Effectiveness Analysis, CEA) • If effectiveness in risk reduction differs the cheapest alternative in terms of risk reduced (Cost Benefit Analysis, CBA) Flood proofing relocation. Levees
Cost Benefit Analysis of Risk Reducing Measures • Costs for (structural) risk reducing measures are relatively less difficult to estimate • Estimating the benefits is a major challenge ! We need to know: • Avoided damage • Probability of damage We need to estimate: • how often natural hazard events occur (frequency) • how much damage and losses occur as a result of the event
Flooding Example Direct damage Indirect damage • buildings • infrastructure • crops and livestock • Machines • human victims • landscape/nature • income forgone • interruption of economic and social activities • extra costs of transportation due to infrastructure damage
Damage functions Damage-probability curve Damage-probability curve in case of flood protection against events upto 1:100 years
Basic CBA steps • Define scope of the project • Identify the type of costs and benefits • Put monetary values on costs and benefits • Compare costs and benefits • Calculate profitability indicators/decision criteria • Sensitivity analysis • Make recommendations
Example CBA Flood Reducing Measures Scenario I(removal) • removal of housing in the 10-year Return Period flood zone • 10 year RP flood zone is converted into green areas • buildings are demolished, new terrain to be bought, and new buildings have to be constructed in other hazard free zones • the set-up of a vigilance group is required • The risk in the area that was formerly threatened by a 10 year Return Period flood will be reduced to 0 Scenario II (retention) • construction of an upstream storage lake • engineering works • flood retention basin and drainage need maintenance • the retention basin will reduce the flood losses. • It will retain the discharge for 2 and 5 years RP and reduce the risk to 0. • For the other return periods the damage will reduce the losses
Damage without risk reduction, Scenario I and II at different Return Periods
Risk reduction • Once you have calculated the annual loss for the existing situation, you can now evaluate the reduction in total annual losses for the two scenarios. • Calculate the amount of risk reduction, comparing Scenario 1 and Scenario 2 with the original average annual risk. Risk reduction
Costs • After calculating the risk reduction (benefit) and the investment costs of the two flood scenarios we can now continue to evaluate the cost/benefits. The following table indicates the costs of the two scenarios.
Maintenance and operation costs • Each of the two scenarios will also require long term investments. • Scenario 1 requires the set-up of a municipal organization that controls the illegal spread of housing in highly hazardous areas. It will require staff, office and equipment costs, which will rise over time depending on the increases of salary and inflation. The annual costs are estimated to be 250.000. We consider that these costs will increase with 5 % each year. • Scenario 2 also requires maintenance and operation costs. The flood retention basin contains a basin in which sediments are deposited. Annually the sediments from this basin have to be removed using heavy equipment. Also the drainage works needs regular repair. The costs for maintenance are considered to be 500.000 per year. We consider that these costs will increase with 5 % each year. See table below.
Investment period • The investments for both scenarios are not done within one single year. They are spread out over a larger number of years, because normally not all activities can be carried out in the same year. • It is quite difficult to remove existing buildings. The municipality would like to buy the land of private owners, but they will resist, and there will be many lawsuits that might take a lot of time. Therefore we consider that the entire relocation of all building might take as much as 10 years. The investment costs are therefore spread out over this period. • The construction of the engineering works for scenario 2 will take less time. Still it is considered that the costs are spread over a period of 3 years. • The benefits will start in the year that the investments are finished. For scenario 1 this is in year 11 and for scenario 2 it is in year 4.
Project lifetime • The lifetime of the scenario 2 is considered to be 40 year. After that the structure will have deteriorated and it needs to be rebuilt. For the relocation scenario it is more difficult to speak about a life time, but we will also keep the same period of 40 years.
Result • Question: • Which Mitigation Scenario would you advice the Municipality?
Elements often overlooked in CBA in Natural Hazard and Disaster Management • Indirect economic damage • Social effects • Irreplaceable items • Stress induced by disaster • Temporary evacuation • Social disruption • Environmental effects • Evaluation of non-structural measures
CBA -strengths • Systematic way of thinking and analysis • Focus on use of scarce resources • Strong methodological basis • Monetary measurement provides comparison • Appeal to policy makers
Limitations Cost-Benefit Analysis • One approach to assess the efficiency of (structural) risk reducing measures • Take care of uncertainty of all parameters used • Estimated values of objects at risk • Probabilities of the hazard • Take care of all aspects NOT considered: • Social effects • Irreplaceable items • Stress induced by disaster • Temporary evacuation • Social disruption • Environmental effects • Indirect effects • Discounting favours present generations • One single outcome hides assumptions and value judgements
THE END THANK YOU