Wednesday, February 1, 2012

Economic Benefit-Cost Analysis vs. Financial Feasibility Analysis: Clear definitions needed for BDCP discussions

As an economist, it was painful to sit at the Delta Protection Commission meeting last week and listen to Jerry Meral's five minute answer to a question about benefit-cost analysis and the BDCP.  My understanding is that there have been similar exchanges at various meetings.  The problem isn't just his answer, the questions are often unclear, and even Allison Huber's failed bill wasn't very clear about the analysis she wanted the LAO to do.

To keep these conversations simple in the future, I recommend the question be phrased in the future as a simple yes/no question that relies on the Department of Water Resources' Economic Analysis Guidebook for definition of the terms.  It's not the only source for this, but it is pretty good, and it should be acceptable to Dr. Meral and the Resources Agency since it is their guidebook.

The guidebook is clear about the key difference in benefit-cost analysis and financial feasibility analysis.  The key definitions from the executive summary are:

Benefit-cost analysis determines whether the direct social benefits of a proposed project or plan outweigh its social costs over the analysis period. Such a comparison can be displayed as either the quotient of benefits divided by costs (the benefit/cost ratio), the difference between benefits and costs (net benefits), or both. A project is economically justified if the present value of its benefits exceeds the present value of its costs over the life of the project. (page ix)

Financial Analysis. The objective of financial analysis is to determine financial feasibility (that is, whether someone is willing to pay for a project and has the capability to raise the necessary funds). A financial analysis answers questions such as, Who benefits from a project? Who will repay the project costs, and are they able to meet repayment obligations? Will the beneficiaries be financially better off compared to what they will be obligated to pay? (page xii)

The test of financial feasibility is passed if (a) beneficiaries are able to pay reimbursable costs for project outputs over the project’s repayment period, (b) sufficient capital is authorized and available to finance construction to completion, and (c) estimated revenues are sufficient to cover allocated costs over the repayment period. (page xii)

Here is my interpretation of the exchange between Larry Ruhstaller and Jerry Meral about benefit-cost analysis if it had been asked and answered clearly.

LR: Are you doing a benefit-cost analysis of the BDCP or any of its elements as defined by the DWR Economic Analysis Guidebook?  Are you doing a financial feasibility analysis?

JM: No, we are not doing benefit-cost analysis. Yes, we are doing a financial feasibility analysis of the isolated conveyance.

I am pretty sure that I have translated Dr. Meral's answer correctly in terms of these definitions, but it would be helpful to get a simple yes/no question and response to this in the future.  And if you are involved in these financing and policy discussions, please learn these terms and do not use them interchangeably.

4 comments:

  1. Jeff good comments. In addition additional analyses need to be performed:

    Analyzing the benefit-cost ratios and net benefits of alternatives to the proposed project.

    Analyze the economic feasibility (i.e. willingness and ability to pay) of alternatives to the proposed project.

    It could very well be that there are one or more alternatives that would achieve equal or greater benefits at less cost. For a project that would cost taxpayers and ratepayers tens of billions of dollars it is amazing that the BDCP refuses to look for more cost effective and affordable solutions.

    Jonas Minton

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  2. Thanks for the pearls of wisdom. These would be very helpful to newbie investors. I am always thankful to see others giving high quality info towards community. Will be referring a lot of friends about this. Keep blogging.
    SAC Capital

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  3. Jeff, it looks like you may get your C/B analysis. Congratulations.

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  4. Financial feasibility measures only the direct effects on cash flow of the organization of an investment decision.
    Economic feasibility considers not only the impact of a project on the organization sponsoring the project but also considers the external benefits and cost of the project for other govt. agencies ,private sector enterprises and individuals.

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