Sensitivity and Risk Analysis and Use of Shadow Prices - Essay Example

In the context of the economic analysis of projects in the water sectors, critically review the approaches taken to Sensitivity and risk analysis and Use of shadow prices. Water Project Appraisal and Economic Analysis In the world today, water has become a treasured natural resource and its allocation especially in developing countries, is characterised with a range of economic issues. As such in evaluating the economic models used to allocate water, the situation is complicated by few factors. Reforms of water pricing as a tool for improving efficient use of water is major concern to water economists. There are various aspects that are critical in evaluation water projects as well as water projects appraisal. The sensitivity and risk analysis of water projects is among the aspects that need assessment in order to determine those variables that may lead to success or failure of the water projects. In addition, water projects are focused on pricing in order to maximize profit for investments. However, this may lead to shadow pricing which may have a significant impact on the social wellbeing of the community served by the water project. This research essay takes a closer look at and as well discusses approaches relating to shadow water pricing and sensitivity risk analysis in regard to economic evaluation water projects. In the shadow prices the paper will evaluate and explain the various ways in which water projects managers can adopt the best pricing policies to avoid social problems that may results from shadow prices. This will include the methods of determine in prices that can be recommended. In water project, the viability of the project is evaluated in comparison with the internal return rate for the financial costs of the capital required in the water project. Additionally, water projects are considered to be viable when there is a positive net present value. Therefore, sensitivity and risk analysis in water project is done to evaluate the changes in the most salient variables that determine the water project worthiness. In the sensitivity and risk analysis, the paper will cover those variables which focus on the success of the water projects. This will include the purpose of analysis and its aspects as well as the analysis process and its implications in water projects. Shadow Pricing and Shadow Pricing Systems In evaluating water projects, it is necessary to provide reliable processes that will facilitate in choosing among various alternative investment decisions. Profits are the main indicators in that respect but it is worth noting that public profitability is usually measured using shadow prices (Qureshi et al, 2012, p. 90). In the context of a water project, shadow price refers to the effects of social welfare that result from unit increase in supply of the service or good by the public sector. Therefore, a project that results to a profit at shadow prices will eventually result in positive impact to the general welfare of the community. In the context of water projects, shadow prices that are applied in economic evaluation of a project are planned to provide a limited relief of any distortion that may result from a market failure (Papps, 1993). According to Giannoccaro et al. (2010), adopting the best water pricing policy would come in handy at ensuring and improving use of water. In most cases, setting up specific water prices has been proven to be an affective gauge of scarcity of water as a resource. However, in most cases, it is often challenging to set effective for natural resources in which case property rights are not defines properly. On the other hand, introducing price controls in water sector with the objective of enhancing efficiency of allocation may not auger well with impartial water distribution policy among various communities. The main concern for policy makers is that by increasing the pricing scheme, will automatically results in increased income inequalities. As such, it affects low-income users to a large extent that wealthy users in addition to igniting a conflict of interest among various communities thereby hindering reform process of water pricing systems (Loehman, 2008). As earlier mentioned, allocation of water matters especially where chances of market failure is highly possible. The market failure maybe artificially or naturally caused. In that case under specific conditions, free water markets automatically leads to attainment of economic efficiency. In instances where markets departs from such conditions without government involvement, naturally caused market failure exists. Besides, the situation may be heightened by external economies, monopolistic elements, public paradoxes, goods, and fallacies. As such, the results of natural market failure make it necessary for government to intervene in such projects in two ways: macroeconomic involvement that stabilizes market prices and ensures external balance; and market- and sector –level interventions. On the other hand, artificially caused market failure is usually excessive and insufficient where in most cases disrupts a well-functioning market. In achieving proper water supply, introduction of shadow pricing, especially by governments, is an optimal intervention but it is much dependent on policy environment. As such, shadow prices are the link between policies and projects (Ali, 1990). In another aspect, according to Balassa (1977) discusses various methods that can be used in evaluation of projects. They include the effects method which can be suitably applied in projects aimed at planning of national development for instance water projects. The method is contrasted to conventional cost-benefit analysis that puts into consideration the neoclassical general optimality and equilibrium theory. In that case, the planning context of the effects of a project is in constant reference to analysis of situations. The cost-benefit analysis of water projects puts into consideration the current economic models of a society because it analyses projects under the applied policies. As such, cost-benefit analysis provided a tangible analysis of situations. Cost-benefit analysis surpasses the neo-classical frameworks applied in project evaluation. In that case, whereas in neoclassical assumptions where economic evaluation of a project is derived without undue difficulty from financial analysis of profitability to the entrepreneur, the rationale of cost-benefit analysis is that financial evaluations is not the best method in such cases. To be precise, cost-benefit analysis allows for the fact that there is remarkable underemployment of various factors, structural disequilibria, substantial and wide-ranging state intervention. These are exempted under neoclassical assumptions of project evaluation accosting to Balassa (1977). In regard to the above, the economic analysis of a project is substituted for financial analysis of the project and this entails the use of shadow prices in place of actual market prices. By using shadow prices in economic analysis of a project involves condemning reality by depending on imaginary costs that are calculated by use of abstract concepts for instance shadow prices. In this regard, the failure to meet the conditions proposed by neoclassical models implies that market prices do not properly express costs of options foregone. As such, shadow prices of factors and products are unavoidably used in order to reflect the opportunity costs. Besides, it is worth noting that estimating shadow prices of various factors is unique to specific projects, varies from one locality to another and others are determined on the economy level of the nation. Prices used to estimate operation cost of a project and/or shadow prices should quantify true economy costs of using various goods and services (EDRC, 1997). Sensitivity and Risk Analysis The viability of a water project is determined by its cost effectiveness. The financial and economic benefits costs of fundamental water projects are based on the prediction of quantifiable variables. These variables include the demand for water, the cost of the water project, the availability of the water and benefits that will be derived from the water project. These values are determined depending on the anticipated value which includes certain duration (McLaney, 2009, p. 58). These variables are also subject to changes in future developments, in the water industry. Sensitivity analysis is able to show the extent at which the water project is feasible despite the influence of other variables. The probability that the changes in the quantifiable variables are likely to occur constitute the risk analysis of the water project. In water project, the viability of the project is evaluated in comparison with the internal return rate for the financial costs of the capital required in the water project. Additionally, water projects are considered to be viable when there is a positive net present value. Therefore, sensitivity and risk analysis in water project is done to evaluate the changes in the most salient variables that determine the water project worthiness (Weiss and Ward, 2013, p. 125). The Purposes of Sensitivity and Risk Analysis The sensitivity and risk analysis seek to determine the factors and combinations of factors that may lead to unfavourable conditions in water projects. The sensitivity and risk analysis to investigate the changes in these variables and their impact on the water project. The analysis identifies the key variables that are likely to affect the cost and benefit. These variables include water demand, investment cost, benefits of the water project, water tariffs and discount rates. The analysis also investigates the impact of the changes in these key variables on the viability of the water project. Moreover, the sensitivity and risk analysis identifies the mitigations that can be employed in overcoming the effects caused by changes in the variables (Bringham & Ehrhardt, 2011, p. 436). The Aspects in Sensitivity and Risk Analysis Demand Analysis: This aspect analyse the sensitivity of the demand of clean drinking water forecast in relation to changes in population growth, per capita consumption, and various changes in the water tariffs. The population growth in the location of the water project is estimated so that the project can be planned in a way that it sustains the population. Apart from the population growth, evaluating the per capita consumption will also help in determining water project sensitivity. Depending on the economic activities in tea res, water consumption may vary from one region to another (Bringham & Ehrhardt, 2011, p. 436). Least Cost Analysis: This helps in establishing whether the preferred least cost is viable in the prevailing conditions. This seeks to establish the alternative methods of producing the required output for the community in order to meet their water demand. This is considered by choosing the least cost alternative that is feasible in water provision. In this case, the most efficient and economical technological option is selected for the water project. This may include different technologies and designs as well as different settings for the project (McLaney, 2009, p. 245). Sustainability Analysis: This addresses the possible threats that are likely to affect the water project from sustaining the estimated population size. For the project to be able to sustain the communities for a long period, it should have proper funding, and social back up from the communities as well as technical support. Distributional Analysis: This is used to analyse whether the distribution of water will benefit all people in the community. This is because some people in the community are poor hence may not be able to access the water. The water project should identify such factors and also address them in the developmental stages of the water project. Sensitivity Analysis Process Identifying the variables: The water project incorporates a number of variables which include the relation between quantity and its variable, price of the water, economic value of the water and the time of project effects. Water demand: the possible quantifiable variables in water demand include the population growth and the household consumption rate. Investment cost: this includes assessing the cost involved in water demand quantifiable variables, period of constricting the water project and the real prices in the water project. Financial revenue: the quantifiable variables include water demand and income generated from water connection fees (McLaney, 2009, p. 124). After the variables have been identified, the effect of changing variables is calculated using sensitivity indicators and switching values. The effect, which is calculated is then analysed to determine the impact of the changes on the water projects (Bringham & Ehrhardt, 2011, p. 456). Qualitative Risk Analysis In water project, the risk analysis plays a vital role in influencing decisions of the project and its management. In fact, risk analysis is done in cases where the results of the project are likely to be affected by sensitive variables. The importance of risk assessment in a project is to establish the likelihood of occurrence of the sensitive variables that influence the water project. The risk analysis is done by comparing the experiences are other water projects as well as investigate the factors in the water industry. Therefore, steps are taken during the execution of the water projects so as to reduce the uncertainty of the variables. This involves the use of remedial plans, which occur at different levels including the national level, project level and sector or industrial level (Asian Development Bank, 2003, p. 54). At the national level, the actions that can be taken include entering into a performance agreement with the contractors. This will ensure that the contractors in the water project are able to commit themselves to making sure that the project is completed despite the uncertainties. In reducing operation costs and its uncertainties, there is the need to enter into supply agreements of specified quality supplies at relative reduced prices. Moreover, there is a need to set some approval criteria in all subproject such as community involvement. Apart from the national level remedies, the sector level remedies may include adjusting the tariffs and prices in order to maximise revenues and conduction of technical aid for operational managements (Asian Development Bank, 2003, p. 63). Quantitative Risk Analysis In any project, it is crucial to estimate the probability that EIRR will fall below the cost of the capital or the discount rate will fall below zero. The quantitative risk analysis is considered crucial in water projects that have a wide range of uncertainties. This is because large water projects should include the government since they require a large capital investment. Therefore, operational disruptions need to be analysed for large projects in order to assess the level of their effects on the water projects (Asian Development Bank, 2003, p. 58). Conclusion The evaluation of the water project is necessary in order to ensure sustainable water development project. For example, a project that results to a profit at shadow prices will eventually result in positive impact to the general welfare of the community. Additionally, shadow prices that are applied in economic evaluation of a project are planned to provide a limited relief of any distortion that may result from a market failure. In the world today, water has become a treasured natural resource and its allocation, especially in developing countries, is characterized by a range of economic issues. As such in evaluating the economic models used to allocate water, the situation is complicated by a few factors. In the context of a water project, the shadow price refers to the effects of social welfare that result from a unit increase in the supply of the service or good by the public sector. It is necessary to control the prices of water in order to make it affordable to all individuals. The failure to meet the conditions proposed by neoclassical models implies that market prices do not properly express costs of options foregone. As such, shadow prices of factors and products are unavoidably used in order to reflect the opportunity costs. Moreover, in water projects it is necessary to conduct a sensitivity and risk analysis in order to establish key variables that are likely to affect the viability of water projects. The sensitivity and risk analysis are vital since they help in eliminating factors that may result in failure of water projects. References Asian Development Bank, 2003. Handbook for integrating risk analysis in the economic analysis of projects. Mandaluyong City: Asian Development Bank. Ali, I., 1990. Interrelationship between Shadow Prices, Project Investment and Policy Reforms - An Analytical Framework. [Online] Available at: < http://www.adb.org/sites/default/files/pub/1990/rs52.pdf>. Accessed 23 April, 2013. Bringham, E., & Ehrhardt, M., 2011. Financial Management: Theory and Practice. New York: Cengage Learning. Balassa, B., 1977. The ‘Effects Method’ Of Project Evaluation Once Again. Oxford Bulletin of Economics and Statistics, vo. 39, no. 4, pp. 345–353. EDRC, 1997, Guidelines for the Economic Analysis of Projects. [Online] Available at Accessed 23 April 2013. Giannoccaro Giacomo, Prosperi Maurizio & Giacomo Zanni, 2010, Assessing the Impact of Alternative Water Pricing Schemes on Income Distribution, Journal of Agricultural Economics, Vol. 61, No. 3, pp. 527–544. Loehman, E. T., 2008, Pricing for water conservation with cost recovery. Water Resources Research, vol. 44, no. 8, pp. 1-13. McLaney, E., 2009. Business Finance: Theory and Practice: New Jersey: Financial Times Prentice Hall Papps, I, 1993. Shadow Pricing With Price Controls. Srorrish Journal of Polincal Economy, Vol. 40, No. 2. pp. 199-209. Qureshi, M. E., Proctor, W., Young, M. & Wittwer, G., 2012. The Economic Impact of Increased Water Demand in Australia: A Computable General Equilibrium Analysis. Economic Papers, vol. 31, no. 1, pp. 87–102. Weiss, J., and Ward, K., 2013. Projects and Risk’ in Weiss J. and Potts D. eds. Current Issues in Project Analysis for Development. Camberley: Edward Elgar Publishing Read More