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Jan Rączka, PhD
Warsaw University
Warsaw, 13.06.03
The cost-effectiveness analysis – a superior alternative to the costbenefit analysis of environmental infrastructure investments
A paper submitted to the Fifth European Conference on Evaluation of The Structural
Funds “Challenges for Evaluation in an Enlarged Europe”, Budapest, 26/27 June
2003.
Introduction
Both the Polish government and the European Commission wanted to allocate ISPA
grants only to economically efficient investments. The necessity for carrying out costbenefit analysis was stressed in the ISPA strategy in Poland (MS 2001), while the
Commission disseminated guidelines on socio-economic appraisal of investments
(EC 1997). All interested parties (civil servants, prospective beneficiaries and their
consultants) followed these instructions but in fact they were misguided. This paper
tries to sort out some problems that are related to environmental investments to be
financed from EU funds.
The main thesis of this paper concerns a methodological problem. It is argued that
the cost-benefit analysis is not a relevant method for making economic appraisal of
investments that respond to compulsory ecological standards. Since the ISPA serves
as a measure that helps accession countries to comply with EU ecological standards,
the appraisal procedure should rely rather on the cost-effectiveness analysis. This
method answers a relevant question, i.e. “what is the lowest cost of meeting
standards?”
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While cost-effectiveness is a simple economic concept, literature that shows how to
make it operational is surprisingly small. Hence, the paper reviews a number of
indices that are used in Poland for measuring cost-effectiveness. It is argued that
Dynamic Generation Cost (DGC) is the best one.
The cost-effectiveness method has a number of advantages that are particularly
convenient in the appraisal process of environmental infrastructure investments. This
discussion emerges from the experience gained in the process of preparing ISPA
applications in Poland. While it is not possible to present systematic data, the author
presents some general remarks that justify a statement that in case of ISPA the costeffectiveness analysis is a more suitable approach to economic appraisal than costbenefit analysis.
The paper is organized in the following way. The first section explains why a standard
criterion for allocating investment grants does not work in case of ISPA projects. The
following section discusses methods of measuring cost-effectiveness that are used in
Poland. Next, some practical problems with implementing CBA and CEA to ISPA
projects prepared in Poland are discussed. Conclusions are presented in the last
section.
1. The golden rule for allocating investment grants and cost-effectiveness
There are two dimensions in the project appraisal: economic efficiency and financial
viability. If a market operates smoothly there is no room for a government intervention
– all investments that are economically efficient will be financially viable and should
be financed from commercial sources. Once there is a market failure (e.g.
externality), there is a deadweight loss and the market is not efficient. In order to
improve welfare, the government may correct the market mechanism, e.g. by
allocating investment grants.
Table 1. The rule for allocating investment grants
Financial viability
Economic efficiency
Yes
-
Yes
No
2
No
+
-
Source: Zylicz et al. (2000).
The government should not co-financed investments that are not economically
efficient because their implementation will lower social welfare. Also financially viable
investments should not be co-financed from public means since they can rely on
commercial financing. The golden rule for allocating grants says that the government
should support only these investments that are economically efficient but are not
financially viable. If one applies financial analysis and CBA, then one should select
projects that have positive ENPV and negative NPV.
The above discussion suggests that project appraisal procedures should incorporate
a combination of financial analysis and CBA. However, this is not true in case of
investments that respond to compulsory regulations (like ISPA projects). The
justification is as follows.
In the CBA one compares a discounted flow of benefits with a discounted flow of
costs. If benefits outweigh costs, then investment is economically efficient and should
be supported from public means. If not, the investment should be abandoned.
However, what is a nature of investments to be co-financed by ISPA. Can they be
abandoned? No, the cannot as the municipalities and utilities must meet UE
standards. They must implement these investments in order to be in compliance with
legal regulations. Hence, the logic of the CBA is broken. The investment have to be
undertaken even if the costs outweigh benefits. Investors can only blame politicians
for adopting too stringent ecological standards.
A question “do benefits outweigh costs” is not relevant in this context. An adequate
question is ”what is the lowest cost of meeting environmental standards”. The
appropriate method that should be used to answer the latter question is CEA. Hence,
it is strongly recommended to use the combination of financial analysis and CEA in
economic appraisal of investments to be financed by ISPA.
2. The cost-effectiveness analysis (CEA)
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The CEA can be applied when investments produce homogenous ecological effects.
It answers a question what is the lowest cost of achieving a defined environmental
target (e.g. compliance with a standard). The logical procedure is as follows. First,
one should define a goal that one would like to obtain. Second, feasible options
should be identified. Third, investment expenditures, operational costs and an
environmental effect should be estimated. The CEA index is a ratio between costs
and an environmental effect. The lower this costs, the better it is -- the society spends
less money on purchasing the unit of the environmental effect. As cost-effectiveness
is a main focus of this paper, measures used in Poland are described below.
1.3.1. Unit Cost
This is a static index used by all environmental funds in Poland (with the exception to
EcoFund and Regional Fund for Environmental Protection and Water Management).
This is a simple ratio between investment expenditures and an ecological effect that
is generated in a first year after the completion of the investment (NFOŚiGW 2001).
A formula is given below.
(1) UC=I/EE
Where:
UC
-- Unit Cost,
I
-- a total investment cost,
EE
-- an ecological effect in the first year of operations.
This index has a number of drawbacks. First, it does not account for operational
costs. One can easily give an example that a more expensive device is preferred
because of low operation and maintenance. Second, a unit cost is invariant to
changes in a profile of the environmental effect. It may happen that a reduction in
pollution will change over life-time of the investment (e.g. the plant will be closed
down or change the production profile to less polluting). Third, the unit cost does not
account for differences in a operation period of installations. There is a possibility that
a more expensive device will serve longer than a cheaper one. The unit cost will
always give a priority to the latter even if the difference in operational period is so
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large that true cost of achieving an environmental effect is lower for the former.
Hence, a unit cost should not be used in professional cost-effectiveness analyses.
In spite of these methodological deficiencies, official governmental documents that
describe how Poland will use structural funds indicate the unit cost as a main criterion
for selecting environmental investment projects (see for example MG 2003). It is not
surprising – each country depends on its own experience in shaping the strategy for
using structural funds. As the unit cost is very popular in domestic environmental
funds, it gains wide acceptance among civil servants that work in this area.
1.3.2. Unit Annual Cost
This is a dynamic index used by EcoFund. It is calculated as a sum of Annualised
Capital Cost and yearly operational costs divided by an average ecological effect
expressed in physical units (Peszko 1998). It takes a following form.
(2) UAC = AC / EE
Where:
UAC
-- Unit Annual Cost,
AC
-- an annualized cost of a project (ACC plus yearly O&M costs),
EE
-- an average annual ecological effect expressed in physical units.
The Annualised Capital Cost is defined:
(3) ACC  I 
r
1  (1  r )
n
Where:
ACC – Annualised Annual Cost,
I
-- a total investment cost,
r
-- a discount rate (or an expected rate of return on a project),
n
-- a lifetime of a project.
Unit Annual Cost is a very good indicator which gives very precise estimates of a true
long term average cost when the ecological effect is distributed evenly over the life5
time of the investment. This index also proves useful when different investments
have the same profile of the ecological effect. Otherwise UAC may produces
estimates that do not reflect true cost-effectiveness of an investment.
In order to understand this feature, one should wonder in what way timing of
achieving an environmental effects affects welfare of the society. Imagine a polluted
lake that is revitalized either next year or ten years later. A rational citizen should
prefer the former. In fact during these ten years he or she will enjoy an additional
stream of environmental benefits generated by the cleaned lake. So, the sooner an
environmental effect is obtained, the better it is to the society.
Hence, a measure of cost-effectiveness should account for the distribution of the
environmental effect over time. UAC will rank equally an investment, which produces
10 units of an ecological effect in a first year of operations and 1 unit per year in the
remaining 9 years of operation, and an investment, which has a reverted profile of an
ecological effect (1 unit per year during first nine years and 10 units in the tenth year).
While UAC is still not an ideal measure of cost-effectiveness, it produces good
estimates and it works well in most typical cases. In some cases it is very difficult to
make a projection of an ecological effect. So, applying a more sophisticated methods
that will depend on imprecise projections does not generate any value added.
1.3.3. Dynamic Generation Cost
This is a dynamic index used widely in Germany (sometimes called Dynamic Prime
Cost) and applied in Poland by the National Fund for Environmental Protection and
Water Management to ISPA investments (Rączka 2002a). This index has a similar
structure like Cost-Benefit Ratio used in CBA, i.e. it is a ratio between discounted
costs and discounted benefits. However, benefits are not monetised, are expressed
in physical units. The formula is given below:
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KIt  KEt
(1  i )t
(2) DGC  t  0t  n
.
EEt

t
t  0 (1  i )
t n

Where:
DGC -- Dynamic Generation Cost,
KIt
-- investment expenditures in year t,
KEt
-- O&M costs in year t,
EEt
-- an ecological effect in year t,
i
-- a discount rate,
n
-- a lifetime of an investment.
Dynamic Generation Cost is the ideal measure of cost-effectiveness. It has all
advantages of UAC and additionally is sensitive to changes in distribution of an
ecological effect over time. In fact DGC is the best proxy of a long run average cost.
DGC has been already used in appraising ISPA investments in Poland since June
2002. This allowed to improve the appraisal procedure in different ways (see section
3). This index will be apply to Polish investments to be financed from the Cohesion
Fund.
3. Practical issues in the economic appraisal of Polish ISPA investments
More than 30 applications from Poland have been so far accepted by ISPA. It was
not possible to research them in a systematic way. However, the author of this paper
went through app. 10 applications during his 2-year appointment as TRANSFORM
consultant in the National Fund for Environmental Protection and Water
Management. This is a basis for some general remarks concerning the economic
appraisal of Polish ISPA investments.
3.1. Quality of the CBA in ISPA applications
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Poland has long tradition of co-financing environmental investments by the state. The
system of environmental funds have supported hundreds of projects per year since
the early nineties. However, appraisal procedures differ from EU standards. In
particular, Polish environmental funds usually do not require a detailed financial and
economic analyses of investment projects. It turned out that consulting companies
were able to accommodate financial analyses quite easily because they are based
on tools used in a commercial sector. However, the CBA was a completely new
approach which puzzled consulting companies. Consultants were not conscious that
the CBA is a standard economic tool emerging from the professional literature. It still
happens that consultants produce a socio-economic analysis that has nothing in
common with the CBA.
In other cases – when the logical structure resembles the CBA – quality is very low.
The author have not seen any analysis that is based on original valuations of external
effects. Few analyses rely on the benefits transfer method. It happens that
consultants are able to prove economic efficiency of an environmental investment
(e.g. a new waste water treatment plant) without taking into account ecological
benefits. They show that benefits from higher investment expenditures and higher
employment stimulate a local economy so effectively that total benefits balance
costs. Valuation is the weakest point in the CBA attached to ISPA applications in
Poland. This key element is far away from a minimum academic standard of
monetising externalities.
Also other specific features of the CBA are ignored or treated in an inappropriate
way. Few consultants understand an economic term “transfers” or “shadow prices”.
Problems with the latter are apparent when a consultant treats changes in
employment. There is no doubt that an increase in employment is a cost to a society.
However, if new employees are drawn from the unemployed, the opportunity cost of
hiring them is zero. A researcher has to judge how many new laborers will recruit
from the unemployed -- skilled specialists usually have employment.
Usually an average CBA for investments to co-financed by ISPA is plagued by so
many methodological mistakes that is not informative (always proves economic
efficiency). Neither local politicians nor civil servants care about this as they consider
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the CBA as a necessity. They do not understand this tool and are not able to
incorporate it to a decision-making process. In fact what is a difference between
ENPV equal to EURO 2 million and to EURO 20 million? There is absolutely no
difference as long as it is above zero. So, consultants are asked for producing a
plausible result.
This is not a case of the CEA. This approach is informative both to local politicians
and to civil servants which manage ISPA. Following sections show two actual
applications that show strengths of a cost-effectiveness concept.
3.2. A comparison of options
An economic appraisal of ISPA projects is carried out too late. A project has been
already developed and a prospective beneficiary has spent a lot of money on
preparation (even on detailed designs). In a result the National Fund for
Environmental Protection and Water Management is in a difficult position –
contestation of a selected option imposes additional costs on a prospective
beneficiary. Changes to a scope or a budget of an investment requires a new
consensus among local politicians and pressure groups. This is particularly difficult in
case of municipal unions. Hence, a change in a scope of planned investments has to
be somehow justified. The CEA provides sound argumentation.
Let us consider an example from Grudziadz (Poland). This is a city inhabited by 100
thousand people. The city has a nice ancient downtown which is surrounded by a
number of densely populated districts. This area is connected to the sewerage.
However, there are suburbs that are not sewered. The population is not distributed
evenly there. There are some housing developments and a number of dispersed
detached houses. The city submitted an application that proposed a central
sewerage system for the suburbia.
There are two alternatives to the central system:
 a conservation tank (DGC = 6.05 EURO/m3);
 a domestic sewage treatment plant (DGC = 2.05 EURO/m3).
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However, the latter solution can be applied upon two conditions: (1) plots are large
(at least 2000 m2), (2) a house is connected to a water network. The first condition
constraints applicability of domestic sewage treatment plants.
Table 2. Grudziadz – sewerage in comparison to alternatives
No.
Subproject
1
Collector D and its
catchment area
2
Pumping station PS-4
and its catchment area
3
Collector P (transit), PS1, PS-2, PS-3 and their
catchment areas
4
Inhabitants
connected
Cost
(1000
EUR)
DGC
(EUR/m3)
DGC for Comparis
the best
on to the
alternative alternative
NPV
(1000
EUR)
1376
2719
3.24
6.05
Superior
-2174
456
1072
4.37
6.05
Superior
-1048
820*
775
7.88
6.05
Inferior
-3715
Pumping station PS-5
and its catchment area
474
1276
5.03
6.05
Superior
-1290
5
Pumping station PS-10
and its catchment area
225
938
7.68
6.05
Inferior
-991
6
Pumping station PS-6
and its catchment area
553
1485
4.98
6.05
Superior
-1485
7
Pumping station PS-8
and its catchment area
128
547
7.95
2.50
Inferior
-585
8
Pumping station PS-9
and its catchment area
115
827
13.20
2.50
Inferior
-909
9
Pumping station PS-7
and its catchment area
33
257
14.38
6.05
Inferior
-286
Source: Rączka 2002b.
The estimates of DGC for a central system in different locations are compared with
relevant alternatives. If a domestic sewage treatment plant is feasible, then it is the
cheapest solution (2 areas). The central system is the best option only in 4 areas out
of 9.
This analysis gives a justification for limiting the proposed investment package. The
National Fund of Environmental Protection and Water Protection acknowledge the
results and asked the city for amending the application respectively. A reaction of the
City was also positive. Being surprised by differences in costs, the management of
the City appreciated results and accepted an exclusion of sub-investments that were
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not cost-effective. One statement was very characteristic: “We have never thought
about sewerage extensions in this way”.
This examples shows that the CEA is informative both to local politicians and the
implementing agency. All interested parties receive transparent and precise
information about true costs of investments. This conditions rationalization of the
decision-making process.
3.3. A cost comparison
While the option analysis is the best application of the cost-effectiveness concept, the
additional information can be obtained from comparing investments undertaken in
different cities. This approach is interesting to the implementation agency.
An example is taken from the feasibility study for Sosnowiec. The City would like to
construct a collector (called “Bobrek”) which will serve a number of districts as well as
from neighboring cities. It is not possible to carry out a standard analysis of options
(see section 3.2) as there are not any feasible alternatives. Still it is possible to
compare a cost-effectiveness measure for the collector with other investments that
have been already supported by ISPA. The rationale is simple – Brussels should not
oppose to co-financing investments that are at least as cost-efficient as those
investments that have been already accepted.
Table 3 – DGC for the “Bobrek” collector
City
Type of investment
DGC (EURO/m3)
Lower limit
Upper limit
Jelenia Góra
Sewage systems
1.71
3.74
Mielec
Collectors and sewage systems
0.92
2.46
Suwałki
Sewage systems
1.83
4.46
Sosnowiec
“Bobrek” collector
Szczecin
Collectors and sewage systems
1.37
Source: The City of Sosnowiec 2003.
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0.59
2.72
Table 3 presents values for the lower and upper limits. The values of the lower limit
refer to the least expensive sub-projects included in an investment program in a
given city, and the values of the upper limit refer to the most expensive project. In the
case of Sosnowiec, there is only one project, so DGC has been placed in the middle.
The DGC for Sosnowiec, equal to 1.37 EURO/m 3, is acceptable. It is lower than the
value of the lower limit for Jelenia Góra (1.71 EURO/m 3) and Suwałki (1.83
EURO/m3). The difference in comparison to the upper limit values is striking. DGC for
the ‘Bobrek’ collector is more than 2 times lower than the upper limit value for most
other projects. The investment in Sosnowiec is cost-effective from the point of view of
the society. The environmental effect can be achieved at low costs on the side of the
society. So, the allocation of a grant is justified.
This example shows a strength of the cost-effectiveness approach. The implementing
agency can compare investments from the same area. If high estimates of DGC are
observed, it can put a question what is a reason. Having an answer, a decision
maker can either accept high costs (no alternatives and an important ecological
effect) or reject an application. So, the CEA produces useful information and
rationalizes a decision process.
4. Conclusions
Cost-effectiveness is an adequate approach to ecological investments that respond
to compulsory standards.
Dynamic Generation Cost is the best measure of cost-effectiveness since it takes into
account: operation and maintenance costs, a lifetime of an investment, a profile of an
ecological effect. Being easy in calcus, DGC is the best proxy of a long run average
cost.
Cost-Effectiveness Analysis produces informative results. They can help in shaping
an investment package as well as in making a ranking.
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It is recommended to use Cost-Effectiveness Analysis in project appraisal procedures
for ISPA and the Cohesion Fund.
References
EC (1997), Guide to Cost-Benefit Analysis of Major Projects in the Context of EC
Regional Policy, European Commission, Brussels.
MG (2003), Uzupełnienie Sektorowego Programu Operacyjnego: Wzrost
Konkurencyjności Gospodarki, Ministerstwo Gospodarki, Warszawa.
MŚ (2001), Strategia wykorzystania funduszu ISPA jako uzupełniającego instrumentu
realizacji polityki ekologicznej państwa, Ministerstwo Środowiska, Warszawa.
NFOŚiGW (2000), Procedura dofinansowania przedsięwzięcia, Narodowy Fundusz
Ochrony Środowiska i Gospodarki Wodnej, Warszawa.
Peszko, G. (1998), Project selection criteria in Environmental Funds, Cracow School
of Economics, mimeo, Cracow.
Rączka, J. (2002a), Analiza efektywności kosztowej, Transform Advice Programme,
mimeo Warszawa.
Rączka, J. (2002b), Economic and financial appraisal of the investment programme
„Improvement of the waste water management”, TRANSFORM, Grudziadz.
The City of Sosnowiec (2003), Construction of ”Bobrek” Trunk Sewer and
Modernisation of ”Radocha II” Wastewater Treatment Plant in Sosnowiec, a
feasibility study, Sosnowiec.
Żylicz, T., A. Bartczak, M. Gwiazdowicz, J. Rączka (2000), Analiza ekonomiczna i
ekologiczna przedsięwzięć ochronnych finansowanych przez NFOŚiGW, Warszawski
Ośrodek Ekonomii Ekologicznej, Warszawa.
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