Increasing water scarcity is posing a major challenge for meeting the continuously growing demand for water from all sectors. In many developing countries, in particular, this crisis is likely to be further exacerbated by the negative impacts of climate change on overall water availability. Potentials for mobilizing additional water resources are often limited and extremely costly to realize. Consequently, irrigated agriculture as the largest water user will face growing competition for scarce water resources from other sectors with higher use efficiency and value added. For meeting the ever increasing demand for food, fiber and other products, irrigated areas wherever feasible have to be extended, and existing irrigation schemes often require rehabilitation or modernization to ensure a more rational and efficient water use. However, related additional investments are substantial and accordingly require adequate financial and economic justification.
Background
As for any other productive investment with tangible i.e. quantifiable benefits that is supported by German Financial Cooperation (FC) through KfW Entwicklungsbank, irrigation projects and programs prior to a positive investment decision need to be justified in terms of their financial and economic profitability and the resulting contributions towards increasing a country’s or society’s welfare. Such a justification is particularly required because in KfW’s investment portfolio of the agricultural and / or natural resources management sectors, irrigation projects and programs typically represent the most expensive investment type, in terms of specific unit costs per area developed. Furthermore, in the absence of significant financial participation of farmers to initial investment costs (and often also in subsequently recovering recurrent operation and maintenance (O&M) and replacement costs) public subsidies accruing to project beneficiaries are substantial and usually much higher than for other agricultural or non-agricultural investments. As is the case for other multilateral or bilateral funding agencies, KfW’s past experience in financing mainly large scale public irrigation projects and programs in retrospect often showed a rather poor performance record in terms of economic profitability and sustainably achieving the intended objectives. Consequently, current and future irrigation investments require adequate economic justification for effectively mobilizing the substantial public and private investments that are indispensable for reversing the trend of declining investments in irrigation development observed during the last two decades.
Procedures
Cost-benefit analysis (CBA) remains the main methodological approach and tool for assessing the financial and economic profitability of irrigation investments. CBA is a quantitative approach to analyze whether the present value of benefits of a given project exceeds the present value of costs. [1] Cash-flow analysis is the main instrument for establishing and comparing the annual streams of costs and benefits for both the without and with project situations. This analysis usually produces the following discounted measures of project worth:
- The net present value (NPV) is defined as the aggregated net incremental benefit over the project’s lifetime, thus comparing the discounted costs and benefits at a predetermined discount rate, reflecting the opportunity cost of capital for alternative use of investment funds. Taken alone the NPV is an insufficient measure for project selection, since as an absolute value it is dependent on project scale in terms of both costs and benefits, thereby not allowing to choose between projects of different scale.
- Defined as the discount rate for which the NPV equals 0 (discounted aggregate costs equal discounted aggregate benefits), the internal or economic rate of return (IRR/ERR) is the most commonly used measure of project worth, since it also allows the compare the profitability of a given project against investment alternatives in the same sector as well as other sectors, independently of their scale.
- Benefit-cost-ratios (BCR) or cost-benefit ratios (CBR) are another standard output of cash-flow analysis, providing simple measures for easily assessing how project worth will be affected by changes in benefits or costs, and thus can be considered as indicators of project risk.
- Cash-flow analysis also provides the basis for carrying out sensitivity analyses, by looking at the isolated or combined effects of cost increases and benefit reductions on NPV and ERR values.
CBA is generally carried out from two perspectives. Financial analysis is undertaken from the point of view of individuals or groups of individuals, in irrigation projects usually the investee or implementation agency which often also is the entity in charge of scheme operation and maintenance (O&M) as well as farmers / farm households and their organizations such as water user associations (WUA). With regard to the implementing agency, the main objective of financial analysis is to assess whether incremental project benefits are sufficient for fully recovering incremental costs (recurrent O&M costs, capital replacement etc.) which is the basic precondition for ensuring the project’s long-term financial sustainability. As far as farmers as the main beneficiaries are concerned, financial analysis mainly comprises gross margins calculations of major project-induced activities and their aggregation in the form of representative farm or household models. This is to assess whether incremental benefits accruing to beneficiaries mainly through increases in the value of agricultural production (improved availability of subsistence food production; cash income from sales etc.) are effectively contributing to the intended improvement of farm and household income as the major objective.
On the other hand, economic analysis looks at project profitability form the point of view of the economy or society as a whole. While financial analysis is to be based on real prices and expenditures (costs) and revenues (benefits) that actually correspond to physical outlays / outflows, the prices used for economic analysis have to be net of any taxes, duties, subsidies or any other transfer payment not entailing any value addition. In addition, economic analysis is based on the concept of opportunity prices for both inputs and outputs, reflecting their economic value in the best alternative use.
Application for Finacial Cooperation (FC) projects and programs
As for other international financial institutions and donor agencies, CBA in FC procedures is applied at different stages of the project cycle.
As far as possible and applicable, a first rough and preliminary assessment of the expected financial and economic profitability is carried out as early as the project identification stage, especially for large-scale, single-standing projects with substantial investment costs. The main objective at this stage is to decide whether it generally makes sense to continue with further in-depth project preparation, particularly from the macroeconomic point of view, by identifying the key parameters impinging on project profitability.
A full-fledged financial and economic CBA is then carried out – usually by specialist consulting firms - as integral element of feasibility studies, which are commissioned by the project implementing agency in close consultation with KfW and provide the basis for project formulation and appraisal. At project appraisal by KfW, there might be a need for adapting the CBA results, especially if there are significant changes or adaptations of the basic project design as identified in the feasibility study, thus requiring a review of project costs and benefits. Or the time that elapsed between the feasibility study and appraisal might at least call for an up-date of the financial and economic prices underlying the initial CBA results.
Finally, CBA is applied for retrospective project evaluation (ex-post evaluation) with a view to assess whether intended results and impacts have been effectively attained.
However, since the early to mid-1990s, there has been a significant shift in FC financing of irrigation projects, from predominantly large-scale, single-standing projects inevitably requiring an ex-ante assessment at appraisal, to open programs focusing to a much larger extent on promoting the development or rehabilitation of small to medium scale projects which are definitely selected only during project implementation based on a set of well-defined eligibility criteria. For the application of CBA, this shift also required an adaptation in terms of timing and procedures, and different situations can be encountered depending on the specific characteristics and design of such open programs:
For open programs with a rather homogenous type of eligible sub-projects of generally small size and rather low total investment cost (e.g. rehabilitation of existing small scale irrigation schemes with similar technical characteristics), CBA might be carried out at appraisal for representative sub-project models, based on well-defined key financial parameters and threshold eligibility criteria (e. g. maximum specific unit investment cost which is usually strongly correlated with profitability). In this case, no further CBA might be required during project implementation as a decision-making tool for the final selection of sub-projects, also considering that the required time input and cost of carrying out in-depth feasibility studies might not be justified for such small scale investments. On the other hand, open program might involve sub-projects with very different technical characteristics, highly variable in scale and thus a much larger range of specific investment costs. In this case, CBA carried out at appraisal provides the basis for deciding on the type of sub-projects for which no further CBA is required during implementation, or which have to be subject of a detailed feasibility study including CBA prior to deciding on their eligibility for funding under the program.
In the standard terms of reference for feasibility studies, KfW generally requires that CBA be carried out based on the well-documented standards and procedures of international financial institutions. As in most other international financial institutions, there are at present no specific KfW manual or operational guidelines on how in detail to apply CBA for FC investments in different sectors or sub-sectors including irrigation development.
Some international (e.g. World Bank and Regional Development Banks) or bilateral donors (e.g. Millennium Challenge Account [2]) are more or less strictly applying minimum requirements of ERR in project selection and investment decision. However, such threshold values are not defined for FC irrigation projects and programs. While the economic ERR of course generally has to be positive, the detailed level considered to be acceptable is decided on a case by case depending on a variety of factors such as: type of financing provided (loan versus grant funds; required counterpart investment co-financing); recipient country’s development status and classification; effective existence of alternative investment opportunities; substantial, large-scale poverty alleviation impacts; or importance of intangible benefits (e.g. social and environmental).
