7.1 Cost-Benefit Analysis of the Direct Effects of a Transport Investment

If, for instance, the project will lead to rail freight flows of 300 and to passenger flows of 100—both from a zero baseline, then this rail freight will come partly from a diversion on the same route from road to rail, partly from a diversion from another rail route further to the north, and partly from the creation of new trips. To keep the analysis of the South Trans-Andean Railway in Argentina simple, the computations assume that rail passenger flows are all pure diversions from road transport and that the project will increase congestion around Neuquén. Table 7.1 provides quantity changes for these three alternative types of routes, based on these assumptions.

Valuing Quality Changes. Valuation requires details on how the new service will create time savings and change other costs of travel. These changes will vary depending on the type of flow (diverted from another mode on the same route, from another route, and so on). These costs include the following:

■ The value of time for passenger transport ■ A generalized measure of freight transport costs, including driver salaries, the cost of trucks, and so on ■ Potential improvements in reliability ■ Accounting for other nonmarketed outputs such as changes in carbon dioxide (CO2) emissions and in safety ■ Possible changes in pricing power by the freight industry.

TABLE 7.1 Cost-Benefit Analysis of the Direct Effects of a Transport Investment Quantity change Value per unit Total net benefit

Freight volume (number of units) ■ Diverted from road: 100

■ Diverted from northern route: 100 ■ Newly created: 100 Net benefit per unit freight ■ Diverted from road: $125 − $75 = $50 ■ Diverted from northern route: $100 − $85 = $15 ■ Newly created: [($125 + $75)/2] − $75 = $25 Total freight user benefit ■ Diverted from road: 100 x $50 = $5,000 ■ Diverted from northern route: 100 x $15 = $1,500 ■ Newly created: 100 x $25 = $2,500

Total freight user benefit: $9,000

Passengers (number) ■ Diverted from road: 100 Net benefit per passenger: $100 − $50 = $50 Total passenger user benefit: $100 x $50 = $5,000

Environmental benefit

Freight: ■ Diverted from road: 100 ■ Diverted from northern route: 100 ■ Newly created: 100 Passengers: 100

Other benefits:

Safety impact ■ Expected lives saved: 1 Congestion effect ■ Time lost: −300 $5 − $2 = $3 $2 − $2 = $0 $0 − $2 = –$2 $5 − $2 = $3 100 x $3 = $300 100 x $0 = $0 100 x (−$2) = −$200 100 x $3 = $300 Total benefit from reducing CO2: $400

Value per life: $500

Value per unit time: $ 1 Safety value: $500

Congestion value: −$300

Total net benefit per year

$ 14,600

Source: Duranton and Venables 2018.

To avoid complications, it is assumed that road transport is competitive. The cost of rail per unit of freight is $75, compared to $125 for road transport. As reported in table 7.1, the social benefit for freight that is diverted from road transport on the same route is given by the transport saving per unit of $125 − $75 = $50. Multiplied by the number of units (100), this yields a benefit of $5,000. Note that this calculation is careful to consider only the additional effect of the new rail line.

For the freight that is diverted from another route, assume that the cost with the new route is $85. This is more than $75 because, for the sake of the example, it is assumed that this freight must eventually be carried to a destination further north. The cost of freight on its current route is $100. For this freight, the additional benefit from the new rail line is thus only $15 per unit ($100 − $85). The full calculation of the social benefit for this second source of quantity change is again reported in table 7.1. Note that the social gain per unit for this second source of freight traffic is much less than for the first one: $15 instead of $50. Therefore, it is important to distinguish between quantity changes along alternative routes.

Turning to the freight that did not exist previously, there was no demand at a cost of $125. At a cost of $75, the flow is 100. At one extreme, there is a local producer that was willing to send a unit of freight at a cost of $125. This producer now faces a cost of freight of $75 and makes a surplus of ($125 − $75) = $50 thanks to this new rail line. At the other extreme, there is a producer that would have never sent anything at a cost of $125 but is willing to send a shipment at a cost of $75. Even at this much lower cost, the benefit for this producer is minimal. If it is assumed that the distribution of gains from freight shipments are uniformly distributed, the benefit from this new line is [($125 + $75)/2] − $75 = $25 per unit, on average. Summing the user benefits for the three different sources of freight yields an aggregate user benefit of $9,000.

The fact that CO2 emissions are less with rail than with road transport also needs to be taken into account. Assume, for instance, a cost of CO2 of $5 per unit of freight with road and $2 with rail. This implies a CO2 saving of ($5 − $2) = $3 per unit for freight that is diverted from the road. For the freight that is diverted from the northern rail route, the calculation reported in table 7.1 is different because it was already using a less carbon-intensive mode. The analysis assumes that there is no change in CO2 emissions for this second source of freight. As for the newly created freight, it comes at a cost of $2 per unit because that output was not shipped before.

For passengers, if the cost of road travel was $100 and falls to $50 with the new railroad, the benefit is $5,000, to which can be added a benefit to society of $300 from reduced CO2 emissions. If rail is also safer, and reduces the number of casualties by, say, 1, valued at $500, that yields another benefit of $500. Because the project would increase congestion in the city of Neuquén, the cost of this increased congestion—say, $300—would also need to be factored in. In all, users are gaining $9,000 for freight and

$5,000 for passengers, or $14,000 in total. Adding ($100 + $300) = $400 from the reduction in CO2 emissions, $500 from the decline in accidents or casualties, and $300 from the decrease in congestion yields an aggregate benefit of $14,600 for the direct effects of the project.

While this example is hypothetical, it yields several lessons. First, systematic thinking is needed to ensure that all the key dimensions of the issue at hand are covered, even in a setting requiring estimation only of direct effects. Second, a lot of background work is needed to get the best possible predictions for the quantity changes. The numbers in table 7.1 are for the sake of illustration only. Real projections must be carefully and painstakingly constructed. In particular, displacements and rerouting must be considered, as they affect the valuation.10 Third, the valuation exercise is more challenging because it requires obtaining some prices that are difficult to assess. It also requires some careful thinking to avoid double counting. Imperfect market competition in road transport could complicate these valuations even more. Some of the gains from rail freight would be completely offset because monopoly road transporters have such high profit margins.

While table 7.1 sketches what the direct effects of a project such as the South Trans-Andean Railroad may look like, it falls short of a full cost-benefit analysis. It not only leaves out the analysis of indirect effects, but it is static and considers only one time period. In practice, infrastructure projects are long lived, and annual calculations must be made for every year. This implies making forward projections over a long period of time. A residual value for the project also needs to be assigned for the years that extend beyond the time horizon over which projections can be made. Lastly, and fairly obviously, the cost of the project needs to be factored into any cost-benefit analysis. Construction costs and future benefits can then be compared by calculating present values; the key issue here is which discount factor to use.

Illustration 2. Valuing Indirect Effects: The Northwest Road Development Corridor in Argentina The Northwest Road Development Corridor project, a $300 million loan by the World Bank to Argentina, seeks to make direct transport improvements and offer wider (that is, indirect) strategic benefits by promoting economic development in the Northwest of Argentina, thereby narrowing regional inequalities and delivering inclusive growth. The challenge for an appraisal of such a project is to provide estimates of what the project can be realistically expected to achieve (quantity effects), and the social value that it can create for the country (valuation). This example illustrates the issues surrounding appraisal of indirect effects.

Identifying Indirect Quantity Effects. Place-based policies seeking to change the investment decisions of firms and households must consider the set of complementary

conditions described in chapter 6. These include the region’s policy environment (such as infrastructure, tax, special zones, labor, housing, education), natural geography (such as climate, resource endowment, remoteness), and the business ecosystem (such as cluster of firms, skilled workers, market size). Each of these elements—policy, geography, and the business ecosystem—must reach sufficient standards if a region is to attract private investment. This creates a “weakest link” problem because failure in any one element can deter investment.

It follows that there are threshold effects and discontinuous responses of private investment to policy levers that make it inherently difficult to predict the effect of policy. For example, improving transport in a place may have no effect if other conditions are not present. Or, if other conditions are met, better transport may push the place across a threshold and trigger a large private investment response. These issues are particularly important in the context of lagging regions, which are not likely to have the dense network of related firms, skilled workers, access to capital, or large markets that make a place attractive for investors. This can create a “low-level equilibrium trap”: A region finds it hard to attract investment because there is little investment there. This sort of first-mover problem or coordination failure cannot be solved by the market, which prompts policy makers to intervene. This situation is, however, challenging for policy because private investment decisions depend not only on policy, but to a large extent on other private sector investors. In this process, expectations are crucial. What matters is whether these conditions are expected to be in place over the duration of a long-lived investment.

A further point on the assessment of quantity changes concerns the issue of displacement, as discussed in Principle 4 in chapter 6. If policy succeeds in bringing an increase in activity in some place and some sector, is this simply displacing other activities?

Determining the Social Value of Indirect Quantity Effects. Start with the benchmark case in which markets are efficient such that the net value of indirect quantity effects is zero. The analysis can be illustrated by thinking of effects in the labor market. If the economy is efficient, then the value of labor is the same in all its uses. Creating new jobs simply moves (displaces) workers—and capital—between uses and is therefore of zero value; additional output in the new use is worth just the same as output lost in the alternative. Extending this reasoning to the context of a transport improvement, think of an improvement that induces private investors to bring a previously unutilized area of land into economic use. Does this yield additional value over and above that of the direct transport cost saving (on initial and generated trade)? If there are no market failures, then the answer is no, because the “benchmark” case applies (for details, see Duranton and Venables [2018, 2020]).

Indirect quantity effects generate value (over and above that of direct effects) when they offset or correct market failures. Such failures arise when some of the benefits (or costs) of an activity are not taken fully into account in private sector decision-making (such as productivity spillovers, environmental damage, or coordination failures). Market failures also arise if private sector decisions are based on market prices or wage rates that differ from social valuations—leading, for example, to unemployed labor.11 In the presence of market failures, private sector decision-making will not lead to an efficient set of activity levels in the economy. Thus, there are potential gains from policy that can expand activity in the region—although this may be difficult to achieve in practice.

To reiterate the main points that can be drawn from this example: First, indirect effects are valued only in cases in which there is a real market failure. Remoteness is not a market failure, and it is not efficient to devote resources to attracting activity to a place that is intrinsically high cost. Second, market failures must be carefully diagnosed, and policy should be targeted at addressing these failures. A good test is, why should creating a job in a lagging region be more valuable than creating one in a booming region? Third, caution is required about the likelihood of success because multiple conditions must be met for policy to achieve a sustained improvement in the economic performance of a lagging region. Fourth, while this volume focuses on economic arguments, the wider social and political considerations are as important, if not more so. Deprivation in lagging regions is a reason for intervention, as is the need to mitigate political tensions that can arise. However, policy should rest on a careful diagnosis of the problem and assessment of the likelihood of achieving the stated objectives.

Illustration 3. Overall Project Evaluation: The WECARE (Western Economic Corridor and Regional Enhancement) Program in Bangladesh The WECARE Program seeks to transform 260 kilometers of national highway from Bhomra in the southwestern corner of Bangladesh to Hatikumrul in central Bangladesh into an economic corridor. In doing so, it will turn an old two-lane single carriageway into a state-of-the-art and climate-resilient four-lane dual carriageway. Phase 1 of the program will also improve 600 kilometers of roads connecting rural villages, upazilas (subdistricts), unions (collections of wards or villages), and about 32 rural markets (referred to as growth centers) involving storage, grading, sorting, packaging, collecting, and selling facilities for selected agriculture value chains. Per the DurantonVenables framework, the WECARE project in Bangladesh makes the case for policy intervention by identifying complementary conditions and market failures.

Complementary Conditions. The program is critical for unlocking regional connectivity. The western region is serviced by the country’s two largest overland trade gateways and the Mongla and Payra ports. The program follows a multiphase programmatic approach by building smart highways that install optical fiber cable and deploy fiber

optic internet, provide innovative solutions to reduce congestion, enhance road safety, and improve the overall operation of the network. Private financing in transport and logistics infrastructure and services will also be explored through the program in future phases, including the possible use of the World Bank’s credit enhancement tools (guarantees) to enhance the capacity of the government to raise commercial financing for road sector development.

Market Failures. Unique geographic conditions in the region—lack of transport connectivity and climate risks—present challenges in developing and maintaining the transport system such that private investment will not occur on its own. The intervention on the main corridor is thus based on true market failure. That is, high transport costs and road safety risk in an environment where roads are subject to high climate risks, rather than remoteness of the region, will inhibit the geographic potential for becoming a transit hub in South Asia.

In addition, the local (predominantly agrarian) communities are not able to fully benefit from enhanced connectivity because of poor access of farms to markets, and the lack of agrologistics facilities for processing produce (grading, sorting, packaging, and so on). To overcome these challenges, the project follows a “market-centric” approach to generate local impacts by first identifying high-priority rural markets (designated as growth centers) that need to be connected to the main corridor and then identifying key rural roads that connect these rural markets to the main road and farms to the selected rural markets. The interventions aimed at rural markets and road connectivity are also premised on an identified market failure: that is, high transport costs and missing logistics that cannot be fully internalized by users because of a collective action problem.

In general, to support any place-based policy intervention, one or both of the following statements should be false: (1) the project is of social value only if it is commercially viable (that is, profitable); and (2) if the project is profitable, then the private sector will undertake it, so there is no need for public support. Arguments that challenge the first statement essentially concern quantity changes, while those that challenge the second statement concern valuation. The western region is prone to disasters and vulnerable to climate change. More than 50 percent of the roads are exposed to varying levels of flooding and heavy rainfall. Although the WECARE intervention supports areas that have low economic potential, it carefully picks places with complementary conditions (such as more developed markets for investment) within these regions.

A background assessment yields three main findings related to the quantity and value changes attributed to this project. First, pervasive congestion substantially increases trucking costs. The project is likely to increase the transport mobility for passengers and freight by 11 percent and reduce logistics costs for key value chains by 5 percent. Second, higher congestion leads to road crashes that are about three times higher in this region than in the rest of South Asia and cost about 2 percent to 3 percent

of GDP. The project is expected to reduce road crash fatalities by 50 percent. Third, the corridor is expected to generate 7 million person-days of new employment and help the country recover from the COVID-19 (coronavirus) pandemic. Thus, the intervention is expected to have a modest indirect effect in the near future.

Illustration 4. The Critical Role of Complementary Policies: The Cautionary Tale of the Trans-Kgalagadi Road Project Connecting Botswana and Namibia Botswana’s Trans-Kgalagadi Road Project serves as something of a cautionary tale that underscores the importance of strategic planning, thorough diagnoses of local challenges and conditions, and the execution of complementary actions and investments.12 The overarching aims of the Trans-Kgalagadi Road Project were to “reduce transport costs, enhance social and economic integration of South-Western Part of Botswana and facilitate economic integration with Namibia” (AfDB 2011, 7).

The project centered on the construction of 221 kilometers of bitumen highway to replace what was previously an unpaved stretch of road between Sekoma and the Namibia-Botswana border crossing at Mamuno. Construction of the highway was completed and the road opened in 1998. With time, however, it became clear that the road was underutilized and that traffic volumes were well below those envisioned in the early stages of the project. Concern that the highway “could potentially develop into a ‘white elephant’” (AfDB 2011, 18) inspired authorities to undertake a comprehensive review of the project in hopes of developing some understanding of why the anticipated outcomes of the project had not yet materialized.

The review revealed that the underutilization was attributable, at least in part, to “non-physical barriers to the cross-border movement of people and goods” (AfDB 2011, 19), none of which were considered or factored into the planning process. That is, even though the road was designed as a facilitator of economic integration between Namibia and Botswana, authorities failed to recognize that the cross-border movement of people and goods was inhibited as much by institutional barriers—including customs and unnecessarily complex transit procedures—as it was by the previous lack of physical connectivity. As a result, the project did not include measures or initiatives to increase the ease with which goods and people could cross the border between Botswana and Namibia—a shortcoming that would prove particularly consequential for the economic impact of the highway.

It was only after a series of complementary investments were made and initiatives undertaken—including both physical measures such as the establishment of tradefacilitating “one-stop border posts” and less tangible ones, including institutional reforms and the establishment of bodies (the Trans-Kalahari Corridor Management Committee) to oversee and manage the corridor to transform the highway into a “transit corridor”— that the project began to impel and increase interregional cooperation and integration, promote trade, and yield broader development outcomes (AfDB 2011, 19–21).