Economic and Financial Aspects

by Vijay Paranjpye, Ph.D.

The
feasibility study of the Three Gorges Project was conducted by the CIPM
Yangtze Joint Venture (CYJV) with the principal objective of providing
impartial technical input to the Government of China in its
decision-making process, and to provide the basis for securing funding
from international financing institutions. In the study summary, CYJV
states its objective as:

To establish firmly whether the Three Gorges
Project is technically, economically and financially feasible on a
basis acceptable to international financing institutions.¹

The
report was to be comprehensive with respect to costs and benefits
related to flood control, power generation, navigation, resettlement
and environment. Further, the study was supposed to identify the least
cost option from a range of four schemes defined by normal pool levels
(NPLs) at 150, 160, 170, and 180 metres elevation.

CYJV used the technique of cost-benefit analysis
to arrive at the conclusion that for a total economic cost of $3.7
billion,* spread over 18 years, there would be a net benefit-cost ratio
of 1.48. Based on this analysis, CYJV states:

The Three Gorges Water Control Project is an
attractive solution to reduce the flooding and improve navigation on
the Yangtze, and will be a new major source of renewable energy.²

The
detailed and sophisticated analysis of the cost and benefit values
appears to be quite convincing and logical, but as one starts looking
more closely at the underlying assumptions, and at the data on which
the analysis is based, the shortcomings and discrepancies become
apparent.

The shortcomings and flaws in the feasibility
study are of two types: those which are rooted in the conceptual
framework of the cost-benefit analysis, and those which are errors of
omission and of commission in the process of cost and benefit
computations.

The Absence of River Basin Planning on the Yangtze River

One
would expect that for the largest river in China, planning a project on
the scale of the Three Gorges Dam would take place within the context
of a systematic analysis of the entire river basin. Strangely enough,
the study makes no reference to any such analysis even though
hydroelectric dams are hydrologically interdependent; the design and
operation of one dam directly affects that of other projects in the
river basin.

The lack of river basin analysis is even more
surprising in view of the fact that the main river channel of the
Yangtze is joined by more than 700 sizeable tributaries; each having
development potential for hydropower, irrigation, and flood management,
and each project having a different impact on the short-term and
long-term development of this magnificent river.

The CYJV economic and financial analysis begins with the statement:

The Three Gorges Project will be the only economical
way to significantly increase flood protection in the middle reaches of
the Yangtze.³

However, the CYJV report contains no analysis to support this assumption. As well, CYJV states that the feasibility study:

Demonstrates that the project represents the lowest
cost solution for the benefits obtained and explains how project
features can be optimized within a range of alternatives.⁴

But
the so-called alternatives are four different reservoir operating
levels which are intra-project variations and therefore, in the context
of the river basin, they are not real alternatives at all.

The study thus provides a biased technical input
which does not arrive at a comprehensive “optimum solution,” but gives
a contrived justification for securing funding from international
institutions.

Assumptions Underlying the Cost-Benefit Analysis

It
is normally assumed that there is a market price for all the cost and
benefit items to be enumerated and analyzed. Further, that all the
perceived gains and losses can be quantified in economic prices or
shadow prices (i.e., after adjusting the market price by deducting the
tax elements and adding the subsidy components). In the case of values
which are perceived to be significant but carry no market price, or are
not traded, a serious attempt is usually made to construct models of
surrogate markets in which shadow prices may be derived.

In the case of projects like the Three Gorges
Project, this procedure is made difficult because the two major
benefits, flood control and hydropower, do not have competitive market
prices in China. Let us start by examining the benefits of flood
control, which actually translate into economic losses avoided. Losses
due to a major flood are caused not only by the actual physical
destruction due to inundation, but also depend on the pre and post
flood circumstances (or disaster preparedness). The pre-flood warning
system and the evacuation system, for example, would substantially
change the total value of losses. A repeat of the 1931 flood would be
far less serious today because of a vastly superior advance warning and
evacuation system. Similarly, the aftermath of such a flood today would
be much less severe due to a more efficient public health system and
faster means of goods and food transport.

It is important to note that the CYJV analysis
contains a bias that leads to an overestimation of the flood control
benefits of the Three Gorges Dam. First, the CYJV analysis focuses
mainly on losses subsequent to the future rate of economic growth. They
estimate flood damages under a high economic growth scenario to be $2.9
billion, and $1.6 billion for a low economic growth scenario.
Meanwhile, CYJV largely neglects to estimate the effect of pre and post
flood circumstances – both of which will significantly affect the
amount of flood damage. A natural calamity of an equal magnitude in
future, would likely cause less damage than that recorded in the past.

It must be stressed here that the objection is
not to making investments for flood control, but to the arbitrary
quantification of losses avoided, with the intention of justifying a
particular investment project.

Next in importance to flood control are the
benefits that would accrue from the generation of hydroelectricity. To
begin with, let us acknowledge the fact that electricity in China
carries an administered monopoly price. CYJV uses 1.4 cents per
kilowatt-hour as the price of electricity, but this figure is actually
the average revenue obtained from Central China’s power grid and is
lower than the marginal cost of generating power.

Therefore, the present rate of growth in the
demand for electricity, and consequently the CYJV demand forecast of
122,800 megawatts by the year 2010, is based on a low price situation
and is therefore accompanied by a highly inefficient end-use of
electricity, particularly within the industrial sector. In all
likelihood, if the price were higher, the end-use of electricity would
become more efficient and the demand would be lower than CYJV’s
forecast – a scenario which is quite possible as China’s economy
undergoes progressive decentralization. But CYJV chooses to ignore
this, stating:

Whether increases will have a dampening effect on
the future demand for electricity is unknown and has not been accounted
for in the forecasts.⁵

CYJV does not
incorporate this scenario into its calculations of benefits from power
or in the calculation of the financial rate of return. The objective of
calculating the financial rate of return is to determine whether the
authorities could afford to borrow money for the project at commercial
rates of interest. CYJV works out a financial rate of return of 8.9
percent assuming the price of power to be 1.4 cents per kilowatt-hour.
It also claims that this rate could easily be increased to 1.7 cents
per kilowatt-hour or 2.2 cents per kilowatt-hour, in which case the
financial rate of return would be 10.16 percent or 12.18 percent. Here
it is necessary to point out that in China, increasing the price per
unit of power can be done just by a stroke of the pen. It would
therefore be possible to demonstrate the financial feasibility of the
Three Gorges Dam even if it were to cost twice as much. Similarly by
extension, increasing the height of the normal pool level, thereby
displacing more people and raising resettlement costs, could always be
justified, financially, by continuing to increase the price of power.

It is surprising that the CYJV experts should
feel convinced that the Chinese project authorities would not deviate
from the recommended normal pool level of 160 metres, especially when
the dam height of 185 metres easily permits such changes.
Unfortunately, what appears to be a rational benefit-optimizing
exercise on the computer screen, could easily be converted into a
horrendous nightmare for the displaced population. The experts working
on computer terminals often tend to slur over the fact that in
countries like China and India, human lives and their welfare carry a
very low premium when this interferes with the execution of centralized
development megaprojects.⁶

The Discount Rate

In
theory, the rate of discount reflects the social cost of capital
invested, or the opportunity cost of capital. The discount rate also
implies the degree of importance society ascribes to a benefit which
will accrue in the future, as compared to accruing that benefit today.

In China, the standard discount rate used by the
Ministry of Water Resources and Electric Power is 10 percent, which
CYJV applies to the expected costs and benefits over a 62-year period.
The World Bank, one of the potential financiers for this project,
applies a 12 percent rate of discount in its economic appraisals (as it
did for the Narmada dams in India). The CYJV economic feasibility study
should have used the 12 percent rate of discount; why it did not do so
becomes obvious when we see, as CYJV determined, that:

Applying a 12% discount rate causes a 15% decline
in costs and almost 30% decline in benefits. The net project benefits
decline by 59%.⁷

The choice of discount rate is therefore biased.

The Rate of Exchange

CYJV
uses the administered rate of exchange, 3.7 yuan per U.S. dollar, in
its economic analysis of the Three Gorges Project. However, economic
analysts generally agree that the current rate of exchange between the
yuan and the dollar is highly unrealistic, and, like the rouble in the
Soviet Union, the Chinese yuan is highly overvalued. CYJV acknowledges
this:

Indications that the yuan is overvalued come from
several sources. Chinese foreign exchange reserves have fallen quickly
since late 1986, indicating a need to make imports more expensive in
order to conserve foreign exchange. Based on these indications, it has
been suggested that a rate of 5 or 6 yuan per U.S. dollar may be more
appropriate than the existing 3.7 yuan per U.S. dollar.⁸

CYJV also recognizes that:

A drastic drop in the exchange rate to about 6 yuan per U.S. dollar would increase discounted construction costs by 30%.⁹

Recent
changes in China’s economic policy, especially since the 7th Five Year
Plan (1986 – 1990), suggest that such a devaluation of the yuan is
imminent.

The foreign import component of the project cost
is presently estimated to be from 12 to 18 percent, and so, if the free
market exchange rate is applied, instead of the administered rate of
3.7 yuan per U.S. dollar, the financial as well as the economic cost
would rise substantially, thereby making the project less attractive.
The use of the administered rate of exchange of 3.7 yuan per U.S.
dollar to estimate base costs of the project is therefore incorrect,
biased, and results in an underestimation of the total cost in economic
terms.

Time and Cost Overruns

Past
experience in China and around the world has shown that megaprojects
are rarely completed on schedule. Shortage of funds, bottlenecks in
management and phases of construction, multiplicity of decision-making
bodies, and technical problems, all contribute to project delays. Of
course, the principal cause of delay is cost escalation, which can be
as much as 100 percent or more.

The twin problems haunting designers and planners
of megaprojects are cost and time overruns which fuel each other and
are directly related: the greater the cost overrun, the greater the
time overrun, and vice versa. The Gezhouba Dam downstream of the Three
Gorges Project site is a case in point; its cost overrun was estimated
at over twice the initial budget. In China, 2 to 5-year delays in
construction are quite normal, a factor which would make the Three
Gorges Project totally unattractive, economically.

The CYJV sensitivity analysis acknowledges that a
delay in the Three Gorges construction schedule by even one year
(therefore causing a delay in the commencement of power generation)
would reduce net benefits by $460 million or 22.5 percent. Because of
this, CYJV states that “considerable additional construction
expenditures can be justified to maintain the schedule.”¹⁰

Generally,
delays at other dams have caused funds to run short, diverting funds
allocated for resettlement and other development activities to dam
construction. Project authorities usually justify such a diversion of
funds in the name of national interest, while, in actual fact, it
amounts to involuntary patriotism and compulsory sacrifice.

Estimation, Underestimation, and Omission of Project Costs

A
critical assessment of CYJV’s cost estimation procedure is important
because it would indicate the proportion of tax or subsidy element
contained in the financial price. It would also, therefore, expose any
bias in CYJV’s cost estimates. Unfortunately, CYJV deleted a lot of
important information (“pursuant to 20(1) b,c,d, Access to Information
Act”¹¹) from the feasibility study before its release, which
makes it impossible to determine whether the CYJV economic costs (as
against financial) are correct or not. For example CYJV’s costing of
civil and mechanical works, project management costs, commissioning
costs/rates, wage rates, labour costs, and cost of fuel, etc., have
been deleted from the study. Aggregate values do not mean much if the
rates per unit, wage rates of different categories, etc., are not
known. It is precisely in such a situation that bias and arbitrariness
creep in.

Underestimation of Resettlement and Environmental Mitigation Costs

CYJV
assumes, arbitrarily, that environmental studies and environmental
mitigation measures would cost “2% of the construction and resettlement
costs”¹² despite the report’s admission that “detailed cash flows for the environmental costs have not been prepared.”¹³
In other words, the cost of environmental damage is assumed to be fixed
as a proportion of total costs, even though it is widely accepted that
environmental damage has increasing diseconomies of scale.

For example, if a larger dam is built, more
involuntary resettlement in upstream areas would be necessary. This
would cause changes in land use that would accelerate the rate of
deforestation, erosion, and general deterioration of the habitat. This
would increase the rate of sedimentation in the reservoir and reduce
the economic life of the dam. The problem of sedimentation could then
be mitigated in a number of ways: by constructing another dam (or dams)
upstream mainly for trapping sediments – which would only be a
short-term solution, and the economic viability of such a dam project
would also have to be demonstrated; by dredging large masses of
sediment which are expected to settle in the river channel near the
port of Chongqing; by carrying out massive rehabilitation of the
upstream catchment area which would not only conserve the soil, reduce
the rate of water runoff, and reduce the rate of soil erosion, but
would also significantly increase biomass fuel production.

Theoretically, the cost-benefit analysis requires
that all costs necessary and essential for the accrual of project
benefits must be included in the analysis. Therefore, expenditure to
reduce sediment input to the reservoir should form a legitimate part of
the project cost, but CYJV did not include such costs. Nor did CYJV
anticipate exponentially increasing environmental mitigation costs with
increasing scale of dam. Nor did CYJV collect the primary data
necessary to estimate the costs associated with possible downstream
farming and fishing losses, bank erosion and channel shifting.

CYJV also failed to include the cost of
disruption of navigation downstream of Chongqing during the dam’s
construction period. In addition, CYJV reports that the Ministry of
Communication may ask for $270 million compensation but did not include
this in the total cost estimate, whereas the benefits from navigation
after project completion have been calculated in elaborate detail.

Faulty Selection of the CYJV Recommended Project

Forced
resettlement is always traumatic for those people forced to move,
irrespective of the quality of the resettlement plans on paper. Because
of this, planners and designers of megaprojects usually try their
utmost to minimize the number of people to be involuntarily resettled.
But the CYJV analysis, despite its professed objectivity and social
sensitivity, has recommended a reservoir height which maximizes net
benefits rather than minimizing the number of people to be forcibly
resettled, as shown in Table 1. The figures in Table 1 are based on
CYJV’s own data and do not appear in a consolidated form anywhere in
the CYJV study.¹⁴

In Table 1, option A
is overwhelmingly superior to option B in all respects except for net
benefits. Option A has a superior benefit-cost ratio which means a
better return per dollar invested. The project submerges a far smaller
area, avoids the forced resettlement of 188,000 persons, and costs
almost $540 million less. If any group of economists or development
planners were shown these two options, almost all would plumb for
option A. But in spite of the overwhelming superiority of option A, the
experts of CYJV have recommended option B. This proves, quite
conclusively, that the engineering consultants’ attitude towards
resettlement is downright callous.

Further, CYJV wrongly assumes that the cost of
displacement per person remains constant, irrespective of the scale or
nature of displacement. CYJV takes the estimates prepared by the
Yangtze Valley Planning Office for a 175-metre-high dam with
alternative reservoir operating levels, and extrapolates them for the
185-metre-high dam with alternative reservoir operating levels. To
begin with, the Yangtze Valley Planning Office calculation is an
underestimation because many of the non-market values lost by the
displaced persons are left out and the compensation is not based on
‘full replacement’ cost of the assets lost.

Secondly, anyone familiar with the rehabilitation
process of people and communities who have no occupational mobility or
professional expertise knows that an increase in the scale of
displacement causes an increase in per capita resettlement cost. Not
only do the overheads increase, but the external diseconomies of scale
also increase rapidly. For example, when a large number of persons are
settled involuntarily in an area where there is a scarcity of life
support resources – land, water, fodder, and fuelwood – the host
population look upon the new settlers as encroachers, leading to a
serious clash of interests, and social disharmony. In economic terms,
the increase in the scale of displacement leads to a greater than
proportionate increase in internal resettlement costs, as well as the
externalized costs of social disruption and environmental degradation.
For these reasons, CYJV’s extrapolation of resettlement costs, from the
175-metre dam to the 185-metre dam involves a major underestimation.

Another fundamental reason for the increasing
diseconomies of scale is that the most productive lands in the river
basin are located at the bottom of the valleys and will be submerged by
the reservoir. The higher land, which would be used for resettlement,
becomes progressively inferior with higher elevations. The more people
that are displaced, the higher up and poorer the land on which they
must be resettled.

The CYJV estimates also neglect the following factors which would significantly increase the costs of resettlement:

• The impact of sedimentation in the reservoir and the
  consequent rise in river levels near the city of Chongqing, requiring
  still further resettlement.
• The existence of thousands of “non-persons”
  living in the city, without government permission, who would be
  displaced without compensation.
• The uncertainties in the estimates of the
  unregistered population, the natural population growth rate, and
  migration to the reservoir region.
• The risk and uncertainty analysis in the
  CYJV study indicates that the variations in numbers of people who
  deserve compensation, replacement land, jobs, housing, and so on, could
  result in a total cost increase by as much as 29 percent above CYJV’s
  base estimates.

If all of the above costs were
included in the cost-benefit analysis, it may well make the project
non-viable even without unfavourable changes in the future. If further
legitimate costs, such as transmission and distribution losses, which
can be as high as 10 to 12 percent of the total amount of electricity
generated, are deducted from the power benefits, the project would
become even more unattractive.

The Impact of Inflation

The
cost-benefit analysis is totally incapable of handling the impact of a
general price inflation. The World Bank has estimated the annual price
inflation in China to be about 4.5 percent from 1990 to 1995.
Typically, economists wish it away by assuming that inflation affects
the costs and benefits values equally, and therefore, the relationship
between costs and benefits will hold good so long as the analysis is
conducted at constant prices. In the case of the Three Gorges Project,
the CYJV analysis is conducted with reference to mid-1987 prices. Of
course, all analysts are aware of the fact that some prices escalate
faster than others, causing relative price differentials. In China, as
in many other countries, project construction costs (economic) tend to
rise faster than the price of benefits such as the price of power per
unit, or the price of agricultural products. This has a tendency to
reduce net benefits thereby lowering the ratio of benefits to costs.

The Lack of Ex Post Facto Economic Evaluations

The
best procedure for verifying the CYJV base-case assumptions regarding
anticipated cost, benefits, project construction schedules,
distributional impact, environmental impact and chances of mitigation,
success of resettlement and rehabilitation plans, rates of
sedimentation, etc., is to analyze past performance and experience with
similar projects. But unfortunately, the religious fervour with which
the dam project authorities have conducted ex ante studies has been
totally lost once the dam has been built. Therefore, one can find very
few, if any, studies which have elaborately checked out the reliability
of such ‘base-case’ assumptions.

The next best procedure, albeit very unreliable,
is the risk and sensitivity analysis which CYJV conducted diligently.
Yet in the absence of ground-checks in the form of post facto studies,
the risk and sensitivity analysis remains, at best, in the realm of
speculation. Certainly such analysis should not guide important
investment policy decisions.

Financial Capability

At
current prices the project is estimated to cost about $10.7 billion of
which about $1.4 billion are foreign costs. But the total figure could
easily go up to $13.5 billion if all known costs are included.

In any case, China does not appear to have the
financial capability to contribute the necessary funds. CYJV did not
consider China’s shortage of funds as an uncertainty in its risk
analysis, and the failure to do so is a major omission.

Macro-economic Impact and Regional Distribution of Benefits and Costs

One
of the serious flaws in the conceptual framework for the CYJV
cost-benefit analysis is its preoccupation with the question: What
benefit at what cost? It is unable to answer the question: Benefits for
whom, at whose cost? Volume 11 on Regional Economic Impacts tries to
analyze this problem to some extent and, in brief, the following facts
emerge:

• Hubei, the richest of the three provinces that would
  be affected by the project, and with the smallest population, would get
  the maximum share of power and flood control benefits.
• Sichuan, by far the most populous and
  poorest of the provinces that would be affected, would bear the brunt
  of the externalized cost burdens in the form of displaced population,
  loss of agricultural land and what remains of its forested land. The
  city of Chongqing would also have to forego navigation benefits for at
  least 12 years or more, and later it may have to incur a large
  expenditure on dredging the upstream end of the reservoir.
• The project construction expenditure would
  be made almost entirely in Hubei province and the power generated would
  be used by the central China grid and the eastern grid near the
  industrial centre, Shanghai. Similarly, the employment generated would
  be largely in Hubei province, Shanghai, and the northeast region of
  China.

With any megaproject of this kind,
disparity in distribution of costs and benefits is almost inevitable.
It is unfortunate that the poorer of the three regions would have to
bear the external as well as the direct cost burdens whereas Hubei
province should get the maximum benefits.

Conclusion

The impression
of exactitude and precision which is conveyed through equations, ratios
and percentages in the CYJV study is in fact misleading, as they are
based on assumptions which are unrealistic and untenable. Even a small
but plausible change in some of the basic assumptions can make a
dramatic difference in the present value of net benefits or in the
financial rate of return. As well, the number of uncertainties with
regard to costs, both internal and external to the project – for
example, currency exchange rates, national economic growth rate, price
inflation, and construction schedule delays – render CYJV’s cost
estimate an unacceptable basis for a decision which would have such
enormous social and environmental ramifications

Sources and Further Commentary

*The economic cost is the figure used in the
cost-benefit analysis after adjustments have been made for financial
factors such as taxes and subsidies. Financial costs are the expected
costs to the project builder for all project inputs. The financial cost
of the project is $6.6 billion discounted to mid-1987 prices, and $10.7
billion including cost escalation.

*Costs and benefits in US$ millions

Continue to Appendix A

Back to
Chapter 11