Three Gorges Probe

Chapter 12 – 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

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