1. Incorporating mitigation measures into investment projects
2. Methods for evaluating natural hazard risk
Building natural hazard mitigation measures into investment projects consumes financial and technical resources. Therefore, hazard assessments should include an estimate of the damage the project might suffer over its lifetime and a method for estimating the costs and benefits of mitigation measures. Having this information, the planner can compare the costs of mitigation with the losses that might be incurred if hazards are not taken into account.
With the right information it is theoretically possible to achieve an optimum level of risk management, balancing the cost of mitigation against the value of the elements at risk and the probability of a hazardous event. But to reach such an ideal state, changes in the current institutional environment are needed:
- Governments and development assistance agencies must have access to information on natural hazards.
- National and regional planning institutions and sectoral agencies must undertake the necessary natural hazard assessments and formulate policies for non-structural mitigation.
- These policies, in turn, must become a part of the process of identification and preparation of investment projects.
- Donors or lenders must undertake their own review of individual investments from the natural hazard perspective.
- There must be a strong private insurance sector to optimize risk management and efficiency and spread the costs of unavoidable risks across the entire society.
The priority that governments afford natural hazard mitigation is not very high, judging by the increasing losses to major investment projects from storms, earthquakes, floods, and landslides that could have been greatly reduced. There are a number of explanations for this:
- Governments believe that the risk is limited and that the potential savings from mitigation are low.
- Political and financial pressures make it unappealing to take expensive steps now to avoid losses in the future.
- If losses occur, international agencies frequently provide assistance.
- People are resigned: after repeated events, they tend to accept the inevitability of natural hazards, and they lack knowledge about non-structural mitigation.
- The burden of analysis, institution-building, and implementation discourages the effort.
- The political, financial, and social costs of hazard assessment and mitigation may not always be less than the benefits.
- There are some methodological problems in cost-benefit analysis, including the fact that not all costs or benefits related to disasters are quantifiable.
- The costs fall on public institutions that cannot recapture directly the benefit of preventing losses in the future.
For similar reasons international development assistance agencies sometimes neglect natural hazards that may affect projects for which they have provided funds or assistance.
The preparation of investment projects entails six steps: project idea, project profile, prefeasibility analysis, feasibility analysis, engineering design, and implementation. Some institutions require that hazard considerations be built into the last stages of project preparation, usually at the point of engineering design. While such an approach is preferable to not thinking about them at all, it must be emphasized that the earlier hazard considerations are introduced, the more easily they are handled.
As was said in the previous section, Phase II of the development planning process is dedicated mainly to the preparation of prefeasibility and feasibility analyses of investment projects. The following factors can be incorporated relatively easily in the course of these analyses and would improve an evaluation of the project's risk:
- The incidence of natural hazard risks in the study area.
- The incidence of natural hazard risks in the project's market areas.
- The vulnerability of the supply and cost of project inputs to natural hazards.
- The vulnerability of the project's output prices to natural hazards.
- The vulnerability of project-related physical structures and production processes to natural hazards.
- The effectiveness and cost of alternative natural hazard mitigation measures.
The principal components of a study in which natural hazard considerations should be included are listed in the box below.
Structural and non-structural measures can mitigate the effects of natural hazard events. Structural mitigation includes physical measures and standards such as building codes, materials specifications, and performance standards for the construction of new buildings; the retrofitting of existing structures to make them more a hazard-resistant; and protective devices such as dikes. Non-structural mitigation measures typically concentrate on identifying hazard-prone areas and limiting their use. Examples include land-use zoning, the selection of building sites, tax incentives, insurance programs, relocation of residents to remove them from the path of a hazard, and the establishment of warning systems. Figure 7 gives a variety of approaches for reducing the effects of natural hazards.
A strong case can be made for emphasizing non-structural measures in developing countries. All structural measures have a direct cost that must be added to the costs of the project being considered. Given the prevailing reluctance to include hazard considerations in projects, the added cost would certainly be a constraint. This does not mean that non-structural mitigation measures will have no cost, but that in an area subject to flooding, for example, the economic and social costs of measures such as zoning restrictions and crop insurance are likely to be much lower than those of a large-scale flood control system. Moreover, not every mitigation measure should be adopted, only those for which the benefits exceed the costs.
Experience in the region indicates that the activities that have been most affected by natural hazards are large-scale development projects-precisely the kind that could have been oriented differently by the use of appropriate non-structural mitigation measures.
To summarize, in the prefeasibility study, when the technical and economic viability of the project is assessed, the appraisal of mitigation measures should be included. In the feasibility study, when the final appraisal of project alternatives is made, the project options that are best with respect to mitigation measures should be selected. Final economic appraisals should incorporate risk considerations, and the final project design should include optimal structural and non-structural mitigation measures.
A number of issues are involved in deciding whether to consider natural hazard risk in development planning and project formulation, and if so, how to do it.
First, many governments and international financing agencies are unconvinced that natural hazard risk is a proper consideration for project evaluation. The merits of that viewpoint will be examined.
Second, decision-makers are always faced with competing and conflicting objectives, of which reducing the risk of natural hazards is only one. A technique called multicriteria analysis offers a way to decide on the weights to be given to the various objectives, even before projects are identified and formulated.
PRINCIPAL COMPONENTS OF A FEASIBILITY STUDY IN WHICH TO CONSIDER NATURAL HAZARD INFORMATION
a. Determination of market areas
Determination of Size and Location of the Project
a. Current and expected demand
a. Selection of production technology
a. Capital investments
a. Inputs and other materials
a. Financing sources
Figure 7 - EXAMPLES OF APPROACHES FOR REDUCING THE EFFECTS OF NATURAL HAZARDS
Preparing Development Studies and Plans
Community-facility inventories and plans
Economic development plans
Investment project evaluations
Land-use and transportation inventories and plans
Redevelopment plans (pre-disaster and post-disaster)
Utility inventories and plans
Siting, Designing, and Constructing Safe Structures
Reconstruction after disaster
Reconstruction or relocation of community facilities
Reconstruction or relocation of utilities
Repair of dams
Site-specific investigations and hazard evaluations
Strengthening or retrofitting buildings
Siting and design of critical facilities
Discouraging New or Removing Existing Development
Disclosure of hazards to real-property buyers
Financial incentives and disincentives
Lenders' and insurers' development policies
Location of infrastructure
Posted warnings of potential hazards
Public acquisitions of hazardous areas
Public information and education
Public records of hazards
Removal of unsafe structures
Building and grading ordinances
Design and construction regulations
Engineering, geologic, hydrologic, and seismologic reports
Hazard-zone investigations and regulations
Land-use zoning and setback requirements
Preparing for and Responding to Disasters
Anticipating damage to critical facilities
Damage inspection, repair, and recovery procedures
Disaster training exercises
Emergency response plans
Event prediction and response plans
Event preparedness plans
Monitoring and warning systems
Personal preparedness actions
Source: Kockelman, W.J. U.S. Geological Survey.
Third, a project may provoke the passionate support or opposition of particular interest groups. A way must be found to resolve these conflicts to the reasonable satisfaction of all parties if the mix of projects ultimately selected is to be in the best interest of society as a whole.
Finally, once these issues have been resolved, objective methods are needed for evaluating natural hazard risk as an element of overall investment project evaluation. A number of economic appraisal methods are available for this purpose.
Attitudes Toward Risks from Natural Hazards
Should risk be considered in analyzing public sector projects? The private investor tends to avoid risky propositions, but it has been argued that governments should take a risk-neutral stance. Given that the benefits and costs of public projects are spread over a large number of individuals in the society, the element of risk facing each one is negligible. Since risks are widely shared, the argument goes, governments should be indifferent between a high-risk and a low-risk project provided that the two have the same expected net present value.
Compare two multipurpose dam proposals, both with a project life of 100 years. Dam A will be built on geologically stable ground; Dam B will be built on land that has a 70 percent probability of undergoing an earthquake of magnitude 7.5 Richter by 2010. If future risk is not considered, Dam B has a much higher net present value and the country is inclined to select it. But including the correct factors of risk causes its expected net present value to plummet below that of Dam A. It is wiser for the country to select Dam A.
From the point of view of the international bank providing the financing, the government will be obligated to repay the loan whichever dam it builds. Yet the banks are trying to inculcate fiscal responsibility in the planning and execution of their loan agreements. The bank is indifferent between Dams A and B with regard to loan repayment, but should logically prefer Dam A because it is the more fiscally responsible alternative. Banking institutions, however, may place a higher priority on macroeconomic and political factors-specifically, a government's ability and/or willingness to repay loans-than on evaluating each project loan in terms of realistic cost-recovery criteria.
The OAS, through its participation in the Committee of International Development Institutions on the Environment (CIDIE) together with other organizations concerned with the impact of natural hazards on development projects, is fostering a change in this attitude.
Establishing Evaluation Criteria and Priorities
Multicriteria analysis, or multiple conflicting objectives analysis, is a technique for explicitly incorporating societal goals and priorities into the selection of projects. It has been used in environmental assessments and has been gaining increasing acceptance as a means of addressing this complex issue. The analysis entails the establishment of a set of objectives and a sub-set of attributes representing alternative social, economic, political, environmental, and other societal goals which are to be fulfilled by specific projects. The relevant societal groups (government, interest groups, community leaders, etc.) participate in establishing the objectives and attributes and placing discriminatory weights on them. Projects can then be evaluated in terms of their capacity to fulfill the stated goals. Both single-project analysis and project comparisons can be performed. Natural hazard vulnerability criteria can be introduced into the analysis along with the other goals.
It is important to remember that it is not planners but high-level decision makers who will ultimately rule on public investment options. The value of multicriteria analysis, in contrast to traditional project selection methods, is that it forces decision-makers to state their evaluation criteria explicitly. For economic or political reasons, most decision-makers can be expected to give low vulnerability a high priority in project selection.
Multicriteria analysis can be applied throughout the project cycle, from identification of a project idea to feasibility study, but since it is effective in the identification of more desirable projects or project components, its use at the beginning stages of project planning maximizes its benefits.
The construction of a dam for flood control and energy generation may be in the interest of industry and municipal governments, but may be perceived by local farmers as reducing available agricultural land. This is but one example of the many situations in which opposing factions can take perfectly defensible but intractable positions on an environmental issue. The concept of "negative environmental impact," it turns out, can be defined as a conflict between interest groups over the use of a natural good or service. Thus negative environmental impacts can be seen as activities of one sector or sub-sector that cause problems for another. Since development actions are always legitimate in the eyes of their sponsors, the result is a conflict requiring management. Obviously, the sooner a conflict is identified and made manageable, the better. Obvious also is that "sooner" means in the policy and project formulation stages instead of after funds and prestige have been invested in projects.
Sectoral agencies and their planning efforts are not organized either to identify or to manage such conflicts. Many funding institutions are also unable to do so: so much time, effort, and prestige have already been invested in the projects they receive that any attempt to change them is difficult. Furthermore, to work efficiently within their mandates, the institutions generally prefer comparatively large projects in which interest groups that lack political and economic power are seldom fully represented. A process of "environmental planning" that seeks equitable solutions to development problems and at the same time identifies and resolves the conflicts brought on by development is a requisite part of the development process.
Economic Evaluation Techniques
Occasionally a project with natural hazard risk components works its way past this formidable array of impediments. There are a number of methods available for evaluating the hazard components in the economic analysis of the project. One set of these methods can be applied when little hazard information is available; a second set is appropriate when information on probability distributions can be obtained. All the methods can be used in comparing different projects or comparing alternatives within a project.
The methods used when limited information is available can be applied at project profile, prefeasibility, or feasibility levels of analysis. Those using probabilistic information are usually applied in feasibility studies, but may also be used at the prefeasibility stage. In all cases the methods should be applied as early as possible in the project cycle.
(1) Decision Criteria with Limited Information
Four methods of risk evaluation compensate for a lack of information: cut-off period, discount rate adjustment, game theory, and sensitivity analysis.
Cut-off period. This is the crudest procedure for incorporating natural hazard risk into economic analysis. It is used primarily by private investment agencies with a primary interest in capital return. To be economically feasible under the cut-off-period method, a project must accrue benefits that exceed its cost in relatively few years. For very risky projects, such as those at high risk of flooding or landslides, the cut-off period might be set as low as two to three years. The logic of the cut-off-period rule is that, because of the uncertainty of costs and benefits beyond the cut-off date, they should be ignored in determining project feasibility. To determine the length of the cut-off period, a rough idea of the riskiness of the project should be sought during the prefeasibility analysis. The method is appropriate when three conditions are present: (1) few records concerning natural hazard risk are available; (2) the likely hazards are of fast rather than slow onset, and (3) the magnitude of potential disasters is great.
Discount rate adjustment. Adding a risk premium to the discount rate is another ad hoc way to reflect uncertainty in project analysis. A variation of this is to add a premium to the discount rate for the benefits accruing to the project as a result of mitigation, and subtract a premium for the costs, a procedure consistent with the fact that hazards decrease benefits and increase costs. Introducing these premiums into the calculations of feasibility has the effect of giving less weight to increasingly uncertain costs and benefits in the future. This is consistent with the conventional expectation that an investor will require higher rates of return for riskier investments. The analyst using this method must determine an arbitrary risk premium to add to the discount rate. The same kind of hazard information used for the cut-off method is applicable here, and the method is applicable to both slow- and rapid-onset hazards. Again, this information should be available by the prefeasibility stage of planning.
Game-theory approaches. Two strategies from game theory are applicable to the task of introducing risk assessment into the economic appraisal of projects: the "maximin-gain" and the "minimax-regret." Both can be applied at the earliest stages of project formulation, as the necessary minimum information on historical hazardous events and damage becomes available. From this information, it is possible to estimate the comparative benefits of equivalent project alternatives, given varying severities of a hazardous event. The game-theory approaches are best suited to short-term, high-impact hazards for which most/least-damage scenarios can be produced.
Given the possible net benefits accrued under different hazard conditions, the maximin-gain approach seeks the project alternative that will give the highest net return in the worst-case scenario; the selection of a particular project alternative is based entirely on security and is thus very conservative. The minimax-regret takes a different approach by considering the sum of the losses that each project alternative might incur given the probabilities of hazardous events occurring. The alternative with the smallest sum of possible losses when all scenarios are considered is the one that would be selected.
Sensitivity analysis. Using this method, an analyst tests the effect of changes in the values of key project parameters (e.g., halving the income from admission fees or doubling the maintenance cost) on net costs and benefits. To assess the impact of natural hazards, values are changed according to previous hazard information, damage reports, etc., so that the effects of a possible natural event on the economic feasibility of the project can be quantified. With this type of analysis it is possible to determine how much a key parameter can change before the project becomes economically unfeasible. The analysis can also be used to test the effect of mitigation measures.
(2) Decision Criteria with Probabilistic Information
A more rigorous analysis of risk can be made if probabilistic distributions of the key variables (such as net present value, NPV) are available. These distributions can be based on historical information or on the estimates of experts, and ideally include probabilistic information on natural events. NPV probability distributions can be estimated by holding constant a number of variables and repeatedly sampling values for other variables to calculate a large number of possible NPV values, which are then used to approximate the probability distribution of the NPV.
Once the NPV probability distributions for the proposed projects have been prepared, the mean value of the distributions can be compared. However, considering only the average NPV ignores the relative riskiness of the project. To make better use of the risk information in a probability distribution, two methods are available: mean-variance analysis and safety-first analysis.
As the name implies, mean-variance analysis considers not only the mean economic indicator (NPV) for each project, but also the degree of dispersion (or variance) around the mean. As an example, consider three agricultural development projects being evaluated for a flood-susceptible area. Projects A and C have been designed without flood mitigation measures, while Project B foresees the construction and protection of retention basins, stream channelization, and terracing. The probability distributions and expected net present values for the three projects are shown in Figure 8.
Projects A and B both have an expected NPV of US$5 million. However, Project A is vulnerable to floods, and thus could have an NPV of 0. Project B is less susceptible to flood damage, and has a NPV range of US$3 million to US$7 million. Since the mean NPV for the projects is the same but the capital costs of Project B are higher, society might choose Project A. Conversely, society may decide it cannot afford to invest in a large project that might yield no benefits at all in flood years and so choose project B. The comparison of Projects B and C is less evident. Project C has an expected NPV of US$8 million - US$3 million more than Project A - but its variance or variability of returns is also greater. The trade-off between higher expected net returns and greater risk or lower expected NPV and lower risk will have to be carefully considered by the decision-maker.
Safety-first analysis differs from mean-variance analysis in that it focuses on the lower tail of the distribution, seeking to maximize expected NPV with the proviso that it does not fall below a critical level.
Figure 8 - MEAN-VARIANCE ANALYSIS
Source: OAS. Primer on Natural Hazard Management in Integrated Development Planning. (Washington, D.C.: OAS, in Press).
For example, the criterion used to select between projects could be stated as follows: "Choose the project with the highest expected NPV, as long as the probability of its falling below US$1 million is less than 5 percent."
A more detailed explanation of each of these methods is given in the Primer on Natural Hazard Management in Integrated Development Planning.