"AN EXPLANATION OF SENATE DOCUMENT 9711 By
J.
Karl Lee, Chief, Economics Branch Division of Project Development Bureau of Reclamation, Hashington, D.C. For Presentation at 19th Annual ?1eeting Colorado River Hater Users' AssociationOne of the things I miss in my present employment in Hashington, D.
c.,
is the contact that I used to have with water user groups. During the 15 years I was in Boise, Idaho, previous to my transferto Hashington, I frequently had occasion to meet with such groups and to assist them in working out plans to irrigate new land or to develop supplemental uater for lands that were already irrigated. These meetings gave me a deep-seated source of satisfaction, and I enjoyed them very much. All this is to say that I am delighted to have the opportunity to meet with a group of water users again. I consider it a distinct honor to be invited to discuss Senate Document 97 with you.
As a preface to a discussion of Senate Document 97, it may be in order to point out that during the past two decades, the economic analysis of water resource projects has almost grm-m into an exact science. It has attracted much attention and has been the subject of consideration and debate by both individual students and pro-fessional associations.
The term "economic analysis" as I use it encompasses such
subjects as project formulation, benefit-cost analysis, cost alloca· tion, assignment of repayment responsibility or the reimbursability of costs allocated to specific functions, and, finally, the actual
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The requirement for a benefit-cost analysis can be traced back to the 1936 Flood Control Act. The Congress, at that time, authorized the construction of flood control works on a nonreimbursable basis. Since they were to be nonreimbursable, it was necessary that an analysis be made to show that the construction of the project uas in the public interest. Therefore, the requirement was made that a comparison of the benefits and costs be made to be sure that the benefits e::ceeded the costs. Since that time, the requirement has been reconfil'"!Iled on several occasions and extended to other project
functions or purposes.
There is, however, no such actual requirement in the case of Reclamation law; but, nevertheless, we adopted the practice about 1944, and now the use of this analysis is so firmly established in our program that it would be impossible to depart from it.
It is this subject of economic analysis as affected by Senate Document 97 that I am going to discuss with you today. Uhenever I undertake such a discussion, I find myself fac~d i·1ith the question of hoi:·1 much theory I should go into. For a clear understanding of Senate Document 97, it is necessary to understand the related t.heoretical background. Even though the theory is very important, e2~cept for one or two instances I am going to restrain myself today. I am doing this on the assumption that your main interest is ~-,hat Senate Docume.nt says, rather than i~hy it says it. I realize there are certain hazards in omitting the theory, but there are also hazards in trying to cover it in too short a time.
I propose to divide my presentation into three major parts, including historical background, changes resulting from the new procedures, and, finally, the probable impact of these changes on water resource development.
His tori cal Background
In the dying days of the Truman Administraticn--December 31,
1952--Budget Bureau Circular A-47 t·1as issued. So far as l·1ater resource development is concerned, this uas, in my opinion, the most significant Administrative directive on this subject that had bean isGued up to that date. It turned out to be a much discussed and cussed document. It should be noted, hm·1ever, that Budget Bureau Circular A-47 was patter~ed after the report of the 3ubcommittee on Benefits and Costs of the Federal Interagency River Easin Committee which was issued in May 1950. This re:pcrt, which was generally knm-m as the :.green book," was reissued in 1958. It ::;hould also be noted that both the "green book" and the Budget Bureau Circular A-47 were generally accepted and endorsed by many groups, including most specialists in the field of economic theory. Even so, many interests, particularly those involved in irrigation, found the Budget Bureau circular highly unsatisfactory. It was objected to primarily because it limited the benefit-cost
analysis to 50 years and precluded the use of indirect benefits. At its Bakersfield meeting in N0vember of 1960, the National Reclama-tion Associftion devoted an entire session to this subject.
In 1954 some time after the Eisenhower Administration took office, the Departments of the Army and Interior and the Federal Pm·1er
Commission entered into an agreement involving methods of calculating
power benefits and methods to be used in cost allocation. This agree-ment provided for the recognition of tru~es forgone as an element of economic cost. The ta:~es forgone refer to the tcn~es that t·10uld have been paid had the project been developed by a non-Federal entity. This treatment of tru~es fox-gone was also the subject of criticism and continuous confusion.
In recognition cf such criticism, President Kennedy, by his memorandum of October 6, 1961, requested that the Secretaries of Agriculture; Army; Health, Education, and Uelfare; and Interior, acting under the chairmanship of the Secretary of the Interior, undertake a review of the evaluation procedures and report back by December 6. The four Secretaries appointed a working committee, composed of George Selke of the Department of Agriculture; Eugene :Teber of the Corps of Engineers; J. J. Flannery of Health, Education,
and Uelfare; and Henry Caulfield of the Department of the Interior.
Mr. Caulfield was Chairman. This working committee was assisted by various staff members. I sat in on ruost of the meetings.
The l·1orking committee found it impossible to cover all aspects
of economic evaluation by the assigned date of December 6 and,
there-fore, it confined its original consideration to the subjects of project formulation and benefit-cost analysis. It deferred the questions of cost allocation, repayment, and cost sharing or reim-bursability for later consideration. This latter part of the assignment remains to be completed.
Even though the working committee completed its report by December 6, the four Secretaries did not submit their report-until
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May 15 , 196 2. It was , however, approved by the President on the same day. Thus, we nou have new procedures for economic evaluation under the title of Policies, Standards, and Procedures in the Formula-tion, EvaluaFormula-tion, and Reviel·7 of Plans for Use and Development of Hater an_!i Related Land Resources_. For the sake of brevity, it has come to
be referred to as Senate Document No. 970
Perhaps, at this point, it should be noted that Budget Bureau
Circular A-47 was officially l.,i thdral·m on Eay 15, 1962, the same date t.he President approved the neu standardso
Ch.anges Resul. ting from New Procedures
~-Ti th this background, I nm·1 want to turn to the document itself.
As I have already indicated, it is concerned primarily with project
formulation and project justification, or benefit-cost analysis.
Project formulation refers to the principles that are used in
putting multiple-purpose projects together. It is concerned with
such things as what functions should be served, hou much service
should be provided each function, and how big the total project should be. It is particularly aimed at developing techniques for
resolving conflicts for the use of water supplies in those cases
uhere there is not enough to meet all competing requirements.
Senate Document 97 endorsed the same general procedures for project
formulation, which are aimed at mrudmizing net benefits, as
pre-viously provided in Budget Bureau Circular A-47. These procedures
provide that:
1. Separate segments of functions should be added up to the point where the benefits just equal the costs;
2. A demonstration should be made that the benefits for
specific functions could not be produced more cheaply
through single-purpose alternatives; and
3. A demonstration should also be made that the water or storage space ~Till be used for the function that produces the highest benefits.
All this is to be done, of course, within the limits established
by State law and inter-State compacts.
So far as detail of application is concerned, Senate Document
97 did make one important procedural change in project formulation.
In applying the second test--that of alternative cost--it specified
that the alternate should be one which would be physically displaced
or economically precluded, rather than the most economical or most likely previously used. The net effect of this change is to avoid
underdevelopment of dam and reservoir sites.
In connection with project formulation, it should also be noted that Senate Document 97 provided for the recognition of additional functions, such as recreation and area redevelopment as well as miscellaneous effects.
Economic justification, or benefit-cost analysis, involves a
comparison of benefits and costs. In order to make such a comparison,
it is necessary that both the benefits and costs be reduced to
equivalent amounts. This is done through the use of interest rates
The neu document made its most important changes in this area. In addition to the additional project functions uhich I have just referred to, it provided for the use in the analysis of a 100-year period or the economic life, whichever is shorter, in place of the 50 years previously used. At three percent interest, this has the same effect as increasing the project benefits 23 percent.
It also provided for the elimination in Frojects involving hydroelectric poller of the tru: component in the economic cost on the cost side of the ratio. The effect of this change will vary from .r.:ea to area, depending upon the financing involved in the poller benefit analysis, b·'Jt it Hill generally serve to improve the ratio of benefits to costs.
There was another significant, but more subtle, change. This involves the question of ''Jhat is a benefit?" Both the "green book" and Budget Bureau Circular A-47 were based upon the assumption that economic efficiency was the objective of water resource development and that the benefit from such development t·1as the net increment in production over that which could be secured from the possible
alternative uses of ca~ital, labor, and management involved.
This concept might be best illustrated by visualizing an economy
in complete balance with a constant population which is fully employed. If people or capital move from one employment to another, production
in the second activity is gained only at the expense of the first. Therefor~, the gain, if any, is the net difference in the second use compared to the first.
This concept did not recognize economic growth, or that in the long run, water resource development results in neu wealth, new jobs,
and new investment opportunities.
It uas an inherent part of this idea, which has been described as an equilibr~um concept, that the use of limited resources for one activity uould have the same indirect effect on the economy as the use of those resources for another. Therefore, indirect effects were considered as a constant in the equation l'1hich could be eliminated.
It l·1as for this reason that Budget Bureau Circular A-47 provided for the use of only the direct benefits, or profit to the initial user, after recognizing alternative opportunity in determining the justifi-cation for projects. From a national point of viel·1, it was concluded that the indirect effects canceled out.
The neu docur.1ent takes a different approach to this question. Rather than economic efficiency, it recognizes economic development, preservation of resources, and well-being of people as the objectives of resource development. This opens the door to recognizing certain effects of projects as benefitc which were precluded by previous procedures.
Perhaps the significance of this can best be illustrated by
reference to the 160-acre limitation in Reclamation law. The
limitation on size of farm uas directed tm·1ard the provision of
l·1ide-spread opportunity for self-employment, or to the well-being of people, and to economic development. It is a well-known fact
that under most conditions, a farm size of 160 acres or less is
too small to result in optimum efficiency. Thus, on the one hand we uere establishing size of farm to meet one set of objectives and measuring the benefit of irrigating those farms in terms of other ob~ectives. There was a basic inconsistency in these procedures.
The new document partially removed this inconsistency. However, after defining the objectives of water resource development in a
manner consistent with the actual programs, it defined direct benefits
in much the same way as they wer~ defined in Budget Bureau Circular
A-47. It did not define indir.ect benefits for the various functions, which seems to imply they uill not be used; but, subsequently, it recognized that indirect benefits may be included from the national point of view in project formulation. Therefore, I am forced to
conclude that from the national £:Oint of view, the document is not
clear with respect to the use of indirect benefits.
It is clear, houever, that indirect benefits, as well as
intangible effects, can be included in a supplemental analysis which
uill represent the regional or State point of view.
Personally, I regard the redefinition of objectives and the implications of this redefinition in terms of analysis as the most
significant part of the documf:nt. It begins to open the way to
analyses which are consistent l·1ith and r·ecognize the basic objectives
of uater resource development programs.
Another change which is significant, but in which I uill not
go into detail, involves alternative costs. Such costs are used in
use in project formulation. They are used as a measurement of
benefits, particularly for municipal and industrial l·1ater and power. In some instances, they will also be used to measure benefits of water quality control. Alternative costs are also used to determine
the maximum justifiable limit on the cost allocation to any single function. The new procedures remove confusion that has e:dsted regarding the theoretical basis for these alternates.
It is nou clear that the alternative cost, when used as a
maasure-ment cf benefits, should be based upon the alternate l·1hich would most likely be developed in the absence of the multiple-purpose project. Thi.s means, among other things, that such alternates would be hased upon the interest rates and periods of financing that would be
available to any organization proposing a specific development. The use of such interest rates and periods of financing tends to result
in higher benefits for these functions than was sometimes secured by previous procedures. As a mrudmum 1 imi t, however, the benefit calculated in this mmner should not e:cceed the willingness of the consumer to pay.
Before discussing the probable effects of the document, I would
like to make one further observation. Senate Document 97 retainl?d the interest formula previously embodied in Budget Bureau Circular
A-47. The cur~ent int2rest rate under that formula is 2-7/3 percent,
in contrast to a rate of 2-5/8 percent for last fisc:tl year. I e:tpect the rate to go up again ne::t year.
It would be interesting to review the discussion of the working committee on the role of the interest rate in economic evaluation. Two fundamentally different points of view were expressed in those meetings. The first was that the interest rate should measure the alternative opportunity for the use of capital as reflected by the market price of money, or the supply and demand for money. The other was that the role of interest in Federal water resource development projects should e,:press public time preference, or the relative
importance the public places on consuming commodities now in contrast to saving them for future use or for future generations. This
question occupied more of the working committee's time than any other single item. The interest rate prescribed by Budget Bureau Circular A-47 and carried into Senate Document 97 is directed toward
the first approach, or the measurement cf the alternative opportunity
f~r the use of capital.
Implications in Ter~s of Uate.r Resource Development Programs
The adoption of the new procedures will facilitate the water
resource development program. The recognition of additional functions, includir..g r~creation and area redevelopment; the use of the 100-year period of analysis; the elimination of tru~es forgone as an element of economic cost; the r~cognition of intangible and indirect benefits from the regional point of viE:.w; and the clarification of the use
of alternative cost in benefit evaluation, will serve to implement
the program of water resource development.
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At the moment, the only disquieting note on the horizon is the
climbing interest rate. However, as I have indicatad, this is not a
result of change in procedure.
All agencies are proceeding with the implementation of the new
procedureso He in the Bureau of Reclamation issued letter
instruc-tions covering the obvious changes immediately after they were
r~leased. t!e now have in draft form a n2w manual that would implement
all changes 8
One final point I would like to make involves the committees
of Congress. To niy knm·1ledge, they have not as yet had an
oppor-tunity to review spc:cific proposals based upon these procedures, so
we do not know what their reaction l·1ill be. In this connection, it
should be noted that the progra~s of the various agencies are
authorized by different committees; and it is possible that the
individual comreittees will react differently to the new procedures. There are many aspects of Senate Document 97 that I have not touched upon. HoweYer, I have attempted to cover those parts of
it ,-,hich are the most important. On the whole, I consider the
document a real step forward--one that ·will serve the cause of
w.-.-;:er resource development.
