Incorporating externalities in the cash flow:

•Internalizing externality means incorporating the positive and 

negative impact of the project in its economic analysis so that it 

becomes the direct cost and benefit of the project

•There are many options available for measuring externalities and

 including them in the project’s economic cash flow.

•Some of them are discussed as:

1.Internalizing the externality via project redesign:

2.Internalizing the externality via compensation

3. Internalization by taxation and subsidies

1. Internalizing the externality via project redesign:

•In case where the project produce a negative externality like environmental degradation, it will often be optimal to redesign the project to reduce such negative impacts or prevent them all together

•For e.g. if the project generates air or water pollution, the project could be redesigned to include antipollution devices to prevent the release of these pollutants in atmosphere or waterways.

•The government may intervene to force the projects to internalize its negative externalities. For e.g. Impose the emission controls by fixing the legal maximum levels of pollutants that may be released by polluting factories.

2. Internalizing the externality via compensation

•In some cases the technology to control the pollution may not exist, or may be so expensive that it far exceeds the economic cost of the pollution prevented. In this case, the only possible solution may be to either stop the production or compensate the sufferer.

•Those receiving the compensation could include local farmers whose crops have been destroyed or local residents who have lost their environmental amenities or utility which they are receiving from clean environment.

•In case where the victims of some negative externality have inadequate property rights, it may not be feasible to internalize the externalities.

•This may make it difficult to devise satisfactory compensation schemes. The problem therefore will be how to directly value positive or negative externality experienced by such groups to that they could be included in the economic cash flow of the project

3. Internalization by taxation and subsidies

•Another important way to internalize the externality is by taxing the consumer goods whose consumption causes large negative externality.

• For e.g. high excise taxes on cigarette and alcohol are designed to discourage the consumption and internalize the high public cost of individual consuming these products.

•On the other hand government often subsidizes and provides free goods and services such as primary and secondary school education and mass inoculation programs, whose consumption creates large positive externalities.

•This is done to ensure that their production is at a socially optimal level.

•Sometimes it is not technically possible or desirable to internalize the externality of a project.

•In such cases it will ne necessary to value the externality directly for inclusion in the project’s economic cash flow even if it will not enter into financial cash flow.

• For e.g. in the case of dam project the project conceivably charges local farmers to use the roads built as a part of project and add the toll collected to the project’s direct benefits.

• However, the project may decide that it is too expensive to setup the toll road.

• In this case it will need to directly value the external benefits created by the road so that these can enter in the project’s economic cash flow.