EN

Regional Policy

EUROPEAN COMMISSION

2007 - 2013

Cost-Benefit Analysis and

Revenue-generating projects

Francesco ANGELINI

European Commission

DG for Regional Policy – Evaluation Unit

Riga, 23 March 2007

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2

Presentation outline:

• Cost-Benefit Analysis (CBA):Definition, Objectives, and Structure

• Option and Feasibility Analysis

• Financial Analysis and rationale for EU funding

• Economic Analysis

• Sensitivity and risk analysis

• Revenue-generating projects (Art. 55)

• EU grant calculation: a numerical example

Table of contents

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CBA

guidelines

Reg. 1083/06 requires the Commission to provide guidance on CBA methodology

DG REGIO has drawn up a working document aiming:

• to present a set of common working rules to be used in CBA, while allowing for flexibility across MS.

MS to develop their own CBA frameworks

• to outline the method for determining the EU grant (application of Art. 55)

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DEFINITION: CBA is an evaluation methodology to assess public investments projects.

OBJECTIVES: CBA is aiming at identifying

• the best feasible alternative

• the financial resources needed to carry out the project

• the project impact on the area where it will be implemented

• project risks and its financial and economic implications

Definition

&

Objectives

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CBA and major projects under the

Structural and Cohesion Funds

• To assess whether the project is

worth co-financing

– Economic desirability

– Contribution to EU regional policy goals

• To assess whether the project needs

co-financing

– "Funding-gap" method

Why a CBA for major projects?

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The role

of CBA in

the

allocation

of Funds Financial allocations to

MS and regions

Definition of programmes and priorities

Projects

Macroeconomic criteria

CBA and funding-gap method

Microeconomic criteria

Impacts on regional

development

Community Strategic

Guidelines

Socio-economic conditions

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METHODOLOGY

• Identify, quantify and monetise (where

possible) all project's impacts

• Determine the project incrementalcosts and benefits over a given time

horizon

• Find net benefits (benefits – costs) and

discount them to present

• Compute performance indicators and

draw conclusions on the desirability of

the project

CBA

methodology

(in a

nutshell)

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THE STRUCTURE OF CBA

1. Option and Feasibility Analysis: How can an objective be achieved? Are the selected options

feasible?

2. Financial Analysis: How much money is necessary to implement the option selected?

3. Economic Analysis: What is the impact on the area where the project is going to be

implemented?

4. Risk Analysis: Which are the most likely financial and economic results?

CBA

main

elements

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1. OPTION AND FEASIBILITY ANALYSIS

Step 1. Macroeconomic and Sector Context

Step 2. Option Identification

Step 3. Feasibility Analysis

Step 4. Option Selection

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Step 1. MACROECONOMIC AND

SECTOR CONTEXT

It aims at identifying the scenario within

which the project is going to be implemented

In particular, this analysis is aimed at

collecting the information needed to forecast

the demand for the project goods/

services

Macro

economic

context

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DEMAND ANALYSIS

Demand Analysis identifies the need for an investment by assessing

• Current Demand (by using models and actual data)

• Forecasted Demand (from macroeconomic and sector forecasts and elasticity estimates of demand to relevant prices and income)

• Induced Demand (depends on the option chosen)

Demand

Analysis

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Step 2. OPTION IDENTIFICATION

It aims at identifying investment alternatives along with their key features. A crucial information of this identification is the demand inducedby each alternative

At least two out of the three options should always be considered

Do Nothing

Do Minimum Option

Do Something Option

Options

Analysis

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Note that CBA is carried out on an

incremental basis, i.e. on the

difference between

• a scenario with the project (do

something or do minimum)

• and a scenario without the project (do

nothing or, in some cases, do

minimum).

Important implications for projects

expanding existing networks

Incremental

approach

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Step 3. FEASIBILITY ANALYSIS

It identifies the project potential economic

(capital, labour, technology) regulatory and

management constraints and related

solutions.

Step 4. OPTION SELECTION

Based on the results of the feasibility

analysis, the most suitable option should be

chosen.

Option

selection

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Financial

Analysis

2. FINANCIAL ANALYSIS

FINANCIAL

SUSTAINABILITY

FINANCIAL

PROFITABILITY

What is the project financial profitability?

How will the project be financed?

What will be the EU contribution?

The answers to these questions are given by the

financial analysis of the project

FINANCIAL VIABILITY

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Financial analysis

Methodology: Discounted cash flow (DCF)

• Only cash flows are considered (i.e., no amortisation, contingency reserves, etc.) over a given reference period

• Cash flows are discounted to present time

Financial analysis aims at:

• Evaluating the financial profitability of investment and (national) capital

• Determining the appropriate (maximum) contribution from the Funds

• Checking the project's financial sustainability

Financial

Analysis

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Sector Reference period

Energy 15-25

Water & Environment 30

Railways 30

Roads 25-30

Industry 10

Other services 15

Reference period: number of years for

which forecasts are provided in the cost

benefit analysis. It should reflect the

economic useful life of the asset.

A residual value should be considered

where appropriate

CBA time

horizon

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Discounting future cash-flows…• Why?

1€ today is worth more than 1€ tomorrow

(opportunity cost of capital)

• How?

Convert (i.e. discount) future values to present value:

Where:

P = present value

F = future value

r = discount rate

n = number of years

nr

FP

1

Discounting

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…to find profitability indicators

Net Present Value (NPV)

Internal rate of return (IRR)

where CFt is the project cash-flow in year t

n

nn

tt

t

r

CF

r

CF

r

CF

r

CFNPV

1...

1112

2

1

1

1

011

n

tt

t

IRR

CFNPV

NPV

&

IRR

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NPV

&

IRR

Relationship between NPV and IRR

FDR

FNPV

FRR

If FDR then FNPV

FDR < FRR FNPV > 0

FDR = FRR FNPV = 0

FDR > FRR FNPV < 0

Be careful: in some cases FRR may be not

defined or may have multiple solutions.

NPV is generally more reliable.

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Discount

rate

A 5% financial discount rate in real termsis recommended as a benchmark for public investment projects co-financed by the Funds.

Values differing from the 5% benchmark may be justified on the grounds of:

- MS’s specific macroeconomic conditions

- The nature of the investor (public/private).

- The sector concerned (e.g., transport, environment, energy, etc.).

Consistency must be ensured amongst the discount rates used for similar projects in the same region/MS

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Financial Profitability of the Investment

FNPV/C e FRR/C

Measure of investment return regardless the

way it is financed (i.e. regardless the project

financial structure)

Cash-flows to be used:

- Investment cost

- Operating and maintenance cost

+ Revenue

+ Residual value

Financial resources are not taken into account for

the calculation of FNPV/C and FRR/C

Profitability

of the

investment

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Financial Profitability of CapitalFNPVK e FRR/K

Measure of the project return considering its financial structure regardless its investment cost, i.e. profitability to the national “investor(s)”

Cash-flows to be used:

- National capital contributions (no EU grant)

- Operating and maintenance costs

- Loan reimbursement (where relevant)

+ Revenue

+ Residual value

Profitability

of capital

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Financial SustainabilityTo verify that financial resources (project revenues included) can consistently match disbursement year by year

Cash-flows to be used:

- Investment cost

- Operating and maintenance costs

- Loan reimbursement (where relevant)

+ All Financial resources (both national and EU)

+ Revenue

Check if the cumulated (not discounted!) net cash-flows are non-negative for all the years of the time horizon considered.

Financial

sustainability

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Tab.2.5. Calculation of the Financial Internal Rate of Return of the Investment

Discount rate 6,0%

Years 1 2 3 4 5 6 7 8 9 10

Revenues - - - 3,0 3,0 3,0 3,0 3,0 3,0 3,0

Residual value - - - - - - - - - 20

Total Revenues - - 3,0 3,0 3,0 3,0 3,0 3,0 23,0

Operating Costs - - - 2,0 2,0 2,0 4,0 2,0 2,0 2,0

Investment Costs 10,0 25,0 20,0 - - - - - - -

Total Expenditures 10,0 25,0 20,0 2,0 2,0 2,0 4,0 2,0 2,0 2,0

Net Cash Flow 10,0 - 25,0 - 20,0 - 1,0 1,0 1,0 1,0 - 1,0 1,0 21,0

Discounted net C-F 9,4 - 22,2 - 16,8 - 0,8 0,7 0,7 0,7 - 0,6 0,6 11,7

FRR/C -10,2%

FNPV/C -33,95

Financial Profitability

Financial

profitability

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Financial Sustainability

Financial

sustainability

Tab.2.4. Financial Sustainability Table

Years 1 2 3 4 5 6 7 8 9 10

National Contribution 3 8 9

EU Contribution 7 17 11

Private Equity 0 0 0

Revenues - - - 4,0 4,0 4,0 4,0 4,0 4,0 4,0

Residual value

Total Inflow 10 25 20 4 4 4 4 4 4 4

Operating Costs - - - 3,0 3,0 5,0 3,0 3,0 3,0 3,0

Investment Costs 10,0 25,0 20,0 - - - - - - -

Total Outflow 10 25 20 3 3 5 3 3 3 3

Net Cash Flow 0 0 0 1 1 -1 1 1 1 1

Cumulates Net C-F 0 0 0 1 2 1 2 3 4 5

Check that for each year there is enough cash to cover investment or operating cost

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The rationale of the EU grant

Rationale of

EU grant

The EU grant targets the project “funding gap”. The

Community contribution aims to guarantee a given

level of financial profitability so that the project can be

implemented.

FNPV (without EU

contribution) <0

FNPV⇨0

“funding-gap” method

Financial sustainability

FNPV/C FNPV/K

EU grant

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What is the “Funding-Gap”?

Funding gap rate:DIC

DNRDICR

Funding

gap

The “funding gap” is the part of the investment cost

which is not going to be paid back by the project net

revenue. The funding-gap rate is the complementary

to 100% of the gross self-financing margin.

* Discounted net revenue = + discounted revenue

– discounted operating costs + discounted residual value

DIC: Discounted Investment cost

DNR: Discounted Net Revenue*

Funding gap

R%

Gross self-financing

margin

(100-R)%

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3. ECONOMIC ANALYSIS

It aims at assessing the project economic

desirability by

– Determining economic performance

indicators (ENPV, ERR, B/C)

– Considering non-monetised

economic impacts

The economic analysis is done from the

point of view of the whole society, while

the financial analysis is done from the

point of view of the owner(/operator)

Economic

Analysis

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Rationale of the economic analysis

The economic analysis is done at shadow (accounting) prices:

• project’s inputs should be valued at

their opportunity cost (e.g. opportunity

cost of labour, depends on whether the

worker was previously employed or

not)

• the outputs should be valued at

consumers’ willingness to pay (e.g.

WTP for improved water quality in

rivers).

Economic

Analysis

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• Financial (observed) prices may be

distorted or even absent; they do not

always reflect opportunity cost and

willingness to pay.

• Starting from the financial analysis cash-

flows we need to find the economic cash-

flows:

– Fiscal corrections

– Externalities corrections

– From market to accounting (shadow) prices (correction of other market distortions)

Economic

Analysis

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Fiscal corrections

• Indirect taxes: should not be included in

the economic analysis (e.g. VAT)

• Direct taxes: economic prices should be

gross of direct taxes (e.g. wages)

• Taxes intended to correct externalities

can be included but avoid double

counting!

• Pure transfer payments should be

omitted (e.g. social security payments)

Fiscal

corrections

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Externalities correctionsTo determine costs and benefits which

are not considered in the financial

analysis

There are two main approaches:

1. “Revealed preference methods”: infer

values from observed behaviour (e.g.

hedonic price, travel cost methods)

2. “Stated preference methods”: directly

asks individual to state their willingness-

to-pay (e.g. contingent valuation). But

risk of possible biases

Externalities

corrections

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Other corrections• Even after fiscal and externalities

corrections prices may still fail to reflect opportunity costs or willingness to pay because of market distortions (e.g. monopolies, barriers to trade, minimum wages, etc.)

• Need to take possible distortions into account (e.g. use border prices or marginal costs, shadow wages, etc.)

• The shortcut to compute shadow prices is to applying conversion factors to financial prices.

Shadow

prices

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The social discount rate

• The social discount rate should be based on long-term economic growth and pure time-preference rate

• Indicative benchmarks for the social discount rate for the Cohesion countries : 5,5% (3,5% for the others).

• Consistency must be ensured in the use of social discount rates across projects

The

social

discount

rate

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The economic analysis resultsUsing the economic cash-flows expressed at

shadow prices and the social discount rate it is

possible to determine:

• Economic net present value (ENPV): a

project is desirable from a socio-

economic point of view if ENPV is

greater than 0

• Economic rate of return (ERR): should

be greater than the social discount rate

• Benefit-Cost ratio (B/C): should be

greater than 1

What

decision

rule?

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CBA

and

Funding-gap

method

Funding-gap method

Economic Analysis

Financial Analysis

EU grant

ENPV > 0

Go ahead: the project leads to a more efficient allocation of resources.

PR

OJ

EC

T S

EL

EC

TIO

N

DE

TE

RM

INA

TIO

N O

F E

U C

O-F

UN

DIN

G

ENPV > 0, FNPV ≈ 0

The project is economically desirable and financially viable

ENPV < 0

Reject: the region is better off without the project.

FNPV < 0

Provide financing: the project needs the contribution from the Funds in order to be feasible .

FNPV > 0

Reject financing: the project can be implemented without the assistance from the Funds.

2000-2006

Filling the funding-gap

2007-2013

Co-financing the funding-gap

Ince

ntives

Tra

de-o

ffs

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4. SENSITIVITY & RISK ANALYSIS

It should be included in the CBA to deal with

uncertainty.

This is done in two main steps:

1) Sensitivity analysis: aims at identifying the

project’s critical variables.

2) Risk analysis: by assigning appropriate

probability distributions to the critical variables,

expected values for the financial and economic

performance indicators can be estimated.

Sensitivity

and Risk

Analysis

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Sensitivity analysis• Apply a given percentage change (e.g. 20%)

to the project disaggregate variables (e.g. raw

materials, land, wages and not just aggregate

“investment cost” variable)

• Determine the critical variables, i.e. variables

to which the performance indicators (e.g.

FNPV/C or ENPV) are most sensitive

• A possible rule of the thumb is to consider a

variable critical when a 1% variation in the

variable results in

– 1% change (one percentage point) in the IRR;

– 5% change in the NPV.

Sensitivity

analysis

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• Interesting information is given by the

variable’s switching value. This is the

percentage change in the variable that

would make the NPV change its sign

(e.g. might find that if travel time savings

decrease by, say, 15% then ENPV goes

to zero)

• However, the sensitivity analysis alone

does not give any information about the

probability of occurrence of a given

change: need risk analysis!

Sensitivity

analysis

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Risk analysis• Need to assume probability distributions

for the critical variables identified in the

sensitivity analysis

• Probability distributions can be discrete

or continuous and can be based on

objective (e.g. time series) or subjective

(e.g. experts opinion) data

• Once the probability distributions for the

critical variables are defined it is

possible to determine the project

expected performance indicators

Risk

analysis

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• Can also determine profitability

indicators’ probability distribution from

which can derive useful information for

decision-making (e.g. what is the

probability that the ENPV is negative?)

• All the performance indicators to be

reported as the CBA results in the

application form should be the expected value which comes out of the risk

analysis

• Indicatively, the inclusion of

contingencies in the eligible cost should

be justified by the risk analysis results

Risk

analysis

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Revenue-generating projects

Article 55 Reg. 1083/2006

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Article 55

Revenue-generating projects

• The “funding-gap” method is confirmed as the basis for calculating the EU grant for revenue-generating projects.

• However, in order to modulate the contribution of the Funds to take net revenues into account, Reg. 1083/2006 provides for the modulation of the eligible expenditure (Art. 55).

Note that under the 2000-2006 programming period the co-financingrate is instead modulated.

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2000-2006

Cohesion Fund

Structural Funds

85%

CR

100% DNR/DIC15%

75%

CR

100% DNR/DIC25%

40%

Commission "interpretation"

Regulation ceilings

Modulation of co-financing rates

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2007-2013

Structural Funds and Cohesion Fund

Modulation of eligible expenditure

M€ 80

100% DNR/DIC

EU grant

EU grant as a function of the project’s gross self-financing margin assuming a total eligible cost of M€ 100 and a priority axis’ co-financing rate of 80%

Single methodology to be applied to all Funds

EU grant is fully linear w.r.t. projects’ net

revenue

Increased leverage effect (no more filling the

funding gap)

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Art. 55 – Scope of application

• It applies to all projects (not just major projects!)

• It applies to investment operations which generate net revenues through charges borne directly by users.

• It does not apply to the following cases:– Projects that do not generate revenues (i.e.,

for which users are not charged)

– Projects whose revenues do not fully cover the operating costs

– Projects subject to state-aid rules

Art 55

Scope of

application

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Article 55

Art. 55(2)

"Eligible expenditure on revenue-

generating projects shall not exceed the

current value of the investment cost

less the current value of the net

revenue from the investment over a

specific reference period […]“

• Note that only the project funding-gap is

eligible for co-financing

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In the 2007-2013 programming period

we have to distinguish between two

dimensions of eligibility:

– “Legal eligibility” according to art. 56:

eligibility according to MS and

specific Funds eligibility rules

– “Financial eligibility” according to art.

55: the part of the investment cost

covered by net revenue is not eligible

Two

dimensions

of eligibility

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What is “eligible expenditure”?

Non-eligible

expenditure

(1)

Net revenue

(2)

Eligible

expenditure

(3)

To

tal in

vestm

ent co

st

Not eligible according to

art. 56, (e.g., paid before

2007 or not eligible

according to MS or Funds

eligibility rules)

Not eligible according to

art. 55 Elig

ible co

st

Eligible expenditure to be

used as a basis for

calculating the

contribution from the

Funds

Eligible

expenditure

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Some specific issues linked to Art. 55

• Affordability

• Polluter Pays Principle

• Normally expected profitability

• Public Private Partnership

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Polluter

Pays

Principle

Affordability

Equity (affordability):

• The Commission encourages MS to provide

information about affordability ratios.

• Tariffs should ideally be levied up to the

affordable level

Polluter Pays Principle:

• The Commission encourages MS to adopt

charging systems which "internalise" the

environmental costs of pollution.

• No "modified" funding-gap formula is

proposed.

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Normally

expected

profitability

Financing

scheme

Expected

Profitability

Mainly loans

(+ low grants) Loans + Grants Public grants

Medium – high

Airports

Energy

Tourism

Telecom/ICT

Industrial estates

and business parks

Productive

investments

Medium Solid waste

Ports

Medium- low

Tolled roads

Public transport

Water supply and waste water

treatment plants

Low

Railways

Health care

Education

Research,

innovation and

technology

transfer

None Roads without

tolls

Flood prevention

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Public Private Partnership

• The financial discount rate may be increased

to reflect a higher opportunity cost of capital

to the private investor.

• Under several types of PPP schemes (e.g.,

BOT, DBFO) the owner of the infrastructure

(typically the public partner) is different from

the operator (the private partner). Then a

consolidated financial analysis (owner and

operator) should be used for the

determination of the funding gap.

PPP

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The determination of the EU grant

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Determine

the EU

grant

3 steps

1) Find R = Max EE/DIC where

R is the funding gap rateMax EE is the maximum eligible expenditure = discounted investment cost (DIC) less discounted net revenue (DNR) (Art 55.2)

2) Find DA = EC*R where

DA is the decision amount, i.e. “the amount to which the co-financing rate for the priority axis applies” (Art. 41.2 – Major Projects)

EC is the eligible cost

3) Find EU grant = DA*Max CRpa where

Max CRpa is the maximum co-funding rate fixed for the priority axis in the Commission's decision adopting the operational programme (Art. 53.6)

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Determination of the EU grant:

a numerical example

Assume we appraise a major project:

• Total investment cost M€ 100, of which

M€ 80 eligible cost.

• Priority axis' maximum co-financing

rate (Max CRpa) is equal to 75%

• 5% financial discount rate in real terms.

• A 20-year time horizon is used

Assumptions

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Cash-flow

profile

M€ - 2007 constant prices

Year Investment

costs Operating

costs Revenues

Residual value

Net cash flow

2007 25 - - - - 25

2008 25 - - - - 25

2009 25 - - - - 25

2010 25 - - - - 25

2011 - 2 4 - 2

2012 - 2 4 - 2

2013 - 2 4 - 2

2014 - 2 4 - 2

2015 - 2 4 - 2

2016 - 2 4 - 2

2017 - 2 4 - 2

2018 - 2 4 - 2

2019 - 2 4 - 2

2020 - 2 4 - 2

2021 - 2 4 - 2

2022 - 2 4 - 2

2023 - 2 4 - 2

2024 - 2 4 - 2

2025 - 2 4 - 2

2026 - 2 4 5 7

Total 100 32 64 5

Total (Discounted)

89 18 36 2 -68,93

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1

Find the

Funding gap rate

(R)

1) Find R = Max EE/DIC where

R is the funding gap rate

Max EE is the maximum eligible expenditure = DIC -

DNR (Art 55.2)

Eligible expenditure EE = DIC-DNR = 89-20 = 69

Funding-gap rate R = EE/DIC = 69/89 = 78%

Discounted values

Undiscounted values

Total investment cost 100

of which eligible cost (EC), say, 80

Discounted investment cost (DIC) 89

Discounted net revenue (DNR) = 36+2-18 20

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2

Find the

Decision Amount

(DA)

2) Find DA = EC*R where

DA is the decision amount, i.e. “the amount to which

the co-financing rate for the priority axis applies” (Art.

41.2 – Major projects)

EC is the eligible cost

Funding gap rate R = 78%

Eligible cost EC = 80

"Decision amount" DA = EC*R = 80*78%= 62

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3

Find the

EU grant

3) Find EU grant = DA*Max CRpa where

Max CRpa is the maximum co-funding rate fixed for

the priority axis in the Commission's decision

adopting the operational programme (Art. 53.6)

Decision amount DA = 62

CRpa = 75%

(Maximum) EU grant = DA*Max CRpa =

= 62*75% = 47

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For more details on CBA and the

grant calculation method see:

• DG REGIO CBA guidehttp://ec.europa.eu/regional_policy/sources/docgener/guid

es/cost/guide02_en.pdf

• DG REGIO working document n° 4

on CBA indicative methodologyhttp://ec.europa.eu/regional_policy/sources/docoffic/2007/

working/wd4_cost_en.pdf

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Thank you for your attention!