Guide to cost benefit analysis of investment project

EUROPEAN COMMISSION Directorate General Regional Policy Guide to COST-BENEFIT ANALYSIS of investment projects Structural Funds, Cohesion Fund and Instrument for Pre-Accession Final Report 16/06/2008 The CBA Guide Team This Guide has been written by a team selected by the Evaluation Unit, DG Regional Policy, European Commission, through a call for tenders by restricted procedure following a call for expressions of interest n 2007.CE.16.0.AT.024 The selected team of TRT Trasporti e Territorio (Milano) in partnership with CSIL Centre for Industrial Studies (Milano), is composed of: - Professor Massimo Florio, Scientific Director, CSIL and University of Milan - Dr Silvia Maffii, Project Coordinator, TRT - Scientific Advisors: Dr Giles Atkinson, London School of Economics and Political Science (UK); Professor Ginés De Rus, University of Las Palmas (Spain); Dr David Evans, Oxford Brookes University (UK); Professor Marco Ponti, Politecnico, Milano (Italy) - Project evaluation experts: Mario Genco, Riccardo Parolin, Silvia Vignetti - Research assistants: Julien Bollati, Maurizia Giglio, Giovanni Panza, Davide Sartori The authors are grateful for very helpful comments from the EC staff and particularly to Veronica Gaffey and Francesco Maria Angelini (Evaluation Unit) and to the participants in the meetings of the Steering Committee, including experts from EIB, JASPERS and desk officers from several Geographical Units at DG Regio The authors are fully responsible for any remaining error or omission ACRONYMS AND ABBREVIATIONS BAU B/C CBA CEA CF DCF EBRD EC EIA EIB EIF ELF ENPV ERDF ERR ESF EU FDR FNPV FRR(C) FRR(K) IPA IRR LRMC MCA MS MCPF NEF NSRF OP PPP QALY SCF SDR SER STPR SEA SF TEN-E TEN-T VAT WTP Business As Usual Benefit/Cost Ratio Cost-Benefit Analysis Cost-Effectiveness Analysis Cohesion Fund, Conversion Factor Discounted Cash Flow European Bank for Reconstruction and Development European Commission Economic Impact Analysis European Investment Bank European Investment Fund Environmental Landscape Feature Economic Net Present Value European Regional Development Fund Economic Rate of Return European Social Fund European Union Financial Discount Rate Financial Net Present Value Financial Rate of Return of the Investment Financial Rate of Return of Capital Instrument for Pre-Accession Assistance Internal Rate of Return Long Run Marginal Cost Multi-Criteria Analysis Member State Marginal Cost of Public Funds Noise Exposure Forecast National Strategic Reference Framework Operational Programme Public-Private Partnership Quality-Adjusted Life Year Standard Conversion Factor Social Discount Rate Shadow Exchange Rate Social Time Preference Rate Strategic Environmental Assessment Structural Funds Trans-European Energy Network Trans-European Transport Network Value Added Tax Willingness-to-pay TABLE OF CONTENTS INTRODUCTION AND SUMMARY 11 CHAPTER ONE PROJECT APPRAISAL IN THE FRAMEWORK OF THE EU FUNDS OVERVIEW 1.1 CBA SCOPE AND OBJECTIVES 1.2 DEFINITION OF PROJECTS 1.3 INFORMATION REQUIRED 1.4 RESPONSIBILITY FOR PROJECT APPRAISAL 1.5 DECISION BY THE COMMISSION 17 17 17 18 20 21 24 CHAPTER TWO AN AGENDA FOR THE PROJECT EXAMINER OVERVIEW 2.1 CONTEXT ANALYSIS AND PROJECT OBJECTIVES 2.1.1 Socio-economic context 2.1.2 Definition of project objectives 2.1.3 Consistency with EU and National Frameworks 2.2 PROJECT IDENTIFICATION 2.2.1 What is a project? 2.2.2 Indirect and network effects 2.2.3 Who has standing? 2.3 FEASIBILITY AND OPTION ANALYSIS 2.3.1 Option identification 2.3.2 Feasibility analysis 2.3.3 Option selection 2.4 FINANCIAL ANALYSIS 2.4.1 Total investment costs 2.4.2 Total operating costs and revenues 2.4.3 Financial return on investment 2.4.4 Sources of financing 2.4.5 Financial sustainability 2.4.6 Financial return on capital 2.5 ECONOMIC ANALYSIS 2.5.1 Conversion of market to accounting prices 2.5.2 Monetisation of non-market impacts 2.5.3 Inclusion of indirect effects 2.5.4 Social discounting 2.5.5 Calculation of economic performance indicators 2.6 RISK ASSESSMENT 2.6.1 Sensitivity analysis 2.6.2 Probability distributions for critical variables 2.6.3 Risk analysis 2.6.4 Assessment of acceptable levels of risk 2.6.5 Risk prevention 2.7 OTHER PROJECT EVALUATION APPROACHES 2.7.1 Cost-effectiveness analysis 2.7.2 Multi-criteria analysis 2.7.3 Economic impact analysis 25 25 26 26 26 27 27 28 28 29 30 30 31 31 32 34 37 38 40 41 43 45 48 52 54 55 55 58 58 61 61 62 63 64 64 65 67 CHAPTER THREE OUTLINES OF PROJECT ANALYSIS BY SECTOR OVERVIEW 3.1 TRANSPORT 3.1.1 Transport networks 3.1.2 CBA of High Speed Rail investment in Europe 3.1.3 Ports, airports and intermodal facilities 69 69 69 69 80 82 3.2 3.3 3.4 ENVIRONMENT 3.2.1 Waste treatment 3.2.2 Water supply and sanitation 3.2.3 Natural risk prevention INDUSTRY, ENERGY AND TELECOMMUNICATIONS 3.3.1 Industries and other productive investments 3.3.2 Energy transport and distribution 3.3.3 Energy production and renewable sources 3.3.4 Telecommunications infrastructures OTHER SECTORS 3.4.1 Education and training infrastructures 3.4.2 Museums and cultural sites 3.4.3 Hospitals and other health infrastructures 3.4.4 Forests and parks 3.4.5 Industrial zones and technological parks 84 84 91 102 105 105 108 110 115 117 117 120 121 124 125 CHAPTER FOUR CASE STUDIES OVERVIEW 4.1 CASE STUDY: INVESTMENT IN A MOTORWAY 4.1.1 Introduction 4.1.2 Traffic forecast 4.1.3 Investment costs 4.1.4 Economic analysis 4.1.5 Scenario analysis 4.1.6 Risk assessment 4.1.7 Financial analysis 4.2 CASE STUDY: INVESTMENT IN A RAILWAY LINE 4.2.1 Introduction 4.2.2 Traffic analysis 4.2.3 Investment costs 4.2.4 Economic analysis 4.2.5 Scenario analysis 4.2.6 Risk assessment 4.2.7 Financial analysis 4.3 CASE STUDY: INVESTMENT IN AN INCINERATOR WITH ENERGY RECOVERY 4.3.1 Project definition and option analysis 4.3.2 Financial analysis 4.3.3 Economic analysis 4.3.4 Risk assessment 4.4 CASE STUDY: INVESTMENT IN A WASTE WATER TREATMENT PLANT 4.4.1 Project definition 4.4.2 Financial analysis 4.4.3 Economic analysis 4.4.4 Risk assessment 4.5 CASE STUDY: INDUSTRIAL INVESTMENT 4.5.1 Project objectives 4.5.2 Project identification 4.5.3 Feasibility and option analysis 4.5.4 Financial analysis 4.5.5 Economic analysis 4.5.6 Risk assessment 129 129 130 130 130 131 132 136 136 137 144 144 144 145 146 148 149 150 156 156 156 158 160 168 168 170 173 175 186 186 186 186 187 189 190 ANNEXES 199 200 205 209 ANNEX A DEMAND ANALYSIS ANNEX B THE CHOICE OF THE DISCOUNT RATE ANNEX C PROJECT PERFORMANCE INDICATORS THE PROJECT’S IMPACT ON EMPLOYMENT AND THE OPPORTUNITY COST OF LABOUR ANNEX E AFFORDABILITY AND EVALUATION OF DISTRIBUTIVE IMPACT ANNEX F EVALUATION OF HEALTH & ENVIRONMENTAL IMPACTS ANNEX G EVALUATION OF PPP PROJECTS ANNEX H RISK ASSESSMENT ANNEX I DETERMINATION OF THE EU GRANT ANNEX J TABLE OF CONTENTS OF A FEASIBILITY STUDY ANNEX D 213 215 220 230 234 240 241 GLOSSARY 244 BIBLIOGRAPHY 248 TABLES Table 2.1 Table 2.2 Table 2.3 Table 2.4 Table 2.5 Table 2.6 Table 2.7 Table 2.8 Table 2.9 Table 2.10 Table 2.11 Table 2.12 Table 2.13 Table 2.14 Table 2.15 Table 2.16 Table 2.17 Table 3.1 Table 3.2 Table 3.3 Table 4.1 Table 4.2 Table 4.3 Table 4.4 Table 4.5 Table 4.6 Table 4.7 Table 4.8 Table 4.9 Table 4.10 Table 4.11 Table 4.12 Table 4.13 Table 4.14 Table 4.15 Table 4.17 Table 4.18 Table 4.19 Table 4.20 Table 4.21 Table 4.22 Table 4.23 Table 4.24 Table 4.25 Table 4.26 Table 4.27 Table 4.28 Table 4.29 Table 4.30 Table 4.31 Table 4.32 Table 4.33 Table 4.34 Table 4.35 Table 4.36 Table 4.37 Table 4.38 Table 4.39 Table 4.40 Table 4.41 Table 4.42 Table 4.43 Financial analysis at a glance Reference time horizon (years) recommended for the 2007-2013 period Total investment costs – Millions of Euros Operating revenues and costs – Millions of Euros Evaluation of the financial return on investment - Millions of Euros Sources of financing - Millions of Euros Financial sustainability - Millions of Euros Evaluation of the financial return on national capital - Millions of Euros Electricity price dispersion for industry and households in the EU, year 2005 Examples of non-market impact valuation Observed ERR of a sample of investment projects sponsored by the EU during the previous programming periods Review of the main analytical items Identification of critical variables Impact analysis of critical variables Example of scenario analysis Causes of optimism bias Simple multi-criteria analysis for two projects Estimated values of travel time savings Recommended values for CO2 emissions Estimated values for casualties avoided (€2002 Purchasing Power Parity, factor prices) Traffic forecast Investment Costs Conversion factors for each type of cost Generalised user costs (€) Consumer’s surplus Gross producer’s surplus (motorway operator) and road user’s surplus Government net revenues Project performances in the scenario analysis Economic analysis (Millions of Euros) - Tolled motorway Economic analysis (Millions of Euros) – Free Motorway Financial return on investment (Millions of Euros) Financial return on capital (Millions of Euros) Financial sustainability (Millions of Euros) Traffic and service forecasts Investment costs Consumer’s Surplus Producer’s surplus Conversion factors for each type of cost Project performances in the scenario analysis Economic analysis (Millions of Euros) - Railway Option Economic analysis (Millions of Euros) - Railway Option Financial return on investment (Millions of Euros) Financial return on capital (Millions of Euros) Financial sustainability (Millions of Euros) Distribution of the investment cost categories in time horizon (thousand of Euros) Sources of finance (current prices) over the time horizon (thousand of Euros): Conversion factors adopted in economic analysis Hypothesis on yearly growth rate – Thousands of Euros Financial sensitivity analysis for FNPV(C) Economic sensitivity analysis for ENPV Sensitivity analysis on the variable growth rates Risk analysis: variable probability distributions Risk analysis: characteristic probability parameters of the performance indicators Financial return on investment (thousands of Euros) Financial return on capital (thousands of Euros) Financial sustainability (thousands of Euros) Economic analysis (thousands of Euros) Distribution of investment cost in the time horizon Sources of finance (current prices) in the time horizon (thousand of Euros) Conversion factors for the economic analysis Critical variables for financial analysis Critical variable for economic analysis 34 35 36 38 39 41 42 44 50 53 56 57 59 60 61 63 67 78 78 79 131 132 132 134 135 135 135 136 139 140 141 142 143 145 145 147 147 148 148 151 152 153 154 155 157 158 159 160 160 161 161 161 162 163 164 165 167 170 171 173 175 175 Table 4.44 Table 4.45 Table 4.46 Table 4.47 Table 4.48 Table 4.49 Table 4.50 Table 4.51 Table 4.52 Table 4.53 Table 4.54 Table 4.55 Table 4.56 Table 4.57 Table 4.58 Table 4.59 Table 4.60 Table 4.61 Table 4.62 Table 4.63 Table 4.64 Table 4.65 Table 4.66 Table B.1 Table B.2 Table C.1 Table D.1 Table E.1 Table E.2 Table E.3 Table E.4 Table H.1 Table H.2 Risk analysis: variable probability distributions Probability distribution for ENPV and ERR Results of risk analysis on Community contribution Financial return on investment (thousands of Euros) Financial return on national capital (thousands of Euros) Financial return on local public capital (thousands of Euros) Financial return on private equity (thousands of Euros) Financial sustainability (thousands of Euros) Economic analysis (thousands of Euros) Main costs as a percentage of sales Cost of labour / Main consumption Conversion factors per type of cost Sales of product C Building costs (thousands of Euros) New equipment costs (thousands of Euros) Results of the sensitivity test Assumed probability distributions of the project variables, Monte Carlo method Probability parameters Financial return on investment (thousands of Euros) Financial return on national capital (thousands of Euros) Return on private equity (thousands of Euros) Financial sustainability (thousands of Euros) Economic analysis (thousands of Euros) Indicative estimates for the long-term annual financial rate of return on securities Indicative social discount rates for selected EU Countries based on the STPR approach Benefit-Cost Ratio under budget constraints Illustrative definition of different market conditions and corresponding shadow wages Example of welfare weights Example of weights for the distributional impact Example of weights for regressive distributional impact Share of expenditure and service exclusion, self-disconnection, or non-payment in some sectors and countries for the bottom quintile Probability calculation for NPV conditional to the distribution of critical variables (€ million) Risk mitigation measures 176 176 176 179 180 181 182 183 185 188 188 190 191 191 191 191 192 193 194 195 196 197 198 205 207 212 214 216 216 217 218 236 239 FIGURES Figure 1.1 Figure 1.2 Figure 1.3 Figure 2.1 Figure 2.2 Figure 2.3 Figure 2.4 Figure 2.5 Figure 2.6 Figure 2.7 Figure 3.1 Figure 3.2 Figure 3.3 Figure 4.1 Figure 4.2 Figure 4.3 Figure 4.4 Figure 4.5 Figure 4.6 Figure 4.7 Figure 4.8 Figure 4.9 Figure 4.10 Figure 4.11 Figure 4.12 Figure 4.13 Figure 4.14 Figure 4.15 Figure 4.16 Figure 4.17 Figure 4.18 Figure A.1 Figure A.2 Figure C.1 Figure C.2 Figure C.3 Figure C.4 Figure C.5 Figure E.1 Figure E.2 Figure F.1 Figure F.2 Figure F.3 Figure H.1 Figure H.2 Figure H.3 Figure H.4 Figure H.5 Project cost spread over the years The project investment cost includes any one-off pre-production expenses The role of CBA in the Commission appraisal process Structure of project appraisal Structure of financial analysis From financial to economic analysis Conversion of market to accounting prices Sensitivity analysis Probability distribution for NPV Cumulative probability distribution for NPV First year demand required for ENPV=0 Waste management systems from waste source to final disposal or removal Chart of the analysis of the water demand Probability distribution of investments costs, Triang (0.8; 1; 2) Results of the risk analysis for ERR Results of the risk analysis for ERR Probability distribution of investments costs Triangular (0.9; 1; 3) Results of the risk analysis for ERR Results of the risk analysis for ERR Probability distribution assumed for the investment cost Calculated probability distribution of ENPV Diagram of the overall scheme for the project infrastructures Results of the sensitivity analysis for FRR(C) Results of the sensitivity analysis for FRR(K) Sensitivity analysis - Inflation rate on FNPV(C) and FNPV(K) Probability distribution of the investment costs Probability distribution of the project ENPV Probability distribution of sales of product C in units – Normal distribution Probability distribution of new equipment costs in Euro – Triangular distribution Probability distribution of ENPV Probability distribution of ERR Demand and supply curves Passengers, goods, GDP, 1990 – 2002 Project ranking by NPV values A case of switching The internal rate of return Multiple IRRs IRR and NPV of two mutually exclusive alternatives Percentage of low income spent on electricity services by low-income consumers Percentage of low income spent on gas services by low-income consumers Main evaluation methods Greenhouse-gas emissions in 2000 Recommended values for the external costs of climate change Discrete distribution Gaussian distribution Symmetric and asymmetric triangular distributions Relationship between utility and wealth for a risk averse society Levels of risks in different phases of a given infrastructure project 19 20 23 25 33 47 48 60 62 62 81 86 96 136 137 137 149 149 150 162 162 169 177 177 177 178 178 192 192 193 193 200 203 210 210 210 210 211 217 217 222 229 229 234 235 235 237 238 10 ... (thousands of Euros) Main costs as a percentage of sales Cost of labour / Main consumption Conversion factors per type of cost Sales of product C Building costs (thousands of Euros) New equipment costs... in the scenario analysis Economic analysis (Millions of Euros) - Tolled motorway Economic analysis (Millions of Euros) – Free Motorway Financial return on investment (Millions of Euros) Financial... source to final disposal or removal Chart of the analysis of the water demand Probability distribution of investments costs, Triang (0.8; 1; 2) Results of the risk analysis for ERR Results of the