What is a Cost Benefit Analysis CBA

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What is a Cost Benefit Analysis (CBA)? Part 1
Financial Analysis Article 55
Seminar on CBA for the Cohesion Policy
2007-2013 Slovenia, November 2008
Ralf Aymar, JASPERS
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What is CBA?
A method of comparing the cost of a program
with its expected benefits and The
benefit-to-cost ratio is a measure of total
return expected per unit of money spent
(Wikipedia)
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Objectives (hidden agenda)

• Force beneficiaries to assess alternatives and
  choosing the best feasible.
• Force beneficiaries to do a with and without
  project scenario (what if we do nothing).
• Assess financial sustainability of the promoter
  and project.
• Define financial resources needed to carry out
  the project.
• Assess if the project deserves grant financing.
• Define the exact grant rate and its total amount.
  
• Assess the project impact on the area where it
  will be implemented.
• Assess if the project has a positive economic
  impact.
• Assess the risk of a project.
• In general Serve as major foundation for
  approval decision by DG-REGIO.

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Need for CBA

•  Article 40. The Member State or the managing
  authority shall provide the Commission with the
  following information on major projects
• (e) a cost-benefit analysis, including a risk
  assessment and the foreseeable impact on the
  sector concerned and on the socio-economic
  situation of the Member State and/or the region
  and, when possible and where appropriate, of
  other regions of the Community

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Methodology

• Identify, quantify and monetise (where possible)
  all project's impacts
• Determine the project incremental costs 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

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Components of CBA

• Definition of project objectives
• Identification of alternatives
• Selection of the most suitable alternative
• Financial analysis
• Funding gap and financial profitability
  indicators
• Economic analysis
• Sensitivity and risk analysis

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(No Transcript)
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Components of CBA

• Definition of project objectives
• Identification of alternatives
• Selection of the most suitable alternative
• Financial analysis
• Funding gap and financial profitability
  indicators
• Article 55

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Definition of Project Objectives (1)
General objective
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Definition of Project Objectives (2)
Specific objectives
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Components of CBA

• Definition of project objectives
• Identification of alternatives
• Selection of the most suitable alternative
• Financial analysis
• Funding gap and financial profitability
  indicators
• Article 55

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Identification of Alternatives

• Comprehensive strategy for waste disposal in the
  project area (Master Plan of equivalent)
• Identification of sites and technologies for
  final disposal of waste (landfill sites, waste
  incinerator or alternative facilities)
• Screening of suitability of the possible sites
  and technologies based on qualitative criteria
• Based on the options that pass the qualitative
  criteria, definition of a number of possible
  combinations of facilities and companion measures
  that will fulfil the project objectives (the
  ALTERNATIVES)
• Estimation of all the costs associated with each
  one of the identified alternatives (investment
  OM)

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Components of CBA

• Definition of project objectives
• Identification of alternatives
• Selection of the most suitable alternative
• Financial analysis
• Funding gap and financial profitability
  indicators
• Article 55

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Selection of Most Suitable Alternative

• Verification of consistency with the underlying
  sectoral strategy and/or Master Plan
• Then,
• If overall impact for each alternative is the
  same least-cost analysis
• If impact is significantly different ranking
  through economic analysis (ENPV or ERR)
• In practice, given that impact (objectives, in
  terms of compliance with directives) is
  pre-defined and technological options (i.e.
  landfill vs incineration) pre-screened at the
  level of sectoral strategy and/or Master Plan,
  most projects will fall into the first case.

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Components of CBA

• Definition of project objectives
• Identification of alternatives
• Selection of the most suitable alternative
• Financial analysis
• Funding gap and financial profitability
  indicators
• Article 55

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Financial Analysis (1)

• The purpose is to verify the project financial
  sustainability and to define the project
  financial structure
• Unless revenues and costs can be ring-fenced,
  this requires financial projections for the whole
  system (typical case regional waste management
  projects)
• Financial projections in nominal local currency
  and then translation into euros
• Two sets of projections with and without project
  in order to provide the incremental revenues and
  costs for the calculation of the funding gap and
  the project profitability indicators

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Financial Analysis (2)

• Verification of compliance with Polluter Pays
  Principle
• Consistency with affordability constraints

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Components of CBA

• Definition of project objectives
• Identification of alternatives
• Selection of the most suitable alternative
• Financial analysis
• Funding gap and financial profitability
  indicators
• Article 55

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Funding Gap and Project Profitability

• Only for revenue generating projects (as per Art.
  55 of Regulation 1083/2006
• Calculation based on incremental revenues and
  costs, and normally using constant euros
• See details in Working Document 4 Guidance on
  the Methodology for Carrying Out Cost-Benefit
  Analysis, (August 06) Guide to Cost Benefit
  Analysis of Investment Projects (June 08)
• Financial Profitability is measured by FRR/C,
  FNPV/C, FRR/K, FNPV/K using discount rate of 5
• If project revenues do not cover operation and
  maintenance costs, then the project is not
  revenue-generating.

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The rationale of the EU grant
The EU grant targets the project funding gap.
The Community contribution aims to guarantee a
level of financial profitability so that the
project can be implemented.
FNPV?0
FNPV (without EU contribution) lt0
EU grant
funding-gap method
FNPV/C
FNPV/K
Financial sustainability
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What is the Funding Gap
DIC Discounted Investment cost
Gross self-financing margin (100-R)
Funding gap R
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.
Funding gap rate
Discounted net revenue discounted revenue
discounted operating costs
discounted residual value
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Components of CBA

• Definition of project objectives
• Identification of alternatives
• Selection of the most suitable alternative
• Financial analysis
• Funding gap and financial profitability
  indicators
• Article 55

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Definition of Revenue Generating Project
Article 55(1) For the purposes of this
Regulation, a revenue-generating project means
any operation involving an investment in
infrastructure the use of which is subject to
charges borne directly by users or any operation
involving the sale or rent of land or buildings
or any other provision of services against
payment.
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Categories of RGPs - Art 55(1)
Investment in Infrastructures which involve

• Charges directly borne by users for the use of
  the infrastructure

2. Sale or rent of land or buildings
3. Any other provision of services against
payment
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Identification of Revenues (Art 55(1)
Classification of Cash In-Flows
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Definition of Revenue Generating Project

• Article 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 for
• investments in infrastructure or
• other projects where it is possible to
  objectively estimate the revenues in advance.
• Where not all the investment cost is eligible for
  co-financing, the net revenue shall be allocated
  pro rata to the eligible and non-eligible parts
  of the investment cost.
• In the calculation, the managing authority shall
  take account of the reference period appropriate
  to the category of investment concerned, the
  category of project, the profitability normally
  expected of the category of investment concerned,
  the application of the polluter-pays principle,
  and, if appropriate, considerations of equity
  linked to the relative prosperity of the Member
  State concerned.

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Eligible expenditures
Not eligible according to art. 56, (e.g., paid
before 2007 or not eligible according to Funds
eligibility rules)
Non-eligible expenditure (1)
Net revenue (2)
Not eligible according to art. 55
Total investment cost
Eligible cost
Eligible expenditure to be used as a basis for
calculating the contribution from the Funds
Eligible expenditure (3)
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Three steps for calculating the EC grant

• Find R Max EE/DIC where
• R is the funding gap rate
• Max EE is the maximum eligible expenditure
  discounted investment cost (DIC) less discounted
  net revenue (DNR) (Art 55.2)
• Find DA ECR 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
• Find EU grant DAMax 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)

Source Working Document nr. 4
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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

Source Working Document nr. 4
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Cash flow profile
Source Working Document nr. 4
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Calculating Funding Gap

• 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

Source Working Document nr. 4
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Find Decision Amount (DA)

• Find DA ECR 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 ECR 8078 62

Source Working Document nr. 4
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Calculate EU Grant level

• Find EU grant DAMax 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 DAMax CRpa
• 6275 47

Source Working Document nr. 4
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Factors to consider in calculations

• Reference Period for the Category of Investment

2. Profitability Normally Expected for the
Category of Investment
3. Polluter-pays Principle
4. Equity
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Reference period for the Investment
The reference period or project time horizon
the number of years of the profit economic life,
that is, the time period beyond which the
investment needs to be replaced.
Indicative values
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Normally expected profitability
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Polluter Pays Principle
Managing authorities must also take into account
the application of the polluter-pays principle
the external costs generated by pollution must be
paid to some extent by the polluter.
Example
Waste Treatment Plants. Waste treatment plants
may generate air pollution, soil and water
pollution. This pollution may affect people's
health and values of lands and buildings of the
surrounding areas. Tariffs paid by users must
also include a part proportional to the
consequences of the pollution generated.
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Polluter Pays Principle (2)

• The Polluter Pays Principle implies that those
  who cause environmental damage should bear the
  costs of avoiding it or compensating for it.
• Not applying the principle results in making
  polluters gain and in generating losses for the
  citizens of the area affected
• Applying the principle might increase consensus
  for project, especially when triggers
  prevention/mitigating measures
• Applying the principle have an impact on the
  tariff levels, so affordability issues needs to
  be taken into consideration

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Equity Considerations
When investment financial profitability is taken
into account, equity considerations are concerned
with assessing tariff affordability i.e. the
ability to pay tariffs by users.
HOW?
By setting tariffs as a percentage of average
income or lower group income depending on the
existing income distribution of the served area.
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When not possible to estimate revenues
Article 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 for
(a) investments in infrastructure or (b) other
projects where it is possible to objectively
estimate the revenues in advance. () Article
55(3) Where it is objectively not possible to
estimate the revenue in advance, the revenue
generated within five years of the completion of
an operation shall be deducted from the
expenditure declared to the Commission. The
deduction shall be made by the certifying
authority at the latest at partial or at final
closure of the operational programme. The
application for payment of the final balance
shall be corrected accordingly.
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Refunding
Article 55(4) Where, at the latest three years
after closure of the operational programme, it is
established that an operation has generated
revenue that has not been taken into account
under paragraphs 2 and 3, such revenue shall be
refunded to the general budget of the European
Union in proportion to the contribution from the
Funds.
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Monitoring revenues
Art. 55(5). Without prejudice to their
obligations under Article 70(1), Member States
may adopt procedures proportionate to the amounts
concerned for monitoring revenues generated by
operations whose total cost is below EUR 200 000.
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Reference Documents

• European Commission DG Regional Policy,
  Guide to Cost-Benefit Analysis of Investment
  Projects (2002)
• European Commission DG Regional Policy, Working
  Document 4 Guidance on the Methodology for
  Carrying Out Cost-Benefit Analysis (2006)
• European Commission DG Regional Policy, Guide
  to Cost-Benefit Analysis of investment projects
  (2008)

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• THANK YOU!

aymar_at_eib.org