COST-BENEFIT ANALYSIS AND INCENTIVES IN EVALUATION: PUBLIC- PRIVATE PARTNERSHIPS Open Days 2006 Brussels 9-12 October 2006 Professor Massimo Florio University of Milan

RESEARCH ON CBA AND INCENTIVES Good project appraisal is done by people with their own incentives, within organizations that wittingly or not set these incentives.Both environments of project appraisal, the intellectual and political-organizational, are keys to the quality of selection overall. This needs to be most seriously considered by those who manage and create this environment (Little and Mirrlees, 1994)

CBA THEORY IN A MULTI- GOVERNMENT SETTING Six type of agents: Individuals: consumers,workers,tax-payers, private shareholders Private firms: profit maximizers Public firms: fully under governments control Regional planners/evaluators National planners/evaluators The supra-national planner/evaluator

What planners do? EC fixes some rules of the game and allocated funds Regions and MS fix production plans Select policies (not projects) Given their constraints solve a planning problem in terms of a set of shadow prices Hire ex-ante and ex-post evaluators Co-finance selected projects, assign performance bonuses

What evaluators do? Gather project data Make forecasts Use shadow prices (they must be price taker!) as given by the planner Check is the project passes the CBA test: positive shadow profits Suggest project approval to the planner

Many players By definition there are three planning problems (European, national, regional) Then there are then three sets of shadow prices, and three evaluations The planning problem is nested because approval and co-financing needs consensus of the three players

How bottom-up evaluation works Regional National EC Each evaluator selects profitable projects:intersection gets approval

Information shared If all players share information, regional evaluators can use other planners shadow prices to find the intersection Typically a small set of shadow prices is needed: SDR, SWR, major types of tangibles inputs and outputs, some intangibles (value of time, statistical life, environment externalities), welfare weights Under PPP information is not shared

Information: uncomplete and asymmetric Planners are uncertain about empirical shadow prices, how much do they need to spend in generating the right signals? Evaluators know less than the private firms managers, but more than the planners:how much evaluation effort is needed? Policy-makers and managers may wish to capture evaluators: what is the prize of honesty in evaluation?

A SIMPLE EXAMPLE OF INCENTIVE MECHANISM FOR CBA STEP 1 - The EU planner signals that the financial discount rate FDR is 4% and the economic discount rate SDR is 4% as well. Other shadow prices are computed and disseminated by national/regional planners. A budget is allocated for acceptable regional infrastructure projects. - The regional planner appoints an ex ante evaluator, establishes a benchmark ERR* in excess of the EU SDR, and asks management teams to offer projects

STEP 2 -The ex - ante evaluator says that: - one project has an expected (i.e. risk adjusted) financial rate of return of real 2% based on costs declared by the proponent (FRR/C), hence the financial FNPV is negative - the expected economic rate of return EERR is 8%, hence the economic ENPV is positive, using the EU shadow prices (and to simplify, the test is passed at regional shadow prices as well)

STEP 3 - The regional planner offers a co-financing grant in two parts: a funding gap part plus a linear incentive, if the EERR exceeds a sector/regional benchmark e.g. ERR* =6% - The funding gap element is a fixed share of the net present value of total costs, for example 80%. - The regional planner promises to pay an economic performance bonus to the projects equal to 50% of the difference between using a 4% EFRR and 8% EFRR. - The total grant is committed to be : 0.8 FNPV(4%)+ 0.5*0.8 (FNPV(8%) - FNPV(4%))= 0.4 FNPV(4%)+ 0.4 (FNPV8%), i.e. a weighted sum of the eligible net costs, using the expected financial and economic rates of return - Payment is in two parts: first the 0.8 FNPV(4%) is disbursed. The incentive element is set aside.

STEP 4 The contract is assigned. Operations start. Some time later an independent ex-post evaluator is sent by the planner, and a re-estimated economic rate of return RERR is computed. If the RERR>EERR >ERR*>SDR the performance bonus is paid. If the ERR*<REER <EERR the bonus is decreased. If REER<ERR* the bonus is cancelled. In my example, if the RERR is below 6% the performance bonus is cancelled. The bonus is co-financed by the EU funds and shared by the regional planner and the project team in some pre-established way:social profit/risk sharing.

ADVANTAGES OF THE INCENTIVE BASED MECHANISM - There is a performance bonus for socially deserving projects, and the incentive to manipulate financial and economic project analysis go in opposite directions - Lack of realism in ex-ante evaluation incurs in a penalty, because the economic performance bonus will be decreased ex-post - If the bonus is shared between the management team and the regional planner, the incentive works for both players. The ex ante evaluator gets a reputation bonus ( or penalty) for realism (or for optimism bias) - If the ex-post evaluator is a rating agency on behalf of the EU there will be a more transparent learning process on regional/national/sector projects success and failures.

CONCLUSIONS - CBA should be the language of a common learning mechanism. Planners should adopt policies, offer shadow prices and hire ex-ante evaluators. Evaluators must act as shadow price takers. - Ex ante evaluators, regional planners, project team should be given financial incentives to out-perform economic benchmarks, and independent ex-post evaluators, on behalf of the EU, should rate projects and observe success and failures. - Research/experiments are needed on how to agree shadow price rules among players, and on incentive mechanism design.