guide2008_en

The first component of the STPR formula is a utilitarian preference; the second one (p) is a pure time preference. The pure inter-temporal preference reflects consumer’s impatience or, more generally, the present value attributed to a future marginal utility. The utilitarian part measures the utility reduction of a marginal Euro caused by increases in real income. This means that in a developing economy where future consumption will be plentiful compared to the present level, individuals will require more compensation for postponing consumption. The social rate of time preference represents, in fact, the minimum return that individuals demand for giving up some of their current consumption in exchange for additional consumption in the future.

All the values in the formula are country specific, especially those of consumption growth (g) that depend directly on GDP, which is quite different across the 27 Member States. Social and individual preferences affect the marginal utility parameter (e); life expectancy and other individual characteristics influence the time preference parameter (p).

If we consider mortality-based statistics, a consistent proxy for the utility discount rate (p), we can observe a death rate close to 1% for the majority of countries.

Estimation of the elasticity of the marginal utility of consumption, e, is less direct and proves to be less homogeneous. A range of values between 1 and 2 is consistent with the evidence provided by behavioural approaches and revealed social preferences based on tax-based data.111

Assuming that income tax structures are at least loosely based on the principle of equal absolute sacrifice of satisfaction, then the extent of progressiveness in the tax structure provides a measure of e.112 The more progressive the tax structure, and thus the greater the extent of social aversion to income inequality, then the larger the value of e.

For the real annual per capita growth rate the best approach would be to estimate a long-term development path for each economy, based on an appropriate growth model. Our estimates are based, however, on past annual growth rates.

In Table B.2, where all these values are summarized, we show a purely indicative SDR for some countries.

Table B.2 Indicative social discount rates for selected EU Countries based on the STPR approach

Source: Our estimates based on World Bank, European Commission and OECD data113.

‘European Economy’, No 2/2005). Where the OECD Economic Outlook 77 database reported different values from those of the European Commission, they have been replaced. Forecasts for the period 2007-2008 (2009-2010) are taken from the Stability or Convergence Programme of member countries, respectively for former European countries and for 2004 entrants. Data for elasticities (e) are taken from the OECD Tax Database (Taxation of Wage Income, 2004) and refer to personal income taxation. The tax rate includes central government and sub-central taxation, plus employees’ social security contributions for single persons without dependants.

209

ANNEX C

PROJECT PERFORMANCE INDICATORS

This annex explains how to calculate and use the main project performance indicators for CBA analysis: Net Present Value (NPV), Internal Rate of Return (IRR) and the Benefit-Cost Ratio (B/C).

The indicators provide concise information about project performance and are the basis for ranking projects. The preferred indicator is the NPV.

The Net Present Value

The Net Present Value of a project is the sum of the discounted net flows of a project. The NPV is a very concise performance indicator of an investment project: it represents the present amount of the net benefits (i.e. benefits less costs) flow generated by the investment expressed in one single value with the same unit of measurement used in the accounting tables.

Financial and economic tables are defined by inflows (I1, I2, I3, …), outflows (O1, O2, O3, …) and balances (S1, S2, S3, … for time 1, 2, 3, …). Inflows and outflows are distributed over a number of years and this could generate problems if we want to sum S at time 1 and S at time 2 and so on. These problems are due to the fact that the marginal utility of one Euro today is higher than the marginal utility of one Euro in year 2. There are two basic interrelated reasons for this:

-there exists a positive opportunity cost of numeraire: a unit benefit is worth less the further it occurs in the future;

-individuals have positive time preferences, because of risk aversion for future events, because income is a function that increases with time, while marginal utility for consumption decreases, and because of pure preferences for present utility compared to future utility.

The aggregation of costs and benefits occurring in different years can be carried out by weighting them. This boils down to applying appropriate coefficients, decreasing with time in order to measure the loss of value of the numeraire.

Such a coefficient is discounting factor at= (1+i)-t, where t is the time, i is the rate of discount and at is the coefficient for discounting a value in year t to obtain its present value.

The Net Present Value of a project is defined as:

Where St is the balance of cash flow at time t and at is the financial discount factor chosen for discounting at time t.

It is important to notice that the balance of costs and benefits in the early years of a project is usually negative and it only becomes positive after some years. As at decreases with time, negative values in the early years are weighted more than the positive ones occurring in the later years of a project’s life. The value of the discount rate and the choice of the time horizon are crucial for the determination of the NPV of a project.

NPV is a very simple and precise performance indicator. A positive NPV, NPV>0, means that the project generates a net benefit (because the sum of the weighted flows of costs and benefits is positive) and it is generally desirable either in financial terms or in economic terms. When different options are considered, the ranking of the NPVs of the alternatives indicates the best one. For instance in Figure C.1 project 1 is more desirable than project 2 because it shows a higher NPV for all the discount rates (i) applied.

211

As IRR rankings can be misleading, and given that the informational requirements for computing a proper NPV and IRR are the same except for the discount rate, it is always worth calculating the NPV of a project. There are many reasons in favour of the NPV decision rule (see Ley, 2007).

The IRR contains no useful information about the overall economic value of a project. This can be illustrated by graphing the NPV as a function of the discount rate (r). Consider Figure C.5 that displays the NPV schedule for two alternative projects. Project A has a substantially higher NPV for any discount rate in the economically relevant range (i.e. for any r less than 30%), yet it crosses the axis to the left of project B, and consequently has a lower IRR—i.e. IRRA = 40% < IRRB = 70%.

Figure C.5 IRR and NPV of two mutually exclusive alternatives

Source: Ley (2007).

Since welfare depends on NPV, not IRR, it is apparent that project A dominates B. For instance NPVA(r) exceeds NPVB(r) by about US$ 1.6 million for a discount rate in the neighbourhood of 10%.

Other shortcomings of the Internal Rate of Return are:

-the sensitivity to economic life: when projects with different economic lives are to be compared, the IRR approach inflates the deliverability of a short-life project because IRR is a function both of the time period and of the size of capital outlay;

-the sensitivity to the timing of benefits: when there are projects that fail to yield benefits for many years, the IRR tends to be lower compared to projects with a fairly even distribution of benefits over time, even though the Net Present Value of the former may be higher;

-the IRR indicator cannot deal with cases in which time-varying discount rates are used. In these cases, the Net Present Value rule allows discount rate changes to be incorporated easily into the calculation.

One advantage of the IRR (under reasonable assumptions) is that it is a pure number and this makes it easier to compare projects that are similar, apart from their size.

Benefit-cost ratio (B/C)

The benefit-cost ratio is the present value of project benefits divided by the present value of project costs:

B/C = PV (I)/PV (O)

where I are the inflows and O the outflows. If B/C >1 the project is suitable because the benefits, measured by the Present Value of the total inflows, are greater than the costs, measured by the Present Value of the total outflows.

Like the IRR, this ratio is independent of the size of the investment, but in contrast to IRR it does not generate ambiguous cases and for this reason it can complement the NPV in ranking projects where budget constraints apply. In these cases the B/C ratio can be used to assess a project’s efficiency.

213

ANNEX D

THE PROJECT’S IMPACT ON EMPLOYMENT AND THE OPPORTUNITY COST OF LABOUR

Labour, like all other project inputs, is valued in the financial analysis with the price to be paid for its use, i.e. the wage. In the economic analysis, however, we should consider the social opportunity cost of labour. The difference between the two values lies in the specificity of the labour market that may overrate (less frequently underrate) the opportunity cost of labour, because of specific market features: legal minimum wage, real wage rigidity, taxes and social contributions, subsidies, monopsony, unionisation, etc. The use of shadow wages accounts for the social cost of using labour, net of all the benefits derived from additional employment and, in principle, no further assessment is necessary of effects in secondary markets.

The social opportunity cost of labour is its alternative use without the project. This means valuing the substitute use of labour time in a particular region. According to the state of the labour market, job seekers and employees will react differently (leave previous employment, take leisure, work on the black market, etc.) and consequently the social opportunity cost will change.

Choosing the appropriate shadow wage then means understanding the social opportunity cost of labour, which depends upon the peculiarity of the local labour market. This is why different types of unemployment imply different formulas for estimating shadow wage rates (SWR).

Competitive labour markets

Even under full employment and in competitive labour markets, shadow wages may differ from market wages because of the social cost of displacing workers from one activity to another. These costs also lead to ‘frictional’ unemployment. For example, in the Lombardy region, the unemployment rate is 3% and typically it is short-term unemployment. The latter comes mostly from the time needed to find the desired post. The labour market functions relatively well and only small corrections are necessary due to project-specific transport, training, relocation and other costs not captured by the wage. Even if these data are project-specific, an average can be inferred from the observation of past projects in the same region. In the case of skilled worker or unskilled worker displacement (i.e. new and former activities are similar), the shadow wage can even be assumed equal to the financial wage. The conversion factor used in Lombardy will be a figure very close to one (e.g. 0.95).

SHADOW WAGES IN IRELAND

In 1999 the Community Support Framework Evaluation Unit (CSF Evaluation Unit, 1999) suggested the use of a shadow price for labour in cost-benefit analysis in Ireland equal to the market wage. Even when a different approach is advisable, the minimum shadow wage applicable is 80% of the market wage. This decision is supported by literature (e.g. Honohan 1996, Honohan 1998) and conditions of full employment (low unemployment and immigration as labour supply). Even if several years have passed, these guidelines are still relevant and, in fact, the Irish labour market now fits even better the conditions necessary for a conversion factor equal or near to one.

Markets with informal activities

In some regions there is both a formal and an informal labour market, often related to urban and rural markets. Informal labour markets can exist also in an urban context with activities in construction or self-employment in micro-business and some illegal jobs. Self-employment in the informal market comes from a lack of opportunities in the formal sector. In these sectors, there are often no formal labour contracts, and unionisation and legal protection of labour are weak. Public projects, in contrast, need to comply with regulations about safety, minimum wage, social contributions, etc. This is the reason why the formal sector usually pays higher salaries.

The lost annual output m of hiring a new employee in a public project can be assessed from the average daily income and number of workers per day in the previous informal occupation. A conversion factor c is then necessary, especially in the rural sector. In fact, CAP (Common Agricultural Policy) keeps domestic prices for some agricultural goods higher than EU border prices. Hence, this conversion factor will be smaller than one. Additional costs of transferring workers (training, relocation, etc.) z are subjected to conversion factor d, which will probably be based on a standard conversion factor. A very simple formula is:

SWR = mc + zd

It is important to remember that informal activities often hide unemployment, particularly in the rural areas.

215

ANNEX E

AFFORDABILITY AND EVALUATION OF DISTRIBUTIVE IMPACT

A key aspect of the financial sustainability of public services is tariff setting. Under a ‘full-cost recovery’ approach114, not only direct costs but also the relevant portion of overheads is included, such as premises, office costs, governance and direction costs, finance, human resources, IT, etc.

Full cost recovery avoids chronic underinvestment in an organisation’s capacity, avoids funding gaps and allows an overall improvement in cost management. This approach is advantageous also for funders as long as it provides enhanced accuracy, transparency and efficiency.

In some countries, however, a cost-reflective tariff reform in industries such as water, electricity or waste disposal may determine sizeable regressive redistribution effects. In fact, tariff setting must also consider social affordability. Obviously, the concern for equity is greater where the local circumstances reveal serious social imbalances, which may be exacerbated by some project features.

Broadly speaking there are three possible methods of analysing distributional issues.

-a more general formula for shadow prices could be used, plugging in the welfare weights in the shadow prices, and thus avoiding further distribution calculations;

-explicit welfare weights derived from social inequality aversion estimates can be attached to the project winners and losers, when shadow prices do not include welfare weights;

-the last approach is to focus on the impact of the projects on the poor, and particularly on the share of income necessary to pay for the service.

In principle, the general shadow pricing formula already includes a social welfare weight called ‘distributional characteristic’ and so it combines efficiency gain and equity loss. In principle it could be properly used as an ex-ante weight of the net benefits of the public project, but this approach is relatively demanding in terms of information requirements. In order to give the reader an idea of the structure of such distributional characteristics, the box below shows relevant values for some goods in two countries.

DISTRIBUTIONAL CHARACTERISTIC FOR SHADOW PRICES

Shadow prices are inversely related to the distributional characteristic r, which is defined as the weighted average of the distribution weights (the share of expenditure on good x in total consumption X by the specific household i).

The weight used to calculate the average (a) is the social marginal utility of income, and under some conditions becomes simply the inverse of income.

Here are some examples of distribution characteristics (r) for various products in the UK:

Brau and Florio (2004) discuss realistic assumptions for price elasticities and the average of distribution weights in order to allow for simple empirical estimation.

114 Defined as: Operational & Management Costs + Depreciation + Return on capital

217