guide2008_en

2.5.1Conversion of market to accounting prices

Figure 2.4 Conversion of market to accounting prices

REAL RESOURCES ECONOMIC FLOWS

Source: Adapted from Saerbeck (1990).

In CBA the objective is to appraise the social value of the investment. Observed prices, as set by markets or by governments, sometimes do not provide a good measure of the social opportunity cost of inputs and outputs. This happens when:

-real prices of inputs and outputs are distorted because of inefficient markets;

-Government sets non cost-reflective tariffs of public services.

These distortions are frequent in some less developed countries, where market opening is limited, and Government tariff policy is constrained by managerial and political issues. Some observed prices, however, can be far from social opportunity costs in any EU country (see examples in the box below and Table 2.9).

EXAMPLE: PRICE DISTORTIONS

A land intensive project, e.g. an industrial site, where land is made available free of charge by a public body, while it may otherwise earn a rent.

An agricultural project that depends upon water supply at a very low tariff, heavily subsidised by the public sector and where output prices are affected by special policy regimes (e.g. under some provisions of the EU Common Agricultural Policy).

An energy intensive project which depends upon the supply of electricity under a regime of regulated tariffs, when these tariffs are below long run marginal costs.

A power plant under a collusive oligopoly regime, which determines a substantial price divergence of electricity prices from long-term marginal costs, the former being higher than the latter: in this case economic benefits could be less than financial profits.

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Table 2.9 Electricity price dispersion for industry and households in the EU, year 2005, €

Source: European Commission, DG ECFIN (2007).

For non-traded items: the standard conversion factor is used for minor non-traded items or the items without a specific conversion factor, while for major non-traded items sector-specific conversion factors are used, based on long run marginal cost or willingness-to-pay. See the example below:

EXAMPLE: SPECIFIC CONVERSION FACTORS BY SECTOR

Land. Assume the SCF is 0.8. Government provides the land at a price reduced by 50% compared with market prices. So the market price is double the current one. The selling price should be doubled to reflect the domestic market and, as there is no specific conversion factor, the conversion factor to turn market price into border price is the standard conversion factor. Conversion factor for land is: CF = 2 * 0.8 = 1.60.

Building. The total cost consists of 30% of non-skilled workforce (CF of non-skilled workforce is 0.48), 40% of imported material cost with import tariffs of 23% and sales of 10% (FC 0.75), 20% of local materials (SCF=0.8), 10% of profits (CF=0). Conversion factor is: (0.3*0.48)+(0.4*0.75)+(0.2*0.8)+(0.1*0) = 0.60.

Machinery. Imported without taxes and tariffs (CF=1).

Stock of raw material. Only one traded material is supposed to be used; the item is not subject to taxes and the market price is equal to the FOB price. CF=1.

Output. The project produces two outputs: A, imported and B, a non-traded intermediate item. To protect domestic firms, the government has imposed an import tax of 33% on item A. The CF for A is 100/133 = 0.75. For item B, as there is no specific conversion factor, SCF=0.8.

Raw materials. No significant distortions. CF=1. Intermediate inputs imported without tariffs and taxes. CF=1.

Electricity. There is a tariff that covers only 40% of the marginal supply cost of electricity. There is no disaggregation of cost components and it assumed that the difference between international and domestic prices for each cost component used to produce a marginal unit of electricity is equal to the difference between all traded items considered in the SCF. CF = 1/0.4 * 0.8 = 2.

Skilled labour force. The market is not distorted. Market wage reflects the opportunity cost for the economy.

Non-skilled labour force. Supply exceeds demand but there is a minimum wage of €5 per hour. Nevertheless in this sector the last employed workers come from the rural sector, where the wage is only €3 per hour. Only 60% of non-skilled workforce wages reflect the opportunity cost. The SCF is used to turn the opportunity cost of non-skilled work into a border price. CF = 0.6*0.8 = 0.48.

EXAMPLE: CONVERSION FACTORS FOR MAJOR TRANSPORT PROJECTS

IN SOUTHERN ITALIAN REGIONS

Within the framework of the 2000-2006 National Operational Programme the Italian Ministry for transport has developed a set of conversion factors for the appraisal of all railway major projects to be implemented in objective 1 regions.

The following table provide some examples:

Source: Italian Transport Ministry (2001).

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2.5.1.2Fiscal corrections

Some items of financial analysis can be seen as pure transfers from one agent to another within society, with no economic impact. For example a tax paid to the Member State by the beneficiary of EU assistance is offset by fiscal revenues to the government. Conversely, a subsidy from the government to the investor, is again a pure transfer that does not create economic value, while it is a benefit for the beneficiary.

Some general rules can be laid down to correct such distortions:

-all prices of inputs and outputs to be considered for CBA should be net of VAT and of other indirect taxes: taxes are paid by consumers to the project, from the project to the Tax Administration, and are then redistributed to the consumers as public expenditures;

-prices of inputs, including labour, to be considered in the CBA should be gross of direct taxes: the employee gets a net-of-tax salary, the tax goes to Government that pays it back to employees, pensioners, and their families, etc., as public services or transfers;

-subsidies granted by a public entity to the project promoter are pure transfer payments and, should be omitted from revenues under economic analysis (i.e. CF=0).

Despite the general rule, in some cases indirect taxes/subsidies are intended as a correction for externalities. Typical examples are taxes on CO2 emissions to discourage negative environmental externalities. In this and in similar cases, it may be justified to include these taxes (subsidies) in project costs (benefits), but the appraisal should avoid double counting (e.g. including both energy taxes and estimates of full external environmental costs in the appraisal). Public funds transferred to economic entities in exchange for services supplied or goods produced by them (e.g. specific subsidies to schools for assisting disabled students) are not to be considered as pure transfer payments and they should be included as revenues in economic analysis, but only after checking if the subsidy reflects the social opportunity cost of the service.

Obviously, the treatment of taxation/subsidy should be less accurate whenever it has minor importance in project appraisal, but overall consistency is required.

In some projects the fiscal impact can be significant, because for example the revenues generated by the project may decrease the need to finance budgetary deficits by public debt or taxation7.

2.5.2Monetisation of non-market impacts

The second step of the economic analysis is to include in the appraisal those project impacts that are relevant for society, but for which a market value is not available. The project examiner should check that these effects (either positive or negative) have been identified, quantified, and given a realistic monetary value (see Table 2.10 for some examples of the assessment of non-market impacts in different sectors).

Appropriate conversion factors applied to the financial values of the operating revenues should already capture the most relevant non-market benefits a project may generate. However, if conversion factors have not been estimated or the project is non-revenue generating, alternative approaches can be used to assess non-market benefits. The most frequently used method is the willingness-to-pay (WTP) approach, which allows the estimation of a money value through users’ revealed preferences or stated preferences. In other words, users’ preferences can be observed either indirectly, by observing consumers’ behaviour in a similar market or directly, by administering ad hoc questionnaires (but this is often less reliable). For the evaluation of some outputs, when the WTP approach is not possible or relevant, long-run marginal cost

of taxation. Under non-optimal taxes, Marginal Cost of Public Funds (MCPF) values higher or lower than unity should be used to adjust the flows of public funds to and from the project. If there are no national guidelines on this issue, MCPF=1 is the default rule suggested in this Guide.

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previously estimated in projects with similar (e.g. geographical) conditions as a proxy for the values of the same goods in the project under analysis. Although some adjustments are often necessary to reflect the differences between the original and the new project, this approach allows the proposer to save research efforts and to have, at the same time, reference values for the environmental benefits (or costs) that arise from the project implementation.

If a benefits transfer is not possible because of lack of data, then environmental impacts should at least be identified in physical terms for a qualitative appraisal in order to give the decision-maker more elements for a considered decision, by weighing up the more quantifiable aspects, as summarised in the economic rate of return, against the less quantifiable ones. Multi-criteria analysis is often useful in this framework (see par. 2.7). A full discussion of the assessment of environmental impact goes beyond the scope of this Guide, but CBA and environmental impact analysis are both required by EU regulations and should be considered in parallel and, whenever possible, should be integrated and consistent.

For a more detailed discussion on methodologies for the monetisation of environmental impacts and how to perform a benefits transfer see Annex F.

2.5.2.1Accounting value of public sector owned capital assets

Many projects in the public sector use capital assets and land, which may be state-owned or purchased from the general Government budget.

Capital assets, including land, buildings, machinery and natural resources, should be valued at their opportunity cost and not at their historical or official accounting value. This has to be done whenever there are alternative options in the use of an asset and even if it is already owned by the public sector. Nevertheless, for some goods there may be no alternative use so that there is no related option value. In that case, past expenditures or irrevocable commitments of public funds are not social costs to be considered in the appraisal of new projects (e.g. ‘sunk costs’).

2.5.3Inclusion of indirect effects

Indirect effects are defined as quantity or price changes occurring in secondary markets. To better understand whether indirect effects can be ignored or not when conducting a CBA, it is important to distinguish between efficient and distorted secondary markets. A distorted secondary market is a market in which prices do not equal social marginal opportunity costs. The existence of taxes, subsidies, monopoly power and externalities is the main cause of distortion of a market.

As anticipated in par. 2.2.2, indirect effects occurring in efficient secondary markets should not be included in the evaluation of the project’s costs and benefits whenever an appropriate shadow price has been given in the primary markets. The main reason for not including indirect effects is not because they are more difficult to identify and quantify than direct effects, but because they are irrelevant in a general equilibrium setting, as they are already captured by shadow prices. Adding these effects to the costs and benefits measured in primary markets usually results in double-counting (see example below).

The circumstances, however, in which indirect effects have to be measured and considered, depend upon the existence of distortions such as taxes, subsidies, monopolistic rents and externalities. These effects may be positive or negative depending on the sign of the distortion in the secondary market and the crosselasticity of the good in the secondary market with respect to the change in the primary market. In a partial equilibrium setting, indirect effects occurring in distorted secondary markets should, in principle, be included in the CBA, because it is only in this kind of market that they may represent important costs or benefits to society. For example, if a government intervention generates changes in the quantities exchanged in secondary markets, the costs or benefits resulting from the increased (or decreased) distortion should be measured. However, in practice, this may be difficult because although distortions are easily identifiable, their sizes are often difficult to measure. In addition, to produce significant changes in secondary markets very large price changes in the primary market are usually necessary, so that the magnitude of indirect effects is often not relevant and their exclusion from CBA accounts results in only a negligible bias.

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FOCUS: ENPV VS. FNPV

The difference between ENPV and FNPV is that the former uses accounting prices or the opportunity cost of goods and services instead of imperfect market prices, and it includes as far as possible any social and environmental externalities. This is because the analysis is done from the point of view of society, not just the project owner. Because externalities and shadow prices are considered, several projects with low or negative FNPV(C) will now show positive ENPV.

The ENPV is the most important and reliable social CBA indicator and should be used as the main reference economic performance signal for project appraisal. Although ERR and B/C are meaningful because they are independent of the project size, they may sometimes involve problems. In particular cases, for example, the ERR may be multiple or not defined, while the B/C ratio may be affected by considering a given flow as either a benefit or a cost reduction.

On the contrary, there might be cases where the use of the benefit-cost ratio is appropriate, for example under the capital budget constraints (see Annex C).

In principle, every project with an ERR lower than the social discount rate or a negative ENPV should be rejected. A project with a negative economic return, uses too much of socially valuable resources to achieve too modest benefits for all citizens. From the EU perspective, sinking a capital grant in a project with low social returns means diverting precious resources from a more valuable development use. For example, from the perspective of Cohesion Policy, a low return investment in a Convergence Objective region means that the project will contribute nothing to achieve the objective.

In some exceptional cases, however, a project with a negative ENPV could be accepted for EU assistance if there are important non-monetized benefits (e.g. for biodiversity preservation projects, cultural heritage sites, landscape). This should be seen as a rare occurrence, and the appraisal report should still specify in a convincing way, through a structured argument, sustained by adequate data, that, in some sense, social benefits exceed social costs, even if the applicant is unable to fully quantify the former. There should clearly be a strong case for such a request for co-financing of a major project.

Table 2.11 Observed ERR in a sample of investment projects sponsored by the EU during the previous programming periods

Source: Authors’ calculations on available DG Regio data. On ISPA projects see Florio and Vignetti (2006). a: 1994-1999 programming period; b: 2000-2006 programming period.

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