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2008/SOM3/EC/SEM/012 Agenda Item: 9

Cost “and” Benefit Analysis in Transport Infrastructure Public-Private Partnerships Projects

Submitted by: Chile

Seminar on Best Practices in Regulation and Promotion of Efficiency in Transport

Infrastructure Facilities Lima, Peru

15-16 August 2008

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Cost “and” Benefit Analysis in Transport Infrastructure

Public-Private Partnerships Projects

August 15-16, 2008Lima,Peru

Sergio A. Hinojosa

Seminar on Best Practices in Regulation & Promotion of Efficiencyin Transport Infrastructure Facilities

Cost “and” Benefit Analysis

1.Methodology2.General Approach

• Elegibility Criteria (Check List)

• Expanded SNPV (Real Options)• Value for Money (VFM) and Public

Sector Comparator• Multi-criteria Decision Making

Agenda

2

Methodology

• Conceptual analysis based on literature review for i) cost-benefit analysis ii) real options and iii) PSC

• Pseudo “ Action Research”• In depth interviews• Principal component analysis [In progress]

Countries

1. Costa Rica2. Peru3. Chile4. Mexico

1. Tabasco2. Aguascalientes3. Chiapas4. Distrito Federal5. Yucatán6. Guanajuato7. Oaxaca8. Veracruz

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General approach to Cost “and”Benefit analysis methodology forDecision Making in PPPs projects

¿ privateNPV> 0?

Is not executable withpublic funds

YES

NO

Public Infrastructure Needs

¿ social NPV > 0?

Private Solution[ market]

¿ Is Eligiblefor PPP ?

NO¿ Expanded

socialNPV> 0?

NO

TraditionalPublic

Investment

NO

VFM = Public provision cost adjusted

by riskPrivate provision cost adjusted

by risk-

YES

YES

YES

Dec

isio

n-M

akin

gP

roce

ss

4

¿VFM > 0? PPPPrivate Provision

NO

Costo de la provisión pública ajustado por riesgo

Costo de la provisión privada ajustado por riesgo-

¿User charges?

PartialPPP

NO PurePPP

Public Provision(RPP)

¿Multi-CriteriaDecisionAnalysis?

NO

VFM = Public provision cost adjustedby risk

Private provision cost adjustedby risk-

YES

YES

YES

Dec

isio

n-M

akin

gP

roce

ss

PPP Eligibility Criteria (25)

“Expanded” Cost-Benefit Analysis =NPV+Real Options

Development and execution of theproject under standard public

modality

Procurement modalityevaluation (VFM – PSC)

Multi-Criteria Decision Analysis

1

2

3

4

Development and execution of theproject under public-private partnerships

modality

Decision - Making Process

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Eligibility Criteria for PPP Schemes[25 Check List Criteria]

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Eligibility Criteriafor PPP projects

Institucionalidad

TechnicalAspects

Institutionality

Business TransactionModel

Public Finance andBancability

Competition andIndustrial

Organization

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8.Presence of a project leader

7.Existence of previuos studies at a feasibility level or an advancedprofile

6.The level of complexity of the engineering design of constructionsites and/or architecture of the building or facilities

Technical aspects of the project

5.Joined – Up in the public sector

4.Degree of institutional innovations that provoke

3.Probability of being reachable in political times [Lame Duck]

2.Making the federal, state or municipal government developmentplans suitable

1.Making the federal, state or municipal government strategies suitable

Institutional Aspects

25.The components of physique technology ( specialized equipment)

24.Existence of suppliers or the asset is very specific

23.Impact in the market structure and the need to regulate the “ natural” monopoly

Industrial organization and competitive strategy

22.Value for Money potential

21.Private atractibility for lenders and equity

20.Degree of impact in the public finances

Public finance and bancability

19.The degree to generate competition in the bidding process (Demsetz effect)

18.Posibility to apply User Charge (prices or tariff)

17.Social Impact

16.Capacity to be replicate due to structure soluction and business design

15.Capacity to the project to transfer risks to private sector

14.The size of stakeholders

13.The degree of risks of rejection towards stakeholders groups (involved)

12.Evidence of previous international experiences from other developed countries

11.Evidence of previous international experiences from other similar countries

10.Creation of a specific solution to a problem ( logical frame)

9.Reasonable size of the project ( 20 million of euros, realistic, dynamic) and time of realization ofconstructions

Business desing of the transaction

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Cost-Benefit Analysiswhith Real Options

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Project Evaluation

1. Social Project Appraisal

2. Economic project appraisal

3. Cost-Benefit Analysis

4. Benefit-Cost Analysis

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Differents Approach

•Consumer+Producer Surplus [Economic Surplus]

•Benefits and Cost ( SNPV, SIRR)

•Cost-effectiveness analysis

•Contingent Valuation

•Hedonic Prices

•Transport Cost

Real options appliedin Public Invesments

Public InvesmentAnalysis

Economic Growth Option Theory

ExogenousHarrod (1936)Domar (1936)Solow (1956)Swan (1956)Arrow (1962)Phelps (1963)

EndogenousRomer (1986)Lucas (1988)Barro (1990)

Rebelo (1991)Aghion y Howitt (1992)

EntrepeneurshipsSchumpeter (1911)

Baumol (1968)

Financial OptionsBlack y Scholes (1973)

Merton (1973)Merton (1974)

Cox, Ross y Rubinstein (1976)Boyle (1977)

Real OptionsMyers (1977)Kester (1984)

Brennan y Schwartz (1985)Majd y Pyndick (1985)

Mc Donald y Siegel (1986)

FlexibilitySapleton (1985)Acs et al (2004)

Guivernau (2005)

MethodologiesLuermanh (1998)

Amram y Kulatilaka (1999)Copeland y Antikarov (2003)

Mun (2006)

Cost-Benefit AnalysisKaldor (1939)Hicks (1939)

Little y Mirrlees (1963)Davis (1964)

Dasgupta, Marglin y Sen (1970)Arrow y Lind (1970)

Haberger (1975)Squire y Van der Tak (1975)

Hanemann (1984)Carson (1991)

Arrow, Solow, Portney, Leamer, Radner, Shuman (1993)Bishop y Welsh (1994)

National Public InvesmentSystem Applications

Fontaine (1973)ILPES (1994)Vizzio (2000)

HM Treasury (2003)Pacheco y Ortegón (2005)

Pearce et al (2007)

Infrastructure PublicInvestment

Aschauer (1989)Gramlich (1994)

Agénor y Moreno-Dodson (2006)

Literature Map

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flexibility

Private CapitalEntrepreneurship MarketCompleteness

PublicInfrastructure

Economic Growth

-Schumpeter (1911)-Baumol (1968)-Acs et al (2004)

-Sappleton (1985)

-Myers (1977)-Kester (1984)

-Brennan y Schwartz(1985)

-Majd y Pyndick(1985)

-Mc Donald y Siegel(1986)

- King y Levine (1993)-Arrow (1964) -Debreu (1959)

-Baidya y Brandão-(2000)

-Barro (1990)-Aschauer (1989a, -1989b y 1989c)-Munnell (1992)-Gramlich (1994)

-Romp y de Haan (2005)-,Agénor y

-Moreno-Dodson (2006)

flexibility

Capacidad Empresarial

PublicInfrastructure

Economic Growth

Public-PrivatePartnerships

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Definición

Flexibility represents owning the right but not the obligation toaccomplish an activity

Many assets, especially the opportunity of growth, can be seen as call options [Myers (1977), Kester (1984)]

Flexibility can be modeled as an OPTION

The right but not the obligation to buy an “S” asset at an “X” cost on a date

T. Max [ S-X,0] = Call

The right but not the obligation to sell an “S” asset at an “X” cost on a date

T . Max [ X-S,0] = Put

Real OptionsNPV and Discounted Cash Flow techniques implicitly assumes that firms hold real assets pasively. It ignores the options found and embedded in real assets- options that managers can act to take advantage of. NVP does not reflect the value ofmanagement, flexibility and options. What options?

The option to abandon a project

The option to make follow-on invesment if the immediate investment project succeeds

The option to wait and learn before investing

The option to change the firm´s output or its production methods

The option to deferThe option to growth when a early investment is a prerequisite or a link in a chain ofinterrelated projects, opening up future growth opportunities

Brealy and Myers (1999) and Trigeorgis (1996)

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Expanded (Strategic) social net present value (SNPV)= Standard (Static, passive or direct) NPV of expected

cash flows + Option Premium ( Value of operatingand strategic options from active management and

Interaction effects of competition, synergyand dependence ( Value of flexibility)

EvidenceEvidence in in thethe PrivatePrivate SectorSector

Energy IT and TelecomInvestment Banks

Fuente: Lisowski (2000)

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Real OptionTransport Infrastructure Project Example

AC

B

PT

10*(1.03)25+10+9+5+3-100FCF203720122011200920082007Years

NPV (10%) US$ -21.64 millions

Project: Road AB

Traditional main benefit:Travel time savings

Growth Option• The total net value discounted at a social 10% rate results in a value

of -21.64 million dollars. The traditional cost-benefit analysis advises us not to invest in the road. The NPV is negative and as a consequence it does not increase the wealth of society.

• Nevertheless, it is important to note that the project not only provides cash flows associated to the construction of the road, but it also creates a call option for developing the port (dock), whichconstitutes the real strategic value of the project for society. Once the road is built, and if the option from the society is exercised, it would be worthwhile to invest in the port, or in the worst case scenario, it would be better to abandon it. The question in matter is, what is the value of the purchase option?

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Growth Option• It is assumed that the port is projected for the year 2011, where

the initial investment is calculated at 150 million dollars and the future value of the cash flows expected in 2011 reaches 300 million dollars. The real value of that amount discounted at a rate of 10% is 205 million dollars. The analytical solution developed by Black and Scholes (1973) for a purchase option with an “X” price of exercise and an “S” spot price is denoted by:

• N(.) is the accumulated normal standard distribution, “r” is the risk free rate and “σ” is the volatility.

)()(),,( 21 dNXedSNXtSc rt−−=

Growth Option• Assuming that “S” has a value of 205, “X” has a value of 300, calculated 

volatility  is 30%, and “r” is 6%,  then  the value of  the purchase option  is equal to:

• The  call  option  has  a  value  for  society  of  37.40 million  dollars,  which exceedingly  compensates  the  negative  profitability  of  the  highway.  The total NPV, which includes the value of the option, goes up to 15.76 million dollars.  Through this point of view, which takes into account the value of the call option of building the dock, it is concluded that the highway that connects locations “X” and “Y” should be constructed.

millionsUSdNedNXtSC 40.37$)(300)(205),,( 2406.1

1 =××−×= ×−

Expanded (Strategic) social net present value (ESNPV)

= -21.64 + + 37.40= USD15.76 millions

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EvidenceEvidencePublic Infrastructure

NationalNational InvesmentInvesment Public SystemsPublic Systems

NoNo requiredNo requiredFixeda) CBAb) Cost-Effectiveness

MEFPeru

NoNo requiredNo requiredFixeda) CBAb) Cost-Effectiveness

MIDEPLANChile

NoRequired in an specific matter

RequiredVariablea) CBAb) Cost-Effectiveness

HM TreasuryUK

NoRequired in general terms

RequiredVariablea) CBAb) Cost-Effectiveness

The White HouseUSA

Real Options

Risk andUncertainty

EquityImpacts

Social DiscountRate

PrincipalMethodologies

AdministrationCountry

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Value for Money and Public Sector Comparator

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Public Sector Comparator[Treasury Taskforce 1999]

“ A hypothetical risk-adjusted costing, by the public sector as a supplier, to an output specification produced as part of a PPP Project.

• It is expressed in net present value terms;• is based on the recent actual public sector

method of providing that defined output (including any reasonably foreseeable efficiencies the public sector could make); and

• takes full account of the risks which would be encountered by that style of procurement.”

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UK [1999]

Australia

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Canada

UK [2006]

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The Netherland

South Africa

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Chile

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Mexico

Value for Money (VFM)

Achieving VFM may be described in terms of the 'three Es' -economy,efficiency and effectiveness*:

a. Economy. Doing less with fewer resources, i.e. makingsavings.

b. Efficiency. Doing the same as before, but with fewerresources (money, staff, space).

c. Effectiveness. Doing more than before with the sameresources as now (or less).

*Imperial College of London

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Retained Risk Retained Risk

Base Costing

Transferred Risk

Cost of ServicePayments

PPPPRPPPPPublic Reference Project

Public Sector Comparator

Risk

Risk can be defined as the volatility of an expeted outcome

( )∑=

−−

=n

ii uu

n 1

2

11σ

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Risk Valuation Methodologies

• Historical Probabilities: Found σ using past data and simulate Bootstrap or Montecarlo analysis)– Quantitative

• State Probabilities: Found σ (over-cost and over-run) through expert panel and simulate with Bootstrap or Montecarlo Analysis Qualitative

• International Benchmark : Found σ taking into consideration international studies

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International Studies

• Probabilidades Históricas: Encontrar σ a travésde datos pasados y simular (Bootstrap o Montecarlo)– Inductivo cuantitativo

• Probablidades Declaradas: Encontrar σ los sobrecostos / sobreplazos a través de panel de expertos y simular (Bootstrap o Montecarlo –Inductivo cualitativo

• Benchmark Internacional: Encontrar σ a partir de estudios internacionales

Qualitative evaluation:• Not to be used for Information

Communication Technology projects• Or projects less than MMUSD 30• Or sufficient market interest for

competition• Or the public sector not be able to

finance the alternative

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Multi-Criteria Decision Making

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Analytical Hierarchy Process“ Analytical Hierarchy Process (AHP) is an approach to decision

making that involves structuring multiple choice criteria into ahierarchy, assessing the relative importance of these criteria, comparing alternatives for each criterion, and determining an

overall ranking of the alternatives“ Source: Decision Support System 2008

Evaluation phase is divided into four steps 1. Generate pairwise matrices2. Generate the weights of the measures3. Normalize weights to get the consistency among measures4. Calculate the overall ratings

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The Decision-Making Process

Develop DecisionCriteria

Allocate Weightsto Criteria

DevelopAlternatives

AnalyzeAlternatives

Select Alternative

ImplementAlternative

Evaluate Results

Identify Problem

Source: Adapted from Ibrahim Ozer - University of Ottawa 2005

Procurement Procurement MechanismMechanism

• Define the objective:Select Procurement Mechanism for the development of a public infrastructure project

• Alternatives:

1. Traditional2. PPP3. Traditional (B) + PPP (O&M) [ Unbundling]

• Criteria:

Value for Money (VFM), Oportunity, Competition, Institutionalexternality.

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Analytic Hierarchy Process

Select ProcurementMechanism

Tradicional PPP Traditional (B) + PPP (O&M)

VFM

Oportunity

Competition

InstitutionalExternality

VFM

Oportunity

Competition

InstitutionalExternality

VFM

Oportunidad

Competition

InstitutionalExternality

ALTERNATIVES

GENERAL CRITERIA

GOAL

PairwisePairwise Matrix Matrix ComparisonsComparisons[ [ SourceSource: : DecisionDecision andand RiskRisk AnalysisAnalysis by by SaatySaaty (2005)](2005)]

Traditional PPP Traditional +PPP

Traditional 1/1 1/2 3/1

PPP 2/1 1/1 4/1

Traditional + PPP 1/3 1/4 1/1

• Numerical representation• Relationship between two elements that share a common parent in the

hierarchy• Comparisons ask 2 questions:

– Which is more important with respect to the criterion?– How strongly?

• Matrix shows results of all such comparisons• Typically uses a 1-9 scale• Requires n(n-1)/2 judgments• Inconsistency may arise

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Many Thanks