GETTING INCENTIVES GETTING INCENTIVES RIGHT: DO WE NEED EX RIGHT: DO WE NEED EX

POST CBA?POST CBA?

Sixth European Conference on Evaluation of Cohesion Policy

Warsaw, 30 November-1 December 2009

Massimo Florio

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Ex-ante CBA and Grant Ex-ante CBA and Grant mechanisms mechanisms For Major projects the EC requires Member

States to submit a Cost-Benefit Analysis (CBA) and then takes a specific co-financing decision.

The applicant should show to the EC that, after a suitable CBA, the project’s economic net present value is positive, if negative, the project will be immediately rejected.

In the case of revenue generating projects, the financial profitability is assessed in order to establish whether the project actually needs a grant and to what extent this applies.

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Common mistakes and pitfalls in Common mistakes and pitfalls in ex-ante CBA ex-ante CBA

The quality of ex ante CBA varies substantially and may not cover essential information or may even contain errors.

In particular, there could be inaccuracy in the estimate of future demand (and particularly demand overestimation) and investment cost (and particularly cost overruns).

In addition, CBAs may consider project periods that differ from those indicated in the CBA guide. Other methodological adjustments carried out relate to exclusion of taxes and duties and adjustments in the calculation of externalities

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Total construction costs Cost

Project Forecast Actual Overrun (%)

ICE Frankfurt - Cologne 2784 6015 116%

Eurotunnel 2702 4568 69%

Oeresund Fixed Link 1795 2924 63%

Paris – Lille TGV 2666 3334 25%

Madrid - Seville AVE 3263 4029 23%

Magdeburg Waterway Crossing 2064 2435 18%

Lyon - Marseilles TGV 4015 4338 8%

Malpensa 2000* 990 945 -5%

Baltic Sea Motorway* 2200 1830 -17%

Forecasts and actual costs of Forecasts and actual costs of EVATREN projects (million EURO)EVATREN projects (million EURO)

Main causes of errors in costs Main causes of errors in costs estimationestimation

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Mag-deburg Water-

way Crossing

Oere-sund Fixed Link

ICE Frankfurt-

Cologne

Paris-Lille HST

Lyon-Marseilles

HST

Madrid-Seville AVE

Euro tunnel

Malpensa Airport

Baltic Sea Motorway

Delays in implementation X X X X X

Changes in project specifications & design X X X

Changes in rates between currencies

Geological risk

Changes in quantity and prices X X

Underestimation of expropriation costs X

Changes in safety requirements X X

Changes in environmental requirements X X X

Technological risks X X

Systematic ex post evaluationSystematic ex post evaluation

Ex-post evaluation: a new appraisal in a moment subsequent to the starting of the operational phase of a project.

Ex-post CBA is extremely informative and useful for understanding whether the conceptual forecasting model adopted before project implementation was adequate to support the investment decision.

The scope is not discovering deviations from forecasts per se, but understanding the causes behind the deviations. The key point is whether the deviation is attributable to endogenous or exogenous factors.

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Systematic ex post evaluationSystematic ex post evaluation

Besides helping to make more realistic estimates in the future, ex post CBA can be even more useful to take corrective actions and to build confidence in the appraisal process by introducing the concept of linking the access to funds to the conditionality of achieving the targets initially set

How to contract co-funding of major projects in the framework of

Incentive theory?7

CBA IN A MULTI-GOVERNMENT CBA IN A MULTI-GOVERNMENT SETTINGSETTING

Six types of agents:

• Individuals: consumers,workers,tax-payers, shareholders

• Private firms: profit maximizers• Public firms: fully under government’s control• Regional planners/evaluators• National planners/evaluators• The supra-national planner/evaluator

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TheThe European Commission European Commission as aas a supra-national plannersupra-national planner

The EC has a European SWF

Has a limited policy opportunity set compared with Member States, but can issue binding regulations and disburse capital grants

Has budgetary constraints

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What evaluators do?What evaluators do?

Select policies (not projects)Given their constraints solve a planning problem

in terms of a set of shadow pricesHire ex-ante evaluators to appraise project

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Gather project dataMake forecastsUse shadow prices (they must be price taker!) as

given by the plannerCheck if the project passes the CBA test: positive

shadow profits

What planners do?What planners do?

How bottom-up evaluation works How bottom-up evaluation works

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Regional

National

EC

Each evaluator selects profitable projects:intersection gets approval

Information: Information: uncomplete and asymmetricuncomplete 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 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?

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Investment game with ex-ante ex-Investment game with ex-ante ex-post evaluationpost evaluation

• The supra-national planner is a European SWF maximizer, who adopts an infrastructure policy, offers shadow prices and grants to regional planners, appoints ex-post (contract assignment) evaluators.

• The regional planner is a regional welfare maximizer, including the private agenda of policy makers. He appoints ex-ante evaluators, selects projects, offers contracts to project managers.

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• The project manager is a profit maximizer, who wants to cover costs, earn a rent, knows technology and knows how much effort is needed to decrease costs

• The ex- ante evaluator using regional shadow prices appraises a project producing one unit of good with gross social benefit S and social cost C.

Total Costs = C + S = β - e + S

• S is fixed, C is variable: is a technology parameter (adverse selection), e is managerial effort to minimize costs (moral hazard): C= e

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• Technological costs are private information of the manager, there are two technologies, but everybody knows their probability distribution: p and (1-p) .

• Managerial effort cannot be observed, its disutility is y(e) (first and second derivative are positive). C can be always observed ex post, technology only when there is ex post evaluation.

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• The manager wants to cover costs, including normal profits, either by regulated tariffs or by a cost reimbursement mechanism, plus wants a rent. He asks an incentive to minimize costs, the regional government offers a contract: C+ t.

• There is no regional co-financing, to the EU taxpayer the social cost is (C+ t) (1+l), where l > 0 is the shadow price of EU grants.

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The project is accepted if mutually compatible at EU and regional shadow prices.

For the EU tax-payer the welfare change is:

V = S - (C+ t) (1+ The utility change for the manager is:

U = t - e).

Social welfare change, without welfare weights is:

W = V + U

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Equivalently: W=S - (1+e+U+ e)) +U= S - (1+e+ e)) -U.

 Under complete information, the regional

government acting on behalf of the supra-national planner, extracts optimal effort, does not leave socially costly rents to the project manager, hence it will offer an incentive t= e*)such that U=0

Under asymmetric information, the regional planner needs a truthful revelation mechanism. One mechanism is here a menu of two contracts: C+t, satisfying the incentive and participation constraints, one for each values of

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• The participation constraint for both management teams is U non negative.

• The incentive constraint for the more efficient firm is that U of the efficient type is greater than U of the less efficient type if he accepts the lower-cost higher –incentive contract than if he accepts the higher cost-lower incentive contract. Symmetrically for the other type.

• In this context it is well known that the efficient types gets an information rent in any case.

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• The rent can be limited by the ex-post evaluator, who is able to discover the technology parameter. If the efficient type is discovered to have mimicked the inefficient type, there is a penalty.

• The optimal frequency of ex-post evaluation is a function of its cost, and of other parameters, including the degree of asymmetric information, the shadow price of public funds, the weight of the private agenda of the regional policy-makers.

• Conclusion: the optimal incentive design is region-specific

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ADVANTAGES OF THE INCENTIVE ADVANTAGES OF THE INCENTIVE BASED MECHANISMBASED 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

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ADVANTAGES OF THE INCENTIVE ADVANTAGES OF THE INCENTIVE BASED MECHANISMBASED MECHANISM (2) (2)

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CONCLUSIONSCONCLUSIONS Ex post CBA allows understanding of where the efforts

for improving the quality of project appraisals should be addressed, identifying those areas where the actual ex ante methodology and decision tools are effective and those where they are weaker.

CBA should be the language of a common learning mechanism. Planners should adopt policies, offer shadow prices and evaluators. Evaluators must act as shadow price takers.

Ex ante evaluators, regional planners, project team should be given incentives to out-perform economic benchmarks, and independent ex-post evaluators, on behalf of the EU, should rate projects and observe success and failures.

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