Investment Appraisal for Sustainable Ports

Transcription

1 Investment Appraisal for Sustainable Ports P. Taneja, M.E. Aartsen, J.A. Annema, H. Ligteringen Abstract The sustainable development of a port is of vital economic and financial importance. Flexible designs and innovative solutions help to advance sustainability goals by addressing future uncertainty and risk. Lack of a suitable decision-making procedure or improper utilization of the standard analytical and evaluation techniques should not be allowed to stand in the way of flexibility. This paper illustrates how investment appraisal procedure in the port sector (or other infrastructure sectors) can be adapted, so that flexibility and sustainability considerations are integrated in the standard procedures, through a case study of Port of Rotterdam. T I. INTRODUCTION he boundary of a port extends much further than its immediate environment. The port can be a source of work and prosperity, but also a source of nuisance and concern, therefore the sustainable development of a port is of vital economic and social importance. It requires investment in environmental preservation measures as well as in innovative solutions. The increasing market uncertainty (highlighted by the recent economic crisis), is placing extra demands on ports which look to innovation as a means for survival. Innovative flexible solutions for port infrastructures, can be instrumental in advancing sustainability goals by addressing future uncertainty [1]. While evaluating the desirability of a (long-term) port project, it seems self evident, in present times, to take uncertainty, flexibility and sustainability aspects related to a port into account. This is however not so, and can lead to misguided decisions. Worthwhile projects may not pass the (financial) feasibility criteria for screening projects and result in missed opportunities for the port, along with lost benefits for the society. Or wrong choice of projects might result in loss of investment. The Port of Rotterdam Authority (PoRA) Manuscript received July 1, This research is carried out within the framework of Port Research Centre Rotterdam-Delft and Next Generation Infrasructures, and sponsored by Water Research Centre Delft and Public Works Department Rotterdam. P. Taneja is a part time researcher at Delft University of Technology (DUT), and is employed at the Public Works Department, Rotterdam as design engineer.(p.taneja@tudelft.nl) M.E. Aartsen is Investment Manager at the Port of Rotterdam Authority and advises the executive board on investment decisions, participations and other economic issues. (me.aartsen@portofrotterdam.com) J.A. Annema is Assistant Professor Transport Policy at DUT since 2009 and has worked at the Netherlands Environmental Assessment Agency and the Netherlands Institute for Transport Policy Analysis. j.a.annema@tudelft.nl H. Ligteringen is professor at DUT and IHE, and co-chairman of the Program Council of Port Research Centre Rotterdam-Delft (h.ligteringen@tudelft.nl) has been considering the use of alternative methods of decision-making for the following reasons (source: PoR): Some recent investments proved to be a waste of resources: a quay wall at Amazonehaven in Rotterdam for Europe Combined Terminals (ECT) proved to be inadequate a decade after its construction; engineering of an innovative design concept of a multi-functional quay wall for Odjfell which was never used; and investment in facilities for Lyondell B.V. at the Maasvlakte resulted in loss of revenue for the port due to inadequate uncertainty considerations. Increasing and tightened environmental regulation, both at national and European level means that many projects at PoR carry the burden of mitigation or compensation measures, which are not included in the project appraisal. PoRA has an extensive R&D-agenda, often in cooperation with the business sector and research institutes. It is difficult to evaluate and justify investments in innovation with conventional valuation methods. A structured decision-making procedure which recognizes uncertainties, embraces a life cycle perspective, and includes use of modern financial tools for optimizing tradeoffs between costs related to flexibility and sustainability measures and the future benefits, is required. In this paper we examine the decision-making process at the PoR, and suggest how it can be made suitable for present volatile times through answering the following questions: 1. Which elements are included in project appraisal at PoR (Section IIB)? 2. What are the drawbacks of the decision-making process in the face of uncertainty (Section IIC)? 3. Which financial evaluation techniques are applied, and what are their limitations (Section IID)? 4. Which solutions will remove the drawbacks (Section IIIA-D)? 5. Can these solutions be synthesized into the present decision-making procedure for the ports (Section IIIE)? 6. In which situations can PoR benefit from alternative financial techniques (Section IIIF)? The research methodology followed included literature study, desk research and intensive communication with the investment department at the PoR, both at top and middle level. PoRA made information related to the firm, as well as many past and on-going projects readily available, and showed great willingness in analyzing the issues at hand. The personal experiences of the authors with port-related projects and their insights in different disciplines contributed to the research.

2 The paper will illustrate through the case study, how investment appraisal process in the port sector (or other infrastructure sectors) can be adapted so that flexibility and sustainability considerations are integrated in the standard procedures. Because of different ownership management models at various ports, goals and policies of various port owners can differ. This means that no specific conclusions can be drawn from the paper that will apply to all types of ports. II. THE DECISION-MAKING PROCEDURE AND ITS LIMITATIONS A. Introduction This section scrutinizes the decision-making procedure related to project investments at the Port of Rotterdam (PoR), examines the suitability of the procedure for present times and discusses the three major limitations. B. Project appraisal The PoRA is the developer and manager of the PoR, currently the fourth largest port in the world. Three types of projects can be distinguished at PoR (Table 1): site or real estate related client projects; public or nautical infrastructure related public projects, and a third category including strategic projects dealing with issues such as accessibility, sustainability spatial planning, ICT, and other internal projects of PoR [3]. Sufficient return on investment is needed to be able to invest in projects that support the ambition of PoRA. TABLE 1 PROJECT CATEGORIES AT POR Projects Small Middle Mega Range of investment < 250,000 > 250,000 in order of 100 million System boundary port land land, Europe Category of projects: Public Client Strategic/ internal Evaluation method for client projects Evaluation method for public or strategic projects simple cost estimation business case none none none no yes no cost-benefit analysis A project at PoR goes through various stages: preliminary design, feasibility study, detailed design, construction, exploitation, and adaptation or decay. Engineers from various disciplines carry out the technical design, and evaluation experts, typically economists aided by other disciplines, calculate the value of proposed designs. A business case is set up in the feasibility stage to check the viability of a project. It comprises the present and future cash flows of the project and the financial feasibility of a project is determined applying discounted cash flow (DCF) method and calculating the Fig. 1 Project appraisal at PoR internal rate of return (IRR) set at 8.5 % for most projects 1. Fig. 1 illustrates the project appraisal process. C. Treatment of uncertainty The uncertainty related to a project, e.g., future cargo flows or market share, investment costs, project lifetime, raw material and product prices, interest and exchange rates, tax and regulatory policies are currently taken into account by considering a certain positive and negative variation ±30% around the base case scenario, which results in an optimistic and pessimistic scenario. The decision to invest or not to invest is based on the base case scenario. If a project seems to face larger risks, say, because of uncertain revenues, a higher rate of return is used or alternatively the payback period, normally set to 25 years, is reduced. Further, PoRA uses derivatives in order to hedge against interest and product price risks [4]. Also, in order to limit the risks on investments, the current practice is to hedge against the market risks by means of guarantees which lead to a minimum return on investment of 6% 7%. This applies only to client projects. D. Limitations of the current decision-making procedure The limitations in the decision-making procedure, as established during in-depth discussions with the Investment Management division at the PoRA are briefly discussed here. The next section will discuss possible solutions. 1) The decision-making process precludes communication between disciplines and consideration of alternatives A typical decision-making process related to port projects involves engineering design based on scenario forecasts, followed by a project evaluation. The process is static and 1 Instead of using a common hurdle rate for all projects, PoR distinguishes projects depending on their risk profile (which is based on risks such as demand, bankruptcy or alternative use of infrastructure).

3 follows a rigid sequential strategy. The engineering and financial disciplines have little communication and not all information is to be traced back in the project documentation. Due to this gap, valuable input from the engineering discipline is often missing, and decision-making related to capital investment can be misguided. A similar gap exists between the economists doing the forecasts and the engineers, so that the latter are unaware of the uncertainty surrounding the forecasts, and treat these as deterministic, thereby ignoring uncertainty. The sequential nature of the procedures means that the best seeming alternative is evaluated in the detailed design stage, and alternatives are not taken into account after the feasibility stage. The decision-making related to technical aspects and investments is independent and carried out in different time frames. The top-management, does not see the technical alternatives, and bases its decisions mainly on the financial value of one design. There is no scope within the standard procedures to re-consider, adapt and re-evaluate another alternative (as to material, design, technology or operation), if the first evaluation results in a negative business case. 2) Business case does not include all the effects of a project In the current practice, a business case is set up for client-related investments, which makes sense. However, for most public infrastructure projects it is difficult or even impossible with the current evaluation method to calculate an NPV or internal rate of return, because there is no direct income involved. The requirement of IRR of 8.5% on the total investment is assumed to justify these two categories of investments. So, in the present practice at PoR, societal impacts of a port development plan are stated separately in the business case, while remaining outside profitability calculations. This involves a risk that societal impacts are represented less prominently than financial items so that the business case is not balanced. In marginal cases, an attempt is made to include the societal costs and benefits in a port development business case. But it is difficult to justify this to the port management, because quantifying societal costs and benefits does not form a part of the standard procedure of project evaluation. Nevertheless, in our view, it is important to give quantified evidence of the beneficial societal effects of a port project, because this evidence could be supportive in making a case for a governmental financial subsidy. 3) Evaluation methods do not take uncertainty and flexibility into account Due to (often) large uncertainties, concerning the project itself, as well as the environment in which the project will function, it is neither possible, nor desirable to express the project value with one deterministic number, and use it as a basis for investment decisions [5]. The financial techniques such as DCF method are adequate for a stable environment, where the projects have deterministic requirements and the management has a clear strategy. But uncertainty poses new challenges. For the majority of projects, the variables such as costs and revenue are uncertain, and the assumptions underlying the determination of these variables questionable, but in a business case they are treated as if certain. DCF method also assumes that decisions are made now and will not change later, and fixes the cash flow streams for future. Though two extreme scenarios are considered, the decision-making is based on the most likely outcome of a situation, e.g., expected value of investment and potential revenues. But with all the uncertainty involved in such projects, the chance of a single NPV value being correct is essentially zero. Flexibility in decision-making, design and operations, enhances the value of a project, but cannot be included in the project evaluation with standard DCF methods. The lack of suitable analytical and evaluation techniques has been a barrier against investments in flexibility in the past. New techniques have evolved, but their use is not widespread. III. POSSIBLE SOLUTIONS A. Introduction Having identified some drawbacks in the previous section, this section proposes some solutions. Fig. 2 integrates these into a decision-making procedure which includes uncertainty and flexibility. B. Decision-making process The decision-making process is linear and can be improved by making it iterative. It is possible that at the end of the feasibility stage or after the detailed design stage, the business case is not viable, the functional requirements have changed, or other circumstances have arisen. In that case the process needs to be examined again (see iterative loops in Fig. 2). Very often, only the financial calculation is modified (through adjusting costs and revenues) so that the financial feasibility criteria are met. This is inadequate since it means that the same alternative has been reassessed and adjusted, whereas another alternative could be more suitable for the changed situation. In some cases, the project is abandoned while another alternative would be viable. The proposed procedure would offer the following benefits: It would ensure that all alternatives including the no-project 2 alternative [5] as well as all technically feasible design options are included in every cycle, so that the decision-making is based on complete information. It would provide the designers with an opportunity to adapt their designs, reconsider alternatives, and incorporate flexibility, and the added value of this flexibility could be included in the decision-making (using methods discussed in IIID). It would lead to increased communication between 2 The no-project alternative for a project is the best alternative use of available means of investment, combined with the best possible solution for the problem to be solved with the project. In case of PoR it could mean intensifying use, other clients, or other cargo-sectors.

4 engineering and financial disciplines, which can only be beneficial. The management, though still basing their decision on economic criteria, would be aware of the alternatives to the project, as well as the alternatives within the project. C. Project evaluation through a Cost Benefit Analysis A financial or profitability analysis is sufficient for the economic appraisal of a (client related) port project from the point of view of PoRA. However, in order to value a public project or a project with a high public character a socio-economic analysis is required. Cost Benefit Analysis (CBA) form the state-of-the-art in the economic appraisal of public projects in most high income countries [6] [7]. In a CBA, all the societal impacts of a project are assessed systematically and valued monetarily. So, for port projects with potentially high societal costs or/and benefits it seems useful to carry out a CBA. We can give three examples of potential effects of port development projects which are not included in standard financial, but which are relevant to show to decision-makers: A port development project, as a result of the core activities of a port, may have indirect effects (second order and multiplier effects), of consequence for the port and the surroundings, e.g., lowered overall transport costs, increased development prospects for other port related industries, clustering of companies with related functions, increase in employment, increase in income and spending, and costs and benefits related to safety and security etc. It could include environmental mitigation measures which generate benefits for the surroundings such as improved working and living environment. It could involve investments in public infrastructure. The benefits in travel time of the infrastructure users may not accrue to the PoRA, but could still be a significant societal benefit. A financial evaluation (business case) at PoR, does not take these effects into account, because these benefits are not financial and accrue to other parties than the PoR itself. For PoRA be able to profit from these, the first thing seems to be to quantify these effects in a CBA. A standard procedure should be established to value the port development related external effects, so that these benefits or costs can be assigned to the rightful parties or government. D. Evaluation methods for investments under uncertainty This section mentions briefly, three evaluation methods which remove the drawbacks of DCF method i.e., probabilistic analysis or simulation, decision tree analysis (DTA), and real options analysis (ROA). Extensive literature is available on the subject. Probabilistic methods involve essentially a Monte-Carlo simulation of NPV wherein uncertain variables in a cash flow model are described in terms of probability distributions. Multiple simulations with the model will result in a probability distribution of the Net Present Value (NPV), which gives more information about project feasibility than a single NPV value computed using the expected mean of input parameters. The method makes many assumptions and becomes complex in case of many uncertainties. Decision Tree Analysis (DTA) is an NPV calculation that incorporates different future scenarios based on the likelihood of that scenario occurring. Cash flow for any given year is the weighted sum of the cash flows for each scenario that could occur in that year and the weights are equal to the probability that a specific scenario will occur. It provides an overview of how uncertainties in the available data and uncertainties about relationships between variables will affect the probabilities of the various outcomes, and any associated decisions. It helps in structuring of a complex problem, definition of the optimal choice for any time period of time and the identification of an optimal strategy over many periods [8]. DTA is difficult to apply when multiple sources of uncertainty are present and the choice of discount rate remains subjective. ROA, based on pioneering work of Black and Scholes [9], uses DCF methods as a building block, and integrates decision trees into a sophisticated framework that that provides decision makers with more meaningful information [10] [12]. Real options can be created on decisions (option to invest, wait, expand or contract), or built in physical infrastructures [13], [14]. Flexible design options and managerial flexibility make it possible to benefit from uncertainty, and result in an extended economic lifetime of port infrastructures. Similarly, investments in flexibility, innovation, and research and development involve extra costs, which can only be justified if they are included in the project evaluation as valuable options which can result in future benefits. This is possible through modern evaluation techniques such as ROA. Recent Dutch government documents have made a mention of real options for investment decisions [5], [15]. E. Synthesis of the solutions Efficient decision-making related to investments requires recognition of uncertainty and the possibility of various future and scenarios [13]. Managers should identify and analyze the long-term risks and uncertainties that have impact on the project. The specification of requirements should not be fixed but allow a range of scenarios. Various alternatives should be ranked based on calculations of costs and benefits using indicative figures, right from the start. The design team should develop flexible designs that permit multiple pathways of project evolution, according to the scenarios that actually develop. The evaluation or appraisal methods should include suitable methods to capture the value of the options designed into various alternatives, and decision-making should be carried out jointly by various disciplines. Management should be made aware of the alternatives in the project and the embedded options even if the options have not

5 Fig. 2 Overview of the proposed decision-making process been monetarily quantified. Fig. 2 gives an overview of the decision-making process where the proposed solutions and suggestions have been incorporated. As can be seen, the decision-making follows a dynamic iterative course whereby changes in the project environment (such as, new policy guidelines and priorities, changes in functional requirements, construction techniques or cost structure) trigger off a new sequence of activities. F. Applicability of various evaluation methods Table 2 gives situations where the use of certain evaluation methods is thought to be most suitable. ROA includes methods based on financial option theory such as Black-Scholes and binomial lattices (these have limited application for engineering systems), as well as simulations methods [13]. IV. CONCLUSIONS In this paper we have examined the decision-making process related to long-term investments through a case study of Port of Rotterdam and illustrated how investment appraisal process in the port sector (or other infrastructure sectors) can be adapted so that flexibility and sustainability considerations are integrated in the standard procedures. An iterative or cyclic process wherein decision-making involves both between engineering and financial disciplines at every stage, and all alternatives included (including no-project alternative), is recommended. Secondly, the port has to invest in public infrastructure projects to improve accessibility and efficiency, in environmental mitigation and compensation measures, and in strategies directed at promoting sustainability. A standard procedure is required for including these in the economic analysis (business case) at PoR. For borderline projects, where a go-no go decision is difficult, a probabilistic CBA is recommended. Similarly, if the indirect or external effects for the surroundings are positive and significant, or negative external effects require major investment in mitigation or compensation measures, the effects should be quantified to make a case for government sanctions. Decision-making at PoR can benefit considerably from application of alternative evaluation methods, such as simulations, decision tree analysis, and real option analysis. The port authority has a strategic vision of the port. It has to accommodate the specific wishes of its 900 different clients (in total 1300 lease contracts involving options on land). This complexity, coupled with the uncertain future demand and land tariffs, and the aspiration to make optimal decisions for PoR while providing sufficient level of service for the client, would suggest use of methods such as decision tree analysis and real options analysis methods above standard methods. Managers often complain about the highly subjective estimates of key variables in methods such as simulations and decision tree analysis and stick to DCF method. Use of such approaches or even considering various options qualitatively can be sufficient to improve the decision-making, since it makes the underlying assumptions explicit and open to discussion. Engineering projects often encompass flexible options, which may be physical or managerial. Flexible design options and generic solutions can result in an extended economic lifetime of port infrastructures. Similarly managerial flexibility enables benefiting from uncertainty. Investments in flexibility, innovation, and research and development involve extra costs, and can only be justified if they are

6 TABLE 2 APPLICABILITY OF ECONOMIC EVALUATION METHODS FOR VARIOUS SITUATIONS AT POR Situation Suitable evaluation methods (DCF/ Simulation/ DTA/ ROA models) Project with deterministic requirements and clear strategy (stable DCF models future) e.g. temporary works for use during construction phase Selecting between mutually exclusive design alternatives In case of low uncertainty, a DCF model is adequate e.g. design variants for a container quay wall construction In case of high uncertainty, if alternatives generate different cash flows in different scenarios, a DCF with simulations or DTA is a better choice Projects or contract negotiations involving contingent decisions DTA, ROA e.g. decision to expand may depend on adjoining space becoming available Project with options such as hedging, growth or insurance If NPV is high, it means Go decision, DCF is adequate (most PoR contracts involve such options) If NPV is negative or low, use ROA to value flexible options Investment in robust design A DCF with simulations for generating extreme scenarios and a e.g. extra margins in dimensioning of the infrastructure distribution of NPV of the project Investment in R&D Staging involves a learning option, use ROA (R&D outcomes almost always involve uncertainty) Project phasing due to uncertain future e.g. Maasvlakte 2 project will be constructed in response to demand Investment in pilot projects, prototypes e.g. a decision to invest in initial market test or technical surveys can have various outcomes which van influence the following decision treated as valuable options which can result in future benefits. Such an analysis reveals the true potential project value, and guides decision-making. Finally, the following steps wise decision-making procedure If the NPV is high, use DCF If NPV is low, and waiting involves learning, use ROA Decision tree. Though this is actually a real options analysis with traditional tools since it does not belong in a framework linked to volatility, lattices and Black-Scholes [2] [2] E. Eschenbach, et al., "Real options and real engineering projects," Engineering Management Journal, vol. 19, pp , [3] PoR, "PM@PoR," Port of Rotterdam, Internal report, [4] Havenbedrijf Rotterdam N.V., "Annual Report 2008," Rotterdam2008. [5] CPB/NEI, "Evaluatie van Infrastructuurprojecten; leidraad voor kostenbatenanlyse," O. E. E. Infrastructuur, is recommended for the projects at Port of Rotterdam: [6] S. M. Grant-Muller, et al., "Economic appraisal of European transport Adopt investment principles that are based on life cycle projects: the state-of-the-art revisited," Transport Reviews, vol. considerations ; 21, pp , Qualitatively define, structure, and understand a project s uncertainties; Consider all available investment alternatives including no-project option at the start; [7] Y. Hayashi and H. Morisugi, "International comparison of background concept and methodology of transportation project appraisal," Transport Policy, vol. 7, pp , [8] R. de Neufville, Applied Systems Analysis: Engineering planning and technology management. New York: McGraw-Hill Inc. New York, Include (physical) flexible options in design alternatives; Include flexible strategies (e.g. staging, delay, growth) [9] F. Black and M. T. Scholes, "The Pricing of Options and Corporate Describe the possible futures with decision trees and future uncertainties with probability distributions (even if applying DCF later), for added insights into the problem; Liabilities," Journal of Political Economy, vol. 81, pp , [10] R. A. Brealey and S. C. Myers, Principles of Corporate Finance Massachusetts Institute of Technology, [11] A. K. Dixit and R. S. Pindyck, Investment Under Uncertainty. Princeton, NJ: Princeton University Press, Estimate the external and indirect effects. If significant, consider a CBA, monetize effects and apply for subsidy; [12] L. Trigeorgis, Real Options. Cambridge, MA: MIT Press, Apply DCF, simulations, decision tree analysis or real options analysis depending on the situation (objective of analysis, validity of assumptions, ease of use and interpretation); Revise decision-making process: make it iterative, involve engineering as well as financial disciplines and include some of the intangible returns in the business case; Consider level of required effort and ease of use while selecting evaluation methods, and beware of a false sense of precision. [13] R. de Neufville, S. Scholtes, and T. Wang, Valuing Options by Spreadsheet: Parking Garage Case Example, ASCE Journal of Infrastructure Systems, vol. 12(2), pp , [14] M. A. Cardin and R. de Neufville, "Direct Interaction Approach to Identify Real Options In Large-Scale Infrastructure Systems," vol. MIT, MA., [15] C. Koopman and F. van Beek, "Toekomstvaste infrastructuur of flexibele opties? Omgaan met scenarios in het investeringsbeleid," ed. Kennisinstituut Mobiliteits Mangement, REFERENCES [1] R de Neufville, Uncertainty Management for Engineering Systems Planning and Design, Monograph, 1st Engineering Systems Symposium, MIT, Cambridge, MA, <Available :