MINISTRY OF ECONOMY AND FINANCE Authority for Coordination of Structural Instruments

Transcription

1 MINISTRY OF ECONOMY AND FINANCE Authority for Coordination of Structural Instruments GENERAL GUIDELINES FOR COST BENEFIT ANALYSIS OF PROJECTS TO BE SUPPORTED BY THE

2 The present guidelines were prepared by the Authority for the Coordination of Structural Instruments with JASPERS assistance, and by consultation with the relevant Managing Authorities and the General Directorate for Regional Policy of European Commission.

3 Table of content 1. Introduction Reference framework Rationale and Objectives of the Guidelines What is CBA and why to perform it When to perform a CBA General methodological approach Steps to be performed within the CBA Investment identification and definition of objectives Option Analysis and selection of the most suitable option Financial Analysis Objectives and scope of the analysis Calculation of financial flows Principles to follow in developing financial projections Determination of EU Grant (Funding Gap Calculation) Profitability Analysis Financial sustainability Summary on financial tables User charges and affordability Economic Analysis Objectives and scope of the analysis Fiscal and price corrections Treatment of externalities Sensitivity and risk analysis Presentation of results...19

4 1. Introduction These Guidelines are intended to provide relevant information and guidance on how to conduct Cost Benefit Analysis (CBA) to the large number of institutions involved in the preparation and appraisal of investment projects to be co-financed by the European Regional Development Fund (ERDF) and the Cohesion Fund (CF) in Romania. This includes Final Beneficiaries, Intermediate Bodies and Managing Authorities. To that extent, the goal of these Guidelines is to be accessible and understandable to a vast audience, at least when referring to the overall objectives, general methodological steps and information requirements. These General CBA Guidelines build on the following framework: - Romanian legislation comprising provisions related to the cost benefit analysis (in particular, the Government Decision 28/2008 on the methodological rules for elaboration and approval of technical and economic documentation for investment projects) - the national programming documents for the implementation of actions to be co-financed by structural instruments (ERDF and CF), namely the National Strategic Reference Framework (NSRF) and the relevant Sectoral Operational Programmes (SOPs); - the relevant EC regulations and guidelines, - statistics, forecasts and other documents that may provide information to be considered for the development of suitable methodological framework to carry out the CBA. 2. Reference framework The Council Regulation (EC) 1083/2006 of 11 July 2006 lays down the general provision ruling programmes and projects financed by the European Regional Development Fund (ERDF), the Cohesion Fund (CF) and the European Social Fund (ESF). In particular, as indicated in Art. 40 (e) of the Regulation, major projects seeking financial support from the Cohesion Fund (CF) and the European Regional Development Fund (ERDF) require the preparation of a Cost-Benefit Analysis (CBA) as part of the applications: Article The Member State or the managing authority shall provide the Commission with the following information on major projects: [ ] (e) a cost-benefit analysis, including a risk assessment and the foreseeable impact on the sector concerned and on the socio-economic situation of the Member State and/or the region and, when possible and where appropriate, of other regions of the Community; For the programming period , the EC has provided a set of working rules to promote consistency in the CBA for CF and ERDF applications (see Working Document 4: Guidance on the methodology for carrying out Cost-Benefit Analysis 1, from now on the WD4). The general methodological framework to carry out CBA in the context of EC Funding is provided in the Guide to Cost-Benefit Analysis of Investment Projects a manual published by the EC in 2002, which has been recently updated 2. In line with the above regulations, Romanian Government Decision 28 of 9 th January 2008 requires CBA as part of the technical-economic documentation related to public investments. 1 Available at 2 The 2008 update of the EC CBA guide is available at the following link:

5 3. Rationale and Objectives of the Guidelines 3.1 What is CBA and why to perform it CBA is an analytical tool which is used to estimate the socio-economic impact (in term of benefits and costs) related to the implementation of certain policy actions and/or projects. The impact must be assessed against predetermined objectives and the analysis is usually made taking into account the sum of all individuals directly and indirectly concerned by the action. In general, the CBA shall make clear if the analysis is carried out adopting a local, regional, national, EU or global perspective. The appropriate level of analysis should be defined with reference to the size and scope of the project, i.e. to the society in which the project has a relevant impact 3. The objective of CBA is to identify and monetise (i.e. attach a monetary value to) all possible impacts of the action or project under scrutiny, in order to determine the related costs and benefits. In principle, all impacts should be assessed: financial, economic, social, environmental, etc. Traditionally, costs and benefits are evaluated by considering the difference between a scenario with the project and an alternative scenario without the project (the so called incremental approach ). Then the results are aggregated to identify net benefits and to draw conclusions on whether the project is desirable and worth implementing. To that extent, the CBA could be used as a decisionmaking tool for assessing investment to be financed by public resources. More specifically, within the framework of preparation and appraisal of investment projects cofinanced from CF and ERDF, a CBA is required to: (1) To assess whether a project is worth co-financing. The goal is to answer to the questions: does it contribute to the goals of EU regional policy? Does it foster growth and boost employment? In simple words, if the net benefits for the society (benefits minus costs) of the project are positive, then society is better off with the project because its benefits exceed its costs. The project should therefore receive the assistance of the Funds and be co-financed. If not, it should be rejected. This assessment is performed using an Economic Analysis. (2) To assess whether a project needs co-financing. Besides being desirable from an economic standpoint a project may also be financially profitable without EU assistance, in which case it would not be co-financed by the Funds. To check if a project should be co-financed requires a Financial Analysis: if the financial value of the investment (project revenues minus project costs) without the contribution of the Funds is negative, then the project can be co-financed. In this case, the EU grant should not exceed the amount of money that makes the project break even, so that no over financing occurs 4. The CBA is therefore needed to provide evidence that, while fitting within the framework of EU regional policy objectives, the project is both desirable from an economic point of view and needs the contribution of the Funds for it to be financially feasible. 3.2 When to perform a CBA When preparing and submitting an application for an investment project requiring co-funding by the CF and ERDF funds, information on the results of all steps of detailed below is required for Major 3 In the CBA literature, the issue of whose costs and benefits count? is known as the standing issue, i.e. whose welfare counts in the aggregation of benefits. In some cases the identification of who has standing needs to acknowledge the presence of a number of social stakeholders because costs and benefits may be borne and accrued by larger or smaller categories of economic/social actors depending on the geographical level adopted in the appraisal. 4 This does not necessarily apply to projects subject to State Aid rules.

6 Investment Projects, which are defined as operations accomplishing a precise and indivisible task whose total costs is in excess of: - EUR 25 million for environmental projects - EUR 50 million for all other fields. For non Major Projects, an Economic Analysis is not obligatory according to the requirements of GD 28/2008. However, for smaller projects which are not subject to a preventive appraisal and approval by the European Commission, the relevant Managing Authority could decide to include a requirement for results of CBA to be assessed as part of the selection criteria. 4. General methodological approach 4.1 Steps to be performed within the CBA The proposed sequence for the CBA in the framework of investment project preparation, which is consistent with the general framework described above, is the following: - Investment identification and definition of objectives - Option analysis; - Financial analysis - Economic analysis - Sensitivity analysis - Risk analysis - Reporting conclusions The following sections provide the general recommendations on the actions to be taken when performing each of the steps mentioned above. 4.2 Investment identification and definition of objectives The basic strategic documents for the implementation of actions to be co-financed by the CF and ERDF are the National Strategic Reference Framework (NSRF) and the relevant Operational Programmes (SOPs) As any other Member State, Romania has prepared a National Strategic Reference Framework (NSRF), coherent with the Community Strategic Guidelines on Cohesion 5, which gives the strategic dimension to the Funds in line with the priorities of the Union. The NSRF is the document that defines the strategy chosen by Romania to contribute to achieving those priorities, and lists the OPs that it endeavor to implement. The OPs present the priorities of the Member State (and/or regions) as well as the way in which it will lead its programming 6. In compliance with the agreement between the Government of Romania and the European Commission, the following Operation Programmes are drafted: Operational Programme Managing Authority 1. Increasing Economic Competitiveness (SOP) Ministry of Economy and Finance 2. Transport (SOP) Ministry of Transport 3. Environment (SOP) Ministry of Environment and Sustainable Development 4. Human Resources Development (SOP) Ministry of Labour, Family and Equal Opportunities 5. Regional Development (ROP) Ministry of Development, Public Works and Housing 6. Administrative Capacity Development (OP) Ministry of Interior and Administrative Reform 7. Technical Assistance (OP) Ministry of Economy and Finance Note: SOP = sectoral operational programme; ROP = regional operational programme 5 Avalaible at 6 Please see for links to the approved NSRF and summaries for the SOPs.

7 Each OP summarises the overall objectives and targets sought at a sectoral level, as well as identifies the priority areas of interventions (priority axes), which, in turn, lists specific objectives. Once a need for an action or a problem to be solved has been identified, the objectives of the proposed actions and projects have to be defined in a manner consistent with the overall objectives and priority axes of the relevant OP, including defining the extent the propose projects will contribute to achieving the results the OP is aimed at. To provide a concrete example, the general objective of a project in the field of solid waste management (an environmental project) will typically be defined along the lines of the example in Table 1. Table 1: Example of definition of the project s general objective General Objective: to develop a sustainable waste management system in the county of [ ] by improving waste management service and reducing the number of historical contaminates sites in line with EU practices and policies and in the context of the Priority Axis 2 of the SOP Environment. Having defined the general objective, the specific objectives of the project will be formulated in a manner consistent with the specific objectives of the referred Priority Axis (see Table 2): Table 2: Example of definition of the project s specific objectives Specific Objective Value without project (*) Expected value after completion 1. Increase in coverage of waste management services 2. Reduction of quantity of landfilled waste 3. Increase of quantity of recycled or reused waste 4. Establishment of efficient waste management structures 5. Reduction of number of historically contaminated sites [tons per year of total waste generated in the beneficiary county that is disposed of in accordance with relevant EU Directives] [percentage of total waste generated in the beneficiary county that is not recycled or reused] [tons per year of recycled or reused waste in beneficiary county] [indication of the adequacy of institutional setting for the sustainable operation of the waste management system, as YES or NO] [number of un-regulated dump sites in beneficiary county] [tons per year of total waste generated in the beneficiary county that is disposed of in accordance with relevant EU Directives] [percentage of total waste generated in the beneficiary county that is not recycled or reused] [tons per year of recycled or reused waste in beneficiary county] [indication of the adequacy of institutional setting for the sustainable operation of the waste management system, as YES or NO] [number of un-regulated dump sites in beneficiary county] (*) Refers not to the current situation but to the projected situation at the date of the foreseen completion of the project if the project is not implemented The user of this Guidelines are encouraged to check carefully the agreed SOPs for Romania in order to identify which priority axis are consistent with the propose actions and projects, and what are the objectives and targets sought under the relevant axis. It is recommended that each proposed project will carefully present both its overall and specific objectives according to the example developed above.

8 4.3 Option Analysis and selection of the most suitable option The presentation of the proposal for a public investment project to be co-financed by the CF and ERDF requires performing a full feasibility study to justify that the project is a well thought series of works, activities and services aimed at the achieving the objectives mentioned above. The results of the feasibility studies need to be presented as part of the Application for Major Investment Projects according to the requirement of Art. 40(c) of Regulation 1083/2006, as well as of HG 28/2008. While these studies are not formally part of the CBA, the results of feasibility studies are the basis upon which the CBA shall be performed. In particular, Evidence should be provided that the selected project is the most suitable alternative between the options considered 7. The identification of options will focus on the different means to achieve the specific objectives (and standards after completion) of the project, already pre-defined as a result of the previous section. This is typically done within the framework of the technical feasibility study and, if properly done in the first place, there is no reason to duplicate it just for the purposes of the CBA. HG 28/2008 requires that at least three options are taken into account: - a zero option (without investment), which implies the continuation of the status quo without any intervention; - a maximum investment option, which implies the implementation of the full scope of the investment proposed, to achieve the intended objectives; - a minimum investment option, which includes all the necessary realistic level of maintenance costs and a minimum amount of investment costs or necessary improvements, in order to avoid or delay serious deterioration or to achieve minimum compliance with safety standards. It is anticipated that more investment options can be considered in the analysis, depending on the characteristics of the project. It is expected that the selection of the option to be retained for the subsequent steps will be performed according to the following: a) If relevant, check all identified options against eventual qualitative criteria (to be established in light technical considerations or prevailing National policy)- to be duly justified in the analysis) and establish a reduced list of suitable and feasible options b) Rank the selected suitable options using economic analysis (with the goal to identify the alternative that allows achieving the intended objectives at the lower, long-term cost) or, depending on specific sectoral features or project characteristics, least cost methodologies (or cost effectiveness analysis, see annex 1 for details) 8. The methodology recommended to select the preferred option will be detailed in the respective sectoral guidelines. It is, however, anticipated that, if in step c) a simple least cost methodology is chosen for the option selection, the following two steps will also have to be taken into consideration. c) assess if the options differs in term of possible external impacts to society that are not captured by the least cost analysis (e.g., disruption of urban traffic when refurbishing roads) d) if differences in term of external impact are identified across options, adjust the least cost analysis to incorporate the identified externalities (this will require monetising the external impact) in order to establish a final ranking that takes into account those externalities. 7 See WD4, ibidem 8 Cost-effectiveness analysis is a comparison of alternative projects targeting a specific common effect or output, which may differ in magnitude. It is intended to select the alternative that, for a given output level, minimises the net present value of all costs (investment and operational costs), or, alternatively, for a given cost, maximises the output level. CEA results are useful for those projects whose benefits are very difficult, if not impossible, to evaluate, while costs can be predicted more confidently.

9 The option analysis performed according to the steps detailed above it is expected to identify the option that achieves the intended objectives at the minimum overall cost to society and that will be assessed in the framework of the CBA. 4.4 Financial Analysis Objectives and scope of the analysis The purpose of the financial analysis is to assess the financial performance of the proposed action and/or project over the period under consideration, with the view to establish the most suitable financing structure for the project. This is based on the extent of its financial self-sufficiency and long term sustainability, its financial performance indicators, as well as the justification for the amount of EU assistance being sought. More specifically, the financial analysis has to cover the following steps: (i) estimate the project revenues and costs and their implications in terms of cash-flow: Projects may generate their own revenues from the sale of goods and services; for example water, public works or toll highways. This revenues will be determined by the forecasts of the quantities of services provided and by their prices (demand analysis). Transfers or subsidies, and VAT or other indirect taxes charged by the firm to the consumer are usually not included in the calculation of future revenues. The operating costs comprise all the data on the disbursements foreseen for the purchase of goods and services, which are not of an investment nature since they are consumed within each accounting period. These include: direct production costs (consumption of materials and services, personnel, maintenance, general production costs), administrative and general expenditures; sales and distribution expenditures. In the calculation of operating costs, all items that do not give rise to an effective monetary expenditure must be excluded, even if they are items normally included in company accounting (depreciation, any reserves for future replacement costs; any contingency reserves). (ii) to determine the funding gap of the selected option and subsequently calculate the eligible expenditure that can be co-financed by the Funds: this is done according to the methodology described in section below. (iii) define the project financing structure and its financial profitability: this is done by taking into account the level of funding that can be obtained from the CF/ERDF funds, and all other source of financing (National sources, equity contributions, loans). (iv) verify the sufficiency of the projected cash flow to ensure the adequate operation of the project and meet all investment and debt service obligations: a project is financially sustainable when it does not incur the risk of running out of cash in the future. The crucial issue here is the timing of cash proceeds and payments. The analysis should show how over the project time horizon, sources of financing (including revenues and any kind of cash transfers) will consistently match disbursements year-by-year. Sustainability occurs if the net flow of cumulated generated cash flow is positive for all the years considered Calculation of financial flows The analysis is typically made up of a series of tables that collect the financial flows of the project, broken down as total investment, operating costs and revenues, sources of financing and cash flow analysis for financial sustainability. The methodology to be used is the discounted cash flow analysis (DCF) 9, which uses an incremental method that compares a scenario with the project with an alternative scenario without project. 9 The DFC method has the following features: Only cash flows are considered; i.e. the actual amount of cash being paid out or received by the project. Non-cash accounting items like depreciation and contingency reserves must not be included. Cash flows must be considered in the year in which they occur and over a given reference period

10 The incremental method is applied as follows: 1. Projections are produced of the operation s cash-flows (in term of expected revenues and costs, as well as other investments planned or needed in any case, for each year of operation) in absence of the proposed project (without project scenario). In case the proposed project is entirely new, the without project scenario is a scenario of no operations. 2. Similar projections of the operation s cash-flows are produced taking into account the proposed projects and its impact in term of operations (with project scenario). The project promoter shall take into account the whole investment plan, account for changes in O&M costs; adjusts tariffs (if relevant), taking into account affordability of services. 3. A cash flow for the investment is the difference between the cash flows in the with project scenario and the no project scenario. In case the proposed project is entirely new, the with-project scenario is the basis for the incremental cash-flow. The result of the process above is the incremental impact of the proposed projects in term of a financial cash-flows statement for all years of operation. The identified cash flow is then used to calculate the project financial performance indicators (i.e. the financial net present values FNPV/C and the corresponding financial return on the investment or FRR/C) in absence of co-financing from the Funds 10. As mentioned earlier, apart from projects subject to State Aid rules, co-financing is required only if the proposed project or action is not financially profitable. To that extent, a project will be eligible for co-financing only if, before EU interventions its FNPV/C is lower than 0, and its FRR/C is lower than the chosen discount rate Principles to follow in developing financial projections The financial projections for the project should be prepared on the basis of a financial model under the following principles: Reference period The reference period refers to the maximum number of years for which forecasts are provided. Forecasts regarding the future of the project should be formulated for a period appropriate to its economically useful life and long enough to encompass its likely medium to long term impact. The recommended reference period by sector is provided in the following table: Table 3: Indicative reference period by sector Sector Reference period (yrs) Energy Water and environment 30 Railways 30 Ports and airports 30 Roads Industry 10 Other services 15 When adding or deducting cash flows occurring in different years, the time value of money has to be considered using a predetermined discount rate. 10 FNPV/C is calculated by calcuting the Present Value of the stream of cash-flows in the net cash-flow statement. FRR/C is the corresponding Internal Rate of Return, at the chosen discount rate. 11 The financing gap and financial profitability indicators (FRR/C, FNPV/C, FRR/K and FNPV/K, before and after Community assistance) are calculated using a financial discount rate of 5% in real terms (unless otherwise justified), according to the regulations and more specifically according to the instructions in the Guide to Cost-Benefit Analysis of Investment Projects and Working Document 4: Guidance on the methodology for carrying out Cost-Benefit Analysis.

11 While these benchmarks are expected to be relevant in most of the cases, specific time horizons based on project-specific features might apply. In such cases, the analysis shall duly justify the choice of a different reference period. Financial discount rate A financial discount rate is used to calculate the present value of the cash flows developed in the analysis, for each given year, to take into account the time value of money. This is meant to reflect the opportunity cost of capital, which could be thoughts as the expected return forgone in the best alternative project. For the programming period , the EC recommends in WD4 that a 5% rate in real term is considered as the reference parameter for the opportunity cost of capital in the long term 12. To that extent, it is recommended to use the 5% in real term benchmark across all projects, unless it can be duly justified that for specific cases the average expected return in real terms shall be higher than the recommended benchmark, due the nature of the investor (for ensuring adequate returns to private equity involvement e.g. in PPP projects), or due to the average return normally experienced in specific sectors/ subsectors. In the latter case, however, the same discount rate value will have to be used for all projects in the sector/ subsector concerned. Last but not least, when the discount rate is expressed in real terms, the analysis shall be conducted in constant prices, while when the analysis is performed in current prices, then a nominal discount rate (which includes inflation) shall be used 13. Macroeconomic assumptions Macroeconomic inputs (namely the inflation and exchange rate for each year of projection) shall be based on the relevant statistical sources. Annex 3 of the Guidelines provides the recommended assumptions to be used Determination of EU Grant (Funding Gap Calculation) For projects that are considered Revenue Generating according to art 55.1 of the Regulation 1083/2006, the determination of the maximum level of EU co-financing is based on the concept of funding gap. The funding gap method does not apply when: - the project do not generate revenues - net revenues are negative, i.e. when operating costs are not covered by the revenues raised by the operation. In such cases, however, a financial sustainability analysis shall be conducted to make sure that enough cash is available to cover the related expenditure during the period of analysis. - also, the funding gap method shall not be applied to projects subject to State Aid rules (Article 55.6 of 1083/2006). For the projects that do not fall under the definition of Revenue Generating according to the above, the maximum level of EU co-financing is the one established in the relevant priority axis of the SOP from which the grant is requested. 12 This is based on the assumption that the Funds are drawn from the EU median taxpayer. This means that even if the project is region - or beneficiary-specific, the relevant opportunity cost of capital should be based on a European portfolio. Moreover, the integration of financial markets should lead to a unique value as long as convergence of both inflation and interest rates across EU countries is expected in the long-term. 13 In presence of low inflation, the real discount rate can be approximated using the Fisher formula, i.e. r = i π where r is the real rate i the nominal rate and inflation is π. In such cases, then, the nominal discount rate is obtained by adding to the 5% benchmark the 1+ i expected level of inflation. However please note that the general formula shall rather read as r = 1 + π

12 The funding gap is intended as the portion of the proposed (eligible) investment that cannot be covered by the net revenues accruing for the investment itself, both expressed in term of their current (present) value. The difference between the two values is considered as Eligible Expenditure when applying the co-financing rates specified in the relevant SOPs. Using cash flows calculated as in the previous section, the project promoters should calculate the maximum EU grant rate. WD4 gives clear instructions, which are replicated in the box below. In performing the calculations for the funding gap, the following points needs to be taken into account: Eligible Costs: The provisions on eligibility of investment costs can be found in Article 56 of Regulation (EC) 1083/2006 (General regulation for structural instruments); in Article 7 of Regulation 1080/2006 of the European Parliament and of the Council (ERDF); and in Article 3 of the Council Regulation 1084/2006 (Cohesion Fund). As a general rules, only costs incurred during the programming period are eligible for funding. Also please note, that eligibility constraints might be envisaged at national level by the relevant SOP. Revenues to be taken into account: only revenues defined as cash in-flows directly paid by users or other provisions of services against payment (including sale or rent of land) have to be taken into account in the determination of the funding-gap as defined in Article 55(2) of Regulation 1083/2006; other cash in-flows can be considered in the analysis of the national capital profitability, but they must be excluded from the determination of the funding-gap. Operating costs savings. operating cost-savings generated by the projects must be considered in the funding-gap calculation (since they are equivalent to net revenues). Operating cost-savings can be ignored where it can be demonstrated that they are offset by an equal reduction in operating subsidies (this needs to be duly explained and supported by evidence). STEPS TO DETERMINING THE EU GRANT PROGRAMMING PERIOD Step 1. Find the funding-gap rate (R): R = Max EE/DIC where Max EE is the maximum eligible expenditure = DIC-DNR (Art. 55.2) DIC is the discounted investment cost DNR is the discounted net revenue = discounted revenues discounted operating costs + discounted residual value Step 2. Find the decision amount (DA), i.e. the amount to which the co-financing rate for the priority axis applies (Art. 41.2): DA = EC*R where EC is the eligible cost. Step 3. Find the (maximum) EU grant: Î where EU grant = DA*Max CRpa Max CRpa is the maximum co-funding rate fixed for the priority axis in the Commission s decision adopting the operational programme (Art. 52.7).

13 Funding gap calculations are performed using the same reference period and discount rate used for the financial analysis. However, the discounted cash flow analysis performed to calculate the Funding Gap, should not include non-cash accounting items such as depreciation and contingency reserves, as clearly stated in Working Document 4. On the other side, replacement costs that are due to be incurred during the period of analysis (e.g., for electro-mechanical equipment with a shorter economic life) are included in the Funding Gap calculation as (discounted) operating and maintenance costs. The result of these calculations needs to be duly described in the Application Form for CF/ERDF funds, an extract of the relevant parts is attached in Annex 2 for reference Profitability Analysis In case of grant funded projects the profitability analysis is used to assure that the grant was properly calibrated and does not transfer too much funding to the project beneficiary. To that extent, the analysis is also expected to calculate the following financial indicators to show that the EU grant rate identified above is not too generous: FRR/C and FNPV/C FRR/K and FNPV/K FRR/C measures the capacity of the project to generate funds to provide an adequate return to all the sources which will be used to finance it (i.e.: equity and debt). As discussed above, FRR/C is calculated from a cash flow projection that covers the project's economic life and includes initial investment, replacement investments, operation and maintenance costs (but not financing costs) and taxes as outflows, and receipts from project revenues and project residual value at the end of its economic life as inflows. FRR/K measures the capacity of the project to provide an adequate return to the national capital invested and to the private equity contribution, if relevant. The FRR/K is calculated from the same cash flow projection, but detracting from the project investment costs both external loans and the EU contribution 14. FRR/K after subsidies should never exceed a certain threshold to avoid an excessive return of the project beneficiary at the expense of the EU tax payer. This threshold shall be justified taking into account the normally expected profitability of similar investments in the sector concerned by the project Financial sustainability The capacity of the project promoter to manage the implementation of the proposed investment is critical for the success of the intervention and, ultimately, to ensure the achievement of the intended objectives. To that extent, the project promoter shall demonstrate that the proposed intervention is financially sustainable and that it will not endanger its capacity to meet all financial obligations over the reference period. Financial sustainability implies having a cumulative positive cash flow for each year of the projections (in simple words, enough cash to run all its operations, present and proposed smoothly in each given year). Temporary shortfalls can eventually be covered by a revolving credit (which then need to be taken into account in the cash flow statement), provided that the assumptions behind this revolving credit are reasonable in regards to the local financial markets. Also, when the financing structure of the project includes a long-term loan to be paid with revenues within the 14 An alternative is to consider as project costs all contributions ensured by national authorities, both at a central and local level.

14 scope on the financial projections, a debt service coverage ratio 15 of at least 1.2 will be required for each year of the loan amortization period 16. When for specific reasons financial sustainability cannot be justified along the suggested lines of analysis (for example in the case of non revenue generating activities, like non toll roads), a clear indication of the potential sources to cover the needed subsidies shall be included as part of the analysis. It is anticipated that the funding authorities might require a formal confirmation from the identified sources to that respect Summary on financial tables Table 3: Financial Analysis at a glance User charges and affordability Where relevant, Managing Authorities shall take into account the implementation of the polluter pays principle during the analysis. This is relevant for the setting of direct user charges for specific infrastructural investment. At the same time, however, when appropriate, Art. 55 of 1083/2006 also allows for considerations of equity linked to the relative prosperity of the Member State concerned, which for all practical purposes implies that the total charges paid by the users for the services should not exceed certain commonly accepted thresholds in term of disposable income of the users. Details on such thresholds will be discussed within sectoral guidelines. 15 Measured as EBITDA/Debt Service, with EBITDA being the earnings before interest, taxes, depreciation and amortization 16 Or higher if required by the IFI co-financing the project, when applicable. 17 Guide to Cost Benefit Analysis of investment projects, 2008, European Commission

15 4.5 Economic Analysis Objectives and scope of the analysis As described above, economic analysis is required only for Major Projects. The purpose of the economic analysis is to prove that the project has a positive net contribution to society and is therefore, worth being co-financed by EU funds. For the selected alternative, the project s benefits should exceed the project s costs and, more specifically, the present value of the project s economic benefits should exceed the present value of the project s economic costs. In practical terms, this is expressed as a positive ENPV, a Benefit/Cost (B/C) ratio higher than 1, or a project ERR exceeding the discount rate used for calculating the ENPV. For the sake of these guidelines, it is recommended to use a social discount rate of 5.5%, as indicated by the EC in WD4. Project economic (as opposed to financial) costs are measured in terms of their resource or opportunity costs; that is, the benefit which has to be foregone (the opportunity lost) by society in using scarce economic resources in the project rather than in some alternative use. Similarly, project economic benefits can be measured in terms of the costs avoided as a result of implementing the project, or in term of external benefits that are results of the implementation of the project and that are not captured by the analysis performed in financial terms. The starting point of the economic analysis is the cash-flows calculated for the financial analysis, which requires two types of corrections to be converted in economic cash-flows: (i) fiscal and accounting (shadow) pricing correction (ii) monetization of externalities Fiscal and price corrections Fiscal corrections are needed for those elements of the financial prices that are not related to the underlying opportunity costs of the resources involved. To that extent, correction shall include deductions for indirect taxes (e.g. VAT), subsidies and pure transfer payments (e.g., social security payments). In particular, investment costs for beneficiaries that are not VAT registered (and for which VAT is therefore not recoverable) should include VAT in the financial analysis. This, however, should be excluded from the economic analysis. However, economic prices should include direct taxes. Once fiscal corrections are taken into account, it is necessary to ensure that the prices used in the economic analysis properly reflect the economic value of the resources concerned. Converting project costs from market to economic prices implies breaking down the project cost into the different categories listed below, with the required treatment specified for each case: a. Traded items: This category comprises all goods and services included in the project cost that can be valued on the basis of world prices. For an open economy with international tenders for procuring the equipment, materials and services, this category will normally cover most of the project costs. No specific conversion is required since market prices are assumed to reflect economic prices (i.e., opportunity costs). b. Non-traded items: This category comprises all goods and services that have to be procured domestically, like for example domestic transport and construction, some raw materials, and water and energy consumption. The conversion from financial to economic prices is usually done through a Standard Conversion Factor (SCF). The SCF is usually computed based on the average differences between domestic and international prices (i.e.: FOB and CIF border prices) due to trade tariffs and barriers. However, given that costs within this category are normally low with regards to total project costs and that roughly 70% of the Romanian trade is internal to the EU and

16 therefore by definition not subject to trade tariffs, the SCF will be 1 unless otherwise justified. c. Skilled labour: This category comprises the labour component of the project cost that is considered scarce and therefore adequately priced in terms of opportunity cost. No specific conversion is required since market prices are assumed to reflect economic prices. d. Non-skilled labour: This category comprises the labour component of the project cost that is considered in surplus (i.e.: in a context of unemployment) and therefore not adequately priced from the economic point of view. The correction to reflect the opportunity cost of labour could be made by multiplying the financial cost of un-skilled workers by the so-called Shadow Wage Rate Factor (SWRF), which can be calculated as (1-u)*(1-t), where u is the regional unemployment rate and t is the rate of social security payments and relevant taxes included in the labour costs 18. e. Land acquisition: This category comprises the land implicitly used in the project, even when no financial cost is included as part of the project cost (for example if the land for the landfill was provided free of cost by the project beneficiary). Correction of land costs intends to adjust for the net output that would have been produced on the land if it had not been used by the project. In those cases in which the land has been acquired at market value, the applicable conversion factor is 1 since it is assumed that the market value reflects the present value of the future output. Otherwise, the adjustment to reflect economic costs will have to be calculated on a case by case basis. f. Transfer payments: This category comprises indirect taxes (i.e.: VAT), subsidies, and pure transfers payments included in the market prices used to estimate the project costs. All these costs have to be eliminated for the purposes of the economic analysis 19. Table 4 summarizes the corrections from market prices to economic prices here indicated. The financial costs are converted into the economic costs by multiplying by the corresponding conversion factor. Also, note that the relevant costs to be considered for the economic analysis are the project s incremental costs, even if the financial analysis used the remaining historical cost method. Table 4: Applicable conversion factor per cost item Cost item Conversion factor Traded goods 1 Comment Non-traded goods 1 Unless otherwise justified Skilled labour 1 Non-skilled labour SWRF Calculated as (1-u) x (1-t) Land acquisition 1 Unless otherwise justified Transfer payments 0 18 This corresponds to a Shadow Wage of SW=FW*(1-u)*(1-t), with FW being the financial (or market) wage, and a Shadow Wage Rate Factor of SWRF=SW/FW. It has to be stressed that this approach is more correct where condition of high involuntary unemployment exists. However, if an investment project already has a satisfactory economic internal rate of return before corrections for labour costs, it is not necessary to spend much time and effort on the detailed estimation of the shadow wage. Having said that, in some cases the employment impact of a project may need careful consideration, in particular when: a) the project is likely to trigger employment losses in other sectors and the gross employment benefits may overestimate the net impact b) one of the objective of the project is to preserve jobs that otherwise would be lost; c) the project objectives are concerned with particular employment targets (e.g. youth, long term unemployed) and it is therefore important to consider the different impacts by target groups. 19 However, economic prices should be gross of direct taxes. Also, specific indirect taxes/subsidies intended to correct externalities do not need to be eliminated as long as there is no double counting.

17 4.5.3 Treatment of externalities Project benefits could take the form of benefits to society that are not properly taken into account in the financial analysis because, even if they are an intended outcome of the project, they are not fully captured by the financial prices due to the lack of a market value (and/or due to market distorsions). A typical example is the improvement in the quality of life of people living in an area that benefit from an environmental project. Quality of life could be improved as results of, for example, expected improvements to general human health in the area (as a result of reduction in pollution), or improvement in the attractiveness of the area subject to the intervention (due to improved environmental condition, for example cleaner watercourse as rivers and lakes). When looking at transport projects, benefits that are not captured in the financial analysis could be identified in term of time saved for commuting (due to a new road or improvement of the existing conditions) or a reduction in the risk and number of accident. Benefits related to projects in the energy sectors are expected, among others, in term of reduction of harmful emissions of gases (including CO2 and SO2), and fine particles (PMs). It is worth keeping in mind that the project could also have negative externalities not reflected in the opportunity costs and that need to be taken into account in the economic analysis. Negative externalities could take the form of possible impacts on the environment (spoiling of scenery, naturalistic impact, loss of local land and real estate value due to disamenities, such as noise and odour), negative impact due to the opening of building sites (temporary effect) or increased emission due to increased transport activities triggered by the project (for example as a result of the establishment of transfer stations for waste distant from the disposal site) Externalities (both positive and negative) are potentially present in all proposed actions and likely to be dependent on the specific characteristics of the projects. To that respect, it is recommended that externalities are identified on a case-by-case basis when performing the Economic Analysis. It is anticipated that, once all potential externalities are identified, the challenge is to take them into account in the Economic Analysis, since this will require translating them in economic terms by assigning a price (or cost) to them. This step could result being fairly complicated since, by definition, externalities don t have a price which is established by the market and, therefore, proxies needs to be used to convert them in economic terms. The general recommendation is to limit the assessment of externalities in the Economic Analysis to those for which a solid economic argument could be presented and for which a monetisation or estimates are realistically possible. In such cases where monetisation is difficult to justify, the identified externalities could be addressed as part of a multicriteria analysis, for example in the framework of option selection. To a certain extent, externalities are similar across projects or action that concern one specific sector, due to the characteristics and features of the actions traditionally concerned Sensitivity and risk analysis As provided for by Art. 40 (e) of the Regulation 1083/2006 and HG 28/2006, a sensitivity and risk analysis shall be included in the CBA. The goal is to deal with the uncertainty related to the implementation of investment projects, which is done by performing a sensitivity and risk analysis The purpose of the sensitivity and risk analysis is to asses the robustness of the project profitability indicators. For this purpose, the first part of the analysis (sensitivity analysis) aims at identifying the key variables and their potential impact in terms of changes in the profitability indicators, and the second part (risk analysis) aims at estimating the probability of these changes actually taking place, with the results expressed as a estimated mean and standard deviation for those indicators.

18 As a minimum, the relevant profitability indicators to be considered for the sensitivity and risk analysis are FRR/C and corresponding FNPV, and ERR and corresponding ENPV, calculated in all cases after the EU grant. The sensitivity and risk analysis consists of three steps, with the result of each one of them having to be reflected in the application for funding: 1. Identification of key variables: This step implies the identification of those variables that are considered critical for the sustainability of the project outcomes. It is done by calculating the values of the profitability indicators after variations of +/- 1% in a set of project variables. 2. Calculation of switching values for the key variables: Given the results of step 1, any project variable for which a variation of 1% results in a variation of more than 5% in the value of the base case FNPV or ENPV will be considered a key variable. These key variables require the calculation of the so-called switching value, which is the maximum variation (in percentage) in the key variable that is permitted before the FNPV or ENPV (whichever is relevant for that specific key variable) turns negative. 3. Estimation of probability distribution for the profitability indicators: this step implies a qualitative assessment of the relevant factors that may affect the values of the key variables as well as the mitigating measures already included in the project to reduce the impact of those factors 20. Then, there are two options to quantify the level of certainty of the calculated values for the profitability indicators: a. If there is reasonable information to define a probability distribution for the key variables 21, then it is possible to use statistical methods as Monte Carlo or similar, which assigns random values to all the key variables simultaneously (within their expected distributions) for a number or repetitions sufficiently high in order to come up with a probability distribution for each one of the profitability indicators. Then each profitability indicator will be expressed as the mean and standard deviation of the values obtained after all the repetitions. b. If there is no reasonable information to define a probability distribution for the key variables, then the risk assessment will be carried out by defining optimistic and pessimistic scenarios that include all the key variables, and then calculating the two extreme values for the profitability indicators based on these two scenarios. 20 For example, project outturn cost could be a key variable, poor definition of the different investments included in the project and their cost could pose a relevant risk in terms of project outturn cost, and the preparation of detailed designs and tender documents with realistic cost estimates as part of the feasibility studies could be a mitigating measure to control this risk. 21 Or at least a reasonable range of variation, assuming a normal distribution between the maximum and minimum value.