COST BENEFIT ANALYSIS, DEVELOPMENT PLANNING AND THE EU COHESION FUND: LEARNING FROM EXPERIENCE Massimo Florio and Silvia Vignetti University of Milan and Centre or Industrial Studies

Contents We consider the experience of project appraisal in the framework of the Cohesion Fund. In particular we discuss typical omissions and errors we have observed 1)Basic features of the context of Cohesion funds 2)Requirements for Cba in project appraisal as for the Regulations, the Guide for Applicants, the Application form and the Cba Guide 3)Technical topics in Cba identified as the most critical in project appraisal for the Cohesion Fund.

Topics  Time horizon, replacement costs, residual values, maintenance consts, depreciation  Financial versus economic discount rates  Shadow pricing of labour and the social benefit of employment  Dealing with risk and uncertainty in project appraisal

Main problems  Time horizon: usually shorter, sometimes longer than what suggested, in the Cba Guide. No clear relation among time horizon, economic life of assets and calculation of residual value.  Financial analysis: there is poor homogeneity among the financial discount rate and poor consistency with the discounted cash flow methods.  Shadow prices: the methodology is not always clear, especially for labour: sometimes employment effects are double counted.  Evaluation of externalities: discretionality is huge in the calculation of externalities and of non-market benefits, especially for effects with no market value.  Sensitivity analysis: it is often poor and with no convincing discussion on how to deal with critical variables in project implementation.  Risk analysis: almost always missing.

Time horizon Stock of machinery and equipment* is different sectors. Average service life (years). Selected countries * Machinery and equipment concern non manufacturing activities and does not include engineering construction. Source: Oecd (1993)

Social discount rate Social discount rate in different member states

Shadow wages Unemployment rates in EU15, 1996 and Source: Third Report on economic and social cohesion, DG REGIO

Shadow wages SW: = 660 CF: 660/1000= 0.66 CF=(1.2*0.2) = 0.66

Sensitivity and scenario  Most of the sensitivity analysis we have seen are mechanical usage of a spreadsheet that shows some critical variables, without any attempt either to transform uncertainty surrounding these key variables in computable risks, or to deal with them at least with a qualitative discussion about possible solutions.  A shortcut we have seen in some projects is to recur to ‘contingencies’. A typical example are price contingencies or physical contingencies.

Risk analysis To move from sensitivity analysis to risk analysis the basic steps are:   identification of critical variables through linear or non linear sensitivity tests   select a range or extreme values for such variables   select the most appropriate probability distribution to the values in the interval   Montecarlo simulations based on random extractions of the states of the world   calculation of probabilistic performance indicators.

Conclusions  Cost-benefit analysis is an evaluation tool that has a great potential for decision making but also shows some implementation difficulties. This is quite clear considering in particular the Cohesion Fund experience.  With the enlargement process the Cohesion Fund will play a fundamental role in fostering the development in the environmental and transport infrastructures in the new member states. For that reason there is a scope for better understanding the theoretical basis and operative rules to implement appropriate cost benefit analysis