1. GETTING INCENTIVES RIGHT: DO WE NEED EX POST CBA? Sixth European Conference on Evaluation of Cohesion Policy Warsaw, 30 November-1 December 2009 Massimo Florio 1

2. Ex-ante CBA and Grant 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 projects 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. 2

3. Common mistakes and pitfalls in 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 3

4. 4 Forecasts and actual costs of EVATREN projects (million EURO)

5. Main causes of errors in costs estimation 5

6. Systematic 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. 6

7. Systematic 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

8. CBA IN A MULTI-GOVERNMENT SETTING Six types of agents: Individuals: consumers,workers,tax-payers, shareholders Private firms: profit maximizers Public firms: fully under governments control Regional planners/evaluators National planners/evaluators The supra-national planner/evaluator 8

9. The European Commission as a supra-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 9

10. What evaluators do? Select policies (not projects) Given their constraints solve a planning problem in terms of a set of shadow prices Hire ex-ante evaluators to appraise project 10 Gather project data Make forecasts Use shadow prices (they must be price taker!) as given by the planner Check if the project passes the CBA test: positive shadow profits What planners do?

11. How bottom-up evaluation works 11 Regional National EC Each evaluator selects profitable projects:intersection gets approval

12. Information: uncomplete 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? 12

13. Investment game with ex-ante ex- post 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. 13

14. 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 14

15. 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. 15

16. 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. 16

17. 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 17

18. 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 18

19. 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. 19

20. 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 20

21. ADVANTAGES OF THE INCENTIVE BASED 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 21

22. ADVANTAGES OF THE INCENTIVE BASED MECHANISM (2) If the bonus is shared between the management team and the regional planner, the incentive works for both players. The ex-ante evaluator gets a reputation bonus (penalty) for realism (optimism bias). If the ex-post evaluator is a rating agency on behalf of the EU, there will be a more transparent learning process on regional/national/sector projects success and failures 22

23. CONCLUSIONS 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. 23