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
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 project’s economic net
present value is positive, if negative, the
project will be immediately rejected.

In the case of revenue generating projects, the
financial profitability is assessed in order to
establish whether the project actually needs
a grant and to what extent this applies.
2
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
Forecasts and actual costs of
EVATREN projects (million EURO)
Cost
Total construction costs
Project
Overrun (%)
Actual
Forecast
ICE Frankfurt - Cologne
2784
6015
116%
Eurotunnel
2702
4568
69%
Oeresund Fixed Link
1795
2924
63%
Paris – Lille TGV
2666
3334
25%
Madrid - Seville AVE
3263
4029
23%
Magdeburg Waterway Crossing
2064
2435
18%
Lyon - Marseilles TGV
4015
4338
8%
990
945
-5%
2200
1830
-17%
Malpensa 2000*
Baltic Sea Motorway*
4
Main causes of errors in costs
estimation
Mag- OereICE
Paris- Lyon- Madrid- Euro Malpensa Baltic Sea
deburg sund Frankfurt- Lille Marseilles Seville tunnel Airport Motorway
Water- Fixed Cologne HST
HST
AVE
way Link
Crossing
Delays in implementation
X
Changes in project specifications & design
X
X
X
X
X
X
X
Changes in rates between currencies
Geological risk
Changes in quantity and prices
X
Underestimation of expropriation costs
X
Changes in safety requirements
Changes in environmental requirements
Technological risks
X
X
X
X
X
X
X
X
5
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.
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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
CBA IN A MULTI-GOVERNMENT
SETTING
Six types of agents:
Individuals: consumers,workers,tax-payers,
shareholders
• Private firms: profit maximizers
• Public firms: fully under government’s control
• Regional planners/evaluators
• National planners/evaluators
• The supra-national planner/evaluator
•
8
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
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What planners 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
What evaluators do?




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
10
How bottom-up evaluation works
EC
Regional
National
Each evaluator selects profitable projects:intersection gets approval
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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?
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Investment game with ex-ante expost evaluation
•
The supra-national planner is a European SWF
maximizer, who adopts an infrastructure policy,
offers shadow prices and grants to regional
planners, appoints ex-post (contract assignment)
evaluators.
•
The regional planner is a regional welfare
maximizer, including the private agenda of policy
makers. He appoints ex-ante evaluators, selects
projects, offers contracts to project managers.
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•
The project manager is a profit maximizer, who
wants to cover costs, earn a rent, knows
technology and knows how much effort is needed
to decrease costs
•
The ex- ante evaluator using regional shadow
prices appraises a project producing one unit of
good with gross social benefit S and social cost
C.
Total Costs = C + S = β - e + S
•
S is fixed, C is variable: b is a technology
parameter (adverse selection), e is managerial
effort to minimize costs (moral hazard): C= b-e
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•
Technological costs are private information of the
manager, there are two technologies, but
everybody knows their probability distribution: p
and (1-p) .
•
Managerial effort cannot be observed, its
disutility is y(e) (first and second derivative are
positive). C can be always observed ex post,
technology only when there is ex post
evaluation.
15
•
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
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+l) > 0
The utility change for the manager is:
U = t - y ( e).
Social welfare change, without welfare weights is:
W=V+U
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Equivalently:
W=S - (1+l) ( b-e+U+ y ( e)) +U= S - (1+l) ( b-e+ y ( e)) -lU.
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=y ( 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 b.
18
•
The participation constraint for both management
teams is U non negative.
•
The incentive constraint for the more
efficient firm is that U of the efficient type is
greater than U of the less efficient type if he
accepts the lower-cost higher –incentive contract
than if he accepts the higher cost-lower incentive
contract. Symmetrically for the other type.
•
In this context it is well known that the efficient
types gets an information rent in any case.
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•
The rent can be limited by the ex-post
evaluator, who is able to discover the
technology parameter. If the efficient type is
discovered to have mimicked the inefficient type,
there is a penalty.
•
The optimal frequency of ex-post evaluation is a
function of its cost, and of other parameters,
including the degree of asymmetric information,
the shadow price of public funds, the weight of
the private agenda of the regional policy-makers.
•
Conclusion: the optimal incentive design is
region-specific
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ADVANTAGES OF THE INCENTIVE
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
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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
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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.
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