Industrial and investment

analysis as a tool for the

regulation of public services
Turin 7 September 2021
Sarah Shababi

Please do not distribute by electronic or other means or cite without permission

Outline
1.Examine investment appraisal and the related techniques;
2.Discuss the practical application of investment appraisal techniques
to the public sector;
3.Case study TRM

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Investment required by public services

Utilities tend to be capital-intensive and the requirement for significant

plant investment increases the need to raise capital to finance it.

Future financing capacities are approximated by the following 3 areas:

i) the ability to raise the price of public services; ii) the ability to
increase public spending; and iii) the ability to access private finance.

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Investment
An outflow/s of cash that is/are expected to lead to future inflow/s of
cash.

(100) 40 40 40

t0 t1 t2 t3

time

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Why do we need investment appraisal?

To determine which projects should be invested in and which should

be avoided or postponed.

In the private sector, the objective of investment appraisal is the

maximisation of shareholders wealth

To obtain (or increase) financing as it can show investors what the
expected returns are on an investment project.

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Investment appraisal techniques

NPV
Net Present Value
Investment Discounting
appraisal techniques
IRR
Internal Rate of
Return

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Discounting technique
NPV (Net Present Value)
It expresses the current value of the future cash flows relating to an investment

It is calculated as the sum of the present value of current and future cash outflows
and inflows related to an investment.

NPV=

• where:
CF= cash flow (inflow or outflow)
t= time period
k= cost of capital
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Discounting technique
NPV (Net Present Value)
NPV=

If NPV is positive, then investment project should be accepted

If NPV is negative, then investment project should be refused

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Net present value -cash flow calculation

(100) 40 40 40

1 1 1
(1 + 0,1) (1 + 0,1) (1 + 0,1)

t0 t1 t2 t3

time

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Net present value -cash flow calculation
NPV=

NPV= + + +

NPV= + + + = -100 +36.36 +33.04+30.04=

-0.56

NPV is negative, investment should be rejected

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Essential points for NPV calculation

Cost of capital

NPV=

Cash flows

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Cost of capital – discounting rate

Cost of Equity
CAPM

𝑘 Capital Asset Pricing

How much will it Model WACC
cost to finance the Cost of Capital Weighted average
investment project? Cost of Debt cost of capital
𝑘 Redeemable

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Cost of capital – Cost of Equity
Capital asset pricing model
• CAPM: =
where:
𝑟 = risk – free rate of interest
𝑟 = return on the market portfolio
𝛽 = index of systematic risk for the investment

• is the market premium. If the market premium is average β = 1. If the investment

project has more systematic risk than market average, β is > 1. If the investment project
has less systematic risk than market average, β is < 1

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Cost of capital – Cost of Debt
• =
= annual interest payment
= amount (market price) of the loan
T = corporation tax rate

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Weighted average cost of capital WACC
The cost of equity and cost of debt of a company must then be
combined to determine the weighted average cost of capital of a
company.
∗ ∗
WACC =
Where
• is the market value of the debt of the company
• is the market value of the equity of the company

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Weighted average cost of capital –
government grants or subsidies?
If the CapEx has been paid for directly by government or donor, and
they do not require any return on their investment, then there is no
financial cost of capital.

However, if a government has taken a loan to fund an investment

programme, then there is a cost of capital to the government and this
should be used as the cost of debt in the WACC calculation.

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2019
WACC – Ofwat risk and reward guidance PR19
Source:
https://www.oxera.com
/insights/agenda/article
s/cma-pr19-final-
determinations/

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WACC – Ofgem risk and reward guidance

Source:https://www.ofgem.gov.uk/ofgem-publications/131558

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Discounting technique
IRR (Internal Rate of Return)
It is directly linked to NPV but it is a relative measure rather than an
absolute measure.
It is the discount rate which makes the NPV of the project equal to
zero.

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Discounting technique
IRR (Internal Rate of Return)
If the IRR > target discount rate, investment project should be
accepted
If the IRR < target discount rate, investment project should be rejected

The target discount rate is the company’s WACC.

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Outline
1.Examine investment appraisal and the related techniques;
2.Discuss the practical application of investment appraisal techniques
to the public sector;
3.Case study TRM

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Qualitative and quantitative factors in making
investment decisions
Investment appraisal
• Policy relevance
• Strategic • Payback period
relevance • Average rate of
• Economic Qualitative Quantitative return (ARR)
rationale factors factors • Net present
• Public service value (NPV)
rationale • Internal Rate of
• Technical design Return (IRR)
• Achievability

BALANCE

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Appraisal and evaluation cycle ROAMEF –
Green Book HM Treasury, UK

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Applying investment appraisal techniques to
public utilities
In the case of a public utility where instead of shareholders, there is a
government, the objective is to maximise citizens’ benefit.

BUT in public sector investments, the benefit to citizens is

disproportionate, i.e. is enjoyed by a small proportion of the
community relative to the contribution that the citizens have made to
this investment (through taxes paid to the government).

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Investment appraisal in public sector -
disproportionate
Pay taxes to
help build
hospital

Benefit from
hospital

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Applying investment appraisal techniques to
public utilities
Pareto improving investments – an economic allocation that makes at least
someone better off and no one worse off. The investments are Pareto
optimal when no further investments can be made without making anybody
worse off.

Kaldor-Hicks improving investments – an economic allocation where

investments are made only if those that are made better off could in
principle compensate those that are made worse off.

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Applying investment appraisal techniques to
public utilities
Capital-intensive investments are appraised by taking into account the whole-life costs
across the complete life cycle of the investment as there may be significant
termination/decommissioning costs. In the public sector, it is common practice to identify
the option with the lowest whole-life cost as the option that offers the best value for
money (VfM).

An alternative is to carry out a Cost/Benefit Analysis of the proposed investment,

identifying all the costs and benefits whether they be social or economic and giving them a
monetary value. Difficult to quantify the future benefits of a public utility investment.
This means that frequently governments tend to take the benefits as given without
quantifying them and concern themselves only with the minimization of costs.
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Investment appraisal in public sector –
indirect benefits
Pay taxes to
help build
water
treatment
plant

Benefit from
Less taxes Less hospital admissions clean water

Less environmental damage from

misuse of scarce resources

Improved equity
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Cost-benefit analysis

The purpose of CBA is to facilitate a more efficient allocation of

resources, demonstrating the convenience for society of a particular
intervention rather than possible alternatives.

CBA is an analytical tool to be used to appraise an investment decision

in order to assess the welfare change attributable to it.

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Investment appraisal in public sector – how to
calculate indirect benefits
If indirect benefits can be expressed as a monetary value, use monetary
value

If indirect benefits can’t be expressed as a monetary value use:

- Willingness – to pay

- Multi – criteria analysis - weight and score the performance criteria

(critical success factors) of the benefits
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Willingness –to- Pay (WTP) or willingness-to-
accept (WTA)
WTA is the minimum
WTP is the
WTP or WTA amount of money
maximum amount
an individual is
of money an
willing to be
individual is willing
compensated for
to give up to
Stated Revealed foregoing a good
receive a good
preference preference

Contingent valuation Choice modelling 1) hedonic pricing

model = valuation of methods = valuation 2) travel cost
a non-market good as of specific attributes
a whole

1) contingent ranking
1) open ended
2) choice experiments
2) bidding game
3) contingent rating
3) payment card
4) paired comparisons Turin 2021
4) dichotomous choice elicitation
Multi-criteria analysis or multi-criteria
decision analysis (MCA or MCDA)
MCA establishes preferences between options by referring to an explicit set of
objectives/focus that the decision making body has identified and for which it has
established measurable criteria to assess the extent to which the objectives are
achieved in relation to the different options/alternatives

MCA is a way of looking at complex problems that are characterized by any mixture
of monetary and non-monetary objectives, of breaking the problem into more
manageable pieces to allow data and judgements to be brought to bear on the
pieces, and then of reassembling the pieces to present a coherent overall picture to
decision makers. Turin 2021
MCA – Analytical Hierarchy Process
Objective

Criteria 1 Criteria 2 Criteria 3

Alternative 1 Alternative 2 Alternative 3 Alternative 4

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MCA – Analytical Hierarchy Process
Improved
connection

Urbanisation Environment Accessibility

New public
Upgrade of
transport New bus route New by-pass
existing road
service

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Public sector – social discount rate
A social discount rate can be broadly achieved in 2 ways:

1)Social opportunity cost rate – is equal to the social rate of return on private investments
(SRRI) as before the government takes resources out of the private sector it must
demonstrate that society will be able to receive a higher return than it would have
received had the resources remained in the private sector.

2)Social rate of time preference (SRTP) - is equal to the marginal rate of substitution
between consumption in one period and the next period, i.e. it is the rate of return
needed to make society indifferent between consuming x today and x(1+r) in the next
period. In other words it is a measure of society’s willingness to postpone consumption
now to later.
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Social discount rates - SRRI
Country Social Discount Rate (real) Source
Australia 8% with sensitivity test over Harrison (2010)
the range 3-10%
Canada 8% with sensitivity test over Boardman et al. (2010)
the range 3-10%
India 12% Zhuang et al. (2007)
Ireland 5% Florio (2006)
Netherlands 4% Florio (2006)
New Zealand 10% Zhuang et al. (2007)
Pakistan 12% Zhuang et al. (2007)
Philippines 15% Zhuang et al. (2007)
USA (EPA) 7% Zhuang et al. (2007)

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Social discount rates - SRTP
Country Social Discount Rate (real) Source
France 4% Quintet (2007)
Germany 3% Florio (2010)
Italy 5% Florio (2010)
Portugal 4% Florio (2010)
Slovak Republic 5% OECD (2007)
Spain Transport 6% Water 4% Florio (2010)
UK 3.5% HM Treasury (2003)
USA (Budget) 2-3% Zhuang et al. (2007)

Social discount rates - WACC

China 8% for short –medium term Florio (2010)
<8% for long term
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Social discount rate – European Commission
Benchmark
SOCIAL DISCOUNT RATE: THE EUROPEAN COMMISSION BENCHMARK for the
programming period 2014-2020 the European Commission recommends that
the social discount rate of:
• 5 % is used for major projects in Cohesion countries and
• 3 % for the other Member States.
Member States may establish a benchmark for the SDR which is different
from 5% or 3 %, on the basis of certain conditions.

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Opportunity cost of capital – World Bank

The World Bank traditionally has not calculated a discount rate for each
project but has used 10 to 15 percent as a notional opportunity cost of
capital in developing countries

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Outline
1.Examine investment appraisal and the related techniques;
2.Discuss the practical application of investment appraisal techniques
to the public sector;
3.Case study TRM

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Case study
Trattamento
Rifiuti
Metropolitani
TRM video
TRM in figures per year
Energy produced per year
Cogenerating combined cycle provides:
• heating for 17.000 homes - thermal energy
170.000 MWh
• electricity for 175.000 3- people families -
electric energy 320.000 MWh

Tons of waste processed per year:

421.000 tons
TRM – company details

Muncipality of Others
Iren SpA Torino

18%
80%
2%

TRM SpA
Case study -details of investment
Cost of investment: € 503m
Useful life: 20 years
Expected tons of waste per year: 421.000 tons
Equity/debt % of company: 17% equity/ 83% debt
Main providers of project finance: EIB European Investment Bank , BNP Paribas
and Unicredit Corporate Banking
Bankability of project guaranteed through the future generation of cash flows
and contractual guarantees rather than real guarantees
Initial waste managment tariff equal to €/ton 97.5
IRR 8.6%
Sources
• Business Finance, The Institute of Chartered Accountants in England and Wales, sixth edition, 2006
• OXFORD REVIEW OF ECONOMIC POLICY, VOL. 13, NO. 4 R. A. BREALEY I. A. COOPER M. A. HABIB London Business School, Investment Appraisal in the Public Sector,1997
• Public Sector Accounting, Rowan Jones, Maurice Pendlebury, Pearson Education, June 2010
• Cost of capital for PR14: Methodological considerations, Ofwat July 2013
• HM Treasury, The Green Book, Appraisal and Evaluation in Central Government, July 2011
• Kaplan Publishing, ACCA paper 9, Financial Management
• A Review of Methods for Measuring Willingness-to-pay Breidert C, Hahsler M., Reutterer T.
• ACCA, IRR image at http://www.accaglobal.com/hk/en/student/exam-support-resources/foundation-level-study-resources/ffm/ffm-technical-articles/the-internal-rate-of-
return.html
• CAPM graphical representation at http://www.spreadsheetml.com/finance/capitalassetpricingmodel_capm_securitymarketline.shtml
• Valuation Techniques for Social Cost-Benefit Analysis: Stated Preference, Revealed Preference and Subjective Well-Being Approaches, DWP. HM Treasury, Daniel Fujiwara and
Ross Campbell, July 2011
• Multi-criteria analysis: a manual, Department for Communities and Local Government: London, January 2009
• Multi-criteria decision analysis for use in transport decision making Barfod, Michael Bruhn; Leleur, Steen, Technical University of Denmark, 2014
• THE EUROPEAN COMMISSION BENCHMARK, Annex III to the Implementing Regulation on application form and CBA methodology, for the programming period 2014-2020
• FLORIO M. (2006) Cost–benefit analysis and the European Union Cohesion Fund: on the social cost of capital and labour, Regional Studies 40, 211–224.
• Florio M. (2014), Applied Welfare Economics: Cost-Benefit analysis of projects and policies
• https://trm.to.it/

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NPV – Discount factor table

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