Cost Benefit Analysis and Value for Money

1. Cost Benefit Analysis and Value for Money 17 June 2014

2. Contents Cost Benefit Analysis 1. Introduction to Cost Benefit Analysis 2. Defining the problem 3. Methodology for Makassar 4. Results for Makassar Value for Money Analysis

3. Benefit-Cost Analysis (BCA) Benefit-Cost Analysis is a systematic process for calculating and comparing benefits and costs of a project for two purposes: • to determine if it is a sound investment (justification/feasibility) • to see how it compares with alternate projects (ranking/priority assignment) Benefit-Cost Analysis works by defining the project and any alternatives; then by identifying, measuring, and valuing the benefits and costs of each.

4. When to Use Benefit-Cost Analysis Benefit-Cost Analysis is most applicable for evaluating proposed projects that meet the following criteria: • The potential project expenditure is significant enough to justify spending resources on forecasting, measuring and evaluating the expected benefits and impacts. • The project motivation is to improve efficiency rather than to meet some legal requirement or social goal. • Environmental or social impacts that are outside of the transportation system efficiency measurement are either: • negligible in magnitude • measurable in ways that can be used within the benefit-cost framework; or • to be considered by some other form of project appraisal outside of the benefit-cost analysis.

5. When to Use Benefit-Cost Analysis Benefit-Cost Analysis is neither necessary nor desirable to justify all transportation projects. It may not always be appropriate in the following cases: • Projects motivated by a need to meet legal requirements — such as safety standards or environmental impact standards. • Projects motivated primarily by a need to address distributional equity concerns — i.e., legal, political or moral desires for fairness. • Projects that are merely maintaining, renovating or rehabilitating already-built transportation facilities, which are necessary to avoid losing the already-demonstrated benefits of those existing facilities (unless there are viable alternatives present)

6. BCA vs Economic Impact Assessment (EIA) Economic impacts are the effects a project or policy has on the economy of a designated project area Economic impacts can result from various sources, including time savings to businesses, operating cost savings, the strengthening of local and regional market connectivity, etc. Economic impacts arise because a transportation investment causes a change in prices, or a change in business behavior that improves business investment, attraction, expansion, retention, or competitiveness

7. BCA vs Economic Impact Assessment (EIA)

8. BCA vs Economic Impact Assessment (EIA)

9. Difference between financial and economic analysis

10. Consumer and Producer Surplus • Consumer Surplus is the difference between the price that consumers pay and the price that they are willing to pay. It is the area between the equilibrium price and the demand curve • Producer surplus is the difference between the price that a producer receives and the minimum amount that the producer would be willing to accept for the good/service.

11. Consumer and Producer Surplus In the case of the expansion of the Port of Makassar, there are three types of user benefits (Consumer Surplus) as a result of a port expansion: • Benefits to existing traffic from efficiency improvements • Benefits to diverted traffic (it is assumed that there is no diverted traffic due to the high costs to use alternative ports) • Benefits to deterred traffic avoided • In the case of the expansion of the Port of Makassar, the producer surplus is the revenue generated through operations less all operating and maintenance costs, also subtracted is the revenue that would have gone to the existing port for traffic that switches over to the new port. • It is assumed that none of the revenue would have been directed to alternative container ports due to their distance from Makassar.

12. Transport CBAs A key aim of an economic appraisal of a transport project is to measure the magnitude of the economic impact resulting from the investment. When it comes to transport, price alone is not an appropriate measure of the consumer's WTP, instead generalized cost is used. Investment costs (including mitigation measures) Change in system operating costs and revenues (Producer Surplus and Government impacts) Change in costs of externalities (Environmental costs, accidents, etc.) Change in transport user benefits (Consumer Surplus) Overall Economic Impact = + + -

13. Project description Makassar Port is the largest port in Sulawesi and the fourth largest container terminal in Indonesia The Makassar Port Master Plan predicts that the Makassar Port would cater up to 33M tonnes by 2022 and 64M tonnes by 2032, far outstripping the current capacity of the port (over 7M tonnes in containers and another 7M tonnes in general cargo and bulk). Given the long term limitation in capacity under the current configuration of the existing terminals at Makassar Port, the 2013 Makassar Port Master Plan suggests the development of container terminal facilities in three phases to the north of existing port. The master plan suggests that the capacity of the port would thus be increased to approximately 3M TEUs by 2032.

14. Project objectives and impacts The development of the new Makassar Port will increase the capacity to around 1,000,000 TEU p.a. with the first terminal expected to have around one-third of this. It will also improve the efficiency of the existing traffic at the current Makassar port. New Makassar Port will serve as a model for the preparation of potential PPP projects by port administrations in future, particularly because until now private investment in public ports has been limited. New Makassar Port is expected to give significant contribution to increasing economic growth in South Sulawesi. The increasing trend of economic growth would be attractive to international port investors.

15. Perspective and scope The perspective of the new Makassar Port benefit cost analysis is taken from South Sulawesi viewpoints which includes the stakeholders who incur some costs and who receive the benefits: • The consumers of port services (the exporters and importers in South Sulawesi). • The producer of port services (the port operator).

16. Time period The time period for the new Makassar Port benefit-cost analysis is 30 years, starts with the first project expenditures, and extends through the useful life of the project which maximizes the estimated economic efficiency of the project.

17. Level of effort Considering that the development of the Makassar Port has very high costs and significant effects, it is clearly worth considerable effort to determine whether benefits exceed costs and to identify the most economically advantageous alternative. It is necessary to compare the benefits and costs that would exist in the event that the project was carried out, with the benefits and costs without carrying out the project by taking into account the key aspects of port development such as engineering, financial, and economic.

18. Defining the Base Case and project option BASE CASE ALTERNATIVE • The current Makassar port constrained at an ‘efficient’ capacity of 550,000TEU p.a. • It has been assumed that the port can continue accepting container traffic beyond this capacity, however this will introduce additional delays. • These delays will cause waiting time to increase as the capacity increases. • The port will continue accepting freight up until the ‘hard’ capacity of 1,000,000TEU p.a. • Develop the new Makassar Port with container terminal facilities to the north of existing port. • The new Makassar Port will have a capacity of around 1,000,000 TEU p.a. with the first terminal expected to have around one-third of this.

19. Timing of costs and benefits With Phase 1 of the Port of Makassar expansion project, the total container capacity will be increased to the extent that Demand will not exceed supply until after 2030.

20. Discounting A dollar today is worth more than a dollar five years from now even if there is no inflation because today's dollar can be used productively in the ensuing five years, yielding a value greater than the initial dollar. Future benefits and costs are discounted to reflect this fact. The purpose of discounting is to put all present and future costs and benefits in a common metric, their present value. Discounting is present in all benefit-cost. Discount rates are typically based on interest rates for government borrowing, which has little risk, with the inflation component removed, yielding the "real" interest rate. Although some development agencies such as the World Bank and ADB recommend using a standard 12% for all projects.

21. Benefits Stream

22. Net Present Value The sum of discounted costs are subtracted from the sum of discounted benefits. Projects with positive net present value should be considered; the greater the net present value, the more justifiable the project. However, a large project could have a higher net present value than a smaller project, even if it has a lower benefit-cost ratio. 

23. Benefit Cost Ratio To calculate the benefit cost ratio, total discounted benefits are divided by the total discounted costs. Projects with a benefit-cost ratio greater than 1 have greater benefits than costs; hence they have positive net benefits. The higher the ratio, the greater the benefits relative to the costs. It is important to remember that simple benefit-cost ratio is insensitive to the magnitude of net benefits. Therefore if comparing two project options it may favour the option with the small costs and benefits over those with higher net benefits.

24. Benefit Cost Ratio Option A: Benefits $150m Costs $100m NPV $50m BCR 1.5 Option B: Benefits $100m Costs $60m NPV $40m BCR 1.66 Which option to choose?

25. Economic Internal Rate of Return (EIRR) • The EIRR determines the discount rate where the PV of benefits is just equal to the PV of costs. • The EIRR is often compared to the discount rate to assess economic viability. Often there will be a hurdle rate that the EIRR must be above for the project to be accepted. Sometimes this is the discount rate although it may be higher.

26. Methodology for Ports In order to develop a CBA, it is necessary to compare the benefits and costs that would exist in the event that the project was carried out, with the benefits and costs without carrying out the project by considering three types of user benefits as a result of a port expansion: • Benefits to existing traffic from efficiency improvements – Improved efficiency of the existing port as throughput above ‘efficient’ capacity is shifted to new port. • Benefits to diverted traffic – If traffic is diverted to alternative ports due to capacity constraints this will impose extra costs on cargo owners. The new port will remove those extra costs. • Benefits to deterred traffic avoided – These are the benefits to traffic that couldn’t be transported through the port at the current capacity but can be transported if the capacity is increased. • In this case, benefits are represented by the consumer and producer surplus and costs are represented by the capital and O&M costs.

27. Methodology for Ports Supply and demand for port services before and after a port expansion Fig. A) Case with competitive alternative port Fig. B) Case with non-competitive alternative port

28. Methodology for Ports Supply and demand for port services before and after a port expansion Case with competitive alternative port • The supply is fixed at S0 which is the current ‘hard’ capacity of the port. • There is an excess of demand over available supply made up by diverted (QS-Q0) and deterred traffic (Q1 – QS). • If capacity is expanded to S1 to meet demand, then both the diverted traffic and deterred traffic will use the existing port. • The consumer surplus is the difference between the demand curve and the generalised cost at the existing port GC0. • The producer surplus is the price received for port services multiplied by the quantity of deterred traffic (Q1-QS).

29. Methodology for Ports Supply and demand for port services before and after a port expansion Case with non-competitive alternative port • The Port of Makassar case is slightly different because the only other port on the island currently moving significant container volumes could not be considered a realistic alternative as it is over 1000 km away from Makassar and the costs to transport goods by road would be prohibitively expensive. • In this case where the generalised cost to transport from the alternative port (GCS) is above the willingness-to-pay, all demand beyond the existing capacity is deterred traffic. Therefore an expansion in port capacity will result in a larger consumer and producer surplus.

30. BREAK

31. Methodology for Makassar • Estimating Benefits • Benefits to existing traffic from efficiency improvements – Improved efficiency of the existing port as throughput above ‘efficient’ capacity is shifted to new port. • Benefits to diverted traffic – due to the high costs to use alternative ports it is assumed that there is no diverted traffic for Makassar. • Benefits to deterred traffic avoided – These are the benefits to traffic that couldn’t be transported through the port at the current capacity but can be transported if the capacity is increased. These have been treated separately for imports and exports due to the different impact of each.

32. Methodology for Makassar The demand forecasts are used as the unconstrained demand for container trade. Without detailed data regarding the shape of the demand curve it is difficult to estimate the total consumer surplus. The approach taken is to use the average value-add of the export volumes as an estimate of the profit margin which is essentially the differences between the generalised cost of transport and the consumer’s willingness-to-pay. Due to the difference in commodity types and economic impacts of imports and exports, these have been treated separately in the analysis.

33. Methodology for Makassar Benefits to existing traffic from efficiency improvements

34. Methodology for Makassar Benefits to existing traffic from efficiency improvements

35. Methodology for Makassar Benefits to existing traffic from efficiency improvements This additional delay is quantified using: the value of the containerised goods converted to a daily value based on borrowing rates. The value of a shipping container converted to a daily value based on borrowing rates. Daily charter rate of the average size ship on a per TEU basis.

36. Methodology for Makassar Benefits to deterred export traffic • These are the benefits to traffic that couldn’t be transported through the port at the current capacity but can be transported if the capacity is increased. • An estimate of consumer surplus for each exported container has been made using the average value-add of export products. This has been calculated using a breakdown of trade products, production quantities, estimated export percentages and value of products.

37. Methodology for Makassar Benefits to deterred export traffic • The following charts shows the estimated quantity of export TEUs that will move through Phase 1 of the new terminal, that would not have otherwise been shipped due to capacity constraints.

38. Methodology for Makassar Benefits to deterred import traffic • Manufacturing in Sulawesi relies on a much higher level of imported products including machinery and chemicals than the Agriculture industry. The manufacturing industry has been growing at an average annual rate of 7.2%p.a (real) over the past decade and, for the purposes for this analysis, has been assumed to continue growing at 6%p.a, in line with the GDP growth forecasts for South Sulawesi. However, this growth rate assumes companies have the ability to import and export at unconstrained levels. It is assumed that once capacity is reached the excess demand for imported containers goes unmet (due to the previously discussed lack of alternative container ports).

39. Methodology for Makassar Benefits to deterred import traffic

40. Methodology for Makassar Producer surplus – benefit to new port operators The producer surplus is the revenue generated through operations less all operating and maintenance costs, also subtracted is the revenue that would have gone to the existing port for traffic that switches over to the new port. The revenue from all throughput at the new port is included in the producer surplus as it is assumed that none of this revenue would have been directed to alternative container ports due to their distance from Makassar.

41. Methodology for Makassar Total Benefits

42. Methodology for Makassar Discounted Benefits

43. Results for Makassar Results of the economic cost benefit analysis • The result of a benefit cost ratio of 5.0 and an economic internal rate of return of 27% shows the project will provide a large net welfare benefit to the region.

44. Results for Makassar There are two elements to this project that result in the high stream of benefits across the appraisal period: • The strong growth in container traffic demand is forecast to continue, quickly outstripping the capacity of the current port and creating a large amount of unmet demand. • Due to the lack of an alternative container port in South Sulawesi, coupled with the distance and poor infrastructure connections to container ports in North Sulawesi, once the existing port reaches capacity the excess demand is unlikely to be able to shift to an alternative port. Therefore the benefit to the shipper of goods is not merely in reduced transport costs but in providing the ability to economically import or export at all.

45. Results for Makassar Results of the sensitivity analysis • The results of the sensitivity analysis demonstrates the findings are quite robust with strong results even at the lower trade forecasts or high discount rate. • The positive result of the economic cost benefit analysis highlights the crucial role the Port of Makassar plays in the economy of South Sulawesi.

46. Results for Makassar Without significant capacity expansion the delays will increase exponentially at the existing port adding additional costs to freight transport costs. The financial analysis shows there is an opportunity for a private operator to make a commercial return from the facility. The economic benefits shown in this project arise without the need for significant government support. For this reason, any government support required to facilitate the success of the project such as providing supporting transport connections, would represent excellent value for money.

47. Break

48. Value for Money Analysis Value for Money (VFM) is the optimum combination of whole-of-life costs and quality (or fitness for purpose) of the good or service to meet the user’s requirements. Broadly speaking, a PPP may provide value for money compared to traditional procurement models if the advantages of risk transfer combined with private sector incentives, experience and innovation outweigh the increased costs of contracting and financing. This raises challenges for policy-makers: how to assess the value for money of different procurement and delivery options—that is, carry out “value for money (VFM) analysis”—and how to use the results of this analysis in PPP decision-making.

49. Value for Money Analysis VFM analysis plays an important role in many PPP programs: a recent OECD study found that 19 of 20 surveyed countries apply some kind of value for money assessment to proposed PPPs. However, even in countries with well-established PPP programs, the approach to and use of this analysis is evolving, and is often the subject of controversy and debate.

50. Value for Money Analysis Achieving VfM in PPP projects is in large part derived from their ability to transfer risk from the public entity to the private partner (Aldrete et al., 2010). The fundamental idea is that the private sector is more skilled at managing certain types of risk than the public sector (MzikayiseBinza, 2008). Risk in PPPs can be defined as the chance that an expected outcome for a project does not occur. More technically, this can be stated as the chance that the benefits and costs of a project are not allocated to the public and private entities as expected at the project’s onset (Aldrete et al., 2010).