The Economic Appraisal of Investment Projects at the EIB - 2nd Edition E-Book

• Herausgeber: European Investment Bank
• Kategorie: Fachliteratur
• Sprache: Englisch
• Veröffentlichungsjahr: 2023

Seitenzahl: 524

Beschreibung

The EIB performs economic appraisals of the projects it considers for investment. Thereby, it ensures that projects add sufficient value to society to merit support. Beyond considerations of financial profitability to investors, the economic appraisal also addresses the wider value generated by the project to society. This comprises benefits and costs to project final users, the taxpayer and third parties, allowing for all applicable market failures, such as environmental externalities. Since the publication of the first edition of this document in 2013, the EIB has been transformed into the EU Climate Bank. The way it values carbon emissions has been updated, as have various other elements of economic appraisal, in keeping with developments in the specialist literature, policy and practice. This second edition of the document gives the reader an updated view of how economic appraisal is currently conducted at the Bank. It also mentions the areas on which the EIB is currently working to ensure that it is at the forefront of economic appraisal practice.

Leseprobe

The Economic Appraisal of Investment Projects at the EIB

2nd Edition, March 2023

About the European Investment Bank

The European Investment Bank Group is the EU bank and the world’s biggest multilateral lender. We finance sustainable investment in small and medium-sized enterprises, innovation, infrastructure, and climate and environment. We have financed Europe’s economic growth for six decades and are at the forefront of EU crisis response, leading the world in climate investment and backing development of the first COVID-19 vaccine. We are committed to triggering €1 trillion in investment in climate and environmental sustainability to combat climate change by the end of this decade. About 10% of all our investment is outside the European Union, where our EIB Global branch supports Europe’s neighbours and global development.

Table of contents

List of abbreviations and acronyms

Contributors

Foreword

1. Introduction

Part 1: Methodology topics: Cross-sector

2. Financial and economic appraisal

3. Defining the counterfactual scenario

4. Cost of carbon

5. Biodiversity and ecosystem services

6. Other environmental externalities

7. Land acquisition and resettlement

8. Wider economic impact

9. Economic life and residual value

10. Social discount rate

11. Multicriteria analysis

12. Risk analysis and uncertainty

Part 2: Methodology topics: Sector-specific

13. Benefits of fixed telecommunications very-high-capacity networks

14. Value of time in transport

15. Value of transport safety

16. Road vehicle operating costs

17. Traffic categories in transport

18. Risk-reduction analysis in the water sector

Part 3: Sector methods and cases

19. Education

20. Power generation

21. Energy networks

22. Energy efficiency

23. Heat supply

24. Health

25. Private Sector Research, Development, Innovation and Digitalisation (RDI)

26. Research infrastructure

27. Manufacturing capacity

28. Telecommunications

29. Forestry

30. Advanced biofuels

31. Interurban railways

32. Roads

33. Urban public transport

34. Airports

35. Seaports

36. Regional development

37. Urban development

38. Solid waste management

39. Water and wastewater

List of abbreviations and acronyms

3G: Third generation (of mobile telecommunications technology)

AIC: Average incremental cost

B/C: Benefit–cost (ratio)

B&E Biodiversity and ecosystem

BGC: Behavioural generalised cost

CAPEX: Capital expenditure

CAPM: Capital asset pricing model

CBA: Cost–benefit analysis

CEA: Cost-effectiveness analysis

CO2: Carbon dioxide

CO2e: Carbon dioxide equivalent

DG REGIO: Directorate-General for Regional and Urban Policy

DH: District heating

DSL: Digital subscriber line

EIB: European Investment Bank, or “the Bank”

ENPV: Economic net present value

EPO: European Patent Office

ERDF: European Regional Development Fund

ERIAM: Economic Road Infrastructure Appraisal Model

ERP: Enterprise resource planning

ERR: Economic rate of return

ETS: Emissions Trading System

EU: European Union

FNPV: Financial net present value

FRR: Financial rate of return

FTTLA: Fibre to the last amplifier

FTTH: Fibre to the home

GC: Generalised cost

GHG: Greenhouse gas

GDP: Gross domestic product

HV: Heavy vehicle

IATA: International Air Transport Association

ICT: Information and communications technology

IER: Institute of Energy Economics and Rational Energy Use

IM: Infrastructure manager

IRR: Internal rate of return

JASPERS: Joint Assistance to Support Projects in European Regions

kV: Kilovolt

kWh: Kilowatt-hour

LC: Levelised cost

l/c/d: Littres/capita/day

LCU: Local currency units

LCOE: Levelised cost of energy

LCOH: Levelised cost of hear

LRMC: Long-run marginal cost

LV: Light vehicle

MCA: Multicriteria analysis

MW: Megawatt

MWh: Megawatt-hour

NOx: Nitrogen oxide

NPC: Net present cost

NPV: Net present value

NTFP: Non-timber forest product

OECD: Organisation for Economic Co-operation and Development

O&M: Operations and maintenance

OPEX: Operating expenditure

PJ: (EIB) Projects Department

PV: Present value

R&D: Research and development

RDI: Research, development and innovation (including digitalisation)

RED II: Renewable Energy Directive II

ROA: Real options analysis

ROIC: Return on invested capital

RP: Revealed preference

RU: Railway undertaking

SDR Social discount rate

SOC: Social opportunity cost

SO2: Sulphur dioxide

SP: Stated preference

SRMC: Short-run marginal cost

STP: Social time preference

SWM: Solid waste management

TEN-T: Trans-European Network - Transport

TEU: Twenty-foot equivalent (container) unit

VAT: Value-added tax

VHC: Very high capacity

VOC: Vehicle operating cost

VOSL: Value of a statistical life

VOT: Value of time

WACC: Weighted average cost of capital

WOP: Without project

WP: With project

WTP: Willingness to pay

Contributors

This guide was authored by European Investment Bank staff members involved in project appraisal and economic analysis, as detailed below. Production of the document was managed by José Doramas Jorge-Calderón and Oliver Henniges.

The authors benefited from the advice of a panel of external academic advisors, comprising Professor Massimo Colombo (Milan Polytechnic University), Professor Ginés de Rus (Universities of Las Palmas and Carlos III), Professor Per-Olov Johansson (Stockholm School of Economics), Professor Bengt Kriström (Swedish University of Agricultural Sciences) and Professor Marc Suhrcke (Luxembourg Institute of Socio-Economic Research). The role of the panel was solely advisory, and no errors or omissions should be attributed to its members.

The authors of the document were as follows:

Introduction

J. Doramas Jorge-Calderón

Part 1: Methodology topics: Cross-sector

Financial and economic appraisal

Harald Gruber and Pierre-Etienne Bouchaud

Defining the counterfactual scenario

J. Doramas Jorge-Calderón

Cost of carbon

Edward Calthrop

Biodiversity and ecosystem services

J. Doramas Jorge-Calderón

Other environmental externalities

Susana Lagarto and Diego Ferrer

Land acquisition and resettlement

Edward Calthrop

Wider economic impact

Edward Calthrop

Economic life and residual value

Diego Ferrer

Social discount rate

J. Doramas Jorge-Calderón

Multicriteria analysis

Christine Blades

Risk analysis and uncertainty

J. Doramas Jorge-Calderón

Part 2: Methodology topics: Sector-specific

Benefits of fixed telecommunications very-high-capacity networks

Anders Bohlin, Tobias Münstermann

Value of time in transport

Diego Ferrer

Value of transport safety

Diego Ferrer

Road vehicle operating costs

Pierre-Etienne Bouchaud

Traffic categories in transport

J. Doramas Jorge-Calderón

Risk reduction analysis in the water sector

Thomas van Gilst

Part 3: Sector methods and cases

Education:

Silvia Guallar Artal and Nihan Koseleci Blanchy

Power generation

Dominik Ruderer

Energy networks

Eugene Howard, Federico Ferrario, Manuel Baritaud, and Susana Lagarto

Energy efficiency:

Isidoro Tapia, Francesco Angelini and Davide Sartori

Heat supply

Susana Lagarto

Health

Dorothee Eckertz

Private-sector research, development innovation and digitalisation:

Antonello Locci and Tom Andersen

Research infrastructure

Martin Humburg

Manufacturing capacity:

Antonello Locci and Tom Andersen

Telecommunications:

Anders Bohlin and Tobias Münstermann

Forestry:

Alexander Horst and Sylvain Caurla

Advanced biofuels

Laura Maria Catana

Interurban railways

Marcial Bustinduy

Roads:

Pierre-Etienne Bouchaud (reviewed by Diego Ferrer)

Urban public transport:

Simona Dobrescu and Mauro Ravasio

Airports

J. Doramas Jorge-Calderón

Seaports

Tom Scheltjens

Regional development

Paul Hickey

Urban development

Mesut Akbas

Solid waste management

Patrick Dorvil

Water and wastewater

André Oosterman and Thomas van Gilst

The authors are grateful to Gina Castro-Mitschke and Carmen Garcea for assistance with revising and preparing the guide, Aktuel Translations Ltd for proofreading and Charlesworth for copyediting.

Foreword

The economic appraisal of an investment project goes beyond the financial appraisal by valuing all benefits and costs brought about by the investment to society as a whole. This way of appraising projects is central to the operations of the European Investment Bank (EIB). It allows the Bank to judge whether an investment will contribute to sustainable economic growth and cohesion in the European Union and to economic progress of its partner countries.

This guide illustrates how the EIB conducts economic appraisal across the various sectors of the economy where it operates. The Bank uses standard economic appraisal techniques, including cost–benefit analysis, cost-effectiveness analysis and multicriteria analysis, taking into account the evolving circumstances of each productive sector of the economy.

Economic appraisal is not a static discipline. With the development of new technologies and industries, advances in techniques and the publication of new academic findings, the methodologies and parameters used in project appraisal must evolve. Also, the policy context within which investments take place changes over time, with implications for appraisal techniques and parameters.

This second edition of the guide follows the EIB’s adoption of the Climate Bank Roadmap in 2020, which incorporated into Bank operations the commitments established in the Paris Agreement. More precisely, through the roadmap the Bank committed to help transform and adapt the European economy and those of its partner countries to meet the 2050 target for an average global temperature no more than 1.5 °C above the pre-industrial level.

Crucially, this policy objective involves a revised approach to valuing greenhouse gas emissions in project appraisals. This second edition of the guide presents the implications for appraisals across economic sectors. Beyond global warming, the revised document also addresses developments in appraisal practice since the first edition was published in 2013. Importantly, the Bank is working to enhance the valuation of project benefits and costs for preserving biodiversity and supporting ecosystem services — a young, rapidly evolving frontier in applied economics. The guide summarises the Bank’s progress in this field.

The overall aim is to keep the Bank at the forefront of viewing projects comprehensively; to identify the value of project outputs to citizens alongside any environmental costs and benefits; to allow for a fair, competitive return to private-sector investors while also valuing the implications of projects for public sector finances. The outcome should be to foster sustainable economic growth while ensuring that any public money invested is well spent, for the European Union and its partners.

Gunnar Muent

Director General, Projects Directorate

1.Introduction

J. Doramas Jorge-Calderón[1]

1.1Objective of the guide

This document presents the economic appraisal methods that the European Investment Bank (EIB or “the Bank”) uses in order to assess the viability of projects. An economically viable project is one that invests resources to generate a sufficiently high return to society. Given the societal focus, the terms economic and socioeconomic are used interchangeably in the document.

This guide gives the general reader an overview of methods, and the specialist insights into how the Bank applies analytical tools across sectors. It is not intended as a manual or set of instructions on how to conduct the economic appraisal of a project — there are already many widely available textbooks and guides.[2] Likewise, the aim is not to review the theory behind economic appraisal, as there are already many widely available references for that purpose.

This document has been written by over 30 EIB economists working on project appraisal, each reporting on their areas of specialisation. Economic appraisal is an ever-evolving field, and individual contributors have identified areas where work is ongoing to update parameters or revise methods. This guide thus gives a snapshot of economic appraisal practices at the time of writing and is intended to be updated over time.

Importantly, the guide covers economic appraisal only. Overall appraisal of a project by the EIB Projects Directorate also considers technical, environmental, social, financial and procurement aspects. More broadly, all Bank operations also involve credit, risk, compliance and legal assessments.

This introductory chapter presents the case for economic appraisal, which complements financial appraisal in measuring the returns of a project to society. It then describes how the conditions under which the Bank operates shape the type of appraisal performed. The chapter concludes by outlining the structure of this guide.

1.2The need for economic appraisal

In competitive, undistorted markets with well-defined property rights, the revenues generated by an investment project measure the value of the output for users, while the costs (involving cash outflows) measure the value (or opportunity cost) of resources used in producing the output. In other words, prices for inputs and outputs are valid measures of societal value and scarcity. In addition, since projects tend to be marginal in relation to the size of the economy at large, they do not affect prices more than marginally, and hence there is no need to make additional considerations about consumer or producer surplus. Under such circumstances, the financial return on capital of the project would be a necessary and sufficient indicator to determine whether the project is worth undertaking or not from the social welfare point of view.

However, markets are not always sufficiently competitive, prices are often distorted, and property rights are sometimes not well defined, leaving externalities with no price assigned to them. For these reasons, a project’s financial return may not be an adequate indicator of the desirability of the project for society at large. At times, such as with some public goods, a financial return may not exist at all. Provision of public goods may be offered free of charge to the user and generate no revenues to the investor, such as a dyke to preserve an eroding beach.

The standard economic appraisal technique for assessing a project’s socioeconomic desirability is cost–benefit analysis (CBA). It is designed to produce a measure of project returns that corrects for the various market distortions and constraints mentioned above.

CBA has a long tradition in Europe. Originally conceived by French engineer Jules Dupuit (1848), it has been extensively developed by economists. CBA has become a standard part of public decision-making in many Member States, notably as a means to justify use of public funds. Besides the EIB, many other international financial institutions and international organisations also use CBA to appraise projects’ economic desirability.

The outcome of a CBA is summarised in two complementary figures—the economic rate of return (ERR) and the economic net present value (ENPV). The ERR of a project is the average annual return to society on the capital invested over the entire project lifetime. It is, in other words, the interest rate at which the project’s discounted benefits equal discounted costs, both valued from the point of view of society as a whole. A project is accepted if the ERR is equal to or exceeds a certain threshold (the social discount rate, or SDR). The ENPV of a project is the difference between benefits and costs, both discounted with the SDR. Projects are deemed to add value to society if the ENPV is positive.

Despite this seemingly schematic way of applying CBA, it is worth emphasising that economic appraisal by means of CBA is more than just a mechanical exercise. Good analysis can help clarify the aim of the project; estimate what will happen if the project is undertaken, and what will happen if it is not; evaluate whether the proposed project is the best option available; identify whether the components of the project are the most efficient; identify who wins and who loses from the project; quantify the overall impact on government’s fiscal position; evaluate whether the project is financially sustainable; assess project risks; and, ultimately, give decision-makers an informed view on whether the project is worthwhile for society.

CBA measures the difference between the flow of costs and benefits with the project and those without — the "with-project" (WP) and "without-project" (WOP) scenarios, respectively. Policy choices are rarely between a project and no project — rather, there are usually several plausible policy alternatives. For instance, decision-makers might choose between constructing a new 100-kilometre greenfield motorway, constructing 50 kilometres of new greenfield motorway and upgrading the existing road for the other 50 kilometres, or upgrading the existing 100-kilometre road. Economic analysis will typically compare several policy scenarios against a common WOP baseline. Moreover, given the typically long lifespan of infrastructure and other capital assets, flows —whether benefits or costs— must be measured over many years for each scenario.

Depending on the nature of alternatives for assessment and on the type of data available, a comprehensive CBA may not be possible. In such cases, the economic appraisal may instead use cost-effectiveness analysis (CEA), which focuses on the cost of attaining a given target, or multicriteria analysis (MCA). These alternatives are not necessarily substitutes and may be seen as complementary to full CBA, particularly if economic viability is to be weighed against other policy considerations. However, the Bank makes a discrete choice among the methodologies, applying CBA where feasible, CEA where the appraisal focuses on choice of technology, and MCA where other methods are deemed impractical.

Much depends on the extent to which output variables, particularly benefits, can be measured and monetised. Where benefits are hard to quantify, traditional CBA becomes challenging and CEA is more practicable. On some occasions, the benefits of projects may be obvious, or policy may require that a project of one sort or another be carried out, without a need to prove societal value added at the project level. In such instances, the type of investment or programme is determined through a political process and CEA is used to determine the best project to achieve the desired results: this is generally the one that achieves the greatest output per unit of input.

MCA combines various evaluation techniques addressing different criteria, applying weightings to each to produce a single score that is used to compare alternative projects. Typical criteria include affordability, income distribution, compliance with strategic objectives, quality of the promoter’s internal decision-making, aesthetic appeal of the project, etc. Both CEA and MCA are mere decision-making tools. Neither of the two measure the value added by the project to society.

The general suitability of the three techniques for different project circumstances is summarised as in Table 1-1. The two drivers are the extent to which output variables can be measured (and monetised) and the degree to which the project produces multiple outputs.

Table 1-1: Suitability of methodologies for project circumstances

Number of output variables

High

Low

Degree to which output variables can be easily measured and monetised

High

CBA

CEA

CBA

CEA

Low

MCA

CEA

The aim of all three techniques is to go beyond financial flows, and to allow for distortions that may be present in markets, to reflect wider benefits and costs to society, in order to assess the viability of the project to meet society’s needs. However, only CBA comprehensively measures societal benefits and costs, making it the preferred method whenever practicable.

1.3Economic appraisal at the EIB

The Bank finances projects in a very broad range of sectors, essentially covering all but a few industries (exceptions include tobacco and gambling). Targeted sectors include competitive industries, oligopolies and natural monopolies, as well as public goods. The outputs produced include manufactured goods and services. These services include, among others, basic services where consumer surplus may be impracticable to measure, as will be apparent in the sector presentations in Part 3 of the document.

Such variety requires the Bank to use an array of methodologies rather than a single, homogeneous one. About half of EIB project appraisals rely on ERR calculations, while the other half use alternative methods. This variety means that the results of appraisals across sectors are not always directly comparable. Nonetheless, it is necessary for appraisals to yield compatible results and guide decision making consistently, meaning that the application of alternative methodologies to projects (where feasible) would yield the same discreet decision on suitability for Bank financing.

1.3.1Context of Bank appraisals

The previous section overviewed the role of economic appraisal in informing political choice on a project’s socioeconomic value. This primarily benefits national authorities, not least in justifying to taxpayers the use of public funds. This type of appraisal is most useful when performed early in the project cycle, when very different courses of action could be taken (e.g. deploying alternative renewable energy technologies; high-speed rail versus upgrading a conventional rail system). In many Member States, economic appraisal is a sizeable industry in itself. A large project may require five to ten person-years of consultancy work on developing models, collecting data, and analysing different scenarios. In some sectors, such as road transport, economic appraisal is often undertaken by Bank services based on the project promoter’s economic feasibility study. In other sectors, however, Bank services must normally construct the economic appraisal from scratch, based on business plans and financial projections.

If the promoter has produced an economic appraisal based on studies of consistently high quality, Bank services review and summarise the available material and their suitability for decision-making. In practice, however, several possible problems may be encountered when discussing a project’s economic justification with the promoter.

1.3.2Possible problems with studies presented to the Bank

“No appraisal”. In some countries, there is only a weak tradition of justifying the selection of a particular project via an explicit analysis of costs and benefits. Whilst regular attempts are made to improve this situation, often initiated by the Bank itself,[3] the fact remains that, for the time being, many projects come accompanied with little more than a financial model. In addition, if the domestic political decision to fund has already been made, there may be inadequate incentives for the promoter to go back and quantify the impact of discarded options or a “without project” scenario. In this case, the Bank’s services perform their own economic appraisal.

“Deficient appraisal”: While views may differ on specific points (e.g. the assumptions of a particular model), a feasibility study prepared by a consultant may not meet the minimum standards for transparency, rigour and internal consistency, such as under guidance from the Directorate-General for Regional and Urban Policy (DG REGIO). In such cases, the Bank extracts the key assumptions from the existing work, discusses them with the promoter, and reworks the analysis within a consistent appraisal framework. In this respect deficiencies may concern the use of impacts on the regional economy or on jobs created as part of the project benefits, which constitutes mostly double counting and confuses benefit and impact analysis.[4]

“Over-optimistic appraisal”: In some cases, promoters are over-optimistic on future demand patterns for their project – indeed, this may even be a strategic response to the need to outbid other competing claims for national and European funds. As a result, Bank services revisit the promoter’s basic model but with different key assumptions – lower demand growth, perhaps, or including a more realistic project implementation schedule, as well as extending the sensitivity analysis. In this exercise, the Bank draws on extensive experience in appraising similar projects. If the Bank lacks access to the promoter’s model, it is necessary to "translate" that model into a simplified format, and then explore how robust findings are to different assumptions on key inputs.

1.3.3Need for consistent tools within the Bank

Even within Europe, promoters’ studies vary in quality as regards plausibility, rigour and transparency. Accordingly, the Bank’s services need to have a common approach when presenting projects to the Bank’s decision makers, including the Management Committee and the Board of Directors. That is to say, even where promoters provide studies that are plausible, rigorous and transparent, there is a need to develop internal tools to provide a consistent view on projects across different countries.

For those sectors where financial appraisal is a poor proxy for economic appraisal, Bank services to develop simple, practical appraisal tools that can be rapidly applied to a wide variety of projects. The Bank has been using such models for many years, developing the nature and type of models over time as new methods become available.

1.3.4Use of methodologies across sectors

In appraising the economic viability of projects, the EIB uses CBA, CEA and MCA as substitutes rather than complements, and employs CBA whenever possible. In some sectors it may not be practical to estimate the benefits yielded by a project, such as where the policy context demands that the output be offered: examples include provision of clean water or a minimum level of healthcare. There are also some projects that normally involve simultaneous interventions in various economic sectors, such as in regional or urban development. The economic appraisal then focuses on whether the project constitutes the most efficient way to supply the good or service. CEA is only practicable when the output or service is homogeneous and easily measurable, such as the provision of electricity. In sectors where outputs can have many dimensions and may not be easily measurable, such as education, health and projects addressing the urban environment, MCA constitutes a better substitute to CBA than CEA.

Table 1-2 summarises the Bank’s use of methodologies across sectors. The table is indicative, as the choice of appraisal technique is ultimately determined by the circumstances of each project.

Table 1-2: Methodology use by the EIB across sectors

CBA

CEA

MCA

Agro-industry

Energy

Health

Manufacturing

Telecommunications

Transport

Water and wastewater

Energy

Solid waste management

Water and wastewater

Education

Health

Research infrastructures

Urban and regional development

1.4Structure of the guide

The document is structured in three parts. The first two parts address methodological topics, whether relevant across many sectors (Part 1) or sector-specific (Part 2). These two parts do not seek to present an exhaustive guide to carrying out an economic appraisal; instead, they describe how the EIB addresses key methodological issues. This 2023 edition of the guide expands on the treatment of environmental externalities in the preceding 2013 edition. Whereas this topic was previously addressed in only one chapter, it is considered in three chapters herein: the first explores the treatment of carbon emissions following the adoption of the Climate Bank Roadmap (CBR) in 2020; the second discusses ongoing work on valuing biodiversity and ecosystem services externalities; and the third addresses other externalities such as air pollution and noise. Future versions of the guide may address additional issues in response to new policies or methodological developments deemed noteworthy.

Part 3 describes the application of appraisal methods to specific sectors. Each chapter identifies the key variables and circumstances affecting economic appraisal in individual sectors, and overviews the important parameters and assumptions used. One or more short case studies are also presented for each sector.

Part 1:

Methodology topics: Cross-sector

2.Financial and economic appraisal

Harald Gruber and Pierre-Etienne Bouchaud

2.1Financial appraisal

The essence of financial appraisal is identifying all spending and revenues over the project lifetime, with a view to assessing the project’s ability to achieve financial sustainability and a satisfactory rate of return. The appraisal is usually performed at constant market prices and in a cash flow statement format, listing all revenues and spending at the time they are incurred.

2.1.1Revenues

The cash flow statement sets out the revenues to be derived from a project. These revenues can take several forms depending on the source. The easiest to identify are the products and services sold through normal commercial channels, as well as any commercially exploitable by-products and residues. Revenue is then forecast by simply estimating the sales values of these products and services. For certain types of projects (e.g. some infrastructure projects), revenues can be derived indirectly by monetising usage or availability. Whereas for projects run by private-sector promoters, or public-sector promotors acting as such, the revenues can be easily identified in the accounts, public-sector projects generally do not generate revenues. The financial appraisal of such public-sector projects is thus limited to determining whether public transfers will cover the operating and capital costs throughout the project lifetime.

2.1.2Expenditures

The cash flow statement lists both capital and operational expenditures. Capital expenditure (CAPEX) is spending on those items needed to set up or establish the project. It usually covers items related to constructing facilities, including site preparation and other construction costs; plant and equipment, comprising not only acquisition cost but also the costs of transport, installation and testing; vehicles; and working capital. For projects involving innovation components, certain cost items such as research and development (R&D) and other current expenses related to innovation can also be capitalised, and hence treated as CAPEX.

Operating expenditure (OPEX) is spending incurred in operating and maintaining the project. It typically comprises raw materials, labour and other input services, repairs and maintenance. Pre-operating expenses, sunk costs, preparatory studies and working capital may be included under certain conditions, particularly when they have longer-term effects on the project. In a financial appraisal used as the basis for economic appraisal, other costs such as depreciation, interest and loan repayments are not included. Depreciation is excluded because it would double-count the capital cost, while interest and loan repayments are excluded because a major purpose of deriving cash flow is to determine what interest rate the project can bear.

Some projects do not lead to any direct increase in revenues but achieve their objective by reducing OPEX. When these flows can be quantified, they are included in the cash flow as negative OPEX. This can be quite straightforward for greenfield projects. However, where the project adds to an existing activity, a difference between WP and WOP scenarios is established and the project’s output should be denoted by increased revenues or decreased OPEX, not the outcome of the activity as a whole. This ensures that only the project’s impact is calculated. Care must be exercised in constructing a counterfactual, as some increases in spending or revenues after the project’s establishment would have occurred even without it. "Before and after" is not the same as "with and without," and in project analysis the "with and without" comparison matters. In such cases it has proven effective to prepare two separate cash flow projections, one with the new project and one without it, and then treat the differences as the project’s impact.

2.1.3Subsidies and other public finance items

Project revenues, as is generally the case with all commercial activities, are subject to taxes and may also attract operating subsidies. Likewise, capital spending can be supported by subsidies. Reporting these items separately in the profitability calculation also helps to identify potential levers for increasing or decreasing the project’s financial profitability.

2.1.4Financial profitability

The financial profitability calculation evaluates the rates of return to the project’s financiers, including suppliers of both equity and debt. This step provides indications about the incentives for improving the project’s operational and financial structure. The cash flow statement illustrates the project’s ability to raise its own financing and whether it is financially sustainable. Sustainability is summarised, for instance, by the financial rate of return (FRR), denoting the discount rate that yields a zero NPV of cash flow over the project lifetime. The FRR is then compared with the overall cost of funding rate, which represents the private incentive to undertake the project. If the FRR falls below the cost of financing,[5] the project is financially not worth undertaking, and thus requires a redesign and/or additional funding sources such as grants and subsidies.[6] These considerations are important for policymakers to determine the appropriate level of subsidies for a project that — owing to market failure — the private sector will not implement independently. In such cases, the level of subsidies should be designed for the promoter to reach the level of cost of funding in a competitive market setting. At the same time, financial profitability also allows competition authorities to determine whether subsides are justified or excessive.

These considerations are illustrated by a schematic example in Table 2-1. With subsidies the project would lead to an FRR of 6%. If the current cost of financing for private-sector companies in the same sector, such as the weighted average cost of capital (WACC), exceeded 6%, the promoter would not undertake the project. Subsidies (or net tax reductions) would need to be higher to make the project financially viable for the promoter. Clearly, if additional subsidies would cause the FRR to rise too much, competition authorities (particularly the European Commission) would step in and object to over-subsidisation under state aid regulations. One often-observed feature of EIB funding is allowing the promoter to significantly reduce the financing cost and, therefore, also ensure the financial viability of projects that previously would not have been undertaken.

Table 2-1: Example financial rate of return (FRR) calculation

For public sector projects, particularly those not raising revenues but requiring transfers from the public treasury, the FRR is not applicable. Financial analysis is thus limited to assessing whether the public sector is willing or able to provide the funding required for costs over the project lifetime.

Finally, the FRR calculation is normally complemented with a sensitivity analysis. This tests the robustness of the FRR base-case estimate against deviations in typical parameters driving profitability, such as price, unit cost and capital cost. This analysis is important for assessing the likelihood of a private-sector project having sustainability issues due to adverse economic effects, and for finding ways to mitigate the possible impact of these effects.

2.2Economic appraisal

2.2.1Elements of economic appraisal

Indications of financial profitability do not necessarily provide reliable estimates of a project’s value from a social welfare or European view, focusing instead on private investors' perspective. Interests do somewhat coincide, making financial appraisal a valid starting point to assess a project’s economic viability: financial profitability can even be valid guidance on economic profitability. In most cases, however, such guidance does not apply, for instance when there are important spillovers or externalities. Projects can lead to both positive and negative externalities for society and the net effect could be in either direction. These costs or benefits would arise as a direct consequence of a project but accrue to economic agents other than the project sponsors or outside the primary market. Such indirect effects can be very important, especially when environmental or information resources such as innovation are involved, and they should clearly be considered when deciding whether or not to accept a project proposal. Accordingly, the analysis must be broadened to include these external benefits of a project. For example, in the transport sector such economic benefits of improved roads typically include (i) the value of time (VOT) saved by users, (ii) the diminution of vehicle operating costs (VOCs), (iii) the reduction in accidents, and (iv) environmental benefits linked with a reduction in CO2 emissions. These may be accompanied by economic costs, such as increased maintenance costs, or negative externalities, such as higher CO2 emissions resulting from induced traffic or higher travel speeds.

Differences between financial and economic profitability can also be due to price distortions resulting from taxes or subsidies. In this case, the prices used in economic analysis should differ from those used in financial analysis, which are typically market prices (on shadow prices, see section 2.2.3). The prices may differ significantly where a project’s inputs or outputs display distorted prices, particularly when they do not include all environment costs, such as CO2 emissions or environmental degradation. This could lead to private investors either investing more than is optimal for society or undertaking projects not in society’s interest. A project may be profitable only for its sponsors because it benefits from subsidies or regulated prices. This is a common situation where the project’s products or inputs compete with others at market prices. The consequence is either the government losing revenue or consumers paying higher prices than they would otherwise pay, with the risk that the country becomes a high-cost producer unable to compete internationally.

Economic analysis also captures positive externalities of projects involving research, development and innovation (RDI). It is well known from the economic literature that innovative activities generate positive knowledge spillovers in the economy, and that product innovation leads to considerable consumer surplus. Such effects are not considered in financial analysis as the private promoter is generally unable to appropriate them. However, economic analysis includes these effects.

The economic analysis should also net out public transfers and subsidies paid to the project, which are neither a benefit nor an economic cost.[7] From the promoter’s perspective, taxes and subsidies affect project revenues and spending, but from society’s point of view, a tax levied on the promoter produces income for the government whereas a subsidy is a public expense. Thus, the flows net out. Transfer payments affect the distribution of project cash flows, so it is important to assess who gains and who loses from the project. Usually, the government collects taxes and pays subsidies. In these cases, the difference between the financial and economic analyses accounts for a major portion of the project’s fiscal impact.

Some care must be exercised in identifying taxes. Not all charges levied by governments are transfer payments: some are user charges levied in exchange for goods sold or services rendered. For example, water charges paid by farmers to the irrigation authority (a government agency) are in exchange for use of water. Whether a government levy is payment for goods and services or a tax depends on whether it is directly associated with a purchase and accurately reflects the real resource flows associated using a product or service. For example, irrigation charges rarely cover the true cost of supplying the service; thus, while they indicate a real resource flow rather than a pure transfer payment, the real economic cost would be better measured by estimating the long-run marginal cost (LRMC) of supplying the water and treating the difference between this cost and the charge as a subsidy to water users.

Subsidies are taxes in reverse and should thus be removed from a project’s receipts when carrying out economic analysis. From society’s perspective, subsidies are transfers that shift control over resources from giver to recipient but do not represent a use of resources. The resources needed to produce an input (or import it from abroad) represent the input’s true cost to society. For this reason, economic analysis uses the full cost of goods, not the subsidised price.

In some cases, a project may not only increase an output but also reduce its price for consumers. Output price changes typically (but not only) occur in power, water, sanitation and telecommunications projects. When a project lowers the price of its output, more consumers can access the same product and existing consumers pay a lower price than before. Valuing benefits using the new quantity and the new, lower price would thus understate the project’s contribution to societal welfare by ignoring the consumer surplus: the difference between what consumers are prepared to pay for a product and what they actually pay. In principle, the benefits of a project include the increase in consumer surplus of existing users (thanks to lower prices flowing from lower costs) and the willingness of new customers to pay, net of incremental cost.

2.2.2Economic profitability

After taking into account all costs and benefits for society, the economic analysis determines whether the project is worth undertaking. The economic analysis is a crucial decision tool for a public sector, policy-driven bank such as the EIB, which is bound by its statutes to support the European public interest. The Bank uses the ERR as a benchmark, i.e. the discount rate that yields a zero NPV of economic net benefits over the project lifetime. The ERR is then compared to the SDR (see chapter 10). If the ERR falls below the SDR, the project as defined is economically unjustified and so should not be undertaken, as it would constitute a misallocation of economic resources. An ERR at or above the SDR is a prerequisite for the Bank to finance the project.[8] A commonly used alternative indicator is the NPV, calculated using the discount rate: a project is economically viable if its NPV is positive. The ERR and NPV capture different aspects of the project return but lead to the same conclusions on viability (except in cases of multiple ERRs, which makes the ERR irrelevant for the decision-making process).

The ERR calculation is illustrated by a schematic example in Table 2-2. The project’s net economic benefits over its lifetime lead to an ERR of 11%. If the SDR of the economy is below 11%, then financing of this project is justified. The nature of the benefits may differ considerably depending on the sector and, in particular, the type of promoter. Projects promoted by the public sector typically have low (if any) revenue streams. Hence, the benefit calculation must include non-monetary benefits accruing from the project and its economic externalities. Projects with an ERR below the SDR are an inefficient allocation of resources and, ultimately, an economic burden to society throughout the project lifetime.

Table 2-2: Example ERR calculation

The ERR therefore captures the net value added by the project to society, while the FRR captures the value added to the investors. The Bank takes the spread between the two (ERR-FRR) as an indicator of the “broader social benefit” added by the project to society (see chapter 10)—broader in in the sense of being over and above the value captured by investors.

2.2.3Shadow prices

In the financial analysis, costs and benefits are valued at prices the promoter is expected to pay and receive. These prices are usually set by the market but may, in some cases, be controlled by the government. However, these prices do not necessarily reflect economic costs to society. The economic values of inputs and outputs may differ from their financial values because of market distortions created by the government, the macroeconomic context or the private sector. Such distortions or market biases can reflect GHG emissions, over- or undervaluation of the domestic currency and imperfect market conditions, including low labour mobility and large underemployment. To compensate for such distortions, shadow prices can be calculated that more closely reflect the project’s opportunity costs and benefits. Compared to possibly distorted market prices amid market imperfections, shadow prices better reflect the values of willingness to pay (WTP) and willingness to accept compensation. Shadow pricing may, for instance, apply to:

Cost of carbon

. The shadow cost of carbon is an important parameter in the economic assessment of investments. As part of the wider framework of alignment with the Paris Agreement, it is important to set the shadow cost of carbon in line with the best available evidence and EU ambition. Accordingly, the shadow cost of carbon is taken as the cost required to drive the world economy to net zero GHG by 2050. Estimating this value requires complex economic-climate models. As discussed in

chapter 4

, authoritative studies suggest that the full shadow cost will rise to around €250 per tonne by 2030 and €800 by 2050. If a project reduces carbon, the economic case is strengthened by adopting a higher cost of carbon, for instance in climate-action projects (e.g. energy efficiency, most public transport, renewable energy).

Situations where the project country’s official exchange rate does not properly reflect the scarcity value of foreign exchange.

This occurs where the costs of imports are held artificially low (in case of overvaluation) or high (in case of undervaluation), meaning that demand for them is arbitrarily altered. To estimate shadow exchange rates reflecting the scarcity value of foreign exchange, conversion factors can be used that establish the correct relationship between the prices of internationally traded goods and services and the prices of goods and services not so traded. Distortions arise from many sources, such as import or export taxes/subsidies and quantitative restrictions on trade. Such distortions vary in their effects on different goods, but it is not practical to use a different conversion factor for each commodity involved in a project. Accordingly, a single conversion factor corresponding to the economy-wide shadow exchange rate, and termed the “standard conversion factor,” is calculated. This is a summary indicator of trade distortions expected to prevail in the future. Notably, globalisation may have reduced the necessity of such shadow pricing.

Cost of labour

. In countries where the labour market functions smoothly, the wages actually paid are adequate for financial and economic analyses. However, government interventions in some labour markets introduce distortions[

9

] that could justify using shadow wage rates to reflect the opportunity cost of using labour in a project. In such cases, the monetary cost of labour does not necessarily equal the marginal output of labour and so needs correction. Most commonly, in an environment where unemployment or underemployment prevails, the economic cost of unskilled labour is less than the monetary cost of labour paid by the project. Reducing labour costs through shadow pricing increases the project’s NPV (social net benefits) in comparison with its financial value.

3.Defining the counterfactual scenario

J. Doramas Jorge-Calderón

3.1Introduction

The economic and financial profitability of a project are estimated by considering the project’s incremental benefits and costs, namely the benefits and costs over and above those that would have occurred without the project.

The analyst makes assumptions on what would happen without the project by building a counterfactual or WOP scenario. Two broad situations arise, involving the degree of competition in the market concerned. In highly competitive markets, where entry and exit is free and the goods or services produced by the project face close substitutes, neither project nor promoter has any power to dictate the price, quantity and quality of the output. If the proposed project did not proceed, other competitors would take the promoter’s place by producing and selling on the same terms as the promoter would have done. In such cases, the project merely adds incremental output on terms determined by the market.[10]

The WOP scenario would thus exclude the capacity supplied by the project, resulting in a marginal price difference and a small loss of consumer surplus relative to the WP scenario. Since competitive markets tend to be highly atomised, the price difference and consumer surplus loss are small. In practical terms they are both ignored, which means that in the absence of other distortions, the financial appraisal closely approximates the economic appraisal. This, in turn, implies that there is no need to construct an ad hoc counterfactual; the WOP scenario thus comprises the opportunity cost of resources devoted to the project, including the cost of capital.

In uncompetitive markets, by contrast, entry is restricted and substitutes are inferior, giving the promoter at least some power to determine market terms on price, quantity and quality. Not carrying out the project at all could even lead to superior profitability for the promoter. With insufficient competition, the project appraisal must include an ad hoc scenario describing what could be expected to happen without the project. Since the promoter has the power to dictate supply terms, various WOP or counterfactual scenarios may be possible.

This section summarises the criteria to be used to define counterfactual scenarios across the various methodologies used by the Bank — CBA, CEA, and MCA — in situations where markets lack sufficiently close competing substitutes.

3.2Types of counterfactual

3.2.1The three basic types

Projects financed by the Bank involve capital formation concerning a facility to produce an output, whether tangible (say, an infrastructure) or not (say, research), and so always entail capacity investment, whether new, upgraded or rehabilitated. In this sense, the project (or WP scenario) is always a “do-something” scenario. There are three basic types of counterfactual (or WOP) scenarios against which to compare the project:

“Do nothing”: This scenario assumes that without the project there will be no investment at all. Capacity will gradually deteriorate, reducing the future ability of the facility to meet demand. This type of WOP scenario is suitable for capacity-rehabilitation projects.

“Do minimum”: This scenario assumes there will be sufficient investment to keep existing capacity operational in the future. It is a suitable counterfactual for capacity-expansion or -upgrade projects. The investment analysis compares the project with the counterfactual scenario of making necessary investments to keep installed capacity operational for the full project lifetime.

“Do something else”: In contrast to the “do-something” scenario embodied in the project, a “do-something else” scenario is an alternative approach to meeting the same objectives. This may involve an alternative technology, a different project scale or an alternative project location. It is an appropriate counterfactual for analysing project benefits and costs after recognition that something must be done (e.g. fulfilling a legally mandated level of service).

As mentioned in chapter 1, appraisal methods must fit the Bank’s remit, which nomally excludes acting as a planning agency and deciding on the best project option. Only when providing technical assistance for project conception may the Bank explore alternative project options. Otherwise, in standard lending operations, the EIB considers projects for financing only once the preferred option has been chosen and preparatory work or construction has begun. Likewise, the Bank does not engage in a budgeting exercise whereby only the projects with the highest returns are financed. Bank operations are embedded in the commercial lending market, and the EIB has limited foresight on the future project pipeline, such that possibilities for budgeting are, at best, limited. Therefore, the Bank focuses on ensuring that supported projects are viable and generate sufficient economic value.

For these reasons, Bank appraisals do not normally evaluate alternative project options. Therefore, the counterfactuals used in project appraisals normally adopt the “do-minimum” criterion for capacity-expansion or -upgrade projects and the “do-nothing” criterion for capacity-rehabilitation projects. With both types of counterfactuals, the appraisal considers the case for a project to take place. The “do something (else)” counterfactual may be used when there is no reason to question the case for a project; the appraisal focuses instead on the relative value of one technology over another.

3.2.2Cost–benefit analysis

For CBAs, the Bank normally uses the “do-minimum” scenario by default, except for capacity-rehabilitation projects. For capacity-expansion or -upgrade projects, the analysis asks, “Do we expand capacity or keep capacity at current levels?” The analysis then compares the “do something” with a “do minimum.”

If the analyst instead compared the “do something” with a “do nothing,” the capacity-upgrade project would be evaluated not against no capacity upgrade but rather against letting capacity deteriorate until potentially inoperable. Using a “do-nothing” instead of a “do-minimum” counterfactual would normally overestimate the returns of a capacity-expansion/upgrade project, as “do-minimum” scenarios include fewer benefits or higher costs to society. This is illustrated in the example in section 3.3 below.

By nature, rehabilitation projects call for comparing the “do something” with a “do nothing.” A pure rehabilitation project generally involves keeping existing capacity constant, rather than expanding it — the WP scenario involves no growth in capacity. In that sense, a rehabilitation project could be viewed semantically as comparing a “do minimum” with a “do nothing.”

Whenever the case to carry out a project is unquestionable or there is a legal obligation to meet demand, the CBA may also use a “do-something (else)” counterfactual. The CBA then measures the relative value of one technology over another, somewhat resembling CEA.

3.2.3Cost-effectiveness analysis

CEA starts from the premise that the good or service concerned must be supplied, meaning the counterfactual must be at least a “do-minimum” scenario. The appraisal then focuses on whether the project constitutes the most effective technology to deliver the desired output per cost unit. Where there is room for selection among alternatives, the analysis may evaluate the “do-something” against several “do-something else” options to help identify the most efficient option.

3.2.4Multicriteria analysis

An MCA-based appraisal can be constructed with the same array of scenarios as a CBA, and the Bank uses the same criteria to define counterfactuals in both types of analysis: for a capacity-expansion/upgrade project, the comparison is between the “do something” and a “do minimum”; for a rehabilitation project, it is between the “do something” and a “do nothing.”

MCA, like CBA, lends itself to considering alternative project options — to comparing “do something” with “do something else.” This type of analysis can be performed when there is no reason to question the case for a project, and the appraisal evaluates whether one project option (such as technology) is more effective than another.

3.3Illustrating the impact of an inadequate counterfactual

A common source of error while building scenarios for capacity-enhancement projects is mixing up a “do-nothing” with a “do-minimum” counterfactual. When the appraisal asks whether capacity should be expanded or kept constant, the WP scenario should be compared with a “do-minimum” scenario. If the appraisal instead asks whether capacity should be expanded or left to degrade, the proposed project should be compared against a “do-nothing” scenario. The economic returns of the capacity expansion would be overestimated if management seeks to answer the first question but the project analyst focuses on answering the second. This may lead management to make a wrong decision, probably by overinvesting.

Table 3-1 illustrates the issue with a hypothetical project, presenting net operating benefits and investment costs for three possible scenarios: “do something,” “do minimum” and “do nothing.” The scenarios are mutually exclusive, but their technologies could be considered cumulative. The “do-something” scenario involves investing €450 million, and will result in benefits growing by 5% per year. It combines rehabilitating existing capacity with expanding capacity. The “do-minimum” scenario involves investing €30 million in rehabilitating existing capacity, leading to constant benefits. The “do-nothing” scenario involves no investment at all and will let existing capacity deteriorate over time, affecting the amount of output the facility can produce. Consequently, net benefits will fall by 5% per year. The table’s first numerical column includes the present value (PV) of the flows along each row, discounted at 3.5%.

Table 3-1: Project return under alternative counterfactuals

The last three rows of Table 3-1 present the calculation of (incremental) project returns for the three possible scenario combinations. Row (7) presents the capacity-expansion scenario, comparing a project that expands capacity with leaving capacity constant. The calculation compares the “do-something” with the “do-minimum” scenario, in which the necessary investments will be made to keep current capacity constant for the entire life of the comparative project (“do-something”). The project presents an IRR of 3%.

In row (8), the capacity-expansion project is instead compared against the “do-nothing” scenario, leading to the IRR increasing to 6%. However, this analysis estimates the returns from not only increasing capacity but also rehabilitating existing capacity. Such an analysis would be correct if the operator could either rehabilitate and expand capacity or let capacity degrade, but not if the choice were between expanding capacity and keeping it constant. Essentially, the IRR value of 6% combines low returns on capacity expansion (3%) with high returns on rehabilitating existing capacity (28%). If the threshold for accepting projects was 5%, for example, then the capacity-expansion investment would clearly not be viable, but it would appear so by using the “do-nothing” instead of the “do-minimum” counterfactual.

4.Cost of carbon

Edward Calthrop[11]

4.1Introduction

The EIB’s approach to estimating the value of GHG emissions is set out in Annex 5 of the CBR (EIB, 2020). The roadmap sets out the conceptual basis for the shadow cost — i.e. the least cost to society of meeting the 1.5 °C temperature goal. It also explains the empirical evidence, reviewing the estimates produced the relevant scenarios from large-scale climate-economy models. Table 4-1 reproduces the EIB shadow cost of carbon (measured in 2016 euros).

Table 4-1: EIB Shadow cost of carbon

Source: Table A6, EIB (2020).

This chapter focuses on the economic and financial assessment of projects associated with GHG emissions. First, it considers the valuation of emissions from projects operating under different regulatory frameworks — notably with a carbon tax or an emissions trading scheme. This is relevant as the EIB supports projects throughout the world, and thus deals with very diverse regulatory environments. The chapter concludes that, under some assumptions, it is reasonable to apply the shadow cost of carbon presented in Table 4-1 to value GHG emitted or saved by the project, irrespective of the regulatory environment.

Second, the chapter considers how to treat any divergence between the shadow cost of carbon and the financial price for carbon faced by a project in practice. It advocates developing a reference scenario consistent with long-term emission-reduction targets, even if the equilibrium values of key variables (e.g. demand, cost curves) reflect carbon prices differing from the shadow cost.

This chapter focuses solely on the economics of projects that will change GHG emissions. In this sense, it is relevant to climate mitigation. The chapter does not consider the economics of projects, or project components, designed to adapt to current and future climate change (though chapter 12 deals with decision making under uncertainty). The EIB will develop separate guidance on the economics of adaptation in due course.

4.2Valuing emissions in practice: Basic intuition

This section provides insight on valuing GHG emissions[12] from projects operating under different regulatory environments. Based on Rosendahl and Wangsness (2020b), and as elaborated in Annex 1, this section distinguishes three regulatory settings:[13] (i) a carbon tax; (ii) an emissions trading scheme with a fixed emissions cap; and (iii) an emissions trading scheme with an endogenous cap. Consider the impact of a project emitting a tonne of CO2 in each setting:

Case A — carbon tax: Given an economy-wide emissions target, if the project emits an extra tonne, society incurs the additional cost of having to abate an extra tonne elsewhere in the economy. This is precisely the shadow cost of the economy-wide emissions constraint, meaning the shadow cost of carbon. Note that this result holds regardless of the level of carbon tax applied in practice, which is relevant solely to assessing the project’s FRR.

Case B — fixed-cap emissions trading scheme: By emitting one tonne of CO

2

within the scheme, the net effect of the project is to require an additional unit of abatement from other economic activities operating within the scheme. As long as the emissions cap is considered fixed, the opportunity cost of one emission unit inside the scheme is measured by the permit price.[

14

] Note that this holds regardless of the shadow cost of carbon, which may be higher or lower than the permit price. In this case, financial and economic analyses of the project refer to the permit price.

Case C — endogenous-cap emissions trading scheme: Assuming that the cap is adjusted positively to demand for emission allowances, Case C[

15

] can be characterised as a weighted average of Cases A and B. In an extreme case where the cap responds one-to-one with the increase in demand, Case C corresponds to Case A (carbon tax) and emissions are valued at the shadow cost of carbon. Under the other extreme case in which there is no adjustment to the cap, Case C corresponds to Case B (fixed cap scheme) and emissions are valued at the permit price. In general, the value of an emissions increase is the weighted average of Cases A (the shadow cost of carbon) and B (the permit price), with weights determined by the cap’s degree of responsiveness. The economic and financial returns will diverge by a fraction — depending on relative weights — of the wedge between the shadow cost of carbon and the carbon tax.

Consider applying this insight in the context of project assessment. For a project operating outside the EU ETS but subject to a carbon tax, it is relatively intuitive[16] that emissions are valued at the shadow cost of carbon (Case A). For projects operating within the EU ETS, the specificities of the Market Stability Reserve make it arguable that the emissions cap is partially endogenous (Case C) — see Perino (2018). The key empirical question becomes the extent to which the change in emissions demand resulting from the project translates into a change in the overall emissions cap via the Market Stability Reserve.

As explored by Gerlagh et al. (2021), in the short run a high share of project emissions will likely translate into reductions in the cap via the Market Stability Reserve – not one to one, but possibly close to that ratio. In the medium to long run, however, the impact on the overall cap is smaller though may still be sizeable, depending on the extent to which the market anticipates these changes in future emissions and therefore adjusts its net emissions banking. This suggests that short-term emissions (with a relatively large impact on the emissions cap) should be valued at the shadow cost of carbon, while longer-term emissions (with less impact on the emissions cap) should be valued closer to the forecast permit price.