INDUSTRIAL AND INVESTMENT ANALYSIS AS A TOOL

FOR THE REGULATION OF PUBLIC SERVICES

TURIN 13 SEPTEMBER 2022

SARAH SHABABI

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

OUTLINE

01 02 03
Examine investment Discuss the Case study –
appraisal and the practical application Trattamento Rifiuti
related techniques; of investment Metropolitani TRM
appraisal SpA
techniques to the
public sector;

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1.EXAMINE INVESTMENT APPRAISAL AND THE
RELATED TECHNIQUES

UTILITIES TEND TO BE CAPITAL- I) THE ABILITY TO RAISE THE II) THE ABILITY TO INCREASE III) THE ABILITY TO ACCESS
INTENSIVE AND THE PRICE OF PUBLIC SERVICES; PUBLIC SPENDING; AND PRIVATE FINANCE.
REQUIREMENT FOR SIGNIFICANT
PLANT INVESTMENT INCREASES
THE NEED TO RAISE CAPITAL TO
FINANCE IT

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 WHY DO WE
To determine which projects should be invested in and which should
NEED

be avoided or postponed.

INVESTMENT  To obtain (or increase) financing as it can show investors what the
expected returns are on an investment project.
APPRAISAL IN  If they are on a commercial basis, to determine potential tariffs

THE applicable and minimise financial costs/losses

If they are on a social basis, to maximise social benefit and minimise

PROVISION OF

financial costs/losses

PUBLIC  To allocate scarce resources more efficiently

SERVICES?

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 Net present
value (NPV)

Discounting
techniques
Internal rate
of
return (IRR)

Investment
INVESTMENT appraisal

APPRAISAL Payback
TECHNIQUES period
Non
discounting
techniques
Accounting
rate of
return
TURIN 2022 (ARR) 5
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.

where:
 CF= cash flow (inflow or outflow)
 t= time period
 r= cost of capital

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DISCOUNTING TECHNIQUE
NPV (NET PRESENT
VALUE)

From a theoretical perspective:

 If NPV is positive, then

investment project should be
accepted

 If NPV is negative, then

investment project should be
refused

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CASH FLOWS

NEED TO BE CASH FLOWS AND SHOULD BE THE INCREMENTAL SUNK COSTS SHOULD NOT BE INTEREST AND DIVIDENDS ARE
NOT PROFITS, HENCE EXCLUDING CASH FLOWS ONLY THAT ARISE TAKEN INTO CONSIDERATION NOT INCLUDED AS PART OF THE
DEPRECIATION/AMMORTISATION/ FROM THE INVESTMENT CASH FLOW CALCULATION AS
PROVISIONS, ETC. THEY ARE TAKEN INTO
CONSIDERATION THROUGH THE
COST OF CAPITAL CALCULATION

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COST OF CAPITAL – DISCOUNTING RATE

Capital Asset Pricing

Cost of equity ke
Model CAPM Weighted
How much will it
cost to finance the Cost of capital average cost of
investment project?
After tax yield to
capital WACC r
Cost of debt kd
maturity

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COST OF CAPITAL – COST OF EQUITY
CAPITAL ASSET PRICING MODEL

CAPM: ke= rf+βj (rm-rf )

where

rf = risk-free rate of interest

rm = return on the market portfolio
βj = index of systematic risk for the investment
rm-rf 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

 I = annual interest payment

 Po = 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 r = (MVe * ke) + (MVd *kd)

MVe +MVd

Where

 MVd is the market value of the debt of the company

 MVe is the market value of the equity of the company

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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.

 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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  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
theoretically no financial cost of capital.

CAPITAL  However, there is the opportunity cost of not investing the resources
elsewhere on alternative projects. Moreover, if a government has
PROVIDED BY 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
DONOR OR debt in the WACC calculation.

GOVERNMENT  The opportunity cost to the government of investing in risk-free real

assets is the reduction in interest payments that it would achieve if
the cash to be invested were instead used to repurchase government
debt.

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OUTLINE

01 02 03
Examine investment Discuss the Case study –
appraisal and the practical application Trattamento Rifiuti
related techniques; of investment Metropolitani TRM
appraisal SpA
techniques to the
public sector;

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QUALITATIVE AND QUANTITATIVE FACTORS IN
MAKING INVESTMENT DECISIONS
• Policy
relevance
• Strategic •Payback period
Qualitative Quantitative •Average rate of
relevance
factors factors return (ARR)
• Economic
rationale •Net present
• Public value (NPV)
service •Internal Rate of
rationale Return (IRR)
• Technical
design
• Achievability

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 APPLYING  In the case of a public utility there is no direct relation between the
INVESTMENT capital invested and shareholders, the objective is hence to maximise
citizens’ benefit.
APPRAISAL  In public sector investments, the benefit to citizens is

TECHNIQUES disproportionate, i.e. is enjoyed by a small proportion of the

community relative to the contribution that the citizens have made to
TO PUBLIC this investment (through taxes paid to the government).

SERVICES

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INVESTMENT APPRAISAL IN PUBLIC SECTOR –
DISTORTION Pay taxes to
help build
water
infrastructure

Benefit from
clean water

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  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
APPLYING
can be made without making anybody worse off. INVESTMENT
 Kaldor-Hicks improving investments – an economic allocation APPRAISAL
TECHNIQUES TO
where investments are made only if those that are made
better off could in principle compensate those that are made
worse off
PUBLIC SERVICES

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  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
APPLYING
termination/decommissioning costs. In the public sector, it is INVESTMENT
common practice to identify the option with the lowest whole-
life cost as the option that offers the best value for money
APPRAISAL
(VfM). TECHNIQUES TO
PUBLIC SERVICES

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  An alternative is to carry out a Cost/Benefit Analysis (CBA) of the
proposed investment, identifying all the costs and benefits whether
they be social or economic and giving them a monetary value.

COST- Difficult to quantify the future benefits of a public utility

investment. This means that frequently governments tend to take

BENEFIT the benefits as given without quantifying them and concern

themselves only with the minimization of costs.

ANALYSIS -  The purpose of CBA is to facilitate a more efficient allocation of

resources, demonstrating the convenience for society of a particular

CBA 
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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 There is as yet no broad consensus on how to measure and determine an
appropriate social discount rate (SDR). A social discount rate can be generally
achieved in 2 ways:
 1)Social rate of return on investment (SRRI) – is equal to the social
opportunity cost of capital as before the government removes resources

CBA –
from 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.

SOCIAL  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.

DISCOUNT
it is the rate of return needed to make society indifferent between
consuming x today and x(1+r) in the next period. It is a measure of
society’s willingness to postpone consumption now to later.

RATE The economic values of investing in long-term public projects are highly
sensitive to the social discount rate (SDR).
A survey of economists published in 2018 indicates that most favour a low
rate: more than three-quarters of the 200 experts finding the median risk-
free SDR of 2% acceptable

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INVESTMENT APPRAISAL IN PUBLIC SECTOR –
DISTORTION Pay taxes to
help build
water
infrastructure

Benefit from
Less hospital admissions clean water

Less environmental damage from misuse of

scarce resources
Less taxes
Improved equity
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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 and/or Willingness to accept

 Multi – criteria analysis - weight and score the performance

criteria (critical success factors) of the benefits

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 WTA is the
WTP is the WTP or WTA minimum
maximum amount of
amount of money an
money an individual is
individual is willing to be
willing to give compensated
up to receive a Stated preference Revealed preference for foregoing a
good good

Contingent
Choice modelling
valuation model = 1) hedonic
methods =
valuation of a non- pricing 2) travel
valuation of
market good as a cost
specific attributes
whole

1) open ended 2)
1) contingent ranking
bidding game 3)
2) choice experiments
payment card 4)
3) contingent rating 4)
dichotomous choice
paired comparisons
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elicitation 25
 MULTI-
CRITERIA  MCA establishes preferences between options by referring to an
explicit set of objectives/focus that the decision making body has
ANALYSIS OR identified and for which it has established measurable criteria to
assess the extent to which the objectives are achieved in relation to
MULTI- the different options/alternatives

CRITERIA  MCA is a way of looking at complex problems that are characterized

by any mixture of monetary and non-monetary objectives, of
DECISION breaking the problem into more manageable pieces to allow data
and judgements to be brought to bear on the pieces, and then of
ANALYSIS reassembling the pieces to present a coherent overall picture to
decision makers.
(MCA OR
MCDA)

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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 Upgrading

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

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OUTLINE

01 02 03
Examine investment Discuss the Case study –
appraisal and the practical application Trattamento Rifiuti
related techniques; of investment Metropolitani TRM
appraisal SpA
techniques to the
public sector;

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3.CASE STUDY –
TRATTAMENTO
RIFIUTI
METROPOLITANI
TRM SPA

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TURIN 2022 31
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:

Approx 500.000 tons

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TRM – COMPANY OWNERSHIP PUBLIC AND
PRIVATE*
TRM V SpA now
Other
owned by Iren Municipality
minority
SpA of Turin
shareholders

17%
80% 3%

TRM SpA

*In November 2020 the Municipality of Turin sold a significant part of its shareholding. It retains greater roles than supported by its shareholding in relation to the
TURIN 2022 appointment of the President and other contractual terms 33
  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

DETAILS OF  Main providers of project finance: EIB European Investment Bank ,

INVESTMENT BNP Paribas and Unicredit Corporate Banking, Banca Popolare di

Vicenza and SACE.

 Bankability of project guaranteed through the future generation of

cash flows and contractual guarantees rather than real guarantees

 Initial waste management tariff equal to €/ton 106.95 in 2015

 IRR 8.6%

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PROJECT FINANCING
The Turin waste -to -energy plant is one of the largest Italian infrastructures financed through project
financing, i.e. the bank loans are guaranteed by the generation of future cash flows secured by
contractual guarantees, rather than real guarantees

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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/st ude nt/exa m-s upport-resources/founda tion-level-study-resources/ffm/ff m-tec hnical-articles/the-internal-rate-of-retur n.ht ml

 •CAPM graphical representation at http://www.spreadsheetml.com/fina nce/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 Universit y 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/

 •Drupp, Moritz A., Mark C. Freeman, Ben Groom, and Frikk Nesje. 2018. "Discounting Disentangled." American Economic Journal: Economic Policy , 10 (4): 109-34.

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