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ECONOMIC REVIEW

ECONOMIC REVIEW

The Strategic Suitability Study chapter in the Pre-FS for a solicited PPP should have confirmation of the conformity with and/or update to the strategic review conducted in the PS. The strategic study or review of the Pre-FS should provide information about the strategic context of the proposed PPP. The review should make observations about the following in relation to the strategic review conducted previously in the PS

  • The existence or absence of new regulations from those that have been used as references in the preparation of the strategic study in the PS
  • Validity of regulations used as references in the preparation of the strategic study in the PS
  • Development of regulatory reviews in accordance with the progress of the PPP project and/or
  • Development of institutional reviews in accordance with the progress of the PPP project.

Social Cost Benefit Analysis

The Social Cost Benefit Analysis (SCBA) is a methodology developed for evaluating the costs and benefits of investment projects on society as a whole. This means it considers the effects on all stakeholders: individuals, communities, governments, and the environment. The assessment looks at monetary and non-monetary aspects, assessing intangible impacts such as pollution, health, education, and social well-being. The preparation of a SCBA is a technical, data- and time-intensive exercise. The SCBA consists of comparison of costs and benefits with or without PPP. Examples of social costs may include environmental damage, health hazards, and, displacement of communities.

Examples of social benefits may include job creation, economic growth, improved infrastructure, and access to public services. The SCBA is calculated by:

  • Determination of economic costs by converting financial prices into economic prices (shadow price) for each input and output based on appropriate economic conversion factors.
  • Determination of economic benefits by converting these benefits into quantitative terms and
  • Economic feasibility assessment parameters through the Economic Internal Rate of Return (EIRR) and Economic Net Present Value (ENPV) approaches.

For small projects, the cost of undertaking a SCBA would often be disproportional to the value of the project. In those cases, a simpler economic assessment is recommended.

  • The GCA assesses the economic costs of the project. Quantitative costs include public contributions to the project in the form of:
    • Preparation costs of the PPP
    • Construction (capital costs) or acquisition of the assets (for example, where the GCA would pay for part of the project construction cost, including value of land contributed or licensed to the project)
    • Mitigation and compensation measures (for example, costs incurred for government guarantees or indemnities for project risks)
    • Loss of the present function or use of the land that will be occupied by the project (this may include lost GCA revenues that are now captured by the project or land acquisition costs)
    • Maintenance and operating costs (for example, where the GCA would pay an availability fee/payment (AP) for part or all of the cost of project operations), and
    • Any other costs caused by or arising from the project.
  • The costs are measured by their economic value or opportunity cost and are expressed in constant price level (real values without expected inflation). Qualitative costs include important costs for which no reliable quantitative estimates can be made for lack of data or calculation models. The GCA shall describe such costs in qualitative terms, so that they can also be included in the Pre-FS in addition to quantitative costs.
  • The GCA shall also assess the economic benefits of the project. The GCA shall calculate the value of the economic benefits of the PPP project by including
    • User willingness to pay for the services
    • The cost savings realised by the GCA, the users of the project, and / or the community
    • New economic opportunities expected to be created by the project
    • Improved quality of life expected to be achieved through the additionality of the project and
    • New revenues, including taxes and fees, expected to be generated by or because of the project.
  • Subsequently, the GCA shall assess these benefits by comparing them to the ‘do nothing’ alternative. The GCA shall clearly document and explain the estimates. The GCA shall indicate the sources of data and basis of assumptions and explain calculations. It shall also describe such benefits in qualitative terms, which are important but for which no reliable quantitative estimates can be made due to lack of data, so that they can be included in the Pre-FS in addition to the quantitative benefits. In assessing qualitative economic costs and benefits, the GCA shall also evaluate the project’s potential (positive or negative) impacts and access on women, people with disability and elderly, and other vulnerable or marginalised groups. These should be reflected in both cost–benefit narratives and risk assessments.

  • The GCA shall determine economic costs by converting financial prices (where appropriate) into economic prices or shadow prices for each input and output based on relevant economic conversion factors. This may, for instance, be the case for unskilled labour (shadow wage factor) and imported goods that are valued at border prices (shadow exchange rate factor).

  • List the economic costs and benefits from the economic assessment model.

  • List the variables having impact on economic output, assessment of risks, and impact assessment from the economic assessment model such as changing demand, higher costs, etc.

  • The GCA shall determine and quantify economic benefits by establishing conclusions on economic cost benefit analysis or feasibility and by establishing results of sensitivity assessments (if any).

I. Calculation of Economic Feasibility

  • The GCA shall draw conclusions on economic costs and benefits based on the calculations of the economic net present value (ENPV) of the stream of costs and benefits during the lifetime of the project. The GCA shall convert future costs and benefits into their present value using the social discount rate i.e., a calculation comparing the quantified socio-economic benefits received by the public and the GCA against the economic costs of the project, based on economic or social discount rate. The GCA shall determine the economically preferred project option based on the highest ENPV. If there are important costs and benefits that have not been quantified because the required data and calculation methods are not available, then the GCA should consider these in addition to the ENPV while determining the preferred alternative.
  • For purposes of presentation, the internal rate of return (IRR) of the stream of net benefits i.e., benefits less costs can be calculated (comparison of the socio-economic benefits and economic costs of the project) – this is the economic internal rate of return or EIRR. The EIRR of the preferred option should exceed the social discount rate.

II. Sensitivity Analysis

  • The GCA shall conduct a sensitivity analysis to assess how uncertainties in PPP implementation may impact the economic feasibility level of the project. This analysis helps understand how sensitive economic and financial outcomes are to key assumptions in the evaluation. This analysis also helps anticipate variations in costs and benefits that may occur. The uncertainties may include:
    • Uncertainty about important assumptions in the calculation of costs and benefits and
    • Project risks on the economic feasibility of the project.
  • The GCA shall carry out the sensitivity analysis by:
    • Identifying variables that may have a significant impact on project outcome
    • Identifying the likelihood of risks occurring
    • Calculating the impact by considering combinations of best and worst-case scenarios for the variables and
    • Identifying changes in key assumptions that could reduce net financial or economic benefits and assess the likelihood of their occurrence.

    • For the above, the GCA shall include the usual sensitivity tests such as increase of costs (usually by about 20 percent) and low demand scenario.

III. Project Risk Indication

  • The GCA shall consider that the significance of the project risk indication activity. The return on investment to the Implementing Business Entity (IBE) i.e., its form (closing of capital cost, operational cost and reasonable profit) and method (payment by users in the form of tariffs, Availability Payment (AP) and/or other forms as long as they do not conflict with the provisions of laws and regulations) can be combined, taking into account the clarity on the allocation of project risks in the PPP.
  • A risk review may also be carried out simultaneously with the quantitative assessment of VfM.

Risk matrix with risk identification, assessment, allocation, and mitigation

The Pre-FS should provide a risk matrix, which identifies all key risks relevant to the project and contains information about each risk. The matrix also contains each risk’s assessment, its allocation and mitigation measures deployed or planned to be deployed.

The information for the risk matrix is collected from the other components/sections/reviews of the Pre-FS (in particular, the technical analysis, the analysis of user demand, and the project due diligence) and the environmental, social and governance (ESG) of the Ministry of Finance (MOF). The GCA may consider holding a risk workshop to complete the information. A risk workshop may be held with key experts of the GCA and the Technical Assistance (TA)/consultants preparing the Pre-FS. The risk workshop brings together parties with different skill sets and expertise to debate the risks and their management.

Each section of the risk matrix is described below.

  • The GCA shall carry out project risk identification to determine and understand factors that may prevent, reduce, delay, or enhance the project's outcomes. A general review of potential risks can be useful to identify possible emerging risks potency. Some main and common categories of risks to the project should have been covered previously in the PS in a ‘risk matrix’ and would have included project physical risks, project operational risks, financial/market risks, and process risks, including those related to ESG compliance, inclusive stakeholder engagement, safety, and access to & affordability of services. During the preparation of the Pre-FS, the GCA shall ensure the risks identified in the PS can be confirmed, decreased or increased and change the risk matrix, accordingly. The GCA shall ensure that identification of these common risks and other more project-specific risks is done by personnel who possess adequate technical and operational experience. These personnel can be from within the GCA or external to it. During the preparation of the Pre-FS, the GCA has a freehand to add as many rows required to include risks not included previously in PS risk matrix. The Pre-FS risk matrix should include the following information about each risk:
    • Name of risk
    • Description of risk
    • Consequence in case the risk occurs (qualitative description)
    • Indication of the probability of occurrence (low/moderate/high)
    • Indication of the likely impact on costs or revenues (low/moderate/high)
    • Grade of risk (scored 1–10 (low to high)) i.e., a product of probability and consequence
    • Proposed allocation. This explains how the risk will be allocated among public entities, private entities or shared
    • Proposed management and mitigation measures (at least for the high-grade risks). This describes what mitigation might be available, for example, additional investment, technology, methodologies, and insurance
    • Additional remarks, if any.
  • For instance, demand risk would mean the risk that the projected numbers of users do not use the service, for example, the actual users are 10% lower than the projected numbers. The risk matrix would identify the probability of this risk occurring, and also if such an event actually takes place, what would be the impact of that risk on the PPP project and finally who/which party would bear the adverse impact of this event.

  • Here the GCA conducts an evaluation of the identified project risks that consider factors such as the level of risk, as well as the likelihood and consequences of these risks. This assessment is beyond the initial evaluation of risks conducted in the PS. Risk assessment techniques can range from subjective assessment methods based on experiences in similar projects to computer-based simulations. The choice of risk assessment approach depends on the significance and complexity of the risks and their impacts on the PPP project. The GCA shall consider that the emphasis at the PS stage was on using subjective methods for assessment. However, during the preparation of the Pre-FS, detailed assessments may be conducted, especially if a more complex assessment with multi-variable simulations is required. For example, GCA may apply an available tool in the ESG Manual of the MOF to support the risk assessment.

  • If the project implementation can be carried out by parties other than the identified GCA, efficient risk management requires allocating risks to parties with the best capabilities to handle them. While at the PS stage, considerations were given to identify which party has the best capability to manage the identified risks, during the Pre-FS, the GCA shall change or confirm the same, as may be required.

  • The GCA may identify mitigation strategies to reduce the likelihood of risks occurring or to lessen the consequences if those risks are materialised. The GCA may use mitigation strategies to prevent occurrences through project structuring or contingency planning. The GCA’s mitigation strategies should strive for a balance between potential costs and the risks involved, as well as the costs incurred to prevent or mitigate the risks.
  • Data permitting, the high-grade risks should be quantified. Minimal quantification includes:
    • Probability of occurrence of the risk and
    • Damage, costs, or revenue loss if a risk occurs.
  • This helps the GCA to quantify the expected loss and the maximum loss due to the risk.

Value for Money (VfM) Analysis (Quantitative)

The GCA shall conduct a quantitative assessment of Value for Money (VfM) during the economic review while preparing the Pre-FS.

The goal of this VfM assessment is to determine the most suitable infrastructure provision method to implement the project that yields the best quantitative VfM. The infrastructure provision methods that can be considered are PPP, government funding through procurement of goods/services, or assignment to state-owned enterprises (SOE).

The aim of this VfM assessment is to follow up and confirm the result of the qualitative VfM review from the preliminary study (PS).

To ensure optimal and quantitatively superior VfM, the GCA’s considerations shall include:

  • Calculation of the VfM generated by the prospective initiator is higher than the VfM calculated by the GCA and
  • The difference in VfM is higher than the preparation cost incurred by the GCA.

In assessing Value for Money, the GCA should consider ESG performance standards and indicators that capture how the project may provide benefits for women and vulnerable groups (e.g. through job creation, improved safety, and/or access to services) as qualitative factors influencing overall project sustainability.

I. Alignment with government plans

  • The GCA shall prepare the cash flow estimates by taking the following costs into account:
    • Construction cost including material cost, labour and inclusive equipment cost, Universal Design application costs, project management cost, public consultation cost, permit cost, and/or other costs relevant to the project's needs.
    • Operations and maintenance cost, including operations costs that generally cover employee salary, insurance expense, inclusive training and development cost, travel expense, management cost, Universal Design implementation costs, expense for services such as cleaning & catering, overhead cost, energy cost, equipment cost, administration cost, and electrical cost. Maintenance costs would include cost of infrastructure maintenance.
    • Repair cost.
    • Preparation cost including bid preparation/financial model cost as the expense incurred by the GCA to and the development of the Public Sector Comparator (PSC) and shadow model.
    • Financing cost including financing arrangement cost, commitment cost, and other costs that arise in relation to fulfilment of project financing.
    • Other costs incurred by the GCA including asset acquisition cost, consultant fee, and other costs related to project implementation including planning, preparation, transaction, and PPP management of contract costs, or costs incurred by the government in planning and implementing procurement of goods/services.

    Cash flow estimation activity shall also include determining the inflation rate of the project and preparing the cash flow for both the PSC and the shadow model, considering costs incurred by the GCA.

  • The GCA does this by preparing a PSC if the project is carried out by the government through traditional procurement of goods and services, in accordance with the relevant laws and regulations related to government procurement and by using a comparative model if the project is implemented through PPP.
  • The GCA shall make adjustments to the financial model of the PSC and the shadow model to ensure comparability between the two. These adjustments involve applying competitive neutrality to the financial model of the PSC and risk analysis of the shadow model.
  • Competitive neutrality to the financial model: The GCA shall conduct this by adding general tax elements issued by the IBE in developing the financial model of the project under PPP scheme to the PSC. These elements include income tax (PPh), value-added tax (PPN), and land and building tax for urban and rural areas (PBB- P2).
  • Risk analysis of the shadow model: This includes
    • Managing risks
    • Compiling a risk matrix
    • Performing risk analysis and
    • Adding the risk analysis to the models of PSC and the shadow model. Details of each activity are provided below.
      • Managing Risks – The GCA shall mange risks through
        • an identification and description of potential main risks of the project
        • analysis of the potential range of consequences resulting from identified risks
        • evaluation of the likelihood and potential impact of risks
        • quantification of risks, if possible, in the financial value of such impact to the project
        • preparation to mitigate and repair strategy of the identified risks and
        • compile the results of the process in the risk matrix.
      • Compiling a risk matrix – In this activity the GCA shall cover
        • risk category: identification of categories of risks based on their nature, for instance design or construction risk
        • risk description: identification of individual risks, causes, and impact and if such event/s occurs
        • risk ranking: identification of the likelihood of a risk happening - for instance: high, medium, low
        • risk quantification: identification of potential premium-based financial risk based on the consequence and likelihood of a risk occurring. The GCA may conduct the risk identification using any of these methods: subjective assessment method or advanced probability valuation method (example: Monte Carlo analysis method)
        • risk allocation: outlining whether a risk can be transferred, divided, or stored and
        • solution options: summarisation of recommended actions and strategies to reduce the probability or mitigate the consequences of specific risks.
      • Performing risk analysis – The GCA shall compile a
        • risk identification matrix covering risk categories and description and
        • a risk ranking matrix covering description including almost certain to occur, likely to occur, possible to occur, unlikely to occur and rare, a range of likelihood probability/single probability value (in percentage) and frequency of occurrence (for instance, in a 30-year contract as once or more in a year, once in three years, once in 10 years etc.).

          • In the risk ranking matrix, the GCA shall also describe consequences and their potential impacts (for instance, catastrophe: project/program can no longer be resumed, major: project or program must be redesigned and/or reworked at a fundamental level, significant: delay in meeting the objectives of project/program, minor: normal administrative issue and/or insignificant: risk impact may be ignored). Risk ranking is derived as Likelihood x Consequence [Score 0-5=Low Score, Score 6-10=Medium, Score 12-16=High, Score 20-25=Extreme. The risk ranking may be classified as R1=Unlikely to occur, R2=May occur, and R3=Possible to occur. R1, R2 and R3 are described on the parameters of consequence, ranking, allocation and mitigation strategy in a tabular format. Following risk analysis, the GCA conducts the activity of

        • risk allocation based on this classification: Transferred risk: risk fully transferred to the IBE. Latent defects in new assets (R1) are an example of transferred risk. Risk borne by GCA (retained risk): risk impacting the government (government bears the cost). Scope changes initiated by the owner (R3) are an example of risk retained by GCA. Joint risk: risk is shared based on a combination of the two allocations above, based on assumptions about the nature of the risk. Example of joint risk: earthquake risk, as the IBE may only be partially responsible for repairing assets, depending on the level of damage.

          • The GCA shall identify risk mitigation strategies to reduce the likelihood of a risk occurring or the consequences, if the risk occurs. Mitigation strategies can be used to prevent the occurrence through project structuring or through contingency planning. Mitigation strategies should seek to balance the potential costs and risks that arise and the costs incurred to prevent or mitigate the risk from occurring.

      • The GCA shall add risk analysis to the models of PSC and shadow model by calculating the expected value of risks during the construction and operational phases, then discounting it to the net present cost to be added to the overall net present cost of the project or by adjusting the annual cash flow during the construction and operation periods to account for risks accurately, allowing the project cash flow to be adjusted for risk

      • In assessing risks, GCA may refer to the insurance premiums paid according to the type of insurance. This may include commercial insurance used by the IBE generally covering construction and contractor insurance, third-party liability, business interruption, equipment failure, technology-related risks and other risks

        After all risk analysis is done, the conclusion of the risk analysis results needs to be written in the Pre-FS report. The amount of risk allocation obtained from the analysis will be used in the calculation of VfM or the calculation of the VfM benefits. The risk value allocated to the IBE and the GCA, respectively, also shows the effectiveness of risk sharing and the effectiveness of the PPP contractual structure.

        The GCA shall note that risk assessment sought is a statistical probability value that is estimated to be close to the actual event. The risk value obtained in this analysis cannot be guaranteed to be true, but the risk value obtained can be close to reality.

  • The GCA derives or calculates the net present cost of capital based on the main input, i.e., the estimated project cash flow and the discounted cash flow rate, from future periods to the commonly used base period (usually the current period). While discounting future cash flows to the present, the GCA shall take the time value for money into account, allowing cash flows occurring in different periods to be summed into a total net present cost.
  • The GCA has an option of one approach to determine the discount rate. It may do so by basing it on the construction cost for a specific project and by considering the discount rate used for analysis in precedent projects.
  • The GCA may apply the standard investment portfolio theory, where the construction cost of the project is based on the weighted average cost of capital (WACC) from various project funding sources.
  • The construction cost is a result of the financial model, with the primary determinants being the financial characteristics of a transaction, including the type of financial instruments used and their relative proportions.
  • To correctly apply the WACC as the discount rate for a project, the WACC, which may change during the project's duration, needs to be considered. The amount of risk premium included in the cash flow, which will be discounted, is determined by the IBE's risk tolerance.
  • In calculating construction cost, the GCA shall use a financial model and consider all incoming and outgoing cash flows over the cooperation period.
  • The GCA shall then express the construction cost as the IRR from cash flow from and to loans/financing and equity capital. For PPP, the net present cost shall include payment to the IBE and investment return to the IBE.
  • The GCA shall conduct sensitivity analysis by:
    • Evaluating the robustness of quantitative analysis concerning various discount rates by examining the percentage range around the specified discount rate for a project.
    • Sensitivity to the discount rate shall also consider the breakeven discount rate, which is the discount rate resulting in zero VfM.
    • The GCA shall ensure that both models remain unchanged during the analysis and apply the discount rate to adjusted cash flows with an increased rate to 25 (twenty-five) or 50 (fifty) points.
    • The GCA shall then compare the resulting net present cost of capital to determine the adjusted VfM.
    • The GCA shall compile a table during sensitivity analysis including columns stating sensitivity (in billion rupiah), discount rate and VfM.

  • The GCA may present the results of the quantitative VfM assessment by preparing a table displaying five main components including:
    • Capital
    • Project lifecycle or capital return
    • Operations, maintenance, and refurbishment
    • Risk and
    • Adjustment of competitive neutrality.
  • Finally, the GCA shall compile the VfM table with a title “Value for Money Analysis - Operations, Maintenance, and Refurbishments for 30 or xx years, (Value in Billion Rupiah)” including Traditional PSC on the left-hand side and PPP (Shadow Model) on the right-hand side including elements such as costs (PSC) and availability payment (PPP), risk borne by the Government/GCA (under non-PPP method), implementation of competitive neutrality, costs borne by the Government and the totals on either side. The derived VfM may be expressed as Shadow Model – PSC xx% from PSC cost, including risk xx%.

Summary