The standing of foreign lenders in cost-benefit analysis: some implications for environmental appraisals

ABSTRACT

International loans often finance projects with environmental benefits and costs. Cost–benefit analysis (CBA) is the default tool to determine the societal economic value of investment projects or policies producing environmental externalities. Standing in CBA concerns whose benefits and costs count in the calculation of societal value. Common practice is to grant standing only to nationals of the country hosting the policy or investment project under appraisal. Foreign lenders therefore do not stand. The social opportunity cost (SOC) approach to the social discount rate (SDR) addresses foreign loans. In the SOC approach, the SDR incorporates the opportunity cost of foreign loans associated to a marginal change in government borrowing, while foreign lenders implicitly do not stand. However, the literature has not addressed the treatment of foreign loans in appraisals following the social time preference (STP) method of discounting. This paper argues that CBA appraisals following the STP approach to the SDR would need to model loan cash flows explicitly as the loan itself may be a source of societal gain or loss. It then discusses implications for projects with long-term benefits or costs and with cross-border externalities, epitomising environmental appraisals. A case study of a forest harvesting project is also included.

KEYWORDS:

• Cost-benefit analysis
• social discount rate
• standing
• distribution
• externalities
• inter-generational transfers
• debt
• forestry

JEL:

• D61
• H23
• H43
• Q58

Acknowledgements

The author is grateful to Professors Per-Olov Johansson and Ginés de Rus for comments on earlier drafts leading to this paper and to Dr Adrian Enache for comments on the forestry case study. The comments of two anonymous reviewers are also appreciated. Any remaining errors are attributable to the author.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Focusing on environmental costs and benefits, practice varies on what effects (or variables) are included in an appraisal and what values are adopted. Much attention has been paid during the last couple of decades to externalities related to climate change, while biodiversity costs and benefits have received significant attention only more recently. See OECD (2018) for a recent review and discussion of CBA practice regarding environmental costs and benefits.

2 This would assume either that the project is too small to affect the price of foreign financing or that the elasticity of supply of foreign funds is, for all practical purposes, infinite. See Burgess and Zerbe (2011a) for the alternative situation where the project or policy causes a change in the price of foreign financing. Harberger (1980) and Edwards (1986) extend the discussion to address considerations of risk premia, including differences in risk perception between borrowing and lending countries.

3 It is possible to think of circumstances where this outcome may not hold. Take for example a government sponsored infrastructure project with private sector participation through a concession. Often concessionaires are foreign companies, particularly in developing countries. The concession may be held through a special purpose vehicle that borrows internationally. In order to lower the cost of finance, such borrowing may enjoy the guarantee of the parent company of the foreign concessionaire. The economy hosting the project would still see either the inflow of foreign exchange from the loan, or the import of equipment purchased with the foreign loan, while the government of the country hosting the project would not need to issue debt. Another possible example would be international concessional lending tied to a specific project. Such exceptions are not addressed here.

4 Occasionally, the idea has been raised that the proportions, or weights, in equation (1) should reflect the actual financing structure of each project (see, for example, Boardman et al. 2018, 249, 2014, 265). This paper follows the standard formulation that the SDR derived under the SOC approach constitutes a single SDR for all appraisals in an economy. Burgess and Zerbe (2011) mention the example of a project financed with a purposely-raised tax. Project flows should still be discounted at the SOC SDR that assumes the project is financed with government debt, since the tax raised by the project would have the alternative use of paying down government debt. Note that an alternative (and unorthodox), project-specific approach would also imply that the SDR would already incorporate the opportunity cost of foreign financing. It would do so more directly, since it would not require substitute uses of foreign exchange in the economy.

5 Assuming that the supply of savings at country D is infinitely elastic, or that the project is too small to cause a change in the domestic lending rate.

6 Note that this benefit would be additional to any additional benefit or cost measured through the use of a shadow exchange rate (or a standard conversion factor).

7 There is a very large number of CBA studies following the STP approach. The shortcut way of reviewing practice is through the guidance documents that govern their preparation. See for example European Commission (2014) and HM Treasury (2018). For a wider review of SDR use internationally see OECD (2007).

8 NPV = 2.16m is the result of discounting at 6% a cash inflow of EUR10m at t = 0, plus a EUR0.4m cash outflow every year from t = 1 to t = 20, plus a cash outflow of EUR10m at t = 20.

9 At the time of writing, December 2019, long-term debt at commercial (rather than concessional) rates is historically low. German debt with 30-year maturity yields 0.223% while Swiss debt with 50-year maturity yields are negative at −0.151% (current data is available on Bloomberg Professional © terminals, although a more readily accessible source of data is https://www.worldgovernmentbonds.com/). In 2017 Austria, a sovereign with a Standard & Poors AA+ rating, sold century bonds at a 2.112% yield (Financial Times 2017). It is not farfetched to take 2% as the interest rate of an eventual 100-year concessional loan product.

10 For a discussion of the CBA treatment of environmental emissions within market-based mechanisms such as cap and trade or offset schemes, see Johansson and Kriström (2018). For an application see Jorge-Calderón and Johansson (2017).

11 Note that a correct CBA appraisal would always account for such external effects. What is being assumed here for illustrative purposes is that the government at hand makes the policy choice of ignoring such benefits and costs. Countries differ in their actual practice of CBA, including both what benefits and costs are accounted for and what unit values are adopted to measure those benefits and costs. Indeed, governments may decide not to use CBA at all in project and policy decision making (see, for example, Mackie and Worsley 2013; OECD 2018).