83859 DEVELOPMENT EFFECTIVENESS UNIT IFC Projects: Benefits to society exceed those to financiers alone by over 50%, with total benefits exceeding costs by 88 cents per dollar invested An analysis of 63 IFC projects evaluated between 2004-2006 showed large benefits to society - $6.8 billion above and beyond investment costs of $7.75 billion, or 88 cents per dollar invested. These benefits were split about evenly between investors and other stakeholders, such as host governments, customers, employees and suppliers. Benefits to society exceeded benefits to financiers in 84% of the projects, and this number has been steadily increasing. As a private sector development finance institution, IFC stimulates economic growth and reduces poverty by investing in private companies in the developing world. Through the provision of financial products and services, including loans, guarantees, and direct equity investments, IFC´s contribution is not limited to generating returns for project financiers. Beyond that, projects also create positive social returns for other impacted stakeholders, such as host governments, customers, suppliers, or employees. IFC’s analysis shows that these benefits to other stakeholders are as large as those to financiers alone. Adequate financial returns are essential to attract private investment and to send a positive signal to other investors. IFC measures returns to a project’s financiers by calculating a financial rate of return (FRR). The FRR is an overall measure of profitability from the viewpoint of the company and its financiers. It is the internal rate of return that makes the present value of the net project cash flows zero. A company should only invest in the project if the FRR is greater than its weighted average cost of capital, otherwise returns are insufficient to pay lenders and adequately compensate equity investors. An adequate financial return is therefore essential to continue to attract private financing, and to signal to other investors that there are profitable investment opportunities in emerging markets. What investors consider adequate returns depends on the level of risk, and historically IFC’s Independent Evaluation Group has 1 estimated adequate returns to be on average about 12%, or 9.5% in real terms, after accounting for inflation. As a development institution, IFC also considers returns to society as a whole, including benefits and costs to other stakeholders. The attractiveness of an investment from society’s standpoint, measured by the economic rate of return (ERR), is different from the FRR in that it accounts for other costs and benefits that affect a broader set of stakeholders who are also impacted by the investment. This can include host governments, employees, customers, new entrants, and suppliers of inputs to name a few. For example, the construction of a new food processing plant will create jobs that could pay salaries and provide benefits above other local opportunities, provide a new source of government taxes, and deliver new or higher quality products to its customers. In some instances, however, the societal returns can be less than those received by the project’s financiers, usually because of protection, subsidies or externalities. The analysis that follows takes a closer look at economic versus financial rates of return within a sample of recently evaluated IFC projects. Recent analysis of IFC investments demonstrates again that large economic benefits were associated with IFC- financed projects. IFC reviewed a representative sample of 63 real sector projects approved from 1999-2001 and 2 evaluated between 2004-2006. At the time of approval, these projects cost their financiers $7.75 billion, of which 13% 1 IEG Annual Review FY04: Satisfactory benchmarks for FRRs ranged from 6.5% to 12.7% in real US dollar terms, with a median of 9.5%. Inflation was in the range of 2.5%. 2 In-depth project level evaluations are carried out by IFC staff and then independently validated by IFC’s Independent Evaluation Group (IEG) who also selects an annual random sample of projects that is representative of IFC’s approvals 5 years earlier. Evaluating investments five years after their approval ensures that the business operations of a given project are sufficiently mature to reliably estimate private and social returns. DEVELOPMENT EFFECTIVENESS DEVELOPMENT EFFECTIVENESS UNIT was financed by IFC and 9% by syndicated commercial bank partners. Data independently verified by IFC’s Independent Evaluation Group (IEG) suggests that five years after the initial investment the estimated benefits of these projects exceeded their cost by roughly $6.8 billion. In other words, each dollar invested was not only returned with 3 interest , but generated an additional 88 cents in benefits. These benefits were split about evenly between investors and the rest of society. In aggregate, economic returns to society overall, at 19.9%, were over 50% higher than 4 private returns to investors at 12.7% in real terms. This repeats similar findings from projects evaluated between 5 2001-2003. IFC considers economic rates of return that are greater than 10% as satisfactory and 20% as excellent. 84% of IFC’s projects had social returns that exceeded those received by project financiers, and in only 3% was 6 the reverse true. To appreciate how society benefits more than financiers in roughly four out of five IFC projects, consider the following example: In 2000, IFC invested $30 million and helped attract an additional $50 million in financing from commercial banks to help finance a $500 million project with an appliance manufacturer in Southern 7 Europe. In addition to providing adequate returns of 12.1% to its financiers, the company generated over $350 million in tax revenues, $38 million in increased salaries and benefits for its workers, and contributed $13 million to community development, for example to improve health, education and the environment. Including these benefits, returns to society were 18.2%. With higher financial returns, satisfactory returns to society also become more likely. As the above graph shows, the higher the financial returns, the more likely it is that benefits to society are also satisfactory. Whereas only a third of projects with financial returns below 10% had satisfactory returns to society, 96% with financial returns above 10% did. This is not to say that projects with low FRRs always have equally low ERRs. Some projects may have low returns for their financiers, but still provide significant social benefits that warrant IFC’s involvement. For example, an IFC investment in a Latin American port in 2000 provided limited returns to its financiers at 6.1%, while society’s return was just above 20%. The gains that accrued to society included the creation of 500 new jobs, tax payments in excess of US$ 16 million and the sourcing of goods from local suppliers at an estimated value of US$ 500,000 annually. Thus, even if financiers of a project earn less than they expected, and sometimes even less than their cost of capital, society can still benefit – but IFC’s data shows this to be the exception, rather than the rule. 3 For this calculation, a real discount rate of 5%, equivalent to about a 7.5% nominal return, was used. 4 Measured in nominal terms (before adjusting for inflation), private and social returns were 15.3% and 22.7% respectively. 5 For 134 projects evaluated between 2001-2003, IFC’s Independent Evaluation Group estimated aggregate returns to society to be 13%, compared to aggregate returns to financiers of 7.9%. Discounted at 5%, these projects generated economic benefits of $8 billion over and above their investment costs of $17.3 billion. 6 In 13% of cases the ERR was equal to the FRR. 7 All US dollar benefit estimates in this paragraph are expressed in net present values, discounted at 10%. DEVELOPMENT EFFECTIVENESS UNIT Returns to society can be lower than those to financiers… Where prices do not reflect opportunity costs or benefits, financial returns can be a deficient indicator of a project’s benefits to society. The reasons for divergences are usually protection, subsidies or externalities. With protection, consumers pay higher prices than they would for imported goods. This benefits a project’s financiers (usually a few) at the expense of consumers (usually many). Subsidies are borne by governments – and ultimately the taxpayer, and can also benefit financiers at the expense of society. Negative externalities, such as pollution, can cause costs to society that are not borne by the financiers, and positive externalities, such as providing infrastructure that can be used by other stakeholders, can result in benefits that financiers do not capture. … but such projects are – increasingly – rare. Only 2 projects evaluated from 2004 to 2006 had returns to society that were lower than those to financiers. To better understand what causes society to benefit less than the company financiers, we therefore broadened the analysis to all projects evaluated from 1996-2006 where the ERR was less than the FRR. This analysis showed that import tariffs (40%) along with other protection or subsidies (16%) were the dominant reasons, and the industries most affected were manufacturing (20%), cement (15%), agriculture (10%) and pulp and paper (8%). The analysis also showed a decrease in the percentage of projects with economic returns below financial returns, from almost a quarter of projects evaluated between 1996-2000, to 9% between 2001 and 2003 and 3% between 2004 and 2006. Conversely, the percentage of projects with benefits to society exceeding those to financiers has been steadily increasing, from 63% to 74% and most recently to 84%. DEVELOPMENT EFFECTIVENESS UNIT The main reasons: Improved screening by IFC… This decrease is largely explained by two reasons – improved screening and reduced distortions. First, IFC screens against the major reasons why financial returns may be lower than returns to society. Following its operating procedures, IFC does not finance projects that depend for their viability on protection and subsidies, and also ensures that negative environmental effects are avoided, or at least mitigated. This also reflects learning from IFC’s experience and makes good business sense: Protection and subsidies are frequently removed over the life of a project, resulting not only in poor development results, but also poor financial performance. …and decreasing distortions. Second, there has globally been a general decline in trade barriers and government protection, resulting in a lower incidence of divergences between financial returns and benefits to society. In the past, national governments often argued that protection is warranted on grounds of supporting the development of nascent industries until they are ultimately competitive on international markets. But such attempts rarely worked, and in addition protectionism deprives consumers of lower cost and possibly higher quality goods that they could have sourced from world markets in the absence of trade barriers. Development Effectiveness Unit International Finance Corporation 2121 Pennsylvania Avenue, NW Manager: Roland Michelitsch MSN F4K-409 Washington, DC 20433 www.ifc.org/results DEVELOPMENT T: 202.47.DOTS2 EFFECTIVENESS