Outline of Lecture 1
• Cost Benefit Analysis
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–
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Definition and history
Welfare economics
Stages in CBA
Limitations, critiques
Alternatives to CBA
• Total Economic Value
– Definition
– Role in CBA
– Environmental valuation methods
• An example: Rainforests
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Cost Benefits Analysis (CBA)
• Benefit Cost Analysis (BCA) is an economic tool for
government policy and investment project analysis
used widely
• Can incorporate environmental impacts of
policies/projects within CBA to correct for market
failure
• “Social” appraisal of policies and projects, carried out
by aggregation of benefits from, and costs of a
policy/project over individuals and over time
• Welfare theoretic underpinning: Economic efficiency
with a temporal dimension
2
Cost Benefit Analysis
•
Relates to the environment in three ways:
1. Projects/policies may have negative
environmental effects, i.e. negative
externalities (public and private)
2. Projects/policies may have positive
externalities (public)
3. Projects/policies may have both positive and
negative externalities (public and private)
•
Externalities should be included in CBA in
order to correct for market failure
3
History of CBA- USA
• 1808 Comparing costs and benefits of water
related projects
• Until 1960s mainly used in water resources
management
• 1960 onwards expanded to other public
goods (wildlife, air quality)
• Since 1970s CBA is required to support
environmental decisions.
4
History of CBA-UK
• 1960s-1970s CBA used in transportation (M1
Motorway, London Victoria Underground, Channel
Tunnel, Third London airport)
• 1990 UK Pearce Report recommended that
environmental impacts should be brought to formal
policy and project appraisal where possible
A government’s policies can affect the environment from
street corner to stratosphere. Yet environmental costs and
benefits have not been integrated into government policy
assessments, and sometimes they have been forgotten
entirely. Proper consideration of these effects will improve
the quality of policy making.
5
History of CBA-UK
• Report affected several policies in the UK since
1990s (landfill tax, national air quality standards,
agri-environmental policies, etc.)
• CBA also used in project appraisal with
environmental impacts (investment in coastal
defences, water quality improvements, inclusion
of biodiversity values in forest return calculations,
etc.)
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History of CBA-EU
• Used widely in some European countries (e.g.
Sweden, Netherlands, Austria) but not so widely in
others (e.g. Germany, Italy, Ireland)
• Until 1990s many EU environmental directives
issued without considering CBA and imposed costs
on member states in excess of benefits (e.g. Bathing
Waters Directive, Packaging and Packaging Waste
Directive, Drinking Water Directive)
• Recently the EU have considered CBA in several
EU policies (e.g. directive on air pollution from
municipal waste incinerators, Water Framework
Directive)
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Welfare Economics Background
•
CBA is firmly based in welfare theory in three
ways
1. In terms of how gains and losses are measured
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Consumers: Changes in consumer surplus as a result
of changes in quantity and quality of environmental
goods
Producers: Changes in producer surplus as a result of
changes in prices and quantity and quality of inputs
Makes use of the opportunity cost (scarcity rents)
concept to asses costs of using scarce resources
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Welfare Economics Background
2. What counts as costs and benefits
– Welfare economics evaluates alternative
resource allocations in terms of their effects on
utility
– CBA includes any impact on utility whether or
not they are reflected in market prices
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Welfare Economics Background
3. In terms of aggregation and comparison of costs
and benefits
– Policies and projects have a mixture of gains and losses
across individuals
– Gains and losses are calculated in money terms, added
up and compared to find out the net impact on welfare
(net gain or net loss)
– Measure of the change in social welfare is based on
Kaldor-Hick Criterion: Could gainers compensate the
losers and still be better off?
– This criterion considers economic efficiency but
interpersonal welfare impacts, i.e.distribution of gains
and losses are not considered
10
Stages of CBA
• Stage 1: Definition of policy/project:
– The reallocation of resources being proposed
– The population of gainers and losers being
considered
• Stage 2: Identification of policy/project impacts:
– Define all impacts that will result from policy/project
implementation
– Consider additionality (net impacts) and displacement
(crowding out)
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Stages of CBA
•
Stage 3: Identification of economically
relevant impacts:
Environmental impacts of a policy/project are
relevant in CBA if either
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They change the utility of at least one person in the
society
They change the quantity or quality of the output of
some positively valued commodity
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Stages of CBA
Stage 4: Physical quantification of relevant
impacts:
– Determine physical amounts of costs and benefits
and when they occur in time
– Use environmental impact analysis to estimate the
impact of policy/project on the environment
– Estimations will be made with uncertainty, calculate
the expected value of costs and benefits
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Stages of CBA
• Stage 5: Monetary valuation of relevant effects
– All physical measures of impacts should be valued
in common units to be comparable
– Common unit = money
– CBA analyst must
• Predict prices for value flows extending into the future
• Correct market prices where they are distorted
• Calculate prices where non exists using environmental
valuation methods
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Stages of CBA
Stage 6: Discounting of costs and benefits:
– Once costs and benefits are expressed in monetary
units they should be converted to present value
terms by discounting
– PV= Xt[(1+r)-t] where X= cost or benefit; r =
discount rate; [(1+r)-t] discount factor; t= time
– The higher the value of t the lower the discount
factor
– The higher the discount rate for a given t the lower
the discount factor
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Stages of CBA
• Stage 7:Applying the net present value test:
– Apply NPV test to choose those policies and projects that are
efficient in terms of their use of resources
Bt  Ct 

t
t 0 1  r 
n
– Where Bt = benefits of the project at period t, Ct = the costs
of the project at period t, r = the discount rate, n = the
number of years over which the project will operate
– NPV is the present value of the project’s/policy’s net benefit
stream, obtained by discounting the stream of net benefits
produced by the project/policy over its lifetime, back to its
value in the chosen base period, usually the present.
– If NPV>0 accept policy or project (Based in Kaldor-Hicks
Criterion) since it would improve social welfare
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Stages of CBA
•
Alternatives to NPV
1. Benefit – Cost ratio (BCR): It is the ratio of the
sum of the project’s or policy’s discounted
benefits to the sum of its discounted costs. If
BCR>1 go ahead with the project/policy
n
( Bt )

t
t  0 (1  r )
BCR  n
(Ct )

t
t  0 (1  r )
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Stages of CBA
2. Internal Rate of Return (IRR): Rate of interest which if used as
the discount rate for a project/policy, would yield a NPV of zero.
It is the discount rate at which it would be just worthwhile doing
the project/policy.
So the IRR is the discount rate, r*, at which:
Bt  Ct   0

t
t 0 1  r *
n
However IRR is a flawed measure of resources allocation
because many projects/policies generate multiple IRRs and also
because it cannot be used to compare projects/policies.
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Stages of CBA
• Optional addition to stage 7
– Change weights in the NPV function since income
distribution is not equal benefits and costs are not
distributed equally across society
– Conventional NPV puts equal weights on each individual
– Weights can be adjusted by wi=Y*/Yi, where Y* is
household income across all groups, Yi is mean income in
group i and wi is the weight attached to impacts on i,
– This gives higher weight to poorer groups and the NPV
becomes NPV= w1B1+w2B2+…..+wn Bn , where Bi is the
discounted net benefits to group i
– This procedure is rarely used except in developing countries
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Stages of CBA
• Stage 8: Sensitivity analysis:
– NPV test gives relative efficiency of a project given
the data on prices, environmental and economic
impacts and discount rate but any of these data
might change due to uncertainty
– Recalculate NPV when the key parameters change
to discover which one(s) of them the NPV is most
sensitive to
– Once the most sensitive parameter is identified
direct forecasting effort to improve best guess and
more effort to manage these parameters carefully
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Limitations of CBA
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Valuation of environmental goods
Ecosystem complexity
Discounting and discount rate
Institutional capture
Sustainability and CBA
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Alternatives to CBA
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Environmental impact assessment (EIA)
Cost-effectiveness analysis (CEA)
Multi-criteria decision-making (MCDM)
Cost-utility approach
Risk-benefit approaches
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Recap on CBA
• CBA is well-established component of applied welfare
economics and of public policy and project analysis
• Include environmental impacts in CBA to make more
efficient decision making and to explicitly recognise the
impact of economy on the environment and the
contribution the environment makes to utility and
economy
• Including the environment in the CBA does not mean
the environment will be conserved since CBA makes
trade-offs between the environment and other resources.
• CBA is concerned with efficiency but generally not
compatible with sustainable development wrt inter and
intra generational fairness
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Total Economic Value (TEV)
• Environmental goods are public goods, they are
not traded in the markets and hence they do not
have readily available market prices
• The value of environmental good is not only
derived from its direct consumption but also
from its indirect consumption, as well as nonuse.
• The broad concept of value is known as the
Total Economic Value (TEV)
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TEV
Total Economic Value
Use Value
Actual use
Value
Direct Use
Value
Option Value
Indirect Use
Value
Non-use Value
Existence
Value
For Others
Bequest
Value
Altruistic
Value
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Environmental Valuation Methods
• Indirect approaches/Revealed Preference Methods:
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Hedonic Pricing Method
Travel Cost Method
Dose -Response Functions
Averting Behaviour
Market Prices
• Direct approaches/Stated Preference Methods:
– Contingent Valuation Method
– Attribute Based Choice Modelling
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•
•
•
Choice Experiments
Paired Comparisons
Contingent Ranking
Contingent Rating
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TEV Example: Tropical Deforestation
• Tropical forests are declining in area by
0.8% per year.
• TEV of that amount is lost
• Forest lost is due to
– Population growth
– Market failure
– Government failure
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TEV Example: Tropical Deforestation
$
MNPBD+SUB
MECL+G
MNPBD
MECL
N
A B
C
D
forest loss
MNPBD = the marginal net development benefits from converting the forest to, say, agriculture
MNPBD+SUB = marginal net development benefits including subsidies to convert the land
MECL = marginal external costs borne locally from forest conversion
MECL+G = marginal external costs borne locally and by rest of world from forest conversion
Note that MEC is measured by the total economic value of the forest services that are lost.
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TEV Example: Tropical Deforestation
• There are 4 points of interest.
– C = local private optimum, i.e. all externalities are
disregarded. There are no subsidies.
– D = local private optimum , i.e. all externalities are
disregarded and forest conversion is subsidised
– B = local social optimum, i.e. local externalities are
internalised but global externalities are ignored
– A = global social optimum, i.e. all externalities are
internalised.
• Assuming a global view is taken, the desirable
position is A.
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TEV Example: Tropical Deforestation
• CD: Government failure, i.e. the amount of forest land that is lost
due to government subsidies to conversion.
• BC: Local market failure
• AB: Global market failure by
• AD: Amount of forest conversion that takes place inefficiently.
• OA: Efficient conversion.
• Population growth also increases rates of forest loss by increasing
the demand for 'developmental' benefits, e.g. land for food.
• This causal analysis shows us how to think about policy. To 'save'
the forests we need:
•
•
•
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to reduce population growth
internalise local externalities
internalise global externalities
remove subsidies to forest conversion
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TEV Example: Tropical Deforestation
• Direct use values: Timber values, fuelwood and charcoal
extraction, non-timber forest products (NTFP),
biodiversity and genetic information, tourism and
recreational values.
• Indirect use values: Protection of watersheds and the
storage of carbon and sequestration.
• Option values: values reflecting a willingness to pay to
conserve the option of making use of the forest even
though no current use is made of it
• Non-use values (also known as existence or passive use
values): these values reflect a willingness to pay for the
forest in a conserved or sustainable use state, but the
willingness to pay is unrelated to current or planned use
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of the forest.
TEV Example: Tropical Deforestation
Environmental valuation methods used to estimate the values of forest
goods and services
Valuation methods
Forest good or
service
HP
TC
CM
MP CV
PF
Timber


Fuelwood


NTFPs



Genetic information 


Recreation/Tourism


Watershed



Climate




Biodiversity
?

Amenity



Non-use values


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TEV Example: Tropical Deforestation
Summary economic values for forest goods and services
($ ha/pa unless otherwise stated)
Forest good or service
Tropical forests
Temperate forests
Timber
conventional logging
200-4400 (NPV)
300-2660 (NPV)
-4000 to + 700 (NPV)
sustainable
Fuelwood
40
NTFPs
0- 100
small
Genetic information
0-3000
Recreation
2- 470 (general)
80
750 (forests near towns
1000 (unique forests)
Watershed benefits
15- 850
- 10 to +50
Climate benefits
360- 2200 (GPV)
90 - 400 (afforestation)
Biodiversity (other than genetics)
?
?
Amenity
Small
Non-use values
Option values
n.a.
70?
Existence values
2- 12
12 - 45
4400 (unique areas
Sustainable forest management
5-15% of timber prices?
5-15% of timber prices?
premium
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TEV Example: Tropical Deforestation
CBA on forest conservation.
1.
Converting primary forest to any use other than agroforestry or
very high value timber extraction fails CBA.
2. Converting secondary forest to the 'cycle' of logging, crops and
ranching could make economic sense but many conversions to
slash and burn agriculture would make no economic sense.
3. Converting secondary forest and open forest to agroforestry
appears to make economic sense, assuming that most of the
forest's services (including biodiversity) are retained.
4. Non-market values almost certainly fail to capture the economic
value of biodiversity which, apart from the value of genetic
information, is omitted from the analysis.
5. Carbon storage is of the utmost importance to the economic case
for forest conservation.
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Recap on TEV
•
Values of environmental goods are complex because
1.
2.
3.
•
They are public goods
They do not have market prices
People derive values other than consumption benefits from them
Value of an environmental good is broad
TEV= (Direct use value+Indirect use value+Option Value) +(Bequest
Value+Altruistic Value+Bequest Value)
•
•
TEV should be estimated using environmental
valuation methods
TEV should be included in CBA in order to ensure
efficient provision/conservation of environmental
goods
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