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LTW2: Cost-Benefit Analysis and the Environment (Stages of CBA (using…
LTW2: Cost-Benefit Analysis and the Environment
Basic Concepts
CBA:
Is flexible (used for many things)
Draws criteria from Welfare Economics
Needs identification of all costs and benefits to
society
Needs systematic counting and valuation
Evaluates whether the total benefits outweigh the total costs
Is about efficiency for total society, therefore there may be individual or groups of losers resulting from a project
Can use redistribution to allow for Pareto Improvements
Easiest way to bring distributional equity into CBA is to give 'more important' groups extra weighting e.g. 1 person counts as 2 for example
Historical/Present Use:
US has longest history with it: Used in Flood Control Act (1936)
World Bank uses it for investment appraisal to decide on loan/investment making
The EU has been slow and selective with use of CBA
Hahn (1995)
: Study found that 50% of all environmental regulations enacted between 1990 and 1995 fail a CBA appraisal
Peace (2004)
: Few, if any, recent EU Environmental Directives likely to pass test
Purpose of CBA:
Improves efficient use of scarce national resources:
Facilitates efficient government intervention in the case of market failure
Important in times of economic difficulty, e.g. with the NHS
Helps choose the best from competing interventions (ideally --> increased social welfare)
Used to maximise the
size
of the pie (other policy instruments can then decide on how to
share
the pie
Private and Social CBA:
Private
Companies also use CBA for cash-flow analysis, but don't normally include social costs
They look at their own costs versus own benefits
The value using market prices, not accounting for distortions
They use a private discounting rate
They don't account for equity
Social
All costs and all benefits to all society compared
They use 'shadow' or 'real' prices to value
Use a social discount rate
Can, but not always, account for equity impacts
From Atkinson
et al
2018
Why use CBA?
Gives a model of rationality: forces decision makers to rationally consider beneficiaries and losers over time and space
Avoids 'lexical' thinking: DMs don't just consider the impact on a single goal/on a single group of people
E.g. consider human health and environment together, not one or the other
CBA is clear in that it shows one of many possible options: Setting out alternatives is a prerequisite
By setting out alternatives, CBA determines optimal scale for the project (e.g. Thames - considers various scale of the pipeline), finding maximisation point of net benefit
Offers a 'do nothing' rule not only to decide between alternatives, but also whether anything should be done at all
Time consideration: Explicit consideration given to time - applies discounting procedure - controversial but necessary
Individual's preferences accounted for: Through stated preference techniques, individuals can participate - considered democratic (others see as weakness if population not well informed + are self-interested versus 'citizen' preferences
Seeks explicit preferences rather than implicit
It's a preference-based approach; requires all preferences can be aggregated, effectively meaning some cardinalisation of utility is used- - potentially a disadvantage
If beneficiaries can HYPOTHETICALLY compensate losers, leaving them some net gains left, it passes the benefits>costs test - this is called the
Kaldor-Hicks Compensation Test
, aka the 'Pareto Condition' - important because if you can compensate the losers, this sort of removes the 'ordinal' aspect and allows us direct comparison of the magnitudes of the benefits and loses
Stages of CBA (using Thames Sewage project as context - 60 overflows per year of sewage into river)
Select Portfolio of alternative projects and define baseline
24 feasible engineering options looked at
E.g. different diameters tunnels, different materials etc.
Baseline: This is for the comparison of what would happen with no policy therefore in this case is the 'do nothing' approach (not always the case)
May have had the baseline as an alternative such as a reservoir project if Thames Water was considering both
Options to be sifted into reasonable and non-reasonable
An often ignored consideration is 'when' - when should the project commence? Can be an important policy design - e.g. before or after Brexit
Should significant sums of public money be spent on this project?
Define relevant/included population
Tunnel runs through central London: could therefore be everyone working/living in London
Would open up benefits for millions, therefore Thames water went with the benefits to their 5M customers only (as they're the ones going to be footing the bill)
In their second CBA, the entire UK population was used
Known as the issue of 'standing'
Non-nationals should be considered if proposal relates to international context where there's legal obligations e.g. treaties, or an accepted ethical reason for counting benefits and costs to non-nationals
International CBAs are split into an analysis of the home country and one for all countries affected
List/quantify potential physical impacts
Can split into market and non-market benefits and costs
Market Benefits: Avoid operating cost of 'bubblers' when sewage system overflows
Market Costs: Capital expenditure (materials etc.) and operating costs
Non-market Benefits: Improved visual amenity, fewer health risk days and fewer fish kills
Non-market Costs: Noise and disruption of construction, energy-related pollution
Also need to include lots of things like air quality and smells from construction, noise and vibration, other non-fish ecological issues, benefits of economic boost through construction employment (aka network externalities)
Is impossible to account for everything, so just try and get the major things
It may be especially difficult to identify specific impacts when un-researched scientific processes are involved
True impacts may be unobservable
Predict quantitative impacts over the life of the project
I.e. predict costs based on the life of the project - very difficult:
Normally done by calculating the costs of each category each year (e.g. number of fish saved in year 1, in year 2 etc., e.g. annual operating costs)
Difficulty arises when unexpected things arrive e.g. Brexit - may change cost of hiring labour etc.
Optimism Bias
: Government knows that people tend to try and minimise costs and maximise benefits
The Green Book therefore accounts for this - tries to make adjsutments based on past objects - compare real costs of the project with predicted
Recommend adjustment of +200% for equipment (based on evidenced results)
Monetise all impacts
Assign monetary values to all items on the list:
Social CBAs like the Thames one use '
shadow prices
' which reflect the true social cost or benefit of the item
Benefits: Use the WTP for the benefit (maximum amount of resource [normally money] willing to be given up in exchange for the change) - aka WTP^G (WTP Gainers)
Cost: Use the opportunity cost (i.e. benefits that are foregone by using resources in the project - use WTP^L (WTP Losers) - unless losers have property rights to what they lose, then use WTA^L
Cost could be compliance or regulation costs
Non-market Costs and Benefits
Use Non-market techniques
Contingent valuation, choice method etc. to elicit a value
E.g. it was found that people would be WTP £1.82 to reduce litter in the Thames by 1%
Market Costs and Benefits
If markets exist, use market price
If imperfect markets exist, use adjusted market prices (e.g. if there are tax differences between items)
Apply discounting to future impacts
Discounting is a reduction in the value of a benefit or cost the further in the future it is obtained / incurred to give their
present values
Social projects currently use 3.5% as a discount rate (for first 30 years, after which it diminishes)
People in developing countries have much higher discounting rates: There's uncertainty of future, and more immediate need for gains now
To discount, divide cost by (1+discount rate)^(years into the future)
Note: Discounting has nothing to do with inflation as real prices are used throughout and has nothing to do with risk - we assume investments are safe
Lower discount rates are better for the environment - it protects it long term by assigning value to it far into the future
Aggregate costs and benefits to give net figure
So for a project, you calculate the net present value, i.e. difference between the present value of the benefits and present value of the costs - this is superior to a benefit-cost ratio
In Thames sewage project, it was found that the NPV of a medium sized tunnel was the greatest (£5bn of benefit), thus justifying Thames Water to go ahead with project
Sensitivity analysis
I.e. check for sources of error:
To minimise these error sources, it's important that a CBA is done retrospectively, after the project's completion to allow for a comparison that can be analysed by other CBA study projects
This is called an ex-post (as opposed to an ex-ante) study
Excellent for learning about the actual value of the project and other similar project's expected values
Strategic Errors: There's lots of 'bad' studies done by 'economists for hire', and CBA analysis's may have pressure from bosses to generate numbers favouring their preferred rule
Omission Errors: Exclude impacts that are important
Measurement Errors: Impacts are often observed, recorded or interpreted inaccurately
Forecasting Errors: Beyond a few months, forecasting is often inaccurate; BC-studies can thus give a false sense of precision to something that is not really known
Valuation Estimates: It's difficult and expensive to get accurate valuations, especially over the long run where choice of discount rate radically alters the outcome
Ways to deal with risk and uncertainty include:
Expected value/expected utility approaches (based on whether they're risk neutral, loving, or averse)
Need to compute different values for the parameters with uncertain elements (aka sensitivity analysis) - See if different values can change the sign of the CBA result - if not it's 'robust'
Recommendation
This is straightforward, unless the sensitivity analysis shows that NPV estimates are very uncertain
Gives a 'what you should do' recommendation
Politics then often gets in the way of whether it is done
Notes on thames project's political economy considerations:
Whilst the evaluation was ongoing, the baseline changed as other schemes improved the water quality
Some argued the project should go ahead due to a statutory duty
PB(B)-PV(C)>0 --> Go ahead
NOTE: need to consider distributional concerns - if there's a £100 benefit for a rich person and a £50 loss to a poor person, is this something we want to be doing?
Interpretation and Critical Evaluation
Examples
Possible Questions
Discuss use of CBA in CC policy
Explain how a CBA could work in the context of a specific Brazilian mine - pros and cons of using analysis
Recent CBA Developments (Atkinson et al 2018)
Finding Monetary Values:
Net sum of WTP and WTA costs and benefits = TEV (Total economic value)
TEV can be split into use (Actual, possible [i.e. people want to preserve the option of using a good] or planned) and non-use values (altruistic, bequest [more specific to having resource there for future generations] or existence value)
Issue: Is intrinsic value encompassed by WTA/WTP statements?
Issue: The 'correspondence problem': scientific information on ecosystem change does not correspond to indicators that individuals recognise - if science isn't measuring things that are used to calculate valuation, there's an issue
Who Gains, Who Loses:
Issue: Does equitability have a place in CBA or only efficiency?
Some argue distributional incidence is nothing to do with CBA - let moral or political mechanisms determine share
Others argue that notions of equity are more engrained in the human psyche than efficiency thus are incorporated more into WTA/WTP measures
Some argue that politics always discusses equity before efficiency, therefore let CBA do the efficiency stuff
Selecting a Discount Rate:
Issue: The 'tyranny of discounting' - makes us ignore situations where we're going to cause huge future issues, but the discounting makes them easy to ignore
There's reemerging interest in 'dual discounting' - different discount rates applied to different classes of goods - e.g. discount scare resources differently to plentiful ones
Wider Limitations
Issue with CBA as a moral guidance mechanism - does looking at preferences for a change give a good measure of what's good for society?