REM 621 TOPIC 5: COST-BENEFIT ANALYSIS

1. REM 621TOPIC 5: COST-BENEFIT ANALYSIS

2. What are the steps in a standard cost-benefit analysis (CBA)? Step 1. Define the project and decide whose benefits and costs count (standing). Step 2. Select the project alternatives or portfolio of projects to be compared. Step 3. Catalogue potential (physical) impacts and select measurement indicators. Decide which impacts are economically relevant. Step 4. Predict quantitative impacts over the life of project. Step 5. Undertake a monetary valuation of relevant effects. Step 6. Allow for the presence of project benefits and costs occurring in different time periods. eg. discounting Step 7. Sum up benefits and costs and apply some project evaluation criterion or decision rule, e.g. Net present value (NPV) = B ‑ C > 0 Step 8. Perform a sensitivity analysis.

3. Ecological Effects of Deforestation System shock Reduced tree cover Fuelwood scarcity Loss of shelterbelt Increased runoff Diversion of dung & crop residues as fuel Increased collection time Reduced soil fertilizer Sedimentation and siltation Pollution and salinity of water Reduced cooking Reduced livestock fodder Reduced fertilizer and mulch Reduced hydropower capacity Reduced irrigation input Flood plain effects Impact on fisheries Drinking water effects Source: Adapted from Markandya and Pearce (1989)

4. Sample Project Benefit and Cost Table

5. COMPOUNDING future value interest interest Value ($) interest initial amount 0 1 2 3 Time (years) DISCOUNTING future amount discounted value Value ($) discounted value present value discounted value 0 1 2 3 Time (years)

6. Recent developments in discounting • Zero or low discounting of environmental benefits; Markandya and Pearce had the following to say: “ … in general, environmental concerns are not best addressed by lowering the discount rate – an action that might have both benefits and costs for the environment. A more promising course would be to incorporate a criterion of sustainability into certain aspects of decisionmaking.” • Time-varying or ‘hyperbolic’ discount rates (Weitzman 1999 and others) e.g. Consider $1 today or $2 tomorrow versus $1 in a year or $2 in a year + a day; are these the same choice?

7. Basic Decision Criteria in CBA

8. Arrow et al.'s Eight Principles for Using CBA • BCA is useful for comparing the favorable and unfavorable effects of policies. • Decision-makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Agencies should be allowed to use economic analysis to set regulatory priorities. • BCA should be required for all major regulatory decisions. • Although agencies should be required to conduct BCA for major decisions and to explain why they have selected actions for which reliable evidence indicates that expected benefits are significantly less than expected costs, those agencies should not be bound by strict benefit-cost tests. • Benefits and costs of proposed policies should be quantified wherever possible. Best estimates should be presented along with a description of the uncertainties. • The more external review that regulatory analyses receive, the better they are likely to be. • A core set of economic assumptions should be used in calculating benefits and costs. Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health. • Although BCA should focus primarily on the overall relation between benefits and costs, a good analysis will also identify important distributional consequences.

9. Key Issues and Problems in Environmental Project Evaluation  • Should we evaluate projects or value the environment at all? • Ecosystem complexity and uncertainty • Discounting and intergenerational issues • Institutional capture and 'conceptual lens‘ • How accurate/credible are project appraisals? ('over-optimism' in rates of return)