COST – BENEFIT ANALYSIS (CBA) OMKAR APHALE

We want our environment to be clean and safe. But ‘how much’ clean and safe ? How to measure environmental benefits and costs ? There is no free lunch.

Our aim is to attain the ‘most efficient’ resource distribution. We will select the option with the ‘maximum’ net benefit Most Efficient Resource Distribution Total Cost Total Benefit Maximum Net Benefit Q0 Q1 Q* Q2

Technical Evaluation ∑ ∑ ∑ Net Present Value (NPV) NPV = ( b – c )t Internal Rate of Return (IRR) = ( b – c )t ( 1 + r )t n ∑ t = 1 Ct ( 1 + i )t ( b – c )t ( 1 + i )t n n ∑ ∑ t= 1 t= 1

Technical Evaluation continued …. Benefit – Cost ration (BCR) ( b – c )t ( 1 + r )t n ∑ t = 1 BCR = Ct ( 1 + i )t n ∑ t= 1

Cost Benefit Analysis (CBA) CBA aims to value the effects of a project as they would be valued in money terms by individuals affected. 2 steps, List all parties affected by the project Value the effects on their welfare as it would be valued in money terms by them.

An ‘Efficient’ project We describe a project as ‘efficient’ if, Benefits gained fully compensate the losers. Gainers, in principle, compensate the losers, even if they do not. Doing a small number of efficient projects produces more benefits as a whole than doing a collection of efficient and inefficient projects.

Project costs Project cost = cost of resources + cost imposed on third parties Include only incremental costs Do not include – interest payments, depreciation

Project benefits Use and Non-use values Use values = all use benefits to man Non-use values = Direct or Indirect use benefits + option values + existence values

Environmental values Indirect Use Values ( Nutrient Recycling) (Timber, Food, Recreation) Direct Use Values Indirect Use Values ( Nutrient Recycling) Non-use Values Optional Use Values (Gene pool) Bequest Values (Conservation Rainforests) Existence values (Conservation of Tiger)

Option values Risk is attached to all decisions Uncertainty about demand and supply in future Pay more to insure demand or supply Option value = value that an individual is willing to pay in excess to expected use value to preserve an asset

Existence values Amount that people would pay to preserve the natural environment or a species above any use benefits Pure existence Altruistic existence Vicarious existence

Secondary benefits Result from primary benefits of the project e.g. project > higher wages to employees > higher expenditure > improve quality of life Not included in CBA Viewed as transfer between communities rather than net addition to community income

Basic Valuation Principles Value of a resource = marginal opportunity cost = highest amount that someone is willing to pay for it in an alternative use Value of a benefit = amount that someone is willing to pay for it Willingness to pay (WTP) values

Willingness to Pay (WTP) WTP = P + CS P’ $ Consumer Surpluses Demand (WTP) P0 Producer Revenues Quantity Q0 Q’

Income and welfare Although income remains constant, welfare changes with rise / fall in prices Marshallian demand curves Need compensation for change in price fall or rise Hickinson demand curve M.D. curve is much easier to use

Willingness to Accept (WTA) Fairer and more appropriate Compensating variation principle - considers existing situation desirable Equivalent variation principle - considers project situation desirable

WTP vs. WTA In practice, CBA studies prefer WTP because, WTP more observable WTA have wide value ranges Difference between WTA and WTP values is usually very small Who has the right to claim compensation ?

Uncertainty ∑ Quantified and Unquantified impacts Need to reduce risk of wild exaggerations Expected value approach ENPV = In risk- neutral case, project with highest ENPV should be preferred. ( Eb – Ec )t ( 1 + r )t n ∑ t = 1

Uncertainty continued …. ENPV P = 0.5 $ 2.5 M $ 5 M $ 2 M Project A $ - 1 M P = 0.5 $ - 0.5 M // Project B P = 1 $ 1.5 M $ 1.5 M

Shadow Prices Imperfect competition - monopoly, subsidy, govt. regulation, taxes Domestic vs. International markets No market SP = MP x CF Surrogate or Proxy prices

Distributional Issues Fiscal policies fail to distribute income fairly WTP values > rich get the edge over poor Sustainable development principle Need to identify social groups Converting WTP values into utility values by use of weights

Discount Rates People require reward for forgoing consumption now Positive real rate of return Present value of future money Example, Accept $ 100 today or $ 110 next year If accepted $ 110 – we forgo $ 100 today We say that the discount rate is 10%.

Valuation of benefits and cost Based on WTP values 3 ways Observe prices in various markets Observe individual expenditures of money and time Ask people what they are willing to pay for goods

Valuation methods (Market based) Market Price Method (MPM) Hedonic Pricing Method (HPM) Travel Cost Method (TCM) Contingent Valuation Method (CVM) Contingent Choice Methods (CCM) Contingent Ranking Method (CRM)

Market Price Method (MVM) Environmental change causes change in outputs or inputs Market based approach Uses economic values of ecosystem products and services for evaluation e.g. soil erosion > output falls > input increases Only used for market goods and services

Hedonic Pricing Method (HVM) Evaluation based on housing prices e.g. reduction in noise> increase in residential property prices Reflects value of local environmental attributes Only measures environmental benefits related to housing prices

Travel Cost Method (TCM) Cost of access How much people are willing to pay to travel or visit the site To value recreation sites Example, Evaluation of annual preservation value of a park

TCM continued…. 30,000 Zone Trips per 1000 persons per annum Average consumer costs ($) Average consumer surplus ($) Population (thousand) Trips per annum Total consumer surplus ($) X 150 5.0 7.5 10 1500 11250 Y 100 10. 20 2000 10000 Z 50 15.0 2.5 2500 6250 all 80 6000 30,000 Maximum Travel Cost = $ 20

Contingent Valuation Method (CVM) Relies on survey techniques Hypothetical change in environmental resources Elicitation methods include, Open ended / Direct Questions Bidding Game Dichotomous Choice Method Double Bonded Dichotomous Choice Method Useful for marketed and non-marketed goods

CVM continued …. Asks people the WTP values for an environmental asset Most widely used for non-market goods Exxon Valdez case

CVM continued …. Prone to bias Types of Biases Strategic Bias Information Bias Starting Point Bias Hypothetical Bias Sampling Bias Non-response Bias

Contingent Choice Method (CCM) Trade-offs between environmental systems Used for use and non-use values Example, Wilderness or Hospital ? Scenic beauty or Mobile network ? Difficult for some respondents to respond

Contingent Ranking Method (CRM) Referendum method Ranking of environmental attributes Easy for the respondent Example, Confusion if too many choices Choice # Savings in travel time (in minutes) Cost of saving (in dollars) 1 10 0.50 2 20 1.50 3 30 2.20 4 40 3.00

Valuation based on public decisions Government judgments Example, Compensation for accidental death Zoning regulations Inconsistent with individual preferences Basis of decision not clearly stated Need more research

Valuation based on defensive expenditure Precautionary expenditure Corrective expenditure e.g. Smoke detectors, seatbelts Routinely included in project expenditures Marginal cost of pollution

Value of life Present value of future output or consumption forgone = human capital method of evaluation U.S. = 350 000 $ (1990s) Depends on age and earnings Value of life of a newborn = 0 $ Risk of death – accept or reject ? Hedonic wedge equation W = W (S, X, R)

Value of life continued …. Risk of death – how to calculate ? 0.44 million – 14.9 million US dollars Wedge / Risk studies should be combined with other valuation methods like CVM Value depends on Individual preferences Risk aversion Level of risk assumed

Alternatives to CBA Cost – effectiveness analysis - Useful finding option with the least cost Environmental Impact Assessment - Describes physical & social impacts of the project Multi-criteria Decision Analysis - Identifies and apply weights to likely impacts to determine a preferred option

Criticisms to CBA Morally unacceptable to put value on nature Not practical – how to measure visual beauty ? CBA does not deal with social values Based on income, thus biased Individuals have different preferences Narrow outlook to environment

Conclusion CBA provides systematic and consistent evaluation method CBA gives clear results CBA highlights trade-offs and opportunity cost ‘One person one vote’ is more preferred ‘over one dollar one vote’

References Project Appraisal and Valuation of the Environment - Peter Abelson, Chp. 2, 3, 4 Cost-Benefit Analysis and the Environment – Cass R. Sunstein Cost Benefit Analysis of Environmental Systems by Applying Contingent Valuation Method – S.U Ahmed, K. Gotoh

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