1. Costs and Benefits Andrew Foss (andrew_foss@ksg09.harvard.edu)andrew_foss@ksg09.harvard.edu Economics 1661 / API-135 Environmental and Resource Economics and Policy Harvard University February 20, 2009 Review Section

2. Agenda  Fish Protection at Power Plants –Overview –Role of Economics  Costs –Concepts –Components –Estimation Methods  Benefits –Concepts –Components –Estimation Methods 1 Note: A good general reference on costs and benefits is EPA, Guidelines for Preparing Economic Analyses, September 2000 (link), Chapters 7 and 8ink

3. Fish Protection at Power Plants: Overview  Many power plants draw water in from lakes, rivers, estuaries, and oceans to cool their equipment  Cooling water intake at power plants kills fish and destroys fish eggs –Impingement: Fish and eggs are trapped against screens –Entrainment: Fish and eggs are sucked into pipes  EPA has adopted rules under Section 316(b) of the Clean Water Act to minimize the adverse environmental impacts of cooling water intake at power plants –EPA has established performance standards for impingement and entrainment based on use of cooling towers (shown on p. 1), which greatly reduce cooling water intake and thus kill few fish 2

4. Fish Protection at Power Plants: Role of Economics  In the original EPA rules on cooling water intake, operators of power plants without cooling towers could apply for less stringent performance standards if they demonstrated that the costs of installing cooling towers or other necessary fish protection technologies were disproportionate to the benefits  In a subsequent legal case, a U.S. court of appeals ruled against use of benefit-cost analysis for individual plants –“…the EPA, given a choice between a technology that costs $100 to save 99 - 101 fish and one that costs $150 to save 100 - 103 fish (with all other considerations, like energy production or efficiency, being equal), could appropriately choose the cheaper technology on cost-effectiveness grounds. Cost-benefit analysis, however, is not permitted…” Riverkeeper, Inc. et al. v. U.S. EPA, 475 F.3d 83 (2d Cir. 2007) 3

5. Fish Protection at Power Plants: Role of Economics  The legal battle continues –Prof. Stavins and other economists urged the courts in July 2008 to allow the use of benefit-cost analysis (link)link –The U.S. Supreme Court heard arguments in December 2008 and is expected to deliver a ruling this spring (link)link 4 Cost- Effectiveness Analysis Benefit / Cost Ratios Benefit- Cost Analysis

6. Costs: Concepts  The economic cost of an activity is the value of whatever must be given up for the activity (opportunity cost) –Opportunity cost typically exceeds monetary outlays 5 ActivityEconomic Cost Attending college or graduate schoolTuition + textbook costs + forgone wages from best possible job if working Building park on vacant public landForgone net benefit of best alternative use of public land (hospital perhaps) Cutting down forestsMachinery cost + labor cost + forgone soil services + forgone water services + forgone CO 2 sequestration + forgone medicines + forgone pollination (see Tietenberg’s Example 2.2) + existence value + … Economic Costs of Activities

7. Costs: Concepts  Transfers between members of society, such as taxes paid by firms or individuals to governments, should not be counted as costs –Any social deadweight loss from taxation and any labor costs to collect and process taxes, however, should be counted 6  Suppose power plant operators failing to meet fish protection standards have to pay the government fines –The fines should not be counted as costs of the regulation, because they are transfers

8. Costs: Components 7 Cost Component Real Resource Compliance Costs Purchase, installation, operation, and maintenance costs of control technologies Costs of changes in production inputs and processes Costs of time spent preparing permit applications, reports, etc. Government Regulatory Costs Costs of administering, monitoring, and enforcing regulation Social Welfare Costs Losses in consumer and producer surplus due to increase in price or decrease in output of goods and services Transitional Costs Costs of reallocating resources due to regulation Indirect Costs Costs of changes in market structure, such as increased market power Costs of changes in product quality Forgone benefits of discouraged investment Cost Component Definitions

9. Costs: Components  Illustration of social welfare costs –Losses in consumer and producer surplus from increased marginal cost across regulated industry 8 Quantity Price D MC 0 = S 0 CS 0 PS 0 Quantity Price MC 0 = S 0 CS 1 PS 1 MC 1 = S 1 P0P0 Q0Q0 P0P0 Q0Q0 P1P1 Q1Q1 Welfare Effects of Industry-Wide Increase in Marginal Cost D

10. Costs: Components 9 Cost Component Real Resource Compliance Costs Purchase, installation, operation, and maintenance costs of fish protection technologies (screens, deterrent systems, cooling towers to reduce water intake) Costs of time spent preparing permit applications and reports for fish protection Government Regulatory Costs Costs of administering, monitoring, and enforcing regulation for fish protection Social Welfare Costs Losses in consumer and producer surplus due to increase in price of power during temporary plant outages to install control technologies for fish protection Transitional Costs N/A: Probably not significant in the case of regulation for fish protection Indirect Costs N/A: Probably not significant in the case of regulation for fish protection Cost Components of Fish Protection

11. Costs: Components  Illustration of social welfare costs in power market –Suppose a nuclear power plant must shut down temporarily to install fish protection technology (cooling towers) –Supply curve shifts left, raising power price and reducing surplus 10 Quantity Price MC 0 = S 0 CS 0 Quantity Price P0P0 Q0Q0 Q0Q0 P1P1 Q1Q1 DD Nuclear Plant Coal Plants Gas Plants Coal Plants Gas Plants MC 1 = S 1 Welfare Effects of Nuclear Plant Outage to Install Technology P0P0 PS 0 CS 1 PS 1

12. Costs: Estimation Methods 11 Cost Component Direct Compliance Cost Method Sum up compliance costs obtained from engineering estimates, and multiply by quantity, then possibly add government administrative costs Assumes no behavioral response Least expensive method of cost analysis May be appropriate when elasticities (behavioral responses) are small or compliance costs (and price increases) are small Partial Equilibrium Analysis Look at effects on supply and demand in affected market Incorporates behavioral responses But assumes that effects of regulation are confined to one market or a few General Equilibrium Analysis [probably necessary for power sector regs] Look at effects on all sectors of economy Complex and expensive, but may be necessary if regulating a key industry Two principal approaches: input / output (I/O) models and computable general equilibrium (CGE) models Cost Estimation Method Definitions

13. Benefits: Concepts  Benefits in environmental economics reflect willingness to pay for improvements in environmental quality 12 TotalMarginal Total Benefits (TB) = Total Willingness to Pay (WTP) Marginal Benefits (MB) = Marginal Willingness to Pay (MWTP) = Demand Measures for Environmental “Goods” (e.g., Fish Protection) TotalMarginal Total Damages (TD) = Total Willingness to Accept (WTA) Marginal Damages (MD) = Marginal Willingness to Accept (MWTA) Measures for Environmental “Bads” (e.g., Fish Kills)

14. Benefits: Concepts  MWTP and MWTA may vary across income classes 13 Note: pphm = parts per hundred million; 1970$ Source: Adapted from Harrison and Rubinfeld, “Hedonic Housing Prices and the Demand for Clean Air,” Journal of Environmental Economics and Management, Vol. 5 (1978), pp. 81-102 0 $1,000 $2,000 $3,000 246810 NO X (pphm) MWTA ($/pphm) Income = $8,500 Income = $11,500 Income = $15,000 Marginal Willingness to Accept Increases in Nitrogen Oxide Concentration

15. Benefits: Concepts  Suppose MWTP is equal in magnitude to MWTA –This is not necessarily so (see Tietenberg’s Debate 3.1) 14 Environmental “Good” (e.g., Fish Protection) MB = MWTP = Demand $100 $0 -$100 MD = MWTA TB = Total WTP TD = Total WTA Q Environmental “Bad” (e.g., Fish Kills) MB = MWTP $100 $0 -$100 MD = MWTA Fish Protected Fish Killed TB = Total WTP TD = Total WTA F

16. Benefits: Concepts  Suppose the marginal benefit to society of protecting Q fish at a power plant is MB(Q) = 100 – Q  Suppose the marginal cost of protecting Q fish at the power plant is MC(Q) = ⅓Q  What is the optimal level of fish protection at the power plant?  If the power plants has the right to kill 100 fish, what is society willing to pay to achieve the optimal level of fish protection? 15 Optimal Level of Fish Protection MB = MWTP = Demand $100 $0 TB = Total WTP Q*=75 Fish Protected 100 MB = MC 100 – Q = ⅓Q Q* = 75 fish protected Total WTP is area under MWTP from Q = 0 to Q* = 75 fish protected Total WTP = 25*75 + ½*75*75 Total WTP = $4,687.50 MC

17. MD = MWTA TD = Total WTA Benefits: Concepts  Suppose the marginal damage to society from killing F fish at a power plant is MD(F) = F  Suppose the marginal savings from killing F fish at the power plant is MS(F) = 33⅓ – ⅓F  What is the optimal level of fish kills at the power plant?  If society has the right to the optimal level of fish kills, what is society willing to accept in compensation for the power plant killing 100 fish? 16 Optimal Level of Fish Kills $100 $0 F*=25 Fish Killed 100 MD = MS F = 33⅓ - ⅓F F* = 25 fish killed Total WTA is area under MWTA from F* = 25 to F = 100 fish killed Total WTA = 25*75 + ½*75*75 Total WTA = $4,687.50 MS

18. Benefits: Concepts  Suppose someone suggests evaluating the benefits of fish protection by calculating the costs that the local fish and wildlife agency would otherwise have to pay to stock the waterbody with fish from a fish nursery 17 –This is the “avoided cost” method of evaluating benefits, and it is incorrect because it does not measure the value to society of improvements in environmental quality –For an example of what NOT to do, see link, p. 111link Avoided Costs Willingness to Pay Willingness to Accept

19. Benefits: Components 18 Use ValueNon-use Value Market Use Value The value to society of using an environmental resource as a market product Existence Value The value to society of knowing that an environmental resource exists Altruism Value The value to society of knowing other people can use an env. resource Non-market Use Value The value to society of using an environmental resource not as a market product Bequest Value The value to society of knowing future generations can use an env. resource Option Value The value to society of having an option to use an env. resource Benefit Component Definitions (Two-Way Taxonomy)

20. Benefits: Components 19 Use ValueNon-use Value Market Use Value Larger stock for commercial fisheries Larger stock for bait suppliers Existence Value Stewardship of waterbody Historical or cultural importance Altruism Value Interpersonal equity re waterbody Non-market Use Value Larger stock for recreational fisheries Larger stock for subsistence fisheries Aquatic recreation (boating, diving) Bequest Value Intergenerational equity re waterbody Option Value Potential future use of waterbody Benefit Components of Fish Protection

21. Benefits: Estimation Methods 20 Use ValueNon-use Value Market Use Value Market quantities and prices Existence, Altruism, Bequest, and Option Values Contingent valuation (CV) Contingent ranking Choice experiments Non-market Use Value Travel cost method, aka Hotelling-Clawson-Knetsch (HCK) Discrete choice models, aka random utility models (RUMs) Hedonic pricing models Revealed Preference Methods (maybe stated preference methods here as well) Stated Preference Methods Benefit Estimation Methods for Fish Protection

22. Benefits: Estimation Methods  Suppose that without new regulation for fish protection at power plants, 1 million pounds of cod would be caught by commercial fisheries each year and the wholesale price of cod would be $1 per pound  Suppose the new regulation would increase the annual cod catch by 0.03 million pounds  Suppose the price elasticity of demand for cod is -1.5 21

23. Benefits: Estimation Methods  What is the change in cod price from the new regulation? What is the change in gross revenue to commercial cod fisheries? 22 Use the price elasticity of demand to estimate the change in cod price ε = (ΔQ / Q) / (ΔP / P) = -1.5 ΔQ / Q = 0.03 million / 1 million = +3% ΔP / P = (ΔQ / Q) / ε = +3% / -1.5 = -2% P 1 = P 0 * (100% – 2%) = $1 per pound * 98% = $0.98 per pound Calculate gross revenue before and after regulation P 0 * Q 0 = $1 per pound * 1 million pounds = $1 million P 1 * Q 1 = $0.98 per pound * 1.03 million pounds = $1.0094 million Change in gross revenue = $1.0094 million - $1 million = +$9,400

24. Benefits: Estimation Methods  Suppose the change in social welfare (consumer surplus + producer surplus) is half of the change in gross revenue to commercial cod fisheries  What is the change in social welfare? 23 Change in gross revenue = +$9,400 Change in social welfare = ½ * Change in gross revenue = ½ * $9,400 = +$4,700

25. Benefits: Estimation Methods  Suppose the new regulation would begin next year and its impacts would persist for all time  What is the net present value of the change in social welfare from a larger stock for commercial cod fisheries, assuming a social discount rate of 7 percent? 24 NPV = Σ $4,700 / (1 + r) t for t from 1 to ∞ Use the perpetuity formula*: Σ A / (1 + r) t for t from 1 to ∞ = A / r NPV = $4,700 / r = $4,700 / 7% = +$67,143 * Proof of perpetuity formula (or see link):link NPV = Σ A / (1 + r) t for t from 1 to ∞ = A / (1 + r) + A / (1 + r) 2 + A / (1 + r) 3 + … Factor out 1 / (1 + r) from right side NPV = [1 / (1 + r)] * [A + A / (1 + r) + A / (1 + r) 2 + …] NPV = [1 / (1 + r)] * [A + NPV] [r / (1 + r)] * NPV = [1 / (1 + r)] * A NPV = A / r

26. To Be Continued…  Next time: More on benefit estimation methods 25