1. Cost-benefit analysis
Ákos Szalai

2. Basic insights
general recommendation to find socially optimal level of emissions is CBA
Goal: maximize well-being.
value that individuals place on improved environmental quality minus
the value to be sacrificed to achieve those environemental improvements. The answer can be fined by the help of CBA.
Efficiency-driven literature proposes this method to
select the standard in regulation;
set the tax rates, user charges;
calculate the compensation in case of tort law.
Not indicate who benefit and who bear the costs
criticized because the benefits and cost are addressed merely from an anthropocentric perspective

3. Basic insights
Boardman, Greenber, Vinig & Weimer break the process down into nine basic steps.
Decide whose benefits and costs count
Select the portfolio of alternative projects
Select indicators to measure the potential (physical) impacts –
Predict quantitative impact of the projects
Monetize the impacts
Discount for time to find present value
Add up the benefits and cost – assess the distributional effects
Perform sensitivity analysis in order to handle the risk in the predictions
Recommend the alternative with the largest net social benefit
Anthony Boardman, David Greenberg, Aidan Vining, and David Weimer, Cost-Benefit Analysis (4th Edition) (The Pearson Series in Economics) 4th Edition

4. Basic insights
ad 1. Performed from global or national (or regional or local) perspectives?
ad 2. impossible to compare all alternatives – to find the highest NPV
enormous costs,
chance to have new project with higher net benefit.
ad 3. The physical impact is often unpredictable, unforeseeable (science is unable to predict, to foresee )
Measurement bias: some indicators more sensitive to the impact of some projects – indicators affect the results of the analysis.
ad 9. to be ranked according to their net social present values.
CBA is a recommendation
other factors (e.g. the political feasibility) prevent.

5. Predict impacts: unpredictable effects
For example global carbon and biogeochemical cycles.
what effect in long period?
to be irreversible?
known for decades, some techniques (e.g. sensitivity analysis)
The same problem as the risk from other uncertainties (e.g. the miscalculation of the monetary value of the effects, disagreement over the discount rate).
New types of problems: behavioral effects and employment effects

6. Predict impacts: behavioral effects
traditionally focus on externalities:
for example a program reducing energy consumption
effects on the air pollution (externality)
effects on private energy consumption – measured by the market (voluntarily private investment, rational decision-maker calculate considering private benefit and cost)
assumption: policy unable to generate consumer benefits.
behavioral economics present private decisions not always reflect on the private benefit and cost.
for example energy paradox.
consumers typically miscalculate the cost and benefit
learn the effects only after the investment,
loss aversion
consumer savings to be incorporated into the CBA.
even if some private decisions completely rational – how to distinguish perfectly rational and not fully rational private decisions?

7. Predict impacts: employment effects
environmental policy attacked because “job killing” effects.
Even if questionable whether the labor effect of the environmental regulation negative or positive
the standard approach based on the assumption of the full-employment unable to consider the employment effects
Uncertain effects
demand effect: increase production costs - quantity of production (and the used capital and labor) reduce
cost-effects: forced indirectly to use more capital and labor per unit of output.
factor-shift effect: influence on the labor/capital ratio in the production (can be positive or negative)
Estimations typically based on very complex analytical models (input-output or computable general equilibrium models) - highly sensitive to the assumptions and the modeling choices.

8. Monetize the impacts: basic insight
Revesz and Stavins (2007), the most important environment-specific challenge to provide monetary value of hard-to-price goods – typically not sold and bought in market
uses money as common metric
obvious problem: no one-to-one relation between the money and the benefit or the sacrificed value. - the value of a unit of money higher for poorer person
Taxonomy of values of natural resources:
direct value from the direct consumption
indirect value from better health, less cost of cleaning, etc.
option value – option to consume it in the future
bequest value - option of the next generations
existence value – satisfaction only from simply knowing that the good exist.
Economics is anthropocentric: because the human beings value the resources according to their preferences – no intrinsic values.
not utilitarian: Bentham take into account any gains or losses of other beings that feel pain (e.g. animals)
willingness-to-pay: how much money to sacrifice to protect

9. Monetize the impacts: methods, assumptions
easiest method: market price – in case of market-goods.
assumption that market prices provide a reasonable proxy for the opportunity cost
correct only if the project not affect the market price – relatively small projects compared to the market.
For valuing the non-market goods: three most important methods in CBA are
hedonic price method. infer the value from the market prices of real property or the labor –
capitalization hypothesis. multivariate regression to separate the various effects which have influence on the prices – how large price changes a given environmental effect causes.
travel cost method to assess the value of a free environmental goods used as recreational site.
travel cost and opportunity cost of time for visitors is proxy: minimum of the visitors’ willingness to pay.
contingent valuation – survey method: to ask a sample of people about there willingness-to-pay some positive changes, or willingness-to-acceptance for some negative effects

10. Monetize the impacts: methods, assumptions
Technical problems of the model: risk of miscalculation
if assumption not hold.
Example: statistical value of life method.
1000 dollars if the risk of a fatal accident increases by 1 percent-point.
statistical life-value: dollars = 100 x 1.000
no reason to assume in linear way.
The willingness-to-pay for avoiding certain death likely to exceed

11. Discounting: basic insights
For project with cost/benefits arising over extended periods
to convert the future costs and benefits to the present ones.
because people prefer current consumption to future ones.
Typical method the present value of 1000 in year t is
NPV = FV * e-tr
r is the discount rate; e is the Euler-number (2,718).
r great influence on the project present value.
effect of r magnifies
Present value of cash flow of received after t years t
r = 4%
r = 7% 1
950,79
932,39 10
670,32
496,59 50
135,34
30,20
100
18,32
0,91

12. Discounting: basic insights
Ramsey-formula:
r = p + Θg
p is the rate of time preference,
Θ is the „absolute value of the elasticity of marginal utility of consumption” (utility from one unit of consumption decreasing as the consumption increases),
g is the growth rate of per capita consumption
Estimating g is the „easiest”
Interpretations for p and Θ: prescriptive and positive approach.

13. Discounting: ethical vs. economic problems
prescriptive approach – from ethical principles.
clear intergenerational effect
relatively high discount rate
to place a lower value on the consumption of future, wealthier generations
will inherit greater stock of human capital
very low discount rate
high discount rate: current generation preferred to next generations
Critics: how to choose between e.g. 4 or 7 % – low/high enough?
positive approach – use observed market interest rates.
assumption: the market interest rate reflects the social time preference (i.e. the rate at which an average person willing to trade future consumption for current today – the increase during a year for which we are ready to postpone our consumption by a year.
market is imperfect: market interest rate does not reflect the STP: debit vs. credit rate differ in the financial market.
even if the market was perfect: why the choices of the current generation relevant for determining the long-run DR?

14. Selecting the best project – distributional effects
concentrate on the Pareto- or potential Pareto-improvement when ranks the projects according to their NPV
SD projects have important distributional effects.
International distribution: countries most likely to benefit from climate change mitigation vs. countries bear the costs.
resemble foreign aid
some argue: CBA should not neglect the distributional problems.
distributionally weighted CBA: to treat the cost and benefits of various groups differently

15. Selecting the best project – distributional effects
distributional effects – two difficult issues.
Ethical: how to define the appropriate weights for various groups.
adding distributive weights into CBA obscure the difficulties
less transparent
economist, technocrats unable to solve ethical issues.
Technical: incidence must be known
how the benefits and cost are distributed
For example: energy tax is levied,
the nominal cost bearers: the energy companies.
able to pass some of costs to other groups – to whom?

16. Sensitivity analysis – treating the risks
many risks of miscalculation
sensitivity analysis – how the choices influence the NPV
recalculations of the NPV under alternative assumptions
to determine the impact of the potential errors in estimation on the result of CBA.
cost-effectiveness analysis – compare not the NPVs but costs of providing the same physical benefit
for example the costs of reducing the global warming with 1 centigrade

17. Philosophical problems
Susan Rose-Ackerman. ‘Putting Cost-Benefit Analysis in Its Place: Rethinking Regulatory Review.’
“Although it remains a valuable tool, a number of pressing current problems do not fit well into the CBA paradigm”.
climate change, nuclear accident risks, and the preservation of biodiversity
Long debate over whether cost-benefit analysis is able to identify the socially desirable environmental policy.
whether CBA (with distributional weights) fair method to consider the distribution of costs and benefits;?
some incommensurable or non-commodified goods have such an intransigent value not to compare with other (marketed) goods?
individual preferences adequate basis to value?
anthropocentric method as CBA is philosophically relevant to evaluate the environmental problems?
Susan Rose-Ackerman. ‘Putting Cost-Benefit Analysis in Its Place: Rethinking Regulatory Review.’ University of Miami Law Review 65: 335–355.

18. Philosophical problems
policy issues for which standard CBA is suitable tool –
some technical, measurement difficulties to be solved:
human life, aesthetic and cultural benefits, and harm to the natural world;
proper discount rate;
risks.
small relative to the overall size of the economy.
But technical problems have no "right" economic answers – philosophical questions to be disputed in transparent way
policies with major distributional effects, or issues of individual rights.
more important to make the value choices in transparent way.
policies with significant global, intertemporal (long-term), and pervasive, irreversible effects – to be analyzed on other grounds BUT to consider results of CBA.
illustrate the problem with the policies against climate change.

19. Philosophical problems
“Society will experience many of the benefits of climate change policy far in the future. Using even a low-end discount rate, say five percent, implies that a one dollar benefit obtained fifty years in the future has a present value of nine cents. At three percent, the present value is twenty-three cents and at six percent it is five cents. Suppose to keep things simple that all the benefits will accrue in year fifty and that they will be five billion dollars. At five percent, the discounted present value of these benefits is $450,000, but it could be much higher or lower depending upon the discount rate chosen. Should that choice determine the global policy on climate change?”

20. Philosophical problems
Rose-Ackerman argue with the concept of Louis Kaplow (simple discounting the future monetized benefit to present value is able to resolve all problems):
“That technique […] downplays the problem of making the required conversion. There would be no difficulty if
we could assume that different generations are essentially similar on average,
that we only care about the average, and
that the distortions introduced to the welfare measure by using a monetary proxy are not so severe as to seriously skew the ranking of options.
Furthermore, there must not be important irreversibilities that threaten overall wellbeing in a way that cannot be balanced by other compensating measures.
Unfortunately, even if the other assumptions hold, the issue of climate change and other large-scale risks do not satisfy the irreversibility condition.”
Louis Kaplow, Discounting Dollars, Discounting Lives: Intergenerational Distributive Justice and Efficiency, 74 U. CI. L. REv. 79
(2007);

21. Philosophical problems
if irreversible effects are possible, then conventional cost-benefit analysis is not an appropriate tool.
if our present actions increase the chances of a global disaster
raise the long-run rate of interest,
present value of very long-term harms or benefits will be lower.
„[therefore] those [future benefits] might be sufficient to persuade the government to initiate policies to limit those risks, but [not] because of the logic of discounting. […] The debate ought not to be framed as a debate over the discount rate. Rather, it concerns the obligations of the present towards the future.”