COST – BENEFIT ANALYSIS (CBA)

1. COST–BENEFITANALYSIS(CBA) OMKARAPHALE

2. 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.

3. 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

4. Technical Evaluation • Net Present Value (NPV) NPV = • 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

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

6. 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.

7. 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.

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

9. 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

10. Environmental values

11. 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

12. 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

13. 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

14. 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

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

16. 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

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

18. 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 ?

19. 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

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

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

22. 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

23. 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%.

24. 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

25. 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)

26. 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

27. 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

28. 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

29. TCM continued…. Maximum Travel Cost = $ 20

30. 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

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

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

33. 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

34. Contingent Ranking Method (CRM) • Referendum method • Ranking of environmental attributes • Easy for the respondent • Example, • Confusion if too many choices

35. 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

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

37. 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)

38. 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

39. 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

40. 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

41. 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’

42. 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

43. Thank You !