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•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.
Total Cost
Total Benefit
Maximum Net Benefit
Q1 Q*Q0 Q2
Most Efficient Resource Distribution
• Our aim is to attain the ‘most efficient’ resource distribution.
•We will select the option with the ‘maximum’ net benefit
•Net Present Value (NPV)
NPV =
•Internal Rate of Return (IRR)
=
Technical Evaluation
( b – c )t
( 1 + r )t
( b – c )t
( 1 + i )t
∑
∑ Ct
( 1 + i )t∑t= 1 t= 1
n n
n
t = 1
•Benefit – Cost ration (BCR)
Technical Evaluation continued ….
( b – c )t
( 1 + r )t
∑ n
t = 1
Ct
( 1 + i )t∑t= 1
n
= BCR
•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.
Cost Benefit Analysis (CBA)
• We describe a project as ‘efficient’ if,
1. Benefits gained fully compensate the losers.
2. Gainers, in principle, compensate the
losers, even if they do not.
3. Doing a small number of efficient projects
produces more benefits as a whole than
doing a collection of efficient and inefficient
projects.
An ‘Efficient’ project
•Project cost =
cost of resources + cost imposed on third
parties
•Include only incremental costs
•Do not include – interest payments,
depreciation
Project costs
•Use and Non-use values
•Use values = all use benefits to man
•Non-use values =
Direct or Indirect use benefits + option
values + existence values
Project benefits
•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
Option values
•Amount that people would pay to preserve
the natural environment or a species
above any use benefits
•Pure existence
•Altruistic existence
•Vicarious existence
Existence values
•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
Secondary benefits
•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
Basic Valuation Principles
•WTP = P + CS
Willingness to Pay (WTP)
P0
Q0
Producer Revenues
P’
$
Quantity
Consumer
Surpluses Demand (WTP)
Q’
•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
Income and welfare
•Fairer and more appropriate
•Compensating variation principle
- considers existing situation desirable
•Equivalent variation principle
- considers project situation desirable
Willingness to Accept (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 ?
WTP vs. WTA
•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.
Uncertainty
( Eb – Ec )t
( 1 + r )t
∑ n
t = 1
Uncertainty continued ….
Project A
Project B
ENPV
$ 1.5 MP = 1
P = 0.5
P = 0.5
$ 5 M
$ - 1 M
$ 2 M
$ 2.5 M
$ 1.5 M
$ - 0.5 M
//
•Imperfect competition
- monopoly, subsidy, govt. regulation,
taxes
•Domestic vs. International markets
•No market
•SP = MP x CF
•Surrogate or Proxy prices
Shadow Prices
•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
Distributional Issues
•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%.
Discount Rates
• Based on WTP values
• 3 ways
1. Observe prices in various markets
2. Observe individual expenditures of
money and time
3. Ask people what they are willing to pay
for goods
Valuation of benefits and cost
1. Market Price Method (MPM)
2. Hedonic Pricing Method (HPM)
3. Travel Cost Method (TCM)
4. Contingent Valuation Method (CVM)
5. Contingent Choice Methods (CCM)
6. Contingent Ranking Method (CRM)
Valuation methods (Market based)
•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
Market Price Method (MVM)
•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
Hedonic Pricing Method (HVM)
•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
Travel Cost Method (TCM)
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. 5.0 20 2000 10000
Z 50 15.0 2.5 50 2500 6250
all 100 10 5.0 80 6000 30,000
TCM continued….
Maximum Travel Cost = $ 20
•Relies on survey techniques
•Hypothetical change in environmental
resources
•Elicitation methods include,
I. Open ended / Direct Questions
II. Bidding Game
III. Dichotomous Choice Method
IV. Double Bonded Dichotomous Choice Method
•Useful for marketed and non-marketed goods
Contingent Valuation Method (CVM)
•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
I. Strategic Bias
II. Information Bias
III. Starting Point Bias
IV. Hypothetical Bias
V. Sampling Bias
VI. Non-response Bias
CVM continued ….
•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 Choice Method (CCM)
•Referendum method•Ranking of environmental attributes•Easy for the respondent •Example,
•Confusion if too many choices
Contingent Ranking Method (CRM)
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
•Government judgments
•Example,
I. Compensation for accidental death
II. Zoning regulations
•Inconsistent with individual preferences
•Basis of decision not clearly stated
•Need more research
Valuation based on public decisions
•Precautionary expenditure
•Corrective expenditure
•e.g. Smoke detectors, seatbelts
•Routinely included in project
expenditures
•Marginal cost of pollution
Valuation based on defensive expenditure
•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
•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
I. Individual preferences
II. Risk aversion
III. Level of risk assumed
Value of life continued ….
•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
Alternatives 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
Criticisms to CBA
•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’
Conclusion
1. Project Appraisal and Valuation of the
Environment - Peter Abelson, Chp. 2, 3, 4
2. Cost-Benefit Analysis and the
Environment – Cass R. Sunstein
3. Cost Benefit Analysis of Environmental
Systems by Applying Contingent
Valuation Method – S.U Ahmed, K. Gotoh
References