ECON 3755: Environmental Economics

Benefit-Cost Analysis

Reading: Field and Olewiler (2005). Chapter 6

Outline:

1. Background

2. Cost-Benefit Analysis

(i) Net Benefits

(ii) Net Present Value

1. Background:

• A Socially Efficient level of pollution is one that minimizes the Total Social Costs
of pollution imposed on society:

Total Social Costs = Total Damages + Total Abatement Costs

• Total social costs will be minimized when the marginal damages of pollution equal
the marginal costs of pollution abatement.

• In the MAC/MD Framework, a Socially Efficient level of pollution is one that sets
MAC = MD

$/CO2 MD
MAC
At Poll*:
Total Damages = A
Total Abatement Costs = B
MAC=MD C Total Social Costs = A+B

Minimized
A B

CO2* CO2c
CO2 emissions
2. Benefit-Cost Analysis:

• When considering a policy to reduce pollution, we typically start from the

unregulated competitive market equilibrium, where polluters set MAC=0.

• By reducing pollution, we:

(i) Generate benefits by reducing the damages imposed on society
(ii) Generate costs by imposing abatement costs on polluters

• Suppose a policy is proposed to reduce pollution to a targeted level, PollT:

Moving from Pollc to PollT:

MAC MD
Benefits = b+c (reduced damages)
$ Costs = c (abatement costs)
Net Benefits (benefits – costs) = c
DWL removal
c
• Often, the socially efficient level of pollution is
a b unknown… the best we can do is compare the
benefits and costs of a proposal
PollT Pollc Pollution
• Steps in BCA:

Step 1: Specify proposed program:

• Identify from what perspective the program is being delivered (local/national),
and the stakeholders impacted
• Describe the scale of the program (location, targets, timing, etc.)
• Discuss the mechanisms through which the program will operate:
• New env. regulations may involve the use of pollution control standards,
technological requirements, etc.
• New physical projects may involve the development of public waste
treatment plants, etc.

Step 2: Describe quantitatively the inputs and outputs of the program

• May require an increased number of inputs such as more environmental
regulators, new production techniques, etc.
• Resulting output may include improved water/air quality, etc. (measured by
reduced emissions or ambient concentrations)
Step 3: Estimate social costs & benefits of the inputs and outputs.
• Social costs of environmental regulations or projects are easy to estimate… they
often involve market transactions
• Social benefits of regulations are often difficult to estimate … they often involve
non-market values.

Step 4: Compare the benefits and costs, and make a decision

(i) Net Benefits (NB):

• One way to compare the benefits and costs of a proposed environmental policy is
to use a simple net benefit calculation

NB = Benefits – Costs

• NB Decision Rule:

if: NB ≥ 0
then: the plan can be supported on economic grounds
 In-class Exercise #1: Benefit Cost Analysis
• Suppose the government proposed to reduce SO2 emissions by 10% of
current levels

• Benefits and costs (in Billions) were estimated as follows:

Benefits and Costs Time Time Time Total Values

Period 0 Period 10 Period 20
Costs:
Private capital
compliance $100,000 $0 $0 $100,000
Private operating $100,000 $10,000 $5,000 $115,000
Public enforcement $30,000 $30,000 $30,000 $90,000
Benefits:
Human health $0 $100,000 $100,000 $200,000
Crops $0 $50,000 $50,000 $100,000
Water quality $0 $50,000 $50,000 $100,000

Total Costs
Total Benefits
Net Benefits

• Calculate the Net Benefits of the proposed policy and determine whether or not it
can be supported on economic grounds
(ii) Net Present Value (NPV):
• The time value of money:
• Many costs and benefits occur in the distant future.

• We all know that a ‘promised’ dollar in the future is valued less than a dollar
in-the-hand today.

• We could invest that dollar in-the-hand today and make more than that
‘promised’ dollar in the future.
• How much less do we value a ‘promised’ dollar in the future compared to a dollar
in-the-hand today?

• This can be calculated using the principle of compound interest…

Compound Interest formula: Compound Interest
Investment r = 0.10 The value of $100 in
Value (VA) 25 years is $1083
Vn = V0 * (1+r)n $1083
r = 0.05 The value of $100 in
25 years is $339
$339
V0 = initial investment
r = interest rate
$100
n = # of years to
compound 25 Years (t)
 • Discounting:
• We can use the principle of compound interest to convert all future values into
present values. This is known as discounting
• We usually discount future benefits at the market interest rate because
we could have received annual interest if invested in bank bonds
• The same argument can be made for a future investment cost

• The formula used to discount a future value is just a re-arrangement of the

compound interest formula...

• Present Value formula:

• The present value of a future cost or benefit in year t is as follows:

V0 = Vn / (1+r)n where r = discount rate

n = # of years to discount

• We can use this formula to compute the Net Present Value (NPV) of an
environmental policy
• This is the most common investment criteria used by economists.
• It involves discounting future values (both benefits and costs) to the present.
• NPV formula:

NB1 NB2 NB3 NBn

NPV NB0 ...
(1 r )1 (1 r ) 2 (1 r )3 (1 r ) n
where: NB = Benefits – Costs in a time period
r = discount rate
n = # of years to discount
• NPV Decision Rule:

if: NPV > 0

then: the plan should proceed.
In-class Exercise #2: Net Present Value analysis
• Suppose we had the same data as in Example #1:

Benefits and Costs Time Time Time Total

Period 0 Period 10 Period 20 Discounted
Values
Costs:
Private capital
compliance $100,000 $0 $0
Private operating $100,000 $10,000 $5,000
Public enforcement $30,000 $30,000 $30,000
Benefits:
Human health $0 $100,000 $100,000
Crops $0 $50,000 $50,000
Water quality $0 $50,000 $50,000

Net Benefits
Net Present Value

• Calculate the NPV of the policy, assuming a 5% discount rate, and determine
whether or not it can be supported on economic grounds
• Effects of the Discount Rate:
• Different discount rates lead to different NPV outcomes.

In-class Example #3: Net Present Value analysis with a changing discount rate
• Suppose we had the same data as in Examples #1 and #2:

Benefits and Costs Time Time Time Total

Period 0 Period 10 Period 20 Discounted
Values
Costs:
Private capital
compliance $100,000 $0 $0
Private operating $100,000 $10,000 $5,000
Public enforcement $30,000 $30,000 $30,000
Benefits:
Human health $0 $100,000 $100,000
Crops $0 $50,000 $50,000
Water quality $0 $50,000 $50,000

Net Benefits
Net Present Value

• Calculate the NPV of the policy, assuming a 2% discount rate, and determine
whether or not it can be supported on economic grounds
• Selecting a Discount Rate:

• The choice of an appropriate discount rate is not always clear

• The private discount rate is typically defined as follows:

Private Discount Rate = minimum acceptable rate of return (MAR)

= market rate of interest (r)

• Historical rates of return on relatively risk-free investments (ie. government

bonds), adjusted for taxes and inflation = 2% to 4%

• However, private market returns have been significantly larger – in the order
of 6%

• Therefore, economists usually use sensitivity analysis to compare the

results using a number of different discount rates
• 2%, 4%, 6%, etc.
What discount rate should we use for our CBA of pollution policies?

• The previous choice of discount rates applies to private investment decisions

• For social investment decisions like that of pollution policies, we need to use a
social discount rate.

• A common approach to estimate a social discount rate is to use expected utility

theory

• Here, it is assumed that citizens in society are not concerned with money
income, but rather with the utility (satisfaction) derived from consumption.
• Key assumptions of expected utility theory:

(i) As incomes rise, a dollar of extra income for consumption today is worth
more than the same amount used for consumption in the future.
• This means that, as incomes rise, we expect a positive discount rate.

(ii) Under uncertainty, a dollar of extra income for consumption in a risky state
of nature is worth more than it is in a good state of nature.
• This means that risky consumption should be worth less than risk-free
consumption (i.e., a positive risk premium should be applied).

(iii) Transferring income for consumption from rich to poor improves global
utility (satisfaction, or welfare)
• This means that the rich countries should give more importance to the
poor and forego some of their income for consumption now and in the
future for the benefit of the poor (i.e., increased discounting in rich
countries for the use of funds in their own countries).
• Using expected utility theory, we can define a social discount rate as follows:
where: sr = social discount rate
sr = r + eta*g eta = elasticity of substitution for consumption
r = inherent discount rate of future utility
g = growth rate of consumption per person
• Determining eta:
• If the previous key assumptions for expected utility theory are ‘high’ (i.e.,
high preference for current income, high aversion to risk, and large benefits
from redistribution), then eta will be large
• However, some suggest that the data supports the use of eta = 1.

• Determining r:
• In the context of some cumulative pollutants, there is a strong argument
that we should not discount environmental impacts on future generations.
• So, one could consider setting r = 0. This would give equal weight to
future generations. However, some have indicated that it should be set
at some positive (less than 1) value.
• Determining g:
• Consumption in most economies grows between 1%-2%.

• Overall: we could justify a social discount rate as low as 1%

In-class Exercise #3: Net Present Value analysis with a 1% discount rate
• Suppose we had the same data as in Exercises #1 and #2:

Benefits and Costs Time Time Time Total

Period 0 Period 10 Period 20 Discounted
Values
Costs:
Private capital
compliance $100,000 $0 $0
Private operating $100,000 $10,000 $5,000
Public enforcement $30,000 $30,000 $30,000
Benefits:
Human health $0 $100,000 $100,000
Crops $0 $50,000 $50,000
Water quality $0 $50,000 $50,000

Net Benefits
Net Present Value

• Calculate the NPV of the policy, assuming a 1% discount rate, and determine
whether or not it can be supported on economic grounds