8 Case Study

This chapter discusses a cost-benefit study that has been undertaken in Australia.
In outlining this study, the intention is only to illustrate and reinforce points made in
the preceding chapters. Thus we do not offer an exhaustive review of the study.

8.1 The Gordon-below-Franklin hydro-electric development proposal

In 1979 the Tasmanian Department of Environment asked the Centre for Resource and
Environmental Studies (CRES) at the Australian National University to assess a Report on the
Gordon River Power Development Stage Two prepared by the Hydro-Electric Commission (HEC).
The CRES assessment was subsequently published (Saddler et al, 1980).

The HEC proposal comprised an integrated development that would harness the water
resources of the Gordon and Franklin rivers to provide additional electricity generating
capacity for the state of Tasmania. The HEC report argued that the proposal was the most
cost-effective way to meet future electricity demand in Tasmania. HEC considered a number
of alternative options, including a coal-fired thermal power station using coal from New
South Wales; however, it found that none were cost-effective. The preferred proposal entailed
the flooding of the Lower Gordon-Franklin area, an area recognised as one of outstanding
natural beauty and significant archaeological interest. The proposal generated widespread
88 community opposition on environmental grounds. In May 1983 the Commonwealth
Parliament enacted the World Heritage Properties Act 1983 which, following an unsuccessful
High Court challenge, prevented construction of the dam from proceeding.

The basic approach of the CRES study was to compare the willingness of consumers to pay for
electricity from the hydro-electric development with both the capital and operating costs of
the scheme and the opportunity cost of the Lower-Gordon-Franklin area as a wilderness area.
The base (or ‘without project’) case involved the construction of a coal-fired thermal station of
comparable capacity to meet future demand. The contrast may be summarised as follows:

With project: NSBn = BH-CH- CWD

Without project: NSBc = Bc - Cc

where B, C and NSB are benefits, costs and net social benefits respectively; and subscripts H, C
and D represent hydro-electricity and coal options, and wilderness destruction respectively.

The CRES study commenced by comparing the costs of meeting the forecast future
demand for electricity via hydro-electricity and coal methods. The study found that, ignoring
the costs of wilderness destruction, the hydro option yielded estimated present value benefits
of $189 million or $11.5 million at discount rates of 5 per cent and 10 per cent respectively.
The study team found that it could not quantify precisely the costs of wilderness destruction
(or conversely the benefits of conservation), due to a lack of adequate identification of those
costs and corresponding data.
 Case Study 8

The study team therefore asked whether it was plausible that the benefits of wilderness
preservation might exceed the estimated cost savings associated with hydro power? The study
found that not to proceed with the hydro option was economically sound given benefits from
preservation in the first year were between $500,000 and $1 million.

We discuss below three specific aspects of the CRES study: the role of pricing in estimating
the net benefits of the two options; discount rates; and the approach taken to valuing
environmental effects.

(a) Pricing and electricity benefit estimation

The HEC estimated that the present value of the savings of the hydro option compared with
the coal-sourced electricity option was $345.5 million (at 1980 prices and using a discount rate
of 5 per cent). This estimate was based on the difference in the unit cost of electricity between
the two fuel sources multiplied by forecast demand, which was the same for both fuel
sources. The CRES study accepted the HEC’s cost estimates but considered that the approach
to demand estimation was incorrect. It found that the cost differential, at the same discount
rate, was only $189.1 million, or just over half of the HEC’s estimate.

(a) Marginal cost (cost option) (b) Hydro based pricing 89

Price (P)/Gwh pricing Price (P)/Gwh
HEC estimates of
Lost consumer cost ($345.1m)
surplus ($189.1m)
Pcoal Pcoal

Phydro Demand Phydro

2000 Demand
2000
Demand Demand
1990 1990
Q0 Q2 Q1 Q0 Q1
Electricity (Gwh) Electricity (Gwh)
Figure 8.1(a) The Gordon-below-Franklin Figure 8.1(b) The Gordon-below-Franklin
proposal: the effect of different proposal: the effect of different
pricing assumptions on cost pricing assumptions on cost
estimates estimates

The CRES study argued that electricity should be sold to consumers at a price equal to
marginal cost - in this case the cost per unit from the incremental supply installations.
Thus, if the thermal option were to be adopted, electricity prices should reflect the higher
real unit costs of power from this source, rather than set at a level which covered average
unit cost for the system as a whole. And a higher price would necessarily lead to a reduction
in demand for electricity.
 8 Case Study

Drawing on international evidence, the study used a price elasticity of demand for electricity
of -0.8 (that is, a one per cent increase in price induces a long-term reduction in quantity
demanded of 0.8 of one per cent). Figure 8.1(a) shows the loss in consumer surplus benefits
resulting from adoption of the coal option with electricity (measured in gigawatt hours)
priced at the cost of the coal option and consumption at Q0. Figure 8.1(b) shows the larger
economic loss from the coal option with electricity priced at the cost of the hydro option and
consumption at Q1.

Although HEC did not take into account the Price (P)/Gwh
responsiveness of demand to price, the HEC estimate
Marginal cost
of the economic cost of the coal option was correct
given a policy intention to adhere to an inefficient
pricing system based on the cost of the hydro option.
In this regard, the CRES study suggested that a
transition from hydro-based prices to coal-based
prices could be achieved by delaying construction of
Q80 Q90 Q94 Q96 Q98 Q2000
the thermal station until such time as the price of
electricity had been increased to a level at which it Q80 Q90 Q2000 Electricity (Gwh)
90 cleared the market at the existing level of capacity.
That is, there would be incremental real price Figure 8.2 The Gordon-below Franklin
increases as demand increased (Figure 8.2) over proposal: investment timing
a number of years. decisions using rationing by price

(b) Discount rates

The two options for generating electricity differed significantly in their cost profiles.
The capital cost of the hydro option was almost twice that of the thermal option. However,
the running costs of the thermal option were around ten times those of the hydro option,
largely due to the cost of coal as fuel.

The difference in cost profile made the value selected for the discount rate particularly critical.
The higher the discount rate, the lower the present value of the thermal option’s fuel costs.
Conversely, the lower the discount rate, the higher the present value of those costs.

(c) Environmental effects

In order to value the wilderness preservation benefits associated with the coal based option,
the study developed a model as follows:

where w = the rate of growth in willingness to pay;

c = the rate of growth of consumption at given prices;
r = the discount rate; and
z = the value of preservation benefits in year one.
 Case Study 8

The basic idea of this model is that the value of preserving the Franklin region in its natural
state will grow over time. This would result in a much higher capitalised present value of
preservation than if the current preservation per annum were to stay constant over time.
This is equivalent to using a lower discount rate for the wilderness benefit stream.

As to the specifics, it was assumed that ‘w’ would be determined primarily by the growth
in household incomes and the rate of technological progress. It was assumed that the
growth in incomes would be associated with changing consumer preferences in favour of
environmental ‘goods’, while the latter was an indicator of the extent to which the real cost
of coal-fired technology could be expected to fall over the life of the hydro project. In the base
case, estimates of 3 per cent for income growth (a little below Australian performance in the
1970s) and 1 per cent for technological change gave a value for w of 4 per cent per annum.

The estimate of ‘c’ was based on recent rates of growth in numbers of recreational visitors
to national parks in Australia and overseas. Many studies showed rates of increase of well over
10 per cent per annum, and a figure of 10 per cent was used for the base case. Thus the base
case value for ‘w+c’ was 14 per cent.

In addition, the model allowed for slower growth in visitor numbers after 30 years due to
capacity constraints and assumed that changes in preferences for wilderness would cease 91
after 50 years.

The model showed that a stream of benefits starting from $1 worth of wilderness benefits
in year one (the value of ‘z’) would be equal to a present value of $259.76 (at a discount rate
of 5 per cent). This number was then divided into the cost differential between the two
options to yield a threshold value for preservation benefits in year one.

The question was then posed implicitly to the decision-maker whether preservation of the
wilderness area was worth $727,980 in the first year at a discount rate of 5 per cent (and
substantially less at a discount rate of 10 per cent).

As in other cases where future benefits are expected to grow at such a high annual rate,
the assumptions in the model can be questioned. Also sensitivity testing was limited: the
minimum value of ‘w+c’ was 10.5 per cent. However, the general model and approach were
innovative and sound.