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EC532 Environmental
Economics, Institutions
and Policy
Lecture 9 Environmental Valuation in
Practice

Introduction
Used to decide whether a project (such as
building a road or a dam) is worth undertaking
or not.
Can be used to select best project from a
range of alternatives
Improving transport links between A and B proposed road passes through different routes
with different environmental impacts or might
be better to improve other forms of transport
such as rail or buses

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Cost-benefit analysis (CBA) - tool used to

assess the economic viability of projects.

BASIC CONCEPTS OF CBA

CBA - simple decision-making procedure
Weigh up gains (benefits) and losses (costs) of a decision, project or policy

Rarely (never) occur in practice.

Alternatively criteria - Pareto potential welfare criterion

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Pareto - change in resource allocation - desirable iff at least one person

gains and all others are made no worse off

Change in resource allocation good if gains, in principle, can compensate

losses and be at least no worse off.
Several value judgements made to operationalise CBA:
1. individual preferences count
2. individual preferences weighted according to the distribution of income
3. social preferences determined by summing the weighted preferences of
all individuals

Economic Prices

Non-market environmental resources and

services, monetary values have to be estimated
(using environmental valuation techniques)

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Most cases market prices can be used to

estimate costs and benefits

Estimates then integrated into CBA

Other price adjustments may also be required if
other distortions exist in the market, eg foreign
exchange or price controls.

Time and Discounting

Typically, people prefer to have benefits now

rather than later, and costs later rather than now
This time preference is incorporated into CBA
through the application of discounting future costs
and benefits.

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Costs and benefits often occur many years in the

future

METHODOLOGICAL STEPS IN
CBA

Step 1: Defining the project

Step 2: Identifying relevant costs and benefits
Step 3: Converting to economic prices
Step 4: Incorporating environmental values
Step 5: Introducing time horizons and
discounting
Step 6: Applying the decision rule to assess a
projects worth

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There are many ways of categorising the

steps taken in CBA and we divide the process
into six main steps.

Step 1: Defining the

project
Describe the main elements of the project

Describe how the project will meet proposed

objectives and who will win/lose

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Define its key objectives

Boundaries of the project:

Area
Project life cycle (number of years)
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Step 2: Identifying relevant

costs and benefits

Benefits/costs function of scope and objectives of the

project
So new road beneficial outcomes might include:
reduction in traffic congestion (time savings)
reduced number of accidents.
cost savings in vehicle operating costs

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Include all direct costs and benefits plus all indirect costs
and benefits (the externalities) borne by third parties.

May also be environmental costs noise and air pollution

reduced
Also need to be clear about when and for how long
costs/benefits will occur (time duration/horizon)

Step 3: Converting to economic

prices

Need to take account of costs and benefits that

might be external to the price system
There can also be distortion in the economy that
impact market prices monopoly so may need to
adjust prices accordingly
Can also be distortions when dealing with foreign
exchange might think stated exchange rate is
appropriate frequently in developing economies
exchange is manipulated

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Need to make sure prices used in CBA are economic

rather financial prices

Step 4: Incorporating
environmental values

Environment - under-priced or not

priced

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Frequently environment is ignored

Role for non-market valuation methods

The choice of method and value
employed frequently trade-off
between theory/practical/cost

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Step 5: Introducing time

horizons and discounting
Environment costs and benefits can occur over the long term

Magnox reactors constructed in the 1960s are now reaching

end of their useful lifetime of power generation.
Costs ongoing - storing and treating radioactive waste

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Eg, The UK nuclear power sector.

Costs involved in decommissioning plants

Need to specify time boundary of a project
Place range over which costs and benefits are being added
up
CBA convert costs and benefits from the future in equivalent
values today (discounted)

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 Environmentalists frequently object to discounting - argue

discount rates - low - accommodate considerations and
interests of future generations
The form of the formula used to assess costs and benefits
over time is as follows:

B benefits
C costs
r rate of interest
t time periods (t=1.....T)

Formula takes all costs and benefits incurred over time period
of project - aggregated and discounted.
This yields an estimate - Net Present Value (NPV).
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Step 6: Applying the decision

rule to assess a projects worth

NPV formula yields a value greater than

zero
If several competing projects and all have
benefits greater than costs then the
choice of project can be made by looking
for the project that yields the highest
benefit to cost ratio.

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CBA typically employs rule - if benefits >

costs then a project is potentially viable

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A Hypothetical
Example
A road building scheme

The transport planners have undertaken an economic

appraisal of two new route options.
Route A shortest and most direct route - substantial
benefits - time savings but passes through an ancient
woodland that is not only used for recreation, but also has
special scientific interest.

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Objective - alleviate traffic congestion and reduce

accidents associated with a narrow stretch of road.

Route B avoids the woodland, but longer route and reaps

fewer economic benefits in terms of time savings.
The transport planners prepare an economic appraisal of
both route options - CBA

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Costs and benefits of route options (in 000)

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 the lifespan of the project is 15 years

environmental costs and benefits are not
explicitly incorporated in the analysis
a discount rate of 8% per annum is to be
employed
construction and land costs are incurred in year
0
all other costs and benefits come on stream in
years 1 to year 15 (inclusive)

We can now calculate the NPV for projects

A and B.

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The following assumptions are made by

the transport planners

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Route B: Calculating the NPV

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Route A: Calculating the NPV

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 However, suppose recent EU directive, required to

undertake an independent valuation of the
environmental impacts of any new public
infrastructure projects

1. WTP for conserving woodland area (CVM) estimates a value

of 250,000 per annum.
2. CVM - but measures WTA compensation for loss or damage
to woodland - 450,000 per annum.

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Two separate studies are commissioned:

These values are additional to the value of land used

in the initial calculations (based on the sale of public
land without planning permission).
Which route will now be selected under the following
decision criteria?

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 (a) Standard CBA

Route A

NPV (Route A): 1,223,600

NPV (Route B): 196,000

Route A is still preferred

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(b) CBA with environmental valuation (using WTP

method)
Revised NPV after inclusion of environmental
based on WTP are

(c) CBA with environmental valuation (using WTA

method)
The revised NPV after inclusion of environmental
based on WTA
NPV (Route A): -488,200
NPV (Route B): 196,000

Route B is preferred

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Cost Effectiveness Analysis

(CEA)
CEA related technique to CBA

Used when benefits difficult to measure benefits, funds are

limited and a choice must be made between differing goals.
Example - environmental damage linked to human health difficult put value on benefits of improved health of a
project

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Only concerned with costs of a project - not benefits.

There are three steps involved in CEA.

Step 1: Setting the goal
Step 2: Analysing costs
Step 3: Choosing the least cost method

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CBA in Practice
Demand for CBA many different sources especially government

Positive view CBA only maintained if application of method

appropriate and correct
Hahn and Dudley (2007) examined issue - how CBA implemented
in US over a number of different administrations.

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Economists advocate use of CBA useful tool

Study reveals a number of interesting features of CBA in practice.

The authors employ a scorecard method.
Large set existing CBA considered wrt basic set of criteria.
Did CBA employ monetary measures of costs and benefits and if
they have been discounted, etc.

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 Data
Sample contains 74 CBAs
27 from the Reagan period of government, 24 for Bush and 23 for
Clinton. The data are from a period 1982-1999. All of the CBA were
undertaken by the Environmental Protection Agency (EPA).

1. Costs
Most CBAs identified, many quantified and a reasonable proportion
expressed in monetary terms.
More recent CBA provide point and a range of cost estimates. Also
costs identified are typically those incurred by producers but
administrative costs are often not included.
2. Benefits
Presentation of benefit estimates is less common than costs.
Benefits frequently quantified but far less frequently expressed in
monetary terms. So 100% of CBA examined expressed some costs
in monetary terms less than 50% express some benefits in
monetary terms. The implication is that benefits are more difficult
to quantify than costs in monetary terms.

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Results
The use of economic information is examined across six categories:

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 4. Consideration of alternatives
Alternative is another policy option that could achieve the same
outcome as policy being examined. Consideration of alternatives is
at best poor and practice over time has seen a reduction in the
consideration of alternatives.
5. Clarity of presentation
Criteria describes how much overall information is included in CBA to
help the reader understand the problem more broadly. For example,
as CBA are frequently very large documents a minimum requirement
is that they contain an executive summary. Interestingly, 80% of
CBA provided an executive summary and this average is falling as
the more recent CBA in the sample are less likely to provide a
summary. It was also noted that most executive summary do not
provide details of key calculations underpinning findings.

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3. Comparison of costs and benefits

The estimation of net benefits is a frequently cited measure to be
used in the evaluation of CBA. But CBA examined - net benefits
frequently failed to be presented. CEA more frequently - reflects
greater collection of cost information in general. Overall net benefit
information is not available for or does not exist for 69% of CBA
examined. Also it was found that even when sufficient information
did exist that a comparison of costs and benefits is not provided.

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 Key Findings
Results do not indicate that EPA failed to meet regulatory
requirements.
Hahn and Dudley note government agencies are allowed
leeway if information that might be used does not exist or
cannot be collected.
Express some concern about the quality of practices they
have examined.
Analysis reveals no real change in practice over time and
that the practical application of CBA is to certain extent
constrained by political reality. Use of fundamental
economic information is limited. Many of the CBA are of
low quality.

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6. The use of analytical assumptions.

Two key analytical assumptions relate to the choice of base
year and the discount rate. On average 73% of CBA state
base year employed. This is important as it describes the
year in which all monetary values are based. Discount rate
stated in 75%. Many CBA do not clarify if the discount rate
being employed is real or nominal.

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Discounting and Net Present

Values
The use of discounting and calculation of net present
values (PV) based on type of behaviour-time preference.

Eg, most individuals prefer benefits now they are not

indifferent between 1 of benefits today and 1 sometime
in the future.
Discounting provides a procedure that allows monetary
costs/benefits accrued in different periods to be expressed
in a common metric. The common metric is the NPV. NPV
allows all future values to be converted to a value today.

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Individuals prefer realise benefits sooner rather than later.

The conversion is constructed such that an individual is

indifferent between 1 in the future and PV of 1 today.
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 Example

We can use formula with t = 10, r = 0.08 and FV =

1,000
PV = (1 + 0.08)-10 * 1,000 = (0.463) * 1,000 =
463

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What is the PV of 1,000 payable in ten years, if r =

0.08 (i.e., 8%)?

So PV of 1,000 payable in ten years is 463

Hence, discount rate of 8% - individual is indifferent
between 463 today and 1,000 in 10 years.

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Is the choice of discount rate

controversial?
Yes

Alternatively social discount rate < risk-free real market

rate of interest (public good issues)
What is the Risk-Free Real Market Rate of
Interest?
Any market rate interest 3 components:
Inflation component
Risk component
Real interest rate

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Argued that the social discount rate should be set equal

to risk-free market rate of interest.

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 Higher inflation rate rate needs to compensate loss

purchasing lower - CBA typically expresses - real terms

In general the Social Discount Rate < Risk-Free Real Market

Rate
Society lower rate time preference than individuals more
concerned about future

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The risk premium relates to the risk default - proxy for risk
free rate is what is called the bond rate - normally gauged
by reference to government treasury bonds which we
assume will always be honoured

Why?
Intergenerational equity for individual do not make
decisions and/or consider the future much beyond their own
lifetime or that of their children.

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In Practice

What these levels of r imply is that project affects that

occur after about 30 years are minimal.
The discount rate at 12% over 30 years is 0.03338

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In practice r = 10 or 12%
Set based on opportunity costs of capital (real return on
additional investment)

So 100 million in 30 years is only worth 3.33 million

today.
Many environmental effects long-term - small impact on a
project decision
Some argue r be set low or even zero

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Different Discounting
Models
There are alternative discount models:

These alternative discounting models are premised

on idea that an individuals preferences are
decreasing & time averse.

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The proportional discounting model

The hyperbolic discounting model
Declining discount rate

An individual might be indifferent between

receiving 100 after 1 month or receiving 110
after 2 months
But, they would prefer 110 after 13 months to
100 after 12.

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 Constant Discounting Model

a(t)=(1+r)-t r>0, t>0
a(t) is the discount factor

Hyperbolic Discount Function

What this formula does is assign greater importance to
the distant future.

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Proportional Discount Function

a(t)=(b/b+t)
where t>0, b>0

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Effect of Discounting Methods on the Discount Factor

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Discount Factor

Proportional/Hyperbolic
Constant
0

Time Periods

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Criticisms of
Discounting
Distributional Issues

Benefits accrue to wealthy, costs borne by poorer sectors in

society.
Also WTP can be influenced by the actual distribution of income
and assets in society.

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Clearly some projects show a high benefit-cost ratio - desirable

on economic efficiency grounds but undesirable on
distributional grounds

WTP constrained by ability to pay

True of all market expressions of preference.
So poorer sections in society have less opportunity for market
expression of their preferences also revealed values that
poorer people attach to environmental assets and quality lower because they are income constrained

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 Future Generations
Discounting places lower importance on future
generations - intergenerational equity.
Projects - large investments today benefits in future

Alternative approach - incorporate sustainability

constraints into economic appraisal
Better way of protecting interests of future generations

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Projects less likely pass CBA with high discount rate

The sustainability constraint - shadow project to offset

any undesirable environmental effects, or to substitute for
lost environmental asset.
Example - development project that involves the
destruction of wetland area may include monies to fund
shadow project to restore partly degraded wetland in the
region under consideration.

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 Utility and Preferences

Theory environmental valuation and CBA - based on
utilitarian ethic that revolves around finding out what
people want, rather than leaving the assessment to policy
makers and politicians.

Private versus community preferences

Peoples behaviour, preferences influenced by role as
consumers and citizens. Valuations individual/citizens differ

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Objections to resource allocations based on utility

maximisation and individual preference revelation. Moral
issue.

Inarticulate groups are under-represented or ignored

Some groups excluded from environmental valuation
methodologies, which as we have seen are based on
preference revelation and WTP:
Living overseas
Living in the future

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 Non-utilitarian values and existence of rights

Clearly from TEV how do we reconcile existence values
So need to be clear about what values being employed in
CBA and what they mean
WTP vs WTA
Need to be aware how use of particular estimates can
influence outcome of CBA

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Incommensurable values
Some environmental values and other non-marketed
values are incommensurable.
Cannot be compared with marketable goods.
In other cases, environmental effects may be measurable
in principle, but the state of science does not enable them
to be quantified at present.
Might argue in response in the real world, choices
between alternative states have to be made.
Better choices made in systematic way - involves
quantification

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 Another option - compensate losers.

Kaldor-Hicks principle does not require payment
of actual compensation.
And compensation payments value
judgement

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Equity Issues
Can employ distributional weights
This modification reliant on some value
judgement
This approach to CBA more consistent with
Rawlsian ethic that explicitly protects the
interests of the disadvantaged groups in society.

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Discounting and Climate Change

Use CBA to examine various policy instruments to deal with
climate change has been growing very rapidly eg Stern
Review.

Key issue - speed with which action to stabilise emissions is

necessary. The majority of studies typically concluded that the
speed of policy response can be reasonably measured. However,
the Stern Report argued that a much more rapid approach to
stabilisation is necessary.

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Way in which studies conducted provides interesting insight into

how CBA can be used to examine a real world problem revealing
many of the strengths as well as weaknesses of CBA in practice.

These differences in emphasis bring into focus the importance of

the discount rate to be used as well as the target of any policy
being analysed.
Stern Report employed a low discount rate. It also was compared
to many other studies very pessimistic about the damages
resulting from climate change.

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The Discounting Method

Social Rate of Time Preference (SRTP) employed. The SRTP estimated by
employing the Ramsey equation which takes the following form:

is the rate of pure time preference

the negative of the income elasticity of marginal utility
g is per capita growth rate of consumption.
2nd term represents how 1 extra dollar is worth more to a poor person
compared to a wealthy individual.
So richer future generations end up being, the higher will be resulting
discount rate.
In practice choice parameters - value judgements (trio of twos)
First term judgement about importance researcher attaches to the welfare
of future generations.
Second term value judgements wrt utility derived by individuals in
different contexts.
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