Multiple Account Benefit-Cost Analysis: A Practical Guide for the Systematic Evaluation of Project and Policy Alternatives 9781442686632

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MULTIPLE ACCOUNT BENEFIT-COST ANALYSIS A PRACTICAL GUIDE FOR THE SYSTEMATIC EVALUATION OF PROJECT AND POLICY ALTERNATIVES

Most commonly used in the economic evaluation of public policy alternatives, benefit-cost analysis traditionally attempts to calculate a bottom line by assigning monetary values to all consequences of a proposed project or action. By contrast, multiple account benefit-cost analysis recognizes that values are complex and that not all consequences can be expressed in monetary terms or incorporated into one summary measure of net benefit. In this textbook, designed for practitioners as well as for intermediate or advanced students, Marvin Shaffer illustrates how the basic principles and concepts of benefit-cost analysis can be applied in a multiple account framework, in the process developing a systematic approach to the evaluation of project and policy alternatives. Though retaining the basic principles of benefit-cost analysis, Shaffer focuses more on identifying the advantages and disadvantages of project alternatives and assessing their key trade-offs in order to better inform public policy debates. marvin shaffer is an adjunct professor in the Public Policy Program at Simon Fraser University.

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MARVIN SHAFFER

Multiple Account Benefit-Cost Analysis A Practical Guide for the Systematic Evaluation of Project and Policy Alternatives

UNIV E R S I TY OF TO RO NTO PRE S S Toronto Buffalo London

© University of Toronto Press Incorporated 2010 Toronto Buffalo London www.utppublishing.com Printed in Canada ISBN 978-1-4426-4112-9 (cloth) ISBN 978-1-4426-1045-3 (paper)

Printed on acid-free, 100% post-consumer recycled paper with vegetablebased inks.

Library and Archives Canada Cataloguing in Publication Shaffer, Marvin, 1949– Multiple account benefit-cost analysis : a practical guide for the systematic evaluation of project and policy alternatives / Marvin Shaffer. Includes bibliographical references and index. ISBN 978-1-4426-4112-9 (bound). – ISBN 978-1-4426-1045-3 (pbk.) 1. Cost effectiveness. HD47.4.S53 2010

I. Title. 658.1554

C2010-904624-2

University of Toronto Press acknowledges the financial assistance to its publishing program of the Canada Council for the Arts and the Ontario Arts Council.

University of Toronto Press acknowledges the financial support of the Government of Canada through the Canada Book Fund for its publishing activities.

To Saul Shaffer, a man who taught me and many others the virtue of applying balance and reason to the challenges of life and the important decisions we must make

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Contents

preface

ix

1 The Basic Concepts

3

What Is Benefit-Cost Analysis? 3 Components of Value 4 How Benefits and Costs Are Measured 6 How Benefits and Costs Are Often Misrepresented Why Benefit-Cost Analyses Are Undertaken 11 Summary 14 Case Study: High-Quality Child Care 15

9

2 Multiple Account versus Traditional Benefit-Cost Analysis Limitations of Traditional Benefit-Cost Analysis 22 The Role of Benefit-Cost Analysis in Public Policy Debates 26 Improving on Benefit-Cost Analysis with a Multiple Account Approach 27 Summary 30 Case Study: Lower Gordon River Hydroelectric Project 31 3 Evaluation Accounts

37

Origins of Multiple Account Analysis Multi-criteria Approaches 43 Recommended Approach 47

37

22

viii

Contents

Summary 51 Case Studies: Electricity Supply

53

4 Measuring Benefits and Costs Under Each Account

65

Market Valuation Account 65 Taxpayer Account 66 User or Target-Beneficiary Account 71 Economic Activity Account 74 Environmental Account 77 Social Account 80 Other Measurement Issues 81 Summary 83 Case Study: Richmond–Vancouver Airport–Vancouver Rapid Transit Line 85 5 Estimation Methods

94

The Basic Alternatives 94 Physical Linkage Method 96 Observed Price and Behaviour Methods Contingent Valuation Method 104 Purpose of Estimating Values 108 Summary 109 Case Study: Lead in Gasoline 111

99

6 Aggregating Benefits and Costs over Time

117

The Discount Factor 117 Rationale for Discounting 119 Time Preference versus the Social Opportunity Cost of Capital Discounting and Sustainability 129 Discounting and Uncertainty or Risk 133 Summary 136 Case Study: Nuclear Power 138

glossary index

151

145

122

Preface

For a number of years I have taught a course on benefit-cost analysis,1 and as a consulting economist over my entire career I have had the (mostly) good fortune to apply the principles of benefit-cost analysis to a wide range of project and public policy issues. In all of this I am struck by the stark dichotomy between the academic and the political worlds in which I work. On the one hand, some academic experts in benefit-cost and welfare economics too often acknowledge but then ignore the fundamental philosophical and empirical limitations of their analysis and consequently overstate the policy consequences of their results. A benefit-cost result will not necessarily dictate which of a range of alternatives should be undertaken, for many of the same reasons that the free interplay of demand and supply in perfectly competitive markets, even in the absence of externalities or other market failures, does not necessarily determine how resources should be allocated. On the other hand, those charged with making policy decisions often have little understanding of the economic consequences or significance of the choices they face. Even where there is a desire to understand the benefits and costs of alternative actions, there is surprisingly widespread misunderstanding of what constitute economic benefits and costs, how they should be measured, and how benefitcost analysis can most effectively inform public policy debates. This book has been motivated to help bridge that gap. It covers the main economic principles and subject areas of benefit-cost analysis and, as such, is suitable for students in benefit-cost and public policy analysis. It also addresses valuation methods and provides numerous examples of applications that may be of interest to analysts. However, this book has been written to be accessible to a broader audience than students and practitioners; it is aimed as well at decision makers,

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Preface

advocates, commentators, and those in the general public interested in public policy matters. The basic objectives are to explain very clearly the purpose of benefitcost analysis, its limitations, and the role it can usefully play in public policy debates; economists’ definition of benefits and costs, and the methods by which they are estimated in theory and in practice; the rationale for and alternative methods of discounting (weighting) benefits and costs that occur at different points in time in order to calculate their equivalent present value. A unique feature of this book is its emphasis on disaggregated, multiple account benefit-cost analysis. The attempt in traditional benefit-cost analysis to reduce all positive and negative consequences to a single bottom line – a monetary measure of overall net benefit – underlies many of the problems that analysts have in conducting such studies and that decision makers have in relying upon them. Multiple account benefit-cost analysis recognizes that often it is not possible to express fully or accurately the significance of some consequences in monetary terms, and in any event it is not generally desirable to aggregate all positive and negative consequences into one summary measure of overall net benefit. Understanding the nature of and the tradeoffs among the different types of benefits and costs, and how they are distributed among different interests, can be as important as or more important than the estimated overall bottom line. In response to concerns and criticisms of benefit-cost analysis – some well founded, some not – a wide range of multi-criteria or multi-attribute methods have been applied to the evaluation of alternative projects and policies. For the most part, the criteria and the performance indicators used in these evaluations are not based on or consistent with the fundamental objectives and principles of benefitcost analysis. Multiple account benefit-cost analysis is very different in this respect. It retains the fundamental goal of identifying and assessing the significance of all of the consequences of different alternatives, based on the values or preferences of all of the individuals who are affected. It is still benefit-cost analysis as economists understand that term. However, it differs from traditional benefit-cost analysis in that it works towards a summary matrix of results, not necessarily a bottom line. It is multiple account. There is a very valuable role that benefit-cost analysis can play in public policy debates. It challenges decision makers and advocates alike to consider the full range of the consequences of different alternatives

Preface

xi

and to take into account the values or preferences held by all affected individuals. However, benefit-cost analysis can only inform, not necessarily resolve, public policy debates. Multiple account benefit-cost analysis is particularly well suited to that. I would like to thank Shel, Blake, and Jodi who have encouraged me to write this book and persevere through its completion. I would like to thank Gale and Stephen for their technical assistance, and Jennifer and the others at University of Toronto Press for their support. I would also like to thank colleagues and students, as well anonymous reviewers, who have given very helpful comments and advice on preliminary drafts. In particular, I would like to acknowledge the advice generously given to me by Professor John Richards in the Public Policy Program at Simon Fraser University and Professor Harry Campbell in the Department of Economics at the University of Queensland. And I must thank my good friend Professor Curt Eaton at the University of Calgary, who instilled in me from the outset of my career a healthy scepticism of misplaced mathematical precision and theory in economics and a yearning for dispassionate, practical analysis of public policy issues.

NOTE 1 While some may be more familiar with the term cost-benefit analysis than with the term benefit-cost analysis, both are used, and they are essentially interchangeable. For me, benefit-cost provides a logical ordering and focus for the analysis – what are the benefits, and how do they compare to the costs? Of course, one could equally ask what are the costs and analyse how they compare to the benefits.

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MULTIPLE ACCOUNT BENEFIT-COST ANALYSIS

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1 The Basic Concepts

What Is Benefit-Cost Analysis? There are many ways that the positive and negative consequences, or the advantages and disadvantages, of alternative projects or policies can be assessed. Private investors will assess projects on the basis of the rate of return they expect to realize in relation to the risk involved. Environmental advocates will assess projects and policies on the basis of potential biophysical impacts and risks. Business and labour groups will look to the economic stimulus that a project or policy may have, such as the amount of employment and income expected to be generated. Different groups have different perspectives and interests and accordingly will assess projects or policies in different ways. Benefit-cost analysis does not take the perspective of any one particular group. Nor does it impose the standards or values that any one group would argue should be applied in the development of public policy. The purpose of benefit-cost analysis is to identify and compare the advantages and disadvantages of alternative projects or policies from the point of view of society as a whole. It is intended to take into account the impacts on all those who are affected, or at least all those with standing1 in the jurisdiction for which the analysis is being done, and to measure the magnitude or significance of those impacts based on the preferences or values held by the affected individuals – specifically, the trade-offs they would willingly make to realize the positive consequences or to accept the negative consequences. There are no intrinsic or inherent values in benefit-cost analysis. The benefits are not defined by politicians, moralists, scientists, or others, by what they believe people should want. Rather, the benefits

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of a project or policy are any output or consequence (for example, an increase in the availability or quality of a good or service, an improvement in environmental or social conditions, or a reduction in health or other risks) that at least some people want, and value positively to the point that they would be willing to give something up in order to get it. The critical point is that people would be willing to allocate some of their limited purchasing power or resources for it and thereby forgo what those resources could otherwise provide. The costs are any input or any consequence (for example, the supply of labour, a reduction in the availability or quality of a good or service, an adverse environmental or social impact, or an increase in risk) that at least some people value negatively and for which they would have to be compensated to willingly incur or accept. The critical feature here is that the supply of the input or the negative consequence would have to be offset by additional purchasing power or resources (and what those resources can provide) in order for the affected people to feel no worse off. In short, benefits are what people are willing to allocate resources to, in other words pay for, and costs are what people must be compensated for. At its most fundamental level, benefit-cost analysis sums and compares the total amount that people would be willing to pay for the outputs and the other positive consequences of a project or policy with the total amount that people require to be compensated for the inputs and the negative consequences. The difference between the total amount people are willing to pay and the total amount they have to be compensated indicates whether, and to what extent, what people are willing to pay exceeds what they would have to pay to offset all of the costs. Components of Value Though cast in what some may think are narrow economic terms, the concept of value in benefit-cost analysis is in fact very broad. Benefits include not only those things that people consume or directly enjoy but also those things or attributes that people value simply because they exist. They also include the availability of options that people value because of the uncertainty about their future needs or opportunities, and the flexibility that people value because it enhances their ability to respond effectively to future unfolding events. In the standard taxonomy of benefit-cost analysis, benefits include use, existence, option, and quasi-option values.

The Basic Concepts

5

Use value refers to something for which people are willing to pay because of the satisfaction they directly and personally derive from it. Use values include those things that people consume, those activities they engage in, or those experiences they enjoy. For example, use values that arise in benefit-cost analyses of recreational areas could include the consumption of recreational-related services (for example, accommodation, boat rentals, or guiding services) and also the undertaking of recreational activities (sports fishing, hiking, or bird or wildlife viewing). Existence value, sometimes further broken down into altruistic, stewardship, and bequest values, refers to those things or attributes that people value for their mere existence or for their preservation for the present and future generations. This could include, for example, the preservation and enhancement of wildlife, natural environments, or sites of cultural and historical significance; or the achievement of social objectives, such as universal access to health care or the elimination of extreme poverty. The key is that people believe these attributes to be important in their own right, not just because of the benefits they themselves might derive from them.2 Existence values are now widely recognized as potentially very important not only in academic or policy-oriented economic analyses but also in litigation. In lawsuits following the Exxon Valdez oil spill, the nature and magnitude of the loss of existence values (the value placed on the pristine environment of Prince William Sound) was a major issue, far greater in significance than the fishing, recreation, and other use values that were affected by the spill.3 Option value refers to a willingness to pay in excess of the expected benefit of a good or a service. It was originally conceived as a willingness to pay for the opportunity or option to use or benefit from a service or an amenity (for example, dedicated parkland), even if one had no immediate plan or expectation of doing so.4 Now it is more generally recognized as the difference between the ex ante willingness to pay for a service or an amenity, or what is termed the option price, and its ex post expected value, a difference which may be positive or negative depending on whether the provision of the good or the service reduces or increases risk.5 Quasi-option value refers to a willingness to pay for flexibility or the expected value of new information. Irreversible alternatives offer no quasi-option value. However, alternatives that enable one to respond more effectively to new information can provide significant quasi-option value. For example, the deferral or attenuated development of a capital-intensive investment can offer quasi-option value if

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it enables the collection and use of more information on what the best long-term strategy may be. Precautionary measures generally offer quasi-option value. The magnitude or significance of quasi-option values will depend on three factors: (i) the probability of acquiring new information in the future that would cause one to want to change one’s decisions or actions, (ii) the ability that one would have to respond or make changes in light of that new information, and (iii) the benefit or cost saving that such changes would have.6 Values in benefit-cost analysis are not limited to material things nor, in concept, are they devoid of moral or social concern. Benefits reflect the moral attitudes and social concerns that people in fact have; they reflect what people are willing to make sacrifices for, whatever that might be. And, while values reflect the preferences of the existing population, they do take the interests of future generations into account. They do so, not by the choices that some advocates might argue should be made on behalf of those not yet born, but rather by what people today actually consider appropriate and want to do. The concept of value in benefit-cost analysis encompasses not only a very wide and diverse range of benefits but also a very wide and diverse range of costs. Costs are not limited to those things that people pay for; they include anything that people would have to be compensated for in order to willingly incur or accept. Critically important in identifying and valuing costs in benefit-cost analysis is the concept of opportunity cost. Opportunity cost refers to the value that could be derived from an input (for example, labour, land, or an environmental resource) in its best alternative use or state. An opportunity cost arises whenever an alternative use or state that would have provided some benefit is forgone. How Benefits and Costs Are Measured The magnitude or significance of a benefit or cost is measured by what economists term its compensating variation. This is the trade-off that people would be willing to make to acquire the benefit or incur the cost. Specifically, the compensating variation or economic measure of a benefit is the maximum amount that people would in principle be willing to pay (the maximum amount of income, or purchasing power over other goods, that they would be willing to give up) for it. The compensating variation or economic measure of a cost is the minimum amount of

The Basic Concepts

7

income, or purchasing power over other goods, that people would have to receive – the compensation they would demand – to willingly incur or accept it. Compensating variations are formally defined as the changes in income or purchasing power that would leave a person no better or worse off than he or she would have been without the positive or negative changes caused by the project. In other words, they are measured by the changes in purchasing power that would offset the project’s impacts, leaving individuals with the same level of utility or well-being as they would have had without the project. An alternative measure of benefit or cost is the equivalent variation. It is defined as the change in income or purchasing power that would leave individuals with the same level of utility or well-being they experience with the project. As illustrated in figure 1.1, instead of the willingness to pay (the amount of income or purchasing power a person would willingly give up) for a benefit, the equivalent variation would be measured by the amount of compensation (additional income or purchasing power) that a person would have to receive in order to realize an equivalent amount of benefit as the positive consequence of the project. Similarly, instead of the compensation required to offset a cost, the equivalent variation would be measured by the amount a person would have to pay or give up in order to incur an equivalent cost as the negative consequence of the project.7 While recommended by some because of its theoretical properties, equivalent variation is seldom used in benefit-cost analysis. Compensating variation better reflects the intent of most project or policy evaluations. The reference point from which benefits and costs are measured is the point at which people would be (what level of utility or well-being they would have) without the project. The reference point with equivalent variation is the point at which people would be with the project. In effect, it implies a prior right to or presumption of the project proceeding. Compensating variation assumes no such prior right; the starting point is the status quo. Compensating variations can be illustrated with standard economic demand and supply curves as shown in figure 1.2 below. A demand curve indicates the quantity of a good or service that people would want to acquire at any given price. By the same token, it also indicates the maximum amount they would be willing to pay (wtp) for any given amount of the good or service (Δq).8 A supply curve indicates the amount of an input or a good that individuals or firms would want to

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Multiple Account Benefit-Cost Analysis

Figure 1.1: Compensating variation vs equivalent variation Compensating Variation (surplus)

Equivalent Variation (surplus) income

income

ye Δye y0 Δyc yc

y0 U0 q0

Δq

q1

quantity of good

U0 q0

Δq

q1

U1

quantity of good

Compensating and equivalent variations can be illustrated with the indifference curves that economists use to portray the different combinations of one good and the purchasing power over all other goods for which an individual would consider himself or herself equally well off. The change in the amount of purchasing power over all other goods (Δyc) that would leave an individual on the same original indifference curve (Uo) as he or she would have been before the change in the amount or price of a good indicates the compensating variation (or, as sometimes termed in relation to quantity changes [Δq] as shown above, the compensating surplus). The change in the amount of purchasing power over all other goods (Δye) that would leave an individual on the same new indifference curve (U1) as he or she would be with the change in the amount or price of a good indicates the equivalent variation (or, in relation to quantity changes [Δq], the equivalent surplus).

provide at any given price and, therefore, the minimum compensation they would demand (cd) to be willing to supply any given amount of the input or good (Δq). Demand and supply curves can in practice be very difficult to estimate. As a result, there are many instances where compensating variations – monetary expressions of benefit or cost – are difficult to measure. However, whether or not readily or reliably measurable in dollar terms, the concept of compensating variation is critically important in benefitcost analysis. It is central to the purpose of the analysis.

The Basic Concepts

9

Figure 1.2: Illustrating compensating variations with demand and supply curves price

price D S

S max wtp for Δq

min cd to willingly supply Δq

D Δq

quantity

Δq

quantity

How Benefits and Costs Are Often Misrepresented Benefits and costs are often misrepresented in what some purport to be benefit-cost analyses of alternative projects and policies, and consequently the results are often not indicative of the choices or trade-offs people would willingly make. A classic example of this concerns the benefits of job creation. Proponents of large projects commonly cite the number of jobs and income generated in construction and operation as major benefits of their project. However, for there to be an economic benefit, the persons hired would have to earn more than they would otherwise or to realize some other advantage. In other words, they would in principle have to be willing to pay or give something up for the newly created jobs. In benefit-cost analysis the benefit is not the jobs themselves, but rather the incremental income or value that the new jobs offer relative to what the persons hired would otherwise earn or do. The creation of jobs that simply attract people from comparable employment in other projects or industries offers no net benefit. There would be no willingness to pay by the workers or anyone else for the creation of such jobs. Benefits can also be exaggerated in the enthusiasm that people bring to different projects. Some proponents of major urban initiatives argue that they are needed in order for the city to be recognized as ‘world class.’ However, being world class is not in itself a benefit; it is only a benefit to the extent people are willing to pay for it. There may be a

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willingness to pay for the specific service or opportunities the urban initiative offers, but not necessarily, or to any great extent, for the civic stature it provides. It is not just proponents of new projects who exaggerate benefits; environmental and social advocates can do the same. Advocates often take the position that the values of certain environmental or social attributes are unlimited or of greater significance than everything else that may be affected. But benefit-cost analysis starts from the premise that resources are limited. Allocating resources or incurring costs to preserve or enhance environmental and social attributes means that fewer resources are available for other initiatives. The issue, therefore, is how much people are willing to allocate or forgo for the attributes in question. That is the measure of value in benefit-cost analysis. Advocates may wish to focus on what people should be willing to pay for the outputs or positive consequences of a particular policy or project, and therefore how much resources they should be willing to allocate. However, in public policy debates it is important to be fully transparent about the amount people would have to pay, and advocates should be prepared to explain why people should be willing to pay that amount. Then the basis for the conclusions and recommendations will be clear, and an informed debate can take place. There are some who understand the basic concept of value in benefitcost analysis but who argue that it is inappropriate to apply it in certain matters. They would suggest, for example, that it is immoral to be concerned with people’s willingness to pay in order to avoid the premature loss of life. That, however, reflects a misunderstanding of what benefitcost analysis is intended to do. When a project or policy affects the risk or incidence of premature loss of life, the benefit-cost issue is not a moral or a metaphysical one; rather it is a question of resource allocation. Societies cannot allocate an infinite amount of resources to reduce the risk of loss of life, nor would they necessarily want to forgo any amount of resources that might be offered as an offset or be otherwise available with an increased risk of loss of life. The resource allocation question is, how much are people willing to allocate to reduce the risk of loss of life, or how much would they need to receive to willingly accept an increase in that risk? The answer to the resource allocation question will differ from country to country depending on the nature of the people, their attitudes to risk, and, very importantly, their per capita income. The willingness to pay to reduce the risk of loss of life in poor countries will be much smaller than

The Basic Concepts

11

in rich ones. That does not mean that life is less valuable in poor countries; it simply means that there are other pressing priorities in those countries constraining what can be invested in measures that reduce the risk of loss of life. From a global social perspective this may not seem just, but it is the disparity in income that is the injustice. The relatively low willingness to pay to reduce the risk of loss of life (or willingness to pay to protect the environment or to expand education and social services) is just one manifestation of that broader issue. The point is, given the level of income that actually exists, a relatively low willingness to pay to reduce the risk of loss of life can be entirely appropriate in the determination of the way in which very limited resources should be allocated. When resources are limited, which they generally are, choices have to be made. Benefit-cost analysis is an evaluation tool that can inform public policy debates about the trade-offs or choices people would willingly make in resource allocation decisions. However, that requires benefits and costs to be properly identified and measured. Only then will the analysis focus on the basic question, how does the total amount of resources that people are willing to allocate for the benefits compare to the total amount of resources required to compensate for or offset the costs? Why Benefit-Cost Analyses Are Undertaken In free market economies, individual households and firms are assumed to undertake their own benefit-cost assessments of the purchases, sales, or investments they may make. When deciding whether to buy a particular good or service, households will compare how much they are willing to pay – the value they place on the good or service – with the cost. When firms consider whether to produce a particular good or service, they will compare the price they expect to receive with the compensation they require to offset the costs they will incur. These individual assessments will govern the demand and supply of different goods and services in the economy and ultimately the amount of each good and service that is produced. A principal strength of free market economies is that resources are allocated in accordance with people’s values or preferences for different goods and services and with the minimum necessary costs required for their production. Under ideal market conditions, the economy will efficiently produce the goods and services that people value most in relation to their costs – that offer the greatest amount of benefit that can be achieved with the amount of labour, capital, and natural resources available in the economy.9

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The question is, if free market economies can efficiently produce those goods and services that offer the greatest amount of benefits with the available amount of resources, why should benefit-cost analyses be undertaken? Why not let the market decide what goods and services should be produced, and restrict government policy to ensuring that markets work effectively? Of course, not everyone accepts the basic premises of a free market economy, in particular that resources should be allocated in accordance with individuals’ preferences or willingness to pay for different goods and services. Preferences can be based on limited or inaccurate information; they can be relatively unstable, changing in response to different media and social influences; and they may not, at least in some people’s view, take the interests of future generations sufficiently into account. Further, what people are willing to pay for depends on their income, and therefore the preferences that a market economy responds to will depend on the distribution of income, which some people may consider to be unjust. As Paul Samuelson wrote in his classic introductory economics text, market economies allow all consumers to vote on what should be produced and for whom; it is just that some consumers have more votes than others. Those who challenge the basic premises of a free market economy would argue that government intervention is required to address deficiencies in individual preferences, or inequities in the distribution of income. However, benefit-cost analysis is not an evaluation tool aimed at those issues. Benefit-cost analysis relies on individual preferences, however formed, to measure benefits and costs. The distribution of income, and the preferences and values it gives rise to, whether fair or just, is taken as given. It is not a failure of individual preferences that motivates benefit-cost analysis; rather it is a failure of the market to fully or accurately take people’s preferences into account. For the market to respond optimally to people’s preferences requires ideal market conditions. There have to be markets for all of the goods and services that people value. All markets have to be perfectly competitive so that individual buyers or sellers cannot manipulate the market price. There must be no taxes, subsidies, regulations, or other factors distorting the market price. There are numerous reasons these ideal market conditions do not prevail and the economy does not produce the mix of goods and services that people value most in relation to their cost. Following are the principal reasons:

The Basic Concepts

13

• Externalities: Positive externalities are beneficial impacts on third parties for which the third parties do not pay; negative externalities are adverse impacts on third parties for which the third parties are not compensated. Immunization and education programs, for example, can generate significant positive externalities. Pollution and traffic congestion are classic examples of negative externalities. Market economies undersupply goods that offer positive externalities and oversupply those that generate negative externalities. • Public goods: Public goods refer to those things or attributes that individuals collectively consume (for example, the preservation of endangered species, parkland, and certain types of infrastructure). Pure public goods are non-rivalrous (one person’s consumption does not detract from the amount available to others) and nonexcludable (individuals can enjoy or benefit from them without paying a fee). The purchase or provision of such goods by any one individual would in effect create positive externalities for others. Market economies do not supply an optimal amount of public goods. • Price distortions: Price distortions arise when prices are not set competitively, do not balance demand and supply, or are subject to taxes and subsidies. Whatever the cause (monopoly market structure, government or regulatory intervention, unemployment, institutional arrangements), the distortions will result in inefficient price signals and consequently suboptimal levels of production. So, for example, benefit-cost analyses of alternative energy projects or strategies are undertaken to account for the air emission, the land and resource use, and the other externalities that the different alternatives may have. They are also undertaken to adjust for price distortions, where the regulated prices of electricity or other energy sources do not reflect their marginal cost of supply. Benefit-cost analyses of public transportation investments or policies are undertaken to adjust for the distorted prices for road or transit use. Road tolls, even where such exist, are generally unrelated to marginal congestion costs; and transit fares are generally regulated on the basis of average, not marginal, costs. Here too benefit-cost analyses are undertaken to account for the air emission, the land use, and the other externalities that the different alternatives may have. Benefit-cost analyses of environmental and land or resource initiatives are undertaken because of the distorted (generally non-existent)

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Multiple Account Benefit-Cost Analysis

prices for environmental goods and services, the environmental externalities, and the public good values that may be affected. Benefit-cost analyses of social programs are undertaken because of the distorted prices for the impacted services, the social externalities, and the public good values that may be affected. In all of these cases, the allocation of resources based on individual household and company decisions does not maximize the total benefits that can be achieved with the total amount of resources available in the economy. The basic problem is that the benefits and costs that individual households and firms consider, and the decisions they make, do not accurately or fully reflect the benefits and costs to society as a whole. Summary • The purpose of benefit-cost analysis is to assess the advantages and disadvantages of alternative projects or policies from the perspective of society as a whole. • Benefits and costs are defined very broadly in benefit-cost analysis, based on the trade-offs that all people with standing in the analysis would willingly make. Benefits include any output or positive consequence for which people would be willing to pay. Costs include any input or negative consequence for which they would have to be compensated to willingly accept. • Included in benefits are use values (what people value for their personal use and enjoyment), existence values (what people value for their mere existence or preservation for present and future generations), option values (what people value for the opportunity that is provided), and quasi-option values (what people value for the flexibility that is maintained). • Included in costs is the provision of any input for which there is an opportunity cost – the forgoing of benefit from some alternative use. • Benefits and costs are measured by their compensating variations – the maximum amount that people would be willing to pay for a benefit and the minimum amount they would have to be compensated in order to offset a cost. • With benefits and costs measured by their compensating variations, benefit-cost analysis serves to assess the way in which the total amount that people are willing to pay or allocate for all of the benefits offered by a project or policy compares to the total amount

The Basic Concepts

15

that they would have to pay to offset all of the costs. It is focused on how people would want limited resources to be allocated. • Benefit-cost analysis is undertaken to account or adjust for market failures, where the decisions that households and firms make do not take into account the benefits and costs of everyone who is affected. This occurs where there are positive or negative externalities, public goods, or distorted prices. With market failures in a free market economy, resources are not be allocated in a way that maximizes benefits for society as a whole.

CASE STUDY High-Quality Child Care There are significant market failures affecting the provision and utilization of child-care and early education services. There are positive educational and social development outcomes from these services that benefit society in general, positive externalities that are not reflected in individual families’ willingness to pay for high-quality services. There are capital market failures (price distortions) preventing families from financing the purchase of these services on the basis of the incremental future income it can generate for participant children. There are public good issues here, too, in that many people value the promotion of educational opportunity and social support for all young children, regardless of the socio-economic circumstances of the families in which they are born. For these reasons the market valuation of high-quality child-care and early education services generally understates their full social benefits. Benefit-cost analysis is required to assess the nature and magnitude of these benefits in relation to their costs. A number of such analyses have been conducted for both targeted and universal childcare programs. One of the better known and extensively analysed targeted programs was the High/Scope Perry Preschool Project in Ypsilanti, Michigan. It was a small pilot program in the mid-1960s that provided preschool and family support to children from low socioeconomic-status families. A similarly targeted but larger program was the development of child-parent centres in Chicago. The benefit-cost analyses of these and other targeted programs are based on longitudinal studies that trace the educational and social

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Multiple Account Benefit-Cost Analysis

outcomes for participant and non-participant control groups through school years and beyond. The data from these studies are used to test for statistically significant differences in grade repetition and special education requirements, graduation rates, post-education employment rates and earnings, incidences of parental abuse or other family dysfunction, and involvement in violent or other crime. The benefit and cost implications of the observed impacts are then assessed for both participants and society as a whole.10 The principal benefit for participant children is the incremental lifetime earnings they realize relative to those of otherwise similar nonparticipants, that is, the maximum they would be willing to pay for the future economic benefit that the program provides. For participant families there is also the benefit of the freed-up time and support that it provides. In most studies this is valued by the minimum wage the parents can earn, though a more accurate measure would be the maximum amount they would be willing to pay for their freed-up time or avoidance of other child-care arrangements. For society as a whole, benefits include the reduction in public education costs because of the reduction in grade repetition and special needs expenditures (net of the increase in education costs because of higher retention rates through to graduation); the reduction in social service costs because of the reduction in incidences of family abuse or other dysfunction; and the reduction in criminal justice and victim costs because of the reduction in crime. The costs of high-quality child-care programs include all of the capital and operating expenditures required to deliver the services. They are typically much higher than average child-care costs because of the staffing ratios, employee qualifications, classroom facilities, educational components, and family support that they entail. While there are differences in the programs, and some uncertainty with respect to their long-term impacts, benefit-cost analyses have consistently found that the benefits of well-designed, targeted programs outweigh the costs. A large amount of the benefits comes from reduced government expenditures, especially for educational and crime-related costs, helping to offset the program costs. The impacts of universal child-care programs are not as well established as those of targeted programs. However, benefit-cost analyses of universal high-quality child-care programs generally conclude that they too will generate positive net benefits for society as a whole. Different approaches have been taken in the benefit-cost analysis of universal programs.11 In their Rand Corporation study of a proposal for

The Basic Concepts

17

Table 1.1 Rand study estimates of the benefits and costs of a universal California preschool program (2003 U.S. dollars per child) Benefits Education cost savings Child welfare – government cost savings – avoided victim costs Juvenile crime – government cost savings – avoided victim costs Parent freed-up time Future college costs Participant lifetime incremental earnings Future adult crime – government cost savings – avoided victim costs Total benefits

876 52 51 508 711 2406 -173 5801 558 585 11,375

Costs Program capital and operating costs Total costs

4339 4339

Net benefits

7036

universal preschool in California, Karoly and Bigelow rely on the outcomes demonstrated in targeted programs, but then they scale the benefits depending on the developmental risks and likely alternative care for the enrolling children. High-risk children who would not otherwise have formal care are assumed to realize 100 per cent of the benefits found in targeted programs. Low-risk children who would otherwise have regulated private care are assumed to realize none. Intermediate percentages of the benefits are assumed for less extreme combinations of circumstances. The total benefits estimated in this manner are then compared with the costs of the proposed program. As shown in table 1.1, the estimated benefits are significantly greater than the costs, with incremental participant earnings, the value of the freed-up time, and reduced crime and education costs all significant factors.12 In their study of a proposed universal high-quality child-care program in Canada, Cleveland and Krashinsky cite the developmental benefits for participating children and estimate the value of those benefits based on the amount that well-off families actually pay for highquality care. They also consider the impact that such a program would have on female participation rates in the labour force and estimate the

18

Multiple Account Benefit-Cost Analysis

incremental income that women would earn as an additional component of the benefits. The sum of the estimated developmental benefits and incremental income are then compared with the incremental program costs in order to determine the net benefits. There are methodological issues raised by both of these approaches. The percentages used in the California study to scale the benefits observed in targeted benefits may not be accurate. The private willingness to pay for high-quality child care used in the Canadian study may not accurately reflect the developmental benefits of a universal program. And the incremental income that women will earn may overstate the value that they realize (the maximum amount they would be willing to pay) for the increased employment opportunity. There can be a significant opportunity cost in their going to work that needs to be taken into account. Critics of universal programs argue that there is little evidence that children from medium- or low-risk families, or who would otherwise be cared for in extended family or other high-quality informal arrangements, will significantly benefit from formal child care.13 They also raise concerns about the distributional impacts that a universal program can have in transferring disposable income from taxpayers in general who fund the program to a disproportionate number of well-off families who would benefit from it. The benefit-cost analysis of universal programs does not resolve this important public policy question, nor, as stated at the outset of this book, should it. However, it does highlight the key issues and can point to potential common ground even in a highly charged debate. There may be, for example, no agreement on whether government should pursue only targeted programs, as opposed to universal programs. However, there are good reasons to support any introduction of universal programs in a targeted way, with the development of new child-care capacity in those neighbourhoods having more high-risk children, and with participant subsidies concentrated, if possible, on lower income families (families who could not otherwise afford high-quality care). Benefit-cost analyses of other social and educational programs follow a similar approach to that of the child-care studies. A recent example is a benefit-cost analysis of intensive private foster-care services in the U.S. Pacific Northwest.14 The basic approach and challenge was to identify long-term differences in participant versus non-participant educational, social, medical, and economic behaviour or outcomes. The implications of those differences for public service costs, third parties,

The Basic Concepts

19

and the participants themselves or their families, and therefore the amounts they could in principle allocate to such programs and be no better or worse off, are used to value the observed outcomes in relation to the incremental program costs.

NOTES 1 With standing refers to those interests and values that are considered to be relevant in the policy debate. While it would generally include the interests and values of everyone within the jurisdiction, there are obvious instances where this would not be the case. One would not consider, for example, the preferences of thieves in a benefit-cost analysis of crime-prevention programs. Nor would you include the value or willingness to pay that addicts place on their addictive behaviour in a benefit-cost analysis of alcohol and drug abuse programs. It is important to be clear in analyses of issues such as these on what and who is and is not considered to have standing. Standing in effect establishes the social, moral, and/or legal frame of reference under which the study is being conducted. For a more detailed discussion see R. Zerbe and A. Bellas, A Primer for Benefit-Cost Analysis (Northampton, MA: Edward Elgar, 2006), chapter 3. 2 The significance of existence values was raised in a classic article by John Krutilla: ‘Conservation Reconsidered,’ American Economic Review 57, no. 4 (September 1967): 777–86. He argued for the preservation of natural, irreplaceable environments because of, among other important reasons, people’s desire to bequest an appropriate mix of public and private assets to future generations. An early attempt to measure existence values, distinct from other values generated by wilderness areas, was made by R. Walsh et al., ‘Valuing Option, Existence and Bequest Demands for Wilderness,’ Land Economics 60, no. 1 (1984): 14–29. 3 For a discussion of the regulatory and legal significance of existence values, and the measurement issues they raise, see P. Portnoy, ‘The Contingent Valuation Debate: Why Economists Should Care,’ Journal of Economic Perspectives 78, no. 3 (1994): 3–17. See also G. Blomquist and J. Whitehead, ‘Existence Value, Contingent Valuation and Resource Damages Assessment,’ Growth and Change 26, no. 4 (1995): 573–89, who argue that best available estimates of existence values are needed to inform public debates. 4 See B. Weisbrod, ‘Collective Consumption Services of Individual Consumption Goods,’ Quarterly Journal of Economics 78, no. 3 (1964): 71–7. In this

20

5

6

7

8

Multiple Account Benefit-Cost Analysis seminal article Weisbrod points out that option value can arise not only for wilderness areas but also for facilities and services like hospitals and transit, where supply cannot immediately adjust to demand if facilities and systems are not already in place. Option value is like a willingness to pay for standby facilities that may or may not be required but would be severely missed if not available when needed. Ex ante willingness to pay, or option price, refers to the value a person places on the availability of a service or an amenity given the range of possible circumstances and uses he or she may have for it. The ex post expected value is a weighted average of the different values the person would place on the service or amenity under every possible circumstance and use, with the values weighted by the probability of each circumstance and use occurring. The difference between the two, the option value, will be positive when the purchase acts as an insurance or a hedge against uncertain future events. For a technical discussion see R. Bishop, ‘Option Value: An Exposition and Extension,’ Land Economics 58, no. 1 (February 1982): 1–15. See also A. Boardman et al., Cost-Benefit Analysis: Concepts and Practice, 3rd ed. (Upper Saddler River, NJ : Prentice Hall, 2006), chapter 8. The term quasi-option value was coined in a seminal article by K. Arrow and A. Fisher, ‘Environmental Preservation, Uncertainty and Irreversibility,’ Quarterly Journal of Economics 88, no. 2 (May 1974): 312–19, in which they argue that a quasi-option value arises when the expected benefits available in a future period are affected by actions taken in the first period. See also J. Conrad, ‘Quasi-Option Value and the Expected Value of New Information,’ Quarterly Journal of Economics 94, no. 4 (June 1980): 813–20, who linked this concept to the expected value of information; and A. Boardman et al., Cost-Benefit Analysis, chapter 7. See A. Boardman et al., Cost-Benefit Analysis, 68–9. For a technical discussion, see J. Bergstrom, ‘Concepts and Measures of the Economic Value of Environmental Quality: A Review,’ Journal of Environmental Management 31, no. 3 (1990): 215–28. It is what economists call a Hicksian demand curve, as opposed to a Marshallian demand curve, that correctly indicates the compensating variation. A Hicksian demand curve indicates the quantity demanded at any given price, holding real income constant. It traces out a pure substitution effect (the change in the demand for a good associated with a change in price because it is relatively more or less expensive than other goods). A Marshallian demand curve indicates the quantity demanded at any given price, holding nominal income constant. It includes an income effect (the change in the demand for a good associated with a change in price because of the

The Basic Concepts

9

10

11

12 13

14

21

change in real income that occurs as the price of any good increases or decreases). See A. Boardman et al., Cost-Benefit Analysis, 66–8. More carefully stated, under ideal market conditions no more of any one good could be produced without reducing the output of other goods, and no reallocation of resources (or change in the mix of output) could be made that would increase the welfare of some people without adversely affecting the welfare of others. See L. Karoly et al., Investing in Our Children: What We Know and Don’t Know about the Costs and Benefits of Early Childhood Interventions (Rand Corporation, 1998); J. Curry, ‘Early Childhood Education Programs,’ Journal of Economic Perspectives 15, no. 2 (2001); R. Lynch, Exceptional Returns: Economic Fiscal and Social Benefits of Investment in Early Childhood Development (Washington, DC: Economic Policy Institute, 2004). L. Karoly and J. Bigelow, The Economics of Investing in Universal Preschool Education in California (Rand Corporation, 2005); G. Cleveland and M. Krashinsky, The Benefits and Costs of Good Child Care: The Economic Rationale for Public Investment in Young Children (Toronto: Childcare Resource and Research Unit, University of Toronto, 1998). L. Karoly and J. Bigelow, The Economics of Investing in Universal Preschool, table 3.2, 94–5. J. Richards and M. Brzozowski, ‘Let’s Walk Before We Run: Cautionary Advice on Childcare,’ C.D. Howe Institute Commentary, no. 237, August 2006. R. Zerbe et al., ‘Benefits and Costs of Intensive Foster Care Services: The Casey Family Programs Compared to State Services,’ Contemporary Economic Policy 27, no. 3 (2009): 308–20.

2 Multiple Account versus Traditional Benefit-Cost Analysis

Limitations of Traditional Benefit-Cost Analysis The basic objective of traditional benefit-cost analysis is to determine whether the value of what a project or policy provides, as measured by what people are willing to pay, exceeds the compensation that must be made to people for them to willingly incur or accept the costs of the project. When the total willingness to pay for the outputs or positive consequences exceeds the total compensation required to offset the costs, the proposed project or policy is said to offer positive net benefits. That does not mean that everyone is necessarily better off. There can be both winners and losers. A finding of positive net benefits simply means that the benefits to those who are better off are greater than the costs to those who are worse off. There is a Potential Pareto Improvement, an economic concept focused on overall net benefits (as explained in the text box below). Another way to express the basic objective of benefit-cost analysis is that it serves to determine whether a proposed project or policy will offer a Potential Pareto Improvement or, where there are a number of alternatives, to determine which will offer the greatest possible Potential Pareto Improvement. In common language, it serves to determine whether a project or policy will increase the ‘size of the pie.’ How that pie is distributed is a separate matter. The general assumption is that adverse distributional impacts can be addressed with appropriate compensatory policies or an appropriate mix of projects. A larger pie, however, means that everyone could in theory be better off. The more zealous proponents of benefit-cost analysis would argue that by identifying the projects or policies that offer Potential Pareto

Multiple Account versus Traditional Benefit-Cost Analysis

23

Potential Pareto Improvement A Pareto Improvement is defined in economics as a change resulting in at least one person being better off and no one being worse off. It arguably would constitute an unambiguous improvement in that no one is worse off. However, most projects and policies have both winners and losers; opportunities for Pareto Improvements are limited. The concept of Potential Pareto Improvement (also known as the Kaldor-Hicks criterion, based on the famous British economists who first proposed it) was developed to attempt to determine if a project or policy would offer net benefits overall, leaving aside the issue of how the benefits and costs would be distributed. Improvements, or the greatest possible Potential Pareto Improvement, benefit-cost analysis determines what should be done. There is, however, no moral, technical, or other justification for such assertions. Distributional or Equity Issues A Potential Pareto Improvement suggests that those who benefit could compensate the losers and still be better off. However, it does not mean that the losers will in fact be compensated or that compensatory measures will be undertaken. Indeed, it is precisely when compensation is not made that one has only a potential, as opposed to an actual, Pareto Improvement. As long as there are losers – people who are worse off as a result of the project – one cannot conclude that the project or policy should be undertaken. Explicit consideration of the number and circumstances of those who lose and the nature and effectiveness of planned compensatory measures would be required before that judgment could be made. Some benefit-cost analysts advocate assigning weights to the benefits and costs to provide a measure of total social welfare, with the overall net benefits taking the relative significance or utility of each dollar of benefit and cost into account. On the widely held assumption that the greater a person’s income, the less significant is a dollar of benefit or cost, less weight would be assigned to benefits and costs accruing to higher, as compared to lower, income groups. There is, of course, a problem in determining exactly what the weights should be in such

24

Multiple Account Benefit-Cost Analysis

analyses. More important, a finding that income-weighted net benefits are positive does not mean that everyone is better off. There still could be adverse distributional consequences (even for the more highly weighted lower income groups) that would need to be considered in the policy deliberations. Theoretical economists would add that there is a more fundamental problem here. A finding of positive net benefits does not necessarily mean that it would be possible for the winners to compensate the losers and still be better off. When compensation is made, people’s income or purchasing power changes, and that in turn can affect the values that people assign to the benefits and costs, that is, their willingness to pay or their compensation demanded. A project or policy that appears beneficial overall before compensation is paid to the losers may not be so after it is paid.1 It is generally assumed that any changes in the valuation of goods and services due to the payment of compensation would be relatively minor. However, they could occur and be significant, particularly when there are major impacts on different groups with significantly different incomes and preferences. Under such circumstances, it is theoretically impossible to separate analyses of the size of the pie from how it is distributed. With relative prices or values dependent on how benefits and costs are shared, there is no constant yardstick to measure the magnitude of benefits and costs.2 Philosophical Concerns Benefit-cost analysis relies on individual preferences – the trade-offs people would willingly make – to measure the benefits and costs of different projects or policies. However, individual preferences can be illinformed, ephemeral, or myopic. Furthermore, they are dependent on the distribution of income, which can result in the whims of the wealthy having greater weight than the basic needs of the poor. Some critics of benefit-cost analysis argue that individual preferences should not be used to govern public policy. They note that the preferences or choices people exhibit are based on perceptions and social and political influences, all of which can change. Preferences, they argue, are not fixed or uniquely defined, but rather are endogenous, dependent on a wide range of contextual circumstances, and they evolve over time.3 The question thus arises: what or whose preferences should be used to measure value? Should they be based on incorrect perceptions or

Multiple Account versus Traditional Benefit-Cost Analysis

25

knowledge, even if widely held, or on the best available science? Should they reflect the preferences that people exhibit as private consumers or that they exhibit as public citizens (it is argued that these can be quite different)?4 Should they be adjusted or constrained by certain social standards of equity, including consideration of the interests of future generations, or should they just reflect the interests and values of the current generation (with whatever weight the current generation gives to the future) and the existing distribution of income? It is true that individual preferences govern the allocation of resources made in free market economies, and, by using individual preferences to indicate value, benefit-cost analysis is simply trying to determine what resource allocation decisions would be made if free markets fully and accurately took individual preferences into account. Critics, however, challenge the legitimacy of the market model, especially when it is applied to environmental, social, and other non-market concerns.5 In short, the preferences that free markets efficiently meet and that benefit-cost analysis tries to discern may not be consistent with the values or standards that some people believe should be considered and applied in public policy matters. They would argue that values should not simply be estimated on the basis of observed or stated willingness to pay (or compensation demanded); they should be carefully considered and debated. The goal of public policy, as one critic stated, should be to educate and elevate preferences, not simply to satisfy the preferences that prevail at any point in time.6 Empirical Limitations To measure the relative value or significance of different benefits and costs, benefit-cost analysis uses dollar estimates of the trade-offs that people would willingly make. That does not mean benefit-cost analysis is only concerned with the consequences that have market prices or commercial value. Many of the most important consequences considered in benefit-cost analysis – for example, impacts on the environment or life expectancy – are not bought and sold at market-determined prices, nor are they valued solely for commercial purposes. The amount of dollars that a person is willing to pay for a benefit indicates the total amount of purchasing power – the total amount of other goods or opportunities – that the person is willing to forgo in order to acquire the benefit. Similarly, the amount of dollars that a person must be compensated indicates the incremental purchasing power that

26

Multiple Account Benefit-Cost Analysis

the person would require as a trade-off for providing the labour or other inputs or for willingly accepting the negative consequences. The dollars themselves are just a convenient unit of measurement. They are used to indicate the relative values of different consequences, relative values that can be summed and compared in order to calculate whether and to what extent alternative projects or policies yield positive net benefits overall. The empirical problem, however, is in trying to estimate what these dollar measures of value in fact are. In many instances, the individuals’ willingness to pay for benefits, or the compensation required to offset costs, cannot be readily inferred from observable behaviour, nor can it be reliably estimated from survey or other means. This is particularly the case in the benefit-cost evaluation of environmental and social attributes that people do not generally consider in relative value terms. Resource allocation decisions still have to be made, and ultimately, where resources are scarce, trade-offs have to be made. However, estimating the trade-offs that people would willingly make can be very difficult. The Role of Benefit-Cost Analysis in Public Policy Debates It is a mistake to suggest that benefit-cost analysis can determine what projects or policies should be undertaken. As discussed above, benefitcost analysis is silent on distributional consequences. It ignores the income and context dependence of individual preferences and does not in general question their legitimacy. It presumes that preferences can be reliably estimated in monetary terms. Nevertheless, it is also wrong to suggest that benefit-cost analysis cannot play an important role in public policy debates. Despite its limitations, benefit-cost analysis is widely recognized as potentially a very valuable tool in the evaluation of government regulations, projects, and policies. The scope of a benefit-cost analysis appropriately takes everyone into account. There is a transparent, objective basis for valuing impacts, consistent with the fundamental principles of decentralized market economies.7 Subject to who is defined to have standing in the analysis, it is the preferences of all those who are affected that governs the valuations, not those of the analyst or any particular advocacy group. Increasingly sophisticated techniques have been developed and refined to estimate or provide some perspective on the relative value or significance of the

Multiple Account versus Traditional Benefit-Cost Analysis

27

different types of consequences that must be addressed.8 Formal guidelines have been issued and updated to promote the consistent, methodologically correct application of benefit-cost concepts and techniques.9 If one accepts that individual preferences do matter, then it is appropriate and necessary to consider what they imply for alternative courses of action. That is what benefit-cost analysis can do in a systematic way. It can inform public policy debates about the benefits and costs of alternative projects or policies based on the trade-offs that all affected individuals would make. There may be reasons to discount those preferences or question the estimates made to represent them. However, a carefully prepared benefit-cost analysis will challenge advocates and decision makers alike to take account of the values and preferences of all of the affected parties, as best as those values and preferences can be understood. As S. Farrow and M. Toman concluded in their assessment of these issues, benefit-cost analysis ‘can provide a disciplining element which forces all sides in a policy debate to more carefully consider, in a world of inherently limited resources, what is gained and what is given when making a decision … There are practical and methodological limits to what can be done with benefit-cost analysis … yet without such a disciplining framework it is much more difficult to challenge the assertions of partisans about the benefits and costs of policies and regulations.’10 Just as there may be limitations in relying on individual preferences to guide policy, there certainly can be problems in relying solely on the views and preferences of political, advocate, or other elites. Those views and preferences can differ from one another and from those of society as a whole. They can impose values that are not widely shared or consistent with other decisions that individuals and governments make. Improving on Benefit-Cost Analysis with a Multiple Account Approach The basic premise of traditional benefit-cost analysis is that one can measure, in dollar terms, the values or preferences that individuals have with respect to the different consequences of alternative projects or policies, and then aggregate those individual values or preferences into an overall bottom line – the total net benefit or cost of each alternative from the perspective of society as a whole. The calculation of an overall bottom line is appealing because it enables a very simple assessment and ranking of alternatives. It answers the question, for each alternative, of whether the estimated benefits

28

Multiple Account Benefit-Cost Analysis

exceed the costs, whether there are positive net benefits, and it indicates which of the alternatives offers the greatest amount of net benefits. Multiple account benefit-cost analysis, however, takes a different approach. As summarized in table 2.1, it does not assume that all values or preferences can or should be measured in dollar terms and then aggregated. It recognizes that some, particularly environmental, social, and other non-market values, may be too conceptually or empirically difficult to monetize. Quantitative physical measures or qualitative summaries of impact may be more meaningful than monetary estimates of the trade-offs people would willingly make, where those estimates could be unreliable or unstable. Furthermore, multiple account benefit-cost analysis recognizes that it is not necessary or even beneficial in all cases to aggregate individual values or preferences into an overall bottom line summary of net benefit.11 Multiple account benefit-cost analysis is based on the premise that the role of benefit-cost analysis is to focus and inform, not resolve, public policy debates. As R. Morgenstern points out in his review of the application of economic analysis at the U.S. Environmental Protection Agency, benefit-cost analysis can best serve as an accounting framework rather than a decision-making criterion. It provides clear and consistent principles for identifying and assessing or measuring benefits and costs. Recognizing benefit-cost analysis as an accounting framework, he suggests, was the intention of the Clinton executive order stating that benefit-cost analyses of proposed regulations should be undertaken to assess whether the benefits justified the costs, which was a matter of judgment and debate that could only be informed by the analysis. The earlier Reagan order had stated that benefit-cost analyses must be undertaken to determine if the benefits exceeded the costs, a more straightforward computational question that was answered by the analysis.12 When the goal is to inform, the need for an overall bottom line disappears. Indeed, it often is not even desirable. A single summary measure of overall net benefit can mask important information about the nature and distribution of the benefits and costs. More fundamentally, it can do a disservice by implying which alternative is best or what unequivocally should be done. In multiple account benefit-cost analysis an evaluation framework is established that enables the consistent, systematic identification and assessment of the different types of benefits and costs arising from project or policy alternatives. The evaluation framework consists of a set of evaluation accounts, with monetary or other indicators used to assess

Multiple Account versus Traditional Benefit-Cost Analysis

29

Table 2.1 Traditional vs multiple account benefit-cost analysis Traditional

Multiple account

Scope

Positive and negative consequences for everyone with standing

Positive and negative consequences for everyone with standing

Basis for valuation

Values/preferences of affected persons

Values/preferences of affected persons

Measurement/ Dollar estimates of willingness to indicators of pay for positive consequences; value compensation demanded to offset negative consequences

Dollar estimates of willingness to pay and compensation demanded or physical/descriptive measures of impact and significance where more reliable or appropriate

Results

Bottom line: overall net benefit, qualified as required for nonquantified effects

Matrix summary: net benefit or indicator of extent and significance of consequences under each evaluation account

Purpose

To identify preferred alternative, subject to qualifications; to help resolve debate

To identify relative advantages and clarify key trade-offs; to help inform debate

relative value or significance for the affected parties. This includes accounts and indicators capturing the consequences for governments and the taxpayers they represent, for consumers or direct beneficiaries of the goods and services that are provided, for workers and businesses whose opportunities and incomes are affected, and for environmental and social goods and services or attributes that are affected. The measures in some accounts will be the same as those used in traditional benefit-cost analysis – dollar estimates of the willingness to pay for the positive consequences, and dollar estimates of the compensation required to offset the negative consequences. However, for other accounts physical or qualitative indicators may be used because of the conceptual or empirical limitations with monetary measures.13 In the end, multiple account benefit-cost analysis produces a matrix summary of consequences, some monetary, some not, to describe the advantages and disadvantages of the different alternatives being invstigated. Like traditional benefit-cost analysis, multiple account benefit-cost analysis is intended to take into account the consequences for all those who are affected, and to assess the magnitude or significance of those consequences on the basis of the values held by the affected individuals.

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Multiple Account Benefit-Cost Analysis

There is no bottom line, but trade-offs can be identified, and critical values – what an impact would have to be worth for a particular alternative to be favoured – can be calculated. The goal is to inform in a clear and consistent way the implications and relative merits of the different alternatives, and the nature of the trade-offs entailed. Summary • The basic objective of traditional benefit-cost analysis is to determine whether and to what extent the total benefits exceed the total costs. However, a finding of positive net benefits does not mean that a project or policy should be undertaken. There are a number of limitations to traditional benefit-cost analysis that need to be recognized. • Positive net benefits overall do not mean that everyone is better off. Benefit-cost analysis is silent on the distribution of the benefits and costs, and distributional consequences typically need careful consideration in any policy debate. • The relative values used to weight different consequences in benefit-cost analysis are based on the trade-offs that individuals would willingly make. These values, however, can be income and context dependent. They need not reflect the best available science; in the eyes of some they may be myopic. • Even if one accepts the validity of relying on the trade-offs that people would willingly make to determine values, these trade-offs can be very difficult to estimate. There are significant empirical limitations, especially for some of the environmental, social, and other non-market consequences that are often central in the analysis. • While there are limitations, it would be wrong to suggest that benefit-cost analysis cannot play a useful role in public policy debates. It is a widely recognized, transparent, and objective evaluation tool. It is consistent with the fundamental principles of decentralized market economies. It challenges advocates and decision makers to take into account the consequences for everyone affected and their preferences with respect to those consequences. • Some of the most significant problems with traditional benefit-cost analysis are avoided with a multiple account approach. Once one recognizes that the goal of the analysis is to inform, not resolve, public policy debates, there is no need or indeed advantage to

Multiple Account versus Traditional Benefit-Cost Analysis

31

calculating an overall bottom line. Not all consequences have to be monetized and aggregated. • In multiple account benefit-cost analysis an evaluation framework is established with different accounts and indicators. Monetary measures are used for some of the accounts, but in others, where monetary measures would not be reliable or broadly accepted, physical indicators or descriptions of impact and their significance may be used. • Multiple account analysis produces a matrix summary of results. The objective is to determine advantages and disadvantages and to identify key trade-offs and critical values – what different consequences would have to be worth in order to favour one alternative over another.

CASE STUDY Lower Gordon River Hydroelectric Project In the late 1970s the Tasmanian Hydroelectric Commission proposed developing the Lower Gordon River (‘Gordon-below-Franklin’) hydroelectric project to meet growing electricity requirements in that Australian state. It was a very controversial proposal. The project would have resulted in the flooding of a large, remote region of southwestern Tasmania that was recognized internationally as a very important and unique wilderness area. In the early 1980s southwestern Tasmania was included in the UNESCO World Heritage list of wilderness areas.14 While there were some recreational activities and other use values that would have been affected by the project, the major issue was the existence value that would be lost – the increasingly scarce and irreplaceable environmental attributes of that remote region that some people wanted to preserve for present and future generations. Tasmanians were sharply divided on the merits of the Lower Gordon River project. Many supported the position of the hydroelectric commission that the project was needed to meet growing requirements in a cost-effective way and, in so doing, would enable the growth of electric-intensive industry and employment in the state. Others argued that electricity requirements and employment benefits were overstated and that there were alternative, less environmentally damaging sources of supply that the commission could develop when required.

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It would have been very difficult to estimate reliably the existence value that Tasmanians and others held in relation to the environmental attributes threatened by the project. Moreover, in the context of the very charged and divisive political debate taking place at the time, any effort to estimate people’s aggregate willingness to pay to preserve those attributes would have been challenged for all of the philosophical and empirical reasons that are raised in opposition to the estimation of complex, irreplaceable environmental values in dollar terms. Nevertheless, benefit-cost analysis was still useful in providing some perspective to the principal trade-off involved. The basic approach taken in a study of the proposed development by Saddler et al. was to estimate the critical value for the wilderness values that would be lost if the Lower Gordon River project were developed.15 The incremental cost of pursuing the best alternative source of electricity supply was estimated, and then the annual value that the wilderness resources would have to offer – what people would have to be willing to pay per year to avoid the loss or diminution of the wilderness resources impacted by the Lower Gordon River project – was determined. In calculating the incremental cost of alternative sources of supply, the Saddler study considered the impact that higher cost supply could have on the total amount of the electricity requirements that the hydroelectric commission would have to meet. Higher cost alternatives would raise rates, and that in turn would reduce the amount of electricity requirements that would have to be met, particularly in the pricesensitive industrial sector. The incremental cost of pursuing higher cost alternatives was consequently measured, not simply by the difference in cost between the Lower Gordon River and the best alternative source of supply, but rather, as illustrated in figure 2.1, by the sum of the higher costs of supply for that amount of electricity that would still be demanded at the higher rate (A), plus the net benefit that consumers would forgo for that amount of electricity that would no longer be demanded because of the higher rates – the consumer surplus that would be forgone (B).16 The Saddler study noted that this measure of the incremental cost was smaller than that indicated by the difference in supply costs alone. In the context of the debate taking place in Tasmania and elsewhere in Australia, this in turn suggested that what people would have to be willing to pay to avoid the loss of the wilderness values threatened by the Lower Gordon River project – the critical wilderness value – was less than what others had stated.

Multiple Account versus Traditional Benefit-Cost Analysis

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Figure 2.1: Impact of higher cost supply price D C1 C0

A

B

A B C0 C1 DD

= = = = =

higher cost of electricity supply forgone consumer surplus cost/price of electricity without project cost/price of electricity with project demand curve for electricity

D

q1 q0

quantity

In order to bring some perspective to the critical wilderness value, the Saddler study followed the methodology that had been applied by Fisher et al. in an analysis of a similar trade-off between hydro development and the preservation of the Hell’s Canyon area on the Snake River in the U.S. Pacific Northwest.17 The Saddler study specifically considered the likelihood that scarce, irreplaceable environmental attributes and resources would increase in real value over time. As discussed in chapter 6 herein, this effectively lowered the discount rate applied to the ongoing stream of benefits that preservation would provide. The Saddler study calculated that with its mid-range assumptions the critical or threshold value for the wilderness values affected by the Lower Gordon River project was in the order of $725,000 per year. That was the annual amount that Tasmanians (or others) would have to be willing to pay in order for the preservation benefits to equal the electricity benefits offered by the hydro development. Whether Tasmanians (or others) would in fact be willing to pay that amount to preserve the Lower Gordon River area, Saddler concluded, would ultimately have to be judged by the decision makers. The study was not a fully developed multiple account analysis; there were in effect only two evaluation accounts – the incremental costs of electricity supply (including forgone consumer surplus) and the impact on the wilderness area. Nevertheless, it illustrates the basic principles of multiple account benefit-cost analysis – focused more on informing the debate about the key trade-off and critical value rather than on calculating a bottom line.

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NOTES 1 A change in the ranking of options due to the payment of compensation (for example, where undertaking a project would be preferred before compensation was paid to the losers, but not undertaking the project would be preferred after compensation was paid) is called a Scitovsky reversal. The possibility of such reversals was first recognized in the classic article by T. Scitovsky, ‘A Note on Welfare Propositions in Economics,’ Review of Economic Studies 9, no. 1 (November 1941): 77–88. 2 For a discussion of the general measurement problem posed by changing relative prices see J. Gowdy, ‘The Revolution in Welfare Economics and Its Implication for Environmental Valuation and Policy,’ Land Economics 80, no. 2 (May 2004): 239–57. 3 See T. Brown, ‘The Concept of Value in Resource Allocation,’ Land Economics 60, no. 3 (August 1984): 231–46, for a discussion of the role of context in determining manifest or assigned values. See J. Gowdy, ‘The Revolution in Welfare Economics,’ for a discussion of the endogenous nature of values and the limitations in conventional assumptions about preferences. 4 M. Sagoff, ‘Should Preferences Count,’ Land Economics 70, no. 2 (May 1994): 127–44. 5 See P. Soderholm and T. Sundquist, ‘Pricing Environmental Externalities in the Power Sector: Ethical Limits and Implications for Social Choice,’ Ecological Economics 96, no. 3 (2003): 337–50, for a discussion of the role of political discourse and moral considerations in the formation of values; and A. Vatn and D. Bromley, ‘Choices without Prices without Apologies,’ Journal of Environmental Economics and Management 26, no. 2 (1994): 129–48, for a discussion of the complexity of environmental and ecosystem attributes that can limit the relevance of individual preferences. 6 M. Sagoff, ‘Should Preferences Count.’ 7 R. Sugden points out that benefit-cost analysis tries to simulate the resource allocation decisions that the free market would generate in ideal market conditions (absent market failures). Context-dependent preferences are not a problem per se but rather a fact of life, affecting many of the decisions or choices people make. That may affect how one should define and estimate individual preferences but not the importance of considering them in public policy debates. See R. Sugden, Cost-Benefit Analysis as Market Simulation (Washington, DC: Resources for the Future, Discussion Paper 07-28, July 2007). 8 For a defence of benefit-cost analysis and a discussion of best practices, see R. Kopp et al., Cost-Benefit Analysis and Regulatory Reform: An Assessment of

Multiple Account versus Traditional Benefit-Cost Analysis

9

10

11

12 13

14

15

16

35

the Science and the Art (Washington, DC: Resources for the Future, Discussion Paper 97-19, January 1997). See also R. Morgenstern, ed., Economic Analysis at EPA: Assessing Regulatory Impact (Washington, DC: Resources for the Future, 1997), and K. Arrow et al., ‘Is There a Role for Benefit-Cost Analysis in Environmental, Health and Safety Regulation,’ Science 272 (April 1996): 221–2. Canadian government guidelines are presented in Federal Treasury Board, Canadian Cost-Benefit Analysis Guide (2007). United Kingdom guidelines are presented in HM Treasury, Green Book: Appraisal and Evaluation in Central Government. In the United States both the Environmental Protection Agency and the Office of Management and Budget have issued benefit-cost guidelines: EPA, Guidelines for Economic Analysis (September 2000), and OMB, Circular A-4 (September 2003). The Organisation for Economic Co-operation and Development has also published a guide on recommended practices, particularly with respect to environmental issues: D. Pearce et al., CostBenefit Analysis and the Environment (Paris: OECD, 2006). S. Farrow and M. Toman, Using Environmental Benefit-Cost Analysis to Improve Government Performance (Washington, DC: Resources for the Future, Discussion Paper 99-11, December 1998): 11. As A. Sen argues, monetization and aggregation is not necessarily the best way to inform major environmental or other policy debates. The relevant social choice problem can lie ‘buried in aggregate statistics.’ See A. Sen, ‘Economic Evaluation and Social Choice: Contingent Valuation and the Market Analogy,’ Japanese Economic Review 46, no. 1 (March 1995): 23–37. R. Morgenstern, ed., Economic Analysis at EPA, 10–12. For a discussion of the use of a disaggregated approach to address some of the limitations of benefit-cost analysis, see M. Toman, Sustainable DecisionMaking: The State of the Art from an Economic Perspective (Washington, DC: Resources for the Future, Discussion Paper 98-39, June 1998). For background on the project and the controversy it generated see H. Bandler, ‘Gordon Below Franklin Dam, Tasmania, Australia: Environmental Factors in a Decision of National Significance,’ The Environmentalist 7, no. 1 (1987): 43–54. See H. Saddler et al., Public Choice in Tasmania: Aspects of the Lower Gordon River Hydro-Electric Development Proposal (Canberra: Australia National University Centre for Resource and Environmental Studies, 1980). As discussed in chapter 4, consumer net benefit or consumer surplus equals the difference between the maximum amount that people would be willing to pay and the amount they would have to pay for the good in question.

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Multiple Account Benefit-Cost Analysis

17 A. Fisher et al., ‘Alternative Uses of Natural Environments: The Economics of Environmental Modification,’ in Natural Environments: Studies in Theoretical and Applied Analysis, ed. J. Krutilla (Washington, DC: Resources for the Future, John Hopkins University Press, 1972).

3 Evaluation Accounts

Origins of Multiple Account Analysis Traditional benefit-cost analyses often recognize that some impacts are difficult to value in dollar terms. Typically such impacts are either incorporated into the analysis with highly qualified estimates or simply left non-monetized. It is also generally understood that the net benefit or efficiency of different alternatives does not address equity, the distribution of the benefits and costs. Even income-weighted benefit-cost results, which are rare in practice, do not reveal the distributional consequences; they simply incorporate one aspect of the distribution of the benefits and costs (the greater significance of a dollar of impact on low income groups as compared to higher income groups) into the estimated single bottom line.1 Multiple account evaluation frameworks were originally developed to recognize more formally and systematically the non-monetized impacts of different alternatives and their major distributional consequences. Instead of being the often ignored qualifications of the analysis, the non-monetized impacts and distributional consequences were central elements of the evaluation process. The U.S. Water Resources Council, mandated under the 1965 Water Resource Planning Act to advise Congress on the economic, environmental, and social consequences of alternative water projects, was one of the first U.S. government agencies to develop formal multiple account evaluation guidelines.2 The council developed the guidelines to assist federal water resource agencies in their evaluation of alternative water projects, in accordance with the objectives and criteria that the council was required to consider.

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Multiple Account Benefit-Cost Analysis

The guidelines set out four evaluation accounts: • National Economic Development: This account addressed a primary objective of Congress – contribution to national economic welfare. It measured the net value of all of the goods and services that the project would provide, including not only those goods and services like power production or irrigation that can be valued directly with market prices but also goods and services like recreational opportunities for which values must be imputed based on behavioural studies or survey estimates. • Environmental Quality: This account documented all of the significant impacts on natural and cultural resources that cannot be reliably or acceptably monetized and taken into account in the national economic development account. • Regional Economic Development: This account addressed the income, employment, and other economic development impacts on specific regions or states. • Other Social Effects: This account documented other relevant effects raised or identified in the planning process that were not captured in the other accounts. The principal objective that Congress directed this federal agency to consider was national economic development. The council was charged with identifying projects that would provide the greatest contribution to national economic development or that, in the language of traditional benefit-cost analysis, would maximize total net benefits. However, the act also required that water resource projects be consistent with protecting the environment and recognize state and local interests and concerns. The environmental quality account was developed to ensure that the council’s recommendations would be governed not simply by measurable net benefits but by measurable net benefits subject to explicit consideration of non-monetized environmental effects. The regional economic development and the other social effects accounts were developed to be sensitive to local and state concerns. Multiple account analyses do not generally point to an unequivocally preferred alternative, one that is better than the alternatives under all accounts. There is, therefore, no simple mechanical process to identify the one alternative to recommend. Recommendations have to be based on a careful consideration of the multiple account results, that is, the performance of each alternative under each evaluation account. The U.S. water resource guidelines required that agencies start first with the

Evaluation Accounts 39

national economic development account and then systematically consider the other accounts. The guidelines stated that the recommended federal plan should be the one that maximized measurable net benefits, provided it was consistent with protecting the environment and unless, in the opinion of the secretary of the department or the head of the agency, there were overriding reasons for recommending another plan. In effect, the environmental account provided a screen through which the recommended alternatives had to pass, and the regional economic development and the other social effects accounts provided the distributional and other impact information that could justify an alternative if the advantages in these accounts were explicitly deemed to be greater in value than the forgone national net benefits. In Canada one of the first agencies to develop and apply a multiple account evaluation framework was the Department of Fisheries and Oceans (DFO). Drawing on the work of the U.S. Water Resources Council, it developed a five-account framework to evaluate salmonid enhancement projects. The accounts were specifically designed to enable government to make informed decisions on hatchery, habitat improvement, and other salmonid enhancement alternatives, taking into account the consequences not only for measurable net benefits but also for other important objectives of government.3 Following are the five accounts in DFO’s evaluation framework: • National Income: Much like the U.S. Water Resource Council’s national economic development account, DFO’s national income account indicated the net value of all of the benefits and costs measurable in dollar terms. This included the net value of the incremental salmon production that a project would generate in commercial, sports, and aboriginal fisheries (the primary purpose of the program), as well as the net value of the other impacts that a project might have (for example, flood control). • Regional Development: This account was designed to indicate the implications for small coastal communities. A rating system was used to summarize the benefits that small communities would realize from different projects based on the size and distribution of the incremental salmon catch and on the socio-economic conditions in the affected communities. • Native People: This account was designed to indicate the implications for aboriginal fishers, workers, and communities. Again a rating system was used to summarize the extent and significance

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Multiple Account Benefit-Cost Analysis

of the impacts on aboriginal catch in commercial and food fisheries, aboriginal employment and investment opportunities, and aboriginal involvement in project design and management. • Employment: This account was designed to measure employment impacts. Projects were ranked based on the amount of employment they would generate and on the estimated extent to which this would result in the employment of persons who would otherwise be unemployed. • Environment: This account was intended to document and rate those environmental consequences not reflected in the national income or other accounts. It included consideration of, for example, impacts on the harvesting of small or unique stocks, use of natural as opposed to artificial enhancement techniques, contribution to broader fisheries and habitat protection goals, competition with natural stocks, and introduction of disease-related risks. The evaluation framework was used in a number of ways. The national income account was used much like traditional benefit-cost analysis to identify projects that were expected to provide significant net economic benefits and that could be recommended on that basis, as well as those that could be rejected because they did not offer significant net economic benefits or offsetting high rankings on the other accounts. Rankings on the other accounts were used to develop different ‘menus’ of projects that would best serve other objectives, for example those that ranked high on the regional development, native, or other accounts. Whether or not the different menus were justified was still very much a matter of judgment, but the multiple account framework facilitated the computation of national income trade-offs – the amount of national income that would be forgone in pursuing these other objectives. This enabled a more informed debate on which projects to undertake and how they should be funded (that is, within which government budget envelopes). For example, program funding from the Department of Indian Affairs was sought in support of projects specifically recommended because of their ranking on the native people account; program funding from the Department of Regional Economic Expansion was sought for projects recommended because of their ranking on the regional development account. The U.S. Water Resources Council and DFO multiple account frameworks extended traditional benefit-cost analysis in two ways. First, they established evaluation accounts to formally take into account

Evaluation Accounts 41

those environmental and social consequences that could not reasonably or reliably be incorporated into a monetized measure of net benefit. Second, they established evaluation accounts to identify and consider impacts on different regions and communities, in particular impacts on regional employment and related economic development. For the most part, these impacts are distributional in nature, focused more on where economic activity takes place than on the total amount of economic activity or value of economic output in the country as a whole. That is why regional employment impacts are not generally considered in traditional benefit-cost analyses. Nevertheless, they are often very important in government decision making. The U.S. Water Resources Council and DFO recognized regional employment and economic development in their account frameworks to ensure that decision makers were systematically informed not only about the extent and nature of these impacts but also, and very importantly from a public policy point of view, about their opportunity cost, that is, the amount of national income or measurable net economic benefits that would be forgone by pursuing them. While these multiple account frameworks improved on traditional benefit-cost analysis by formalizing and making explicit what was often considered in less structured ways (by qualifying results for nonmonetized and distributional effects), they still aggregated market and non-market values in their national income account and did not address all major distributional concerns. More recent multiple account frameworks recommend disaggregating traditional benefit-cost analyses further to deal with these issues. The British Columbia Crown Corporations Secretariat (CCS), a Canadian provincial government agency responsible for monitoring the plans and performance of government-owned corporations, developed a multiple account evaluation framework that British Columbia’s Crown corporations were instructed to use in the evaluation of their proposed plans and projects.4 Two key features in the CCS framework were the separate evaluation of market values from non-market values and of taxpayer interests from other interests. CCS proposed five evaluation accounts: • Government Financial: This account was established to measure the incremental revenues and expenditures of government and the taxpayers it represents. It took into account the revenues and expenditures of the Crown corporation itself as well as any incremental taxes or expenditures of the government as a whole.

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Multiple Account Benefit-Cost Analysis

• Customer Service: This account was established to indicate the net benefits or positive impacts that customers or users of the Crown corporation’s services would realize. • Environment: This account was established to summarize all impacts on the environment, including those that could be measured in dollar terms and those that were more meaningfully or reliably described in physical or qualitative terms. • Economic Development: This account was established to summarize the net benefits that workers and businesses would realize as a result of the project – the incremental income that would be generated because of the employment of persons who would otherwise be unemployed, or the utilization of what would otherwise be underutilized capacity. • Social and Community: This account was established to document the impacts on communities not captured in the other accounts. This multiple account evaluation framework was essentially a disaggregated benefit-cost analysis, separately estimating net benefits or otherwise indicating consequences for taxpayers, consumers, workers, business, the environment, and affected communities. It was specifically designed for Crown corporation or government projects to inform government of the ways in which taxpayers and other interests would be affected and of the trade-offs that might be entailed by different projects or policies. For example, multiple account analyses of public transit service improvements would highlight the benefits to users and the environment in relation to the net costs borne by taxpayers. This could be used to consider not only whether the total benefits were likely to justify the costs but also whether the benefits and costs were appropriately distributed between taxpayers and direct beneficiaries. More recently, a multiple account evaluation framework better suited to private projects and public-private partnerships was developed by University of Queensland economists H. Campbell and R. Brown.5 Focused particularly on the distributional aspects of these projects, Campbell and Brown proposed analysing projects from different perspectives: • Project Perspective: This is intended to provide a market valuation of the project, that is, the net cash flows based on the market prices of all of the outputs and costs of the project.

Evaluation Accounts 43

• Shareholder Perspective: This adjusts the project perspective for taxes and subsidies to the private proponent. It is intended to indicate the amount of the project net benefits (which, with subsidies, could exceed 100 per cent) that the private proponent would capture. • Efficiency Perspective: This adjusts the project perspective for market failures, where market prices do not reflect social benefits or costs. It is intended to indicate the traditional social benefit-cost result. • Referent Group Perspectives: This disaggregates the efficiency results – the total net benefits for society as a whole – to indicate the amount of net benefits accruing to different stakeholder or interest groups (such as taxpayers, workers, and consumers). The results from the different perspectives are designed to assist government in addressing the different questions raised by these types of projects. Does the project make financial sense in terms of its revenues and expenditures? Does the private development or partnership arrangement provide a sufficient or appropriate return to the private parties? Is the project in the public interest, taking all of its effects into account, including those not valued (or not valued correctly) by market prices? How does the project affect taxpayers, workers, and other interests? It is the systematic consideration of all of these questions, Campbell and Brown argue, that will enable government to make better-informed and more consistent decisions on major projects. Multi-criteria Approaches The multiple account frameworks discussed above were designed to incorporate non-monetized and distributional effects more formally into the analysis and to disaggregate the results – something that traditional benefit-cost analysis generally fails to do. They produce, in the end, a matrix summary of results. In recent years there has been considerable interest and development of what are commonly termed multi-criteria or multi-attribute analyses. They too produce a matrix summary of results and have been developed for similar reasons – in particular to describe or assess non-monetized consequences or what some would suggest should be non-monetized consequences in the project or policy evaluation. However, despite the similarities, they are quite different from multiple account approaches to benefit-cost analysis. Proponents of multi-criteria analysis argue that traditional benefit-cost analysis leads to decisions being overly influenced by dollar measures of

44

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net benefit that do not adequately or accurately take into account the diverse and complex impacts on communities and the environment.6 A multi-criteria approach developed for the review of road projects in England illustrates both the concerns about benefit-cost analysis and the steps that were taken to address them.7 Benefit-cost analysis has long been used in England to review road projects in order to ensure that limited government funds are efficiently used. Formal guidelines and benefit-cost computer programs (for calculating time savings, reduced accident risk, and other key impacts of the proposed road projects) were developed in the 1960s for such project evaluations. In the 1970s, requirements for broader environmental impact assessments were developed because of what some felt was the limited scope of benefit-cost analysis. The environmental assessments were intended to be used along with the benefit-cost results and input on local impacts to guide decision making. However, concerns remained about the weight that the environmental and local impact inputs would have. It was not clear whether they would be given the same consideration as the monetized benefit-cost results. In order to elevate the environmental and local impact assessments – to give them the same profile as the benefit-cost results – and more formally integrate the different analyses to enable a clearer and more transparent consideration of the trade-offs, a formal multi-criteria evaluation framework was developed. Five evaluation criteria were established – environment, safety, economic impact, accessibility, and system integration. These in turn were further broken down with a number of sub-criteria to ensure that the full range of issues that needed consideration in road developments was systematically addressed. In a set of guidelines subsequently developed by National Economic Research Associates for the U.K. Department of Transport and Regions more general procedures for the development of multi-criteria analyses were presented.8 Evaluation criteria were to be established based on the specific objectives that the projects or policies were intended to serve. Each criterion had to be measurable or at least capable of being assessed and compared. The performance of each alternative under each criterion could then be analysed and presented in a matrix summary of results. The original multi-criteria approach developed in the United Kingdom for road projects did not recommend weighting and aggregating the assessments under each criterion. It was noted that ‘to do so would implicitly place relative values on the various impacts, even

Evaluation Accounts 45

though a consensus does not yet exist in the UK on what values to apply for environmental impacts.’9 The primary purpose of the framework was to present the results in a way that gave equal prominence to all of the impacts. It would be up to the decision makers to consider the results and resolve any trade-offs indicated. Subsequent guidelines, however, noted that a variety of decision techniques were available to identify preferred options based on the multi-criteria results. Ordinal or cardinal scoring and weighting methods could be used. More complex multi-attribute utility models could be developed and applied. The objective would be to reduce what could amount to a large number of impact indicators to some bottom line, consistent with what was known about the priorities of the decision makers or of the stakeholder interests to which the decision makers would have to respond.10 As stated above, multi-criteria approaches to project and policy evaluation are similar in some respects to multiple account benefit-cost evaluation frameworks. They both respond to concerns about what are or arguably should be non-monetized effects. The nature of the analysis (evaluating the performance of each alternative under each account or criterion) and the presentation of the findings in a matrix summary of results are much the same. However, as summarized in table 3.1, multicriteria analysis is fundamentally different from multiple account benefitcost analysis. Multiple account benefit-cost analysis is an extension of traditional benefit-cost analysis. While broader in scope and more flexible in the valuation of consequences, it is intended to adhere to the basic purpose and principles of benefit-cost analysis – to identify and evaluate the advantages and disadvantages of alternative projects and policies to everyone who is affected, based on the values or preferences held by those affected parties. It simply recognizes that in general this cannot be done with a single bottom-line measure of overall net benefit. Multi-criteria analysis, however, has been developed more as an alternative than an extension to traditional benefit-cost analysis. There is no requirement to consider the impacts on society as a whole; the impacts being analysed are those deemed to be relevant by the stakeholders or decision makers for whom the analysis is being done. In addition, the valuation and weighting of those impacts need not reflect the preferences of all those who are affected; rather they reflect the preferences of those who are participating in or conducting the study and that are implicitly or explicitly defined by the scales and weights used to aggregate the results.

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Table 3.1 Multiple account benefit-cost analysis vs multi-criteria analysis Multiple account benefit-cost analysis

Multi-criteria Analysis

Scope

Positive and negative consequences for everyone with standing

Positive and negative consequences for criteria established in evaluation process

Basis for valuation

Values/preferences of affected persons

Values held or established by participants and stakeholders in evaluation process

Measurement/ Dollar estimates of willingness to indicators of pay and compensation demanded value or physical/descriptive measures of impact and significance where more reliable or appropriate

Indicators or ranking of performance under each criterion

Results

Matrix summary – net benefit or indicator of extent and significance of consequences under each evaluation account

Matrix summary – relative performance under each criterion Bottom line – overall ranking based on weights or decision rules established in evaluation process

Purpose

To identify relative advantages and clarify key trade-offs; to help inform debate

To identify relative advantages and clarify key trade-offs; to help inform debate To engage stakeholders in evaluation process and resolution of trade-offs

For example, a multi-criteria analysis may assess the performance of different options under each criterion, with rating scales from one to ten, and then weight the different criteria in terms of their relative importance. While this can produce overall scores, the values that are assigned to the specific consequences of each alternative (for example, the willingness to pay for whatever is produced, the cost per tonne of air emissions, or the value per job created) will depend on the scales and weights used in that particular analysis and will be difficult, if not impossible, to discern. The problem is that the underlying values for specific consequences are the result, not the driver, of the rating and weighting procss. While multi-criteria or multi-attribute methods can play an important role in the development and assessment of major projects and policies, particularly in stakeholder consultation processes, they are not a

Evaluation Accounts 47

substitute for benefit-cost analysis. They do not provide the objective, consistent evaluation framework that benefit-cost analysis does. In multicriteria evaluations, exactly what is considered and how it is taken into account can vary from application to application. In benefit-cost analysis what is taken into account, and how, is very clear in principle. All positive and negative consequences of the different alternatives are taken into account, and they are assessed in accordance with the values – the trade-offs or weight – that affected individuals would give them. Recommended Approach There is no one set of evaluation accounts that must be used in multiple account benefit-cost analysis. The accounts can vary depending on the mandate and specific concerns of the agency for which the analysis is being done, the type of policies or projects being assessed, the nature of their consequences, and the key questions or issues that must be addressed. However, if the goal is to conduct a multiple account benefit-cost analysis, the evaluation framework must be consistent with the basic purpose and principles of traditional benefit-cost analysis. The accounts must be broad enough in scope to capture all of the positive and negative consequences of the alternatives to everyone (with standing) who is affected. They should not overlap or result in the double counting of the same effects. The measures or indicators of the net benefits or costs under each account should attempt to reflect the valuation or significance of the positive or negative consequences to the affected individuals. The intent of multiple account benefit-cost analysis is not to abandon the basic purpose and principles of traditional benefit-cost analysis; rather, it is to present benefit-cost results in a disaggregated way, enabling the systematic consideration of non-monetized and distributional effects. Therefore, while there is no ‘correct’ set of evaluation accounts and measures or indicators, multiple account benefit-cost analysis should be developed in a similar manner to that of traditional benefitcost analysis, differing primarily in the way some of the consequences are assessed and how the results are presented and utilized. The first step in any benefit-cost analysis is to forecast or estimate the full range of consequences that the project is expected to have – the nature and magnitude of what is provided or produced, the capital and operating expenditures, the social and environmental impacts, and the impacts on government, labour markets, and business activity. Those

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Multiple Account Benefit-Cost Analysis

impacts for which people are willing to pay would be identified as the project benefits; those impacts for which people would have to be compensated in order to be no worse off would be identified as the costs. To measure the magnitude of the benefits, one estimates the maximum willingness to pay for the output and other positive consequences. To measure the magnitude of the costs, one estimates the minimum compensation required to offset the negative consequences (to pay for the incremental capital and operating costs and offset any adverse environmental or social effects). One can estimate directly the maximum willingness to pay and the minimum compensation values. However, a more common procedure, and one that facilitates multiple account analysis, is to recognize that the magnitude of the benefits and costs consists of two quite distinct components: • the amount that people actually pay or are compensated, and • the difference, in the case of benefits, between the maximum that people would be willing to pay and what they actually pay; and in the case of costs, the minimum they would have to be compensated to be no worse off and what they actually are compensated. Benefit Components The amount that people actually pay – the project revenues – is the market value of the output. It is the portion of the benefits that is captured by the project developer or implementing authority. The maximum amount that people would be willing to pay in excess of what they actually pay is the portion of benefits captured by others. For consumers of the project output, it is what economists term the consumer surplus – the net benefits they realize over and above what they actually pay. For others it is the value of the project’s positive externalities – the maximum amount they would be willing to pay for the positive economic, environmental, or social impacts that result from the project and for which they do not directly pay. Cost Components The amount that people are actually compensated – the project expenditures – is the market measure of the costs. It is the portion of the costs that is incurred by the project developer or implementing authority.

Evaluation Accounts 49 Table 3.2 Components of benefits and costs Benefits

Costs

Market-valued consequences

Incremental revenues – what people actually pay

Incremental expenditures – what people are actually compensated

Other social consequences

- Consumer surplus - Positive externalities

- Producer surplus / economic rents - Negative externalities

The differences between the minimum that people would have to be compensated in order to be no worse off and what they are actually compensated are the net impacts incurred or realized by others. Where the amount that people would have to be compensated exceeds what they are actually compensated, for example with negative environmental or social externalities, the difference reflects net costs borne by others. Where the amount that people would have to be compensated is less than what they actually receive, the difference reflects what economists term a producer surplus or an economic rent, which is a net benefit realized by others. The concept of producer surplus is generally used with respect to the supply of a good, where the price received exceeds the marginal cost of production. The concept of economic rent is generally used with respect to the supply of an input, for example when wages exceed the workers’ opportunity cost – the minimum amount they would have to receive to be no worse off than they would be by doing something else. In either case, an adjustment to the expenditures is required to reflect social costs. From Market Valuation to Full Social Valuation A systematic approach to identifying and measuring all of the benefits and costs of alternative projects or policies is to start with the market valuation – the project revenues and expenditures – and then to make a series of adjustments in order to move to a full social valuation. The full social valuation incorporates the benefits and costs that are not reflected in the market values, where willingness to pay exceeds what is actually paid or required compensation differs from the expenditures actually incurred. Proceeding in this manner will serve to identify how a social valuation of the project (taking impacts on all affected parties into account)

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differs from a market or private valuation; in other words, it will identify how and to what extent the market fails to reflect the net benefit of the project for society as a whole. It also facilitates a logical disaggregation of benefits and costs into accounts that can be assessed or described if necessary with non-monetary indicators of significance. Evaluation Accounts The initial market valuation and each of the social adjustments required to move to a full social valuation provide a natural set of accounts to conduct and present multiple account benefit-cost analysis. They are as follows: • Market Valuation: This measures the incremental revenues generated by the project output – what is paid to acquire what is provided or produced, less the incremental expenditures that are incurred to supply it. • Taxpayer: This measures the incremental tax and other revenues that government realizes as a result of the project or policy, less any incremental expenditures that the government incurs. It indicates the net benefits or costs from a taxpayer perspective. In cases where government is the project proponent, this account could be merged with the market valuation account. • User or target-beneficiary: This measures or indicates the net benefits (consumer surplus) that users or target beneficiaries of the project derive – the maximum amount they would be willing to pay for what is provided or produced, in excess of what they actually pay. • Economic activity: This measures or indicates the net benefits (producer surplus or economic rents) that business and workers derive as a result of any incremental economic activity that the project or policy generates – the amount they actually receive in excess of the minimum they would have to receive to willingly provide their goods and services. Although often ignored, it also measures or indicates the net costs where the amounts actually received are less than the minimum compensation required for the goods and services to be willingly supplied at no net loss. • Environmental: This measures or indicates the nature, extent, and significance of the biophysical and natural resource impacts that are not captured in the other accounts, that is, the positive or negative environmental externalities resulting from the project or policy.

Evaluation Accounts 51

• Social: This measures or indicates the nature, extent, and significance of the social and community impacts that are not captured in the other accounts, that is, the positive or negative social externalities resulting from the project or policy. Not all of these accounts will be relevant for all analyses, and, depending on the nature of the issues that must be addressed, some of the accounts may have to be further disaggregated to highlight different types of impacts. However, these accounts provide a very useful starting point for the logical and consistent disaggregation of the consequences of any project or policy into a multiple account analysis. A simple test of the completeness and consistency of the analysis is that if one could monetize all of the effects, one should in theory be able to aggregate the consequences identified under all of the accounts into a traditional overall bottom line. This would mean that all of the positive and negative consequences would be captured in the multiple account analysis and the distributional effects would be properly presented, cancelling one another out in the aggregation to an overall result. With respect to the use of monetary versus non-monetary measures or indicators of impact, it is generally preferable to develop monetary measures wherever possible. The primary purpose of the analysis is to identify the advantages and disadvantages of the different alternatives and facilitate an informed discussion and debate about the trade-offs. That can more readily be done when the majority of the consequences are measured in common dollar units. Whatever is left non-monetized can then be assessed in terms of critical values or opportunity costs. The difficulty with a large number of non-monetized consequences and, in the extreme, an exhaustive list of physical impacts, which one typically finds in environmental and social impact assessments, is that it is very difficult to define and evaluate the trade-offs. Those assessments provide information but in many cases do not assist in assessing the significance of different impacts and the relative advantages for the different alternatives under consideration. Summary • Multiple account evaluation frameworks were first developed to recognize more formally and systematically the non-monetized and distributional consequences of different alternatives in the benefitcost analysis.

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• The U.S. Water Resources Council developed a four-account framework: national economic development, environmental quality, regional economic development, and other social effects. It used this framework to identify the alternatives that could be recommended because they would maximize national economic development (measurable net benefits) and protect the environment, or the alternatives that could be recommended because, while they offered less measurable net benefits, they could be justified by their regional economic or social effects. • Canada’s Department of Fisheries and Oceans developed a similar framework in its evaluation of salmonid enhancement projects. • While the frameworks of the U.S. Water Resources Council and Canada’s Department of Fisheries and Oceans formally integrated certain distributional and non-monetized consequences, they still aggregated market and non-market values to determine the overall measurable net benefits. More recent multiple account frameworks further disaggregate the benefit-cost results to separate market and non-market measures of value and to indicate consequences from the perspective of different interest groups. • In response to concerns about benefit-cost analysis, multi-criteria approaches have been developed and applied in recent years. While similar in some ways to multiple account benefit-cost analysis, multi-criteria analysis is fundamentally different. Multiple account benefit-cost analysis is an extension of traditional benefit-cost analysis, retaining the same basic principles and purpose – to assess the consequences to everyone who is affected, based on the values they hold. Multi-criteria analysis adopts the assessment criteria and values of the participants or stakeholders governing the evaluation process. • There is no one set of accounts that must be used in multiple account benefit-cost analysis. However, the accounts should be broad enough to capture all of the consequences to everyone who is affected, and they should not overlap, double counting the same effects. • A standard approach in benefit-cost analysis is to start with the market valuation of benefits and costs – what people actually pay and are compensated – and then to make adjustments where market prices do not reflect the maximum willingness to pay for the benefits and the minimum compensation required to offset the

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costs. That procedure provides a logical way to disaggregate benefits and costs into a multiple account evaluation framework. • The recommended basic evaluation framework takes this approach. The first account is the market valuation – the project revenues and expenditures. The other evaluation accounts then systematically and comprehensively capture the market failures – benefits or costs for taxpayers, users or target beneficiaries, workers, businesses, the environment, and social concerns or community interests not reflected in the market valuation. • The disaggregated multiple account approach to benefit-cost analysis clearly distinguishes the different types of consequences for different interest groups, utilizing monetary measures of value where possible and non-monetary indicators of benefit or cost where required.

CASE STUDIES Electricity Supply The electricity sector is a classic example of a market failing to ensure the optimal development and utilization of supply to meet requirements. There are very significant environmental and social externalities that need to be taken into account in the evaluation of alternative sources of electricity supply. In many jurisdictions, electricity prices and consequently electricity requirements are distorted by regulation and taxes. For these reasons the market valuation of alternative power projects and policies will not capture the full range of their consequences and people’s preferences with respect to them. Benefit-cost analysis is required for such an assessment. Following are two examples of how this has been done. Burrard Thermal Power Plant The Burrard thermal power plant is a 900-megawatt (MW) natural gasfired generating station located in Greater Vancouver, Canada. It is owned and operated by BC Hydro, a government-owned corporation that supplies approximately 90 per cent of the electricity consumed in the province of British Columbia.

54

Multiple Account Benefit-Cost Analysis

Constructed in the early 1960s, the Burrard plant is relatively old, but it has been upgraded to improve its operating reliability and reduce its nitrogen oxide and other local air emissions. Although originally built as a baseload power plant, it recently has served a more strategic role. It provides a large amount of generating capacity near the load centre that BC Hydro has used to meet peak requirements and maintain voltage stability. It also complements the generating capability of BC Hydro’s predominately hydroelectric system. The Burrard plant has been available as a backup source of energy when low-water conditions have reduced the annual capability of BC Hydro’s hydroelectric generating stations and more economical spot market supplies of energy were not available to meet its annual requirements. Despite the upgrades and its strategic role, there have been persistent calls for BC Hydro to retire the Burrard plant. There are concerns about the amount of maintenance and refurbishment expenditures required and the prudence of investing significant sums in what is an old, relatively inefficient thermal plant. There are concerns about the nitrogen oxide and other air emissions from the Burrard plant aggravating the poor air quality conditions that can occur in the Greater Vancouver and neighbouring Fraser Valley regions. And, increasingly, there are concerns about its greenhouse gas emissions, with green industry advocates arguing that the Burrard plant should be replaced by non-thermal sources of supply. In 2001 the provincial government commissioned a multiple account benefit-cost analysis to assess the advantages and disadvantages of alternative strategies for the Burrard plant.11 Along with a status quo base case under which the Burrard plant would maintain its current role until its scheduled retirement date in 2020, the alternatives included: • constraining the operation of the plant so that it would only be run when needed to serve domestic load, and not opportunistically to enhance export sales in neighbouring wholesale markets; • shutting down the plant within five years and replacing it with non-thermal ‘green’ generating resources in various parts of the province, along with more transmission capacity to the Vancouver area; and • repowering the Burrard plant with modern, efficient combinedcycle generators. The first step in the analysis was to determine how BC Hydro would expand and operate its system in each case – specifically, how BC

Evaluation Accounts 55

Hydro’s expansion plans and operations under each of the alternatives would differ from the base case. It was assumed that the alternatives would not affect BC Hydro’s total domestic requirements; that is, whatever rate impacts occurred would not significantly affect the demand for electricity. This is a common assumption in electricity supply studies, but as discussed in the Lower Gordon River example at the end of the previous chapter, that assumption is not always made and not always correct. It was also assumed that the same firm supply reliability standards would be met. Based on these assumptions, BC Hydro estimated the impact the alternatives would have on the amount and timing of the investments that it would make in new generation and transmission facilities in order to be able to meet reliably its forecast requirements. In addition, it simulated the operation of its system to estimate the impacts on production by type of generating facility and on surplus sales, with the generation and transmission facilities that would be in place each year over a multi-year planning period. BC Hydro estimated that the constrained Burrard alternative would not affect BC Hydro’s investment plans but would result in less Burrard production and less export sales of surplus power from the BC Hydro system. The shutdown alternative would result in the development of more generation and transmission capacity elsewhere in the province and, of course, the elimination of production from Burrard. The repowering alternative would entail the redevelopment of the Burrard facility and, once completed, significantly more production from Burrard; it would reduce the need for investments in new generation and transmission capacity elsewhere. Once these investment and system operation impacts had been determined, the next step in the analysis was to assess their financial, environmental, and other major consequences under each of the valuation accounts. For the market valuation account, BC Hydro’s incremental capital and operating expenditures, less export revenues, were estimated for each year over a twenty-year planning period. That amount indicated the incremental cost to BC Hydro of meeting the domestic load. The present value of the incremental cost each year over the planning period, including a recognition of the value of BC Hydro’s generating and transmission assets remaining at the end of the planning period (which differed among the alternatives because of the different facilities

56

Multiple Account Benefit-Cost Analysis

developed), was calculated to summarize the private BC Hydro market valuation of the different alternatives. For the taxpayer account, the net revenue implications to government were estimated. It was necessary to identify the taxes included in BC Hydro’s incremental expenditures that increased the government revenues, which constituted an incremental benefit for taxpayers. No incremental government expenditures were expected under any of the alternatives. BC Hydro’s expenditures directly and indirectly include a wide range of taxes. However, under the assumption of a well-functioning economy, with little chronic unemployment or underutilization of capacity, general sales and income taxes would not constitute incremental revenues for government. BC Hydro’s expenditures might change the source, but not the total amount, of the tax revenues that governments would receive. Consequently, impacts on those taxes were not estimated. The only taxes that were estimated for this account were water rentals on hydroelectric generation, fuel taxes on natural gas used for power purposes, and property taxes (or grants in lieu of such taxes) paid on generating and transmission assets. These tax payments are incremental; they would not otherwise be made or would not be made in the same amounts, depending on the alternative. Impacts on the amount of these taxes paid were estimated for each year over the planning period, and the present value was used to indicate the net revenue gain or loss to taxpayers. The user account in principle would address the implications for BC Hydro consumers, that is, the impacts on their net benefits. There would be some rate implications that would affect consumer net benefits. However, because BC Hydro is a regulated utility, with rates set to recover its costs, this consequence for consumers is already reflected in the market valuation account, and it would be double counting to incorporate rate impacts in a separate user account. The economic activity account in principle would address the implications for workers and businesses, that is, the impacts on their net benefits or economic rents. It would estimate the net cost imposed on workers who would be laid off as a result of the shutting down of Burrard and the net gain realized by workers on new projects. However, again based on the assumption of a well-functioning economy with no chronic unemployment or underutilization of capacity, it was assumed that the net costs and gains would be relatively small – that laid-off workers would be able to find comparable alternative employment in a

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relatively short period of time, and newly hired workers would otherwise have had comparable jobs – and in any event the losses and gains in employment would largely cancel out. The main issue that this study was intended to address was the impact on air emissions and the environment. Impacts on the amount of local criteria air contaminant and greenhouse gas emissions were estimated for each year over the planning period. As well, impacts on the amount and timing of major generation and transmission projects were identified. To provide some perspective on the emission impacts, the physical quantity of emissions in each alternative was multiplied by estimates of damage costs per tonne in order to indicate the total costs of the emissions. Damage costs of $2000 per tonne for nitrogen oxide and $45000 per tonne for particulates were used in this study, based primarily on health impact studies in other jurisdictions and scaled for the population exposure in the Vancouver area. A social cost estimate of $20 per tonne of equivalent carbon dioxide was used for greenhouse gas emissions, based on (albeit uncertain) damage cost estimates available at the time of the study.12 It was beyond the scope of the study to estimate the environmental and social consequences of the new generation and transmission developments under each of the alternatives. Impacts on the amount and timing of such developments were provided simply to note another key factor needing consideration in the policy debate. The results, expressed in terms of differences from the base case continuation of the Burrard plant, are summarized in table 3.3. Negative values indicate a net cost; positive values indicate a net benefit relative to the base case. The results indicate that the constrained operation or the phased shutdown of Burrard would have negative implications for BC Hydro and taxpayers and, in the case of the phased shutdown, would advance other generating and transmission projects, with whatever environmental and other impacts that would entail. However, both alternatives would significantly reduce local air and greenhouse gas emission costs. The repowering of Burrard would be positive on all accounts relative to the base case. Subject in particular to the emission damage cost values assumed in the analysis, the repowering initiative appeared to be the preferred alternative, and it was certainly better than the base case. However, the greater the social cost is that one assigns per tonne of local air and

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Multiple Account Benefit-Cost Analysis

Table 3.3 Multiple account summary: Alternatives to continued operation of the Burrard thermal plant (2001 present value, in millions of Canadian dollars) Constraining operation

Phased shutting down

Repowering plant

-576

-1274

139

-82

-111

4

Local air emissions

38

45

2

Greenhouse gas emissions

46

354

50

Market valuation (BC Hydro’s net revenues) Taxpayer’s net revenues

Land and resource use

– Does not change amount or timing of new generation and transmission development

– Advances new generation and transmission projects

– Delays the need for new generation and transmission projects

greenhouse gas emissions, the more favourable would the shutdown alternative become. Here is an example where critical value calculations can greatly assist the public debate. A central question is, what cost must one assign to the emissions to prefer the shutting down of Burrard to the repowering option? Various combinations of values are possible, but focusing solely on greenhouse gas emissions, one can calculate that they would have to be valued at over 4.5 times what was assumed in the analysis ($90 per tonne instead of $20 per tonne) before the shutting down of Burrard would be comparable in social cost to the repowering alternative. Even then, there would be other issues to consider, most notably the environmental and other impacts of the new generation and transmission developments required in that case. What to do about Burrard is still a controversial issue in the province of British Columbia. The current provincial government has directed BC Hydro to assume, for planning purposes, that it cannot rely on the energy and capacity available from Burrard. It wants BC Hydro to shut it down as soon as it is practical to do so. However, as this multiple account analysis demonstrates, that will be very expensive for BC Hydro to do. The strength of a multiple account analysis such as this one is

Evaluation Accounts 59

that it can be used to challenge the government and the other advocates of shutting down the plant to be transparent about the greenhouse gas emission and other values that must be assumed in order to justify their position. This in turn can help promote a rational debate about the future of the plant. Wuskwatim Hydroelectric Project versus Wind Generation Wuskwatim is a 200-megawatt hydroelectric generating station being developed by Manitoba Hydro in a joint venture with the Nisichawayasihk Cree Nation. It is located on the Burntwood River in northern Manitoba, Canada, and will operate with limited storage much like a run-of-river project on the already developed Nelson-Burntwood hydroelectric system. The Wuskwatim project is being developed for export purposes. An initial benefit-cost analysis filed with the Manitoba Clean Environment Commission indicated that the project offered considerable net benefits for Manitobans.13 The incremental export revenue will more than offset the project expenditures; the project will generate incremental tax revenue for government; the construction will create incremental employment opportunities in an area of the province that is subject to chronic, high levels of unemployment; and the environmental and social impacts are considered to be small and demonstrably acceptable to those most directly affected, given the mitigation, compensation, and partnership arrangements for the development. A subsequent benefit-cost analysis addressed a follow-up question: would it be preferable to develop, instead of Wuskwatim, a comparable amount of wind energy for export, a source of electricity that some environmental advocates considered to be environmentally more benign than the planned hydro project?14 For this analysis a wind alternative was specified, under which Manitoba Hydro would develop an incremental 450 megawatts of wind capacity instead of the 200-megawatt Wuskwatim hydroelectric plant. Given the estimated capacity factors of wind and Wuskwatim, both alternatives would produce roughly the same amount of energy per year. Similar to that of the analysis for Burrard, the first step in this analysis was to determine how Manitoba Hydro would expand and operate its system under each alternative. The financial, taxpayer, economic activity, environmental, and social consequences were then assessed. For the market valuation account, incremental export revenues, less incremental capital and operating expenditures, were estimated. Included

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Multiple Account Benefit-Cost Analysis

in the incremental costs of the wind alternative were the estimated integration costs that wind energy entails because of the minute-to-minute and longer-term backup that this intermittent source of supply requires. Also included were the costs of storing and shaping the wind energy to provide a product of comparable value to that of Wuskwatim. Wuskwatim energy would be shaped along with the rest of the Nelson-Burntwood river system to higher-valued time periods. The timing of the wind energy by itself would be determined by wind conditions. Included in the costs of both alternatives were incremental transmission expenditures and losses. It was assumed that the wind capacity would be developed in southern Manitoba, with little incremental transmission expenditures and losses for delivery of electricity to U.S. export markets. Wuskwatim, by comparison, would entail considerable incremental transmission cost. For the taxpayer account, impacts on hydroelectric water rentals and capital taxes were estimated. In both alternatives Manitoba Hydro would pay more capital taxes to government. In the Wuskwatim alternative it would also pay more water rentals. It was recognized that there could be impacts on the amount of sales taxes and income taxes paid in both alternatives because of impacts on total economic activity in the province. However, the differences in the amount of sales taxes paid between the two scenarios were estimated to be small, and the impacts on income taxes were taken into account in the evaluation of employment and wage benefits in the economic activity account. For the user account, no impacts on consumer net benefits were estimated other than what had already been captured in the market valuation account (since impacts on Manitoba Hydro’s net revenues would, for the most part, be passed on to customers). It was assumed, as in the Burrard example, that the same domestic requirements would be served with the same degree of reliability. For the economic activity account, two types of net benefits or economic rents were considered. Net benefits from the employment opportunities in both alternatives were estimated. As well, the net benefits from land lease payments in the wind alternative were estimated. It was assumed that the wind capacity would be developed by Manitoba Hydro on private agricultural land. With respect to employment net benefits, it was recognized that a large percentage of the workers hired from northern Manitoba, particularly in high unemployment non-designated trades, would otherwise be unemployed. The net benefits from that employment, estimated to

Evaluation Accounts 61 Table 3.4 Multiple account summary: Wuskwatim vs wind generation (2002 present value, in millions of Canadian dollars) 6% discount rate

8% discount rate

309.5

182.4

Taxpayer net revenues (incremental water rental and capital taxes)

49.3

36.2

Employment net benefit (incremental net income)

25.0

22.9

Land lease net benefit (incremental income less opportunity cost)

-13.6

-9.8

Market valuation (incremental revenues less expenditures)

Environmental impacts and land and resource use

– Similar emission benefit from displacement of thermal sources – Different but similarly relatively low land, resource, and other development impact

– Similar emission benefit from displacement of thermal sources – Different but similarly relatively low land, resource, and other development impact

account for 20 per cent of the jobs that would be generated by the Wuskwatim project, were assumed to equal the wages paid, less the cost of the educational upgrade and training programs that were planned to enhance local employment. The social opportunity cost of labour for those workers who would otherwise remain chronically unemployed was assumed to be very low, essentially zero. For the balance of the employment created by both projects, it was assumed that the jobs would offer some incremental income in order to attract the workers from alternative employment. A net benefit of 10 per cent of the wages paid was assumed. The assumptions were rough but served to illustrate, in order of magnitude, the significance of the difference in the employment net benefits between the two alternatives due to their different locations and labour market conditions. With respect to land lease payments in the wind alternative, it was recognized that the amounts farmers would receive would exceed their

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Multiple Account Benefit-Cost Analysis

opportunity cost, the minimum they would have to receive to willingly accept the development of wind turbines and transmission lines on their land. Based on the estimated impact on agricultural production, the disruption during construction, and the noise, aesthetic, and other impacts during operations, it was estimated that 75 per cent of the payments would constitute a net benefit. Again, the assumptions were rough but served to provide an estimate of the magnitude of this net benefit that was offered by the wind but not by the hydroelectric alternative. Finally, for the environmental and social accounts, the emission, land use, and resource implications were considered. With respect to emissions, the life-cycle greenhouse gas and other emissions for hydro and wind energy were identified and compared.5 They were found to be low in both cases, and consequently both alternatives were considered to offer comparable significant emission benefits by displacing thermal generation in export markets. With respect to land, resource, and other development effects, it was concluded that in both cases the impacts would not be great. Wuskwatim was specifically designed to be low impact, with very limited flooding or water flow changes, and with a project development agreement, including a joint environmental monitoring and mitigation plan, in place with the Cree First Nation people who would be most directly affected. While no specific mitigation or partnership arrangement was incorporated in the wind alternative, it was assumed that the turbines would be sited to avoid migratory bird routes or areas with important aesthetic or recreational attributes. The results, shown as differences between the Wuskwatim and wind scenarios, are presented in table 3.4, with present values calculated at a 6 per cent and an 8 per cent real discount rate. Positive values indicate the advantage of Wuskwatim relative to wind; negative values the advantage of wind relative to Wuskwatim. The results show Wuskwatim to be similar or preferred on all accounts. There are land lease net benefits in the wind alternative, but this economic activity benefit is more than offset by the estimated employment benefits of the Wuskwatim project and in any case is relatively small compared to the other consequences. A range of sensitivity cases were considered and found to indicate generally similar results. Overall, the analysis served to provide some perspective to the arguments being put forward by different advocates, with an assessment of the significance of the different consequences of the two alternatives.

Evaluation Accounts 63 NOTES 1 Weighting impacts by income is needed if one wants to estimate and aggregate changes of economists’ concept of utility. However, the aggregate change in utility only provides an arguably more refined measure of economic efficiency; it still does not indicate whether and to what extent different groups are or are not better off. 2 U.S. Water Resources Council, Economic and Environmental Principles and Guidelines for Water and Related Land Resources Implementation Studies (1983). 3 The multiple account framework is described in detail in an appendix to the department’s 1977 Cabinet submission on the salmonid enhancement program, The Economic Rationale for Salmonid Enhancement. 4 Government of British Columbia, Crown Corporations Secretariat, Multiple Account Evaluation Guidelines (February 1993). 5 H. Campbell and R. Brown, ‘A Multiple Account Framework for CostBenefit Analysis,’ Journal of Evaluation and Program Planning 28, no. 1 (2005): 23–32. See also, H. Campbell and R. Brown, Benefit-Cost Analysis (Cambridge: Cambridge University Press, 2003). 6 Advocates argue that despite limited legal requirements for multi-criteria analysis, it is gaining recognition and wide application in support of complex public decision-making processes. See, for example, C. Gamber and C. Turcanu, ‘On the Governmental Use of Multi-Criteria Analysis,’ Ecological Economics 62, no. 2 (2007): 298–307. 7 See A. Price, ‘Developments in Transport Policy: The New Approach to the Appraisal of Road Projects in England,’ Journal of Transport Economics and Policy 33, no. 2 (1999): 221–6. 8 UK DTLR, Multi-criteria Analysis: A Manual (2001). 9 A. Price, ‘Developments in Transport Policy,’ 224–5. 10 For a discussion of weighting and decision-making methods see L. Greening and S. Bernow, ‘Design of Coordinated Energy and Environmental Policies: Use of Multi-criteria Decision-Making,’ Energy Policy 32, no. 6 (2004): 721–35; K. Yoon and C. Hwang, Multiple Attribute Decision-Making: An Introduction (Thousand Oaks, CA: Sage Publications, 1995); R. Brown, Rational Choice and Judgment (Hoboken, NJ: Wiley and Sons, 2005); T. Selameab and S. Yeh, ‘Evaluating Intangible Outcomes: Using Multi-attribute Utility Analysis to Compare the Benefits and Costs of Social Programs,’ American Journal of Evaluation 29, no. 3 (2008): 301–16. 11 Marvin Shaffer & Associates Ltd. with Constable Associates Consulting Inc. and Alchemy Consulting Inc., Multiple Account Benefit-Cost Evaluation of the Burrard Thermal Generating Plant, prepared for the British Columbia Ministry of Finance and Corporate Relations (April 2001).

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12 The damage cost estimates are based on physical linkage or impact pathway models as described in chapter 5 herein. The specific modelling analyses and reports used in the Burrard study are referenced in Marvin Shaffer & Associates Ltd. with Constable Associates Consulting Inc. and Alchemy Consulting Inc., Multiple Account Benefit-Cost Evaluation, 57–62. A U.S. source cited for comparison purposes was J. Levy et al., ‘Development of a New Damage Function Model for Power Plants: Methodology and Application,’ Environmental Science and Technology 33 (1999): 4364–72. 13 Marvin Shaffer & Associates Ltd., Social Net Benefits of Advancing the Wuskwatim Project, prepared for Manitoba Hydro (August 2003). 14 Marvin Shaffer & Associates Ltd., Social Net Benefits of Wuskwatim vs Wind Development, prepared for Manitoba Hydro (February 2004). 15 The estimates were based on the International Energy Agency Technical Report, Hydropower and the Environment, Volume II, Main Report (2000), and Pembina Institute, Life Cycle Evaluation of GHG Emissions and Land Change Related to Selected Power Generation Options in Manitoba (February 2003).

4 Measuring Benefits and Costs Under Each Account

In traditional benefit-cost analysis the consequences of the alternatives are aggregated to a bottom line that reflects the incremental project revenues and expenditures (the market valuation), adjusted for the differences between market prices and social benefits and costs. In multiple account benefit-cost analysis, the market valuation and adjustments for the differences between market prices and social benefits and costs are reported in separate accounts (taxpayer net benefits, user or targetbeneficiary net benefits, net benefits from the economic activity generated, and environmental and social externalities) in a summary matrix of results, with the objective of informing the debate as clearly as possible about the advantages and disadvantages or trade-offs of the project or policy alternatives. However, whether the objective is to estimate a bottom line or to inform the debate, that objective will only be well served if the analysis is done properly, in accordance with the basic concepts and principles of benefit-cost analysis. Some key principles that need to be followed and issues that need to be considered under each of the valuation accounts in multiple account analysis, and in benefit-cost analysis generally, are outlined below. Market Valuation Account The market valuation account indicates the net benefit or cost of a project or policy based on market prices, before any adjustment to move to a full social valuation. It measures benefits by what people actually pay for what is provided or produced, and costs by the dollar amounts actually received for the goods and services supplied. It requires estimating the

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incremental revenues that are generated and the incremental expenditures incurred. Where there are no prices for the project outputs (for example, in the development of non-tolled road capacity or the provision of certain social services), there would simply be the incremental expenditures incurred. This market valuation is similar to a cash flow analysis that an investor would undertake to analyse the private profitability of a project. The perspective, however, is broader. In benefit-cost analysis it is essential to measure incremental effects. Thus, while the market valuation would initially address the revenues and expenditures of the project itself, it has to take into account the total system or industry impacts in order to estimate the incremental revenues and expenditures for the system or industry as a whole. For example, the market valuation of a rapid transit project would generally start with the revenues and expenditures generated by the project itself . However the incremental effects of the project would be measured by the changes in revenues and expenditures for the transit system as a whole, taking the impacts on bus, rail, or other transit service into account. Similarly, the market valuation of a new convention centre might start with the revenues and expenditures expected for the new facility. However, to determine the incremental revenues and expenditures resulting from the project, one would have to net out the impacts at other convention centre facilities (for example, the revenue losses and reduced expenditures at existing facilities due to any diversion of convention business to the new facility). The reference area for the analysis is important to consider in this regard. One would only net out the impacts on other facilities within the jurisdiction for which the analysis is being done. It is the incremental revenues and expenditures within the jurisdiction of interest that need to be estimated. Taxpayer Account The taxpayer account indicates the net benefit accruing to (or net cost borne by) taxpayers. It requires estimating the incremental taxes and other revenues that the different levels of government would receive as a result of the project in relation to the incremental costs that they would incur. In terms of traditional benefit-cost analysis, this account captures the  social adjustments that have to be made to recognize (i) those

Measuring Benefits and Costs Under Each Account

67

expenditures included in the market valuation that are in fact transfers to taxpayers, as opposed to real economic costs, and (ii) those real economic costs incurred by taxpayers that are not paid for by the project and therefore are not reflected in the market valuation. The project expenditures included in the market valuation typically include a wide range of taxes or other payments to government, for example, natural resource, sales, fuel, income, and property taxes. The benefit-cost issue is whether these taxes and other payments constitute incremental government revenues and benefit for taxpayers, that is, whether they are in excess of what government would otherwise have received and are not offset by incremental government expenditures. As discussed below, whether the taxes are incremental will depend primarily on whether the resources, goods, or services on which they are levied would otherwise have been utilized or produced. Resource Taxes and Charges Energy, mining, and other resource projects have to pay royalties, taxes, or other charges for the publicly owned resources they use or consume. The amount of these charges that constitute incremental government revenues and benefit for taxpayers will depend on whether, when, or to what extent the resource payments would otherwise be made. Only when the resource payments would not otherwise be made in the same amount or time period will there be incremental resource tax revenues due to the project. And only when the incremental revenues are not offset by incremental government costs will there be a net benefit for taxpayers. For example, in the benefit-cost analysis of a hydroelectric versus a natural gas-fired power generation alternative, the market valuation will generally include water rentals paid for the hydroelectric project (taxes paid in relation to the hydroelectric capacity and energy production), and natural gas royalties embedded in the price of the natural gas used for the thermal project. The water rentals would constitute incremental revenues for government to the extent that the water used to generate electricity would not be diverted from other water-rental-paying uses. The water rentals in this case would be a source of revenues that government would not otherwise collect, and they would constitute an incremental taxpayer benefit to the extent that the hydroelectric project did not give rise to any incremental government activity and expense for which taxpayers would have to pay. The water rentals then would simply be a charge by

68

Multiple Account Benefit-Cost Analysis

which government, and therefore taxpayers, captured a share of the value of the hydroelectric resource. The natural gas royalties, however, generally would not constitute incremental revenues and benefit for taxpayers. Even on the assumption that the gas was supplied from within the jurisdiction for which the analysis was being done, the gas royalties would only increase government revenues if the thermal power use of the gas resulted in an increase in total gas production. That would only occur if the demand for gas by the thermal power project was so large that it significantly affected the market price of gas. More likely, the thermal power project use of the gas would simply displace exports or some other use with little impact on the market price. The total amount of gas production and royalties paid would not change. Sales Taxes Often included in project expenditures are sales taxes on the goods and services that are purchased. Whether these taxes constitute incremental government revenues and benefit for taxpayers depends on whether the project purchases result in an increase in the total amount of goods and services produced in the economy and, therefore, an increase in the total amount of sales taxes paid. If there is an increase in production levels and sales taxes paid, then there would be incremental government revenues and benefit for taxpayers. However, if the project simply diverts goods from other users, or results in a different mix of goods and services being produced in the economy, with no change in the total value of production and sales taxes paid, then there would be no incremental revenues and benefit. The same amount of sales taxes would have been paid with or without the project. Another way to think of this is to consider what would be the real economic cost of consuming goods that are subject to sales tax. If they are diverted from other uses, the real cost would be the opportunity cost of the goods – what people would have paid for those goods in the alternative uses. That includes the sales tax. No social adjustment from the actual expenditures would be required. If, however, the goods are newly produced, then their real cost is the value of the resources used in their production. That would not include the sales tax. A social adjustment would be required to recognize that the sales tax in such a case would constitute an incremental revenue and benefit for taxpayers.

Measuring Benefits and Costs Under Each Account

69

Fuel Taxes Unlike general sales taxes, the taxes on gasoline and other fuel purchases may affect total tax revenues even if there is no change in the total amount of goods and services produced in the economy. A project that affects fuel use may change the amount of household and business expenditures subject to the fuel tax. For example, a transit project that reduces automobile use and gasoline consumption would cause a shift in expenditures away from purchases that are subject to fuel tax to other purchases that are not. There would likely be a net reduction in tax revenues. A road project that causes fuel use to rise would likely result in an increase in total fuel taxes paid. Only if there were a constraint on total fuel supply (such that an increase in use by some caused a corresponding reduction by others) would there be no change in the total amount of fuel taxes paid. Of course, projects that result in an increase in fuel use due to increased vehicular travel may not result in an overall net benefit for taxpayers, and projects that cause a reduction in fuel use and related taxes may not result in a net cost. That will depend on the impacts on road and other government expenditures that also take place. And the overall net benefits and costs of the project, going beyond the taxpayer account, will depend on emission, congestion, or other effects. The tax implications are only one part of the analysis. Income Taxes Embedded in wages and the prices of the goods and services purchased for the project are income taxes that workers and businesses have to pay. Whether these income tax payments constitute incremental revenues and benefit for taxpayers depends on basically the same question as that concerning sales taxes. Will the project result in an increase in the total amount of employment and economic activity in the economy, and therefore an increase in the total amount of income taxes paid, or will it simply change the location of people’s employment and the nature of the economic activity that takes place? If a project does increase employment and economic activity overall, by employing people who would otherwise be unemployed or underemployed, then there would be an increase in the total amount of taxes paid. There could also be a reduction in unemployment insurance or

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other government support. However, if the project simply results in the hiring of persons who would otherwise (without the project) have earned comparable income and paid comparable taxes in other activities, then there would be no change in the total amount of income taxes paid. Most benefit-cost analyses start with the premise that labour and other resources in the economy are limited and fully employed. The focus of the analysis is typically on the advantages and disadvantages of different allocations of resources, not their total utilization, which is a matter better addressed by macroeconomic policy. Assuming that resources are fully employed, projects or policies will not tend to increase the total amount of goods and services produced, and therefore sales taxes paid, or the total amount of employment, and therefore income taxes paid. In these circumstances, sales taxes and income taxes would not constitute incremental government revenues, and no recognition or adjustment for them would be required. Even in studies for smaller jurisdictions, where projects can serve to increase total employment and production, but do so primarily through in-migration to fill the new jobs, no adjustment for incremental tax benefits is generally required. There will be incremental employment and income taxes paid, but these will in large part be offset by incremental government costs to provide the services needed for a larger population. The main circumstances where incremental income tax revenues and benefit need to be considered are in analyses that compare alternatives subject to different tax provisions, for example private versus public development strategies, or in analyses for projects or policies targeted to time periods or regions of high unemployment. However, even in these cases care must be taken not to overstate the incremental effects. Ideally, models of the entire economy should be used to determine the extent to which economic activity and employment and related taxes are increased. The overall impact, taking into account the diversion of goods, services, and employment from other industries and sectors, will generally be less than a project impact assessment in itself might suggest. Property Taxes Property taxes, or grants paid in lieu of such taxes, will constitute incremental government revenues if the property value or tax rate is different from what it would otherwise be. With new developments this will generally be the case. However, the net benefit for taxpayers will depend on the

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extent to which the tax payments are offset by the incremental costs of municipal and other property-related services required by the project. Incremental Government Costs There will be incremental government costs that need to be taken into account whenever the cost of the government services provided as a result of the project are not fully paid or accounted for in the project expenditures. This will occur when no price is charged for the government services or when the price that is charged does not reflect the incremental costs of their supply. There will also be incremental government expenditures that need to be taken into account when the project is subsidized. From a social perspective, resources are allocated to the project whether they are paid for by the project developers or by the government. There is a common tendency in the evaluation of local or regional projects to ignore the financial contributions of senior governments, based on the argument that the costs of such contributions are incurred by others and do not involve allocating local or regional resources. That is not entirely correct. First, residents within the locality or region generally pay senior government taxes and therefore bear some of the burden of the contribution. Second, if senior governments try to maintain some equity in their financial spending in different areas, their contributions for any one project will limit what they provide for other projects. In other words, there likely will be a significant opportunity cost to the senior government funds allocated to any particular project that needs to be recognized even in an evaluation from a local or regional perspective. User or Target-Beneficiary Account The market valuation indicates the amount that people pay for whatever is provided, that is, the share of the total benefits that are captured by the project developer or implementing authority. The user or targetbeneficiary account indicates the net benefit that the users or target beneficiaries derive over and above what they actually pay. In traditional benefit-cost analysis this net benefit is measured by the estimated consumer surplus – the difference between the maximum amount that the users or target beneficiaries would be willing to pay and what they actually pay. In multiple account benefit-cost analysis,

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non-monetary indicators might be used, but the objective would be the same – to develop measures or indicators of the potential magnitude or significance of the net benefit that the project or policy generates for the users or target beneficiaries. Not all projects will affect user net benefits or consumer surplus. Generally, projects will only change the amount of consumer surplus that is derived if there is a change in the price of a good or a service, or a change in its quality. As shown in figure 4.1, if a project reduces the price that is charged for a good or a service, there will be an increase in consumer surplus (Δcs) as a result of the lower price in itself (A) and also because of the increase in the amount of consumption that is induced by the lower price (B). If a project increases the quality of what is produced, there will be an increase in consumer surplus because of the increased willingness to pay for the quality improvement (C) and the increase in consumption it induces (D). If there were no change in price or in quality (in economic terms, if there were no movement along or quality-driven shift in the demand curve), then there would be no change in the user net benefit. Average Willingness to Pay versus Incremental Willingness to Pay A common error in the valuation of user net benefits is to use estimates of average willingness to pay as opposed to incremental willingness to pay when measuring the value of the incremental consumption that would be induced by a reduction in price or an improvement in quality. For example, it would be a mistake in a benefit-cost analysis of enhanced recreational fishing opportunities to base the willingness to pay for any increased recreational fishing activity on an estimate of the average amount that existing recreational fishers are willing to pay per fishing day. The willingness to pay for the incremental fishing days will be less than for the existing, otherwise those fishing days would already be taking place.1 Similarly, it would be a mistake in a benefit-cost analysis of an improvement in transit service to assume that the value of the new transit trips attracted by the improved service would be equal to the amount that existing transit users are willing to pay. The fact that the transit trips are new means they are valued less than the existing trips are (what existing users are willing to pay). It is the incremental net benefit or consumer surplus that needs to be measured. That requires

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Figure 4.1: Price and quality impacts on consumer surplus (wtp-p) Change in price price

Change in quality price

D C

P0 P1

A

P0

B

D D

D D q0 q1

quantity

A = Δcs - existing use B = Δcs - new use

q0

q1

quantity

C = Δcs - existing use D = Δcs - new use

using estimates of the incremental or marginal value of any incremental use. Pecuniary Effects versus Real Effects It is important to recognize that the changes in user net benefits or consumer surplus measured in this account can reflect what economists term pecuniary (or distributional) effects as well as real effects. An increase in user net benefits or consumer surplus due to a reduction in price itself (the area A in figure 4.1) would be a pecuniary effect. Consumers would be better off with the lower price, but the suppliers of the good or the service would be correspondingly worse off. However, the increase in user net benefits or consumer surplus due to an increase in the amount consumed (the area B in figure 4.1), or an increase in quality (C plus D) would constitute real effects. There would be an increase in net benefits without any corresponding loss. Traditional benefit-cost analysis is concerned with real effects. Only real effects enter the overall bottom line. In multiple account analysis, the user or target-beneficiary account captures pecuniary effects as well as real effects in order to indicate how different interests are affected by the project. The consumer surplus gain due to a reduction in price appears in the user account; the corresponding loss to the supplier is captured in the market valuation account.

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Economic Activity Account The market valuation of expenditures indicates the amount that people and businesses are paid for the goods and services they provide. The economic activity account indicates the net benefit (producer surplus or economic rent) that people and businesses realize when what they are paid exceeds their opportunity or incremental costs (the minimum amount they require to willingly supply the goods and services). It also indicates the net cost when what suppliers are paid is less than their opportunity or incremental costs, where they incur a net loss. The net benefits measured under this account are not the same as the economic impacts that are generated. Economic impacts indicate the direct, indirect, and induced demand for labour and goods and services generated by the project. They are typically estimated with inputoutput models of the economy that can trace the demand for any one good (or the initial demand for a mix of goods and services in construction or operation) to demands for all other goods in the economy. Summary measures of economic impact – the total income and employment generated – are commonly reported by government and project proponents as indicators of the net benefits of their project. However, for these impacts to constitute net benefits one has to assume that all of the workers in the affected industries would otherwise be unemployed and all of the factories underutilized. Economic impacts measure net benefits only if there are no resource or supply constraints. Of course, if there were no such constraints, there would be little need for benefit-cost analysis. Virtually all projects would appear attractive, and all the more so, the more expenditures they entailed. Greater expense would mean greater impact, and greater impact would mean greater benefit for business and labour. The fact is that there generally are resource and supply constraints, and economic impact estimates do not indicate the incremental income or the net benefit that workers or businesses derive – the maximum they would be willing to pay or give up for the new employment or business opportunities that might be generated by a project or policy.2 For workers, the net benefit of any new employment opportunity depends on what they would otherwise be doing. If they would have been working and receiving roughly comparable wages at other jobs, there would be no net benefit. Their opportunity cost (and therefore the minimum amount of wages they would have to receive to willingly work at the new jobs that would be generated as a result of the project) would be  roughly the same as the wages they would receive in the new job

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opportunity. Only if those hired would otherwise have been involuntarily unemployed or underemployed would there be any significant net benefit. The workers’ opportunity cost would then reflect the lower wages that they would otherwise receive or the value of the time that they would be giving up to take the new work. The net benefit would equal the difference between the wages in the new jobs and this lower opportunity cost. In a simple case where there are only two possibilities for what the workers would otherwise be doing (unemployment or comparable employment elsewhere), the social opportunity cost of labour and net benefit from the employment generated by a project or policy can be expressed as follows: SOCL = pu * vu + (1 - pu) * w NB = w - SOCL = pu * (w - vu) Where SOCL is the social opportunity cost of labour, pu is the probability of hiring people who would otherwise be unemployed, vu is the value of what the unemployed persons would otherwise be doing (the minimum they would have to be paid to willingly work at the new job), w is the wages that are paid in the new or comparable existing job, and NB is the net benefit that is realized from the new job. In this case it can be seen that the net benefit of any employment generated by a project or policy will be greater, the greater is the probability of hiring persons who would otherwise be unemployed (pu), and the greater is the difference between the wages paid in the new jobs (w) and the value of whatever those hired would otherwise be doing (vu).3 Only when the probability of hiring persons who would otherwise be unemployed is near 100 per cent, and the value of what they would otherwise be doing is near zero,4 would the net benefit of newly created jobs approach the amount of wages paid. Estimating the net benefits from the employment generated by a project or policy requires detailed consideration of the extent of unemployed resources in the specific occupations and industries that are affected. The more that demands are generated for occupations where there is significant unemployment, the more that net benefits will be provided by the new employment opportunities. There will be a greater probability of hiring persons who would otherwise be unemployed.5

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The net benefit that businesses derive from new business activity depends on the incremental sales they realize (sales that they would not have otherwise made) and the incremental net income (incremental revenues minus incremental expenditures) that the incremental sales generate. For the economy as a whole, the net benefit depends on whether any incremental income earned by some businesses is offset by losses elsewhere. The development of new sports or rapid transit centres, for example, may generate commercial activity and incremental net income for nearby businesses. However, that can be offset by the loss of business elsewhere. In such a case there would be a distributional impact but no real or overall net gain. In traditional benefit-cost analyses, distributional effects are not included in the calculation of an overall bottom line. In multiple account analyses, it is important to identify distributional impacts where they are significant and relevant to the policy debate, but it is essential to distinguish them from real effects in order to indicate the overall net benefit from the economic activity that is generated. In a well-functioning economy, operating near full employment, the overall net benefit from the economic activity generated by the project will be relatively small. The wages paid to labour will generally reflect their opportunity cost. Business activity in the economy as a whole will be constrained by the total capacity in the economy. As discussed in relation to sales and income tax effects, it is generally assumed that projects will affect what goods and services are produced and for whom, but not necessarily how much is produced and earned overall. It is important, therefore, not to overstate the net benefits in this account.6 In addition to not overstating the net benefits of the economic activity generated by a project, it is important to recognize that some new economic activity can give rise to net economic costs. This will occur when the prices paid for inputs are less than the opportunity or incremental costs of the supply of those inputs, due to regulation, subsidies, or other price distortions. For example, the regulated price of electricity that is charged by Canadian hydroelectric utilities is generally much less than the incremental costs of electricity supply because of the very low-cost, largely amortized hydro assets that are dominating the rates. New demands for electricity will consequently impose a net economic cost on the utility and its existing customers that is equal to the difference between what the utility receives for the electricity it supplies and the incremental costs it incurs to meet the new requirements. In the case of new

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electric-intensive projects, the net cost can be very significant. In traditional benefit-cost analysis a social adjustment is required to reflect the incremental cost of the electricity (as opposed to the price that is paid). In multiple account analysis the difference between the incremental cost and the price paid needs to be recognized as a net cost in the economic activity account.7 Environmental Account The environmental account indicates the nature, magnitude, and significance of the environmental externalities resulting from the project, that is, the enhancement or diminution of the natural resource and environmental attributes that people value for their use or their mere existence. It is critically important in the valuation or assessment undertaken in this account to distinguish between environmental impacts that are reflected in market prices and those impacts that constitute externalities. Only the externalities – the positive impacts for which people do not pay or the negative impacts for which they are not compensated – are included here. Positive environmental impacts for which people pay or the negative ones for which they are compensated are already captured in the market valuation, and it would be double counting to include them again in this account. For example, occupational hazards that are known to the workers and reflected in wages that incorporate occupational risk premiums are not externalities.8 Nor are environmental effects that are fully compensated or offset in an acceptable manner, for example the full offset of air emissions by measures that would not otherwise take place. It is the uncompensated impacts that are measured here. The environmental account in a multiple account benefit-cost analysis is not intended simply to summarize the environmental externalities identified in an environmental impact assessment or similar document. Although obviously based on such assessments, the intent is to bring some perspective to the magnitude and significance of the externalities. There are numerous methods by which the willingness to pay or the compensation demanded for different environmental impacts can be estimated in dollar terms, as discussed in chapter 5. However, where dollar measures cannot reasonably be estimated, non-monetary indicators can be used to provide some perspective to the magnitude and significance of the impacts. This could include quantitative measures in physical units (tonnes of emissions per year, hectares of land of a specified nature)

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or summary descriptions of consequences, along with relevant information on their significance (uniqueness, relative size, potential for offset, and cost). However the impacts are measured or described, a key objective is to facilitate a clear understanding and assessment of any trade-off between the environmental externalities and the results in the other accounts. Ideally the indicators will facilitate the calculation of meaningful critical values. Critical values are those specific values (or combination of values) that would have to be assigned to the environmental externalities to change the ranking of the alternatives based on the other accounts. For example, as discussed in the case studies at the end of the previous two chapters, in a benefit-cost analysis of a thermal power plant, one could compute the critical value per tonne that greenhouse gas emissions would have to be assigned for such a plant to be socially more costly than the alternative sources of supply would be. In a benefit-cost analysis of a hydroelectric project one could calculate the critical value of any wilderness or habitat loss at which the plant would be socially more costly than the alternatives would be. In a benefit-cost comparison between the thermal and hydro projects one could compute the combination of greenhouse gas and habitat values that would favour one over the other. One could then consider how the actual costs of greenhouse gas emissions and wilderness loss are likely to compare to the computed critical values. Willingness to Pay versus Compensation Demanded One of the issues that arise in the valuation of environmental externalities and the assessment of critical values is whether one should measure (or provide indicators of) people’s willingness to pay to reduce or avoid adverse environmental impacts or the compensation they would require to willingly accept the adverse impacts taking place. What is the appropriate measure of compensating variation? The basic question here is, what assumption should be made about the initial reference point or prior rights to the resource or attribute in question? If the reference point is current conditions, then the compensating variation for any improvement to those conditions is measured by willingness to pay; the compensating variation for any diminution is measured by compensation demanded. If the reference point is some different state, then the gains or losses relative to that point would determine which measure should be used.

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In the case of most private goods, the reference point is clear, well defined by ownership or legal entitlement. However, in the case of public goods, the reference point or prior right can be unclear. For example, in the valuation of the adverse impacts that a project is expected to have on wilderness recreation in an undesignated, undeveloped area, should one assume the undeveloped state is the appropriate reference point, in which case the adverse impacts would be measured by the compensation that recreationists would require to willingly accept changes to that undeveloped state? Or should one assume that the lack of any land-use designation means there are no prior rights, and the valuation of the affected recreational opportunity should be based on what recreationists would be willing to pay to maintain the area in the undeveloped state? In their review of this issue R. Mitchell and R. Carson argue that for public goods that are collectively held – to which there are competing, legitimate interests – one should assume no prior right.9 In other words, benefit-cost analysis should value public goods on the basis of what different parties or interests are willing to pay for them, not which parties or interests are presumed to have a prior right. J. Knetsch, however, argues that the reference point for benefit-cost analysis should be based on what people feel entitled to, not on what legal or other specific rights they may have. This will determine the gains and losses that people actually feel and the preferences and trade-offs they truly have with respect to different project or policy initiatives.10 This issue would not be so significant if the willingness to pay and the compensation demanded for any particular good or attribute were similar in magnitude, which is in fact what traditional economic theory would suggest. In a classic article, R. Willig concluded that in general the difference between the willingness to pay and the compensation demanded for the same good will be small, less significant than the estimation errors to which either measure would be subject in an applied study. Both measures reflect the trade-off that people would willingly make between the one good or attribute and all others, and traditional theory suggests that this trade-off will not be very different unless there is a very strong income or wealth effect.11 However, experimental studies and modern behavioural theory have conclusively shown that there are marked differences between what people are willing to pay to acquire a good and what they would have to be compensated to give it up. There is a pronounced endowment effect that greatly increases the value that people attach to what they

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have, relative to the same good that they must acquire. Based on his own and other studies, Knetsch states that the difference can be a factor of seven or more.12 Thus, whether one should use willingness to pay or use compensation demanded can have great impact; it can be central to the public policy debate. There is no correct answer to this issue. What is important to recognize, however, is that the measure one uses will govern what the analysis is actually reflecting – a valuation from a public-good perspective with no assignment of prior rights, or a valuation reflecting the changes in welfare that the affected parties truly feel. From a practical point of view it is generally easier to estimate the willingness to pay than to estimate the compensation demanded; the latter is particularly difficult to discern with survey methods. However, where there is ambiguity, both measures ideally should be considered in the efforts to bracket the range of possible values and significance that the externalities may have to the affected parties. Social Account This account indicates the nature and significance of all of the community and other social externalities resulting from the project. As with the environmental account, only the externalities, not all of the impacts, are included, and the objective is to provide some perspective to their significance, not just to list consequences. In many cases it will be very difficult to measure the magnitude or the significance of the social externalities in dollar terms. In these cases relevant indicators or descriptions will be required, again with a view to facilitating the computation of meaningful critical values. However, there will be some types of externalities where dollar measures of compensating variation can be calculated. For example, as discussed in chapter 5, residential property hedonic price studies can be used to estimate the willingness to pay to avoid noise, crime, or other neighbourhood effects, and provide some perspective to the significance of the impacts. It is very important, however, not to double count when using changes in property prices to value externalities. For example, if one has included an estimate of the cost of air emissions in the environmental account, it would be double counting to include any consequent reduction in property prices as an additional social cost. Or, if one has included an estimate of the time-savings benefits resulting from a transit or road project in the user account, it would be a mistake to include the

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consequent increase in property prices here. In these cases the change in property prices would be another measure – in effect, the capitalized value – of the same impact. It is not a separate benefit or cost. It is also important in this social account to distinguish real effects from pecuniary or distributional effects. For example, an increase in traffic or noise in one neighbourhood could constitute a real effect. However, it would be more distributional in nature if accompanied by reductions elsewhere. In a multiple account benefit-cost analysis it is important to identify major distributional impacts, but as stated earlier, they should be explicitly recognized as such. They are different from gains or losses that are not offset in any way, that would affect the overall bottom line in a traditional benefit-cost analysis. Other Measurement Issues Scope of Analysis The consequences of any initiative depend not simply on what a proponent or an agency may be responsible for, but also on all of the activities that are undertaken as a result of it. For example, a benefit-cost analysis of hosting the Olympic Games requires identifying and valuing the consequences of all of the activities arising from it, including the upgrade of highways and public transport, the provision of security, any related increase in expenditures for training and athlete development, and all the other commitments that are made. The scope of activities – the project – can be much greater than what the Olympic organizing committee itself is responsible for or what may be narrowly defined by government or Games proponents as an Olympic-related impact or expense.13 Similarly, the consequences of ending a moratorium on offshore oil and gas exploration where such exist go well beyond the oil and gas exploration and development activities themselves. Ending the moratorium can be expected to lead to production and the development and operation of marine- and land-based transportation systems. All of those related consequences need to be considered in a benefit-cost analysis of that policy issue. The basic question that must be addressed in defining the scope of the analysis is, what will be different if the initiative proceeds? What resources will be allocated or reallocated and what effects will that have? It is the full scope of what will change that should be analysed.

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Determining what will change requires careful consideration of the base case, the reference point from which changes are measured. Generally the base case will refer to the status quo, a continuation of existing policies, trends, or circumstances. Where there is any ambiguity as to what the status quo in fact is or might mean, it is necessary to be clear on how the base case is defined. Positive and negative consequences of different alternatives only have meaning in relation to what would otherwise take place. Primary Market Effects versus Secondary Market Effects The direct impacts of a project or policy on a particular good or service are termed primary market effects. Impacts on one market, however, will typically affect others. The impacts on all other markets are termed secondary market effects. For example, the impacts of a power generation project on electricity supply and price would be primary market effects. The impacts of the electricity project on competing fuels (substitute goods) like natural gas would be secondary market impacts. Similarly, the impacts of the development or enhancement of a recreational area on the amount of and willingness to pay for recreational activity would be primary market effects. The impacts of any increased recreational activity on related purchases of recreational equipment (complementary goods) would be secondary market effects. The question for benefit-cost analysis is, when and in what ways do secondary market impacts need to be taken into account? The general answer is that except for the identification of distributional impacts, secondary market impacts only have to be considered when there are externalities or price distortions, where the prices for the secondary market goods and services do not reflect their marginal social costs. In the power generation example, any reduction in natural gas demand caused by a reduction in electricity prices would only be relevant in the benefit-cost analysis of the electricity project to the extent that it resulted in a reduction in air emissions or other externalities associated with natural gas use, or it affected the net benefits realized from gas sales because of a difference between the price and the marginal cost of supply. Otherwise, the impact on natural gas sales would not in itself give rise to an overall net benefit or cost. Assume, for example, that there were no externalities or differences between price and marginal costs. If the reduction in natural gas sales

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does not affect the price (only the volume of sales), no one would be better or worse off. The remaining consumers would pay the same amount for what they purchase. The suppliers would have less revenues because of the reduced volume of sales, but on the assumption that prices reflect marginal costs, they would have correspondingly less expenditures. If the lower demand for natural gas resulted in a lower price, there would be benefits and costs in this secondary market. The remaining consumers would be better off, but suppliers would be correspondingly worse off. In this case there would be a distributional effect but no real effect on overall net benefits.14 Summary • The validity and usefulness of any benefit-cost analysis, whether seeking a traditional bottom line or a multiple account analysis of the trade-offs, will depend on how well the benefits and costs are identified and assessed. • The market valuation account requires estimating incremental revenues and expenditures for the project or policy in a way much like that of a private profitability analysis. However, the scope of the assessment is broader. The incremental revenues and expenditures for the system, sector, or industry as a whole, not just the project itself, need to be taken into account. • The taxpayer account requires estimating incremental revenues and expenditures for government. Incremental revenues will only be realized from taxes or charges levied on resources, goods, or services that would not otherwise be utilized or produced, that is, from taxes and charges that would not otherwise be paid. Taxpayers will realize net benefits when there are such incremental revenues and the incremental revenues are not offset by incremental government costs. Incremental costs arise when governments provide services at no charge or at charges that do not reflect the incremental cost of supply, or when governments make financial contributions to the project. • The user or target-beneficiary account requires estimating the net benefit or consumer surplus that users derive – the difference between the maximum amount they would be willing to pay and what they actually pay. User net benefits will arise when there is a reduction in price or a quality improvement. • In estimating user net benefits it is important to measure the incremental willingness to pay for whatever has changed, not the

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average willingness to pay for the total amount consumed. It is also important to distinguish real effects from pecuniary effects, that is, to distinguish the user net benefits that add to the overall net benefits from those that just redistribute benefits between users and whomever is providing the good and the service. The economic activity account requires estimating the net benefits that workers and businesses realize as a result of the employment and business activity generated by the project, or the net cost when goods are supplied at a loss. It is important not to confuse worker and business net benefits with the total economic impacts that are generated. Workers will only realize net benefits to the extent that new employment opportunities enable them to earn more than they would otherwise (or more than they value what they would otherwise do). Businesses will only realize net benefits to the extent that any incremental sales result in increased net income and that the incremental sales and net income earned by some firms are not offset by reductions for others. In a well-functioning economy it is generally assumed that there is full employment and full utilization of capacity; therefore, the economic activity net benefits will be limited. The question that benefit-cost analysis generally addresses is what are the benefits and costs of different allocations, not of the greater utilization of scarce resources. The environmental and social accounts require identifying and assessing the significance of the externalities associated with the project, being careful not to double count impacts that are already reflected in the market valuation or other accounts. It is externalities, not simply impacts, that are addressed in this account. When trying to assign a value to environmental or social externalities, it is important to recognize that there can be a large difference between the amount that people would be willing to pay to avoid an impact and the amount that they would require in compensation to willingly accept it. The correct measure of value will depend on the initial reference point – the prior rights or perspective one assumes. With respect to the scope of the analysis, all of the activities undertaken as a result of the initiative need to be taken into account. The question is, what will change relative to what would otherwise occur, and that could include much more than what a proponent or an agency defines as its project.

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• In terms of primary and secondary market impacts, the analysis can generally focus on the former, the directly affected goods and services. It is only to the extent that there are distorted prices and externalities that secondary market impacts will affect the overall net benefits of a project.

CASE STUDY Richmond–Vancouver Airport–Vancouver Rapid Transit Line Like the electricity sector, public transportation is subject to a wide range of market failures. There often is no pricing of road capacity, and where there are prices (road tolls), they are not generally set to reflect the marginal cost of road use, including the marginal congestion cost imposed on others. Prices are charged for public transit, but they too generally do not reflect marginal costs. In addition to pricing distortions, there are environmental and social externalities – impacts on air emissions and development patterns – that different transportation projects or policies may have. Here again, the market alone will not result in optimal investment decisions being made. Benefit-cost analysis is required to evaluate the full range of consequences of transportation infrastructure or service alternatives. Some of the earliest applications of benefit-cost analysis were to road and bridge projects. The analyses basically involved estimating the impact that the projects would have on traffic volumes, travel times, and accident risk and then comparing the value of the time savings and other benefits to the construction, maintenance, and other costs that the projects would entail.15 The benefit-cost analysis of transit projects is similar, being careful to include the benefit and the cost implications to roads as well as to the transit system. The road network is a ‘secondary’ market, the primary market being transit service. However, impacts on the road network must be included in the analysis of transit projects because of the externalities (air emissions and accident risk) and price distortions for road use. A multiple account benefit-cost analysis of a rapid transit project requires estimating the impacts on transit service, transit use, vehicular traffic, transit and vehicular travel times, accident risk, neighbourhoods, and regional growth patterns, as well as the impacts on total

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transit and road system expenditures. The evaluation of these impacts under each account involves the following: In the market valuation account the incremental revenues and expenditures for the transit system as a whole are estimated. This would reflect the forecast revenues and expenditures for the project itself, adjusted for revenue and expenditure impacts on the rest of the transit system. In the taxpayer account incremental government revenues and costs are estimated. That would reflect reductions in fuel tax revenues and government road-related expenditures due to reduced vehicular traffic. It would also take into account any subsidies, or other government support for the project, that are not captured in the market account (for example, the opportunity cost of any land provided for the project). There can be other tax implications of transit projects, but care must be taken not to confuse distributional effects with overall increases (as typically occurs with property taxes) and not to assume that income taxes and sales taxes are necessarily incremental. In the user or target-beneficiary account the net benefits for existing transit users, new transit users, and remaining vehicular traffic are estimated. The principal benefit for existing users is the reduction in travel time and the more reliable service they will experience as a result of the project.16 New transit users may or may not experience reduced travel times or greater reliability. They do avoid auto or other transportation costs, and the benefit for new transit users is often measured by the reduction in their vehicle operating, insurance, and parking costs, but this will overstate the benefits. It ignores the value that new transit users must have placed on their auto travel, preventing them from previously switching to transit. The correct measure of the net benefit they derive is their maximum willingness to pay for the transit service, less the amount they actually pay. The benefit for remaining vehicular traffic is the reduction in travel time and the vehicular-operating cost savings because of the reduction in vehicular traffic and congestion with the transit project. There is also the benefit of the reduced accident risk due to the reductions in vehicular traffic.17 In the economic activity account the net benefits that workers and businesses realize as a result of expenditures on the project and the development it generates are estimated. However, as with the tax account, care must be taken to very clearly distinguish distributional effects (for example, the relocation of business activity) from overall effects and not assume necessarily that workers would otherwise be unemployed and

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business capacity underutilized. Also, it is important not to double count the benefit to the goods movement industries. The benefit they derive from transportation improvements is already reflected in the user account by the value that they place on reduced travel times and expense. In the environmental account the amount and estimated value of the reduction in local air and greenhouse gas emissions resulting from the expected diversion of vehicular traffic to the new transit line are estimated. The nature and significance of the biophysical and natural resource impacts that construction and operation of the line are expected to have are also addressed. In the social account the nature and significance of the impacts on neighbourhoods – for example, disruption during construction, and noise, crime, or other impacts during operations – are addressed. Also addressed are impacts on regional growth patterns, which can be very important, especially for major new rapid transit lines. A multiple account evaluation undertaken for the Richmond– Vancouver Airport–Vancouver rapid transit project, now called the Canada Line, provides an example of how this type of analysis has been done.18 The Canada Line, recently developed by Vancouver’s regional transportation authority, TransLink, provides a grade-separated rapid transit service connecting Richmond (a major suburb of Vancouver), Vancouver International Airport (located in Richmond), and downtown Vancouver. It replaces a high-frequency express bus service between Richmond and Vancouver, providing significantly reduced and more reliable travel times. The multiple account evaluation examined a number of alternatives, including the one that was ultimately implemented, a grade-separated (exclusive right-of-way) line coming into service prior to 2010. The market valuation of this alternative, relative to a continuation (and normal expansion) of the existing bus service, found that there would be significant net costs for TransLink. The incremental expenditures for a grade-separated line built for 2010 were estimated to exceed the incremental revenues by over $1 billion. The study concluded that the net costs, however, would be offset by the positive consequences in the other accounts. The project was estimated to generate significant tax revenues from income, sales, and property, which in total would greatly exceed the reduction in fuel tax revenues caused by a reduction in vehicular traffic.

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User or target-beneficiary benefits were estimated to total over $1.4 billion, which in itself would be more than the net financial costs borne by TransLink. The study also suggested that there would be very significant economic development benefits, possibly as much as $2.8 billion. With respect to the environment, there would be benefits from reduced greenhouse gas and local pollutant emissions. There would be some biophysical impacts during construction, but these would be mitigated in construction planning. As for social impacts, it was recognized that there would be some adverse impacts on those neighbourhoods affected by construction and operation. However, there would be significant urban development benefits. The results overall, as summarized table 4.1, were largely positive, lending considerable support to the project proceeding. However, there were reasons to question the estimates and the conclusions that were reached. First, as the authors carefully acknowledged, the evaluation considered only a narrow range of alternatives for improved transit service in this corridor. In particular, it did not consider a far less costly option of enhancing the existing express bus service (with more frequent and parallel-corridor bus service). More important, from a methodological point of view, the evaluation did not properly measure the largest sources of benefit identified in the study – user, taxpayer, and economic activity benefits. Taxpayer benefits were estimated by the total income taxes, sales taxes, and property taxes generated by the project. However, income taxes and sales taxes will not constitute incremental revenues for government if the economy is functioning well, at or near capacity (which it in fact was during the construction of this project). Also, the property tax impacts estimated in the study are largely distributional in nature, shifting the burden of taxation to property owners in the vicinity of the new line and station. They do not measure a net tax contribution by the project itself, which would reduce the overall amount collected from existing property owners. The net benefits for the forecast new transit users were estimated by the vehicle-operating and parking costs that the new transit users would avoid. However, this ignores the value of travelling in their own vehicles that the new users would forgo when travelling by transit. Avoided vehicle costs greatly overstate the consumer surplus or net benefit that would be derived. New users are by definition marginal users. They are attracted by the improved service, but the benefit theyderive (their willingness to pay for transit) will be less than for existing users; otherwise they would already have abandoned their vehicle.

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Table 4.1. Multiple account summary: Canada Line project (2001 present value, in millions of Canadian dollars) Exclusive right-of-way service in 2010 Market valuation Incremental system revenues less expenditures Taxpayer Sales and income Property Fuel

-1003 116 28 -15

User Travel time, vehicle savings Parking cost savings Reduced accident risk

1365 51 37

Economic activity Regional development impact

2850

Environment Air emissions Other Social Urban development Other

16.5 biophysical impacts during construction 75 disruption, noise during construction and operations

As illustrated in figure 4.2, absent better information, one could assume that the consumer surplus for new users equals approximately half the net benefit to existing users. The net benefit that new users derive will be between zero (or just above zero – the minimal amount that would induce them to take transit) and the value (or very close to the value) that existing users derive. The assumption of an even distribution between those points results in an average value for new users that is equal to half of the average net benefit or incremental consumer surplus for existing users. The economic activity benefit was based on general studies that indicated the amount of productivity improvements and growth that could be generated by transit improvements such as this. However, some of the productivity benefit double counts the estimated user benefits; it is  reflected in the willingness to pay for the travel-time savings and the  cost savings on the less congested road network by commercial

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Figure 4.2: Consumer surplus benefits for existing and new users consumer surplus

D

D

CS0

CS0 = increased willingness to pay (consumer surplus) for existing trips CS1 = average consumer surplus for new trips q0 = existing trips q1 = existing plus new trips D = willingness to pay in excess of price without project D = willingness to pay in excess of price with project

CS1 q0

q1 quantity of trips

vehicles. Also, a large part of the growth impact is almost certainly distributional in nature, reflecting investment in the vicinity of the new line and stations that would otherwise take place elsewhere in the region. Without these methodological errors, the case for the line would have been much less clear and the trade-offs more apparent. It may or may not have changed the ultimate decision to proceed, but a more careful analysis consistent with the principles of benefit-cost analysis would have enabled a more informed debate on the advantages and disadvantages of the project to take place.

NOTES 1 In a study of the implications of alternative allocations of chinook salmon in the Gulf of Georgia off the west coast of Canada it was found that an increase in the allocation to the sports fishery would have only a small impact on the participant net benefits. The increased allocation would improve success rates (catch per fishing day), which in turn would attract more fishing effort (fishing days). This increased effort would dampen the improvement in success rates and increased willingness to pay by existing fishers. While there would be a willingness to pay and a net benefit for the new fishers or fishing days, it would be less than the average willingness to pay and net benefit for the existing fishing days. See Marvin Shaffer & Associates Ltd.,

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2

3

4

5

6

91

with the assistance of Pacific Coast Bio-Resources Ltd., An Analysis of the Economic Efficiency Implications of Alternative Chinook Allocations in the Gulf of Georgia, prepared for Fisheries and Oceans Canada, January 1987. For a discussion of the difference between economic impacts and net benefits, see M. Shaffer et al., Olympic Costs and Benefits: A Cost-Benefit Analysis of the Proposed Vancouver 2010 Olympic and Paralympic Games (Vancouver, BC: Canadian Centre for Policy Alternatives, February 2003), 7–8. The net benefit to a worker who would otherwise be unemployed is measured by the difference between after-tax wages and the sum of the value of his or her time plus any income support he or she would have received while unemployed. For society as a whole, the net benefit would be measured by the difference between pre-tax wages and the value of the worker’s time. The income taxes the worker pays and the reduction in income support add to the overall social net benefit. In multiple account analysis this part of the employment net benefit should logically be included in the taxpayer account. However, if it is captured as part of the economic activity net benefits, it cannot then be included there. While it is often assumed that the opportunity cost of an unemployed person is near zero, that is not generally correct. There can be value in the domestic work, educational, or other activity in which unemployed persons can engage. See, for example, H. Campbell, ‘The Shadow-Price of Labour and Employment Benefits in a Developing Economy,’ Australian Economic Papers 47, no. 4 (December 2008): 311–19. See R. Haveman and J. Krutilla, ‘Unemployment, Excess Capacity, and Benefit-Cost Investment Criteria,’ Review of Economics and Statistics 49, no. 3 (August 1967): 382–92. In an analysis of the social opportunity cost of labour in Canada, A. Harberger argued that one should assign at most a 30 per cent benefit to employment opportunities created during periods of cyclical unemployment, and that high level would only apply during severe downturns and for a limited time period. Many of the persons hired, even with high unemployment, would otherwise be employed, and even those who would not would have an opportunity cost that was significantly greater than the commonly assumed zero. He also argued that employment created in cyclical and seasonal sectors would offer less benefit (possibly even a social cost) by attracting people to industries that are regularly subject to periodic layoffs. See A. Harberger, ‘The Social Opportunity Cost of Labour: Problems of Concept and Measurement as Seen from a Canadian Perspective,’ Technical Study 15, Canada Employment and Immigration Commission Task Force on Labour Market Development, July 1981.

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7 For an illustration of the potential magnitude of this net cost see Marvin Shaffer & Associates Ltd., An Assessment of the Benefit-Cost Trade-Off of the Proposed Kemess North Project, prepared for the Gitxsan House of Nii Kyap, 25 September 2006, submitted to the CEAA Joint Panel Review of Northgate’s Kemess North Gold-Copper Mine Project, pp. 9–10. 8 See D. Pearce, ‘Energy Policy and Externalities: An Overview,’ in Externalities and Energy Policy: The Life Cycle Analysis Approach (Paris: OECD Nuclear Energy Agency, Workshop Proceedings, 15–16 November 2001). 9 See R. Mitchell and R. Carson, Using Surveys to Value Public Goods: The Contingent Valuation Method (Washington, DC: Resources for the Future, 1989), 30–41. 10 See J. Knetsch, ‘Gains, Losses and the US EPA Economic Analysis Guidelines: A Hazardous Product,’ Environmental and Resource Economics 32, no. 1 (2005): 91–112. 11 R. Willig, ‘Consumer Surplus Without Apology,’ American Economic Review 66, no. 4 (September 1976): 589–97. 12 J. Knetsch, ‘Gains, Losses.’ See also J. Horowitz and K. McConnell, ‘A Review of WTA/WTP Studies,’ Journal of Environmental Economics and Management 44, no. 2 (2002): 426–47. 13 For a discussion of the appropriate scope of a benefit-cost analysis of the Vancouver-Whistler initiative to host the 2010 Olympic and Paralympic Winter Games see M. Shaffer et al., Olympic Costs and Benefits, 9–10. 14 For a detailed discussion see A. Boardman et al., Cost-Benefit Analysis: Concepts and Practice, 3rd ed. (Upper Saddler River, NJ : Prentice Hall, 2006), chapter 5. 15 For a review of early applications of benefit-cost analysis to transport, water resource, and other projects see A. Prest and R. Turvey, ‘Cost-Benefit Analysis: A Survey,’ Economic Journal 75, no. 300 (December 1965): 683–735. 16 For a review of the value of time savings and other transit quality improvements see T. Litman, Valuing Transit Service Quality Improvements (Victoria, BC: Victoria Transport Policy Institute, May 2007). Government transportation agencies commonly set guidelines on the value of traveltime savings for their economic analyses of alternative projects and policies. See, for example, U.S. Department of Transportation, ‘The Value of Saving Travel Time: Departmental Guidance for Conducting Economic Evaluation,’ 1997, and ‘Revision,’ 2003; and British Columbia Ministry of Transportation and Infrastructure, ‘2007 Update for MicroBENCOST Default Values,’ 2007. 17 Recent studies and guidelines suggest that in North America reductions in the accidental loss of life should be valued at $6 million to $6.5 million per

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life saved. See L. Chestnut and P. de Civita, ‘Economic Valuation of Mortality Risk Reduction,’ prepared for the Policy Research Initiative, Government of Canada, March 2009; and U.S. Department of Transportation, ‘Revised Department Guidance: Treatment of the Value of Preventing Fatalities and Injuries in Preparing Economic Analyses,’ 2009. For reviews of alternative estimation methods and results see M. Jones-Lee, ‘Safety and the Saving of Life,’ in Cost-Benefit Analysis, 2nd ed., ed. R. Layard and S. Glaister, 290–318 (Cambridge and New York: Cambridge University Press, 1994); W. Kip Viscusi, ‘The Value of Risks to Life and Health,’ Journal of Economic Literature 31, no. 4 (December 1993): 1912–46; and J. Mrozek and L. Taylor, ‘What Determines the Value of Life? A Meta Analysis,’ Journal of Policy Analysis and Management 21, no. 2 (2002): 253–70. 18 IBI Group in Association with PriceWaterhouseCoopers, Richmond/AirportVancouver Rapid Transit Project Multiple Account Evaluation, 16 April 2001.

5 Estimation Methods

The Basic Alternatives A major strength of benefit-cost analysis is its focus on the value that people place on the different consequences of alternative projects and policies. Even in multiple account benefit-cost analysis, where some consequences might not be measured in dollar terms, the evaluation still focuses on relative value or significance. This is very different from many economic, environmental, or social impact assessments, which tend to document consequences but not address their relative value or the trade-offs that people would willingly make with respect to them. This strength, of course, is limited by the difficulty in developing reliable estimates of value. It is one thing to recognize the importance of assessing relative value or significance; it is quite another to determine what that is for the full range of a project’s or policy’s consequences. It would be considerably easier to assess relative value if one could simply rely upon market prices for the outputs and inputs (positive and negative consequences) of alternative projects or policies. However, benefit-cost analysis is needed precisely where, at least for some of the major consequences, prices do not exist or are subject to significant market failures. In these circumstances, market prices do not directly indicate value, that is, the maximum amount that people would be willing to pay to acquire the benefits or the minimum amount of compensation that people would require to willingly incur or accept the costs. Values must be estimated or inferred. There are many methods that can be used to estimate values for benefit-cost analysis. However, all the different methods are based on one or some combination of the following:1

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• what people should be willing to pay (or accept) • what people appear to be willing to pay (or accept) • what people say they are willing to pay (or accept) Estimates of what people should be willing to pay rely on impact pathway or physical linkage models that trace direct consequences for which there are no market prices (or no market prices that accurately reflect value) to consequences that can be valued with market prices. Impact pathway or physical linkage models are often used to estimate the cost of emissions (or the benefit of emission reductions). There may be no market price for air quality, but people’s willingness to pay for improved air quality can be estimated on the basis of the estimated reduction in respiratory disease and related health-care costs, plus the increase in agricultural or other resource productivity and earnings that the improvement in air quality is expected to cause.2 Impact pathway or physical linkage models are also used in the evaluation of social and educational programs like the child-care example discussed at the end of the first chapter, where the magnitude of the benefits is estimated on the basis of the measurable consequences – the estimated improvement in participant educational outcomes and future earnings; the child development impacts and the related reduction in the costs of special education, criminal justice, and social services; the increase in parental earnings; and other impacts of such programs. Estimates of what people appear to be willing to pay rely on observed behaviour and prices, that is, their revealed preferences. In hedonic pricing studies the values of non-priced goods or attributes are estimated on the basis of the impact they have on observable market prices. For example, to estimate the value that people place on neighbourhood characteristics like air quality, noise, or incidence of crime, one can use econometric estimates of the impact that these characteristics have on house prices.3 Similarly, to estimate the value that people place on risk of injury or death, one can use econometric estimates of the impact that differing levels of risk have on wages.4 Other ways in which observed behaviour and prices are used to estimate value include travel cost studies to estimate the willingness to pay for destination recreational areas;5 analyses of travel mode and route choice to estimate the value of time savings and other travel attribtes;6 and studies of preventative or defensive expenditures to estimate the value of health or whatever it is that the preventative or defensive expenditures are intended to provide.

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Estimates of what people say they are willing to pay are based on surveys designed to elicit people’s preferences, or willingness to pay, for different goods, services, or attributes – their stated preferences. In contingent valuation surveys, people are presented with a scenario defining what is to be valued and all of the factors or contextual information that may affect their valuation of it. They are then asked, with open-ended willingness-to-pay questions or referendum-style yes-or-no questions, what the specified good in the specified context is worth to them. The valuation responses and information on the respondents’ income and other characteristics are then used to estimate willingness-to-pay equations and average values.7 These different methods of estimating value are described in more detail below. They all have advantages and disadvantages that need to be well understood in order to gauge how they can best be used in benefit-cost analysis to enhance and inform public policy debates. Physical Linkage Method There are three basic steps in a physical linkage estimate of value, as illustrated in figure 5.1. First, the direct consequences to be valued have to be fully specified. For example, in the valuation of nitrogen oxide, particulate, or other air emissions, this would include specifying not only the specific type and volume of emissions to be valued but also all of the variables that affect their consequences – the rate and timing of emissions, their specific location, and the context in which they occur (ambient air quality, topography, population density, resource activity, and other factors as required). There is no single value for a tonne of air emissions; there can be significantly different values depending on exactly what they are and when and where they occur. The next step is to trace what has been specified to the consequences that can be valued. For air emissions, this would include using meteorological and other models of the air shed to predict the dispersion and the land or aquatic deposition of the contaminants; human exposure and dose-response studies to estimate the likely incidence of illness and death; agricultural, forestry, and fishery models to estimate the impacts on the quality and quantity of the resource production and related activity; and other models as required to estimate other significant consequences (for example, impacts on buildings or infrastructure). The final step is to estimate the value of the consequences that have been determined with these models and studies – the change in

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Figure 5.1: Physical linkage method Specification • volume or rate of emissions • context

⇒ Impact pathway modelling • dispersion • land, soil, aquatic deposition • human exposure, doseresponse, consequent health effects • productivity, resource output effects

⇒ Valuation • impacts on health-care costs and earnings due to illness and death • impacts on resource activity net benefits

health-care costs and household earnings due to the estimated impacts on the incidence of illness and death; the change in business and employment income due to the estimated impacts on agricultural, forestry, and fishery production; and the change in maintenance and other costs due to the estimated impacts on buildings and infrastructure. The physical linkage method can be used to estimate a wide range of benefits or costs and has a number of advantages: • There is an objective, scientific basis for the valuation. • The physical linkage method provides a clear rationale for the estimated values. • The context for the valuation can be specified, consistent with exactly what is being investigated. • The assumptions underlying the valuation are transparent and can be varied in sensitivity analyses to determine their impact on the results. There are, however, a number of problems and limitations with the physical linkage method. First, the validity of the estimates is limited by the accuracy of the models that are used to trace consequences. Just to estimate the human health impacts from air emissions, for example, one must rely on air dispersion, exposure, and dose-response models, all of which can be subject to significant uncertainty. Second, assumptions have to be made about the adaptive or averting behaviour that people will take to minimize adverse effects. In a physical linkage study of the costs of greenhouse gas emissions, for example, one has to make assumptions about the infrastructure that people will develop and the other measures that they will take to avoid the costs and losses that would otherwise occur with the predicted climate change. It is the minimum necessary costs and losses that need to be estimated.

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Determining exactly what those would be, particularly in future years when technology and other factors will change, is very difficult. Third, physical linkage estimates of value are often not complete. The intent of the method is to trace the direct consequences of a project or policy to those consequences that can be valued with market prices, but this cannot always be done. There are consequences of air emissions, for example, like the visual aspects of smog, that cannot be directly valued with market prices. Also, the costs of some consequences, like illness and death, can only partially be measured with market prices. The full social costs of illness and death go well beyond the changes in health-care costs and household earnings that market price-based estimates capture. Other valuation methods are required for those consequences that cannot be valued or valued fully with market prices. Finally, the essence of the physical linkage method is to estimate what an analyst believes people should be willing to pay or should require in compensation given what the analyst can determine about the consequences. That need not always reflect what people would in fact be willing to pay or require in compensation. People’s perceptions and valuation of risk may be different from the scientific approach that the analyst uses, and more generally their valuation of the consequences may be different. They may legitimately hold different values from what the analyst considers appropriate. Damage Cost versus Abatement Cost or Offset Cost Physical linkage valuation of air emissions and other impacts is generally based on damage costs – the estimated costs and losses that the air emissions or other impacts are predicted to have. A variant of the physical linkage method that avoids problems in the estimation of damage costs is basing the valuation on abatement costs or offset costs. Abatement measures refer to those investments that could be made, or steps taken, on site to reduce or avoid the emissions, or other impacts being valued, and their damages. Offset measures refer to those investments that could be made, or steps taken, elsewhere to reduce similar emissions, or the other impacts being valued, in order to eliminate any net effect. With full abatement or offset there is no need to trace and value the damages that would otherwise occur. There are some obvious attractions to the use of abatement costs or offset costs in the valuation of emissions or other impacts. Limitations in the modelling and valuation of consequences would not matter; the

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modelling and valuation of damages is not required. Nevertheless, it too has its problems. First, it is not clear that the abatement cost or the offset cost will provide a valid economic measure of value. It could well exceed the damages that would otherwise occur or, more generally, the amount that people would be willing to pay to avoid (or the compensation that they would require to willingly accept) what is being valued. It may provide a maximum but not an accurate economic measure of value. Second, it is the costs of marginal abatement or offset measures that need to be estimated – the most efficient measures that would not otherwise take place. It can be very difficult to determine or agree on exactly what the marginal measures would be, when there is a wide range of measures that could be taken at markedly varying costs. It is important to distinguish the requirement to undertake abatement or offset measures as a matter of policy and the use of abatement costs or offset costs to estimate value. As a matter of policy, full abatement or offset may be justified because of the distributional issues that it would address. As an estimate of value in benefit-cost analysis, it has its limitations. Observed Price and Behaviour Methods Economists generally prefer estimating values on the basis of what people actually do, not what they say they will do or even what analysts may think they should do. Estimates of value based on what people actually do can be made by observing prices and behaviour – the choices people make – in related markets. There are a number of different methods for this, the most sophisticated being hedonic pricing. Hedonic Pricing Hedonic pricing methods rely on the fact that the value of many goods and services depends on their underlying characteristics or attributes. By determining the impact that different characteristics have on observable prices, one can infer how much those underlying characteristics are considered to be worth. Any good or service that has a market price dependent on its underlying characteristics or attributes can be used in a hedonic pricing study. House prices and wages are most commonly used. The basic steps are as follows:

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1. Identify a good or service that has an observable market price that is dependent on, among other things, the characteristic or attribute of interest. 2. Determine all of the factors that independently affect the market price of that good or service – all of the explanatory variables. 3. Specify the equation or functional form that relates the explanatory variables, including the characteristic or attribute of interest, to the market price. 4. Collect data on the market price and explanatory variables, and estimate the parameters in the specified equation. 5. Calculate, with the estimated equation, the impact that the attribute of interest has on the observed market price, holding all other explanatory variables constant.8 In algebraic terms, an equation p=f(X1, X2, X3, X4, …) is specified and estimated, where the Xi represent all of the explanatory variables for the observable price, p. The value of any given Xi is inferred by the partial derivative ∂p/∂Xi (the change in p caused by a change in Xi – holding all other variables constant). The partial derivative may be an equation, in which case the value of the characteristic Xi would be dependent on the values of the other variables. In hedonic house prices studies, an equation relating house prices to underlying neighbourhood characteristics and other variables is estimated. The impact that each characteristic has on house prices in the estimated equation is used to infer the value that people place on the characteristic. In hedonic wage risk studies, an equation relating wages to all of the factors governing wages, including occupational risk of injury or loss of life, is estimated. The impact that occupational risk has on wage levels in the estimated equation is then used to infer the value that people place on (the compensation they require to willingly accept) risk of injury or loss of life. The main advantage of hedonic pricing estimates of value is that they are based on the trade-offs that people actually make, or at least the trade-offs that one can infer from observable price data. A further advantage is that they can be used to estimate long-term values, after adjustments have been made to changes in the attributes being valued. These values are arguably less context dependent (more stable) than are the estimates from stated-preference methods.9 The difficulty with hedonic pricing, however, is in correctly isolating and estimating the trade-off of interest. There are a number of reasons the estimated values may not be correct.

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First, the equation that is used to explain the observable market price may be incorrectly specified. The explanatory variables may be incomplete or measured inappropriately. The functional form – the precise manner in which each explanatory variable is assumed to affect the price – may be incorrect. In such cases the impact of the characteristic or attribute of interest in the estimated price equation may not accurately reflect (or, in statistical terms, be an unbiased estimator) of the true value. Second, the explanatory variables used to explain the observable market price may be correlated with one another. There can be a statistical problem of multi-collinearity. The estimated parameters indicating the independent effect of correlated variables are often not statistically significant. It is consequently not clear whether the estimated impact of any one variable reflects its own effect or that of another with which it is correlated. Third, there can be a problem of ‘self-selection’ bias. For example, people who have less concern about occupational risk will not need a large wage premium to work in higher-risk occupations. Or households that have greater tolerance for noise will not pay a much higher price for a house in a quieter neighbourhood. The differences in occupational risk or noise in these cases will then have more of an effect on who takes the riskier jobs or who lives in the noisier neighbourhoods than on wage or house price levels. As illustrated in figure 5.2, under such circumstances the observed supply curve indicating, for example, the impact of additional risk on wage levels will not reflect the average value that the population as a whole places on risk of injury or loss of life. Fourth, the estimated values reflect the willingness to pay or the compensation demanded for a marginal change in the attribute being valued. This will not in general provide an accurate estimate of a large change, because of changing marginal valuations. The more the attribute is available, for example the cleaner the air is, the less people will typically be willing to pay for a further improvement in it. Finally, there are limitations in the transferability of some hedonic price estimates. Wage-risk studies use the premium paid for riskier jobs to estimate the value that people place on more or less risk of injury or loss of life. The issue is, can values estimated for occupational risk of injury or loss of life be used in the valuation of risks of injury or loss of life in, for example, vehicular accidents. People’s attitudes and valuations may be quite different in the two quite different situations.

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Figure 5.2: Wage-risk self-selection wage rate Risk Averse Supply

Risk Takers

Observed Supply Curve

risk

Travel Cost The travel cost method uses information on the costs that different people incur and the correspondingly different number of times they visit a specific recreational area, to estimate a demand curve for that area. The total amount that people travelling from great distances have to incur is assumed to indicate what the people living closer to the recreational area would be willing to pay if they had to. There are different travel cost models that are used to estimate demand curves for recreational areas. However, they all involve two basic steps. First, data on the number of visits, travel time, expense, income, age, knowledge of the recreational area, and other factors assumed to affect the number of visits are collected to estimate a demand curve. In zonal models the average travel time, travel expense, and number of visitor days from different zones (more or less distant places) are collected; in individual models the specific travel time, travel expense, and number of visitor days for individuals or family units are collected. A demand curve is then estimated, showing the relationship between the number of visitor days to the area and the travel cost and other explanatory variables. The estimated demand curve is assumed to apply to all potential visitors to the area, indicating their maximum willingness to pay for different numbers of visits. Comparing the actual travel time and expense that people from different zones or distances must incur to visit the area with the maximum amount that they would be willing to pay, as suggested by the estimated demand curve, indicates the net benefit

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or consumer surplus they derive. People living close to the area derive the highest consumer surplus; those most distant the least consumer surplus. Adding the consumer surpluses across all people who may visit the area (or, more precisely, adding across all potential visits) indicates the total recreational use value (net of actual travel cost) that people place on the area. Like hedonic pricing, the main advantage of this method is that it provides an estimate of value based on actual behaviour. While it was originally developed to estimate the use value of recreational areas, it can in principle be applied more broadly, for example to estimate the value that people place on recreational-related attributes10 or the value that people place on being able to attend specific sporting or cultural events. However, it too is subject to a number of limitations. A major difficulty is estimating total travel cost. There is the problem of valuing time – in some cases travel to a recreational area is a real cost; in other cases it may be a source of enjoyment and not part of the total travel cost. There is the more general problem of multi-purpose travel. How to allocate the time and expenses incurred for more than one destination or purpose can be unclear. There is also the problem of assuming that people close to a recreational area would be willing to pay the same as what people very distant from it have to pay. Tastes and information about the area may be different in ways that the other explanatory variables do not capture. Other Observed Price and Behaviour Methods There are many other methods that are used to infer value based on observed prices and behaviour. Wages, or some proportion of wages, are often used to estimate the value of travel time on the assumption that they represent what people have to be compensated to forgo leisure or additional work time. The choices of travel mode or route that people make when facing different travel-time or other travel attributes and costs are used to infer the value that people place on travel time and the other attributes. These methods have the advantage of being based on observed prices or behaviour, but they too have their limitations. For example, wages represent far more than compensation for leisure time, and they are not always a measure of the work-related opportunity cost of additional travel time. People typically cannot vary their work time on a minuteto-minute or even hourly basis. In addition, travel choice models are

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subject to similar limitations as is hedonic pricing, including misspecification and multi-collinearity of the explanatory variables. Contingent Valuation Method Perhaps the most significant limitation of all of the observed price and behaviour models is that they require some observable price or behaviour that can be used to infer value. For existence values, such observable prices or behaviour typically do not exist. There are donations that people make in support of different environmental and social initiatives, but they are not generally a good indicator of the full value that people place on the existence of different environmental and social attributes. Donations typically do not reflect the maximum amount that people would be willing to pay for any given environmental or social attribute, because of concerns about overheads or the efficiency of the recipient agency or group, uncertainty about how funds will be directed in multi-purpose agencies, and uncertainty about the behaviour of others and the effectiveness of individual contributions for what are pure public goods. Existence values depend more on what people feel than what they do. To estimate these values survey methods are required. There are different survey methods that can be used to estimate value. Some focus on the choice that people would make among different alternatives or baskets of goods. Others, in particular contingent valuation, more directly elicit the amount that people would be willing to pay for different goods, services, or attributes, or the compensation that they would require to offset their diminution or loss. These survey methods are based on stated, as opposed to revealed, preferences. This raises concerns among economists about the reliability of what people say, compared to what they might actually do. Nevertheless, stated preferences can be elicited for a broader range of goods and services or attributes than what is revealed by actual prices and behaviour – in particular, for those things like existence values for which there generally is no observable behaviour from which to infer value. There are three basic components of a contingent valuation survey. First, there is the description of the market scenario. The good, service, or attribute being valued has to be specified, along with all of the factors that may affect an individual’s valuation of it. Second, there is a set of questions designed to elicit each respondent’s willingness to pay (or compensation demanded) for the specified good, service, or attribute.

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Finally, there are questions to determine the respondent’s income, age, education, and other characteristics that may systematically affect the valuation. Describing the market scenario is a critically important component of contingent valuation surveys. Exactly what is being valued has to be clearly and fully presented to the survey respondents in order that they can make an informed valuation, in the same way and with the same consideration that they would in an actual market situation. The market scenario needs to define the costs, if any, of maintaining or accessing the good and the availability and cost of substitutes. It should include a reminder of income constraints. Basically any economic or contextual factor that could affect willingness to pay needs to be specified. The values that are elicited are contingent on the hypothesized market scenario. The usefulness and the reliability of the results therefore depend on how fully and accurately the scenario is described. Eliciting each respondent’s valuation of the specified good, service, or attribute can be approached in different ways. Early contingent valuation studies relied on open-ended willingness-to-pay questions. A variety of techniques were used, including cue cards and bidding games, but in the end the goal was to determine the maximum amount that each respondent would be willing to pay. In recent years, referendum-style yes-or-no questions are more commonly used. In these studies the total survey sample is divided into a number of subsamples, and each subsample is presented with a different price. Instead of being asked their maximum willingness to pay, people are asked whether they would be willing to pay the specified amount. The proportions of respondents in each of the subsamples that are willing to pay the specified amounts are then used to estimate a demand curve and the maximum willingness to pay for the total sample and the population as a whole. The referendum approach can also be based on individual responses tabulated at a wide range of prices, much like the travel cost method can be based on visits made by individuals instead of on visits made from specified zones. In both cases, however, logit curves, as opposed to linear regressions, are estimated because of the discrete yes-or-nodependent variable.11 Determination of each respondent’s income and other characteristics is required to be able to test for the impact of the different characteristics on the willingness-to-pay results. It enables willingness-to-pay equations to be estimated as a function of respondent characteristics.

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This is important in order to be able to apply the results derived from the survey sample to the population as a whole or to other jurisdictions. While contingent valuation avoids the limitations of observed price and behaviour methods and can be applied more broadly, it has a number of its own limitations. First, in a survey, unlike in an actual commitment of funds, there is no direct consequence to an incorrect response. Therefore, the results may be affected by hypothetical and strategic biases. Hypothetical bias refers to the possibility that with no direct consequence to an incorrect response, people will not take the time to consider fully the value that they place on the good, service, or attribute presented to them. Strategic bias refers to the possibility that people will provide a well-considered response, but it will be one that is intended to influence policy as opposed to reflect their true willingness to pay. For example, the valuation of the preservation of a wilderness area that environmental advocates want, but do not expect to have to pay for directly, may be exaggerated in order to increase the likelihood of the area being preserved. Or the valuation of a new bridge that residents believe will be built, regardless of the survey results, may be understated in order to reduce the likelihood or the amount of a toll being charged. There are other potential biases that can affect the reliability of contingent valuation survey results. Value cue and compliance biases can arise if the survey design, or the prompts in the questions, systematically influences respondent valuations. For example, the starting point in the bidding games designed to elicit respondent’s maximum willingness to pay can bias the results. The range of prices posited in referendum-style surveys can bias the results. The problem is that the results can vary depending on what starting points or price ranges are used. There can also be non-response and other statistical biases when the respondent sample is not representative of the population as a whole, and adjustments cannot reliably be made for the differences between the sample and the total population. Misspecification of the good or market scenario is another potential source of bias. Some argue that this is a major limitation of contingent valuation estimates of value. It is not just the technical problem of fully and accurately describing what is to be valued, which can be particularly difficult for non-market goods, services, or attributes with which the respondents are not familiar. Critics of contingent valuation argue that one can never be certain that the willingness-to-pay responses

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reflect the valuation of what the survey intended. They point to evidence of problematic ordering effects, where the valuations of a group of related goods depend on the order in which they are presented in a survey, and embedding effects, where the valuation of a subset of a larger group (for example, the preservation of one area) is little different from the valuation of the larger group itself (for example, the preservation of a large number of areas). These effects suggest that the survey responses may not reflect the value of what is specifically presented in the survey but rather a more general willingness to pay in order to make some effort ‘to do the right thing.’12 Proponents of contingent valuation counter that well-designed contingent valuation surveys with well-specified scenarios can provide reliable estimates of value. Hypothetical and strategic biases can be minimized by presenting a very plausible scenario, for which an incorrect or biased response could have real direct consequences. Value cue and compliance biases can be minimized by explicitly advising the respondents to focus on their own valuations, not on any prices put forward in the survey. Misspecification bias can be minimized by ensuring that respondents are provided with all relevant information about the good, service, or attribute to be valued.13 Moreover, what some suggest are anomalous results, like the insensitivity to the scale or scope, may reflect real preferences and concerns – for example, where preservation itself, not scale, is dominating the valuation.14 In response to concerns about the use of contingent valuation in the setting of regulations and in litigation, the U.S. National Oceanic and Atmospheric Administration (NOAA) established an expert panel of economists to consider whether contingent valuation could in fact provide reliable estimates of value. The panel cautiously concluded that contingent valuation surveys ‘can produce estimates reliable enough to be the starting point of a judicial process of damage assessment, including loss of passive use values.’ For this, however, the surveys would have to be very well designed and implemented. The panel specifically recommended: • personal interviews as opposed to mail-out or telephone surveys, • valuation of willingness to pay, not of compensation demanded, • elicitation of value with referendum-style yes-or-no questions as opposed to open-ended willingness-to-pay approach, • careful description of the scenario, including a reminder of income constraints and substitutes, and

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• follow-up questions to determine the reason or basis for the valuation response and understanding of the scenario.15 In his review of the contingent valuation debate and the NOAA panel report, P. Portnoy suggests that it is important to find a middle ground. It is wrong to dismiss contingent valuation as a flawed method, and it is also wrong to assume that contingent valuation studies can provide useful, reliable information, regardless of how they are implemented. The quality of the research matters, and the challenge for contingent valuation is to do what is necessary to develop estimates of value that can usefully inform public policy debates.16 Purpose of Estimating Values All of the methods used to estimate the value of non-market goods, services, or attributes are problematic. They each have their advantages and, if applied well, can provide reasonable estimates in some circumstances. However, they all have significant limitations. As a result, it would be a mistake to assume that the value of nonmarket goods, services, or attributes can be estimated with the same reliability as can readily observable, competitive market prices. Estimates can be made and, in traditional benefit-cost analysis, used to assign value in order to aggregate the different consequences of alternative projects and policies, but they should be used with caution. At a minimum, ranges of values should be considered, recognizing the uncertainty that surrounds point estimates. Estimates of non-market values are not required in multiple account benefit-cost analysis. Nevertheless, estimates of value can be very useful in providing perspective to the trade-offs identified by the analysis. As Blomquist and Whitehead wrote with specific reference to contingent valuation estimates, ‘public decisions informed by the best estimates from reasonably valid contingent valuation markets are likely to be better than public decisions without these imperfect estimates … the political process [absent such estimates] is imperfect also.’17 A large and growing number of studies have been undertaken to estimate a wide range of non-market values, many of which have been very carefully done. Attempts have been made in recent years to synthesize the results of these studies in order to facilitate the transfer of benefit estimates to other comparable situations. These meta-analyses serve to provide average or ranges of values and, in more sophisticated

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analyses, functional relationships between value estimates and key underlying factors.18 All of this research can greatly assist in assessing the relative significance of the different consequences that alternative projects and policies can have. Estimation of values is important and should be undertaken with as much care as possible, recognizing that precision is neither achievable nor needed. The goal is to inform public policy debates about the values that people may hold and the trade-offs that they would willingly make. In multiple account analysis the purpose is to determine not so much exactly what a particular value is but whether it is more or less than the critical values that would cause one to favour one alternative over another. In this context the limitations of the estimation methods are not a problem per se; they are part of the information that needs to be conveyed in the full multiple-account reporting and assessment of the benefits and costs of different alternatives. Summary • A major strength of benefit-cost analysis is its focus on the relative value of the different consequences of alternative projects and policies. However, the challenge is to develop reliable estimates of value, particularly where market prices cannot be used directly. • There are three basic ways in which values can be estimated – on the basis of what analysts believe people should be willing to pay, what people appear to be willing to pay, or what people say they are willing to pay. • Impact pathway or physical linkage models are used to estimate what people should be willing to pay. With these models the impacts of whatever is being valued are linked to consequences for which there are market prices. For example, the valuation of contaminant air emissions is based on the estimated health and resource damage costs they are estimated to cause. • The main advantage of physical linkage models is that the basis for and the assumptions underlying the estimated values are very clear. However, there can be limitations, particularly in the accuracy of the models used to estimate consequences and in the scope of the impacts that can be valued with market prices. • Basing estimated values on abatement or offset costs instead of on damage costs can avoid some of the limitations with the physical linkage approach, but can raise other problems. The abatement or

110

•

•

•

•

•

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offset measures may not be economically efficient, serving to provide maximum estimates of value. Also, when there is a wide range of abatement or offset opportunities with markedly different costs, it can be difficult to identify the appropriate measures to use. Hedonic pricing, travel cost, and other behavioural models are used to estimate what people appear to be willing to pay. With hedonic pricing, the estimated impact of an attribute on observable prices is used to estimate value. With travel cost, the amount that people actually spend to visit specific recreational destinations is used to infer the maximum that people would be willing to pay if they had to. With other models, the choices that people make in relation to alternatives with different attributes and costs are used to infer the value of the different attributes. The great advantage of all of these behavioural models is that they are based on what people actually do, the amounts they actually pay. The limitations are in isolating the incremental effect of the attributes of interest on observable market prices or behaviour. Further, in some cases, especially with existence values, there may not be observable prices or behaviour that can reasonably be linked to the good or attribute of interest. Contingent valuation methods are used to estimate what people say they would be willing to pay. This method involves specifying the good or attribute of interest and the full context or hypothetical market in which it is to be valued. Surveys are administered to elicit people’s valuation of the specified good or attribute with open-ended or referendum-style yes-or-no questions on their willingness to pay. The advantage of contingent valuation is that it avoids the problems and limitations of the other methods. The great disadvantage is that it is based on what people say, and it may not reliably indicate what they would actually do or be willing to pay. There is considerable controversy about the validity of contingent valuation estimates of value, especially for existence or passive use values. Critics contend that the results may not reflect valuations of what is being specified. Proponents counter that well-designed and implemented surveys can provide legitimate and reasonably reliable estimates of value. An expert panel constituted in the United States to consider this issue concluded that contingent valuation can provide reliable ‘starting point’ estimates of value, and it made a number of recommendations regarding how this can and should be done.

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• All of these methods have their limitations. It would be a mistake to think that estimates of non-market values can be made with the same reliability as can observable market prices. However, if carefully done, estimates of non-market values can be very useful in providing perspective to the critical values and trade-offs that need to be considered in public policy debates.

CASE STUDY Lead in Gasoline Under the Reagan administration U.S. government agencies were required by law to support regulatory initiatives with benefit-cost analyses demonstrating that the benefits exceeded the costs. (Under the Clinton administration that requirement was subtly changed to require that the benefits justified the costs). A classic benefit-cost study undertaken in the 1980s to satisfy the Reagan regulatory requirement was the Environmental Protection Agency’s benefit-cost study of reducing lead in gasoline.19 There were concerns that the Reagan benefit-cost requirement was designed to limit environmental and other regulation in the United States. In this case, however, the benefit-cost analysis provided strong support for a regulatory change that would markedly reduce lead content in gasoline, and arguably hastened its implementation.20 The EPA lead-in-gasoline study is a good example of the application of physical linkages to estimate value or benefits. Four types of benefits were analysed in the study: (i) child health benefits due to reduced exposure to lead; (ii) adult health benefits, in particular reduced incidence of blood-pressure-related illness and death, due to reduced exposure to lead; (iii) health benefits due to reduced exposure to nitrogen oxide and other pollutants as a result of the reduced lead content; and (iv) reduced vehicle maintenance and fuel costs due to the reduced lead content. The child health benefits were based on statistical studies demonstrating the linkage between lead in gasoline and elevated levels of lead in children’s blood. The impact of the proposed reduction in the lead content in gasoline on the number of children whose blood lead levels exceeded an established safe threshold level, and consequently on the incidence of child lead-related illness and cognitive problems, was

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estimated. This impact was then valued with estimates of the medical and remedial education costs that would be avoided due to the reduced number of children with lead-related health and cognitive problems. The adult health benefits were similarly estimated based on statistical studies linking exposure to lead and the incidence of blood-pressurerelated diseases. The impact of the proposed regulatory change on the number of blood-pressure-related illnesses and deaths in the most vulnerable demographic group (males between the ages of forty and fiftynine) was estimated. The impact on illness was valued with estimates of the avoided medical costs and lost earnings. The impact on the number of deaths was valued with a conservative estimate of the willingness to pay to reduce the loss of life. Willingness-to-pay studies available at that time indicated values ranging from $400,000 to $7,000,000 per life saved.21 A willingness-to-pay value of $1,000,000 per life saved was used in the benefit-cost analysis. The benefits from reduced exposure to nitrogen oxide and other pollutants were estimated in two ways: by using a physical linkage estimate of the avoided damage costs (the medical cost savings due to reduced incidence of respiratory and other disease) and by developing an estimate of the avoided abatement costs (air pollution control cost savings). The two types of estimates were averaged for the study. Finally the benefits from reduced vehicle maintenance and fuel consumption costs were based on the estimated impacts on vehicle performance – the direct cost savings. The costs of the regulatory initiative were estimated with linear programming models of the oil-refining industry in the United States. Refining costs with and without the proposed new lead regulatory constraint were used to estimate the cost impact. As shown in the table 5.1, the study found that the estimated annual benefits of a reduction from 1.1 grams to 0.1 grams per leaded gallon exceeded the costs by a wide margin.22 The single largest category of benefit was the reduced incidence of blood-pressure-related illness and death.23 The authors noted that even without that category of benefit, which is difficult to value reliably, the estimated benefits exceeded the costs. Indeed, the estimated savings in vehicle maintenance and fuel costs alone exceeded the costs. This suggested that the refining industry could pass on the costs of meeting the new lead requirement without adversely affecting gasoline consumers. In a multiple account framework, the market valuation alone could be positive without any offsetting consumer surplus loss.24

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Table 5.1 Environmental Protection Agency Results of lead-in-gasoline benefit-cost analysis (in millions of 1983 U.S. dollars) Benefits Child health benefits – reduced exposure to lead Adult health benefits – reduced exposure to lead Health benefits – reduced exposure to NOX and other pollutants Vehicle – maintenance cost savings – fuel cost savings Total benefits Costs Incremental refining costs Net benefits

600 5897 222 914 187 7821

608 7213

While no formal analysis of risks and uncertainties was undertaken, sensitivity cases were undertaken, particularly around implementation strategies. In this study the uncertainty inherent in physical linkage estimates of health benefits was less important to consider in terms of the overall result. Whatever the magnitude of those benefits, they would simply add to the case that the total benefits exceed the estimated costs. The regulatory change was controversial, with industry facing hundreds of millions of dollars of implementation costs. The benefit-cost study helped put those costs in perspective, doing what benefit-cost analysis can do best – informing and facilitating a rational debate about the merits of the regulatory proposal.

NOTES 1 For a full description of all of these methods see G. Garrod and K. Willis, Economic Valuation of the Environment (Cheltenham, U.K.: Edward Edgar, 1999). For a description of different specific methods that can be used in environmental, health, and other regulatory studies see R. Kopp et al., ‘CostBenefit Analysis and Regulatory Reform: An Assessment of the Science and the Art’ (Washington, DC: Resources for the Future, Discussion Paper 97–19, January 1997). A more technical discussion of the different methods is provided in A.M. Freeman, The Measurement of Environmental and Resource

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5

6

7

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Values: Theory and Methods, 2nd ed. (Washington, DC: Resources for the Future, 2003). The impact pathway approach for estimating the cost of air emissions is described and used in the European Commission study of electricity and transportation externalities, External Costs: Research Results on Socio-Economic and Environmental Damages Due to Electricity and Transport (EUR 20198, 2003). Other examples of the application of this approach include K. Palmer et al., ‘Reducing Emissions from the Electricity Sector’ (Washington, DC: Resources for the Future, Discussion Paper 05-23, June 2005); and D. Burtraw et al., ‘The Costs and Benefits of Reducing Acid Rain,’ Contemporary Economic Policy 16 (1998): 379–400. For a summary and an attempt to synthesize the results of numerous air quality hedonic price studies see V. Smith and J. Huang, ‘Can Markets Value Air Quality? A Meta-analysis of Hedonic Property Models,’ Journal of Political Economy 103, no. 1 (1995): 209–27. For a review of wage-risk hedonic price studies see W. Viscusi and J. Aldy, ‘The Value of a Statistical Life: A Critical Review of Market Estimates Throughout the World,’ Journal of Risk and Uncertainty 27, no. 1 (2003): 5–76. The seminal study using this method was M. Clawson and J. Knetsch, The Economics of Outdoor Recreation (Baltimore, MD: John Hopkins University Press, 1966). For a more recent review of this method see F. Ward and D. Beal, Valuing Nature with Travel Cost Models (Northampton, MA: Elgar, 2000). For example, the choices that people make between tolled and more congested, non-tolled alternatives can be used to estimate the value that people place on time savings. See D. Brownstone and K. Small, ‘Valuing Time and Reliability: Assessing the Evidence from Road Pricing Demonstrations,’ Transport Research Part A 39, no. 4 (2005): 279–93. For a detailed discussion of the contingent valuation survey method see R. Mitchell and R. Carson, Using Surveys to Value Public Good: The Contingent Valuation Method (Washington, DC: Resources for the Future, 1989); and R. Cummings et al., Valuing Environmental Goods: A State of the Arts Assessment of the Contingent Valuation Method (Totowa, NJ: Rowman and Allanheld, 1986). There are simultaneity issues that complicate the estimation of the price equation. The supply of, as well as the demand for, characteristics can be affected by their prices. Therefore, two-stage least squares or other such methods are required. Nevertheless, the estimated equation will indicate the marginal valuation of the different characteristics underlying an observable price. This was first demonstrated in a technical seminal paper by S. Rosen, ‘Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition,’ Journal of Political Economy 82, no. 1 (1974): 34–5.

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9 See R. Sugden, Cost-Benefit Analysis as Market Simulation (Washington, DC: Resources for the Future, Discussion Paper 07-28, July 2007). 10 See V. Smith and Y. Kaoru, ‘Signals or Noise? Explaining the Variation in Recreational Benefit Estimates,’ American Journal of Agricultural Economics 72 (1990): 419–33. 11 For an explanation of the logit model see J. Loomis, ‘Contingent Valuation Using Dichotomous Choice Models,’ Journal of Leisure Research 20, no. 1 (1988): 46–56. 12 See D. Kahneman and J. Knetsch, ‘Valuing Public Goods: The Purchase of Moral Satisfaction,’ Journal of Environmental Economics and Management 22, no. 1 (1992): 57–70; and P. Diamond and J. Hausman, ‘Contingent Valuation: Is Some Number Better Than No Number?’ Journal of Economic Perspectives 8, no. 4 (1994): 45–64. 13 In response to Kahneman and Knetsch, see V. Kerry Smith, ‘Arbitrary Values, Good Causes and Premature Verdicts,’ Journal of Environmental Economics and Management 22, no. 1 (1992): 71–89. In contrast to Diamond and Hausman, see Michael Haneman, ‘Valuing the Environment Through Contingent Valuation,’ Journal of Economic Perspectives 8, no. 4 (1994): 19–43. 14 See, for example, E. Ojea and M. Loureiro, ‘Valuation of Wildlife: Revising Some Additional Considerations for Scope Tests,’ Contemporary Economic Policy 27, no. 2 (2009): 236–50. 15 U.S. National Oceanic and Atmospheric Administration, Report of the NOAA Panel on Contingent Valuation, Federal Register, 58, 10 (1993), 4602–14. 16 P. Portnoy, ‘The Contingent Valuation Debate: Why Economists Should Care,’ Journal of Economic Perspectives 8, no. 4 (1994): 3–17. 17 G. Blomquist and J. Whitehead, ‘Existence Value, Contingent Valuation and Resource Damages Assessment,’ Growth and Change 26, no. 4 (1995): 585. 18 For an extensive discussion of these benefit transfer efforts see M. Wilson and J. Hoehn, ‘Valuing Environmental Goods and Services Using Benefit Transfer: The State of the Art and Science,’ Ecological Economics 60, no. 2 (2007): 335–42, and other articles in the same special edition. 19 J. Schwartz et al., Costs and Benefits of Reducing Lead in Gasoline: Final Regulatory Impact Analysis (Washington, DC: U.S. Environmental Protection Agency, February 1985). 20 For a retrospective assessment of the lead benefit-cost study and its impact see A. Nichols, ‘Lead in Gasoline,’ in Economic Analyses at EPA, ed. R. Mortgenstern (Washington, DC: Resources for the Future, 1997). 21 J. Schwartz et al., Costs and Benefits of Reducing Lead in Gasoline, p. V-43.

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22 The table shows the results for the first full year of implementation, 1986, for an intermediate case of partial fuel misfiring. J. Schwartz et al., Costs and Benefits of Reducing Lead in Gasoline, table VIII-3c, p. VIII-15. 23 It is common in air emission studies for changes in the risk of loss of life to dominate the results. For example, in D. Burtraw et al., ‘The Costs and Benefits of Reducing Acid Rain,’ the estimated benefits from reductions in mortality were an order of magnitude greater than any of the other benefit categories, far greater than the benefits from the reduction in resource impacts with which acid rain is generally associated. Although not the case in this lead-in-gasoline study, where the other benefit categories were sufficient to justify the costs, the reliability of estimated mortality benefits can be a critical issue. This is particularly the case when the lives saved are predominately those of older people and those with pre-existing health conditions. It is often argued that benefit-cost studies should measure benefits in terms of quality life years saved. However, it is not clear whether and to what extent the willingness to pay to reduce the risk of loss of life varies by remaining life expectancy and health condition. See A. Alberini et al., ‘Does the Value of a Statistical Life Vary with Age and Health Status? Evidence from the United States and Canada,’ Journal of Environmental Economics and Management 48, no. 1 (2004): 769–92. 24 A multiple account evaluation of this initiative would focus on three accounts: market valuation, user or consumer net benefit, and the environmental and health account. The market valuation would estimate the change in the refining industry net revenues – the incremental amount that consumers pay for the lower-lead-content gasoline relative to the incremental expenditures that refiners incur to produce it. If the refiners passed on the total cost, which it would appear they could do given the consumer benefits from reduced maintenance and improved fuel efficiency, the market valuation would indicate no net benefits or costs. The consumer net benefit account would consider the incremental willingness to pay for the lower-lead-content gasoline relative to the incremental amount that consumers have to pay. The estimated impact on vehicle maintenance and fuel costs suggests that this would be positive even if the refiners passed on all of the incremental refining cost. The environmental and health account would consider the willingness to pay for, or assess the significance of, the health and reduced mortality effects. This, of course, would be significantly positive, particularly with the adult health benefits included.

6 Aggregating Benefits and Costs over Time

The Discount Factor Benefit-cost analysis requires weighting and aggregating the very different positive and negative consequences of alternative projects and policies. The relative values or weights attached to different consequences that occur at any point in time are based on the compensating variations that people hold with respect to them, that is, the maximum that people would be willing to pay for the positive, and the minimum compensation that they would require to offset or willingly accept the negative. The weights that are attached to consequences that occur at different points in time are defined by the discount factor, which in turn is based on the discount rate – the rate at which people would willingly trade off present for future benefits or costs. Discount factors are used to convert the magnitude of benefits and costs that are forecast to occur at different points in time to their equivalent present value, that is, the amounts that individuals would have to receive or incur today to be of equal value to the amounts forecast to occur in the future. Once all benefits and costs are expressed in terms of their equivalent present value, they can be summed and compared in order to calculate the overall net benefits – the net present value – of the project or policy, or, in multiple account benefit-cost analysis, the net benefit or cost under any account measured in dollar terms. On the assumption that the discount rate remains constant over time, an assumption that is generally made but (as noted later in this chapter) is not necessarily correct, the discount factor will equal one over one plus the discount rate to the power i, where i is the number of time periods into the future that the benefit or cost is forecast to occur. Time

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periods are usually measured in years from a base date. The discount rate then refers to the rate at which people are willing to trade off benefits or costs from one year to the next. In algebraic terms: PV[Xi]={1/(1 + r)}i * Xi Where: PV[Xi] is the equivalent present value of a benefit or cost Xi (the amount of benefit or cost forecast to occur in year i), r is the discount rate, and {1/(1 + r)}i is the discount factor for benefits or costs forecast to occur in year i. Therefore: PV[B] = ∑PV[Bi] = ∑{1/(1 + r)}i * Bi , for all i (years) over the life of the project PV[C] = ∑PV[Ci] = ∑{1/(1 + r)}i * Ci , for all i (years) over the life of the project NPV = PV[B] – PV[C] Where: PV[B] is the total present value of the benefits over the life of the project, PV[C] is the total present value of the costs over the life of the project, ∑ refers to the sum of, Bi and Ci are the amount of benefits and costs forecast to occur in year i, and NPV is the net benefit or net present value of the project (or evaluation account). The discount factor or weight applied to a future benefit or cost depends on both the discount rate and the timing of the future benefit or cost. The discount factor will be smaller the larger is the discount rate and the further from the present the benefit or cost is forecast to occur. As illustrated in the table 6.1, the discount factor is increasingly sensitive to the discount rate the further out one goes. Relatively high discount rates result in very little weight being given to more distant benefits and costs. At a discount rate of 8 per cent, for example, the

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Table 6.1 Discount factor (by time period and discount rate)

5 years 15 years 30 years

2%

5%

8%

.906 .743 .552

.784 .481 .231

.681 .315 .099

weight applied to a benefit or cost expected in thirty years’ time is 0.099, less than 10 per cent. In other words, a benefit or cost of $100 in thirty years’ time would have an equivalent present value of less than $10. The overall net benefit or net present value of alternative projects or policies that have long-term effects can consequently depend greatly on the discount rate used. Lower discount rates will tend to favour capitalintensive projects relative to those that have less initial capital but more ongoing operating costs (for example, a hydroelectric power project compared to a thermal power project). The ongoing operating and fuel costs of the thermal power alternative are given greater weight, the lower the discount rate. Lower discount rates will also tend to favour projects or policies that generate benefits in the long term, like conservation, over those that offer benefits only in the short term. It is important to note that it is not the consequences of the projects or policies that are affected by the discount rate; it is the valuation of those consequences, specifically the equivalent present valuation. The choice of discount rate is often a central issue in benefit-cost analysis, and the results can only be understood in the context of the discount rate that is assumed. As discussed later in the chapter, this is particularly the case when considering very long-term effects, like the consequences of greenhouse gas emissions. It is therefore critically important to consider the basis and validity of the discount rate that is used in any benefit-cost analysis, and the impact that it has on the results. Rationale for Discounting There are people, including a number of well-known classical economists, who argue that it is myopic (some would say immoral) to discount future benefits and costs.1 They would suggest that the discount factor or weight given to future benefits and costs should be one, or (to say the same thing) the discount rate should be zero. However, benefitcost analysis is not based on the values that some argue people should

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have; it is based on the values that people do have. The fact is, most people do value the benefits or costs that occur in the future less than those that occur today. This, it should be noted, is not due to inflation. Most people apply a real discount rate2 to values measured in real terms, that is, that have already been adjusted for inflation. One reason that people discount future benefits and costs is uncertainty, the uncertainty that they will be in the same circumstances (or even alive) to enjoy future benefits or incur future costs, as well as the uncertainty that benefits and costs will materialize as currently forecast. But even without uncertainty (for example, if one were dealing with certainty equivalents, the certain amounts that people would value equally to a range of possible outcomes), there are still two fundamental reasons people discount future benefits and costs. First, there is time preference – the fact that most people simply prefer benefits to occur sooner rather than later (and costs to be deferred). Second, there is the social opportunity cost of capital – the fact that benefits realized sooner (or resources that are available because of the deferral of costs) can be invested and grow to larger amounts in the future. Time Preference Rate In economic terms, the time preference rate refers to the marginal rate of substitution between present and future consumption opportunities, that is, the extra amount of future consumption a person would require to willingly defer any given amount of consumption today. It is commonly estimated by the after-tax real interest rate on savings because this indicates the extra amount that people actually receive when they save. In other words, the real interest rate indicates what people are actually compensated when they defer current consumption. Underlying time preference are two different factors. There is pure time preference, which refers to the rate at which people are willing to trade off present for future utility. (It is this pure time preference rate that classical economists and others have argued on moral grounds should be equal to zero.) There is also the effect of rising real incomes. In growing economies a dollar of consumption opportunity will have less significance in the future as real incomes rise; it will offer less incremental utility or satisfaction. The greater the expected rate of growth in per capita real income, the greater will be the rate of time preference, that is, the more one will prefer any given amount of consumption opportunities in the present when one is relatively poorer to consumption opportunities in the future when one is relatively better off.

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These two factors underlying the time preference rate can be expressed as follows: rs = rp + g*U’ Where: rs is the time preference rate, rp is the pure time preference rate, g is the rate of growth of per capita real income, and U’ is the rate at which the marginal utility of consumption falls as per capita real income increases. Social Opportunity Cost of Capital In economic terms, the social opportunity cost of capital refers to the marginal rate of transformation, that is, the rate at which consumption opportunities can grow over time through investment. It is measured by the real (inflation-adjusted), pre-tax social rate of return on investment. It is measured by the pre-tax rate of return in order to capture the return not only for the investor but also for taxpayers. Also, it is measured by the social rate of return, including adjustments for any systemic external benefits or costs, in order to capture the return for society as a whole. There is considerable controversy over the magnitude of this rate of return on investment. In a seminal Canadian study, G. Jenkins estimated that the real, pre-tax social rate of return on investment was over 11 per cent in Canada in the 1960s and 1970s.3 That estimate was challenged in a subsequent study by D. Burgess who argued that Jenkins’ estimate exaggerated both the tax and the economic rent components of the social rate of return. Burgess estimated that the rate of return was in the order of 9.5 per cent.4 The U.S. federal government Office of Management and Budget (OMB) estimated that the real, pre-tax rate of return on all sources of private capital in the United States is approximately 7 per cent. The rate of return on business investment alone is higher, at approximately 10 per cent.5 Some recent studies suggest that the social opportunity cost of capital is considerably lower than these estimates. M. Moore et al. emphasize that the social opportunity cost of capital should be based on the marginal, not the average, return on investment, that is, on the rate of return that can be realized on the least profitable but still viable investments. Based on the real return on corporate bonds, they estimated the

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social opportunity cost of capital to be in the order of 4.5 per cent.6 However, that rate does not include any premium for risk, an important component of the return on equity investment, nor does it include any provision for tax or other social benefits that private sector investments can provide. In a 2007 update of his earlier work, Jenkins and colleague C. Kuo estimated that the social opportunity cost of capital has ranged between 10 and 14 per cent over the past fifty years. They concluded that a reasonable value to use would still be 11.5 per cent.7 Although there is a wide range in estimates of the social opportunity cost of capital, it is generally agreed that whatever the precise rate is, it is significantly higher than the time preference rate. Moore et al.’s 4.5  per cent estimate of the social opportunity cost of capital, for example, is three times greater than their 1.5 per cent estimate of the time preference rate. Jenkins and Kuo’s 11.5 per cent estimate of the social opportunity cost of capital is also roughly three times their 4.0 per cent estimate of the time preference rate. The U.S. OMB’s 7 per cent estimate of the social opportunity cost of capital is more than double their 3.1 per cent estimate for the time preference rate. There are two reasons for this marked difference in rates. First, the social opportunity cost of capital is based on pre-tax rates of return, whereas the time preference rate is measured by after-tax interest rates. Taxes on the return on investment create a wedge between the social opportunity cost of capital and the time preference rate. Second, the rate of return on investment includes some compensation for risk. The average premium that investors require to compensate for risk creates a further wedge between the time preference and social opportunity cost rates.8 If one were estimating the social opportunity cost of capital by the rate of return that could be earned on risk-free investments (for example, secure government bonds), then there would not be this additional wedge between the time preference rate and the social opportunity cost of capital. However, it is more common to include the average premium required to compensate for risk as part of the social opportunity cost of capital. It is part of the return that would in fact be earned. Time Preference versus the Social Opportunity Cost of Capital Time preference and the social opportunity cost of capital are both important and valid reasons for discounting, but they imply using quite different discount rates. This creates a problem because the different

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Table 6.2 Net benefits at time preference rate vs social opportunity cost rate (millions of dollars) Time preference rate (4%) Present value benefit Present value cost Net present value

13.5 10.0 3.5

Social opportunity cost (11.5%) 6.7 10.0 -3.3

rates can generate significantly different results, as the following simple example shows. Suppose a $10 million maintenance project would eliminate the need for $20 million in major refurbishment expenditures in ten years’ time. For illustrative purposes, assume the time preference rate is 4 per cent and the social opportunity cost of capital is 11.5 per cent. As shown in table 6.2, the present value cost of the project, occurring in year zero, would be $10 million for both the time preference and the  social opportunity cost rate. (The discount factor in year zero, {1/(1 + r)}0, is one, regardless of the discount rate.) However, the present value of the benefit – the $20 million avoided cost in ten years’ time – would be quite different depending on the discount rate. At a 4 per cent time preference rate, the present value of the benefit would be approximately $13.5 million. At an 11.5 per cent social opportunity cost of capital, the present value of the benefit would be only $6.7 million. In terms of people’s time preference, the maintenance project appears to offer positive net benefits. The $13.5 million present value of the benefit in ten years’ time is $3.5 million more than the initial $10 million cost. In terms of the social opportunity cost of capital, however, the project appears to result in a net loss. At $6.7 million, the present value of the benefit is $3.3 million less than the initial cost. The result with the time preference rate indicates that the future benefits are valued more than is the initial cost, based on the trade-off that people are willing to make between present and future consumption. The result with the social opportunity cost of capital indicates that people could have had even greater benefit if the $10 million initial cost were invested elsewhere. At an 11.5 per cent rate of return, the initial $10 million could have yielded almost $29.7 million of benefits in ten years’ time, or $9.7 million more than the benefits from the maintenance project. That is why the maintenance project appears to generate a net loss when one discounts at the social opportunity cost rate.

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The issue therefore arises about which basis for discounting one should use – the rate at which people are willing to trade off present for future consumption opportunities or the rate at which consumption opportunities can grow through investment. U.S. government guidelines call for both to be used – a base case 7 per cent, representing the social opportunity cost of capital, and sensitivity results at 3 per cent to reflect the time preference rate. If the project or policy is expected to displace corporate business investment, then sensitivity at a higher than 7 per cent opportunity-cost-of-capital rate is called for, reflecting the forgone rate of return in that sector.9 The problem with using such a wide range of discount rates is that they can provide quite different results, as the simple example above illustrates. To settle on a single rate or discounting procedure, the two main alternatives are to apply either a weighted average social opportunity cost of capital or a hybrid shadow pricing approach in which a time preference rate is used to discount the potential consumption opportunities created or forgone by alternative projects. Weighted Average Social Opportunity Cost of Capital Applying a weighted average social opportunity cost of capital is a standard approach in benefit-cost analysis. The weighted average rate is based on estimates of how the economy would respond to a hypothetical increase in the demand for capital required for any given project. More specifically, it is a discount rate that reflects the extent to which an increase in the demand for capital would be met by an increase in saving (the deferral of current consumption) as opposed to the crowding out (displacement) of other investments. The opportunity cost of saving is measured by the trade-off that people would willingly make between present and future consumption – the time preference rate. The opportunity cost of displacing other investment is measured by the rate of return that is forgone – the social opportunity cost of capital. The overall cost and therefore rate at which future benefits should be discounted is the weighted average, that is, the proportion of capital that is met by increased saving, times the time preference rate, plus the proportion of capital that is met by displacing other investment, times the social opportunity cost of capital. r = a1*rs + a2*rI

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Where: r is the weighted average social opportunity cost of capital, rs is the time preference rate, rI is the social opportunity cost of capital, a1 is the proportion of capital that is met by increased saving, a2 is the proportion of capital that is met by displacing other investment, and a1 + a2 = 1. This formulation of the weighted average social opportunity cost of capital assumes that there are only two ways by which an increase in the demand for capital can be met – an increase in savings or the displacement of other investment. In an open economy or from the perspective of smaller jurisdictions within larger economies, there is a third source. An increase in the demand for capital can be met by inflows of capital to the country or the region from foreign or outside investors. The cost of this source of capital is the after-tax rate of return that flows back to those investors. The weighted average social opportunity cost of capital in this more general case includes the proportion of capital that is met by this source, times its cost.10 r = a1*rs + a2*rI + a3*rFB Where: rFB is the after-tax rate of return to foreign investors, a3 is the proportion of capital that is met by increased foreign investment, and a1 + a2 + a3 = 1. The weighted average discount rate typically used in benefit-cost analysis is therefore based on the estimated impact that any incremental demand for capital will have on saving, domestic investment, and inflows of foreign capital, and their respective costs. As summarized in table 6.3, in his seminal study Jenkins estimated that the principal impact of an increase in the demand for capital in Canada (75 per cent of the total impact) would be to displace domestic investment, and the opportunity cost of that is quite high (a forgone return of 11.45 per cent). Jenkins estimated that savings would only meet 5 per cent of the incremental demand for capital, and foreign

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Table 6.3 G. Jenkins’s estimate of the weighted average social opportunity cost of capital

Proportion of capital Opportunity cost Weighted cost

Savings

Displaced investment

Inflows of foreign investment

Total

0.05 4.14 0.21

0.75 11.45 8.59

0.20 6.11 1.22

1.00 10.02

investment 20 per cent. Overall, Jenkins estimated that the real (inflation-adjusted) weighted average social opportunity cost of capital in Canada was approximately 10 per cent.11 Based on Jenkins’s analysis, the Canadian Federal Treasury Board Secretariat recommended that a 10 per cent real discount rate be used as the ‘base case’ discount rate in benefit-cost analyses.12 However, there were concerns that a 10 per cent real discount rate was too high and would result in the excessive discounting of the benefits of conservation and other projects or policies with long-term benefits. In his critique of Jenkins’s seminal study, Burgess argued that there were a number of reasons a 10 per cent real discount rate was too high. As noted earlier, Burgess argued that Jenkins overestimated the social opportunity cost of capital, that is, the pre-tax social rate of return that could have been earned on alternative investment. He also argued that Jenkins’s estimate of the proportion of capital financed from increased savings (5 per cent) was too low, and the estimated cost of that (4.11 per cent) too high. Most important, he argued that Jenkins’s estimates did not properly reflect the extent to which an increase in the demand for capital in an open economy like Canada attracts foreign investment. The more foreign capital that is attracted, the less will be the displacement of alternative investment and the lower will be the weighted average social opportunity cost of capital. Burgess presented a range for the weighted average social opportunity cost of capital, depending on the responsiveness of foreign investment to demands for capital in Canada. He suggested that a real discount rate in the order of 7 to 7.5 per cent should be used.13 For an open economy such as in Canada, and certainly from the perspective of an individual region or province, one could argue that the weighted average social opportunity cost of capital is likely to be no more than the cost of foreign investment. That would suggest that a ‘base

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case’ discount rate of 6 per cent would probably be more appropriate than the 10 per cent rate established by the Canadian Treasury Board in the 1970s. There is a problem, however, in assuming that all demands for capital can be met by increased foreign investment with no crowding out of alternative investment or other economic activity. There are limits to the amount of labour, material, and equipment available in an economy, and this can constrain the total amount of real investment that takes place. A low discount rate based solely on the cost of foreign investment or foreign borrowing does not take real resource constraints into account.14 It also does not recognize the impact that increased foreign borrowing for any one project can have on the cost of foreign borrowing for all others. Generally one can expect the cost of foreign borrowing to increase, the greater the amount of foreign borrowing that takes place. In their update of the weighted average social opportunity cost of capital, Jenkins and Kuo acknowledge that an incremental demand for capital would induce more foreign capital and displace less alternative investment than estimated in Jenkins’s seminal work. They also conclude that there would be a greater savings response than that originally estimated by Jenkins. Overall, they conclude that the weighted average social opportunity cost of capital in Canada – the social discount rate one should use in Canada – is approximately 8 per cent.15 This is lower than Jenkins’s earlier 10 per cent estimate and more consistent with the 7 per cent rate recommended by the U.S. OMB, but it is still higher than the cost of foreign borrowing. Hybrid Shadow Pricing Approach The weighted average social opportunity cost of capital is well suited to projects or policies that entail an incremental demand for capital, thereby putting upward pressure on interest rates and, in so doing, having a typical impact on savings, investment, and foreign borrowing in the economy. However, benefit-cost analysis can be applied to a wide range of issues, and not all of them fit that description; some may not entail any demand for capital at all. For example, an initiative to reduce recreational fishing activity in order to conserve fish stocks need not have impacts on savings, alternative investment, and foreign borrowing in the manner assumed in the estimation of the weighted average social opportunity cost of capital. The initial public investment in this case would be the forgoing of fishing

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opportunities. It is not clear why a weighted average opportunity social cost of capital should be applied in such circumstances. An alternative approach that is more sensitive to different types of projects and policies and their different impacts on savings and investment is a hybrid shadow pricing approach. The essence of this approach is to convert all benefits and costs to potential consumption opportunities and then to discount those consumption opportunities at a time preference rate.16 To convert benefits and costs to potential consumption opportunities, one first has to identify those benefits that are likely to be reinvested and those costs that are likely to displace alternative investments. Then, the potential consumption opportunities that can be generated by the reinvestment of the benefits and that are forgone by the displacement of investments are estimated based on the social opportunity cost of capital. These estimated consumption opportunities replace the original benefit and cost values in the analysis. With all benefits and costs expressed in terms of potential consumption opportunities created or forgone, they can be discounted at the time preference rate. Suppose, for example, that the government is considering building a winter sport facility in a remote area. The project entails an initial investment of $30 million – $25 million for construction and an estimated $5 million in lost existence values due to the change from the area’s natural wilderness state. (The $5 million is meant to represent what people would be willing to pay to retain the area in its wilderness state. Clearly there are issues regarding the reliability of such an estimate, and in multiple account analysis the lost existence values might not be monetized but rather addressed in terms of a critical value, that is, what the existence value would have to be to prefer the current state over a developed state. A specific value is assumed here simply to illustrate how the hybrid method would be applied to different types of benefits or costs.) Of the $30 million in initial investment, only the $25 million in construction expenditures would potentially displace other investments. In the hybrid shadow pricing approach this $25 million would be replaced by the consumption opportunities that it could have yielded had it been invested elsewhere. On the assumption of an 11.5 per cent social opportunity cost of capital, the $25 million would be replaced by a stream of consumption opportunities of $3.25 million per year (over a twenty-year planning period). The present value of that, at a 4 per cent time preference rate, would be $44 million.

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The analysis would effectively replace the $25 million in construction expense with the $44 million present value of forgone potential consumption opportunities. The total initial investment, including the $5 million lost existence value, would be $49 million instead of $30 million. The shadow price factor would be 49 divided by 30, or approximately 1.63. The overall project net benefits would then be calculated by comparing this initial investment with the present value of the annual benefits and costs. They would be discounted at the time preference rate without any shadow pricing, on the assumption that the annual benefits would not be reinvested and the annual expenditures would not displace any investments. The advantage of the hybrid shadow pricing approach is its explicit recognition of when and how one should take into account the social opportunity cost of capital as opposed to the trade-off that people are willing to make between present and future consumption. The analysis is not constrained by the fixed parameters underlying the estimated weighted average social opportunity cost of capital. However, this approach is not commonly used, largely because of the difficulty in determining exactly which benefits and costs need to be shadow priced, that is, which benefits are likely to be reinvested and which costs are likely to displace other investment. Guidelines can be developed for this, but if there is no consistency in the application, there will be no consistency or transparency in the results. Discounting and Sustainability The discounting of benefits and costs, even at a relatively low time preference rate, gives little weight to very long-term effects. For example, at a 3 per cent discount rate, costs expected in one hundred years’ time would be weighted by a discount factor of only 0.052 to calculate their present value. A $100 cost would be considered equivalent to a cost of approximately $5 today. At an 8 per cent discount rate, the discount factor is 0.00045. The $100 cost expected in one hundred years’ time would be considered equivalent to a cost of less than $0.05 today. For many, this effect of discounting is inappropriate, particularly in the context of sustainability. They argue that any discounting will not adequately take long-term impacts into account and consequently is not fair to future generations. They take the position, for example, that catastrophic impacts of climate change or the destruction of major

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ecosystems are of equal concern whether they take place in one year or one hundred years. Only a discount factor of one, or a discount rate of zero, would properly recognize the significance of such potential events. Applying a zero discount rate has a very profound effect on the valuation of future benefits or costs. The 2007 Stern report on climate change, for example, concluded that the costs of continuing greenhouse gas emissions would be very high, the equivalent of some 15 per cent of global gross product.17 That was much higher than the cost estimates in previous analyses of greenhouse gas emissions. However, W. Nordhaus pointed out in his critique of Stern’s analysis, ‘The [Stern] Review’s radical revision of the economics of climate change does not arise from any new economics, science or modeling. Rather, it depends decisively on the assumption of a near zero discount rate.’18 The rationale for applying a zero discount rate to very long-term effects is to give equal weight to the interests of present and future generations. However, there are a number of reasons that this is inappropriate in benefit-cost analysis.19 First, application of a zero discount rate is not necessarily equitable to all generations. With economic growth, a benefit or cost in the future would be less significant than the same amount of benefit or cost today. Future generations would be in less need of (would get less incremental utility from) a dollar of benefits in the future, and they would be better able to cope with a dollar of costs. Second, as a practical matter, application of a zero discount rate will not enable any meaningful sum of permanently ongoing benefits or costs. Any permanently ongoing impact will have an infinite total present value. Third, applying a zero discount rate presumes that estimates of very long-term consequences are as reliable as estimates of consequences that are expected in the short term. It gives equal weight to an estimated consequence in hundreds of years as it does to one that will occur today, even though there is much less reason to believe that the future consequence will unfold as currently predicted. Finally, application of a zero discount rate is inconsistent with the basic principles of benefit-cost analysis. The weight given to a future consequence is not what some argue it should be; rather, in benefit-cost analysis it is what people today would choose it to be. Benefit-cost analysis is concerned with the choices or the resource allocation decisions that people today would want to make. This does not mean that the interests of future generations are ignored; it simply means that those

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interests are taken into account to the extent that the current generation wishes or considers it appropriate to do so. There is little doubt that people value sustainability and are concerned about the state of the environment and the quality of life that future generations will inherit. However, there are better ways to take this into account in benefit-cost analysis than by imposing a zero discount rate in the evaluation of forecast long-term consequences. The most direct way is to recognize that most issues of long-term sustainability or quality of life are not discounting issues at all. It is not the future values discounted to the present that need to be addressed, but rather the values that people hold today in respect of the possible long-term consequences. Specifically, the following need to be explicitly considered and assessed: • the existence or bequest values that people currently hold – their current willingness to pay or allocate resources to support the sustainability of resources and the avoidance of environmental costs over the very long term, • the value that people currently place on precautionary actions (or insurance) – their current willingness to pay or allocate resources to avoid the risk of catastrophic events in the future, and • the value that people place on flexibility (or quasi-option value) – their current willingness to pay to be able to respond effectively to new information that may arise in the future. The resource allocation question is, what are people (the current generation) willing to pay or allocate today? That is quite different from, and more directly relevant than the question, what is the present value of the benefits or costs that future generations may realize or incur? Future generations are not making the current resource allocation decisions. Therefore, the present value of what they would be willing to pay or would have to be compensated in the future is not the issue. The benefit-cost issue is what people today are willing to pay.20 Recognizing the issue of very long-term effects and sustainability directly in terms of the trade-off that people today are willing to make not only avoids the arbitrary and problematic use of a zero or near zero discount rate, but also identifies better the questions that need to be analysed. With regard to existence and bequest values, it requires consideration of the mix of natural and manufactured assets that people want to ensure is available for future generations. Those who value

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strong sustainability will want to ensure that natural capital is maintained and enhanced for future generations.21 With regard to precautionary measures and the need for flexibility, it requires consideration of the range of possible consequences – in particular, the negative tail events – as much as the expected or most likely outcomes, and people’s willingness to pay to avoid them.22 There are circumstances where it is necessary and appropriate to calculate the present value of long-term effects. There are the intragenerational effects that can take place over many years. As well, the present value of future impacts may be useful to calculate in order to provide some perspective to the value that people may hold today in respect of them. However, while it is important to ensure that longer-term impacts are given appropriate weight, there are better ways to proceed than imposing the use of a zero or near discount rate for certain types of goods or attributes. One way is to consider and explicitly recognize changing real values, as was done in the Saddler case study discussed at the end of chapter 2. On the one hand, environmental attributes that will become increasingly scarce are likely to grow in real value over time. Manufactured goods, on the other hand, are more likely to fall in real value. Recognizing these expected changes in real values will impact the effective discount rate. The effective discount rate is approximately equal to {1/(1 + r - p’)}i where p’ is the forecast annual rate of increase in the real value of the good or attribute in question. The greater is p’ the lower is the effective discount rate. Anything that is expected to grow in value will be effectively discounted at a lower rate. Anything expected to fall in value will be effectively discounted at a higher rate. This may appear similar to the application of different discount rates to different goods and attributes, but it is quite different. It requires explicit consideration and justification for the forecast change in real value; it is not simply an asserted judgment about what discount rate to apply. It is also important to recognize in the valuation of very long-term effects that the discount rate will likely fall over time. Traditional discounting with a discount factor equal to {1/(1 + r)}i assumes that the rate of discount (or relative present value) is the same from year one to year two as it is from year fifty to year fifty-one. However, there are theoretical reasons and empirical evidence that this does not reflect people’s actual preferences. Recognizing that the rate of discount will fall over time gives greater weight to long-term effects.23

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As said at the outset, benefit-cost analysis can inform but not resolve public policy debates. It may be that policy will be governed by the weight that some people believe should be given to the interests of future generations. However, policy decisions ought to be informed by what people would prefer if given the choice. This applies to what people would prefer with respect to long-term effects as much as to other resource allocation issues. Intergenerational impacts are not the only equity issue of importance to people. There are extreme poverty, war, inequality of opportunity, and many other issues of immediate concern. Consideration of people’s preferences can help in establishing priorities and commitments for all of these matters. Discounting and Uncertainty or Risk In discounted cash flow analyses of private investment decisions, a discount rate reflecting the cost of capital for the specific investment is generally used. Riskier investments – those subject to greater uncertainty or a wider variance in the forecast rate of return – will entail a higher cost of capital and therefore be analysed with a higher discount rate. The cost of capital in private investment analyses is a weighted average of the interest cost on debt and the rate of return required to attract equity. Riskier investments have a higher cost of capital because of higher interest rates on debt, a higher proportion of equity relative to debt, and a higher required return on equity to compensate for the greater risk. The effect of using higher discount rates for riskier investments is to require a higher expected return before the riskier investments are considered worthwhile to undertake. The internal rate of return has to be higher. The internal rate of return is the specific discount rate that equates the present value of revenues and expenditures, for which the net present value is zero. It generally indicates the maximum cost of capital up to which one would have positive net benefits. One could consider similarly adjusting the discount rate used in benefit-cost analysis to reflect the uncertainty or risk in the forecast net benefits. In other words, one could require a higher expected net benefit or internal rate of return to justify (find positive net benefits for) a riskier project or policy. However, that generally is not done. There are a number of problems with adjusting the discount rate to account for uncertainty or risk.

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Increasing the discount rate for riskier projects will reduce the weight given to future benefits and costs by the same proportion from one year to the next, thereby applying an exponentially growing risk factor even though that might not reflect the nature of the uncertainty and its growth over time. Increasing the discount rate for riskier projects or policies will reduce the weight applied to all future benefits and costs even though that may not be consistent with the weight that people would want to give to different long-term effects. It could result, for example, in giving virtually no weight to the long-term benefits that major hydro projects can provide relative to power projects with significantly shorter lifespans, despite the value that people would place on the prospect of such longterm benefits. Adjusting the discount rate in a manner analogous to private investment analyses assumes a conventional profile to the benefits and costs – that costs are initially incurred and net benefits follow. However, benefit-cost analysis can be applied to projects or policies with quite different benefit and cost profiles. Major costs can be forecast to occur over the longer term, for example in the management of nuclear wastes as discussed at the end of this chapter. In such cases, applying a higher discount rate to account for greater risk can have the opposite of the intended effect. It can make such a project appear relatively more attractive because of the reduced weight given to the back-end costs. Even if one were to consider adjusting the discount rate for risk in a project or policy with a conventional benefit-and-cost profile, the magnitude of adjustment that would be appropriate for government projects and policies would be questionable. It is not the risk associated with any one initiative that would be of concern; it is the systemic or undiversifiable risk of the mix of projects and policies a government undertakes in any given period that would be of concern. Also, it is the significance of the risk borne by individual taxpayers or residents and businesses that governs the adjustment that should be made. In an analysis of these issues Arrow and Lind argued that because of the diversity of projects that government undertakes and, more important, the spreading of any remaining systemic risk among large numbers of taxpayers or stakeholders, little if any adjustment for risk is required. Certainly no adjustment to the discount rate to take account of risk is warranted in the same way as individual investors might do.24 The standard approach to risk in benefit-cost analysis is to apply the same weighted average social opportunity cost of capital (or hybrid

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shadow pricing approach) to all projects. The social opportunity cost of capital (or forgone return in the shadow pricing approach) may include some premium for the average degree of risk in the investments displaced as a result of any project. But it does not include any premium or adjustment for the uncertainty or degree of risk for the project itself. The analysis and valuation of the project uncertainty and risk are dealt with separately. The first step in a risk analysis is to identify the nature of the uncertainty or risks that may affect the benefits and costs of any project. This requires an understanding or estimate of the range of consequences that the project may have. Uncertainty refers to the possibility of different outcomes or values for which there is no objective basis for assigning probability distributions. The analysis of uncertainty is generally undertaken with scenario or sensitivity analyses where the effect of different assumptions about the uncertain variables can be assessed. Risk refers to the possibility of different outcomes or values for which there is an objective basis for assigning probability distributions. Here, more formal Monte Carlo analyses can be used, where repeated simulations with random draws based on the probability distributions of each of the underlying variables determine a probability distribution of the overall result. In multiple account benefit-cost analyses, the uncertainties and risks can be analysed within each account or, where more appropriate, within a separate ‘risk’ account focusing on how the various alternatives differ with respect to uncertainty and risk. The range or probability distribution of outcomes can then be considered along with the expected net benefits in the overall assessment of alternatives. There is no simple way in which any trade-off between expected net benefits and uncertainty or risk can be resolved. In theory, one could replace the expected stream of net benefits with a hypothetical certain stream that would be considered equivalent in value. In effect, this would deduct from the expected net benefits the cost that people assign to the uncertainty or risk involved. The problem, however, is in calculating or estimating what the equivalent certain stream (the quantitative adjustments) would be. Politicians are generally willing to forgo a significant amount of expected net benefits to avoid project-specific risks. For the general public, however, the trade-offs are more complicated, depending on the nature and severity of the risks in question and on the effects of the pooling and spreading of risks that can diminish their impact on any

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individual. In any event, the goal of the analysis is to inform as clearly and comprehensively as possible about the nature and potential significance of the uncertainties and risks – not to prejudge with an artificial adjustment to the discount rate or other means the value that should be attached to that. Summary • The discount factor is the weight applied to future benefits and costs used to calculate their equivalent present value. The discount factor will be smaller the larger is the discount rate – the rate at which people are willing to trade off a present for future benefit and cost – and the further into the future a benefit or cost is forecast to occur. • There are two fundamental reasons for discounting future values in benefit-cost analysis – time preference and the social opportunity cost of capital. • Time preference refers to the rate at which people are willing to forgo present for future consumption opportunities. It is generally measured by the after-tax rate of interest on savings because that is the rate at which people are compensated for deferring consumption. • Underlying time preference are two factors. There can be pure time preference, meaning simply that people may prefer realizing benefits or utility more today than in the future. There is also the effect of growth. With rising per capita incomes, a dollar of consumption opportunity is less significant in the future when one is wealthier than it is today when one is relatively poorer. • The social opportunity cost of capital refers to the rate at which consumption opportunities can grow through investment. It is generally measured by the pre-tax social rate of return on investment. • While there is some controversy over the magnitude of the pre-tax social rate of return on investment, it is recognized that, whatever the exact rate, it is significantly higher than the time preference rate because of taxes and risk. That raises the question of which rate one should use. • The discount rate can be a critically important parameter in benefitcost analysis. Lower discount rates will favour capital-intensive alternatives over those with less capital but more ongoing costs,

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•

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and projects that offer benefits over the longer term over those that offer benefits only in the short term. A standard approach in benefit-cost analysis is to use a discount rate based on a weighted average social opportunity cost of capital that reflects the extent to which an increase in the demand for capital attracts more savings, displaces other investment, or, in an open economy, attracts foreign capital. The proportions from each of these sources are multiplied by their respective costs to calculate the weighted average rate. A seminal study in Canada suggested that the real (inflation-adjusted) weighted average social opportunity cost of capital was 10 per cent. Subsequent critiques and studies suggest that it is 8 per cent or less. An alternative hybrid shadow pricing approach recognizes the unique reinvestment opportunities or investment-displacing effects of any particular project or policy. In this approach, benefits that are likely to give rise to new investment, and costs that are likely to displace investment, are replaced by the potential consumption opportunities generated or forgone. Once all the benefits and costs are expressed in terms of potential consumption opportunities, they are discounted at the time preference rate. A concern with any discounting of benefits and costs is the limited weight given to very distant effects. Some argue that a zero or near zero rate should be used to give proper consideration to future generations. However, a zero rate may not be equitable, specifically if there are rising real incomes. It would not enable meaningful comparisons of impacts that continue in perpetuity. It does not recognize the much greater uncertainty around very distant effects, and it does not necessarily reflect the resource allocation choices that people today would want to make. A better way to give proper weight to very distant effects is to recognize that in many instances the question is, what are people today willing to pay for existence, precautionary, or quasi-option values? That does not require calculating the present value of what people in the very distant future would be willing to pay. Where discounting is required, recognizing changing real values and declining discount rates over time is preferable to arbitrarily reducing the discount rate. In financial analyses, discount rates are commonly increased for riskier projects. That is not generally done in benefit-cost analysis. The risk premium to be added would be unclear as it depends on

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the mitigating effect of pooling and spreading risks among all affected persons. Also, adding a premium to the discount rate would assume that risks increase exponentially over time, which may not be valid, and it may have the unintended effect of excessively discounting longer-term benefits and costs. • The standard approach in benefit-cost analysis is to analyse uncertainty with sensitivity or scenario analyses, and more quantifiable risk with Monte Carlo simulations. Information on uncertainty and risk can then inform the debate on the range of possible outcomes, along with the expected benefits and costs.

CASE STUDY Nuclear Power There has been limited development of nuclear power capacity in OECD countries in recent years, and little expected in the future, without considerable government support. Nuclear power has been more expensive than have been the conventional alternatives such as coal or natural-gas-fired thermal plants, and the capital requirements and development risks are major constraints for private sector investment.25 There is, however, renewed interest in nuclear power; it is seen by some as a potentially important part of the effort needed to shift away from fossil fuels and meet greenhouse gas (GHG) reduction targets. The life-cycle GHG emissions from nuclear power (including the emissions in uranium mining, refining, fuel fabrication, transport, fuel reprocessing, waste management, as well as plant construction and operation) are minimal. Life-cycle emissions from a 1000-megawatt nuclear plant operating at a capacity factor of 85 per cent would be some 2.5 million tonnes of equivalent carbon dioxide less per year than those of a comparably sized and operated natural gas thermal plant.26 Also, nuclear power, unlike wind and other renewables, provides dependable capacity, making it a more valuable source of electricity than those other emission-free sources of supply. The question therefore has arisen, what are the costs and benefits of nuclear power, and is it an efficient way to reduce GHGs? A number of studies have been undertaken that address this question or key aspects of it.27 While some address a range of externalities associated with nuclear power relative to other sources of power, the central

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issue that most focus on is the cost of nuclear power (the market valuation) compared to the value of the GHG benefits that it offers. There is considerable uncertainty in the cost estimates for developing new nuclear capacity, and little comfort from the actual experience in past project developments, where capital costs have been underestimated by factors of two to three.28 Nevertheless, estimates in the studies provide some perspective to the cost of nuclear power. They also illustrate how sensitive is the cost of nuclear power to the discount rate, with respect to both the initial capital costs and the future decommissioning and waste management costs. A recent U.K. study suggests the following central assumptions in the analysis of the costs of nuclear power (converted from pounds to U.S. dollars at a 1.6 exchange rate):29 • Pre-construction costs of $400 million • Construction and other development costs of $2.1 million per megawatt of capacity ($2.1 billion for a 1000-megawatt plant) • Operating, maintenance, and fuel costs of $19 per megawatt hour • Decommissioning and waste management costs at the end of the project life of $1.5 billion • A six-year construction period and forty years of plant operation • An average operating capacity factor of 85 per cent. Based on these assumptions, the average levelized cost of nuclear power per unit of output – the annualized capital and all other costs divided by the annual output – would be $56 per megawatt hour calculated at an 8 per cent real discount rate.30 That is a relatively low cost, one that would compare favourably with natural-gas-fired facilities even without any benefit recognized for the large amount of GHG emissions that nuclear power would avoid. This levelized cost, however, depends critically not only on the accuracy of the capital and other cost estimates but also on the discount rate. As shown in table 6.4, just changing the discount rate from 8 to 10 per cent increases the estimated average levelized cost to $66 per megawatt hour. A 10 per cent rate is what the U.S. OMB estimated the opportunity cost of business investment to be in the United States, and a rate of at least that amount is what private industry would apply in an analysis of nuclear power costs. A higher discount rate has such a marked effect on the average levelized cost because of the capital intensity of nuclear power. A higher

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Table 6.4 Average levelized costs of nuclear power (2007 U.S. dollars per megawatt hour) Estimated cost 8% real discount rate 10% real discount rate 2.5% discount rate for decommissioning and waste management fund Two-year delay in start-up of operations

56 66 78 90

discount rate greatly increases the capital cost per unit of output. At the same time, however, a high discount rate greatly diminishes the present value of the decommissioning and waste management costs at the end of the project. Of the total $66 average levelized cost at a 10 per cent discount rate, less than $1 per megawatt hour would be included for these future costs. This is an example where standard discounting may not properly capture the weight that people would assign to distant costs. Ensuring there are sufficient funds for the safe and secure decommissioning of nuclear facilities and management of wastes at the end of the facilities’ operating lives is a major concern to the present generation, even if the impacts would fall on others. Arguably, a better measure of these future costs is the size of the fund that would have to be set aside today to be sufficient, even assuming a conservative rate of return, to provide the resources required in the future for safe and secure decommissioning and waste management. In other words, discounting at a much lower rate, say 2.5 per cent, might better reflect the amount that people today would require to willingly accept the prospect of that future cost. Applying such a rate would increase the levelized decommissioning and waste management cost from less than $1 per megawatt hour to over $12 per megawatt hour. It would increase the total levelized cost to $78 per megawatt hour. In short, any analysis of nuclear power costs requires careful consideration of the discount rate in order to capture the opportunity cost of the initial capital expenditures and the present significance or weight that people would want to assign to the distant, but very important, decommissioning and waste management costs. A full analysis also requires careful consideration of the all of the assumptions underlying the cost estimates, given the many uncertainties associated with nuclear power. The range of possible costs is as

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important to consider as a single-point estimate, particularly in this case with such uncertainty over actual costs. To illustrate the sensitivity of the costs to just one factor, the timing of the in-service date, the levelized costs are shown in table 6.4 with a twoyear delay in start-up. That alone would increase the costs (maintaining a 10 per cent discount rate for the capital and operating expenditures, and a 2.5 per cent rate for the end-of-project decommissioning and waste management fund) to $90 per megawatt hour. A full multiple account benefit-cost analysis of nuclear power would require (in addition to the market valuation of its costs) consideration of the taxpayer, user, economic activity, environmental, and social externalities that it entails, relative to the alternative sources of power. There are interesting taxpayer issues raised by nuclear power, particularly in the United States where nuclear operator liability for nuclear accidents is capped under the Price-Anderson Act. There is also a range of externalities to take into account, including the very small, but nonetheless concerning, risk of accidental release of radiation. The major positive externality is the GHG and other emissions that nuclear power avoids. As noted above, a 1000-megawatt nuclear facility would emit 2.5 million tonnes of equivalent carbon dioxide less per year than would a natural gas plant. To put that in perspective, the annual GHG benefit of nuclear power relative to natural gas power would be approximately $10 per megawatt hour, assuming a GHG cost of $30 per tonne. Nuclear power can raise passionate arguments both for and against. A multiple account benefit-cost analysis taking into account these and other consequences of nuclear power can at least bring some focus to the many issues it raises. Such an analysis is essential for getting beyond simple positioning and enabling a rationale debate to take place.

NOTES 1 See, for example, A.C. Pigou, Economics of Welfare, 3rd ed. (London: MacMillan, 1928), who describes the discounting of future benefits as irrational, evidence only that ‘our telescopic faculty is defective’ (p. 25). 2 A real discount rate is approximately equal to the nominal rate that one would apply to nominal dollar values (values that have not been adjusted for inflation) less the expected rate of inflation. In benefit-cost analysis one

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4 5 6 7

8

9 10

11 12 13 14 15 16

17

Multiple Account Benefit-Cost Analysis generally uses real discount rates applied to real or constant dollar estimates of value. See G. Jenkins, ‘The Measurement of Rates of Return and Taxation from Private Capital in Canada,’ in Benefit-Cost and Policy Analysis, ed. W. Niskonen et al. (1973); and ‘Capital in Canada: Its Social and Private Performance 1965–74,’ Economic Council of Canada Discussion Paper no. 98, 1977. See D. Burgess, ‘The Social Discount Rate for Canada: Theory and Practice,’ Canadian Public Policy 7, no. 3 (1981): 383–94. U.S. Office of Management and Budget, Circular A-94 (1992): 8. See also Circular A-4 (September 2003): 33–4. See M. Moore et al., ‘“Just Give Me a Number”: Practical Values for the Social Discount Rate,’ Journal of Policy Analysis and Management 23, no. 4 (2004). G. Jenkins and C. Kuo, ‘The Economic Opportunity Cost of Capital for Canada: An Empirical Update,’ Queens University Department of Economics Working Paper no. 1133, July 2007. For a classic discussion explaining the difference between these rates see W. Baumol, ‘On the Social Rate of Discount,’ American Economic Review 58, no. 4 (1968): 788–802. U.S. Office of Management and Budget, Circular A-4 (September 2003): 33–4. For a technical exposition see A. Sandmo and J. Dreze, ‘Discount Rates for Public Investment in Closed and Open Economies,’ Economica 38, November 1971: 395–412. See G. Jenkins, ‘The Measurement of Rates of Return and Taxation.’ Treasury Board Secretariat, Benefit Cost Analysis Guide (Ottawa: Government of Canada, 1976). See W. Burgess, ‘The Social Discount Rate.’ See G. Jenkins, ‘The Public Sector Discount Rate for Canada: Some Further Observations,’ Canadian Public Policy 7, no. 3 (1981): 399–407. G. Jenkins and C. Kuo, ‘The Economic Opportunity Cost of Capital for Canada.’ This approach is recommended in the widely referenced R. Lind, ‘A Primer on the Major Issues Relating to the Discount Rate for Evaluating National Energy Options, in Discounting for Time and Risk in Energy Policy, ed. R. Lind (Washington, DC: Resources for the Future, 1982). It is also recommended in the recent review of the different discounting approaches in M. Moore et al., ‘“Just Give Me a Number.”’ N. Stern, The Economics of Climate Change: The Stern Review (Cambridge and New York: Cambridge University Press, 2007).

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18 W. Nordhaus, ‘A Review of the Stern Review on the Economics of Climate Change,’ Journal of Economic Literature 45, no. 3 (2007): 686–702. 19 For a discussion of these issues see P. Portnoy and J.P. Weyant (eds.), Discounting and Intergenerational Equity (Washington, DC: Resources for the Future, 1999); and K. Arrow et al., ‘Intertemporal Equity, Discounting and Economic Efficiency,’ in Climate Change 1995: Economic and Social Dimensions of Climate Change, ed. Bruce et al. (Cambridge: Cambridge University Press, 1996), 125–44. 20 For a discussion of how this approach could be informed by individual preferences, in a manner consistent with the basic principles of benefit-cost analysis, see R. Kopp and P. Portnoy, ‘Mock Referenda and Intergenerational Decision-Making,’ in Discounting, ed. P. Portnoy and J.P. Weyant, 87–98. 21 See E. Neumayer, ‘Global Warming: Discounting Is Not the Issue, but Substitutability Is,’ Energy Policy 27 (1999): 33–43. He argues that the call for strong action on greenhouse gas emissions must be assessed in terms of the demand for strong sustainability, not the present value of future impacts. 22 See M. Weitzman, ‘A Review of the Stern Review on the Economics of Climate Change,’ Journal of Economic Literature (September 2007): 703–24. In similar vein to that of Neumayer, he argues that the call for strong action on greenhouse gas emissions should be understood in relation to concerns about tail events (worst-case scenarios). He suggests that Stern may have reached the right conclusion about people’s desire for strong action, but not because of his estimated present value cost of future damages. In response to Nordhaus and other critics of his 2007 Review, Stern himself argues that uncertainty is the key factor, stating that investing in measures to limit greenhouse gas concentration levels is like investing in insurance against uncertain but potentially catastrophic effects. See N. Stern, The Global Deal: Climate Change and the Creation of a New Era of Progress and Prosperity (Philadelphia, PA: Perseus Books, 2009). 23 A key reason for declining discount rates is uncertainty about what discount rates to apply in the future. See M. Weitzman, ‘Why the Far-Distant Future Should be Discounted at Its Lower Possible Rate,’ Journal of Environmental Economics and Management 36 (1998): 201–8, and ‘Gamma Discounting,’ American Economic Review 91, no. 1 (March 2001). 24 K. Arrow and R. Lind, ‘Uncertainty and the Evaluation of Public Investment Decisions,’ American Economic Review 60, no. 3 (June 1970): 364–78. 25 A. Owen, ‘Nuclear Power for Australia?’ Agenda 13, no. 3 (2006): 195–210. 26 D. Kennedy, ‘New Nuclear Power Generation in the UK: Cost-Benefit Analysis,’ Energy Policy 35 (2007): 3711.

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27 In the United States a major study was undertaken by an interdisciplinary MIT study team, The Future of Nuclear Power (Boston: MIT, 2003). In the U.K. a study of nuclear power costs was undertaken by NERA Economic Consulting and Science and Technology Policy Research, ‘The Economics of Nuclear Power,’ paper no. 4 in The Role of Nuclear Power in a Low Carbon Economy (UK Sustainable Development Commission, March 2006). See also D. Kennedy, ‘New Nuclear Power Generation in the UK,’ and A. Owen, ‘Nuclear Power for Australia?’ 28 A. Owen, ‘Nuclear Power for Australia?’ 195. 29 D. Kennedy, ‘New Nuclear Power Generation in the UK,’ 3708. 30 Annualized cost is the constant real annual amount that yields the same present value costs over the life of the project as the actual pattern of expenditures. It equals the present value costs, times the annuity factor {1 - 1/(1 + r)n}/r, where r is the discount rate and n is the number of years that the project operates. Average levelized cost per unit of output is the constant real annual amount that one would have to charge for each unit of output over the life of the project in order to generate revenues equal in present value to the present value of costs. A standard way to calculate the levelized cost is to divide the present value of costs by the present value of the output. It is the solution to the following: PV[c*.Oi] = PV[Expi] c*PV[Oi] = PV[Expi] c = PV[Expi]/PV[Oi] Where: PV means present value of, c is the levelized cost, Oi is the output each year over the life of the project, and Expi are the expenditures each year over the life of the project

Glossary

abatement cost – the cost of investments that could be made, or steps taken, on site to reduce or avoid the emissions or other impacts being valued and their damages annualized cost – the constant real annual amount that yields the same present value costs over the life of the project as does the actual pattern of expenditures baseload – requirements that must be met at all times, including offpeak periods benefit-cost analysis – the analysis of the advantages and disadvantages of alternative projects or policies to everyone with standing, based on the values of those affected capacity factor – the ratio of a plant’s output in relation to the maximum amount it could produce if it were operated at 100 per cent capacity, 100 per cent of the time capitalized value – the present value of the benefits or costs that occur over a period of time cardinal scoring – an assessment based on numeric value cash flow analysis – the analysis of the annual revenues and expenditures received or incurred during each year of the project’s life certainty equivalent – the certain amount that would be of equal or equivalent value to a range of possible outcomes compensating variation – the trade-off that people would willingly make to acquire benefits or incur costs – specifically, the maximum amount of income or purchasing power that people would be willing to give up for the benefits, and the minimum amount of income or purchasing power that they would have to receive to offset the costs

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Glossary

compensation demanded – the minimum amount of income or purchasing power that people would have to receive to willingly incur or accept a cost consumer surplus – the difference between the maximum amount that people would be willing to pay and the amount that they actually pay for a good or service contingent valuation – the stated valuation of a good, service, or attribute in a hypothesized market setting critical value – the amount that a non-monetized consequence would have to be worth to change the ranking of alternatives based on the monetized consequences damage cost – the health, resource, and other costs or losses due to emissions or other such impacts estimated with impact pathway or physical linkage models demand curve – a curve indicating the quantity of a good or service that people would want to purchase at any given price dependent variable – a variable in an equation whose value is determined by the values of other variables discount factor – the weight applied to a future benefit or cost to calculate its equivalent present value discount rate – the rate at which people would be willing to trade off present for future benefits or costs from one time period (usually one year) to the next economic impacts – the direct, indirect, and induced demand for labour, goods, and services generated by the construction and operation of a project or other demand for goods and services made in the economy economic rent – the difference between the amount that people receive for the supply of an input and the minimum that they would have to receive to willingly supply it endogenous – determined by factors within the system or model equivalent variation – the amount of additional income or purchasing power that people would have to receive to realize an equivalent amount of benefit as the positive consequence of a project, and the amount that people would have to pay or give up to incur an equivalent cost as the negative consequence of the project existence value – those things or attributes that people value for their mere existence and preservation expected value – a weighted average (statistical mean) value calculated by summing the value that would result in each possible state or

Glossary

147

outcome, multiplied by the probability of each possible state or outcome occurring explanatory variable – a variable in an equation whose value affects the value of the dependent variable externality – an impact on third parties to an activity or transaction, for which the third parties do not pay (in the case of positive impacts) or for which they are not compensated (in the case of negative impacts) income effect – the change in the demand for a good or service, or a trade-off that people would willingly make between one good or service and all others, due to a change in real income incremental (marginal) cost – the increase in the amount of costs incurred to supply an additional unit of a good or service incremental (marginal) value – the increase in the amount that people would be willing to pay to acquire or consume an additional unit of a good or service indifference curve – a curve indicating the combinations of one good and the purchasing power over all other goods for which people would consider themselves equally well off internal rate of return – the discount rate for which the present value of revenues (or benefits) equals the present value of expenditures (or costs) levelized cost – the constant real annual amount that one would have to charge for each unit of output over the life of a project to generate revenues equal in present value to the present value of costs market failure – where market prices fail to signal the marginal value or marginal cost of a good or service to everyone affected market valuation – the valuation of benefits or costs based on market prices and transactions; what people actually pay for the benefits and are actually compensated for the costs meta-analysis – an analysis and synthesis of the results of a wide range of studies aimed at estimating the same impact or value monetized consequence – a positive or negative consequence whose magnitude or significance is measured in dollar (or other currency) terms multi-criteria analysis – the analysis of the advantages and disadvantages of alternative projects or policies in relation to criteria or attributes of concern, as established in the evaluation process multiple account benefit-cost analysis – an analysis of the advantages and disadvantages of alternative projects or policies to everyone with

148

Glossary

standing, based on the values of those affected, that is disaggregated into a set of evaluation accounts and presented in a matrix summary of monetized and, in some cases, non-monetized results offset cost – the cost of measures taken to offset emissions or other such impacts and thereby avoid the damages they would otherwise have caused opportunity cost – the forgone value that would have been derived from an input in its best alternative use or state option price – the willingness to pay for a range of possible outcomes before the outcomes are known option value – the difference between the willingness to pay for an array of possible outcomes (the option price) and their expected value ordinal scoring – an assessment indicating relative ranking (first, second, third …) Pareto Improvement – a change in which at least one person is better off and no one is worse off pecuniary effect – a change in the distribution of benefits and costs, but not in the amount of net benefits overall Potential Pareto Improvement – a change in which there are net benefits overall, where the winners could in theory compensate the losers and still be better off present value – the amount people would have to receive or incur today that would be of equal or equivalent value to a benefit or cost forecast to occur in the future price distortion – where a price received or paid for a good does not reflect its marginal value or marginal cost primary market – the market for a good or service directly affected by a project or policy prior right – the right to a good or service in a particular state, which defines the reference point for assessing the value or cost of a change producer surplus – the difference between the amount that people or firms receive for a good or service and the minimum that they would have to receive to willingly supply it public good – a good that is collectively consumed because it is nonrivalrous (one person’s consumption does not detract from the amount available to others) and non-excludable (it can be enjoyed or consumed without payment of a fee) quasi-option value – the willingness to pay for flexibility, or the expected value of new information real effect – an impact that results in a change in the magnitude of net benefits overall

Glossary

149

secondary market – a market for a good or service that is impacted by changes in the primary market affected by a project or policy, for example a market for a substitute or complementary good shadow price – a value assigned to a good or service to reflect its social valuation social opportunity cost of capital – the rate at which consumption opportunities can grow over time through investment (the pre-tax social rate of return on investment) social opportunity cost of labour – the wages that workers would otherwise earn or the value of time they would assign to what they would otherwise be doing in their best alternative opportunity or activity social valuation – the valuation of positive or negative consequences based on the impacts on everyone with standing and the trade-offs they would willingly make in respect of them standing – defines persons within geographic boundaries or groups whose interests are taken into account in a benefit-cost analysis strong sustainability – the preservation or enhancement of the value of natural capital from one generation to the next substitution effect – the change in the demand for a good or service due to a change in its relative price, holding real income constant supply curve – a curve indicating the quantity of a good or service that would be willingly supplied at any given price tail event – a result or an outcome whose probability of occurrence is in the lower or upper ends of the probability distribution of all possible outcomes time preference rate – the rate at which people are willing to trade off present for future consumption opportunities use value – those things that people consume or experience and are willing to pay for because of the enjoyment or satisfaction they directly and personally derive utility – a measure of well-being or satisfaction weighted average social opportunity cost of capital – the discount rate reflecting the sum of the proportions of an incremental demand for capital that would be met by increased saving, displaced domestic investment, and inflows of foreign capital, each multiplied by its respective social cost willingness to pay – the amount of income, or purchasing power over other goods, that people would be willing to give up in order to acquire a benefit

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Index

benefit-cost analysis: limitations of, 22–7; purpose of, 3, 29, 47, 145; rationale and strengths, 12–14, 26– 7; traditional vs. multiple account, 27–30 benefits, definition of, 3–4, 6–7, 9–11, 48–9 child-care benefit-cost analyses: targeted programs, 15–16; universal programs, 16–18 climate change, 97, 129–30 compensating variation, 6–9, 20n8, 78–80, 145 consumer surplus, 32–3, 71–3, 88–90, 146 costs, definition of, 4, 6–7, 48–9 critical value, 30, 32–3, 58, 78, 146 damage cost, 57, 111–12, 146; vs. abatement or offset, 98–9, 112, 145, 148 discount rate, 117–19, 126–7, 139–40, 146; and risk, 133–4; declining, 132; impact on nuclear power cost, 139– 40; use of zero rate, 129–31; with changing real values, 33, 132

economic impacts, 41, 74, 146 economic rent, 49, 74, 146 electricity supply multiple account benefit-cost analyses: BC Hydro Burrard thermal, 53–9; Manitoba Hydro Wuskwatim hydro vs. wind, 59–62; Tasmania Lower Gordon hydro (Saddler et al.), 31–3 employment benefits, 9, 60–1, 74–6 equivalent variation, 7–8, 146 existence value, 5, 31–2, 104, 131, 146 externalities, 13, 49; vs. impacts, 77, 80. See also market failures foster-care benefit-cost analysis, intensive private vs. public (Zerbe et al.), 18 hedonic pricing, 95, 99–102 hybrid shadow pricing discount method, 127–9 income-weighted net benefits, 23–4, 37 internal rate of return, 133, 147

152

Index

lead-in-gasoline benefit-cost analysis (EPA), 111–13; multiple account approach, 116n24 market failures, 12–13, 15, 53, 85, 94 multi-criteria analysis, 43–7, 147; vs. multiple account benefit-cost analysis, 45–7 multiple account benefit-cost analysis: purpose and approach, 28–30; recommended accounts, 47–51 multiple account evaluation frameworks, examples of: BC Crown Corporation Secretariat, 41–2; Canada Department of Fisheries, 39–40; H. Campbell and P. Brown, 42–3; U.S. Water Resources Council, 37–9 option value, 5, 148 potential Pareto Improvement, 22–3, 148; vs. Pareto Improvement, 23 preferences, income and context dependence of, 12, 24–5 price distortions, 13, 15, 76, 85. See also market failures primary versus secondary markets, 82–3, 85, 148, 149 producer surplus, 49, 74, 148 public goods, 13–15, 79, 104. See also market failures

quasi-option value, 5–6, 131, 148 rapid transit multiple account benefit-cost analysis, 85–90 recreational benefits, 72, 82, 90n1. See also travel cost method referendum style contingent valuation, 105 risk of loss of life, 10–11, 93n17, 100– 2, 112, 116n23 risk pooling and spreading, 134 scope of analysis, 26, 66, 81–2 senior government contributions, 71 social opportunity cost of capital, 121–2, 149; and risk, 134–5; vs. time preference, 122–4; weighted average, 124–7 social opportunity cost of labour, 61, 74–5, 91n4, 91n6, 149 tax benefits, 50, 56, 60, 66–71, 86, 88 time preference, 120–4, 149 travel cost method, 102–3 travel time, 86–7, 92n16 U.S. NOAA contingent valuation panel, 107–8 use value, 5, 31, 149 willingness to pay versus compensation demanded, 78–80, 107