The OECD has a long history of giving guidance on the social evaluation of projects (investments) and policies. In the late 1960s and in the 1970s it was instrumental in developing social cost-benefit analysis. Since that time, cost-benefit analysis has enjoyed widespread application and the theory has developed further. In the last few years, some major advances have taken place in the underlying theory, and this is the justification for the current volume.
The Foundations of Cost-benefit Analysis
The underlying theory of CBA has been developed most over the past 50 years. It is based on the notion of a human preference. Preferences are linked to "utility" or "wellbeing" by rigorous rules and axioms. In turn, CBA provides rules for aggregating preferences so that it is possible to speak of a "social" preference for or against something.
The Stages of a Practical Cost-benefit Analysis
Conducting a well executed CBA requires the analyst to follow a logical sequence of steps. This chapter provides an overview of those steps, beginning with the nature of the problem being addressed and the alternative options for dealing with it. Determining "standing" – i.e. whose costs and benefits are to count – is a further preliminary stage of CBA, as is the time horizon over which costs and benefits are counted.
Crucial to the final steps of a CBA is the decision rule. That is, the criterion whereby a particular project or policy can be recommended (or otherwise) on cost-benefit grounds. In this chapter it is noted that the correct criterion for reducing benefits and costs to a unique value is the net present value (NPV) or net benefits criterion. The correct rule is to adopt any project with a positive NPV and to rank projects by their NPVs.
Policy and Project Costs
This chapter presents a range of challenges and responses facing practitioners in the task of measuring project and policy costs as accurately as possible. For example, the costs of complying with regulations and the costs of major projects are likely to be highly uncertain as well as have the potential to affect other costs and prices in the economy by a significant amount.
Total Economic Value
The notion of total economic value (TEV) provides an all-encompassing measure of the economic value of any environmental asset. It decomposes into use and non-use (or passive use) values, and further sub-classifications can be provided if needed. This chapter reviews this central concept which has been so important for properly understanding changes in well-being due to a project or policy that has environmental impacts.
Revealed Preference Methods for Valuing Non-market Impacts
Many impacts of projects and policies are of an intangible nature and are not traded in actual markets. In some cases, discussed in this chapter, non-market goods and services may be implicitly traded. In such instances, revealed preference methods can be used to "tease out" their values embedded in observed prices.
Stated Preference Approaches I
Stated preference methods offer a direct survey approach to estimating willingness to pay for changes in provision of (non-market) goods. In this chapter, the most prominent example – the contingent valuation (CV) method – is discussed. The CV method is applicable to almost all non-market goods, to ex ante and ex post valuations and it is one of the few available methodologies able to capture all types of benefits from a non-market good including those unrelated to current or future use.
Stated Preference Approaches II
Widely used in the market research and transport literatures, choice modelling (CM) (which is actually a family of survey-based methodologies) has only relatively recently been applied to the environment. A clear strength of CM lays in this ability to value environmental changes which are multidimensional. What this means is that an environmental asset affected by a policy often will give rise to changes in component attributes each of which command distinct valuations.
Quasi Option Value
Costs and benefits are rarely known with certainty, but uncertainty can be reduced by gathering information. Any decision made now and which commits resources or generates costs that cannot subsequently be recovered or reversed, is an irreversible decision. In this context of uncertainty and irreversibility it may pay to delay making a decision to commit resources. The value of the information gained from that delay is the option value or quasi-option value.
Willingness to Pay vs. Willingness to Accept
Until recently, CBA has worked with concepts of willingness to pay (WTP) and willingness to accept compensation (WTA). Which concept is used depends on the assumption about property rights. If there is no right to the benefit of a project or policy, then WTP is the correct measure. If there is a right to the benefit, then WTA compensation to forego the benefit is the correct measure.
The Value of Ecosystem Service
Ecosystems function like other capital assets – they generate a flow of services through time, and the capital can be held intact if the services are consumed in a sustainable fashion. Moreover, any ecosystem tends to generate many such services. This chapter analyses ecosystems from this multi-functional perspective, making a clear distinction between the total value of the ecosystem as an asset and the value of small or discrete changes in its service flow. The valuation issues are illustrated with reference to the debated benefits of ecosystems as providers of genetic value for pharmaceutical research.
Critics of CBA often focus on the use of positive "discounting " – the procedure whereby a lower weight is put on the future than on the present. This chapter shows how discount rates have traditionally been determined and raises the issue of whether a constant discount rate is justified. Not only are discount rates that vary negatively with time observable in practice, but there are various theoretical justifications for such rates.
Valuing Health and Life Risks
The last few decades have seen major developments in the theory and practice of giving economic values to premature mortality and to morbidity. The traditional concept of a "value of a statistical life" remains valid but has been brought into question by analyses showing that, in rich countries, risk-reducing policies may alter life chances only moderately.
Equity and Cost-benefit Analysis
Conventional CBA for the most part continues to regard distributional or equity concerns as having little or no place in social decisions about project selection and design. Yet challenges to this perspective form a rich tradition within the CBA literature.
Sustainability and Cost-benefit Analysis
The notions of sustainability and "sustainable development" have permeated significant parts of policy and public discourse about the environment. This chapter discusses the handful of recommendations do exist with regards to how CBA can be extended to take account of these concerns. One perspective starts from the assertion that certain natural assets are so important or critical (for future, and perhaps current, generations) so as to warrant protection at some target level.
Transfer studies are the bedrock of practical policy analysis in that only infrequently are practitioners afforded the luxury of conducting original studies. This is no less true in the case of borrowing or transferring WTP values to policy questions involving environmental or related impacts which are the subject of this chapter. Although there are no generally accepted practical transfer protocols, a number of elements of what might constitute best practice have been discussed widely.
Cost-benefit Analysis and Other Decision-making Procedures
CBA is often contrasted with other decision-making aids such as cost-effectiveness analysis (CEA) and multi-criteria analysis (MCA). But the assumption that these aids are substitutable is not valid and great care is needed in defining the question to be asked and in determining which technique is most relevant to helping with the decision.
The Political Economy of Cost-benefit Analysis
CBA works with a well-defined "objective function" – the thing to be maximised. But this is unlikely to coincide with what political bodies actually do. This chapter reviews the goals that political entities might actually maximise (the "political welfare function") and shows why the resulting decisions are likely to diverge from those using CBA.
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