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Cost-Benefit Analysis and the Environment

Further Developments and Policy Use

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This book explores recent developments in environmental cost-benefit analysis (CBA). This is defined as the application of CBA to projects or policies that have the deliberate aim of environmental improvement or are actions that affect, in some way, the natural environment as an indirect consequence. It builds on the previous OECD book by David Pearce et al. (2006), which took as its starting point that a number of developments in CBA, taken together, altered the way in which many economists would argue CBA should be carried out and that this was particularly so in the context of policies and projects with significant environmental impacts.

It is a primary objective of the current book not only to assess more recent advances in CBA theory but also to identify how specific developments illustrate key thematic narratives with implications for practical use of environmental CBA in policy formulation and appraisal of investment projects.

Perhaps the most significant development is the contribution of climate economics in its response to the challenge of appraising policy actions to mitigate (or adapt to) climate change. Work in this area has increased the focus on how to value costs and benefits that occur far into the future, particularly by showing how conventional procedures for establishing the social discount rate become highly problematic in this intergenerational context and what new approaches might be needed. The contribution of climate economics has also entailed thinking further about uncertainty in CBA, especially where uncertain outcomes might be associated with large (and adverse) impacts.

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Uncertainty

Methods of dealing with uncertainty – specifically probabilistic risks – in CBA have typically focused on expected utility theory which provides a strong theoretical basis for deviating from the simple use of expected values in a deterministic framework, towards estimating welfare corrections for use in CBA. However, estimating the resulting certainty equivalent values requires assumptions about the nature of society’s utility function, and some demanding estimates of the probability distributions of the risky quantities associated with any given project. Even so, practitioners are increasingly prepared to use these methods, given emerging evidence about the errors associated with simpler approaches. That said, more ad hoc ways of addressing this such as sensitivity analysis and Monte Carlo simulations have their place, and the chapter shows how a nuclear power project appraisal might utilise and interpret a Monte Carlo analyses. Nor should a focus on formal economics ignore the fact that there are many other principles that could be applied in CBA to make decisions in the face of uncertainty, such as “safety first” and “precaution”.

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