Cost Benefit Analysis

Cost benefit analysis
Cost-benefit analysis (CBA) is the primary tool / analytical method for economic valuation in public decision-making processes. It is based on a utilitarian ethic, in which changes in utility arise from changes to marketed and non-marketed commodities. The theoretical origins of CBA date back to infrastructure appraisal efforts of France in the 19th century but it was popularized by the World Bank after 1945 especially for the building of dams.

CBA involves valuing, adding up, and comparing in monetary terms the positive (benefits) and negative (costs) effects associated with a particular action/decision. The values of economically relevant costs and benefits over the lifespan of an action are expressed using indicators such as net present value (NPV). For economists, the objective of CBA is to select the most efficient action(s) in terms of resource use.According to CBA criterion, a policy/program/project is justifiable in terms of the public interest and contributes to social welfare if the benefits, to whomever they accrue, outweigh the estimated costs (i.e., NPV is greater than zero).

This approach is in line with the Kaldor-Hicks potential compensation principle, which is a very widely accepted variation on the Pareto criterion. Pareto efficiency is achieved when it is not possible to make some (or all) people better off without making others worse off. The Kaldor-Hicks principle only requires that the net gains from an action are positive. If society as a whole gains with the action, and if it is, at least in theory, possible to transfer some of the winners´ gains to the losers, then the project is in the public interest. CBA is intended to help decision-makers to identify projects/programs with potential net gains by evaluating all relevant costs and benefits.

CBA methods
There are several important steps in a CBA:

• Perspective: decide on the perspective from which the study is to be done (Eg: societal, governmental, provider, payer...);
• Project definition: develop a complete specification of the main elements of the project or program and implications in terms of resource allocation (e.g location, timing, groups involved, population of affected people, connections with other projects/programs);
• Classification of impacts: determine the full range of consequences of the project/program, including a physical and quantitative description of the inputs and outputs (e.g. consumption of materials, emissions, effects on local employment levels, land occupation). This can be difficult for regulatory programs;
• Conversion into monetary terms: placing monetary values, estimating the social costs and benefits of these inputs and outputs (including adjustments for inflation and shadow prices);
• Compare the benefits and costs: the various costs and benefits over time are made commensurate through a process known as ―discounting‖, which converts them into what they would be worth today. The fundamental assumption is that future costs and benefits count for less than present ones. To calculate the present values of costs and benefits it is important to select the appropriate discount rate, which is a difficult and sometimes controversial task (see, for example, Field and Field, 2009);
• Project assessment: several indicators can be adopted to make judgements about the overall value of the action under study (e.g. net present value, benefit/cost ratio, distribution of costs and benefits). The relation between total benefits and total costs is a question of economic efficiency. But the distributional issues are also very relevant. Distribution is a matter of who gets the benefits and who bears the costs;
• Sensitivity analysis: since several types of uncertainty are present in a CBA exercise, it is important to test the influence upon decision indicators of changes in the most important variables.

A wide range of techniques have been developed for performing economic environmental valuation, namely for valuing goods and services that do not have a market value. These techniques have been classified in many different ways. For example, Munasinghe (1993) considers three broad groups of economic techniques: a) conventional market approaches – establishing a link between an environmental impact and some other good with a market value (e.g. defensive or preventive expenditures; replacement or restoration costs); b) implicit market approaches – assuming that the behaviour of individuals reveals implicit valuations of features of the environment (e.g. hedonic pricing methods; travel cost method); c) constructed market approaches – simulating a hypothetical market of a particular good or service (e.g. contingent valuation).

Applications
CBA has been widely applied and endorsed in both public and private decision-making processes. Applications in the environmental area can include the assessment of investment and development projects (e.g. public waste treatment plants; beach restoration projects; habitat improvement projects) or policies (e.g. pollution-control standards, restrictions on land development). In the United States, CBA was first used in conjunction with the United States Flood Control Act of 1936. The Regulatory Right to Know Act, from 2000, required that agencies conduct a CBA of their programs and regulations .

Objections and Criticisms
The status and potential role of CBA in ecological economics is controversial. Several objections and criticisms are described in the literature and/or are part of the scientific debate (e.g. Baer and Spash, 2008; Spash, 2007; Vatn, 2000; Edward-Jones et al, 2000; Hanley and Spash, 1993; Martinez-Alier et al, 1998). Historically, CBA was developed to evaluate well defined small-scale projects, but even at project level there is often skepticism relating to the necessary simplifications and assumptions. Skepticism increases when CBA is used for global-scale problems, where uncertainties surrounding the relationship between causes of environmental problems, their potential impact and valuation raise additional challenges.

Critiques and objections to CBA are mainly related to the controversial ethical choices and practical application involved, and include aspects such as its: a) incapacity to acknowledge incommensurability and to capture non-economic values; b) incapacity to distinguish distributional aspects (e.g. CBA treats gains and losses equally and is unconcerned with who gains and who loses) assuming the possibility of appropriate compensation, which has implications for equity; c) problems with discounting and its approach to accounting for future generations and non-human species; d) approach to dealing with risk, uncertainty, ignorance and ecosystem complexity, including non-linear and stochastic (random) relations; e) accuracy and acceptability of monetary valuations; f) treatment of irreversibility; g) potential for manipulation and institutional capture; h) lack of a strong sustainability criterion; i) reliance on consumer values which are a limited subset of all values in society (citizen values). In the CBA of dams, Krutilla introduced an interesting discussion in 1967 using different discount rates for benefits and for costs.

Despite the considerable range and number of serious critiques however, the CBA approach remains influential and continues to be applied to valuation of the environment, as it can provide relevant information concerning economic aspects of multicriteria assessment processes.