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Cost-benefit analysis in Disaster

Risk Management
Cees van Westen
westen@itc.nl

INTERNATIONAL INSTITUTE FOR GEO-INFORMATION SCIENCE AND EARTH OBSERVATION

Disaster Risk Management

Risk Evaluation.
Risk evaluation is the stage at which values and
judgment enter the decision process, explicitly or
implicitly, by including consideration of the importance
of the estimated risks and the associated social,
environmental, and economic consequences, in order to
identify a range of alternatives for managing the risks.
We have analyzed the risk either qualitatively or
quantitatively. Now questions arise:

Is the risk too high?


Where is the risk too high?
What is too high?
What do the people think?

Risk evaluation versus perception


Risks can classified into involuntary risk and voluntary risks.
Risks associated with natural hazards are often classified as
involuntary risk.
They often relate to rare events with catastrophic potential
impacts.
Lay perceivers (or non-experts) give more weight to hazards that
take many lives at ones that is to major disasters ( Smith, 2001).
Technical experts assess infrequent hazards that take many lives
at one time equal to regular hazards that take a similar number
of lives just once in a time (over an equivalent period) ( Smith,
2001).

Two dimensions of risk


The factual dimension, which indicates the actual measured
level of risk, and which can be expressed in probability of losses
(e.g. number of people, building, monetary values)
The socio-cultural dimension, which includes how a particular
risk is viewed when values and emotions come into play.

Risk perception
Risk perception is the way how
people/communities/authorities judge the
severity of the risk.

Do they know?
Are they worried?
Are they prepared to act?
Who they think should act?
What is it worth to them?

Factors that determine risk perception

Their personal situation.


Cultural and religious background.
Social background
Economic level
Acceptable risk: a risk which the society or impacted
Political background
individuals are prepared to accept. Actions to further reduce
such risk are usually not required unless reasonably
Level of awareness
practicable measures are available at low cost in terms of
money, time and effort.
Media exposure
Tolerable risk: a risk within a range that society can live
Other risks
with so as to secure certain net benefits. It is a range of risk
regarded as non-negligible and needing to be kept under
review and reduced further if possible.
Risk reduction situation
ALARP (As Low As Reasonably Practicable) principle:
Principle which states that risks, lower than the limit of
tolerability, are tolerable only if risk reduction is impracticable
or if its cost is grossly in disproportion (depending on the
level of risk) to the improvement gained.

Risk evaluation.
The ALARP principle is that the residual risk shall be as low as
reasonably practicable.

Must be avoided or
reduced;
Risk reduction cost
may be taken into
account. Beyond a
certain point
investment in RR
may be inefficient.

Risk evaluation based on F-N curves

Which risk is acceptable?


During the life of an average person, the chance of death is never less
than 1:10,000 (1.000E-4): this is due to all causes.
So it would not be realistic to require the risk due to natural disasters to
be lower than this.
These curves differ from country to country. No international standards
Voluntary involuntary risk is also relevant.

F-N curves

Risk acceptability is mostly defined on the basis of F-N curves

Risk acceptance criteria in Netherlands


dyke rings that protect a
part of the country against
flooding.
The more important the
area, the lower the chance
that the dyke ring breaks and
the area will be flooded.

Cost- benefit analysis


An important aspect
in risk evaluation is
also:
How much do we
need to spend in
order to reduce the
risk
Benefits

Costs

Tools to evaluate best risk reduction


measures

Cost Benefit Analysis (CBA) is used to compare costs and benefits of a one
specific measures or a set of alternative measures over a period of time for
a. CBA assesses the measure(s) mainly on the basis of the efficiency criterion.
It requires the monetization of all the effects. The effects that cannot be
expressed in monetary terms will be usually described in their original unit of
measurement.
Cost Effectiveness Analysis: (CEA) has most of the features of CBA, but does
not require the monetization of either the benefits or the costs (usually the
benefits). CEA does not show whether the benefits outweigh the costs, but
shows which alternative has the lowest costs (with the same level of
benefits). CEA is often applied when the norm for a certain level of safety
has been set. CEA analyzes which types of solution is the cheapest given a
certain level of safety standard.
Multi Criteria Analysis (MCE) is a tool that allows comparing alternative
measures on multiple criteria. In contrast to CBA, MCE allows the treatment
of more than one criterion and does not require the monetization of all the
impacts. MCE results in a ranking of alternatives.

c. Which alternative is economically the


most
attractive?
If all
alternatives
are all as effective in terms of risk reduction
the cheapest alternative (Cost Effectiveness Analysis, CEA)
If effectiveness in risk reduction differs the cheapest alternative
in terms of risk reduced (Cost Benefit Analysis, CBA)

Levees

Flood proofing
relocation.

What is an optimal level of a risk


reducing measure?
A number (most?) risk reduction measures could be applied
in a variable way

Height level of dikes


Earthquake resistance of buildings
Legal restrictions land use
..

A higher level of risk reducing measures reduced risk, BUT


diminishing returns
Often at higher variable costs
MORE is not necessarily more beneficial

EXAMPLE: small example CBA_risk_reducing

Cost-Benefit Analysis and Damage


Assessment for whom??
Government and funding
agencies
National and provincial
governments
Governments/general public
Emergency planners
Insurance companies
Private firms/house owners

Ex-ante project appraisal


Accountability - Tax money
Economic loss compensation
Identification of critical
risk areas
Financial loss
Insurance or other
protection measures

Perspective damage/cost/benefits for


whom?
Public: national
ministries, provincial
governments,
emergency planners

Economic values real


values broad economic
perspective

Private: private firms, Financial values


private property
monetary values
owners, insurance
companies

Cost Benefit Analysis of Risk Reducing


Measures
Costs for (structural) risk reducing measures are
relatively less difficult to estimate
Estimating the benefits is a major challenge !
We need to know:
Avoided damage
Probability of damage

We need to estimate:
how often natural hazard events occur (frequency)
how much damage and losses occur as a result of
the event

Do we include all losses?

Costs of Natural Hazards


- e.g. flooding
Direct damage

buildings
infrastructure
crops and livestock
Machines
human victims
landscape/nature

Indirect damage
income forgone
interruption of economic
and social activities
extra costs of
transportation due to
infrastructure damage

Damage functions

Damage-probability curve

Damage-probability curve
in case of flood protection
against events upto 1:100
years

Basic CBA steps


1.
2.
3.
4.
5.

Define scope of the project


Identify the type of costs and benefits
Put monetary values on costs and benefits
Compare costs and benefits
Calculate profitability indicators/decision
criteria
6. Sensitivity analysis
7. Make recommendations

What do we need to know of both


scenarios?
1. The costs of both scenarios (investment and
annual)
2. The investment period
3. The benefits (i.e. annual risk reduction) of
both scenarios
4. The life time of the investment
5. Discount rate

Cost benefit analysis

Calculate economic risk


Define risk reduction measures
Define cost of risk reduction measures
Define characteristics
Analyze cost benefits

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Calculating economic losses

First we will calculate the total floorspace


within each mapping unit. We do this by
multiplying the building footprint area with
the number of floors.
Then we use unit costs (per square meter)
per urban landuse type for buildings and for
contents of buildings. We multiply these with
the floorspace to get the total costs per
mapping units.
Then we will generate attribute maps that
contain the costs of buildings affected for
each hazard type and hazard class.
We will then use the results from the annual
loss estimation to combine these with the
vulnerability and probability if these are not
yet included.
We will then combine the data and generate
risk curves.

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Economic risk

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Risk reduction measures


The municipality of RiskCity has made a
study and the report came up with the
following possibilities for risk reduction. The
following table shows a number of possible
risk reduction measures, including also a
very general indication of the costs that
these measures would take. In the following
section we will evaluate some of these in
more detail.

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Example CBA Flood Reducing Measures


Scenario I (removal)
removal of housing in the 10year Return Period flood zone
10 year RP flood zone is
converted into green areas
buildings are demolished, new
terrain to be bought, and new
buildings have to be constructed
in other hazard free zones
the set-up of a vigilance group
is required
The risk in the area that was
formerly threatened by a 10
year Return Period flood will be
reduced to 0

Scenario II (retention)
construction of an upstream
storage lake
engineering works
flood retention basin and
drainage need maintenance
the retention basin will reduce
the flood losses.
It will retain the discharge for 2
and 5 years RP and reduce the
risk to 0.
For the other return periods the
damage will reduce the losses

Damage without risk reduction, Scenario I


and II at different Return Periods
Flooding
Return
Period

Annual
without Scenario Scenario
Probabili mitigation
1
2
ty
2
0.5
0.0
0.0
0
5
0.2
19.3
0.0
0
10
0.1
34.4
19.3
0
25
0.04
100.0
34.4
65.6
50
0.02
199.0
100.0
164.6
100
0.01
510.0
199.0
475.6
200
0.005
1134.0
510.0
1099.6

3. Annual risk reduction of both scenarios


Costs Scenario I (removal)

Costs Scenario II (retention)

Triangles and
rectangles
method

The area under the


curve is divided into
trangles, which connect
the straight lines
between two points in
the curve and have Xaxis difference as
difference between the
losses of the two
scenarios. Y-axis of the
triangles is the
difference in
probability between
two scenarios. The
remaining part under
the curve is then filled
up with rectangles, as
illustrated in the graph
and table below.

This is the annual risk,


taking the sum of the
triangles 32
and squares in

Simplified
rectangles
method

In this method
we simplify the
graph into a
number of
rectangles, which
have as Y-axis the
difference
between two
successive
scenarios, and as
X-axis the
average losses
between two
successive loss
events. See graph
and Excel table
below

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Risk reduction

Now that we have calculated the annual loss for the existing
situation, we can also now evaluate the reduction in total
annual losses for the two scenarios.
Calculate in Excel in the same way the average annual risk
for Scenario I and Scenario II ( see earlier table with the
losses for the two scenarios for the various return periods
that you filled in yourself)
Calculate the amount of risk reduction, comparing Scenario
1 and Scenario 2 with the original average annual risk. Fill
in the table below.

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Calculating the investment costs

After calculating
how much the risk
reduction is on an
annual basis for
the two different
scenarios, we can
now evaluate the
benefits. The
benefit is equal to
the amount of risk
reduction.
However, the two
risk reduction
scenarios also
involve certain
costs. The next
table indicates
the investment
costs for
implementing the
two scenarios.

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Calculate costs
To calculate the A to D component costs from
the table above, you need to know first the
number of buildings in the flood zone of 10
years return period. For the component E
you need to know the area pf the 10 year
flood zone.

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Costs
After calculating the risk reduction (benefit) and the
investment costs of the two flood scenarios we can
now continue to evaluate the cost/benfits. The
following table indicates the costs of the two
scenarios.

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Maintenance and operation costs


Each of the two scenarios will also require long term
investments.
Scenario 1 requires the set-up of a municipal organization that
controls the illegal spread of housing in highly hazardous
areas. It will require staff, office and equipment costs, which
will rise over time depending on the increases of salary and
inflation. The annual costs are estimated to be 250.000. We
consider that these costs will increase with 5 % each year.
Scenario 2 also requires maintenance and operation costs. The
flood retention basin contains a basin in which sediments are
deposited. Annually the sediments from this basin have to be
removed using heavy equipment. Also the drainage works
needs regular repair. The costs for maintenance are considered
to be 500.000 per year. We consider that these costs will
increase with 5 % each year. See table below.

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Investment period
The investments for both scenarios are not done within one
single year. They are spread out over a larger number of years,
because normally not all activities can be carried out in the
same year.
It is quite difficult to remove existing buildings. The
municipality would like to buy the land of private owners, but
they will resist, and there will be many lawsuits that might
take a lot of time. Therefore we consider that the entire
relocation of all building might take as much as 10 years. The
investment costs are therefore spread out over this period.
The construction of the engineering works for scenario 2 will
take less time. Still it is considered that the costs are spread
over a period of 3 years.
The benefits will start in the year that the investments are
finished. For scenario 1 this is in year 11 and for scenario 2 it
is in year 4.

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Project lifetime
The lifetime of the scenario 2 is considered to
be 40 year. After that the structure will have
deteriorated and it needs to be rebuilt. For
the relocation scenario it is more difficult to
speak about a life time, but we will also keep
the same period of 40 years.

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Cost of flood reduction scenarios


Costs of the Flood Risk Reduction Scenarios
(costs in .10 6)

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Incremental benefit

Create in Excel a new table:


called Flood Mitigation
Scenario I ( see figure left).
Column 1: Years ( starting with
1 up to 40 year)
Column 2 Risk Reduction (i.e.
Risk avoided, or Benefit)
Column 3: Invest cost for the
risk reduction scenario.
Column 5: Maintenance
Column 4: Incremental
Benefits
Enter the values and calculate
the incremental benefit over
the 40 years period.

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Net present value


We need to take into account that the same amount
of money in the future will be less valuable today.
We will need therefore to calculate the so-called
net present value (NPV)

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Time value of money

Money today is worth


more than money in
the future

Why ?

Inflation
Risk
Consumption
Earning power
(investment
opportunities)

Compounding and Discounting


Techniques for comparing values at different
points in time
In CBA mainly concerned with Discounting
for better understanding first: Compounding

Compounding

suppose amount of $ 100 on bank account


interest 10%
after 1 year ?
After 2 and 3 years ?

Compounding
start: 100
after 1 year:
after 2 years:
after 3 years:
etc.

100 + 10 = 110
110 + 11 = 121
121 + 12.1 = 133.1

Discounting
the reverse of compounding
it looks from the future back to the present
and asks:
what is the present value of a known future
amount ?

Discounting

What is the present value of $ 133.1 received


at the end of 3 years from now, assuming an
interest rate of 10% ?

Discounting in formula
X0 = Xt / (1 + i)t
X0 = present value
Xt = value in year t

Discounting - example
X3 = 133.1; i = 0.10; t = 3

X0 ?
X0 = Xt / (1 + i)t
X0 = 133.1 / (1 + 0.10)3
X0 = 133.1 / (1.331) = 100

Time Value of Money


To care of time value of money
We apply discount rates
We discount each future annual amount

Flood mitigation Scenario I

year

incremental benefits NPV_10%


1

-8.333

-7.576

-8.333

-6.887

-8.333

-6.261

15.690 year 10.716

Until

15.690

40

9.742

Flood mitigation Scenario II


incremental
benefits

year

NPV_10%

-8.333

-7.576

-8.333

-6.887

-8.333

-6.261

15.690

15.690

Until
year
40

10.716
9.742

Internal Rate of Return (IRR)


NPV decreases if i (interest rate) increases
At one i (interest rate):

=0

IRR

Internal rate of return


Now we are going to calculate the Internal
rate of return. The Internal Rate of Return is
the discount rate/interest rate at which the
NPV=0

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NPV Scenario I and II at 10%


Scenario I:

$ -0.38 * 106 (negative !)

Scenario II:

$ 39.69 * 106

IRR Scenario I and II at 10%


Scenario I:

9.91 %

Scenario II:

42.32%

NPV and IRR

Criterion

Decision rule
accept

NPV

IRR

reject

NPV and IRR

Criterion

NPV

IRR

Decision rule
accept

reject

NPV > 0

NPV < 0

NPV and IRR

Criterion

Decision rule
accept

reject

NPV

NPV > 0

NPV < 0

IRR

IRR >
interest rate

IRR <
interest rate

Summary CBA scenario I and II

Flood Risk
Reduction
Scenario

NPV at 5 NPV at 10 NPV at 20


%
% interest % interest
interest
rate
rate
rate

IRR

Scenario I

42.23

-0.38

-14.96 9.91%

203.80

93.69

27.79 42.32%

Scenario II

Result
Question:
Which Mitigation Scenario would you advice
the Municipality?

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CBA -strengths

Systematic way of thinking and analysis


Focus on use of scarce resources
Strong methodological basis
Monetary measurement provides comparison
Appeal to policy makers

Elements often overlooked in CBA in


Natural Hazard and Disaster
Management
Indirect economic damage
Social effects

Irreplaceable items
Stress induced by disaster
Temporary evacuation
Social disruption

Environmental effects
Evaluation of non-structural measures

Limitations Cost-Benefit Analysis


One approach to assess the efficiency of (structural) risk
reducing measures
Take care of uncertainty of all parameters used
Estimated values of objects at risk
Probabilities of the hazard

Take care of all aspects NOT considered:


Social effects

Irreplaceable items
Stress induced by disaster
Temporary evacuation
Social disruption

Environmental effects
Indirect effects

Discounting favours present generations


One single outcome hides assumptions and value judgements