Video: Cost benefit analysis

2. Time in cost benefit analysis

• How should we “add up” costs and benefits

that occur at different points in time?
– For example, how to compare policy costs
incurred today with environmental benefits that
occur ten years from now? 100 years from now?
 Time value of money
• What is worth more: $100 today or $100
received a year from now?
• Suppose the interest rate is 5% and you
put $100 in the bank today, how much will
you have in a year? Two years?
 Present value
• Suppose you put $613.90 in the bank
today and the interest rate is 5%. How
much will be in the account in 10 years?
• The present value is the value today of
money received in the future. What is the
present value of $1000 received in 10
years if the interest rate is 5%?
• What is the formula for the present
value?
Opportunity cost

• What discount rate?

– Return on next best
investment opportunity
• For example, real return on
capital (4% plausible) or
return on investment in
education/public health/etc.
 Example
• Suppose policy makers are choosing
between an investment in education that
has a rate of return of 5% and an
environmental policy that would reduce
environmental damages by $1000 in ten
years. Suppose the environmental policy
cost $800 today. Should we do it? Why?
• By this logic, the discount rate for public
policies should reflect the rate of return on
the next best investment—it could entail
education, national defense, or something
else
Adding costs and benefits over time
• Two add apples with apples, we convert
everything into the equivalent present value
• Consider two projects with the following
benefit streams
– A: 20 20 20 20
– B: 50 10 10 10
• Suppose the interest rate is 6%, which do you
choose?
• PV(A) = $73.45; PV(B) = $76.73
• What if the interest rate were 1%? 10%?
 Key formula
• In general:
T
PVNB = å (Bt - Ct ) / (1 + r)t
t =0
Video
 Structure of long-lived
environmental problems
• Damages from current activities
spread over many years—
perhaps centuries
• Meanwhile, cost of policies to
address the problem typically
front-loaded
 Example
• CO2 released when fossil fuels–
e.g., coal or gas, are burned
• CO2 accumulates in the
atmosphere
• Higher concentrations trap more
solar radiation and cause the
temperature of the planet to rise
Concentrations profiles: DICE 2008
1300
Optimal
1200
Baseline
1100
< 2 deg C
Carbon concentrations (ppm)

1000 Strong Kyoto

900

800

700
Double of
600 Pre-industrial
level
500

400

300

12
 Key feature of the problem
• Long term harm from current path
could be very large; though most of the
damage happens 50 to 100 years out or more
• At same time, cost of transforming
existing energy system also very large
 Key point:

When costs and benefits

accrue over long periods of
time, the discount rate
matters a lot!
Present value of damages
• Fix discount rate at 4%.
What is present value of
$ 1 billion in 100 years?

• 200 years?

• 300 years?
The Island of Manhattan
• One of the most valuable pieces
of real estate in the world
• Purchased in 1624 for $24

Answer: about $24

 What’s missing?

• Discussion has focused on efficiency—

maximize size of the aggregate pie
 Ignores distribution!

Current Slice left for

generation’s slice: future generations:
 Two applications of CBA
1. The Copenhagen Consensus (Lomborg 2004)
– Compared a number of global problems
– Argued that short run projects such as fighting
malaria and AIDS, or improving drinking water are
much more cost-effective then efforts to address
global climate change
2. The Stern Report (2007)
– Argue that aggressive and immediate action to
address climate change is warranted (and more
important than fighting malaria or AIDS in the short
run)
 What’s the difference
• Lomborg discount rate: 5.5%
• Stern discount rate: 1.4%
• Consider a project that pays off in t=100 years
– To justify the project, the Copenhagen Consensus
would require a rate of return 36 times greater
than the Stern review
– Viewed differently, $1000 worth of damage in 100
years has a present value of $250 under the Stern
discount rate, but only $7.60 under the Lomborg
discount rate
 Three obstacles to adding up

1. How to compare monetary expenditures on

policy with non-monetized damages to
human health and the environment?
(valuation)
2. How to compare net benefits this year with
net benefits 10 years from now? (time)
3. How to incorporate uncertainty?
 Group project
• Suppose we all believed
the following:
– There is a 90% chance the
consequences of our current
trajectory of CO2 emissions will, at most,
be moderate and manageable
– But there is a 10% chance the consequences
will be severe, including sea level rise and
extended draughts that lead to the forced
dislocation of 100’s of millions of people

How should policymakers think about this decision problem?

 Risk
• Often for environmental problems, we don’t
know what is going to happen, even if we do have
a directional sense of what plausible outcomes
may be
• In fact, we face the same kind of uncertainty
when making personal decisions such as where to
go to college, what to major in, who to marry,
etc.
• For scientific problems, information is often
available in the form of probabilities
– (similar to the probabilities one might have when
gambling in Vegas)
 Example
• Based on past experience, scientists
predict that if a certain chemical is
released into the FC water supply, the
risks are described in the following table:
Number of deaths Probability

0 0.8

1 0.14

2 0.05

3 0.01

4 0

• How should we use this type of

information?
 Expected value
• Gives a kind of average
• It is the quantity that a “risk-neutral”
decision maker would typically accept
– Like a casino or an insurance company
Number of deaths Probability Expected Value of Deaths

0 0.8 0 x .80 = 0

1 0.14 1 x .14 = .14

2 0.05 2 x .05 = .1

3 0.01 3 x .01 = .03

4 0 4x0=0

Expected value = 0.27

 Are we risk neutral?
i.e., do we or should behave like
casinos?
• Consider a “fair” bet: I’ll flip a coin and if it is
heads, you give me $20, if tails I give you $20
– It is “fair” because the expected value is zero
– Will you take the bet?
• Typically individuals are risk averse
• When the environment is involved, people
may be very risk averse
• This means we would value a risk
more than the expected value
 The Precautionary Principle
• Developed in response to perceived failure by
governments to protect the public interest
amid novel threats to the environment or to
public health
• It is a mandate to err on the side of caution
when:
– Potential harm is severe and irreversible
– Effects are cumulative or delayed
– Scientific evidence is preliminary
 Two versions
• Rio Declaration (1992):
– “Where there are threats of serious or irreversible
damage, lack of full scientific certainty shall not be
used as a reason for postponing cost-effective
measures to prevent environmental degradation.”
• United Nations (2005):
– “When human activities may lead to morally
unacceptable harm that is scientifically plausible but
uncertain, actions shall be taken to avoid or diminish
harm. . . . Actions should be chosen that are
proportional to the seriousness of the potential
harm.”
 Motivating example: asbestos
• Asbestos is a mineral that has high industrial value
because of it is widely available, strong, and heat
resistant: used widely in building materials
• A British factory examiner first noted the “evil effects”
of asbestos dust after observing it under a microscope
in 1898
• Widely noted death of asbestos factory workers over
subsequent decades
• Not banned in UK until 1998 (banned in the U.S. in
1989)
• In meantime, tens of millions of people have died of
asbestos-related illnesses worldwide
 Why so difficult to regulate?
• Health effects delayed
• Scientific evidence was for a very long time
“preliminary” and inconclusive
• Effects severe and irreversible
• At the same time, very valuable in industrial
applications, so expensive to ban

• In hindsight, it would have been a great place to

apply the precautionary principle
 Other examples
• Chlouroflourocarbons
• Emerging infectious diseases
– Swine flu
– SARS
– Mad Cow Disease
• Oil Drilling?
• Risk of abrupt climate change?