Pricing Nature: Cost–Benefit Analysis and Environmental Policy by Nick Hanley and Edward B. Barbier


Pricing Nature: Cost–Benefit Analysis and Environmental Policy
By Nick Hanley and Edward B. Barbier

Pricing Nature Cost-Benefit Analysis and Environmental Policy

Acknowledgements vi
1 Introduction 1
2 The theoretical foundations of CBA 15
3 Stated preference approaches to environmental valuation 44
4 Revealed preference methods (1): the travel cost model 79
5 Revealed preference methods (2): hedonic pricing 98
6 Valuing the environment: production function approaches 116
7 Discounting and the discount rate 142
8 CBA in developing countries: what’s diff erent? 167
9 Valuing ecosystem services 205
10 Costs and benefits of water quality improvements 238
11 Valuing habitat protection 265
12 Cost–benefi t analysis and renewable energy 284
13 The strengths and weaknesses of environmental CBA 307
Index 335

1. Introduction
This chapter has four purposes:

● to explain the basic method of cost–benefi t analysis (CBA);
● to refl ect on why CBA might be a useful tool for environmental policy analysis and environmental management;
● to provide a very brief history of the use of CBA in policy and project appraisal;
● to explain what this book tries to achieve, and how it is organized.

In essence, the idea behind CBA is very simple. It is a technique for measuring whether the benefi ts of a particular action are bigger than the costs, judged from the viewpoint of society as a whole. By an ‘action’, we mean a deliberate decision to commit resources, which may involve two broad types:

● deciding on whether to introduce or reform a particular government policy, such as introducing a new energy tax; or
● deciding on whether to go ahead with a particular investment project, such as a new motorway or hydroelectric scheme.

To assess either type of decision using CBA, the analyst adds up the benefi ts of the project or policy and compares them with the costs. If the benefi ts are indeed bigger than the costs, then the project or policy makes society better off as a whole. If the costs are bigger than the benefi ts, then society is worse off as a whole if the project or policy goes ahead. However, it quickly becomes clear that there are a lot of unresolved questions here. What do we mean by ‘society’? What should we include as the ‘benefits’ and the ‘costs’ of a project or policy? How do we put a monetary value on these? What about projects where costs stretch far into the future? And how do we judge whether the benefi ts to society as a whole are bigger than the costs? This book will go some way to providing answers to these questions. To begin with, though, and to focus our discussion, we present an overview of how a cost–benefi t analysis is conducted. Let us take as an example a decision over whether to allow a new hydroelectric power scheme to be constructed in Scotland. The CBA method involves six stages of analysis:

i. Project/policy Definition
This involves setting out exactly what is being analysed, whose welfare is being considered and over what time period. The CBA in this example is concerned with a new hydroelectric plant at a particular location, involving the building of access roads and a dam, the fl ooding of a valley, and the consequent generation of electricity, but a decision must be made about whether linked, ancillary investments (such as new transmission lines) should be considered as well. In terms of ‘whose welfare’, the usual answer is that it is national well-being that is considered, that is, all impacts are defined in terms of eff ects on people living within the UK. The analysis is to be carried out over the expected life time of the plant, say 30 years. Often, defi ning the ‘relevant population’ is a diffi cult issue. For instance, if the dam would threaten an internationally rare habitat, should the costs to non-UK conservationists also be counted? The relevant time period may also be problematic. If nuclear waste storage proposals are being analysed, then it is necessary to make allowance for the very long half life of some radioactive wastes.

ii. Identification of Physical Impacts of the Policy/project Any project/policy has implications for resource allocation: in this case, labour used to build access roads; additional electricity production due to the creation of a new power station; land used up in the creation of the reservoir; less pollution being generated from a coal fi red power station which can now be closed early. The next stage of a CBA is to identify these outcomes in physical magnitudes: so many man-hours of labour, so many megawatt hours of electricity, so many hectares of land. For environmental impacts, Environmental Impact Analysis will often be used to produce predictions. Frequently, these changes in resource allocation will not be known with certainty – for example, how many tonnes of pollution will be displaced? How many hours of the year will the power station operate for? For environmental impacts, uncertainty in outcomes is to be expected to an even greater degree than with other impacts. The eff ects on invertebrate fauna from a reduction in acid deposition, or the eff ects of enhanced global warming on species migration are examples.

Once physical impacts have been identifi ed and quantifi ed, it is then necessary to ask which of them are relevant to the CBA. Essentially, anything which impacts on the quantity or quality of resources, or on their price, may be said to be relevant if these impacts can be traced back to a link to the well-being of the relevant population. Since we specify relevant impacts in terms of utility impacts, it is not necessary to restrict attention to market-valued impacts, since non-market value changes (such as an improvement in air quality) are relevant if they aff ect people’s utility.

iii. Valuing Impacts
One important feature of CBA is that all relevant eff ects are expressed in monetary values, so that they can then be aggregated. The general principle of monetary valuation in CBA is to value impacts in terms of their marginal social cost or marginal social benefi t. ‘Social’ here means ‘evaluated with regard to the economy as a whole’. Simple fi nancial investment appraisal, in contrast, values costs and benefi ts in terms of their impact on fi rms and their shareholders only. But where are these marginal social benefi ts and costs derived from? Under certain conditions, this information is contained in market prices, as the next chapter explains. Market prices contain information on both the value to consumers of a particular product (say electricity) being supplied, and the costs to producers of supplying it. The market wage rate, similarly, shows both the value of labour to employers and the value of leisure to workers. Assuming that the impacts of the project are not large enough to actually change these prices, then market prices are a good fi rst approximation to the values of benefi ts and costs (Sugden and Williams, 1978). Where markets work well, market prices and market supply and demand curves contain useful information about social costs and benefi ts of more electricity produced, or more land being used up. But markets often ‘fail’, for example when the actions of private fi rms and households impose costs on others, for example when pollution from a coal fi red power station harms the health of those living nearby. Moreover, for some ‘goods’, like biodiversity and river water quality, no market exists at all from which a price can be observed. In such cases, market prices are no longer a good guide to social costs and benefi ts. Chapter 2 explains how in principle this valuation problem can be solved in CBA, while Chapters 3–6 contain detail on the methods which can be used to measure such ‘non-market’ values. Box 1.1 shows guidance from the US EPA (2000) on the diff erent kinds of costs which can make up the social costs included in CBA.

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