introduction to cost-benefit analysis: using market prices presentation by dr. benoit laplante...

Introduction to Cost-Benefit Analysis: Using Market Prices

Presentation by Dr. Benoit LaplanteEnvironmental Economist

ConsultantAsian Development Bank

BangkokSeptember 30 to October 4, 2013

Outline of Presentation

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1. Cost-benefit analysis: 8 steps

4. Methodologies to evaluate impacts

2. Quantifying the impacts of a project

5. Using market prices

3. Concept of economic value


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Cost-benefit analysis: 8 steps

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Step 2: Identify all potential physical impacts of the project.

Step 4: Monetize impacts.

Step 5: Discount to find present value of costs and benefits.

Step 6: Calculate net present value.

Step 8: Make recommendations.

Step 3: Quantify the predicted impacts.

Step 1: Define the scope of analysis.

Step 7: Perform expected value and/or sensitivity analysis.


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Quantifying the impacts of a project

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• This is perhaps the most important and most common failure in CBA.

Suppose the following (hypothetical) situation:

In a specific region of the country, agricultural yield has been going down for the last few years (which may or may not be related to climate change).

Suppose a project (for example a supplementary irrigation project) which aims to offset some or all of this adverse affect.

How would one assess the impact of the project on agricultural yield given the projected increases in air temperature? In other words: How would one assess the benefits of this project?


Projected increases in air temperature is expected to have an adverse effect on agricultural yield.

Yield (tons per month)

Today

Existing yield

TimePast Looking in the future

Which question do we need to ask to quantify the possible impacts of the project?


Question 1: What is likely to happen WITHOUT the project?


Today

Existing yield

TimePast

Suppose this is estimated yield given projected increases in temperature WITHOUT project.

Looking in the future



Today

Existing yield

TimePast



Question 2: What would be ag yield given projected increases in temperature WITH the project?



Today

Existing yield

TimePast



Question 2: What would be ag yield given projected increases in temperature WITH the project?

Suppose this is estimated yield given projected increases in temperature WITH project.

Impact of project



Today

Existing yield



Under PPCR, the baseline is the value of the existing yield at the time the PPCR is negotiated.

Suppose one goes back a few years later and find this.What will PPCR conclude?


Today

Existing yield



Under PPCR, the baseline is the value of the existing yield at the time the PPCR is negotiated.

Suppose one goes back a few years later and find this.PPCR will conclude project is a failure.

But in fact, if this was without project, then the project is a success.

• This is perhaps the most important and most common failure in CBA.

• We must always ask: What would happen if the project did not take place. We must compare how the situation will be “with the project” and how it is expected to be “without the project”.



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The concept of economic value

Consider an individual in an initial state of well-being W0 thathe/she she achieves with a money income Y0 and a level of access to irrigation IR0:

W0 (Y0, IR0)

Now consider a project which would increase access to irrigation water to IR1. This increased access to IR wouldproduce a new level of well-being to W1:

W1 (Y0, IR1)

Since this individual’s well-being would increase with theproject, we know that:

W1 (Y0, IR1) W0 (Y0, IR0)>

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W1 (Y0, IR1) W0 (Y0, IR0)-

In order to assess the appropriateness of this project andcompare the costs of the project with the benefits, we wouldlike to know how much the well-being of this individual is increased with increased access to irrigation, i.e. howlarge is W1 minus W0?

ΔW =

How could we measure this change in well-being? How large is W1 minus W0?

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Determine the maximum amount of income the individualwould be willing to pay (WTP) for the change in IR.

In effect, the individual is asked to consider two combinationsof income and access to irrigation water that both yield thesame level of well-being:

One combination in which his/her income is reduced and access to IR is increased; and

Another combination in which income is not reduced and access to IR remains the same as it is (no change).

W0 (Y0 – WTP, IR1)W0 (Y0, IR0) =

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W0 (Y0 – WTP, IR1)W0 (Y0, IR0) =

WTP is defined as the amount of money that makes these twocombinations of income and traffic congestion yield the samelevel of well-being. This is the maximum the individual wouldbe willing to pay for the positive change in welfare resultingfrom a greater access to irrigation water. This maximum WTP is defined as the economic value of thechange in well-being resulting from the increased access toirrigation water from IR0 to IR1.

All economic valuation methodologies aim to measure thismaximum WTP. Some methodologies do this well, some notso well.

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Total economic value

Non-use value

Use value

Indirect use

value

Direct use

value

Non-consumptive direct use value

Consumptive direct use value

Existence value

Bequest value

+

+ +

+

Among use value, we also add: Option value

Relatively easy to measure

Relatively difficult to measure



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Methodologies to evaluate impacts

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Non-use value

Use value

Indirect use value

Direct use value

Non-consumptive direct use value

Consumptive direct use value

Bequest value

Existence value

Group 1: Change of productivity methodology

Group 2 (Revealed preferences) and Group 3 (Stated preferences)

Group 3 (Stated preferences)

Methodologies to evaluate impacts


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Group 1: ‘Change of productivity’ methodology

This methodology is generally applied in the specific case where the environmental impact represents a change in a component of the environment (or ecosystem) which has a direct consumptive value.

This impact will be measured by a change in the production of a good for which there is already a market, and therefore market prices.

Market prices or shadow prices will be used to assess the economic impact of this change in productivity.

Using market prices

• Water pollution may impact fisheries yield;

• Reservoir sedimentation may impact power production;

• Floods may impact agriculture production;

Examples where appropriate to use this methodology:


• Increases in temperature may reduce agricultural yield.

Using market prices

Proceeds in two steps:

Step 1: Establish the link or the relationship that exists between a change in environmental quality and the resulting impact on production.

This is generally called a dose-response function.

Examples of dose-response functions:

• Relationship between fisheries yield and water pollution;

• Relationship between reservoir sedimentation and power production;

• Relationship between temperature and agricultural production.


Using market prices

Step 2: Once the change in production is established, market prices (or shadow prices which are market prices corrected for the presence of subsidies, taxes or for any other market imperfections) are then used to estimate the economic value of the estimated change in production.



Using market prices


Step 1: Establish the link or the relationship that exists between a change in environmental quality and the resulting impact on production.


Using market prices

Step 2: Once the change in production is established, market prices (or shadow prices which are market prices corrected for the presence of subsidies, taxes or for any other market imperfections) are then used to estimate the economic value of the estimated change in production.

Step 1 is the difficult step.


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Steps and expertise

ECONOMIC VALUATION OF IMPACTS

QUANTIFICATION OF IMPACTS

IDENTIFICATION OF IMPACTS

Task of economists

Task of technical, scientific and economic

experts

Task of technical and scientific experts

Need multi-disciplinary team

Introduction to Cost-Benefit Analysis: Using Market Prices

Presentation by Dr. Benoit LaplanteEnvironmental Economist

ConsultantAsian Development Bank

BangkokSeptember 30 to October 4, 2013