How to complete a cost benefit analysis

how to complete a cost benefit analysis

Essentials, Section 4

Applying Ecosystem Value Estimates – Benefit-Cost Analysis

This section describes how ecosystem values are applied to decision-making using benefit-cost analysis.

The most common use of ecosystem values for decision-making is in benefit-cost analysis. Benefit-cost analysis compares benefits and costs to society of policies, programs, or actions to protect or restore ecosystems. Benefit-cost analysis measures the net gain or loss to society from a policy or action.

The objective of benefit-cost analysis is to determine whether society, as a whole, will be better off if the policy or action is implemented. This requires enumerating and evaluating all of the measurable benefits and costs and comparing them. In this manner, a single policy or action may be evaluated to determine whether it provides net economic benefits to society. Alternatively, several policies or programs may be compared to determine which provides the greatest net economic benefits.

Benefit-cost analysis is only one of many possible ways to make public decisions about the natural environment. Because it focuses only on economic benefits and costs, benefit-cost analysis determines the economically efficient option. This may or may not be the same as the most socially acceptable option, or the most environmentally beneficial option. Remember, economic values are based on peoples’ preferences, which may not coincide with what is best, ecologically, for a particular ecosystem. However, public decisions must consider public preferences, and benefit-cost analysis based on ecosystem valuation is one way to do so. Often, when actual decisions are made, a benefit-cost analysis will be supplemented with other information, such as equity implications or overriding environmental considerations.

Benefit-cost analysis is conducted in four steps, which will be illustrated below using the example of a proposed upgrade to a sewage treatment plant.

Step 1:

The first step is to specify and describe the policy or action to be evaluated, including such information as its location, timing, and the people who will be affected. For example, if the action being considered is a proposed upgrade to a sewage treatment plant, the researcher would compile information on the municipality or municipalities that the plant serves, the water body that it discharges into, and the expected completion date and life span of the plant.

Step 2:

The second step is to describe and quantify the effects of the policy or program that will lead to benefits and costs to society. For example, the researcher would gather information on the annual costs of the upgrade to the sewage plant, how it is expected to affect water quality, and how the improvements in water quality are expected to affect people. The researcher might use scientific studies or models to predict changes in water quality and the resulting effects on the ecosystem, and recreation participation studies to predict changes in water-related recreation when water quality improves.

Step 3:

The third step is to estimate the social costs and benefits. For this example, the costs are fairly straightforward – the cost of upgrading the plant. Benefits will result from improved water quality, and would be expected to include increased recreational opportunities and enjoyment. For example, swimming and fishing might be allowed in more areas, and water-based activities might be more enjoyable if the water is cleaner. Benefits might also include non-use values for the improvements in affected ecosystems. These benefits would be quantified using one or more of the methods described in Dollar-Based Ecosystem Valuation Methods.

The researcher must use professional judgment to select the most appropriate benefit estimation method(s). First, the researcher would narrow the range of appropriate methods to those that are able to measure the types of benefits that are important, in this case both recreational use and possibly non-use values. Second, the researcher would balance the accuracy and costs, in terms of time and money, of the relevant methods,

with the importance of the decision and the expected magnitude of economic benefits.

While a more expensive and complicated method might measure a more complete range of benefits, and may be more accurate, the importance of the issue or expected level of benefits may not justify the greater expenditure of time and money to estimate benefits. Thus, for projects where the benefits and/or the costs of making a less complete or accurate decision are expected to be low, less expensive benefit estimation methods will be satisfactory, although these methods may not measure the full range of benefits and may, in some cases, be less accurate. However, when the stakes are higher, the choice of method becomes more important, and greater time and expense for the analysis may be justified.

Step 4:

The final step is to compare benefits and costs of the proposed project. Because the benefits and costs usually occur over many years, this step involves calculating and comparing the present value of benefits and costs. The present value is the current value of benefits and costs that are received in the future. A discount rate is used to reduce future benefits and costs to their present time equivalent. For example, if the upgraded sewage plant is expected to function for 30 years, benefits and costs for each of the 30 years would be discounted to their present values, and summed to get the net present value, or the sum of discounted net benefits over time. If the net present value of a project is positive, the project is worthwhile in terms of economic efficiency.

Discounting

Discounting is applied to benefits received and costs incurred in the future for two reasons. First, people generally prefer to receive benefits sooner rather than later, and to pay costs later rather than sooner. Second, money that is available now can be invested and earn a return. Thus, money available now is worth more to people than money received in the future.

For example, if $1 is invested at a 10% interest rate, it will be worth $1.10 after one year, $1.21 after two years, and so on. Discounting reverses this process, by calculating the value, in today’s dollars, of a given amount received in the future. For example, if a person is promised $1.10 at the end of a year, and their discount rate is 10%, they would be equally happy with $1.00 today.

Thus, the discounted present value of a benefit received in the future is calculated as: Bt /(1+r) t, where Bt is the benefit to be received in year t, and r is the discount rate. Costs would be similarly discounted. So, a benefit of $1.21 received in two years, where the discount rate is 10%, is worth $1.21/(1.1) 2 = $1.21/1.21 = $1 today. Thus, $1 is the discounted present value of $1.21 received in two years, for a 10% discount rate.

For decisions related to natural resources, the appropriate discount rate is the rate that reflects society’s preferences for allocating natural resource use over time. However, determining the social discount rate is controversial, and the choice of discount rate can have a large effect on the results of a benefit-cost analysis. A larger discount rate gives more weight to the present in relation to the future, and thus benefits to the current generation are given more weight than benefits to future generations. Many have argued for a social discount rate for environmental projects that is lower than the market rate, in order to leave more opportunities for future generations. In many cases, the discount rate is set by federal regulations. For example, the U.S. Department of the Interior sets the discount rate for Federal water and related land resources planning, based on the average yield of interest-bearing marketable securities of the United States.

Source: www.ecosystemvaluation.org

Category: Credit

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