Slides Class 6 ENRE Decision Support Techniques

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Mónica Meireles 
monica.meireles@iscte-iul.pt 
Office D5.15 
 
Environmental and Natural 
Resource Economics 
 
Bachelor in Economics 
1.1 Market Failures 
 
1.2 The Economics of pollution 
 
1.3 Methods to analyze environmental issues 
(Decision support techniques and CBA) 
 
I. Introduction 
How to measure the benefits and the abatement costs 
of improving the environment? 
 
1. Environmental Impact Analysis (EIA) 
2. Economic Impact Analysis 
3. Regulatory Impact Analysis 
4. Cost-Effectiveness Analysis 
5. Damage Assessment 
6. Risk Analysis 
7. Benefit-Cost Analysis (BCA) 
Decision Support Techniques (1) 
Decision Support Techniques (2) 
1. Environmental Impact Analysis 
 
Identifies and studies all significant environmental impacts 
stemming from a project or an action 
 
Work of natural scientists identify and describe the 
physical impacts of environmental projects or programs 
that result from the complex linkages within the ecosystem 
 
The decision on pursuing with the project or program will 
depend on those impacts 
 
 
Decision Support Techniques (3) 
E.g.: Suppose it is proposed to build a dam that will flood a river 
valley, while providing new recreation possibilities. 
 A substantial environmental impact will result from the 
innundation itself and the resulting losses in animals, 
plants, farmland, and so on. But, much also could change. 
Recreators travelling into and out of the region could affect 
air pollution and traffic congestion. New housing or 
commercial development resulted from the recreation 
possibilities could have negative impacts on the 
environment. 
 
 To study the full range of environmental impacts it is 
necessary to include the physical effects of the dam, but 
also the ways people will react to this new facility 
Decision Support Techniques (4) 
2. Economic Impact Analysis 
 
Analyses how some action (a new law, technology, and so forth) will 
affect an economic system, as a whole, or in its various parts 
 
E.g.: Local environmental groups might be interested in the impact 
of a wetland law on the population growth rate and on the tax 
base in their community. 
 Regional groups might be interested in the impacts of a 
national regulation on their economic circumstances 
 At the global level one might be interested in the impacts of a 
CO2 emissions control on the growth rates of rich and poor 
countries 
 
Whatever the level economic impact analysis requires a basic 
understanding of how economies function and how their several 
parts fit together 
Decision Support Techniques (5) 
3. Regulatory Impact Analysis 
 
Identifies and estimates the impacts following from 
regulations 
 
 
 
Decision Support Techniques (6) 
4. Cost-Effectiveness Analysis 
 
a) Takes an objective as given 
b) Identifies the several alternative ways of attaining that objective 
c) Estimates the costs of the  alternatives 
d) Calculates: ; ; (…) 
 
e) Chooses the option with the lower ratio (the option that attains 
the specified objective at the least possible cost) 
 
E.g.: Suppose a community whose current water supply was 
contaminated by some chemical and had to switch to some 
alternative supply 
 It has got several possibilities 
nDegradatiotalEnvironmen
AeAlternativofCost
 nDegradatiotalEnvironmen
BeAlternativofCost

Decision Support Techniques (7) 
5. Damage Assessment 
 
Estimates the value of the damages caused to a resource, so that 
these values could be recovered 
 How to measure? 
 
 Damage value = to the lesser of the 2 following values: 
 
 Lost value of the resource Value of restoring the resource 
 to its former state 
 value of the resource loss 
 (camping, hiking, etc) restoration costs, replacement costs 
 / costs of acquisition of equivalent res. 
Decision Support Techniques (8) 
The following table represents resource and restoration values for 2 
cases: 
 
 
 
 
Case A Resource loss from an oil release = €1,2 million 
 Cost of restoring resource to its former state = €0,6 million 
 €1,2 > € 0,6 true measure of damages 
 
Case B Lost resource value is substantially < than restoration costs: 
 €1,6 < €3,8 
 true measure of damages 
 
A B 
Lost Resource Value €1,2 million €1,6 million 
Restoration Cost €0,6 million €3,8 million 
Decision Support Techniques (9) 
6. Risk Analysis 
 
 Future Uncertainty 
- It is difficult to predict exactly the preferences of future generations 
(they may have  perceptions about environmental quality concerns) 
- Advances in pollution-control technologies can shift future abatement 
costs 
- New chemicals can have very uncertain damage effects 
 
 3 steps in Risk analysis : 
- Risk Assessment studies the origin of the risk + how people respond to it 
 works of physical and health scientists 
- Risk Valuation studies the WTP people place on risk ↓ 
 work of economists 
Decision Support Techniques (10) 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Both Programs have exactly the same expected value: 
 
Program A Net Benefits and Probabilities are similar 
 
Program B The Probability that Net Benefits will be €500,000 
is very high, while the probability of a disaster is very small 
 
Program A Program B 
Net Benefits Probability Net Benefits Probability 
€500,000 
€300,000 
0,475 
0,525 
€500,000 
- €10,000,000 
0,99 
0,01 
Expected value = €395,000 = 
0,475 x €500,000 + 0,525 x €300,000 
Expected value = €395,000 = 
0,99 x €500,000 - 0,01 x €10,000,000 
Decision Support Techniques (11) 
If decisions are based on the expected values those 
projects will be treated as the same 
 
 Risk-neutral behaviour 
 
If it is decided that the low probability of a large loss in B 
represents a risk we do not want to expose ourselves we 
might be risk-averse preferring A over B 
 
 the most adopted behaviour 
 
- Risk Management studies how  policies affect the 
environmental risk levels to which people are exposed 
Decision Support Techniques (12) 
7. Benefit-Cost Analysis (BCA) 
 
Measures, adds-up and compares all the benefits and costs of a 
particular public project or program (similar to the profit-and-loss 
analysis for a private firm, but not =) 
 
BCA helps making public decisions about policies and programs that 
have no market prices. E.g. improvements in the environmental 
quality 
 
 BCA involves basically 5 steps: 
a) Specify clearly the scope and size of the project / program 
b) Identify the specific impacts of the project 
c) Describe quantitatively the inputs and outputs of the program 
d) Estimate the Net Present Value of the Program (to compare its social 
 benefits and costs) 
e) Sensitivity Analysis 
Decision SupportTechniques (13) 
a) Specify clearly the project or program 
 
Includes a complete specification of the main elements of the 
program (it defines the boundaries of the analysis) 
 
Location, time, groups involved, connections with other programs, etc 
 
There are 2 basic types of public environmental programs for 
which BCA is done: 
 
- Physical projects involve direct public production. E.g. Public 
waste treatment plants, land purchase for preservation, etc 
 
- Regulatory projects involve environmental laws and 
regulations. E.g. pollution-control standards, technological 
choices, waste disposal practices, etc 
Decision Support Techniques (14) 
b) Identify the specific impacts of the project 
 
Determines all consequences of the specified program / project 
 
Factors to use (work hours, equipment, raw materials) and their 
impact: 
 
i) Additionality actions that would have not happened 
without the project. E.g. impact on the traffic congestion, in 
the prices of houses, etc 
 
ii) Displacement the program ↑ the economic activity, but 
sometimes it ↓ in another place 
Decision Support Techniques (15) 
c) Quantification of the relevant impacts 
 
• The dimension 
• The importance 
• The durability 
• The reversibility (is it possible to restore the resource as it was before?) 
• The characteristics of the environmental factors that were affected 
 
 Using monetary units to express the economic value of the resources 
 (through economic valuation methods of environmental damages) 
 
 How to measure? 
 
i) Using the market prices – in case they reflect correctly the cost 
(opportunity cost) and the benefit (WTP) 
ii) Using estimates – in case there are no markets for the 
environmental services affected by the project 
Decision Support Techniques (16) 
2 main forms of estimating monetary measures: 
 
i) Direct asks people their evaluations in relation to the 
 affected environmental services (mainly used when 
 the observed behaviour can not provide the 
necessary information) 
 uses the Artificial Market 
 
ii) Indirect estimates the prices of the affected environmental 
 services through the observed behaviour of the 
 individuals in relation to related goods that have 
 market prices 
 uses the Substitution Market 
Decision Support Techniques (17) 
d) Estimate the Net Present Value of the Program 
 
A cost that will occur 10 years from now does not have the 
same significance as a cost that occurs today 
 
 PV value I have to put in the bank today to have what I 
need in t years 
 the > the discount rate the < the PV of any future 
 amount (the < the capital we have to put today) 
 
 NPV = = - 
 
 
 r = discount rate 
 t = number of years involved 
 tr
Benefits


1  tr
Costs


1 
t
r
BenefitsNet


1
Decision Support Techniques (18) 
E.g.: (considering the benefits only): 
 
 ; 
 
E.g.: Benefits per year of 2 different projects: 
 
 
 
 
Project A = 20 + 20 + 20 + 20 = 80 
Project B = 50 + 10 + 10 + 10 = 80 BUT 
 
Project A has got equal annual benefits 
Project B has substantial benefits in the first period and lower annual 
 benefits thereafter 
 
9,613
5,01
1000€
10

 
2,463
8,01
1000€
10


t=1 t=2 t=3 t=4 
Project A 20 20 20 20 
Project B 50 10 10 10 
Decision Support Techniques (19) 
To compare the total benefits of the 2 projects we have to 
calculate the PV of total benefits of each project: 
 
• PVA= €20 + 
 
• PVB= €50 + 
 
 PVB > PVA Because in B, benefits are more heavily 
concentrated in earlier years than in A 
 
Discounting ↓ PV (PV always < undiscounted sums of benefits) 
 
NPV = PV Benefits – PV Costs > PV Environmental Costs 
 
 Fundamental Equation for Natural Habitat Preservation 
     
45,73€
06,01
20€
06,01
20€
06,01
20€
32





     
73,76€
06,01
10€
06,01
10€
06,01
10€
32






Decision Support Techniques (20) 
e) Sensitivity Analysis 
 
How can we be sure if the program under evaluation is of the appropriate scope? 
 
 Current emissions level = e1 (uncontrolled) 
 
 Control Program proposes↓emissions to e2 
 
 Total benefits (total damages ↓) = a + b 
 Total abatement costs = b 
 
 Net benefits = a 
 
 However, for an emission ↓ program to 
 give maximum net benefits, it would have 
 to ↓ emissions to e* (where MAC = MD ) 
 Net benefits = a + d 
Decision Support Techniques (21) 
But, when we do a BCA of a specific proposal, how can we be 
sure we are dealing with e* and not e2? 
 
 We have to carry out the sensitivity analysis 
 
Recalculate benefits and costs for a program with more 
restrictive emissions ↓ and for a program less restrictive 
 
If the chosen program has the appropriate size or scope 
each of the variations will produce < net benefits 
Decision Support Techniques (22) 
Main BCA Problems 
 
1. Attempt to apply the market philosophy to non-market situations 
 E.g. Biodiversity Adequate values? Irrealism 
2. Ecosystems complexity (sometimes we don’t know the impacts until 
we have caused them) 
3. Difficulties in estimating (preferences must be taken into account) 
 (But of whom?) 
4. Benefits are given by WTP and not by XC (consumer surplus) 
5. The choice of discount rate 
 Reflects the current generation’s view about the relative weight to be 
given to benefits and costs occurring in  years 
 r should reflect the way people think about time 
 What discount rate? Why discounting? 
 should reflect the interest rate banks charge to their borrowers 
 pay to people’s savings account 
Decision Support Techniques (23) 
6. Risk, uncertainty, irreversibility 
7. Since we use monetary values we can face ethical 
problems 
 E.g.: Evaluate a life 
 
 BCA just makes sure that benefits > costs 
 
 It does not tell if the project is adequate 
 
 All these methods must be seen as a way of giving information 
to decision makers and not as a way of giving an answer