Natural Resource Economics Archives - Page 17 of 17 - An Economic View of the Environment

Is Benefit-Cost Analysis Helpful for Environmental Regulation?

With the locus of action on Federal climate policy moving this week from the House of Representatives to the Senate, this is a convenient moment to step back from the political fray and reflect on some fundamental questions about U.S. environmental policy.

One such question is whether economic analysis – in particular, the comparison of the benefits and costs of proposed policies – plays a truly useful role in Washington, or is it little more than a distraction of attention from more important perspectives on public policy, or – worst of all – is it counter-productive, even antithetical, to the development, assessment, and implementation of sound policy in the environmental, resource, and energy realms. With an exceptionally talented group of thinkers – including scientists, lawyers, and economists – now in key environmental and energy policy positions at the White House, the Environmental Protection Agency, the Department of Energy, and the Department of the Treasury, this question about the usefulness of benefit-cost analysis is of particular importance.

For many years, there have been calls from some quarters for greater reliance on the use of economic analysis in the development and evaluation of environmental regulations. As I have noted in previous posts on this blog, most economists would argue that economic efficiency — measured as the difference between benefits and costs — ought to be one of the key criteria for evaluating proposed regulations. (See: “The Myths of Market Prices and Efficiency,” March 3, 2009; “What Baseball Can Teach Policymakers,” April 20, 2009; “Does Economic Analysis Shortchange the Future?” April 27, 2009) Because society has limited resources to spend on regulation, such analysis can help illuminate the trade-offs involved in making different kinds of social investments. In this sense, it would seem irresponsible not to conduct such analyses, since they can inform decisions about how scarce resources can be put to the greatest social good.

In principle, benefit-cost analysis can also help answer questions of how much regulation is enough. From an efficiency standpoint, the answer to this question is simple — regulate until the incremental benefits from regulation are just offset by the incremental costs. In practice, however, the problem is much more difficult, in large part because of inherent problems in measuring marginal benefits and costs. In addition, concerns about fairness and process may be very important economic and non-economic factors. Regulatory policies inevitably involve winners and losers, even when aggregate benefits exceed aggregate costs.

Over the years, policy makers have sent mixed signals regarding the use of benefit-cost analysis in policy evaluation. Congress has passed several statutes to protect health, safety, and the environment that effectively preclude the consideration of benefits and costs in the development of certain regulations, even though other statutes actually require the use of benefit-cost analysis. At the same time, Presidents Carter, Reagan, Bush, Clinton, and Bush all put in place formal processes for reviewing economic implications of major environmental, health, and safety regulations. Apparently the Executive Branch, charged with designing and implementing regulations, has seen a greater need than the Congress to develop a yardstick against which regulatory proposals can be assessed. Benefit-cost analysis has been the yardstick of choice

It was in this context that ten years ago a group of economists from across the political spectrum jointly authored an article in Science magazine, asking whether there is role for benefit-cost analysis in environmental, health, and safety regulation. That diverse group consisted of Kenneth Arrow, Maureen Cropper, George Eads, Robert Hahn, Lester Lave, Roger Noll, Paul Portney, Milton Russell, Richard Schmalensee, Kerry Smith, and myself. That article and its findings are particularly timely, with President Obama considering putting in place a new Executive Order on Regulatory Review.

In the article, we suggested that benefit-cost analysis has a potentially important role to play in helping inform regulatory decision making, though it should not be the sole basis for such decision making. We offered eight principles.

First, benefit-cost analysis can be useful for comparing the favorable and unfavorable effects of policies, because it can help decision makers better understand the implications of decisions by identifying and, where appropriate, quantifying the favorable and unfavorable consequences of a proposed policy change. But, in some cases, there is too much uncertainty to use benefit-cost analysis to conclude that the benefits of a decision will exceed or fall short of its costs.

Second, decision makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Removing statutory prohibitions on the balancing of benefits and costs can help promote more efficient and effective regulation.

Third, benefit-cost analysis should be required for all major regulatory decisions. The scale of a benefit-cost analysis should depend on both the stakes involved and the likelihood that the resulting information will affect the ultimate decision.

Fourth, although agencies should be required to conduct benefit-cost analyses for major decisions, and to explain why they have selected actions for which reliable evidence indicates that expected benefits are significantly less than expected costs, those agencies should not be bound by strict benefit-cost tests. Factors other than aggregate economic benefits and costs may be important.

Fifth, benefits and costs of proposed policies should be quantified wherever possible. But not all impacts can be quantified, let alone monetized. Therefore, care should be taken to assure that quantitative factors do not dominate important qualitative factors in decision making. If an agency wishes to introduce a “margin of safety” into a decision, it should do so explicitly.

Sixth, the more external review that regulatory analyses receive, the better they are likely to be. Retrospective assessments should be carried out periodically.

Seventh, a consistent set of economic assumptions should be used in calculating benefits and costs. Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

Eighth, while benefit-cost analysis focuses primarily on the overall relationship between benefits and costs, a good analysis will also identify important distributional consequences for important subgroups of the population.

From these eight principles, we concluded that benefit-cost analysis can play an important role in legislative and regulatory policy debates on protecting and improving the natural environment, health, and safety. Although formal benefit-cost analysis should not be viewed as either necessary or sufficient for designing sensible public policy, it can provide an exceptionally useful framework for consistently organizing disparate information, and in this way, it can greatly improve the process and hence the outcome of policy analysis.

If properly done, benefit-cost analysis can be of great help to agencies participating in the development of environmental regulations, and it can likewise be useful in evaluating agency decision making and in shaping new laws (which brings us full-circle to the climate legislation that will be developed in the U.S. Senate over the weeks and months ahead, and which I hope to discuss in future posts).

Does economic analysis shortchange the future?

Decisions made today usually have impacts both now and in the future. In the environmental realm, many of the future impacts are benefits, and such future benefits — as well as costs — are typically discounted by economists in their analyses. Why do economists do this, and does it give insufficient weight to future benefits and thus to the well-being of future generations?

This is a question my colleague, Lawrence Goulder, a professor of economics at Stanford University, and I addressed in an article in Nature. We noted that as economists, we often encounter skepticism about discounting, especially from non-economists. Some of the skepticism seems quite valid, yet some reflects misconceptions about the nature and purposes of discounting. In this post, I hope to clarify the concept and the practice.

It helps to begin with the use of discounting in private investments, where the rationale stems from the fact that capital is productive – money earns interest. Consider a company trying to decide whether to invest $1 million in the purchase of a copper mine, and suppose that the most profitable strategy involves extracting the available copper 3 years from now, yielding revenues (net of extraction costs) of $1,150,000. Would investing in this mine make sense? Assume the company has the alternative of putting the $1 million in the bank at 5 per cent annual interest. Then, on a purely financial basis, the company would do better by putting the money in the bank, as it will have $1,000,000 x (1.05)³, or $1,157,625, that is, $7,625 more than it would earn from the copper mine investment.

I compared the alternatives by compounding to the future the up-front cost of the project. It is mathematically equivalent to compare the options by discounting to the present the future revenues or benefits from the copper mine. The discounted revenue is $1,150,000 divided by (1.05)³, or $993,413, which is less than the cost of the investment ($1 million). So the project would not earn as much as the alternative of putting the money in the bank.

Discounting translates future dollars into equivalent current dollars; it undoes the effects of compound interest. It is not aimed at accounting for inflation, as even if there were no inflation, it would still be necessary to discount future revenues to account for the fact that a dollar today translates (via compound interest) into more dollars in the future.

Can this same kind of thinking be applied to investments made by the public sector? Since my purpose is to clarify a few key issues in the starkest terms, I will use a highly stylized example that abstracts from many of the subtleties. Suppose that a policy, if introduced today and maintained, would avoid significant damage to the environment and human welfare 100 years from now. The ‘return on investment’ is avoided future damages to the environment and people’s well-being. Suppose that this policy costs $4 billion to implement, and that this cost is completely borne today. It is anticipated that the benefits – avoided damages to the environment – will be worth $800 billion to people alive 100 years from now. Should the policy be implemented?

If we adopt the economic efficiency criterion I have described in previous posts, the question becomes whether the future benefits are large enough so that the winners could potentially compensate the losers and still be no worse off? Here discounting is helpful. If, over the next 100 years, the average rate of interest on ordinary investments is 5 per cent, the gains of $800 billion to people 100 years from now are equivalent to $6.08 billion today. Equivalently, $6.08 billion today, compounded at an annual interest rate of 5 per cent, will become $800 billion in 100 years. The project satisfies the principle of efficiency if it costs current generations less than $6.08 billion, otherwise not.

Since the $4 billion of up-front costs are less than $6.08 billion, the benefits to future generations are more than enough to offset the costs to current generations. Discounting serves the purpose of converting costs and benefits from various periods into equivalent dollars of some given period. Applying a discount rate is not giving less weight to future generations’ welfare. Rather, it is simply converting the (full) impacts that occur at different points of time into common units.

Much skepticism about discounting and, more broadly, the use of benefit-cost analysis, is connected to uncertainties in estimating future impacts. Consider the difficulties of ascertaining, for example, the benefits that future generations would enjoy from a regulation that protects certain endangered species. Some of the gain to future generations might come in the form of pharmaceutical products derived from the protected species. Such benefits are impossible to predict. Benefits also depend on the values future generations would attach to the protected species – the enjoyment of observing them in the wild or just knowing of their existence. But how can we predict future generations’ values? Economists and other social scientists try to infer them through surveys and by inferring preferences from individuals’ behavior. But these approaches are far from perfect, and at best they indicate only the values or tastes of people alive today.

The uncertainties are substantial and unavoidable, but they do not invalidate the use of discounting (or benefit-cost analysis). They do oblige analysts, however, to assess and acknowledge those uncertainties in their policy assessments, a topic I discussed in my last post (“What Baseball Can Teach Policymakers”), and a topic to which I will return in the future.

Using Markets to Make Fisheries Sustainable

Around the world, over-fishing is leading to severe depletion of valuable fisheries. This is as true in U.S. coastal waters as it is in many other parts of the world. In New England waters, for example, after two decades of ever more intensive fishing, the groundfish fishery has essentially collapsed. But, we are not alone. According to the United Nations Environment Program, fully 25 percent of fisheries worldwide are in jeopardy of collapse due to over-fishing. Clearly, something needs to be done. Yet, what has long been considered the obvious answer – restrictions on fishing – has been shown time and time again to be the wrong answer. The right answer is enlightened use of markets.

The fundamental cause of the depletion of fish stocks is well known to economists: virtually all ocean fisheries are “open-access,” that is, fishermen – small operations or large corporations – can fish all they want. These individuals and companies are no more greedy than the rest of us, but because no one holds title to fish stocks in the open ocean, everyone races to catch as much as possible. Each fisherman receives the full benefit of aggressive fishing (that is, a larger catch), but none pay the full cost (an imperiled fishery for everyone). One fisherman’s choices have an effect on other fishermen (of this generation and the next), but in an open-access fishery – unlike a privately-held copper mine, for example – these impacts are not taken into account. What is individually rational adds up to collective foolishness, as the shared resource is over-exploited. This is the “tragedy of the commons.” What to do?

Government intervention is, alas, required. Fishermen don’t welcome such regulation in their economic sphere any more than anyone else does. And they have a point. Conventional regulatory approaches have driven up costs, but not solved the problem. And we know why. If the government limits the season, fishermen put out more boats. If the government limits net size, fishermen use more labor or buy more costly sonar. Economists call this over-capitalization. Costs go up for fishermen (as resources are squandered), but pressure on fish stocks is not relieved.

The answer is to adopt in fisheries management the same type of innovative policy that has been used for decades in the realm of pollution control – tradeable permits, called “Individual Transferable Quotas” ( ITQs) in the fisheries realm. Sixteen countries – some with economies much more dependent than ours on fishing – have adopted such systems with great success. New Zealand regulates virtually its entire commercial fishery this way. It’s had the system in place since 1986, and it’s been a great success, putting a brake on over-fishing and restoring stocks to sustainable levels - while increasing fishermen’s profitability!

There are several ITQ systems already in operation in the United States, including for Alaska’s pacific halibut and Virginia’s striped-bass fisheries. More important, the time is ripe for broader adoption of this innovative approach, because a short-sighted ban imposed by the U.S. Congress on the establishment of new ITQ systems has expired.

The first step in establishing an ITQ system is to establish the “total allowable catch.” The next step – and a crucial one – is to allocate shares of that total limit to fishermen in individual quotas that are theirs and theirs alone (read: well-defined property rights). Setting the individual quotas will not be easy. The guiding principle should be simple pragmatism – using the allocations to build political support for the system. Making the quotas transferable eliminates the problem of overcapitalization and increases efficiency, because the least efficient fishing operations find it more profitable to sell their quotas than to exploit them through continued fishing. If you can’t catch your whole share, you can sell part of your quota to someone else, instead of buying a bigger boat.

In addition, these systems improve safety by reducing incentives for fishermen to go out (or stay out) when weather conditions are dangerous. And it was just such perverse incentives of conventional fisheries regulation that were blamed for the tragic loss of life when a fishing boat was lost in a storm off the New England coast just a few winters ago.

Further, because ITQ systems eliminate the motivation for government to limit the duration of the fishing season, supplies available to consumers improve in quality. Prior to the establishment of an ITQ system for Alaskan halibut, for example, the government had reduced the fishing season to just two days, but subsequent to the introduction of the system, the season length grew to more than 200 days.

A decade ago, environmental advocates – led by the Environmental Defense Fund – played a central role in the adoption of the sulfur dioxide allowance trading program that’s cut acid rain by half and saved electricity generators and rate-payers nearly $1 billion annually, compared with conventional approaches. The time has come for environmentalists to join forces with progressive voices in the fishing industry and in government to set up ITQ systems that can keep fishermen in business while moving fisheries onto sustainable paths.