COST-BENEFIT ANALYSIS

The notion that a zero pollution objective is not necessarily ideal policy is one of the
more difficult concepts for environmental economists to convey. After all, if pollution
is bad shouldn't we design policy to completely eliminate it? Many of us are drawn to
the field based on a genuine concern for the environment and the belief that
economics provides a powerful tool for helping solve environmental problems. Yet
we are often in the position of recommending policies that appear on the surface to
be anti- environmental. How can these observations be reconciled? The answer lies
in understanding scarcity: we have unlimited wants, but live in a world with limited
means. Economists in general study how people make decisions when faced with
scarcity. Scarcity implies that resources devoted to one end are not available to meet
another; hence there is an opportunity cost of any action. This includes
environmental policy.

For example, funds used by a municipality to retrofit its water treatment plant to
remove trace amounts of arsenic (a carcinogen) cannot also be used to improve
local primary education. Environmental economists are tasked with recommending
policies that reflect scarcity of this type at the society level. For both individuals and
societies scarcity necessitates tradeoffs , and the reality of tradeoffs can make the
complete elimination of pollution undesirable. Once this is acknowledged the
pertinent question becomes how much pollution should be eliminated. How should
we decide? Who gets to decide? To help provide answers economists use an
analytical tool called cost-benefit analysis.

Cost-benefit analysis provides an organizational framework for identifying,

quantifying, and comparing the costs and benefits (measured in dollars) of a
proposed policy action. The final decision is informed (though not necessarily
determined) by a comparison of the total costs and benefits. While this sounds
logical enough, cost-benefit analysis has been cause for substantial debate when
used in the environmental arena. The benefits of environmental regulations can
include, for example, reduced human and wildlife mortality, improved water quality,
species preservation, and better recreation opportunities. The costs are usually
reflected in higher prices for consumer goods and/or higher taxes. The latter are
market effects readily measured in dollars, while the former are non market effects
for which dollar values are not available.

Environmental economists tend to favor cost-benefit analysis in the policy arena

because of the discipline and transparency it provides in evaluating policy options. It
is easy to evaluate absolutes. Most would agree that reducing nitrogen
contamination of groundwater wells, limiting the occurrence of code red ozone alerts,
and preserving habitat for grizzly bears are worthy goals. Determining the relative
merits of any one of these compared to the others, or compared to non-
environmental goals such as improving public education, is much more daunting.
Because policy making is ultimately about evaluating the relative merits of different
actions some mechanism is needed to rank the alternatives. Without the discipline of
cost-benefit analysis it is not clear how the interests, claims, and opinions of parties
affected by a proposed regulation can be examined and compared. Criterion such as
'moral' or 'fair' do not lend themselves well to comparison and are subject to wide
ranging interpretation.

To many of the more extreme type of environmentalists, no level of human

destruction of the environment is acceptable. They would demand an end to
environmental problems such as pollution. Other more moderate environmentalists
and many modern economists instead turn to what is known as cost-benefit analysis.
This process seeks to compare the social costs and social benefits associated with a
public policy decision.

Often this process is very successful. For example, a cost- benefit analysis of
pollution in Los Angeles, California revealed that the combined benefits of pollution
reduction would greatly outweigh the calculated costs, and government policy was
successfully affected by this finding. One problem with cost-benefit analysis is that
not everything can be expressed in money terms. How much does it "cost" society if
a person dies?

There are other problems as well. It is impossible to completely predict every result
of a policy decision. In other words, not every factor can be taken into account in the
analysis. Also, aspects such as health hazards have to be based on risk
assessments because the exact outcome cannot be known beforehand. The fact
that the concerns of future generations are not always represented in cost-benefit
analyses also makes the process less reliable.

Ultimately, the goal of cost-benefit analysis is to enable a government policy that

enforces environmental regulations up to the point where the marginal social cost
and the marginal social benefit of these regulations are equal. This basically means
that, for example, the government should continue reducing the amount of pollution
allowed up to the point where a further reduction of pollution levels would mean
greater costs for polluters than benefits for society.

Cost-benefit analysis heavily affects modern government policy. In the United States,
the Environmental Protection Agency (EPA) regularly employs cost-benefit analysis
in making policy decisions. However, some laws, such as the Clean Air Act, ignore
cost-benefit analysis.

Sensitivity Analysis
Sensitivity analysis determines how different values of an independent variable affect
a particular dependent variable under a given set of assumptions. In other words,
sensitivity analyses study how various sources of uncertainty in a mathematical
model contribute to the model's overall uncertainty. This technique is used within
specific boundaries that depend on one or more input variables.
Sensitivity analysis is used in the business world and in the field of economics. It is
commonly used by financial analysts and economists and is also known as a what-if
analysis.

 Sensitivity analysis is used to identify how much variations in the input values
for a given variable impact the results for a mathematical model.
 Sensitivity analysis can identify the best data to be collected for analyses to
evaluate a project's return on investment (ROI).
 Sensitivity analysis helps engineers create more reliable, robust designs by
assessing points of uncertainty in the design's structure.

How Sensitivity Analysis Works

Sensitivity analysis is a financial model that determines how target variables are
affected based on changes in other variables known as input variables. This model is
also referred to as what-if or simulation analysis. It is a way to predict the outcome of
a decision given a certain range of variables. By creating a given set of variables, an
analyst can determine how changes in one variable affect the outcome.

Both the target and input-or independent and dependent- variables are fully analyzed
when sensitivity analysis is conducted. The person doing the analysis looks at how
the variables move as well as how the target is affected by the input variable.

Sensitivity analysis can be used to help make predictions about the share prices of
public companies. Some of the variables that affect stock prices include company
earnings, the number of shares outstanding, the debt to equity ratio (D/E), and the
number of competitors in the industry. The analysis can be refined about future stock
prices by making different assumptions or adding different variables. This model can
also be used to determine the effect that changes in interest rates have on bond
prices. In this case, the interest rates are the independent variable, while bond prices
are the dependent variable.

Sensitivity analysis allows for forecasting using historical, true data. By studying all
the variables and the possible outcomes, important decisions can be made about
businesses, the economy, and making investments.

Environmental Risk Analysis

Environmental Risk Analysis (ERA) or sometimes known as Quantitative Risk

Analysis (QRA) is used to estimate potential environmental risks in order to protect
human health or ecosystems from contaminated land and/or water. Environmental
Risk Assessment (ERA) is a process that evaluates the likelihood or probability that
adverse effects may occur to environmental values, as a result of human activities
(i.e., a formal procedure for identifying and estimating the risk of environmental
damage).
The ERA procedure is triggered prior to a significant decision affecting the
environment.

It can be broken into three broad stages:

 Preparation, involving collecting and examining relevant background

information, and establishing the focus for the assessment;
 Conducting the assessment; and,
 Interpreting, reporting and applying results of the assessment.

ERA is a support tool for policy evaluation, land use planning, and resource
management decision making. It is systematic, and can be applied in a variety of
situations, ranging from those with minimal available data and resources, to those
with detailed inventories and complex systems modeling.

Strengths of Environmental Risk Assessments

ERA has the following strengths:

 a concept (risk or threat) widely understood by the public, clearly illustrating

the future consequences of choices;

 provision of explicit criteria for consideration in making decisions, encouraging

transparency and accountability;

 creation of a framework for debate that clearly separates risk assessment

from decision making, and can provide a vehicle for improving dialogue over
highly contentious environmental management or development issues;

 providing reassurance to stakeholders that potential changes to the

environment due to human activities are being considered;

 building understanding of the relationships between the environment and

human activity;

 identification of the consequences of alternative management actions;

 acknowledgement of assumptions and information used; and,

 scientific validity, defensibility and replicability.

Limitations of Environmental Risk Assessment

ERA will clarify risk to the environment from a decision, but it will not be able to set
an acceptable threshold of risk. Determining acceptable risk is an issue of risk
management. Risk assessment is a basis for judgments about impacts but not for
judgments on the acceptability of impacts. Decision-makers must choose a desired
or acceptable level of risk.

ERA has the following limitations:

 risk tolerance is relative - individuals and institutions have differing

perceptions, tolerance and acceptance of risk; and,

 isolating the risks associated with a decision can be difficult there is a range of
natural variability within ecosystems, differing tolerances to stress, and
varying rates of recovery.