Cost Analysis

Costs of Restoration - Benefits of Restoration - Overview of Benefit-Cost Analysis

Overview of Benefit-Cost Analysis

Traditional BCA | Alternative Analytical Methods

Benefit-Cost Analysis (BCA) is a tool for organizing information on the relative value of alternative public investments like environmental restoration projects. When the value of all significant benefits and costs can be expressed in monetary terms, the net value (benefits minus costs) of the alternatives under consideration can be computed and used to identify the alternative that yields the greatest increase in public welfare. However, since environmental goods and services are not commonly bought or sold in the marketplace, it can be difficult to express the outputs of an environmental restoration project in monetary terms.

A couple of things can be done to overcome this. Either specialized measurement techniques must be used to estimate the value of goods and services produced by the project–techniques that can be expensive and whose results can reflect a much higher degree of uncertainty–or alternative analytical methods must be used to allow the "apples and oranges" comparisons of monetary costs and non-monetized outputs.

The tools associated with BCA and value estimation have been developed to evaluate the overall economic efficiency of proposed actions, but the efficient use of resources is only one of many important social goals. Equity and justice are two others. For this reason, traditional BCA or alternative tools for assessing efficiency should not be used without also considering such factors as distributional effects (who pays vs. who benefits) and environmental justice (disproportionate share of negative impacts born by low-income and minority populations).

Traditional BCA
BCA analysis is commonly used to evaluate the economic feasibility of traditional public expenditures. Harbor deepening projects, for example, are usually evaluated using BCA since most of the costs and benefits of the deepening alternatives can be easily expressed in monetary terms. The costs are the monetary costs of mobilizing and operating a dredge for the initial deepening and for future maintenance dredging. The benefits are the transportation cost savings that result from being able to use larger, more efficient ships or from more fully loading the large ships that are already in use. However, there are many complicating factors in this apparently straightforward example.

First, a lot of money must be spent up front to deepen a harbor, but the benefits are realized little by little over time. That time span must be accounted for because a dollar spent today is worth more than a dollar received next year, even when you ignore the effects of inflation. This principle is what economists call the "time value of money." It reflects the fact that a dollar received today can be invested or saved in an interest bearing account and next year will be worth anywhere from $1.04 to $1.15 or more. In investment decisions, the time value of money is accounted for by using a discount rate to put the entire stream of benefits and costs on equal temporal footing–expressing all benefits and costs in terms of their worth at a single point in time. Most economists agree that the discount rate used to evaluate public investments should be equal to the average rate of return of funds in the private sector. In its 1999 publication, "Discounting And The Treatment Of Uncertainty In Natural Resource Damage Assessment," NOAA's Damage Assessment and Restoration Program explains it like this: "Each dollar spent on assessment, emergency restoration, or restoration represents a dollar that is not allocated to another use. These costs are discounted at a rate that represents the productivity of alternative uses of these funds in the economy." However, economists do not agree on the magnitude of the "opportunity" cost of capital--sometimes called the""social discount rate"--or even on how it should be measured. In the interim, most government agencies use the cost of government borrowing as a surrogate for the social discount rate.

Second, not all the costs of harbor deepening can easily be monetized. There are very real costs, for example, associated with the resuspension of contaminated sediments, the use of upland sites or ocean bottom for the disposal of materials, and the loss of marine life, such as loggerhead turtles, during the dredging process. But even when the expected environmental impacts of proposed alternatives are explicitly evaluated and quantified, the costs are usually not monetized. When they are treated separately in an environmental assessment, their full impact may not be appropriately reflected in the final ranking of alternatives.

Third, deep-draft navigation projects are funded in part by the federal government and in part by a non-federal sponsor–usually a state port authority. The resulting transportation cost savings are shared by a number of parties–port authorities; shipping companies; U.S. producers and foreign consumers of exported goods; and foreign producers and U.S. consumers of imported goods all share in the cost savings. Any consideration of the goodness of the fit between who is paying for the project and who is benefiting from it must happen outside the framework of BCA. The distributional effects of publicly funded projects must be considered from the standpoints of equity and justice.

Fourth, harbor deepening can result in significant externalities–benefits or costs that are not directly generated by the investment under consideration, but that are the indirect result of that investment. When there are significant externalities, a plan may seem cost-effective only because project costs are passed on to someone else. Thus, calculated benefits, costs, and benefit-cost ratios can differ significantly from the project's true value to society.

For example, the improved efficiency of a deeper navigation channel often induces the flow of additional traffic as U.S. goods become more competitive in foreign markets and foreign goods become more competitive in U.S. markets. This induced traffic can result in externalities in the form of uncompensated social costs associated with the added noise, light, traffic, and pollution. These costs are as real as dredging costs, whether they show up in declining property values or quality of life. Either the social and environmental costs of these negative impacts or the cost of their avoidance should be included in benefit-cost analyses. However, they usually are not because they are hard to predict, hard to measure, and sometimes hard to express in monetary terms.

Finally, it is possible that many of the supposed benefits would have occurred without public expenditures for harbor deepening. Perhaps one of the most important and difficult components of BCA is the definition of the most likely future without-project condition, which forms the baseline against which all the with-project alternatives are measured.

Alternative Analytical Methods
If a correct application of BCA to a traditional civil works project like harbor deepening is problematic, its application to environmental restoration projects is even more so. Many outputs of environmental restoration projects–cleaner water, greater species diversity, improved ecosystem health–aren't commonly bought and sold in the marketplace. That doesn't make them less valuable, but it does greatly increase the difficulty of measuring their value and expressing it in monetary terms.

According to Orth et al. (1998), "[d]ecisions regarding potential investments in watershed resources can leave decision makers comparing 'apples to oranges' when the costs of watershed improvements are measurable in dollars but the benefits are not." There are two ways to address this problem: (1) estimate the monetary value of environmental benefits or (2) develop tools to help decision makers compare apples with oranges. Some tools for comparing apples and oranges will be described in the next three paragraphs.

When it's not possible or desirable to monetize the benefits of the project alternatives that are being evaluated, as would be needed for BCA, there are other economic tools that can help resource managers incorporate cost considerations into decision-making. Two of the most commonly used tools are closely related to BCA–Cost-Effectiveness Analysis and Incremental Analysis.

Cost-Effectiveness Analysis (CEA) is used when there are two or more ways to achieve the same goal or to produce the same type and level of outputs. Given some environmental goal, such as enabling specified numbers and types of anadromous fish to pass a low dam, CEA helps users to identify the least-costly means of achieving that goal. When correctly applied, CEA takes into account the full stream of project costs, including construction, maintenance, and monitoring costs, as well as the time-value of money. Unlike BCA, CEA cannot be used to identify optimal plans when outcomes are dissimilar either in type or magnitude, but it does support the incorporation of cost considerations into decision-making.

Incremental Analysis (IA) is used primarily to evaluate alternatives that produce varying quantities of similar outputs. If, for example, the salinity of a wetland has been altered by a series of culverts and channel modifications, IA can be used to rank each increment of restoration (e.g., replacing culverts and restoring altered stream morphology) in terms of their cost-effectiveness. Like BCA and CEA, IA takes into account the full stream of project costs and the time value of money, and, like CEA, it does not require that the value of outputs be monetized. Unlike CEA, it does require that the outputs be quantified. In the example above, analysts would need an estimate of the salinity change associated with each increment of improvement.

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References

Orth, K., R. Robinson, and W. Hansen. 1998. Making more informed decisions in your watershed when dollars aren't enough. IWR Report 98-R-1. U.S. Army Corps of Engineers, Alexandria, Virginia.

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