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Posts Tagged ‘cost benefit analysis’

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A shipping lane is being proposed which would go through the Great Barrier Reef so as to improve access to a mining complex.

We must ask some questions that help decide whether the proposed lane should go through the reef or not. Who will benefit or lose out in each scenario, when, and for how long, and by how much?

In economic analysis, as £1 now is worth more than £1 in the future, future costs and benefits are discounted to create a Present Value for each impact, which you can then weigh against each other.  For a project to be recommended on economic analysis grounds only, its benefits over time need to outweigh its costs. In economic terminology Net Present Value (benefits minus costs) > 0 or Benefit Cost Ratio > 1. There are of course many other considerations in making a decision about a project that economic analysis can capture. But let’s see how we can think about this project if we were attempting to do an economic analysis (cost benefit analysis in this case).

Let’s briefly look at the case where the shipping lane does go through the reef. This will not cost the company anything extra than they had already planned. It may, however, have an economic cost to society (a negative externality); reef damage, caused by the ships, will reduce tourism in the area- a huge source of local GDP and employment in Queensland.

We can also look at the case where the shipping lane is diverted to avoid the reef. The tourist numbers and revenues don’t change, but the diversion would cost extra money to the mining and shipping companies in the form of fuel and time.

The comparison of cost of diversion and avoided damage (benefit of diversion) to the reef can conclude:

(a)    if the cost of diverting ships is less than the lost money from tourism and other marketable impacts, the shipping lane should be diverted.

(b)   if the cost of diverting ships outweighs the lost money from tourism and other marketable impacts; the direct lane should go ahead on efficiency grounds.

But hang on a minute, it’s not that simple!

We have to think about the characteristics of the reef that generate values other than the market price and revenues. It’s these social values that are not paid for in a market that are often most important to people and are what make the Great Barrier Reef, well, GREAT.

It’s not that different to what people care about when their house burns down. Do people care about the games console or the expensive pair of new jeans? No, it’s the family photos, the postcards from friends, and the paintings your son made when he was 4 years old that hang in the kitchen.

The same goes for the reef; it’s the bio-diversity, cultural heritage, national pride, the wonder and mystery, and the sheer size of it that are the most ‘valuable’.

These characteristics lead to types of value that cannot be bought, such as: Option value (I may be willing to pay to have the option to see the Reef in the future, even though I have no intention going now); Existence value (I may be willing to pay for the knowledge that the Reef exists without any intention to ever see); and Bequest value (I may be willing to pay so that my descendants can see the Reef).

By including these values, we can build a better understanding of the Total Economic Value of the Reef. ‘But how do you measure them if we can’t buy or sell them?’ I hear you cry. This is where environmental economists earn their money; they realise that these values may be hidden within the price of another good/service that is bought and sold and thus can extract it. Another method is to survey people’s preferences of different scenarios regarding the environmental asset and their associated income in each scenario.

By eliciting these values, we can monetise damage done to the reef that isn’t seen through the market and incorporate it into the decision process.

Accounting for some leeway either side, if the true cost of having a lane directly through the reef i.e. losing all values associated with reef damage, is more than the cost to companies of circumventing the reef, then there is a compelling argument that the direct lane should be shelved.

So what if, even after including these non-marketed values, the damage to the reef is less costly than the cost to the companies of bypassing it?

In reality, we can’t monetise everything and we are never 100% certain what the consequences of reef damage is in the long term; perhaps, with data only available in the future, the costs are found to be so much more than previously thought. In that case, instead of attempting to put a market value on certain attributes, we could just say that, ‘some things are critical for nature and for the people, both now and in the future, and should be protected’.

Yes, economic development may bring us monetary wealth, but perhaps we lose immaterial wealth in the process in terms of wellbeing, morals and principles. Some things are irreplaceable, and should remain that way.

Here is a link to the online petition against the lane.

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I was watching an old Big Bang Theory episode the other day; it was the one where Penny buys Sheldon and Leonard (Star Trek enthusiasts) a Spock Transporter each from the comic book store.

Penny wants to open them up and play with them, which stuns the boys; Leonard says, ‘Once you open the box, it loses its value.’ (Watch the 2 minute clip here)

Here, Sheldon and Leonard realise that things don’t always have a ‘use’ value in the traditional sense of consuming them. They recognise that the toys have an embedded value in leaving them in the box untouched i.e. mint in box. Neither of them may even consider selling them in the future, despite the toys being ‘worth’ more.

Instead, they enjoy looking at them in their pristine condition (a non-consumptive direct use value) and, also, may want to pass them on to their children – if Sheldon knows how to make a child – or donate them to a museum so that others can see them in their original state (a bequest value).

Perhaps, then, we can learn something from comic book enthusiasts and apply their ‘mint in box’ mentality to the environment. Policy-makers now take into account these direct and indirect use and non-use values into project appraisal by considering a project’s total economic value.

People wouldn’t pay as much to visit Yosemite National Park if it wasn’t kept looking beautiful, as they would not derive as much value. Therefore, it makes sense to keep it looking beautiful (see picture below).

Another non-consumptive direct use value that can be compared to the Big Bang Theory example would be improving bathing water standards. People don’t go to beaches to drink the sea water, which would be a consumptive use value. Instead, they derive value from playing in the water. If the water is not safe, then people cannot play in it; therefore there is a benefit (amongst many others) from improving it that doesn’t have a market price.

Later on in the episode, Spock comes to Sheldon in a dream and asks him what the purpose of a toy is. Sheldon replies by saying, ‘to be played with’ and thus comes to the conclusion to open it and play with it. Therefore, we need to think about what the purpose of the environment is before making decisions to change it.

The herd has done some head-scratching over this topic, and we would appreciate your input- do you agree or disagree, can you think of other analogies?

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A few weeks ago I read with thoughtfulness Rick Outzen of the Daily Beast’s post on “BP’s Shocking Memo”.  I thought about writing a blog post about how I didn’t agree with Outzen.  But I haven’t until now because, well, it is a touchy and controversial subject.  However, the reason we started and continue to write Cow Burps is to explain our view of the world through an (environmental) economics lens and to therefore bring greater understanding of (environmental) economic concepts to those reading the blog.  I will cover quite a large scope in this post and I hope that by the end I can convince you, maybe not fully, but at least that there is a valid viewpoint to be had.

So I ask you please to read to the end before making the decision to make me your next steak dinner!  We of course welcome your views and any comments you have.

See, the thing is, I believe that Rick Outzen’s piece on BP’s cost benefit analysis is hugely misleading on three points:

1)     BP does not estimate “the value of a worker’s life”

2)     BP should be congratulated for using the figure of $10 million

3)     The major failure of BP’s cost benefit analysis was not on using the $10 million figure, it was on their estimation of risk.

For example, the large font print reads:

EXCLUSIVE: This internal BP document shows how the company took deadly risks to save money by opting to build cheaper facilities for workers. The company estimated the value of a worker’s life at $10 million.

It is likely that BP did not actually estimate “the value of a worker’s life”, but instead used the value of a statistical life, also known as a ‘value of a prevented fatality’ and ‘value of mortality risk’.  They value the benefit of risk reduction or the costs of risk increases to individuals. The concept is used regularly, not only in cost benefit analyses but also by you in your everyday life.

Consider, for instance, the last time you rode in a car without your seatbelt on. Or the last time you took a shortcut at night through some dark street. Or the last time you didn’t chew properly when you ate something.  In these cases you valued the added comfort of not being strapped in, the quicker travelling time and the convenience of not having to chew (…) over the risk that you could be killed or injured.

It is impossible to put an infinite value on reducing the risk of fatalities to zero. Everyday you and I trade off tiny (and in some of your cases, especially if you are an Alaskan king crab fisher, maybe not so tiny!) risks to our lives to get to work, to have fun, to nourish ourselves.  Similarly, organisations such as BP send workers out to do tasks that could endanger their lives. Just like the Alaskan king crab fishers, the workers accept these high-risk tasks for the higher pay they receive (to compensate for the risk they take) compared to other jobs they could undertake that are less dangerous.  From another angle, governments make decisions about spending money to reduce fatalities such as building better roads to reduce the risk of accidents.  They know that accidents and fatalities will still happen, however the only real way to rule this out would be to ban motor vehicles altogether – a not impossible plan but one that, even if citizens agreed, would be crippling to the economy and would, in most people’s point of views, make everyone worse off.

Outzen’s point is that BP should have housed workers in blast-resistant structures rather than trailers.  However, if we look at the slide he presents, it still shows that blast-resistant structures have a vulnerability of 0.01. If, as is implied by Outzen’s article, Outzen feels that any risk of fatality is too high, he should instead have argued that BP should not have sent their workers out to the oil refinery in the first place, rather than that they should have housed them in blast-resistant structures.

So now that we have established that it is possible and not morally corrupt to use a value of statistical life for cost-benefit analysis, let’s look at BP’s value and ask ourselves whether it is enough. Outzen claims that BP used a value of $10 million per worker. This is actually $2.6 million more than the value the US Environmental Protection Agency (EPA) puts on the value of statistical life, and the EPA traditionally uses the highest value of statistical life amongst all US government agencies.

So what did go wrong?  From reading Outzen’s article, it is clear that with regards to the explosion in Texas, what was wrong with the cost-benefit analysis was the assessment of existing risk, or how frequent “the big bad wolf blows… per piggy lifetime”.  As the benefit of risk reduction measures to society is calculated as the value of a statistical life x reduction in risk x people affected by the reduction in risk, this assessment of existing risk is important, since a reduction in risk is the product of existing risk and the measures you put in place to mitigate against the existing risk.  This benefit calculation directly affects what kind of measures are taken.

For example, if you live on a farm in the middle of the countryside surrounded by farmland where explosions are not very likely (say 1 in a million), you will benefit less from building a blast resistant structure that mitigates your risk by 50% (reducing your risk to 1 in 2 million) than if you lived on an operating oil field where explosions are more likely, say 1 in 500, where it would halve your risk to 1 in 1000 (making the reduction in risk 2000 times more ‘beneficial’ in the oilfield than in the countryside).

Outzen writes “At Texas City, all of the fatalities and many of the serious injuries occurred in or around the nine contractor trailers near the isom unit, which contained large quantities of flammable hydrocarbons and had a history of releases, fires, and other safety incidents.”

From this description it looks like the big bad wolf could blow at any point and as the estimation for the probability of an explosion at the refinery is nowhere to be found, one is left wondering what it was and how it was estimated.

Coming up in a future post: Everything else BP left out of their cost-benefit analysis.

More information on Value of Statistical Life:
EPA – Value of Statistical Life Analysis and Environmental Policy: A White Paper for Presentation to Science Advisory Board – Environmental Economics Advisory Committee

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