Economic Analysis of Options

The Role of Economic Analysis in Decision-Making

The economic analysis of the high priority proposals emerging from the brainstorming is based on objective information and widely used techniques. However, its results should not be seen as constituting “the decision” – economic analysis provides only one form of input to the policymaker’s final decision.

The term “benefit” covers any improvement in human welfare that arises from a project. Thus, if a proposal for environmental improvement means that the costs of environmental damage (see Module 3) are avoided then this is a benefit.

Normal cost-benefit analysis is used, but the nature of the information that is required is special to the TDA/SAP process.

Relevant Costs and Benefits

The basic test for whether a cost or benefit is relevant is that it only arises if the project goes ahead. On this basis, costs and benefits associated with options that have already been accepted and implemented independent of the one under consideration should be ignored, although they may of course affect the amount of costs and benefits associated with the option under review.

To illustrate this point, consider the following example. In this, the costs of one option (B) are reduced if another option (A) has been implemented. This could be a case where, say, the costs of reaching EcoQO’s in the area covered by Option B is reduced because of a reduction in pollution pressures from the area covered by Option A:

Now, assume Option A has been implemented and a decision is needed as to whether option B should also be undertaken. The benefits and costs of Option A are irrelevant to this decision – these are sometimes referred to as being “sunk”, they arise whatever is decided about Option B. However, as is clear from the figures, given that Option A has been implemented, the costs of Option B have fallen to the extent that they are less than the benefits.

A natural question that arises in identifying relevant costs and benefits is: Whose costs and benefits should count? There is not a clear technical answer to this question and generally decision-makers will need to define the scope of the option depending on the precise circumstances. Where an option is being assessed at a national level then decision-makers will tend to focus on costs incurred and benefits arising in their own country.

For transboundary issues, this national level of assessment is only a first step. National representatives will want an assessment of the national costs and benefits of each available option under review, in order to discuss and negotiate on the options that should be prioritised at the transboundary level. Even if a option is judged unattractive to country X on a stand-alone basis, its representatives may support the option at an international level if the benefits to all countries involved are sufficiently large. Moreover, this stance encourages other countries to support another option beneficial to X that they might not otherwise have supported.

Evaluation of Costs and Benefits

Having identified which costs and benefits are relevant to the analysis of an option, the next requirement is to quantify them as far as possible.

In Module 3, a hierarchy was used to quantify the assessment of socio-economic consequences. The type of quantification with the highest information content was valuation in money terms. Similar considerations apply here. And if all costs and benefits can be expressed in the same monetary units, there can be a single figure which can be readily interpreted.

The costs of a proposed option will be easier to assess and to express in monetary terms than the benefits. This is because a option is defined to achieve a specific goal and its component elements can be specifically identified. Each element can then be costed in terms of either resource requirements (e.g. direct expenditures by businesses in reducing pollution flows) or foregone benefits (e.g. lost surplus from the reduction of natural resource extraction).

The difficulty of evaluating benefits will depend on the quality and quantity of information on socio-economic consequences obtained at the TDA stage. The amount of avoided costs is a measure of the benefit. For example, if marine pollution is imposing costs of $1m each year on affected fisheries then the benefit of eliminating that environmental damage is at least $1m.

The following discussion reviews three techniques for assessing a option in terms of its costs and benefits.

• Cost-Effectiveness Analysis

• Multi-Criteria Analysis

• Cost-Benefit Analysis

These are organized according to the extent to which costs and benefits can be directly compared. In cost-benefit analysis all costs and benefits are represented by monetary values that can thus be directly compared.

In comparing these three techniques it is assumed that all costs and benefits arise at the same time and with certainty. At the end, we will discuss the variables of time (when costs and benefits are expected to arise) and uncertainty (how likely they are to arise), and how this should be factored in.

Cost-Effectiveness Analysis

At this level of comparison, the benefits, whilst defined, do not need to be expressed in a uniform measure or even in monetary value terms. However, the costs do need to be expressed in comparable terms, and preferably as monetary values.

Consider the case in which three options A, B and C are under review. Each is expected to achieve a given set of benefits, say resulting from an equivalent reduction in pollution pressure. Now, if the costs involved are, say, $50m, $60m and $40m respectively then we can conclude that option C is superior to the alternatives. It is more cost-effective in that the same benefits are achieved at the lowest cost.

The advantage of the Cost-Effectiveness Analysis technique is clearly that we do not have to precisely quantify or value the benefits as long as we are sure that they are the same for each option. However, the limitations of this technique are that:

1. The results don’t tell us whether the superior option should be implemented – it is a matter of judgement as to whether the benefits justify the costs involved. In the above example, we know that option C is superior to the others but do we know that the benefits are worth $40m? This is a judgement that is left to the decision-maker.

2. It is only effective in assessing different options that are designed to achieve precisely the same objectives. It cannot be used to prioritise options that are intended to yield different benefits. Continuing the above example, say there were an additional option under review, D, which would yield a different set of benefits and we could only undertake C or D. In these circumstances, cost-effectiveness analysis could not help us. Instead the decision-maker would again have to exercise judgement. For example, if the cost of D were also $40m then the decision-maker could select the option which they judged yielded greater benefits. However, if the cost of D were, say, $50m, it would be clearly more costly than C but how could we compare the extent to which the benefits differ? The decision-maker would have to decide whether the benefits of D were worth at least $10m more than those of option C.

Multi-Criteria Analysis

The decision-maker’s difficulties in having to compare different sets of benefits, as illustrated above, can be overcome to some extent if the decision-maker has a method for aggregating benefits expressed in different units. Multi-criteria analysis is such a method.

It involves attributing weights to different types of benefits, each expressed in its own units, and adding the weighted measures together to obtain a single measure of benefit.

Consider options C and D above and say that they would yield the following benefits:

Now, purely for the purposes of illustration, say that the decision-maker weights the benefits in these terms in the following ratio:

health:recreation:biodiversity 30%:25%:45%

It is then possible to calculate an aggregate number of “benefit units” for each option as shown in the following table:

Thus the decision-maker finds that the benefits of option D are somewhat greater than those of option C. However, it is then necessary to consider the relative costs of the options, for which we have to return to the concept of cost-effectiveness since the costs and benefits are expressed in different units. The basic approach is to ask: How many “benefit units” are achieved for each unit of cost? If options C and D have equal costs then option D is preferred but if option D has costs of, say, $4.5m then C is preferred because the ratio of benefit to cost is lower, i.e.

	Option C	Option D
Benefit units	6.1	6.4
Cost/$’m	4	4.5
Ratio	1.525	1.422

Furthermore, we can see that option D will not be preferred as long as its benefit/cost ratio is less than 1.525. Since we know it involves benefits evaluated at 6.4 units, this means that option D will not be preferred if it costs any amount over about $4.2m (i.e. 6.4/1.525).

This need to revert to the concept of cost-effectiveness means that the technique shares some of the limitations of cost-effectiveness analysis outlined above. However, it has the advantage that the judgement as to the valuation of benefits is more transparent because both the measurement base for each type of benefit and its relative importance have to be defined. This is also the technique’s largest potential drawback since the aggregation of benefits in this way is still largely based on judgement, especially as to the relative weightings.

Nevertheless, the technique does allow for the judgments of many stakeholders rather than that of just the decision-maker to be reflected in the decision, since stakeholders can be consulted on the relative importance that they would ascribe to the various types of benefit.

Cost-Benefit Analysis

The technique of cost-benefit analysis overcomes the limitations of the techniques described above since it is based on the evaluation of all costs and benefits in a common measure, monetary units. Thus, it enables all available options to be assessed on an equal, objective footing so that they can be prioritised. Moreover, it reveals whether any option is worthwhile since it embodies the basic decision rule that a option is only worthwhile if its benefits at least outweigh its costs.

These advantages can be illustrated by continuing the above example but with additional information on the value of benefits attaching to the options, and including two new options, E and F. These options entail different sets of benefits from each other and from options C and D^.1

The first point to note is that options E and F involve benefits and costs on a much greater scale than those of options C and D. However, this is immaterial in cost-benefit analysis; the basis for decision-making is the sign and magnitude of the net benefit or cost, as shown in the column at the far right-hand side of the above table. Thus, although option F involves benefits almost ten times greater than those of option C, it is not necessarily preferable on the basis of cost-benefit analysis since the net benefit of each of these options is the same, $1.5m.

Secondly, we can see immediately that although option E yields greater benefits than any of the other options it has a higher net cost. Therefore, on the basis of cost-benefit analysis alone, and ignoring other considerations, it should not be pursued. The ability to draw this conclusion is in contrast to the other techniques described above where it was in each case a matter for the decision-maker’s judgement as to whether the benefits of a option justified its costs.

Finally, considering only the options with net benefits, we see that option D is preferred to the others since the value of its net benefits, $2m, exceeds the value of their respective net benefits, $1.5m.

Cost-benefit Decision-making

How this information is used depends on the resources available. If the resources are available to meet the expenditure on all or any of the options then the result of this analysis would be that options C, D and F should be undertaken. This is because each yields a net benefit and, as assumed above, each has a different set of benefits.

If, alternatively, not all of the options can be undertaken because of limited resources then the amount of the net benefits provides a means for ranking or prioritising the options. In this case, option D would be the most preferred of the options. We might be indifferent then between options C and F. However, if there are limited resources available for direct expenditure then option C is likely to be preferred to option F since it entails much smaller costs.

The cost-benefit analysis technique supports decision-making in a number of ways, with considerable advantages over the other techniques. However, it is much more demanding in terms of the information that is needed for the analysis – generally, monetary values will not be easy to obtain, especially for benefits. Furthermore, while cost-benefit analysis appears to provide relatively simple decision-making rules, it must be borne in mind, as with the other techniques, that its results are only one input to the decision-making process; policy-makers will want to take other factors into consideration that are not directly reflected in cost-benefit analysis.

Interpretation of cost-benefit analysis results needs care, since in practice there will always be scope for judgement in how benefits and costs are assessed. There are two extreme positions.

• At one extreme is “accounting prudence” in which costs are assessed at the upper end of the range of estimates. Consequently, this form of prudence tends to militate against environmental improvement options.

• At the other extreme, there is the type of prudence that results from the application of the precautionary principle, i.e. the concept that where there is uncertainty about environmental effects then we should do whatever is necessary to minimize any impact. This principle would tend to support a generous assessment of benefits.

Accounting for Time

Thus far, we have ignored the issues of when the costs and benefits of options arise and the degree of uncertainty as to whether they will arise or their value if they do. Buy in economic analysis these factors must be taken into account.

The question of timing is important because costs and benefits that arise further in the future are less “valuable” than those that arise sooner in economic terms. This is perhaps easiest to understand with a simple example in which we are offered a personal choice of receiving $100 now or in a year’s time. If we choose to receive the money now then we could invest it for a year. Therefore $100 now is ore valuable than in a year’s time. Again, if we knew we had to spend $100 – we would prefer to spend $100 in a year’s time rather than now because this way we could invest that money for a year.

To reflect this factor of timing values arising over a period of time need to be discounted to their current equivalent, known as their present value. Discounting is the opposite of interest compounding. So, in the above example, we would say that the present value of $110 in a year’s time is $100 if we use a discount rate of 10%. In this case the discount factor, what we divide the future amount by to calculate its present value, is 1.1 = 1 + 10%.

The same approach is then used for any period of time. At a 10% rate of interest our $100 today would in two year’s time be worth $121 ($100 x 1.1x1.1). And at the same discount rate the present value of $121 received in two year’s time is $100.

This technique can be illustrated by reference to option C above, the costs of which were stated to be $4m. In an economic analysis, this amount would be the present value of the option’s costs. These might have been arrived at as follows, using a 10% discount rate:

Thus, the costs of the option are $4.7m but because they arise over a number of years their present value is considerably less, $4m.

Continuing the example of option C, but just focusing on costs for the present, consider another option that also costs $4.7m but all of this amount arises at the end of year 1. The present value of its costs is then $4.3m = $4.7m/1.1; greater than the present value of option C’s costs.

The use of discounting means that projects with costs or benefits that arise at different times can still be compared on an equal footing.

Where benefits are also evaluated, as in and cost-benefit analysis, then these too should be discounted – although this is in practice less often seen with multi-criterion analysis. In the case of cost-benefit analysis, costs and benefits must both be discounted to arrive at the present values of costs and benefits respectively. The difference between these amounts is referred to as the net present value (NPV) of the option.

It is normal to calculate NPV by taking the balance of net benefits and costs that arise for each year, discounting these balances, then adding them together.

Accounting for Uncertainty

Uncertainty also has to be accounted for. The underlying principle is that in decision-making less weight should be accorded to costs and benefits that are less likely to arise than those that are more likely to arise. One way to do this is to adjust cost-benefit discount rates to reflect how likely they are to occur (referred to as risk-adjusted discount rates).

However, the preferable approach involves weighting outcomes according to their probability. This concept can be illustrated by reference to the last example of option C’s costs. Say there are two independent possibilities (sometimes called “states of the world”). In the pessimistic case, the costs in years 1 and 2 are each $3m; in the optimistic case they are only $1m. If these states are equally likely then we can weight the alternative outcomes according to their probability, 50% or 0.5, and calculate the so-called expected value of the costs:

$3m x 0.5 + $1m x 0.5 = $2m.

Thus the expected value of option C’s costs is $2m and the present value of $4m can be referred to as an expected present value since it represents an “average” amount.

But this approach can be misleading, because the average is not expected to occur – it will either be the pessimistic or the optimistic case. Where the difference between optimistic and pessimistic outcomes is large, as in this example, this must be made transparent to the decision-maker by specifying the two scenarios and their estimated probabilities. Continuing the example of Option C, it would be better to present both calculations in a combined table

Optimistic Scenario (50% probability)

Pessimistic Scenario (50% probability)

:

This form of presentation emphasises the substantial differences between the two scenarios – the present value of the costs more than doubles in the pessimistic scenario. Decision-makers need to be aware of possible variations of this magnitude since they will need to exercise judgements about the degree of risk that they are willing to undertake in public options.

In conclusion, although the techniques of discounting and risk-weighting enable timing and uncertainty to be dealt with on a rational basis, in any long-term option there are bound to be uncertainties that are impossible to judge at the outset. Therefore economic analysis can only be a contribution to the decision-making process; the expected net present value of a option is not the final arbiter of whether a option should proceed!

A Note on Currency Units

Currency units of $ have been used here as a matter of convenience, but the calculations will generally be in a country’s own currency. When it is necessary to translate a value in one currency to another – for example, when making regional calculations - the exchange rate that should be used is the purchasing power parity rate (PPP) rather than the currency exchange rate quoted in financial markets. This is because the PPP is based not just how much of one currency can be bought with another but what goods and services can be bought with that money. Thus, the PPP indicates the value of a currency in terms of what is its spending power. The World Bank calculates PPP’s for most countries in terms of the US$.