Risk & Policy Analysts/Metroeconomica Induced and Opportunity Cost and Benefit Patterns in the Context of Cost-Benefit Analysis in the Field of Environment Final Report - February 1999 prepared for European Commission DGIII - Industry by Risk & Policy Analysts Limited, Farthing Green House, 1 Beccles Road, Loddon, Norfolk, NR14 6LT, UK Tel: +44 1508 528465 Fax: +44 1508 520758 email: [email protected] and Metroeconomica 108 Bloomfield Road, Bath, Avon, BA2 2AR, UK RPA REPORT - ASSURED QUALITY Project: Ref/Title J241/CBA Approach: As set out in RPA Proposal and taking account of associated discussions. Report Status: Final Report Report prepared by: M Postle, Director of RPA A Markandya, Director of Metroeconomica R Boyd, Consultant with Metroeconomica M Hickman, Consultant with RPA Report approved for issue by: M Postle, Director of RPA Date: 2 February 1999 i Risk & Policy Analysts/Metroeconomica ii Risk & Policy Analysts/Metroeconomica CONTENTS Page 1. INTRODUCTION 1.1 Key Characteristics of Environmental Policies 1 1.2 The Appraisal Tools 2 1.3 Scope of the Report 4 1.4 Structure of the Report 4 2. DEFINITIONS 2.1 Introduction 7 2.2 Externalities 7 2.3 Cost-Benefit Analysis 8 2.4 Cost-Effectiveness Analysis 9 2.5 Direct Effects 10 2.6 Indirect and Induced Effects 11 2.7 Secondary Effects 12 2.8 Opportunity Costs and Benefits 13 3. A FRAMEWORK FOR COST-BENEFIT ANALYSIS 3.1 Introduction 17 3.2 Boundary Issues in CBA 19 3.3 Key Analytical Issues in CBA 27 4. IMPACTS AND THEIR VALUATION 4.1 Introduction 31 4.2 Estimation of Impacts on Industry and Consumers 31 4.3 Administrative Costs 34 4.4 Employment 34 4.5 Environmental Effect 36 4.6 The Valuation of Mortality Impacts 43 4.7 Morbidity Effects 60 4.8 Key Issues 61 *5. AIR POLLUTION CASE STUDY 5.1 Policy Overview 69 5.2 Scope of the Analysis 70 5.3 Comprehensive CBA of the Policy 81 5.4 Cost-Effectiveness and Opportunity Costs 96 *6. MUNICIPAL SOLID WASTE CASE STUDY 6.1 Policy Overview 97 iii Risk & Policy Analysts/Metroeconomica 6.2 Scope of the Analysis 98 6.3 Indirect and Secondary Costs and Benefits 110 6.4 Comprehensive CBA Framework 115 6.5 The Opportunity Costs Question 118 7. Municipal Solid Waste Case Study 7.1 Policy Overview 113 7.2 Scope of the Analysis 114 7.3 Excluded Indirect and Secondary Costs and Benefits 126 7.4 Comprehensive CBA Framework 131 7.5 The Opportunity Costs Question 134 8. Short-Chain Length Chlorinated Paraffins Case Study 8.1 Policy Overview 139 8.2 Scope of the Analysis 139 8.3 Comprehensive CBA of the Policy 142 8.4 Cost-Effectiveness and Opportunity Costs 146 9. Opportunity costs and Policy Evaluation 9.1 Introduction 147 9.2 Opportunity Costs and Valuation 148 9.3 Policy Selection Criteria 152 9.4 Cost-Effectiveness and Opportunity Costs 160 9.5 Opportunity Costs in EU Policy Making 163 10. Summary and Conclusions 169 10.1 Overview 169 10.2 The Economic Appraisal Methods 169 10.3 The Valuation of Costs and Benefits 171 10.4 The Opportunity Costs Issue 174 10.5 Opportunity Cost at the Cross-Policy Level 177 10.6 Guidelines for Policy Makers 178 10.7 Recommendations for Further Research 180 11. References 181 ANNEX 1: DIRECT COSTS AND BENEFITS ANNEX 2: GENERAL EQUILIBRIUM EQUATIONS Page 4 Risk & Policy Analysts/Metroeconomica 1. INTRODUCTION 1.1 Key Characteristics of Environmental Policies Governments need to make choices and when faced with the protection of either the environment or human health, two truisms must be recognised. The first is that such protection does not come ‘free’, and the second is that such choices are constrained by limited resources. Decisions makers, therefore, need to balance the benefits of protection against the cost of such protection, especially when resources could be allocated to other policy areas (such as health, education, transport, etc.), which may be able to provide comparable levels of protection or other gains. What are the costs and benefits associated with environmental policies? In general, they are the same range of effects which may be of concern in any policy appraisal, with the potential characteristics of importance being: • the scale and relative magnitude of the direct policy effects, and hence potential for such effects to lead to further indirect and secondary effects; • the level of integration of the affected industry sectors and hence the potential for impacts on related markets; • the degree to which equity considerations are of concern given the likely divergence between those who would gain and those who would lose; • related to the above, the degree to which the policy affects all EU countries equally and countries outside the EU; • the relative significance of both environmental and human health effects, where this includes both the negative and positive effects of the policy; • the inter-relationship with other policies and policy areas; and • the timing and duration of policy measures. The first two characteristics are important in that they help set the boundaries for any policy appraisal. Firstly, they establish a role in establishing the degree to which more than just the direct compliance costs of the policy will need to be taken into account. Secondly, and related to the above, they determine the type of appraisal required. For example, if a policy results in non-marginal changes, then ‘conventional’ Cost-benefit analysis (CBA), which is based on partial equilibrium analysis, is no longer an appropriate appraisal framework. In such circumstances, a general equilibrium type of approach is required. This type of approach automatically considers the so-called ‘wider’ effects. As will be discussed later in this report, where a regulation affects a product acting as a minor input to a production process the analysis is likely to require the consideration of only the direct costs to industry and the direct environmental and human health effects associated with the adoption of an alternative product. However, where a policy affects a product which accounts for a significant share of production costs, and/or affects an industry sector which is highly integrated with other sectors of the economy, then the analysis may need to go wider. In this case, the analysis may need to consider the effects Page 5 Risk & Policy Analysts/Metroeconomica of the policy on the structure and functioning of the whole economy (including direct, indirect and possible secondary effects. Examples abound of both types of environmental policy, with many hazardous chemical management policies falling into the first category and environmental taxes falling into the second category. With regard to the other characteristics, however, it is more difficult to make any generalisations. The implications of these will vary in importance across policies on a case-by-case basis. Indeed, the first two characteristics are likely to determine the importance of the other aspects. It is also useful to consider whether policies aimed at protecting the different environmental media (air, water, land) or at protecting human health may have fundamentally different characteristics and thus appraisal requirements. Consider a series of policies: • a policy aimed at reducing sewage effluent discharges into the aquatic environment by requiring secondary and tertiary treatment; • a policy aimed at reducing damages associated with acidifying emissions from industrial and power plant sources; and • a policy aimed at reducing health effects to workers by placing restrictions on the use of a widely used chemical. The first policy will obviously have direct effects on the associated utilities and if sewage treatment costs increase significantly may also have indirect effects on other industrial sectors. It will also have direct benefits to the aquatic environment, but contrastingly may result in negative effects to the other environmental media. For example, the generation of additional sewage sludge will require some form of disposal, whether to land, through landfill, composting or the use of incineration. Similarly, a policy aimed at reducing acidification related effects will result in direct and indirect effects on industry, but may also have wider macro-economic effects should it affect the energy prices paid by consumers for example. Although it may provide benefits across the range of environmental media (and to a number of different impact categories) and to human health, there will also be negative effects associated with particular treatment technologies and the need to dispose of their residuals (e.g. ash). With regard to the chemical restrictions, as they would affect a widely used chemical, there may be direct effects on a range of industry sectors, but the degree to which these result in indirect effects would depend on the change in costs faced by those sectors. Although the policy should generate direct health benefits for the relevant workers, indirect damages may arise from the introduction of substitute chemicals which may pose their own health or environmental risks. 1.2 The Appraisal Tools The issues which must be examined within any policy appraisal may therefore be complex, requiring consideration of potential effects at a number of different levels. One Page 6 Risk & Policy Analysts/Metroeconomica of the tools commonly used for this purpose is that of social CBA, which is aimed at determining whether or not the benefits of introducing a policy outweigh its costs. In its fullest sense, it requires the assessment of all the effects of a policy, whether positive or negative and, through the use of market data or specialist valuation techniques, the expression of these effects in a common unit, typically money, to facilitate comparison. The use of CBA is not without its criticisms, however. The first, and often repeated criticism, concerns the need to convert all information on costs and benefits to a monetary value.