Prophets and Profits:
A Critique of Benefit/Cost Analysis for Natural Resource Decisions
Edward W. Manning (from Alternatives Magazine, Vol. 15 No.1, 1987, pp36-41)
Once upon a time a Prince was faced with some vexing problems. Should he expand the moat at the expense of the adjoining village? Was it wise to burn down the forest and create new pastures? Should his precious treasuries be used to pay for the repair of the irrigation system? Perplexed by these complex decisions, the prince called for his faithful wizard. With great ceremony a chicken was slaughtered, and the answers were divined from the entrails. The moat augured well. Burning of the forest was fraught with peril, and the Gods favoured repair of the irrigation works. Thus, the Prince, reassured by the expertise of his principal prophet, could proceed confident that he was doing the right thing.
Nowadays we are much more modern. We no longer believe that type of mumbo-jumbo, and chickens may live long and healthy lives far from the prediction process. The modem Official does not believe in rites and incantations. Instead, he or she turns to an advisor schooled in economics, in engineering and in computer science. When faced with a seemingly insolvable problem, the Official has modern techniques to assist in divining truth. But to a great extent, I would suggest that the net result has changed little. While the soothsayer may have been replaced by an economist the liturgy is now chanted in numbers. The entrails have been replaced by a complicated computer programme and the ritual has been replaced by a compulsory feasibility study.
As in medieval times, the Official seldom understands what he or she is given. The advisor has the power of choice but no responsibility. Often the numbers crunched to provide an answer to the unanswerable have as much or less relevance to the real social, economic, and environmental problems as the configuration of the entrails did in medieval times. And in like fashion, non-believers are excommunicated as heretics for espousing the “uneconomic. These are unfortunate similarities which pervade the provision of advice to those who must make complicated decisions affecting the future of the environment and society.
While the parallel put forward in the preceding paragraphs may be laughable, it is regrettably real and has real human and environmental consequences. The salient points are that an analogue model is put forward which supposedly simulates reality either in entrails or in numbers and which calls for particular actions; the ultimate decision maker is generally unable to understand, question or challenge the inner workings of the model; if the predicted does not come true it was because the Prince was not devout enough, or the Official did not follow instructions adequately, rather than through any fault in the model.
The modem uniform of the wizard or prophet is not a black cape and pointed hat but a three-piece suit. The wand has been replaced by a pile of computer printout, but the ultimate effect is often the same. One particular incantation has achieved a political currency which far exceeds its real relevance or utility – that of benefit-cost analysis. It has become the liturgy for an entire generation of decision makers – the public profession of a faith in the economic and therefore implied rational spending of public monies. Yet this, perhaps the most common of tests for project proposals and decisions, is usually misapplied. Benefit/cost analysis often is used to address entirely the wrong questions, and even if done properly is ill-suited to the types of decisions politicians must really make.
It is becoming increasingly clear that just as in the long run the entrails often failed to provide clear paths to enlightened and lasting government so do the current practices of benefit/cost applications. Yet such is the strength of the myth surrounding benefit/cost analysis that it will be extremely difficult to dislodge it as a touchstone for most public investment decisions. Therefore, those concerned with long-term resource sustainability and with socially responsible decision making, must either learn to adapt and modify the current benefit/cost analysis procedures in a way that adequately reflects the broader and longer-term concerns of society, or devise something better with which to replace it. In any case, it is incumbent upon those who deal in the resource decision milieu to be conversant with benefit/cost procedures as long as they remain current and to attempt to make them as useful as possible in resource decisions.
Revelations
To begin, benefit/cost analysis is not a modelling procedure although it is often misrepresented as such. Benefit/cost analysis is a tool which is of maximum use in aiding (not making) choices between similar options. Originally devised as a method for individual industries to decide on the timing of production line expansion or on options for production line investment, its use has been expanded away from private enterprises with single, definable economic goals, and away from the type of decision where most externalities can be held constant.
| Planning boards and tribunals commonly ask whether the proposal has a return greater than its cost. This is the wrong question. Furthermore, benefit/cost analysis is the wrong technique to answer it. The right question is: Is this the right option in the right place at the right time? |
Most of the problems with application of benefit/cost analysis to public policy derive from this expansion – a problem which has only partially been overcome by the addition of complicating factors. Although major advances have been made in the development of social benefit/cost methodologies, in the valuing of externalities, in the use of shadow pricing, and in the development of sensitivity analysis procedures, several of the fundamental flaws in benefit/cost analysis as a model for real decisions remain. The technique has generally been applied outside the range of conditions for which the tool/model was developed. Although useful as a way of raising questions, benefit, cost analysis is of very limited utility as a prescriptive model for producing definitive answers to resource questions.
Nine Sins of application
The current practice of applying benefit/cost techniques to decisions regarding resource planning is beset by many problems. Several of the most important are listed here:
· Failure to define the perspective. Benefits and costs from the perspective of a firm differ greatly from social benefits and costs. Yet pnvate benefits are frequently used to justify a project even if significant social costs can be incurred.
• Selectiveness in the incorporation of externalities. Because there is much leeway in how far an evaluator need go in following external benefits or multipliers, or in seeking data on external costs, downstream effects or shadow values the choice is often very subjective yet hidden in the result. Checklists of procedures such as those produced by development agencies can be of considerable assistance in dealing with this problem.
• Selection of discount rate. There is no agreement on what discount rate is best – whether an overall rate or a sectorial rate, a long-term rate, short-term rate, or even a negative rate chosen for social reasons should prevail. Because the outcome, particularly with reference to long-term streams of benefits (e.g., resources) is especially sensitive to which rate is selected, this renders many benefit/cost analyses subject to challenge. In the hearings over proposals for a new dam at “Peace Site C” in northern British Columbia much of the debate focused on which discount rate was selected. At a high discount rate, the dam was deemed “economic”. At a lower rate renewable resource values associated with future agriculture, fisheries and wildlife could be shown to bring greater benefits.
• Valuation of intangibles. As there is a range of possible ways to value intangibles such as environmental, aesthetic or social benefits the choice of high or low values can determine the outcome. Public debate on such valuations is common in hearing proceedings and individual perceptions of value can vary greatly.
• Misrepresentation of simple benefit/cost analyses as social benefit/cost. The mere addition of calculations of jobs added or of selected externalities does not make an internal project-oriented benefit/ cost analysis into one reflecting a social or governmental perspective. • Failure to use benefit/cost analysis to compare alternatives – its design application. This use reduces the sensitivity of the tool to valuations, the choice of externalities, even (to an extent) the choice of a discount rate, if these are held constant across comparative evaluations.
• Cost. A thorough social benefit/cost analysis may be prohibitively costly, heavily dependent upon data which may be unavailable, and time consuming in the extreme. Therefore, most practitioners cut corners. ‘ • The appearance of providing simple answers to complex questions. Benefit/cost analysis is useful to raise questions or to identify sensitivities. It is much less useful in the evaluation of answers.
• The illusion of certainty Benefit/cost analysis gives the appearance of certainty to decisions which must often be made under conditions of uncertainty. It therefore gives confidence to decision makers who have little reason to be confident.
Illustrations
In the following paragraphs, three specific types of problems relating to application of benefit/ cost analysis to natural resource decisions are highlighted, with both the drawbacks and some of the opportunities for adaptation identified. Decisions on site use
Should we put a supermarket on that farm? A common abuse of benefit/cost procedures comes in the decision process over the urbanization of farmland; on the choice between development of a site and retaining it in renewable resource production. Planning boards and tribunals commonly call for benefit/cost studies. Decisions are then made on which option brings the greatest benefit. This is the wrong question. Furthermore benefit/cost analysis is the wrong technique to answer it. Traditional applications of benefit/cost analysis almost automatically favour the super-market over the farm, the subdivision over the wetland – any stream of benefits deriving from a development which occurs in the short term over any stream of benefits derived over the longer period. What is obvious and irrefutable is that more profit is derived from a super-market than from a farm in any given year. Most applications of benefit/cost go no further than this, proving the obvious beyond any reasonable doubt but not really addressing the relevant question. More sophisticated applications then show that the tax base of the municipality involved will benefit more from development revenues than from the longer-term renewable resource use. The benefits are then sometimes translated into jobs which have even greater appeal to the political decision maker. This is not only misapplication of benefit/cost analysis, but it is also poor benefit/cost analysis. As benefit/cost analysis was designed to be a decision process for comparing alternatives, the simple introduction of a spatial perspective can immediately make benefit/cost more relevant as a measure. From a municipal or regional perspective, it is totally false to ascribe all of the benefits accruing to the owner of the supermarket as benefits to the municipality. In fact, from a social perspective only the incremental benefits accruing from locating the supermarket on that particular site, over and above the benefits which would come from locating it on the next best site, can fairly be counted. From a social benefit/cost perspective the incremental value of any particular site may be very small. It is possible that the development would be just as profitable if displaced a few hundred yards or even a mile. On the other hand, (depending upon the availability of other alternative farmlands or wetlands within the jurisdiction), the net benefit of having renewable resource production remain on that land may be significant. Displacement of some particular uses could result in elimination of that production from an entire region, especially when no substitution is possible. This is the real case in such situations as the Okanagan or Niagara fruitlands, where very constrained physical circumstances limit the availability of land with suitable climate and soils for replacement.
Another approach is to use the replacement cost for a similar wetland or piece of farmland as an approximation of its value and to count it all in the current year. This is based on the premise that it would cost a calculable sum to re-create a replacement of the same quality as lost wetland habitat or built upon specialty-crop producing land. This value can therefore be used to approximate the value of the current wetland or farmland. This would approximate reality if the lost use must be replaced. The situation is not so clear cut with respect to more general cropland: unused cropland areas still exist in most parts of Canada, and direct replacement may not really occur. Although insistence on the use of only the incremental value accruing from the use of a particular site assists somewhat and in fact is a more appropriate use of benefit/cost analysis, such factors as urban proximity may still easily overwhelm incremental values derived from using land for renewable resource production. Nevertheless, application of benefit/cost analysis in this context comes somewhat closer to its intended use as a model – simulating the real (albeit current) situation and helping to decide whether the net social value exists. If incremental cost of a site is all that is considered, at least occasionally the wetland could appear more socially valuable than the development, but maybe not to the owner.
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The Official usually expects and receives information in the form of an apparently objective benefit/cost ratio. But this ratio subsumes many assumptions, including very subjective decisions on what to include, whether to seek shadow values for benefits, and whether or not to assess externalities. But the Official usually accepts it as objective evidence that a project is “economic” or” uneconomic”. At more involved or sophisticated hearings like those at Peace Site C or over pipeline siting, lengthy debates occur over such factors as choice of discount rates, which environmental costs to allow, or which estimates of future benefits are right. At least in these cases the internal assumptions are tested and information on the real implications of decisions is brought forward. But too often decisions are made on the basis of an unchallenged benefit/cost ratio.
Decisions on long-term investment
Should we invest in future renewable resource production? One of the fundamental hypotheses behind benefit/cost analysis procedures is time preference: money received now is worth more than money received in the future. Thus, a procedure called discounting has been developed which reduces the net present value of benefits, the further in the future they are to be received. In Canada, in mid 1980s the federal Treasury Board commonly applies a discount rate of between 7 and 10 percent. At 10 percent that $100 received next year is worth only $90. if received two years from now it has a net present value of $81, and so on. The impact of a discount rate of this nature (commonly used in public investment decisions) is profound particularly when it is applied to the 20-year or longer stream of benefits which characterizes many agricultural enterprises. Benefits received in the 20th year are worth only 12 percent of their nominal value in net present value terms. In the case of such investments as reforestation, for example, a million dollars’ worth of benefit achieved in 50 years’ time (when the trees are mature) has a present value of $5150. When translated into decision-making terms, for each $1 million worth of product to be received in 50 year’s time the investor can afford a current investment of less than $5150, assuming no interim maintenance costs through to the production of $1 million worth of profit from timber harvest. Thus, it is quite clear why so few private firms or individuals (or even governments) appear prepared to make investments in reforestation, or indeed in any long-term land improvements for renewable resource production.
These investments may be socially and environmentally desirable, even vital, but benefit/cost analysis will not demonstrate that. Instead, most benefit/cost results urge decision makers to liquidate and spend their environmental capital – now. The Official is being told that it is more “economic” to exploit and that it is uneconomic to invest in sustainability. That may be true for individuals or firms, but it is folly at a social or environmental level.
In some jurisdictions, attempts have been made to build in the concept of social capital – to internalize as a cost of harvest the replacement of resources. But many timber firms have been successful in employing benefit/cost analyses to defend their contention that reforestation is uneconomic. This implies that the term “economic” is synonymous with a measure of social or environment desirability. Among the inputs which need to be considered in evaluating such long- term resource investment options is the concept of social capital, specifically the totality of natural resource capital which may be diminished over time.
Although we may wish to argue that benefit/cost analysis is misapplied when used as a measure of desirability of reinvestment in sustainability, in fact we are usually forced to play the benefit/cost game. One strategy may be to employ available resource inventory information and resource capability information to constrain future options. If it can be demonstrated that through failure to reforest or to manage land properly there are long-term production supply constraints, we may be able to argue that future values of the remaining production will escalate significantly – possibly at a rate approaching the discount rate (e.g., 10 percent per annum) – thus offsetting the impact of discounting on long-term futures. This entails development of a greater knowledge of the true productivity relationships of resources over space and time, and the development of greater knowledge on what is happening to those resources in a nationwide or region-wide context. Such knowledge may aid in showing that in some circumstances it makes economic sense (at least to governments) to reforest. Further problems remain in making it attractive for an individual or business to do so.
Decisions on management strategy
Should we favour sustainability or depletion? Figure 1 shows the perspective of the farmer on evaluation of land management strategies. Should he or she obtain 20 percent more crop this year, or reduce cropping levels so that, over the longer term, an 80 percent level can be sustained in perpetuity? With high interest rates and therefore high discount rates, needs for immediate profits will often outweigh long-term sustained streams of benefits. Particularly in constrained economic times farmers may virtually be forced to over crop just in order to meet the mortgage. The same process is occurring at an international level where debtor nations are forced to liquidate base resources and forego investment in conservation in order to repay debts.
Since most farmers now have accountants who can apply discount rates and can cost investment options, in times of high inflation the prospect for individual long-term investments remains small. The stream of benefits to be derived from such investments must be very high to warrant current expenditures. Similarly, loans for such investments also undergo “economic” scrutiny and are available only to those investments which bring to the investor streams of benefits clearly exceeding investment costs. Thus, from the individual perspective it may not make financial sense to invest in maintenance of fields or measures to counter soil degradation.
From a social perspective however it makes very good sense for a nation to make investments in key prime resource areas order to maintain its long-term production capacity. In fact, some of the strongest arguments for government intervention and even subsidy can be made on the basis of maintenance of long-term productivity where the net social benefit far exceeds the expenditures which society must make. This is particularly true when resource base constraints are known, and when the demand for production can be seen to approach them over the longer term. As individuals may not have the capacity to make such investments it is probable that no one but governments will be able to do so.
A key challenge is to identify the present localities where the resource base is most amenable to long-term maintenance. Thus, prime resource lands can be targeted for maintenance in support of the long-term socio-economic and environmental objective of society.
The Pinto parable
In The Political Economy of Environmental Hazards, T.F. Schrecker examines the problems of applications of benefit/cost to certain hazard problems. Of particular note is the question of investment in hazard reduction. In the case of Ford Pinto, it was demonstrated through the use of conventional benefit/cost techniques that the earnings lost by a potential 180 deaths, and the expense of the destruction of 2100 cars a year, would not equal the additional costs of $11 per car to install explosion-resistant gas tanks. This conclusion was based on the commonly used technique of estimating the foregone earnings of individuals over their lifetime, as well as the costs of repair, replacement, medical care and so on. But the current and common methods are based on rather tenuous assumptions. One of the central assumptions of economics is that of perfect knowledge of the market. Yet this information is not provided to individual purchasers. Although one approach to benefit/cost analysis shows that it is not “economic (for example) to put safe gas tanks in cars, another approach using an equally conventional economic assumption – that of willingness to pay – could yield quite a different outcome. Imagine, if you can, a potential Pinto purchaser presented with perfect knowledge by a salesperson. The pitch would go something like this. “Would you like this Pinto or, for only $11 more, one that won’t explode?’ Simple logic suggests that most buyers would choose the $11 non-explosion option.
What lessons are to be learned from this example with respect to risk? First, as currently used, benefit/ cost analysis is seldom a realistic model of human behaviour, and seemingly illogical and potentially harmful decisions can be taken if it is misrepresented as such a model.
Second while Ford may not wish to internalize the costs, operating on the assumption that government will bail them out after the fact, society may be quite prepared to make such investments. Willingness to pay for a future, for reduced health or economic risk may far exceed the potential cost. People may be prepared to pay through their government for programmes to provide or protect a social good.
It is much easier to criticize than to create, and this paper is at risk of emphasizing only criticism. Unfortunately, the economists, geographers and planners who deal in natural resource decision making have not yet successfully developed alternatives which appear to meet the requirements of decision makers to understand the implications of complex decisions. Clearly there is a need for new tools.
Institutions like the World Bank and several of the aid organizations have developed expensive and sophisticated modifications to benefit/cost analysis which, at least in theory, permit it to better simulate real conditions. These include the use of border costs, shadow pricing and sensitivity analysis. The incorporation of probability measures and the development of means to calculate in detail the cross-sectorial costs and multiplier effects. However, such approaches are usually too expensive and are seldom followed. Even the data necessary to power them are prohibitively expensive and may even exceed the cost of the proposed project. As currently applied most benefit/cost analyses are incomplete because of lack of technical expertise by consultants, or because of lack of time or lack of data. Even if carried to the ultimate level of current sophistication such analyses remain terribly sensitive: the outcome is dependent on assumptions regarding such critical items as discount rate, multipliers of economic spin-offs, estimations of values of intangibles and estimations of the costs or benefits of alternatives. Yet as practitioners we must depend on some form of measure and benefit/cost analysis tends to be the most current and accepted. It seems to provide simple answers, and the Official wants a simple answer, one which is easily understood by his or her constituency. Benefit/cost analysis gives this but may hide the implications. The Official may proceed on the advice that the benefit/cost ratio exceeds unity when what he or she needs to know is the impact on jobs and the environmental costs to downstream users, etc. We may be able, through sophisticated techniques, to reduce the decision over whether or not to fill in a wetland to a seemingly simple question of sensitivity over what a duck is worth ($2.70/ lb. at the supermarket), but this is reducto ad absurdum. The Official thinks benefit/cost assessment allows a simple, understandable and defendable decision on the value of a duck, which may have provable social value but whose true worth is not clear. In fact, he or she is making a multi-faceted decision on ecosystems and livelihood. Consulting duck innards would have been as useful.
What is clear is that significant amounts of work, both at the conceptual and applied levels are required. Work is required to elaborate the concept of environmental capital even if it only means adapting conventional capital depletion and investment concepts from business to resource capital. Introduction of ideas with respect to resource replacement cost is also required. In particular, the spatial element needs to be introduced to show comparative advantages of sites. Costs associated with pursuit of alternatives, and the relative carrying capacities of alternative sites and alternative management options. In addition, ideas with respect to risk and risk reduction need to be introduced both on a site-specific basis and in terms of broader social risk from particular options. What are the long-term risks associated with the loss of prime production land, with the decision to construct in environmental hazard zones, or with increasing dependence on a limited number of examples of habitat? By analogy, is insurance” required? What is the realistic level of insurance payment to ensure a risk-reduced future? Further, broader approaches more suited to valuing social wellbeing need to be developed – ones founded on empirical analysis of human behaviour and incorporating a range of human objectives. At the least, a means to promote broader discussion and understanding of what is being traded-off when decisions are made must occur.
The purpose of this paper has been to try to demystify and debunk the current approaches being used most frequently to evaluate resource options. A recent paper by Van Kootenarid Furtan suggests that other aspects of neo-classical economics also preclude the social evaluation of resource management options: instead, they mechanistically “prove” that what may be philosophically unacceptable is in fact ‘economic’. Non-sustainable and degrading uses of forests are often the most profitable yet may be morally or environmentally unsound. While economic measures are one way of weighing decisions, they are only one which must be used alongside other measures of value to permit more holistic decision making.
At present, influence on the decision makers is dominated by a particular dogma which often bears little relationship as a model to the real questions being asked. Because of bias towards the short term, serious long-term costs are being incurred by society as a whole, and current tools do not adequately permit us to incorporate these into our planning process. If we allow decisions to continue to be confused by simplistic benefit-cost approaches we will be no better off than the Prince, guided by superstition. The moral of the story is: don’t let them baffle you with entrails.
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