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Newsletter and Technical Publications Choosing Regulations: Benefit-Cost Analysis In the previous section a variety of different instruments were considered for controlling eutrophication. In practice, a government agency will design a much more specific set of regulations which draw from the broad classes of instruments. In fact, the agency may have several candidate "solutions" to the eutrophication problem, and a finely honed set of regulations or incentives to apply to the eutrophied lake in question. The problem then arises of how to choose the best regulatory approach? Benefit-Cost Analysis (BCA), also called Cost-Benefit Analysis, is a useful tool for assessing the economic effects of projects, policies or programs. Simply put, this approach entails enumerating all significant benefits and costs of a given policy or management objective. The purpose is to provide a filter that would systematically eliminate projects that do not provide enough benefit relative to their costs. Implementing Benefit-Cost Analysis It is important to realize that BCA has a very specific purpose: to help decision-makers choose among several very specific proposals for controlling a specific eutrophication problem. These may be new policies or modifications of old policies. BCA is not used to study a problem or explore solutions to a problem. When an agency has winnowed down its candidates for controlling a eutrophication problem to a few alternatives, BCA can be used to help make a choice and help defend that choice in deliberations within and outside the agency. In implementing BCA, the first task is to enumerate the physical consequences of the several regulatory options under consideration. The second step is to convert these physical estimates into a common denominator. The costs of a policy that improves water quality in a lake or reservoir would first include the monetary expenditure required to implement the policy and the necessary pollution controls. These expenditures include any necessary investments (for example, investments in water treatment plants), operating costs (for example, dredging costs) and monitoring and evaluation costs. Costs represent resources that have to be diverted from productive uses elsewhere in the economy. The value of the foregone opportunities is the appropriate measure of the cost of combating eutrophication. A commitment of resources to improving water quality may affect economic growth as well as affecting the distribution of economic welfare among various social groups. For example, it may reduce investments in industrial development while also providing jobs for rural people. The consequences for growth and income distribution are particularly important in developing countries. It is important to realise that costs need not involve any out-of-pocket expenditures. If the government owns land that is used for a constructed wetland (see Chapter 2), then there is a cost associated with using that land, even though it was not purchased. The land is not unusable for other purposes; there is an opportunity cost of using it for the wetlands which is just as real as if it had been purchased. Environmental costs are another set of costs that need to be taken into account. For example, reducing eutrophication may reduce yields of certain fish species, which is an environmental cost. The value of the existence of a wide range of different species in a specific water body or during a specific period of time also needs to be considered in benefit-cost analysis. Issues in Benefit-Cost Analysis Benefit-cost analysis alone is not enough upon which to base a decision but provides important information for the decision making process. It can be used as a filter, ranking device or contribute to other forms of social and economic information. Whatever the circumstances of the benefit-cost analysis application, it is important to ensure quality control in the implementation of the procedure. Two important issues relating to quality control are: first, the principles are clearly specified for empirical benefit-cost analysis and are based on sound economic principles; and second, the benefit-cost analysis documents are available for public scrutiny to expose the improper use of theory and practice. Benefit-cost analysis can be applied to a spectrum of policy choices. For instance, eutrophication can be examined at the farm level, industry level, local level, State or Provincial level and Federal level. Each requires a different set of information about the benefits and costs. Generally, the appropriate scope to use for a particular BCA is that associated with the agency doing the analysis or the reviewing agency. For instance if a lake is shared by two countries and one of the countries is considering action, then costs and benefits are typically restricted to the single country, for the purposes of decision-making. The estimation of costs is relatively simple compared the estimation of the benefits. In many cases a policy change has low costs but determining the benefits and or beneficiaries can be difficult. This is particularly prominent when markets are not working well or a market does not exist for the good in question. Benefits from natural resource conservation are the gains that result from the sustainable uses of biodiversity. Presently, there is a serious lack of data available on the value of biodiversity. The absence of such data may induce people to assume that these values are small or even insignificant. The benefits of a policy that reduces eutrophication might include an increase in recreational activities, an increase in fish yields, improvements in human health, a reduction in water treatment costs for potable water and increases in the aesthetic values of water based on appearance, taste and odor. It is useful to distinguish between private or individual benefits and collective benefits. Private benefits are enjoyed by one individual while collective benefits are enjoyed simultaneously by many individuals. Many of the benefits associated with improved water quality are enjoyed collectively. Collective benefits are not easily included in markets and, accordingly, are difficult to measure. Benefit cost analysis is typically done in two stages. First, the benefits and costs of a given measure are calculated for each year that it is effective. Second, these are added up over the different periods of time to obtain an aggregate, or "net present value." This is done by weighting ("discounting") benefits and costs at different points in time, with the future having slightly lower weights than the present. If the net present value is positive, that is, present value benefits exceed present value costs, the policy makes economic sense. Discounting is done so that benefits and costs occurring at different times can be aggregated and expressed in composite form. There are two justifications for discounting. First, most consumers consider present day benefits to be more valuable than future. This explains the willingness to borrow funds and pay interest. Second, resources invested now will increase well-being in the future. This explains the willingness to borrow funds and pay interest to invest in new businesses and technologies. In both cases, people are willing to pay a premium in the future to have access to funds in the present. The discount rate, r, is the premium they are willing to pay, expressed as a percentage over a specified period. Funds received today are worth, at the end of the first period, a total of (1+r) times the amount of funds. Equivalently, an amount of funds to be received at the end of the period are worth 1/(1+r) times that amount at the beginning of the period. While discounting is a common procedure, the issue of what is an appropriate discount rate to use for public projects can be debated. Since higher discount rates disadvantage investments that take many years to pay off, the choice of a discount rate can directly influence the choice of policies to implement. For investments in projects that yield tangible products and services, such as waste treatment plants, dams and recreational facilities, the appropriate discount rate should be guided by market rates, at least equal to the interest rate on government bonds. For policies or programs, particularly those having consequences lasting well beyond the typical 10 to 25 year life spans of most private sector investments, a lower discount rate may be warranted, reflecting the fact that society may be less impatient than the private sector. This is also based on the idea that consumption by distant generations is a public good and current policies should take that into account. The treatment of inflation is another issue in the determination of a discount rate. The nominal rates observed in the market place include a component that reflects expected inflation. An interest rate that removes the inflation is called a "real" interest or discount rate. Real discount rates between 3 and 8 percent are most often used in benefit-cost analysis in developed countries while in developing countries it can be as high as 10 or 12%. Often, rates used by government agencies or international organisations such as the World Bank are used as benchmarks. Finally, in a benefit-cost study, a sensitivity analysis should be done to see how net benefits are affected by different discount rates. Examples of Benefit-Cost Analyses in Lake Management. At present, the average cost of treatment of water for drinking or public supplies amounts to US$10 per thousand m³. However, the cost decreases to US$2 per thousand m³ when the water treated is of good quality. Therefore, the costs of water treatment increase in eutrophic systems. There are also different indirect economic effects of eutrophication, such as the loss of days of work from health failures due to exposure or drinking of water with algal toxins. Economic losses due to eutrophication of lakes and reservoirs may be severe. In one case in Brazil, in São Paulo State, a devaluation of 50% of the price of properties occurred as a consequence of algal blooms and macrophyte growth, and a loss of recreational capacity of a water body. Bad odors and danger of toxicity contributed to this devaluation. On the other hand, at a small recreational reservoir, also located in São Paulo State, water quality, which was maintained in good condition during 25 years, stimulated economic investment in tourism, provided job opportunities, and created a booming regional industry. The reservoir, which is only 7 km² large, has stimulated an investment of US$ 250 million in 25 years, showing the clear advantage of prevention over remediation. In contrast, the recovery of the Tietê River in São Paulo City cost an estimated US$ 4 billion over 10 years. The need to control and manage the effects of urban, industrial and agricultural development on Japan’s largest lake, Lake Biwa, led to the formation of the Lake Biwa Comprehensive Development Project. Although the basic objective of the project was to promote development of the Keihanshin region by providing additional water, other important objectives included the onservation of the natural environment, the promotion of public welfare, and the restoration of water quality. The planned cost of the project was Japanese Yen 426,637 x 106 in 1971. However, the actual cost of the project, carried out from 1972 to 1992 was Japanese Yen 1,524,850 x 106. Under controlled eutrophic conditions, aquaculture in lakes can be a source of revenue and of job opportunities. Benefit-cost analysis was carried out to evaluate the economic effect of fertilization of Lake Kootenay, British Columbia, Canada, in 1995 (K. Ashley, Ministry of Fisheries, British Columbia, personal communication). The surface area of the lake is approximately 390 km2. Total costs for fertilization of the lake were estimated at Can$ 511,000. Of this sum, the cost of a liquid fertilizer and its application to the lake was Can$ 310,410. The rest of the total cost (i.e., Can$ 199,590) was spent on sampling, monitoring, travel and data processing. Estimated gross benefit for the same year was Can$ 2,000,000. Calculated cost per km2 was Can$ 1,293, and the benefit was Can$5,063 per km2. The total cost is expected to decrease in 1999/2000 to approximately Can$300,000, and therefore the benefit-cost ratio will be greater than that of 1995.
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