Cost Benefit analysis in a Climate Change Context Theoretical Foundations and approaches

1. Cost Benefit analysis in a Climate Change Context Theoretical Foundations and approaches Bruce A. McCarl Distinguished Professor of Agricultural Economics Texas A&M University mccarl@tamu.edu http://agecon2.tamu.edu/people/faculty/mccarl-bruce/ ClimateChangeAdaptation Energy ClimateChangeImpacts ClimateChangeMitigation

2. Common need • Appraise costs and benefits of • Effects • Adaptation Practices • Mitigation Practices

3. Cost Benefit analysis • CBA has at its heart the objective of implementing socially profitable management alternatives while discarding socially unprofitable ones. • Criteria for "social profitability' is anything but clear. • Society involves many individuals. • Management or policy strategies may affect the welfare of these individuals differentially. • Future members of society may also have their welfare altered. • Virtually any judgment on social profitability involves a value judgment as to whether the benefits summed across some parts of society outweigh the costs to other parts of society.

4. Criteria for Judging Social Profitability • Several criteria have been proposed for making judgments on social profitability. • Pareto criterion where a strategy is socially profitable as long as the resultant welfare of every member of society is improved. • Rarely if ever satisfied • If satisfied true social profitability attained. • Since the Pareto criterion is rarely satisfied other criterion have arisen.

5. Compensation Principal • Kaldor-Hicks and Scitovsky • Kaldor-Hicks states a strategy is socially profitable as long as there is the potential for Pareto improvement, • Gainers receive more than the losers lose, so the gainers can potentially compensate the losers • Scitovsky says strategy is socially profitable when the losers cannot bribe the gainers into not undertaking strategy. • Main difference between "compensation" and the Pareto criterion is that the compensation criteria do not impose differential welfare weights for individuals, whereas the Pareto does

6. Class Approach • For this class the approach we follow will • principally concentrate on the valuation of the various components of climate change issue. • When adding up is called for an unweighted sum will be used following the compensation criteria. • This assumes that society's marginal preferences for welfare increases of the various individuals involved is equal. • Squire and van der Tak present material on differential weighing schemes for cases where this is inappropriate.

7. Basics of welfare • The criteria for judging socially profitable management or policy strategies rely upon measures of welfare. • Economically accepted on measures of welfare are compensating and equivalent variations and economic surplus as commonly measures (approximately) through consumers' and producers' surplus, as elaborated on in Appendix A or Just, Hueth, and Schmitz.

8. Basics of welfare • Do you gain value when your apartment rent is lowered or lose it when it is raised • Free up your money for other uses • You gain value from paying less for something then you were willing to pay • Consumers' Surplus • Does a trucking company gain value when its gasoline price is lowered or production yield increases -- Increases profits • They gain value from making more money • Producers' Surplus

9. Measures of Welfare • Consumers' and producers' surplus are measures which, in some cases, represent the utility gained by individuals in a society when • Consumers in consuming goods, they obtain goods at a price less than the maximum they would be willing to pay, and • Producers in producing goods, they sell goods at a price above the minimum price they would have been willing to supply those goods. The surpluses are portrayed for a simple single commodity market in equilibrium in Figure 1.

10. Consumers' surplus • excess of the price which one would be willing to pay for the thing rather than go without it, over that which they actually pay

11. Consumers' surplus Why is this a measure of welfare. • An individual in consuming derives utility. • Utility is a very difficult concept to measure, • In buying goods, individuals reflect the value or utility they place on a good. • Demand schedule is collection of price-quantity points representing marginal utility of consumption • When individual consumes at price P*, total utility (welfare) the sum of satisfaction from consuming the first unit of good at this lower price plus the second etc. • This sum equals the integral of the area under the demand curve from zero to Q* less the total amount paid (i.e., P* Q*).

12. Consumers' surplus Why is this a measure of welfare. • This sum equals the integral of the area under the demand curve from zero to Q* less the total amount paid (i.e., P* Q*).

13. Aggregate consumers' surplus Above was for individual In theory, the aggregate demand function is simply the horizontal sum of the individual demand functions. Area under the aggregate demand function is the summation of the individual consumer's surpluses and constitutes a measure of aggregate welfare. Sums welfare of individuals ignoring weighting Calculation procedures for consumers' surplus are given in Appendix 2.

14. Producers' Surplus Producers' surplus is the excess that producers receive over the minimum price at which a seller would part with a bundle of goods. Minimum price at which a seller is "induced" is given by the supply curve and is the marginal cost of producing that unit for the seller. Total cost is sum of marginal costs or area under supply curve

15. Producers' Surplus Total Revenue is price times quantity Total cost is sum of marginal costs or area under supply curve Producer surplus is Total Revenue less total cost or the area between price line and supply curve. Equilibrium price times equilibrium quantity (total revenue) minus area under supply curve from zero to equilibrium quantity (sum of marginal costs or total cost).

16. Producers' Surplus Short run concept is analogous to profit.

17. Producers' Surplus • Producers' surplus is not as readily accepted in a welfare context as is consumers' surplus. The reasons for this are twofold. • First, some think economic rent is a more meaningful term. • Mishan economic rent provides "a money measure of the welfare change arising from a movement of factor prices in exactly the same way that consumer's surplus provides a money measure of the welfare change arising from a movement in product prices." • an imputed rent to the factors of production

18. Producers' Surplus • In summary, as a welfare measure producers' surplus is useful but it does need to be used carefully with thought on • dynamic nature and form of the supply curve and, • to who the surpluses accrues. • The term producers' surplus, while common, should be used at least along with the term economic rent, indicating that this "surplus" is really a return to factors of production.

19. Total Welfare for CB analysis TSW=CS+PS

20. Conceptual Background on types of changes Not all items affected by climate change directly traded within markets particularly environmental quality items (i.e., ecosystems and wildlife population changes) are. Valuation of changes in their levels is then done by related markets to discover resultant welfare effects.

21. Approaches to estimating costs and Benefits of climate item • Can examine by examining effects on the firm by examining • the profits obtained by production, • the costs of production, • the prices paid for and quantity used of inputs, • the revenue obtained for outputs.

22. Appraisal Based on Changes in Net Income • The basic approach when conducting such an appraisal involves the appraiser • examining situations where economic agents are operating in a setting characterized by varying climate attributes and where all other factors either do not vary or can be controlled • estimating a relationship between net income and the climate attribute • calculating the change in net income induced by the change in climate attributes • utilizing the quantitative relationship between climate change and net income . • Assumes prices don’t change so demand is perfectly elastic and ignores CO2 But remember global climate changeso does this make sense

23. SmallProducer Case Change in Net Revenue Supply Supply Price Price Supply’ Supply’ Perf Elas Demand Perf Elas Demand P* P* PS PS ΔPS ΔPS Quantity Quantity Q* Q* Q Q

24. Appraisal Based on Changes in Total Costs • The basic approach when conducting such an appraisal involves the appraiser • examining a situation where economic agents are operating in a setting where the climate attributes vary and where all other factors either do not vary or can be controlled. • estimating a relationship between cost and the climate attributes (i.e., the C function above), • calculating the change in costs induced by the change in climate attributes, all other things held constant, and • utilizing the quantitative relationship between the calculated climate attribute change and cost • Such an approach requires data on the costs, levels of the climate related attribute and levels of other factors which influence costs.

25. Change in Total Cost • Demand perfectly inelastic Price Price Supply’ Supply’ P’ P’ Supply Supply PS P* P* ΔPS ΔPS Q Quantity Q Quantity

26. Appraisal Based on Changes in Input Demand The appraiser executing such an analysis again needs to examine a situation in which the climate related item is varying wherein other factors do not change or can be controlled for. The appraiser then gains an estimate of how the price of the input (like land value) is affected by the change in the climate attribute. Finally this is related to the management or policy strategy under appraisal. The theoretical basis upon which "hedonic" estimates are done e.g. estimating the effects of climate on land values Appraisers utilizing this approach require data on input prices along with data on climate attributes, other factor prices, and factor usage.

27. Change in Marginal Cost This requires one to assume a fixed quantity demand curve for the goods and a totally elastic supply curve. Under such assumptions, total social welfare as measured by the area above the demand curve but below the supply curve of the goods will equal the quantity calculated above. Price Price Demand’ Demand’ P’ P’ ΔPS ΔPS Demand Demand P* P* Supply Supply Q Quantity Q Quantity

28. Appraisal Based on Changes in Output Supply One would need to calculate in this case the changes to the consumer surplus at the same time one was considering the changes in the rents to the producers. S1 S2 Price Demand Pa b Q2 Q1 Quantity

29. Shift in Total Welfare Total Welfare for CB analysis for a project TSWbefore=CS old+a+bTSWafter=CSold+a+b+c+d+e+f PSbefore=a+bPSafter=b+c+f CSbefore=CS oldCSbefore=CSold+a+d+e ∆TSWbefore=c+d+e+f ∆PSbefore=c+f-a ∆CSbefore=a+d+e

30. Shift in Factor Demand Welfare comparison in market after climate change induced change in factors CSbefore= a+c PSbefore= b+d+e CSafter= a+b PSafter= e Change ∆CS = -c+b(indefinate) ∆ PSr = -b-d (indefinite) ∆ Welfare=-c-d (loss) Demand’ Supplyafter Price a c Pa b d c Pb e Demand Qa Qb Quantity of a good

31. Avoiding Double Counting Above we have discussed several different ways of obtaining the welfare effects of a management or policy strategy. All of these methods, under different assumptions, lead to an estimate of the change in consumers' and producers' surplus or total social welfare. The appraiser must be careful not to double count, measuring the same benefit in more than one way. Consumers' surplus in a factor market is equal to either a) the sum of consumers' surplus in the ultimate market plus the sum of producers' quasi rents obtained in the intermediate markets when product prices vary with changes in output; or b) producers' profits when the demand price to the producer is fixed. Thus, consumers' surplus as measured in a market is consumers' surplus at the consumption stage plus the rents to fixed factors used in transforming production The implications are that a) a marvelous opportunity exists for double counting by, for example, measuring consumers' surplus in both

32. Should we consider Induced Effects • Induced (secondary) impacts. • Induced impacts refer to economic effects which are stimulated by management or policy strategies. Examples include increased economic activity within the marketing channel caused by an increase in farm production. The evaluation of such impacts and their inclusion in management or policy strategy appraisals has been a controversial theoretical subject. • This controversy has involved discussion of secondary affects from both a national cost benefit prospective and from a regional distributional perspective. • "Secondary effects in the region in question would be offset by effects with the opposite sign in other regions. – don’t count • Induced effects also play a role in the analysis of regional distributional effects.

33. Valuation Methods a) development of value estimates from observed economic behavior, b) development of value estimates from elicited responses, and c) development of value estimates from synthesized or simulated economic behavior.

34. Estimates Many different ways of developing estimates from different viewpoints are given above. It is possible for an appraiser to develop a number of different estimates for the same phenomena, particularly using the cost basis such as prevention cost versus maintenance costs versus mitigation costs versus eventual replacement costs. The benefit estimate obtained to particular change in climate should be the lowest of any mutually exclusive groups of these costs, assuming the estimate is developed using reasonable assumptions. A management or policy strategy's benefits to society should be no more than the costs of generating the effect on society via the cheapest alternative method. Combining Diverse

35. Theoretical Background to Farmer Technology Adoption The above theoretical background relates only to management or policy strategy appraisal. There is a very important second area which is also relevant when regarding management or policy strategies. Clearly farmers have to adopt the management or policy strategy in order to have it be successful.

36. Dynamic Implications Discount rate, public, private, risk, inflation Intergenerational equity, Irreversibilities, and Uncertainties.

37. Global perspectiveCommon property atmosphere and climateFree riderWho should paySheer size of market Economic Needs

38. Valuation of Climate impacts

39. Climate change impacts Price Demand Market before climate change Here we see Consumers (CS) and Producers Surplus (PS) Supplybefore CS Pb PS Who gains and loses Qb Quantity of a good

40. Climate change impacts Who gains and loses Supplyafter Market after climate change What happened price went up quantity produced went down Price Demand Supplybefore Pa Pb Qb Qa Quantity of a good

41. Climate change impacts Who gains and loses Supplyafter Welfare comparison in market after climate change CSafter = a PSafter = b+e CSbefore = a+b+c+d PSbefore = e+f+g Change ∆CS = -b-c-d (a loss) ∆ PSr = +b-f-g (indefinite) Price Demand Supplybefore a Pa b c d Pb g e f Qb Qa Quantity of a good

42. Does this happen? Case of US agriculture 1996-2009 17% gain 42% lower price 22% less income

43. Valuation Approaches Lost Services (P-C)*(Qa-Qb) price minus cost times lost quantity Replace services Cost of replacing the lost facility With and without price and input cost change

44. Basic Setting between regions Dregion1 Dregion2 Sregion1 P r i c e Sregion2 ED region2 region1 Quantity

45. Basic Setting between regions Dregion1 Dregion2 Sregion1 P r i c e Sregion2 ED region2 region1 Quantity

46. Basic Setting between regions Dregion1 Dregion2 ES Sregion1 P r i c e Sregion2 ED region2 region1 Quantity

47. Basic Setting between regions Dregion1 Dregion2 S’ Sregion1 P r i c e Sregion2 S’ region2 region1 Quantity

48. Basic Setting between regions Dregion1 Dregion2 ES S’ Sregion1 P r i c e Sregion2 S’ ED region2 region1 Quantity

49. Basic Setting between regions Dregion1 Dregion2 ES S’ Sregion1 P r i c e Sregion2 S’ ED region2 region1 Quantity

50. Basic Setting between regions Dregion1 Dregion2 ES S’ Sregion1 P r i c e Sregion2 S’ ED region2 region1 Quantity