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Extending cost-benefit analysis for energy investment choices
Extending cost-benefit analysis for energy investment choices David Simpson and James Walker
Although cost-benefit analysis is still widely practised, because it addresses real and continuing problems, the technique has been frequently called into question. The present paper identifies three major limitations in the technique, and offers suggestions for improvements. While costs and benefits of e n e r g y i n v e s t m e n t s have several dimensions, CBA attempts to give all effects an economic value. This often requires arbitrary and subjective judgments which have discredited the technique. It is proposed that CBA should be extended from the single economic dimension to Include three others, environmental, technical and the analysis of risk. It is suggested that important subjective judgments should be made by the ultimate(political)decision maker, and not by the analyst,
Cost-benefit analysis is still one of the most widely applied tools of economic evaluation in the public decision-making process. Its use in practice can be traced to 1844 when Jules Dupuit, a French engineer, made reference to the benefits of public works.t However, the modern concept of cost-benefit analysis is widely recognized as originating in the 1930s in the USA, where it was first applied to the evaluation of water resource projects. Indeed, a great deal of the early empirical work on cost-benefit can be found in material primarily concerned with water and river resource development. 2 Since these first studies cost-benefit analysis has been employed in a wide range of applications, eg highway development, transport systems, defence, health, education, airport siting, housing and energy choices.
Results and interpretations of these studies have revealed a number of limitations in cost-benefit analysis, which have called the technique into question. Moreover there is a general feeling that cost-benefit analysis can be used to produce almost any result desired by the analyst to suit his own prejudices or the interests of his sponsor: ~ Keywords: Cost-benefit analysis; Energy Cost-benefit analysis is nevertheless enjoying a vogue amongst investment decisions; Environment applied practitioners, not all of whom are economists with experience in The authors are with the Department of modelling. This is not surprising since cost-benefit analysis addresses a Economics and The Fraser of Allander continuing real problem - the need on the part of public authorities to Institute, University of Strathclyde, 100 Cathedral Street, Glasgow G40LN, Scot- make investment choices. The pressing budgetary constraints of land. governments everywhere, coupled with insatiable expectations on the The authors are deeply grateful to Donald part of their electorates, have meant that an increasing sophistication is Bain, Richard Brooks, Anthony Clunies required about the potential implications of public investment decisions. Ross, David Pearce, Alex Scott and Alan However unsatisfactory may be the present state of cost-benefit Williams for their comments on an earlier analysis, for many such choices there is no alternative method of version of this paper. The authors are solely responsible for the views expressed in the paper,
organizing the desired information which is evidently superior, readily available or widely accepted.
1jules Dupuit, 'On the measurement of the utilityof public works', InternationalEconomic Papers 2, (translated from the French Annals des Ponts et Chassees, 2nd Series, Vol 8, 1844) 1952. 2For example, O. Eckstein, Water Resource Development, Harvard University
As its title suggests, the purpose of this paper is to propose some pragmatic modifications to the existing methods of cost-benefit analysis for evaluating energy choices. In the following section, three specific weaknesses in present practice are identified and discussed. They are: the exclusive concern with economic values, the treatment of uncertainty, and the neglect of intergenerational effects. Appropriate remedies
continued on p 218
are proposed in the third section of the paper, while a summary of these proposals is given in the fourth and final section.
Press, Cambridge, MA, 1958. O. Eckstein and J. Krutilla, Multiple Purpose River
0301-4215/87/030217-11 $03.00 © 1987 Butterworth & Co (Publishers) Ltd
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Extending cost-benefit analysis for energy investment
Problems The one-dimensional nature o f cost-benefit analysis
When we are discussing investment in the field of energy, both costs and benefits have more than one dimension. Yet traditional cost-benefit analysis attempts to reduce everything to a single dimension - the monetary value of the potential effect (whether cost or benefit). It may be true that everything has a monetary value, or that a monetary value can be attributed to everything, but the fundamental weakness of the one-dimensional approach is that economic values may be inappropriate in many particularly contentious cases (eg valuing human life, threats to civil liberties, environmental bads or epidemiological effects), and consequently that these may result in incorrect decisions being indicated. 4 Moreover, the attempt to transform every potentially significant effect into monetary values requires an arbitrary and subjective judgment on the part of the analyst• With regard to energy, many conversion activities have potentially degrading effects on the environment. While some of these costs can adequately be represented by such monetary values as the cost of abatement, others cannot. Classic examples include thermal pollution from nuclear power plants (leading to reduced oxygen carrying capacity in waterways), particulate and noxious chemical emissions from fossil fuel fired power stations with their consequences for public health and the possibility of catastrophic climatic effects from energy sources, eg continued from p 217 the build up of C 0 2 leading to the 'greenhouse' effect. Development, Johns Hopkins Press, BaltiPearce argues that ecological stability ( i e a biological or physical more, MD, 1958. J. Hirschleifer, J. De Haven and J. Milliman, Water Supply: Economics Technology and Policy, University of Chicago Press, Chicago, IL, 1960. Water Resources Council, Proce-
dimension) has to be introduced as a constraint into the decision process over and above purely economic considerations, s In a later paper, 6 the
same author is sceptical of the ability of cost-benefit analysis, confined
dures for Evaluation of Water and Related
to economic values alone, to handle issues associated with nuclear waste
Land Resource Projects, Water Resources
Council, Washington, DC, USA, June 1969.
disposal. On questions of civil liberties and nuclear proliferation (both issues which can arise from the building of a nuclear waste reproce'ssing
LXXX, No 2, May 1966. 8A. Wildavsky, 'The political economy of efficiency: cost-benefit analysis, systems
factors 'a serious deficiency'• 8 Williams disagrees with this approach and advocates the use of shadow prices to bring information from the fields of science, politics etc into the realm of economic analysis. 9
• Williams, 'Cost-benefit analysis: bastard science? and/or insidious poison in the body politick', Journal ofPublicEconotalcs, Vol 1, No 2, August 1972.
non-economic variables, economists create the possibility of a range of quite arbitrary values entering the analysis, thus discrediting it as a technique. Furthermore, economists may not be best qualified to evaluate non-economic variables, and decision makers may be sceptical
3See L. Merewitz and S.H. Sosnick, The Budget's New Clothes: a Critique of plant) economic values are certainly not the only, and perhaps not even Planning-Programming-Budgeting and the most important, consideration. Benefit-Cost Analysis, Chicago, IL, M a r Pearce's extension of decision taking criteria to include physical and, kham 1971, on the California Water Project and the Federal Aviation Authority's indeed, political dimensions is echoed elsewhere. For example, Maass 7 supersonic air transport programme and writes: E.M. Gramlich, Benefit-Cost Analysis of Government Programs, Prentice-Hall, NJ, Where government programmes are intended for complex objectives they USA, 1981, on the Tellico Dam project. 4D.W. Pearce, 'The limits of cost-benefit should be designed, where this is possible, for such objectives, not designed for analysis as a guide to environmental poll- one objective (economic efficiency) which may not be the most important, and cy, Kyklos, Vol 29, Fax 2, 1 9 7 6 . subsequently modified in an effort to account for others. 7 51bid. 6D.W. Pearce, 'Social cost-benefit analy- Support for the addition of a political dimension to cost-benefit analysis sis and nuclear futures', Energy Economics, Vol 1, No2, April 1979, pp66-71, also comes from Wildavsky who, while recognizing the merit of 7A. Maass, 'Benefit-cost analysis: its rele- cost-benefit analysis as a tool which can make implicit judgments vance to public investment decisions', explicit and subject to analysis, considers the omission of political Quarterly Journal of Economics, Vol
analysis and program budgeting', Public Administration Review, Vol 26, No 4, Au~Aust1966.
218
It is our view, however, that by attempting to put shadow prices on
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Extending cost-benefit analysis for energy investment
of their attempts to do so. Indeed, even although economic considerations may be the most important ones in an investment decision, they are not the only ones which are taken into account in practice. The attempted economic valuation of such intangibles as travelling time, pollution, noise and human life has brought about some of the strongest criticisms of cost-benefit analysis. 1' The specification of costs and benefits in a single dimension - the economic one - has the apparent advantage that the result of the analysis is expressed in a single parameter, the difference between the net present value of the costs and the benefits. In practice, the results of a cost-benefit analysis constitute only one ingredient of the decision albeit an important one. The ingredients of a public investment decision are multi-dimensional, and a modified cost-benefit analysis should recognize this explicitly. Thus, a serious consequence of the single-dimensional approach of conventional cost-benefit analysis is that differences between hard and soft data are obliterated, giving rise, in Dorfman's famous metaphor, 1~ to the 'rabbit-and-horse stew' situation, where the relatively harder valuations (the rabbit) are swamped by the larger but 'softer' subjective valuations (the horse) made by the analyst. It is impossible for the ultimate consumer (the commissioning public authority) to discern the flavour of the rabbit because of the predominance of the flavour of the horse. ~2 1°For example, G.H. Peters, Cost-Benefit Quantification in a single dimension means that data of varying Analysis and Public Expenditure, Institute degrees of reliability and measurability are mixed together inextricably. of Economic Affairs, London, 1973. E.J. In particular: Mishan, 'What is wrong with Roskill?', Journal of Transport Economics and Policy, Vol 4, No 3, 1970. P. Self, 'Nonsense
•
subjective judgments to which the overall result may be sensitive
•
are thereby concealed, and subjective judgments are made by the analyst rather than by the
on stilts: cost-benefit analysis and the
Roskill Commission', Political Quarterly,
Vol 41, No 3, July 1970. P. Self, Econocrats and the Policy Process: The Politics and Philosophy of Cost-Benefit Analysis, Macmillan, London, 1975. R. Dinkel, 'Cost-benefit analysis: a helpful tool for decision-makers', paper presented at the 3rd International Conference on System Science in Health Care, 1984.
t~R. Dorfman, ed, Measuring Benefits of Govemrnent Investments, The Brookings Institute, Washington, DC, 1965. ~2Fries warns against this type of distinction showing that, in some cases, eg arthritis clinical trials, reliance on 'hard'
ultimate decision maker. Uncertainty and risk Since it concerns the future, every element which enters the evaluation
of any proposed investment is necessarily uncertain. Such elements can differ from each other in two important respects. First, a sensitivity analysis can show that variation in the values of only a limited number of variables are critical to the outcome of a cost-benefit analysis. Thus, energy investment appraisals are usually critically sensitive to the choice of discount rate as well as to future relative fuel prices. Second, the
data has been replaced by 'soft' measures, ie patient complaints. However, he extent and nature of the uncertainty surrounding each of the critical finds the terms acceptable if 'used to refer variables differs. to the actual measurement characteristics When the future value of a sensitive variable is uncertain, it is often of a variable rather than to the origin of the data (the laboratory or from the patient)',
(J.F. Fries, 'Toward an understanding of patient outcome measurement', Arthritis
and Rheumatism, Vol 26, No 6, June 1983). It is with this definition in mind that
we use these terms, ~3N. Lucas and D. Papaconstantinou, 'Energy planning under uncertainty', Energy Policy, Vol 11, No 3, September 1983, pp 204-216.
~4C.W. Hope, 'Assessing renewable ener-
gy research and development', Energy: The International Journal, Vol 7, No 4, 1982, pp 319-334.
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suggested that a probability distribution should be used instead of a single-valued estimate. Such a distribution might be objectively based on past experience as, for example, estimates of system load and thermal efficiency in an electricity generating network or of plant
lifetime. In the great majority of cases, however, the evidence for an objectively-based probability distribution is lacking, and a subjectively." based probability distribution is often recommended in its place. While elegant mathematical forms, such as truncated normal distributions t3 and subjective probabilistic analysis, 14 have been proposed, the fact remains that one expert's judgment can and does differ from another's, and we shall never know in advance which is correct.
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Extending cost-benefit analysis for energy investment
15See J. Tobin, 'Liquidity preference as behaviour towards risk', The Review of Economics Studies, Vol XXV, February 1958 and J. "robin, 'The theory of portfolio
selection', in F.H. Hahn and E.P. Brechling, eds, The Theory of Interest Rates, International Economic Association, London, 1965.
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The most common approach is for the analyst to propose a range of possible future values for the sensitive variable or variables, with or without a single central or most likely value. But if he chooses a wide range of values, the results will be of little assistance to the decision maker, while if he chooses a narrow range, he may be quite wrong. The fact is that mathematical formulations do not reduce our ignorance about the future, they merely formalize it. Whatever efforts we expend, there will remain elements of irreducible uncertainty about the future. We should begin by accepting this. Decision makers should therefore be cautious about accepting any single-valued parameter representing the outcome of a cost-benefit analysis. In addition to the general uncertainty about the future, it may be clear that some prospective investments, in the public as well as in the private sector, are riskier than others. The risk of an investment is often measured by the variability or dispersion of the probability distribution of its outcomes. From the point of view of an individual acquiring a financial asset, however, the riskiness of that asset by itself may be of little concern: what is important is its effect on the overall riskiness of his whole portfolio.15 He is interested.in the variability of any single component of a portfolio only insofar as it effects the variability of the total portfolio. Therefore, the covariance of the outcomes of the asset with those of the rest of the individual's portfolio becomes the accepted measure of risk. If the covariance of the two is positive, then the dispersion of the range of outcomes would be widened. In other words, the riskiness of the total portfolio would be increased by the acquisition of the proposed asset. If the covariance was zero there would be no change in risk, but if the two probability distributions were negatively correlated, then the overall risk of the total portfolio would be reduced, and the acquisition of the proposed asset would take on the characteristic of an act of insurance. The same principle is true if one looks at a 'portfolio' of investments as seen from the point of view of the nation as a whole. The riskiness of a public investment that constitutes a small fraction of national income (where national income is regarded as the return on all the nation's investments) depends, from the perspective of the national economy, on the covariance of its return with national income. If the returns to the proposed investment have a positive covariance with national income, it will involve some risk, if they have a zero covariance the risk is minimal, while if there is a negative correlation then the investment has the characteristic of insurance from a national perspective. To take an example of a proposed investment having the effect of increasing the energy supply, then it is likely that the higher are future energy prices, the greater will be the returns to this investment. But higher energy prices tend to be associated with lower than otherwise levels of national income, because of the recessions which are provoked by abrupt increases in such prices. If the returns to energy investments were correlated negatively with the returns to other investments they would constitute risk-reducing projects, ie national 'insurance policies' for the future. If this is the case, the question is: how is this contribution to a reduction in risk to be reflected in an investment appraisal exercise, such as a modified cost-benefit analysis? In private decision making risk is usually accounted for by explicitly or implicitly (eg by the use of the so-called 'pay-back' period method) altering the discount rate, so that effectively a higher rate of discount is
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Extending cost-benefit analysis for energy investment
applied to those projects which are thought to be more risky. Theoretically, it is improper to mix up questions of time preference with questions of risk, but this has not deterred private practitioners, not only households and smaller firms, but even large firms in the energy sector, from doing so. ~ I n t e r - g e n e r a t i o n a l bias
While the principle of discounting future streams of costs and benefits on the grounds of time preference or capital productivity has been widely accepted by economists, despite the occasional philosophical protest, t7 the practice of applying this procedure far into the future can lead to problems. There is a similar conflict between principle and practice in the choice of discount rate. It is possible that a different rate of discount may be appropriate for every project, ~ but practitioners insist that a single rate of discount must be used for evaluating competing projects. However, in the public sector, it is common to find that discount rates used in investment appraisal calculations are 16R.0. Lindet al, Discounting for Time and between one half and one third of the rates used in the private sector, eg Risk in Energy Policy, Resources for the Future, Washington, De, 1982. compare the 15% rate proposed for evaluating geothermal energy l~For example, A.C. Pigou, The Econo- projects 19 with the range of rates (0.5% to 10%) advised by public mics of Welfare, 4 ed, Macmillan, London sector energy evaluators. 2°
1932 and D. Parfit, 'Energy policy and the further future: the social discount rate', in D. MacLean and P.G. Brown, eds, Energy and the Future, Rowman and Littlefield, Totowa, N J, 1983,
It is not our purpose in this paper to enter into the question of the choice of discount rate, but rather to discuss the consequences of applying any discount rate over a period of 20 years or more, which is
lSLind et al, op cit, Ref 16, p 4 4 3 . frequently the lifespan of many investment projects in the public sector. 19P.K. McDevitt and K.R. Nowotny, 'High Table 1 illustrates the discount factors which are applied to any future temperature geothermal energy supply
forecasts for the USA', Energy Economics, cost or benefit according to year and rate of discount. Vol 2, No 4, October 1980, pp 223-229 When a project with a 20-year lifespan is considered, a discount rate and M.G. Zimar and L.S. Rosenberg, 'A of 15% means that the discount factor applied to the benefits or costs of comparison of economic evaluation mod- the last year is 0.061. Even when a rate below 10% is used, the range els as applied to geothermal energy tech-
nology', Energy: The International Journal,
Vol 8, part 10, 1983, pp 797-812. 2°ETSU, Strategic Review of the Renewable Energy Technologies: An Economic Assessment, 1982, Energy Technology Support Unit, AERE Harwell Official Re-
most frequently applied in public sector cost-benefit analyses, it can still make a considerable difference to the results of an analysis if extended
over a sufficiently long time span. It is well known that a high discount rate will favour projects with high net benefits in the early years. It should also be evident from Table 1 that costs extending several decades
port, AERE, Harwell, UK, March 1982. DIW-ISI, Abschatzung des Potentials
or even centuries into the future will effectively be ignored by the
Ernererbarek Energiequellen in der Bundesrepublik Deutschland, Deutsches Insti-
application of any positive discount rate. It is this fact that has led one authority to question the scope of cost-benefit analysis:
tut f0r Wirtschaftsforchung, Berlin (DIW), Fraunhofer-lnstitut for Systemtechnik und Innovationsforschung, Berlin, October 1984. lEA, Energy Policies and Programmes of lEA Countries, 1983 Review, OECD, Paris, 1983.
a~Pearce, op cit, Ref 6, p 67.
There must be some doubt as to whether it is suited to any context in which there are effects which are long-lived and potentially significant. The example of persistent eeo-damage may be cited, as might the examples of lead or cadmium,
or, if scientifically proven to be a problem, the accumulation of C02 in the atmosphere. 21 Table 1. Values of discount factors. Number of years from present
Discount rate
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(%)
10
20
30
40
50
3.0 5.0 10.0 15.0 20.0
0.744 0.614 0.386 0.247 0.162
0.554 0.377 0.149 0.061 0.026
0.412 0.231 0.057 0.015 0.004
0.307 0.142 0.022 0.004 0.001
0.228 0.087 0.008 0.001 0.000
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Extending cost-benefit analysis for energy investment
Where a project has benefits and/or costs which extend beyond 50 years, then the application of almost any discount rate will ignore these effects, and thus ignore the interests of future generations. 22 In broad terms this argument may be seen as a case of equity versus efficiency. Solutions
Some earlier critics of cost-benefit analysis have wished either to limit its role, 23 or to replace it altogether, 24 as a technique of investment appraisal. Some favour technology assessment as an alternative to cost-benefit analysis. 25 This approach proposes to incorporate costbenefit analysis as one of its elements: other elements might include technology forecasting, systems analysis and the consideration of social and political factors. However, technology assessment has not yet developed a systematic or unified procedure for the evaluation of projects. Our proposals, as we shall demonstrate in this section, involve the extension of cost-benefit analysis to incorporate a limited number of additional dimensions. Choice of these dimensions is itself a difficult question - we put forward our tentative suggestions based on our experience in examining research priorities in the field of energy technologies. 22T. Page, Conservation and Economic Other alternatives to cost-benefit analysis such as cost-effectiveness Efficiency, Johns Hopkins Press for Re- analysis and cost-utility analysis have also been developed. These sources for the Future, Baltimore, MD, 1977. B. Barry, 'lntergenerational justice in techniques avoid one of the major problems of cost-benefit, ie they do energy policy', in MacLean and Brown, op not require that benefits, often the most intangible elements of a public cit, Ref 17. D.A.J. Richards, 'Contractarian investment project, be valued in monetary terms. A cost-effectiveness theory, intergenerational justice, and ener~3y policy', in MacLean and Brown, ibid. ratio is found by dividing the benefits to a project (valued in physical Maass, op cit, Ref 7, and J.J.C. Brug- units) by the costs (in money terms). Cost-effectiveness ratios for gink, 'Socio-economic aspects of energy various alternative projects are then compared and the one yielding the planning in developing countries: some methodological issues', contribution to a highest ratio, ie greatest benefits per unit of costs, is selected as the most Seminar on Methodology on Energy Plan- cost-effective option. This approach has been used extensively in health ning, Rio de Janeiro, Brazil, 10-14 care, 26 and environmental studies, 27 but suffers from the same September 1984. 24A. de Valle, Cost-Benefit or Technology one-dimensional problem as the technique it purports to replace. Assessment?', Pamphlet Series No 22, Furthermore, in the studies incorporating these techniques a plausible The OPEC Fund for International Develop- alternative numeraire has been present. For example, Kind, Rosser and ment, Geneva, 1982. 25See E. Hetman, Society and the Assess- Williams 28 use psychometric tests to arrive at a consistent numeraire ment of Technology, OECD, Paris, 1973 quality adjusted life years. But there is a very real difference between and OECD, Social Assessment of Tech- proposing psychometric tests (impressive though they are) for studies of nology: A Review of Selected Studies, OECD, Paris, 1978. health care and disability (where test subjects can, without too much 26For example, WHO, Geneva, Cost- difficulty, 'think' themselves into the various proposed situations, eg of Benefit Analysis in Mental Health Services, disability and distress) and proposing them for certain types of Report on a Working Group, The Hague 21-25 June 1976. A.H. Packer, 'Applying environmental issues (eg the possibility of cancerous illnesses occurring cost effectiveness concepts to the com- in the next century because of low-level radioactive waste emissions to munity health system', Operations Re- the seas around us, the climatic effects of continued CO2 build up, search, Vol 16, No 2, 1968. 27L.j. Perl and F.C. Dunbar, 'Cost- particulate emissions and krypton-85 release). Whereas in the former effectiveness and cost-benefit analysis of experience, expertise and the ability to assess familiar occurrences can air quality regulations', AER Papers and be taken as given, in the latter this is obviously not the case. Proceedings, Vol 72, No 2, May 1982, and A.L. Nichols, 'The importance of exposure in evaluating and designing environmental m m u l t i - d i m e n s i o n a l a p p r o a c h regulations: a case study', AER Papers and Proceedings, Vol 72, No 2, May 1982. Our solution to the single-dimensional problem is the adoption of an 2ap. Kind, R. Rosser and A. Williams, explicit multi-dimensional analysis, in which the economic dimension is 'Valuation of quality of life: some supplemented by other dimensions, the parameters of which are treated psychometric evidence', in M.W. JonesLee, ed, The Value of Life and Safety, as being important in their own right. The following example is drawn Elsevier/North Holland, Amsterdam, 1982. from the field of energy, but analogous procedures can be applied in any
222
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Extending cost-benefit analysis for energy inw~stment
field of investment appraisal to which cost-benefit analysis is appropriate. Four dimensions of analysis, the economic, the technical, the risk and the environmental are specifically identified. Only the context indicates the appropriate number of dimensions, which may vary from one field of application to another. Economic analysis. The economic analysis can proceed in the conventional way. It is possible to envisage three separate stages, viz the analysis of financial aspects, economic factors and uncertainty. In the first of these, an analysis of the financial costs and benefits associated with any project or technology is undertaken. This would include the normal discounting procedure based on net present value (NPV) or internal rate of return (IRR) methods (although we would recommend the former in all instances as do most other commentators2')). The second stage incorporates economic factors, eg the social discount rate and shadow prices into the analysis. In this instance shadow prices would be limited to costs and benefits already included under the financial heading, but would allow incorporation of elements such as distributional weights (related to either income or locale), and corrections of market imperfections (eg shadow wage rates and shadow prices for foreign exchange and capital). Finally, uncertainty elenients would be introduced in the third stage. The most uncertain critical variables in the evaluation of energy projects are the choice of discount rate and relative future fuel prices. A sensitivity analysis based on a range of values for these variables would allow the 'limits' (or changeover points) between technologies to be assessed. The risk element involved in the project as a whole, as opposed to the uncertainty attached to the future values of specific variables, is dealt with in a separate dimensional analysis.
290.J. Hawkins and D.W. Pearce, Capital Investment Appraisal, Macmillan, London, 1979. 3°R.E. Munn, ed, Environment Impact
Principles and Procedures, 2 1979. 31L. Leopold et at, 'A procedure for evaluating environmental impact', Geological Survey Circular 645, Government Printing Office, Washington, De, 1971. Battelle Memorial Institute, Environmental Considerationsin Future Energy Growth, Report
Assessment
ed, Scope 5, John Wiley, Chichester,
for the USEPA, Battelle Columbus Laboratories, Columbus, OH, 1973, and R.E.
Munn, ed, opcit, Ref 30.
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Environmental analysis. 'Economic systems aim to maximise gains over the short-term; ecological considerations suggest ways to minimise liabilities over the long-term'. 3° The emergence of environmental interests in the form of pressure groups and political parties has forced the hand of governments over issues such as lead in petrol, nuclear waste storage and emissions of a multitude of pollutants. This trend is reflected in current legislation both in Europe and the USA. The Environmental Policy Act of 1969 made environmental impact statements a necessary concomitant of public (and private) projects. Follow-up statutes from the US federal government have set, among other things, targets for pollution control and similar legislation has been passed in Sweden, France, the Netherlands and Germany. Recently the European Commission announced an initiative to encourage environmental impact assessments for projects within the community. A number of methods have been proposed to handle this issue 31 but none simply enumerate the 'costs and benefits' in a single figure. They all have drawbacks but the Leopold matrix is attractive in its simplicity and its ability to present a great deal of information quickly. The columns of the matrix are characterized by 'actions' and the rows by 'impacts' (of a physical/biological nature mostly but it also includes some social characteristics), 88 in all. The procedure consists of identifying the cells whose impacts occur and scoring in these according to magnitude (preceded by ' + ' or ' - ' depending on whether it is a
223
Extending cost-benefit analysisfor energy investment benefit or a cost) and importance or significance. The procedure has no dynamic qualities nor allowances for uncertainty and therefore these aspects must be clarified in the accompanying text. Clearly this scoring approach leaves much to be desired and begs a number of questions (eg the degree of subjectivity required of the analyst) as well as being open to a number of interpretations depending on prior conceptions. 32 Erroneous impressions, theories, or data processing strategies, therefore, may not be changed through mere exposure to samples of new evidence. It is not contended, of course, that new evidence can never produce change - only that new evidence will produce less change than would be demanded by any logical or rational information-processing model. A more fruitful method of analysis for this, and the next, dimension may be contained in work where non-metric data analysis is employed. 33 • . . these methods provide a sound and operational methodology for a coherent and integrated assessment of multifaceted impacts of all courses of action. 34
Energy technology analysis. Two technical elements (of particular importance in deciding a research strategy) are identified which add a further dimension to energy choice decisions. The first of these is taken from a recent US D e p a r t m e n t of Energy report on research and development into renewables. 35 1
2
32L. Ross, 'The intuitive psychologist and his shortcomings: distortions in the altribution process', in L. Berkowitz, ed, Advances in Experimental Social Psychology,
Academic Press, New York, 1977. 33p. Nijkamp, Multidimensional Spatial Data and Decision Analysis, John Wiley, Sussex, 1979. J.H. Voogd, Multicriteria Evaluation for Urban and Regional Planning, Pion, London, 1983. P. Nijkamp, H. Leitner and N. Wrigley, Measuring the
Unmeasurable, Martinus Nijhoff, The Hague, 1984. up. Nijkamp, 'Information systems for regional development planning', Planning and Design, Vol 10, No 3, 1983, p 2 8 8 . 3sUS Department of Energy, Office of Conservation and Renewable Energy, Renewable Energy Research and Development Outlook, Volume 1, Washington, DC, February 1985.
224
Energy contribution potential. One of the most important criteria in deciding whether or not to invest in a particular technology is the size of that technology's potential contribution to the net energy supply. Details of the method are contained in the D O E report but, in summary, it requires that source to end-use linkages be identified (by sector, eg residential, industrial etc, by type, eg electricity, gas etc, and by discrete end-use, eg heating, lighting etc) along with performance feasibility (the long-term capability of the energy technology to compete with other technologies), resource availability limits and supply/demand mismatching. These components are brought together in a 'score' for each technology under consideration. Quality of supply. Irregular and unpredictable availability of supply, whether diurnal or seasonal, has been, and will continue to be, a significant impediment to the deployment of many energy technologies. However, precise assessments of resources are essential to the adoption of new and unconventional technologies. In many areas, the actual availability and worth of energy options at the local level are not known and therefore use of appropriate technologies is under-utilized• This element of the energy technology analysis would outline the scope, advantages and unique characteristics which each energy technology possesses.
While political factors are inescapable in a project evaluation decision, we believe that these are seldom appropriately quantifiable. So, in a four-dimensional example of an energy investment evaluation, the economic, environmental, risk and technical effects would be quantified where appropriate, and it would be left to the ultimate decision-maker, ie the political or administrative authority, to decide the weights to be assigned to the results of each dimensional analysis. The adoption of a multi-dimensional analysis not only avoids the dubious practice of transforming all other values into economic values,
ENERGY POLICY June 1987
Extending cost-benefit analysis for energy investment
it separates out some of the more important subjective judgments and forces the decision maker to rank these explicitly. This in turn opens the decision maker to more public criticism from a variety of interested sources. Whatever systems of scoring are adopted in these multi-dimensional analyses, it is apparent that the results are not going to be represented by a single parameter - as is the case with conventional cost-benefit analysis. However, we regard this as a positive feature of our proposal for three important reasons: • Major subjective and technical parameters are de-coupled. • Major subjective judgments, such as the weighting of the different dimensions, are made explicitly and are therefore open to scrutiny. • Major subjective judgments must be made by the ultimate decision maker, and not by the analyst. According to the multi-dimensional procedure, analysis proceeds independently in each dimension. How much weight is to be attached to the results of each analysis (ie the relative importance, in our example, of economic, technical, and environmental values) is a matter of explicit judgment on the part of the ultimate decision maker. Of course, the proposed procedure cannot claim completely to have separated all subjective and objective factors. Whatever the field of analysis, many of the technical assessments made in completing the appropriate matrix will remain quite subjective. But this criticism is equally applicable to any ranking or formalization method which deals with the possible effects of any future set of actions. It may be objected that there is no provision in the matrix scoring methods we have suggested for time and uncertainty. The text accompanying the matrix is the appropriate place for this information. A cost-benefit analysis is not an automatic calculating machine producing a final decision but an instrument for organizing and presenting information to a decision maker in a systematic and comprehensive way. It may also be argued that there is a risk of double-counting in a multi-dimensional analysis. No general solution to this problem can be presented, other than alertness on the part of the analyst, but an example may be given from an investment evaluation in the field of energy (this work was commissioned by the European Commission and remains unpublished). Under consideration were a range of energy supply technologies, ie coal, nuclear, oil, renewables, etc, each of which had potential environmental effects. To avoid double-counting, effects were allocated into one of three classes. The first consisted of those effects where occurrence was certain, and where economic costs were meaningful and readily measurable, eg the costs of pollution abatement by flue gas desulphurization and lead emission controls. These costs were assigned to the economic analysis. Second, there were effects which were uncertain in occurrence, and where economic values were either difficult to measure or inappropriate or both. Such effects included low-level radiation or acid rain, and they were assigned to the environmental analysis. Finally, there was the category of effects that were characterized by a remote possibility of occurrence coupled with a catastrophic outcome. These included long-term climatic effects and nuclear accidents, and they were treated as affecting solely the risk element of the project. ERGY POLICY June 1987
225
Extending cost-benefit analysis for energy investment The treatment o f uncertainty and risk
Potential investment projects differ from each other in the degree of risk which is perceived to attach to them. It is tempting to suggest that any assessment might be carried out by according a lower rate of discount to less risky projects. After all, the usual response of a private decision maker to the appraisal of what appears to him to be a risky investment is to increase the rate of discount explicitly or implicitly. However, it is theoretically undesirable to mix a risk measure with a time preference measure. And we can see why. A lower rate of discount would favour some types of energy investments (eg hydro, solar) but not others (eg fossil fuels, and conservation), whereas we wish in our calculation to reward all energy investments given the assumption 36 that all investment in energy sources/ technologies is negatively correlated with movements in GNP, ie investment in energy reduces the variance of the national portfolio. There is a further difficulty. We cannot know the true value of the benefit of the 'insurance' contribution of our hypothetical project without knowing the attitude to risk of the relevant decision-making public authority. It is almost inconceivable that a public authority should be risk-loving, or even risk-neutral. It is safe to assert that the typical public authority would be risk-averse; to a lesser degree than the average citizen, perhaps, but to what precise extent we cannot, in general, determine. These considerations point to the conclusion that risk should itself constitute a further independent dimension of the analysis, in which such factors as we have discussed are brought into focus. The elements of risk and uncertainty which enter into an investment decision can be allocated into one of two categories: (a) elements which are specific to a particular variable, and (b) elements which relate to the investment as a whole. The variable-specific elements can be dealt with within the other individual dimensions of analysis as described in the section above. The project-specific elements, however, should be the subject of the risk dimension analysis itself (perhaps utilizing such methods as fault/event trees and decision analysis37). We have mentioned already two examples which occur in the evaluation of energy investments - the 'insurance' effect of some kinds of investments, and the remote probability of catastrophe associated with others. It is 3BLind et al, op cit, Ref 16. unlikely that a quantitative analysis of risk in these circumstances would 3rH. Raiffa, Decision Analysis: Introductory be very useful. But a formal risk dimension would draw the decision Lectures on Choice Under Uncertainty, maker's attention to these factors. It would remain for him to decide Addison-Wesley, Reading, MA, 1968. R.L. how much weight should be attached to them - as to the other
Keeney and H. Raiffa, Decisions with Multiple Objectives: Preferences and Value Trade-Offs, John Wiley, New York, 1976. M. Zeleny, Multiple Criteria Decision Making, McGraw-Hill, New York, 1982. aSD.H. Meadows et al, The Limits to Growth, Universe Books, New York, 1972. N.Georgescu-Roegen, Energy and Economic Myths, Pergamon, Oxford, 1976. J.
Davoll, in D.F. Durkhardt and W.H. Ittelson, eds, Environmental Assessment of Socio-economic Systems, Plenum Press, New York, 1978. agFer example, W. Beckerman, 'The myth of 'finite' resources', Business and Society Review, Vol 12, 1974-75. J.M. Griffin and H.S. Steele, Energy Economics and Pofi-
cy, Academic Press, New York, 1 9 8 0 . 226
dimensions. The treatment o f discounting
The question facing the public sector decision maker is, whose interests (the present generation or future generations) are of most importance? And, perhaps more fundamentally, is there a real conflict of interests?
Some writers 38 clearly believe there is a conflict and recommend drastic action to redress the balance between consumption (especially of natural resources) and investment; whereas others 39 either think technological change will occur which will compensate for the resource usage or question the rights of future (unborn) generations to consideration in this existence.
Richards explains the concept of intergenerational justice as follows: ENERGY POLICY June 1987
Extending cost-benefit analysis for energy investment In order to consider how to apply the contractarian framework in the context of integenerational justice, we should remind ourselves of the underlying idea the framework is intended to explicate, namely, to treat persons in the way one would oneself reasonably like to be treated. 4~ One practical way of applying the Kantian ethic in this way is to carry out research into potential alternative energy sources (eg renewables and conservation) which are less potentially intergenerationally biased because of their avoidance of the combustion stage of conversion (widely recognized as the point of maximum pollutant emission). A positive real discount rate exacerbates the intergenerational bias when the principle of equal opportunity is not specifically recognized and a fortiori the higher the discount rate the greater will be the potential 'injustice' effects. It is tempting therefore to alter the discount rate when evaluating those projects which are expected to have significant intergenerational effects. But to do this would not only conflict with existing government practice in both the UK and the USA, but would also conflict with accepted theoretical principles which call for a separation of elements of risk from questions of time preference. Accordingly, we suggest that the way to deal with intergenerational bias differs according to whether the foreseeable effects are reasonably certain. If we are talking about the decommissioning costs of a nuclear reactor, it should be sufficient that the generating authority is statutorily obliged to bear these costs, while if we are dealing with less certain, but possibly catastrophic environmental side effects, these should be incorporated in a risk analysis.
Conclusions Cost-benefit analysis is by far the most widely-practiced technique of project appraisal and evaluation. Experience has shown that it has a number of weaknesses, and to overcome some of these for energy investment choices we have in this paper advanced three specific proposals for energy choices. These may be summarized as follows: 1
2
4°Richards, op cit, Ref 22. 4~R. Wilson, 'Risk measurement of p u b l i c projects', in Lind et al, op cit, Ref 16.
ENERGY POLICY June 1987
3
Quantification should be extended from the single economic dimension to three other dimensions (ie the environmental, energy technology and risk). Important subjective judgments should be made by the ultimate (political) decision maker, and not by the analyst. It is, after all, he who must eventually be held politically responsible for decisions. The assessment of risk should include an appraisal of the covariance of the expected returns of the investment under evaluation with those of existing investments. 41
227
Although cost-benefit analysis is still widely practised, because it addresses real and continuing problems, the technique has been frequently called into question. The present paper identifies three major limitations in the technique, and offers suggestions for improvements. While costs and benefits of e n e r g y i n v e s t m e n t s have several dimensions, CBA attempts to give all effects an economic value. This often requires arbitrary and subjective judgments which have discredited the technique. It is proposed that CBA should be extended from the single economic dimension to Include three others, environmental, technical and the analysis of risk. It is suggested that important subjective judgments should be made by the ultimate(political)decision maker, and not by the analyst,
Cost-benefit analysis is still one of the most widely applied tools of economic evaluation in the public decision-making process. Its use in practice can be traced to 1844 when Jules Dupuit, a French engineer, made reference to the benefits of public works.t However, the modern concept of cost-benefit analysis is widely recognized as originating in the 1930s in the USA, where it was first applied to the evaluation of water resource projects. Indeed, a great deal of the early empirical work on cost-benefit can be found in material primarily concerned with water and river resource development. 2 Since these first studies cost-benefit analysis has been employed in a wide range of applications, eg highway development, transport systems, defence, health, education, airport siting, housing and energy choices.
Results and interpretations of these studies have revealed a number of limitations in cost-benefit analysis, which have called the technique into question. Moreover there is a general feeling that cost-benefit analysis can be used to produce almost any result desired by the analyst to suit his own prejudices or the interests of his sponsor: ~ Keywords: Cost-benefit analysis; Energy Cost-benefit analysis is nevertheless enjoying a vogue amongst investment decisions; Environment applied practitioners, not all of whom are economists with experience in The authors are with the Department of modelling. This is not surprising since cost-benefit analysis addresses a Economics and The Fraser of Allander continuing real problem - the need on the part of public authorities to Institute, University of Strathclyde, 100 Cathedral Street, Glasgow G40LN, Scot- make investment choices. The pressing budgetary constraints of land. governments everywhere, coupled with insatiable expectations on the The authors are deeply grateful to Donald part of their electorates, have meant that an increasing sophistication is Bain, Richard Brooks, Anthony Clunies required about the potential implications of public investment decisions. Ross, David Pearce, Alex Scott and Alan However unsatisfactory may be the present state of cost-benefit Williams for their comments on an earlier analysis, for many such choices there is no alternative method of version of this paper. The authors are solely responsible for the views expressed in the paper,
organizing the desired information which is evidently superior, readily available or widely accepted.
1jules Dupuit, 'On the measurement of the utilityof public works', InternationalEconomic Papers 2, (translated from the French Annals des Ponts et Chassees, 2nd Series, Vol 8, 1844) 1952. 2For example, O. Eckstein, Water Resource Development, Harvard University
As its title suggests, the purpose of this paper is to propose some pragmatic modifications to the existing methods of cost-benefit analysis for evaluating energy choices. In the following section, three specific weaknesses in present practice are identified and discussed. They are: the exclusive concern with economic values, the treatment of uncertainty, and the neglect of intergenerational effects. Appropriate remedies
continued on p 218
are proposed in the third section of the paper, while a summary of these proposals is given in the fourth and final section.
Press, Cambridge, MA, 1958. O. Eckstein and J. Krutilla, Multiple Purpose River
0301-4215/87/030217-11 $03.00 © 1987 Butterworth & Co (Publishers) Ltd
21 7
Extending cost-benefit analysis for energy investment
Problems The one-dimensional nature o f cost-benefit analysis
When we are discussing investment in the field of energy, both costs and benefits have more than one dimension. Yet traditional cost-benefit analysis attempts to reduce everything to a single dimension - the monetary value of the potential effect (whether cost or benefit). It may be true that everything has a monetary value, or that a monetary value can be attributed to everything, but the fundamental weakness of the one-dimensional approach is that economic values may be inappropriate in many particularly contentious cases (eg valuing human life, threats to civil liberties, environmental bads or epidemiological effects), and consequently that these may result in incorrect decisions being indicated. 4 Moreover, the attempt to transform every potentially significant effect into monetary values requires an arbitrary and subjective judgment on the part of the analyst• With regard to energy, many conversion activities have potentially degrading effects on the environment. While some of these costs can adequately be represented by such monetary values as the cost of abatement, others cannot. Classic examples include thermal pollution from nuclear power plants (leading to reduced oxygen carrying capacity in waterways), particulate and noxious chemical emissions from fossil fuel fired power stations with their consequences for public health and the possibility of catastrophic climatic effects from energy sources, eg continued from p 217 the build up of C 0 2 leading to the 'greenhouse' effect. Development, Johns Hopkins Press, BaltiPearce argues that ecological stability ( i e a biological or physical more, MD, 1958. J. Hirschleifer, J. De Haven and J. Milliman, Water Supply: Economics Technology and Policy, University of Chicago Press, Chicago, IL, 1960. Water Resources Council, Proce-
dimension) has to be introduced as a constraint into the decision process over and above purely economic considerations, s In a later paper, 6 the
same author is sceptical of the ability of cost-benefit analysis, confined
dures for Evaluation of Water and Related
to economic values alone, to handle issues associated with nuclear waste
Land Resource Projects, Water Resources
Council, Washington, DC, USA, June 1969.
disposal. On questions of civil liberties and nuclear proliferation (both issues which can arise from the building of a nuclear waste reproce'ssing
LXXX, No 2, May 1966. 8A. Wildavsky, 'The political economy of efficiency: cost-benefit analysis, systems
factors 'a serious deficiency'• 8 Williams disagrees with this approach and advocates the use of shadow prices to bring information from the fields of science, politics etc into the realm of economic analysis. 9
• Williams, 'Cost-benefit analysis: bastard science? and/or insidious poison in the body politick', Journal ofPublicEconotalcs, Vol 1, No 2, August 1972.
non-economic variables, economists create the possibility of a range of quite arbitrary values entering the analysis, thus discrediting it as a technique. Furthermore, economists may not be best qualified to evaluate non-economic variables, and decision makers may be sceptical
3See L. Merewitz and S.H. Sosnick, The Budget's New Clothes: a Critique of plant) economic values are certainly not the only, and perhaps not even Planning-Programming-Budgeting and the most important, consideration. Benefit-Cost Analysis, Chicago, IL, M a r Pearce's extension of decision taking criteria to include physical and, kham 1971, on the California Water Project and the Federal Aviation Authority's indeed, political dimensions is echoed elsewhere. For example, Maass 7 supersonic air transport programme and writes: E.M. Gramlich, Benefit-Cost Analysis of Government Programs, Prentice-Hall, NJ, Where government programmes are intended for complex objectives they USA, 1981, on the Tellico Dam project. 4D.W. Pearce, 'The limits of cost-benefit should be designed, where this is possible, for such objectives, not designed for analysis as a guide to environmental poll- one objective (economic efficiency) which may not be the most important, and cy, Kyklos, Vol 29, Fax 2, 1 9 7 6 . subsequently modified in an effort to account for others. 7 51bid. 6D.W. Pearce, 'Social cost-benefit analy- Support for the addition of a political dimension to cost-benefit analysis sis and nuclear futures', Energy Economics, Vol 1, No2, April 1979, pp66-71, also comes from Wildavsky who, while recognizing the merit of 7A. Maass, 'Benefit-cost analysis: its rele- cost-benefit analysis as a tool which can make implicit judgments vance to public investment decisions', explicit and subject to analysis, considers the omission of political Quarterly Journal of Economics, Vol
analysis and program budgeting', Public Administration Review, Vol 26, No 4, Au~Aust1966.
218
It is our view, however, that by attempting to put shadow prices on
E N E R G Y POLICY June 1987
Extending cost-benefit analysis for energy investment
of their attempts to do so. Indeed, even although economic considerations may be the most important ones in an investment decision, they are not the only ones which are taken into account in practice. The attempted economic valuation of such intangibles as travelling time, pollution, noise and human life has brought about some of the strongest criticisms of cost-benefit analysis. 1' The specification of costs and benefits in a single dimension - the economic one - has the apparent advantage that the result of the analysis is expressed in a single parameter, the difference between the net present value of the costs and the benefits. In practice, the results of a cost-benefit analysis constitute only one ingredient of the decision albeit an important one. The ingredients of a public investment decision are multi-dimensional, and a modified cost-benefit analysis should recognize this explicitly. Thus, a serious consequence of the single-dimensional approach of conventional cost-benefit analysis is that differences between hard and soft data are obliterated, giving rise, in Dorfman's famous metaphor, 1~ to the 'rabbit-and-horse stew' situation, where the relatively harder valuations (the rabbit) are swamped by the larger but 'softer' subjective valuations (the horse) made by the analyst. It is impossible for the ultimate consumer (the commissioning public authority) to discern the flavour of the rabbit because of the predominance of the flavour of the horse. ~2 1°For example, G.H. Peters, Cost-Benefit Quantification in a single dimension means that data of varying Analysis and Public Expenditure, Institute degrees of reliability and measurability are mixed together inextricably. of Economic Affairs, London, 1973. E.J. In particular: Mishan, 'What is wrong with Roskill?', Journal of Transport Economics and Policy, Vol 4, No 3, 1970. P. Self, 'Nonsense
•
subjective judgments to which the overall result may be sensitive
•
are thereby concealed, and subjective judgments are made by the analyst rather than by the
on stilts: cost-benefit analysis and the
Roskill Commission', Political Quarterly,
Vol 41, No 3, July 1970. P. Self, Econocrats and the Policy Process: The Politics and Philosophy of Cost-Benefit Analysis, Macmillan, London, 1975. R. Dinkel, 'Cost-benefit analysis: a helpful tool for decision-makers', paper presented at the 3rd International Conference on System Science in Health Care, 1984.
t~R. Dorfman, ed, Measuring Benefits of Govemrnent Investments, The Brookings Institute, Washington, DC, 1965. ~2Fries warns against this type of distinction showing that, in some cases, eg arthritis clinical trials, reliance on 'hard'
ultimate decision maker. Uncertainty and risk Since it concerns the future, every element which enters the evaluation
of any proposed investment is necessarily uncertain. Such elements can differ from each other in two important respects. First, a sensitivity analysis can show that variation in the values of only a limited number of variables are critical to the outcome of a cost-benefit analysis. Thus, energy investment appraisals are usually critically sensitive to the choice of discount rate as well as to future relative fuel prices. Second, the
data has been replaced by 'soft' measures, ie patient complaints. However, he extent and nature of the uncertainty surrounding each of the critical finds the terms acceptable if 'used to refer variables differs. to the actual measurement characteristics When the future value of a sensitive variable is uncertain, it is often of a variable rather than to the origin of the data (the laboratory or from the patient)',
(J.F. Fries, 'Toward an understanding of patient outcome measurement', Arthritis
and Rheumatism, Vol 26, No 6, June 1983). It is with this definition in mind that
we use these terms, ~3N. Lucas and D. Papaconstantinou, 'Energy planning under uncertainty', Energy Policy, Vol 11, No 3, September 1983, pp 204-216.
~4C.W. Hope, 'Assessing renewable ener-
gy research and development', Energy: The International Journal, Vol 7, No 4, 1982, pp 319-334.
E N E R G Y P O L I C Y June 1987
suggested that a probability distribution should be used instead of a single-valued estimate. Such a distribution might be objectively based on past experience as, for example, estimates of system load and thermal efficiency in an electricity generating network or of plant
lifetime. In the great majority of cases, however, the evidence for an objectively-based probability distribution is lacking, and a subjectively." based probability distribution is often recommended in its place. While elegant mathematical forms, such as truncated normal distributions t3 and subjective probabilistic analysis, 14 have been proposed, the fact remains that one expert's judgment can and does differ from another's, and we shall never know in advance which is correct.
219
Extending cost-benefit analysis for energy investment
15See J. Tobin, 'Liquidity preference as behaviour towards risk', The Review of Economics Studies, Vol XXV, February 1958 and J. "robin, 'The theory of portfolio
selection', in F.H. Hahn and E.P. Brechling, eds, The Theory of Interest Rates, International Economic Association, London, 1965.
220
The most common approach is for the analyst to propose a range of possible future values for the sensitive variable or variables, with or without a single central or most likely value. But if he chooses a wide range of values, the results will be of little assistance to the decision maker, while if he chooses a narrow range, he may be quite wrong. The fact is that mathematical formulations do not reduce our ignorance about the future, they merely formalize it. Whatever efforts we expend, there will remain elements of irreducible uncertainty about the future. We should begin by accepting this. Decision makers should therefore be cautious about accepting any single-valued parameter representing the outcome of a cost-benefit analysis. In addition to the general uncertainty about the future, it may be clear that some prospective investments, in the public as well as in the private sector, are riskier than others. The risk of an investment is often measured by the variability or dispersion of the probability distribution of its outcomes. From the point of view of an individual acquiring a financial asset, however, the riskiness of that asset by itself may be of little concern: what is important is its effect on the overall riskiness of his whole portfolio.15 He is interested.in the variability of any single component of a portfolio only insofar as it effects the variability of the total portfolio. Therefore, the covariance of the outcomes of the asset with those of the rest of the individual's portfolio becomes the accepted measure of risk. If the covariance of the two is positive, then the dispersion of the range of outcomes would be widened. In other words, the riskiness of the total portfolio would be increased by the acquisition of the proposed asset. If the covariance was zero there would be no change in risk, but if the two probability distributions were negatively correlated, then the overall risk of the total portfolio would be reduced, and the acquisition of the proposed asset would take on the characteristic of an act of insurance. The same principle is true if one looks at a 'portfolio' of investments as seen from the point of view of the nation as a whole. The riskiness of a public investment that constitutes a small fraction of national income (where national income is regarded as the return on all the nation's investments) depends, from the perspective of the national economy, on the covariance of its return with national income. If the returns to the proposed investment have a positive covariance with national income, it will involve some risk, if they have a zero covariance the risk is minimal, while if there is a negative correlation then the investment has the characteristic of insurance from a national perspective. To take an example of a proposed investment having the effect of increasing the energy supply, then it is likely that the higher are future energy prices, the greater will be the returns to this investment. But higher energy prices tend to be associated with lower than otherwise levels of national income, because of the recessions which are provoked by abrupt increases in such prices. If the returns to energy investments were correlated negatively with the returns to other investments they would constitute risk-reducing projects, ie national 'insurance policies' for the future. If this is the case, the question is: how is this contribution to a reduction in risk to be reflected in an investment appraisal exercise, such as a modified cost-benefit analysis? In private decision making risk is usually accounted for by explicitly or implicitly (eg by the use of the so-called 'pay-back' period method) altering the discount rate, so that effectively a higher rate of discount is
E N E R G Y P O L I C Y June 1987
Extending cost-benefit analysis for energy investment
applied to those projects which are thought to be more risky. Theoretically, it is improper to mix up questions of time preference with questions of risk, but this has not deterred private practitioners, not only households and smaller firms, but even large firms in the energy sector, from doing so. ~ I n t e r - g e n e r a t i o n a l bias
While the principle of discounting future streams of costs and benefits on the grounds of time preference or capital productivity has been widely accepted by economists, despite the occasional philosophical protest, t7 the practice of applying this procedure far into the future can lead to problems. There is a similar conflict between principle and practice in the choice of discount rate. It is possible that a different rate of discount may be appropriate for every project, ~ but practitioners insist that a single rate of discount must be used for evaluating competing projects. However, in the public sector, it is common to find that discount rates used in investment appraisal calculations are 16R.0. Lindet al, Discounting for Time and between one half and one third of the rates used in the private sector, eg Risk in Energy Policy, Resources for the Future, Washington, De, 1982. compare the 15% rate proposed for evaluating geothermal energy l~For example, A.C. Pigou, The Econo- projects 19 with the range of rates (0.5% to 10%) advised by public mics of Welfare, 4 ed, Macmillan, London sector energy evaluators. 2°
1932 and D. Parfit, 'Energy policy and the further future: the social discount rate', in D. MacLean and P.G. Brown, eds, Energy and the Future, Rowman and Littlefield, Totowa, N J, 1983,
It is not our purpose in this paper to enter into the question of the choice of discount rate, but rather to discuss the consequences of applying any discount rate over a period of 20 years or more, which is
lSLind et al, op cit, Ref 16, p 4 4 3 . frequently the lifespan of many investment projects in the public sector. 19P.K. McDevitt and K.R. Nowotny, 'High Table 1 illustrates the discount factors which are applied to any future temperature geothermal energy supply
forecasts for the USA', Energy Economics, cost or benefit according to year and rate of discount. Vol 2, No 4, October 1980, pp 223-229 When a project with a 20-year lifespan is considered, a discount rate and M.G. Zimar and L.S. Rosenberg, 'A of 15% means that the discount factor applied to the benefits or costs of comparison of economic evaluation mod- the last year is 0.061. Even when a rate below 10% is used, the range els as applied to geothermal energy tech-
nology', Energy: The International Journal,
Vol 8, part 10, 1983, pp 797-812. 2°ETSU, Strategic Review of the Renewable Energy Technologies: An Economic Assessment, 1982, Energy Technology Support Unit, AERE Harwell Official Re-
most frequently applied in public sector cost-benefit analyses, it can still make a considerable difference to the results of an analysis if extended
over a sufficiently long time span. It is well known that a high discount rate will favour projects with high net benefits in the early years. It should also be evident from Table 1 that costs extending several decades
port, AERE, Harwell, UK, March 1982. DIW-ISI, Abschatzung des Potentials
or even centuries into the future will effectively be ignored by the
Ernererbarek Energiequellen in der Bundesrepublik Deutschland, Deutsches Insti-
application of any positive discount rate. It is this fact that has led one authority to question the scope of cost-benefit analysis:
tut f0r Wirtschaftsforchung, Berlin (DIW), Fraunhofer-lnstitut for Systemtechnik und Innovationsforschung, Berlin, October 1984. lEA, Energy Policies and Programmes of lEA Countries, 1983 Review, OECD, Paris, 1983.
a~Pearce, op cit, Ref 6, p 67.
There must be some doubt as to whether it is suited to any context in which there are effects which are long-lived and potentially significant. The example of persistent eeo-damage may be cited, as might the examples of lead or cadmium,
or, if scientifically proven to be a problem, the accumulation of C02 in the atmosphere. 21 Table 1. Values of discount factors. Number of years from present
Discount rate
ENERGY POLICY June 1987
(%)
10
20
30
40
50
3.0 5.0 10.0 15.0 20.0
0.744 0.614 0.386 0.247 0.162
0.554 0.377 0.149 0.061 0.026
0.412 0.231 0.057 0.015 0.004
0.307 0.142 0.022 0.004 0.001
0.228 0.087 0.008 0.001 0.000
221
Extending cost-benefit analysis for energy investment
Where a project has benefits and/or costs which extend beyond 50 years, then the application of almost any discount rate will ignore these effects, and thus ignore the interests of future generations. 22 In broad terms this argument may be seen as a case of equity versus efficiency. Solutions
Some earlier critics of cost-benefit analysis have wished either to limit its role, 23 or to replace it altogether, 24 as a technique of investment appraisal. Some favour technology assessment as an alternative to cost-benefit analysis. 25 This approach proposes to incorporate costbenefit analysis as one of its elements: other elements might include technology forecasting, systems analysis and the consideration of social and political factors. However, technology assessment has not yet developed a systematic or unified procedure for the evaluation of projects. Our proposals, as we shall demonstrate in this section, involve the extension of cost-benefit analysis to incorporate a limited number of additional dimensions. Choice of these dimensions is itself a difficult question - we put forward our tentative suggestions based on our experience in examining research priorities in the field of energy technologies. 22T. Page, Conservation and Economic Other alternatives to cost-benefit analysis such as cost-effectiveness Efficiency, Johns Hopkins Press for Re- analysis and cost-utility analysis have also been developed. These sources for the Future, Baltimore, MD, 1977. B. Barry, 'lntergenerational justice in techniques avoid one of the major problems of cost-benefit, ie they do energy policy', in MacLean and Brown, op not require that benefits, often the most intangible elements of a public cit, Ref 17. D.A.J. Richards, 'Contractarian investment project, be valued in monetary terms. A cost-effectiveness theory, intergenerational justice, and ener~3y policy', in MacLean and Brown, ibid. ratio is found by dividing the benefits to a project (valued in physical Maass, op cit, Ref 7, and J.J.C. Brug- units) by the costs (in money terms). Cost-effectiveness ratios for gink, 'Socio-economic aspects of energy various alternative projects are then compared and the one yielding the planning in developing countries: some methodological issues', contribution to a highest ratio, ie greatest benefits per unit of costs, is selected as the most Seminar on Methodology on Energy Plan- cost-effective option. This approach has been used extensively in health ning, Rio de Janeiro, Brazil, 10-14 care, 26 and environmental studies, 27 but suffers from the same September 1984. 24A. de Valle, Cost-Benefit or Technology one-dimensional problem as the technique it purports to replace. Assessment?', Pamphlet Series No 22, Furthermore, in the studies incorporating these techniques a plausible The OPEC Fund for International Develop- alternative numeraire has been present. For example, Kind, Rosser and ment, Geneva, 1982. 25See E. Hetman, Society and the Assess- Williams 28 use psychometric tests to arrive at a consistent numeraire ment of Technology, OECD, Paris, 1973 quality adjusted life years. But there is a very real difference between and OECD, Social Assessment of Tech- proposing psychometric tests (impressive though they are) for studies of nology: A Review of Selected Studies, OECD, Paris, 1978. health care and disability (where test subjects can, without too much 26For example, WHO, Geneva, Cost- difficulty, 'think' themselves into the various proposed situations, eg of Benefit Analysis in Mental Health Services, disability and distress) and proposing them for certain types of Report on a Working Group, The Hague 21-25 June 1976. A.H. Packer, 'Applying environmental issues (eg the possibility of cancerous illnesses occurring cost effectiveness concepts to the com- in the next century because of low-level radioactive waste emissions to munity health system', Operations Re- the seas around us, the climatic effects of continued CO2 build up, search, Vol 16, No 2, 1968. 27L.j. Perl and F.C. Dunbar, 'Cost- particulate emissions and krypton-85 release). Whereas in the former effectiveness and cost-benefit analysis of experience, expertise and the ability to assess familiar occurrences can air quality regulations', AER Papers and be taken as given, in the latter this is obviously not the case. Proceedings, Vol 72, No 2, May 1982, and A.L. Nichols, 'The importance of exposure in evaluating and designing environmental m m u l t i - d i m e n s i o n a l a p p r o a c h regulations: a case study', AER Papers and Proceedings, Vol 72, No 2, May 1982. Our solution to the single-dimensional problem is the adoption of an 2ap. Kind, R. Rosser and A. Williams, explicit multi-dimensional analysis, in which the economic dimension is 'Valuation of quality of life: some supplemented by other dimensions, the parameters of which are treated psychometric evidence', in M.W. JonesLee, ed, The Value of Life and Safety, as being important in their own right. The following example is drawn Elsevier/North Holland, Amsterdam, 1982. from the field of energy, but analogous procedures can be applied in any
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Extending cost-benefit analysis for energy inw~stment
field of investment appraisal to which cost-benefit analysis is appropriate. Four dimensions of analysis, the economic, the technical, the risk and the environmental are specifically identified. Only the context indicates the appropriate number of dimensions, which may vary from one field of application to another. Economic analysis. The economic analysis can proceed in the conventional way. It is possible to envisage three separate stages, viz the analysis of financial aspects, economic factors and uncertainty. In the first of these, an analysis of the financial costs and benefits associated with any project or technology is undertaken. This would include the normal discounting procedure based on net present value (NPV) or internal rate of return (IRR) methods (although we would recommend the former in all instances as do most other commentators2')). The second stage incorporates economic factors, eg the social discount rate and shadow prices into the analysis. In this instance shadow prices would be limited to costs and benefits already included under the financial heading, but would allow incorporation of elements such as distributional weights (related to either income or locale), and corrections of market imperfections (eg shadow wage rates and shadow prices for foreign exchange and capital). Finally, uncertainty elenients would be introduced in the third stage. The most uncertain critical variables in the evaluation of energy projects are the choice of discount rate and relative future fuel prices. A sensitivity analysis based on a range of values for these variables would allow the 'limits' (or changeover points) between technologies to be assessed. The risk element involved in the project as a whole, as opposed to the uncertainty attached to the future values of specific variables, is dealt with in a separate dimensional analysis.
290.J. Hawkins and D.W. Pearce, Capital Investment Appraisal, Macmillan, London, 1979. 3°R.E. Munn, ed, Environment Impact
Principles and Procedures, 2 1979. 31L. Leopold et at, 'A procedure for evaluating environmental impact', Geological Survey Circular 645, Government Printing Office, Washington, De, 1971. Battelle Memorial Institute, Environmental Considerationsin Future Energy Growth, Report
Assessment
ed, Scope 5, John Wiley, Chichester,
for the USEPA, Battelle Columbus Laboratories, Columbus, OH, 1973, and R.E.
Munn, ed, opcit, Ref 30.
ENERGY POLICY June 1987
Environmental analysis. 'Economic systems aim to maximise gains over the short-term; ecological considerations suggest ways to minimise liabilities over the long-term'. 3° The emergence of environmental interests in the form of pressure groups and political parties has forced the hand of governments over issues such as lead in petrol, nuclear waste storage and emissions of a multitude of pollutants. This trend is reflected in current legislation both in Europe and the USA. The Environmental Policy Act of 1969 made environmental impact statements a necessary concomitant of public (and private) projects. Follow-up statutes from the US federal government have set, among other things, targets for pollution control and similar legislation has been passed in Sweden, France, the Netherlands and Germany. Recently the European Commission announced an initiative to encourage environmental impact assessments for projects within the community. A number of methods have been proposed to handle this issue 31 but none simply enumerate the 'costs and benefits' in a single figure. They all have drawbacks but the Leopold matrix is attractive in its simplicity and its ability to present a great deal of information quickly. The columns of the matrix are characterized by 'actions' and the rows by 'impacts' (of a physical/biological nature mostly but it also includes some social characteristics), 88 in all. The procedure consists of identifying the cells whose impacts occur and scoring in these according to magnitude (preceded by ' + ' or ' - ' depending on whether it is a
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Extending cost-benefit analysisfor energy investment benefit or a cost) and importance or significance. The procedure has no dynamic qualities nor allowances for uncertainty and therefore these aspects must be clarified in the accompanying text. Clearly this scoring approach leaves much to be desired and begs a number of questions (eg the degree of subjectivity required of the analyst) as well as being open to a number of interpretations depending on prior conceptions. 32 Erroneous impressions, theories, or data processing strategies, therefore, may not be changed through mere exposure to samples of new evidence. It is not contended, of course, that new evidence can never produce change - only that new evidence will produce less change than would be demanded by any logical or rational information-processing model. A more fruitful method of analysis for this, and the next, dimension may be contained in work where non-metric data analysis is employed. 33 • . . these methods provide a sound and operational methodology for a coherent and integrated assessment of multifaceted impacts of all courses of action. 34
Energy technology analysis. Two technical elements (of particular importance in deciding a research strategy) are identified which add a further dimension to energy choice decisions. The first of these is taken from a recent US D e p a r t m e n t of Energy report on research and development into renewables. 35 1
2
32L. Ross, 'The intuitive psychologist and his shortcomings: distortions in the altribution process', in L. Berkowitz, ed, Advances in Experimental Social Psychology,
Academic Press, New York, 1977. 33p. Nijkamp, Multidimensional Spatial Data and Decision Analysis, John Wiley, Sussex, 1979. J.H. Voogd, Multicriteria Evaluation for Urban and Regional Planning, Pion, London, 1983. P. Nijkamp, H. Leitner and N. Wrigley, Measuring the
Unmeasurable, Martinus Nijhoff, The Hague, 1984. up. Nijkamp, 'Information systems for regional development planning', Planning and Design, Vol 10, No 3, 1983, p 2 8 8 . 3sUS Department of Energy, Office of Conservation and Renewable Energy, Renewable Energy Research and Development Outlook, Volume 1, Washington, DC, February 1985.
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Energy contribution potential. One of the most important criteria in deciding whether or not to invest in a particular technology is the size of that technology's potential contribution to the net energy supply. Details of the method are contained in the D O E report but, in summary, it requires that source to end-use linkages be identified (by sector, eg residential, industrial etc, by type, eg electricity, gas etc, and by discrete end-use, eg heating, lighting etc) along with performance feasibility (the long-term capability of the energy technology to compete with other technologies), resource availability limits and supply/demand mismatching. These components are brought together in a 'score' for each technology under consideration. Quality of supply. Irregular and unpredictable availability of supply, whether diurnal or seasonal, has been, and will continue to be, a significant impediment to the deployment of many energy technologies. However, precise assessments of resources are essential to the adoption of new and unconventional technologies. In many areas, the actual availability and worth of energy options at the local level are not known and therefore use of appropriate technologies is under-utilized• This element of the energy technology analysis would outline the scope, advantages and unique characteristics which each energy technology possesses.
While political factors are inescapable in a project evaluation decision, we believe that these are seldom appropriately quantifiable. So, in a four-dimensional example of an energy investment evaluation, the economic, environmental, risk and technical effects would be quantified where appropriate, and it would be left to the ultimate decision-maker, ie the political or administrative authority, to decide the weights to be assigned to the results of each dimensional analysis. The adoption of a multi-dimensional analysis not only avoids the dubious practice of transforming all other values into economic values,
ENERGY POLICY June 1987
Extending cost-benefit analysis for energy investment
it separates out some of the more important subjective judgments and forces the decision maker to rank these explicitly. This in turn opens the decision maker to more public criticism from a variety of interested sources. Whatever systems of scoring are adopted in these multi-dimensional analyses, it is apparent that the results are not going to be represented by a single parameter - as is the case with conventional cost-benefit analysis. However, we regard this as a positive feature of our proposal for three important reasons: • Major subjective and technical parameters are de-coupled. • Major subjective judgments, such as the weighting of the different dimensions, are made explicitly and are therefore open to scrutiny. • Major subjective judgments must be made by the ultimate decision maker, and not by the analyst. According to the multi-dimensional procedure, analysis proceeds independently in each dimension. How much weight is to be attached to the results of each analysis (ie the relative importance, in our example, of economic, technical, and environmental values) is a matter of explicit judgment on the part of the ultimate decision maker. Of course, the proposed procedure cannot claim completely to have separated all subjective and objective factors. Whatever the field of analysis, many of the technical assessments made in completing the appropriate matrix will remain quite subjective. But this criticism is equally applicable to any ranking or formalization method which deals with the possible effects of any future set of actions. It may be objected that there is no provision in the matrix scoring methods we have suggested for time and uncertainty. The text accompanying the matrix is the appropriate place for this information. A cost-benefit analysis is not an automatic calculating machine producing a final decision but an instrument for organizing and presenting information to a decision maker in a systematic and comprehensive way. It may also be argued that there is a risk of double-counting in a multi-dimensional analysis. No general solution to this problem can be presented, other than alertness on the part of the analyst, but an example may be given from an investment evaluation in the field of energy (this work was commissioned by the European Commission and remains unpublished). Under consideration were a range of energy supply technologies, ie coal, nuclear, oil, renewables, etc, each of which had potential environmental effects. To avoid double-counting, effects were allocated into one of three classes. The first consisted of those effects where occurrence was certain, and where economic costs were meaningful and readily measurable, eg the costs of pollution abatement by flue gas desulphurization and lead emission controls. These costs were assigned to the economic analysis. Second, there were effects which were uncertain in occurrence, and where economic values were either difficult to measure or inappropriate or both. Such effects included low-level radiation or acid rain, and they were assigned to the environmental analysis. Finally, there was the category of effects that were characterized by a remote possibility of occurrence coupled with a catastrophic outcome. These included long-term climatic effects and nuclear accidents, and they were treated as affecting solely the risk element of the project. ERGY POLICY June 1987
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Extending cost-benefit analysis for energy investment The treatment o f uncertainty and risk
Potential investment projects differ from each other in the degree of risk which is perceived to attach to them. It is tempting to suggest that any assessment might be carried out by according a lower rate of discount to less risky projects. After all, the usual response of a private decision maker to the appraisal of what appears to him to be a risky investment is to increase the rate of discount explicitly or implicitly. However, it is theoretically undesirable to mix a risk measure with a time preference measure. And we can see why. A lower rate of discount would favour some types of energy investments (eg hydro, solar) but not others (eg fossil fuels, and conservation), whereas we wish in our calculation to reward all energy investments given the assumption 36 that all investment in energy sources/ technologies is negatively correlated with movements in GNP, ie investment in energy reduces the variance of the national portfolio. There is a further difficulty. We cannot know the true value of the benefit of the 'insurance' contribution of our hypothetical project without knowing the attitude to risk of the relevant decision-making public authority. It is almost inconceivable that a public authority should be risk-loving, or even risk-neutral. It is safe to assert that the typical public authority would be risk-averse; to a lesser degree than the average citizen, perhaps, but to what precise extent we cannot, in general, determine. These considerations point to the conclusion that risk should itself constitute a further independent dimension of the analysis, in which such factors as we have discussed are brought into focus. The elements of risk and uncertainty which enter into an investment decision can be allocated into one of two categories: (a) elements which are specific to a particular variable, and (b) elements which relate to the investment as a whole. The variable-specific elements can be dealt with within the other individual dimensions of analysis as described in the section above. The project-specific elements, however, should be the subject of the risk dimension analysis itself (perhaps utilizing such methods as fault/event trees and decision analysis37). We have mentioned already two examples which occur in the evaluation of energy investments - the 'insurance' effect of some kinds of investments, and the remote probability of catastrophe associated with others. It is 3BLind et al, op cit, Ref 16. unlikely that a quantitative analysis of risk in these circumstances would 3rH. Raiffa, Decision Analysis: Introductory be very useful. But a formal risk dimension would draw the decision Lectures on Choice Under Uncertainty, maker's attention to these factors. It would remain for him to decide Addison-Wesley, Reading, MA, 1968. R.L. how much weight should be attached to them - as to the other
Keeney and H. Raiffa, Decisions with Multiple Objectives: Preferences and Value Trade-Offs, John Wiley, New York, 1976. M. Zeleny, Multiple Criteria Decision Making, McGraw-Hill, New York, 1982. aSD.H. Meadows et al, The Limits to Growth, Universe Books, New York, 1972. N.Georgescu-Roegen, Energy and Economic Myths, Pergamon, Oxford, 1976. J.
Davoll, in D.F. Durkhardt and W.H. Ittelson, eds, Environmental Assessment of Socio-economic Systems, Plenum Press, New York, 1978. agFer example, W. Beckerman, 'The myth of 'finite' resources', Business and Society Review, Vol 12, 1974-75. J.M. Griffin and H.S. Steele, Energy Economics and Pofi-
cy, Academic Press, New York, 1 9 8 0 . 226
dimensions. The treatment o f discounting
The question facing the public sector decision maker is, whose interests (the present generation or future generations) are of most importance? And, perhaps more fundamentally, is there a real conflict of interests?
Some writers 38 clearly believe there is a conflict and recommend drastic action to redress the balance between consumption (especially of natural resources) and investment; whereas others 39 either think technological change will occur which will compensate for the resource usage or question the rights of future (unborn) generations to consideration in this existence.
Richards explains the concept of intergenerational justice as follows: ENERGY POLICY June 1987
Extending cost-benefit analysis for energy investment In order to consider how to apply the contractarian framework in the context of integenerational justice, we should remind ourselves of the underlying idea the framework is intended to explicate, namely, to treat persons in the way one would oneself reasonably like to be treated. 4~ One practical way of applying the Kantian ethic in this way is to carry out research into potential alternative energy sources (eg renewables and conservation) which are less potentially intergenerationally biased because of their avoidance of the combustion stage of conversion (widely recognized as the point of maximum pollutant emission). A positive real discount rate exacerbates the intergenerational bias when the principle of equal opportunity is not specifically recognized and a fortiori the higher the discount rate the greater will be the potential 'injustice' effects. It is tempting therefore to alter the discount rate when evaluating those projects which are expected to have significant intergenerational effects. But to do this would not only conflict with existing government practice in both the UK and the USA, but would also conflict with accepted theoretical principles which call for a separation of elements of risk from questions of time preference. Accordingly, we suggest that the way to deal with intergenerational bias differs according to whether the foreseeable effects are reasonably certain. If we are talking about the decommissioning costs of a nuclear reactor, it should be sufficient that the generating authority is statutorily obliged to bear these costs, while if we are dealing with less certain, but possibly catastrophic environmental side effects, these should be incorporated in a risk analysis.
Conclusions Cost-benefit analysis is by far the most widely-practiced technique of project appraisal and evaluation. Experience has shown that it has a number of weaknesses, and to overcome some of these for energy investment choices we have in this paper advanced three specific proposals for energy choices. These may be summarized as follows: 1
2
4°Richards, op cit, Ref 22. 4~R. Wilson, 'Risk measurement of p u b l i c projects', in Lind et al, op cit, Ref 16.
ENERGY POLICY June 1987
3
Quantification should be extended from the single economic dimension to three other dimensions (ie the environmental, energy technology and risk). Important subjective judgments should be made by the ultimate (political) decision maker, and not by the analyst. It is, after all, he who must eventually be held politically responsible for decisions. The assessment of risk should include an appraisal of the covariance of the expected returns of the investment under evaluation with those of existing investments. 41
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