Reconciling sustainability and discounting in Cost–Benefit Analysis: A methodological proposal

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a v a i l a b l e a t w w w. s c i e n c e d i r e c t . c o m

w w w. e l s e v i e r. c o m / l o c a t e / e c o l e c o n

METHODS

Reconciling sustainability and discounting in Cost–Benefit Analysis: A methodological proposal Carmen Almansa Sáez a,⁎, Javier Calatrava Requena b a

Departamento de Gestión de Empresas, Universidad Pública de Navarra, Campus de Arrosadía s/n, 31.006 Pamplona, Spain Departamento de Economía y Sociología Agrarias, Instituto Andaluz de Investigación y Formación Agraria y Pesquera, Alimentaria y de Producción Ecológica (IFAPA), Junta de Andalucía, Camino Purchil s/n, 18.080, Granada, Spain

b

AR TIC LE I N FO

ABS TR ACT

Article history:

The incorporation of the intergenerational equity objective has rendered the traditional

Received 1 September 2005

Cost–Benefit Analysis (CBA) approach obsolete for the evaluation of projects presenting an

Received in revised form 3 April 2006

important number of environmental externalities and for those whose impacts extend

Accepted 3 May 2006

throughout a long period of time.

Available online 3 July 2006

Based on the assumption that applying a discount rate rewards current consumption and, therefore, that it is only possible to introduce a certain intergenerational equity in a Cost–Benefit

Keywords:

Analysis, in this work we propose an approach to discounting based on a different rationale for

Intergenerational equity

tangible and intangible effects. We designed two indicators of environmental profitability: a) the

Sustainability

Intergenerational Transfer Amount (ITA), which quantifies in monetary units what the current

Social Discount Rate

generation is willing to pass on future generations when an environmental restoration project is

Environmental discounting

carried out, and b) the Critical Environmental Rate (CER), measures the implicit environmental

Cost–Benefit Analysis

profitability. These concepts were tested through an empirical case study pertaining to the assessment of an Erosion Control Project in the southeast of Spain. The results yield traditional profitability indicators that are higher — and probably closer — to the real values set by the contemporary society. The information provided by the environmental profitability indicators proposed renders more transparency to the quantification of the levels of intergenerational equity applied, thereby facilitating the difficult reconciliation of the CBA technique with the objective of sustainability. © 2006 Elsevier B.V. All rights reserved.

1.

Introduction

The incorporation of the intergenerational equity objective has turned the traditional Cost–Benefit Analysis (CBA) approach into an obsolete tool for the evaluation of certain types of projects, particularly those exhibiting many environmental externalities and those whose effects extend throughout a long period of time. A series of changes in the CBA is being proposed in the literature, in order to adapt the analytical

context to the demand for sustainability, resulting in what is alternatively denominated Extended or Environmental Costs Benefits Analysis (ECBA). From an analytical point of view, changes in the CBA are taking place in a twofold way: Firstly, by developing new tools for the economic valuation of environmental externalities that were traditionally left out of the analysis. Secondly, through an in-depth revision of the theoretical foundations underlying the traditional approaches to discounting, since

⁎ Corresponding author. Tel.: +34 948 169425; fax: +34 948 169404. E-mail address: [email protected] (C.A. Sáez) 0921-8009/$ - see front matter © 2006 Elsevier B.V. All rights reserved. doi:10.1016/j.ecolecon.2006.05.002

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the repercussions of decisions that are presently being debated will extend to a distant future (in some cases for centuries), whereas in the classical CBA we deal with few decades at best. Therefore, many authors are stressing the need for a modification of the Social Discount Rate (SDR) by questioning the assumptions that are traditionally taken for granted and applied in its calculation. The present work begins with some reflections on the discounting problem drawn from a review of the different approaches found in the literature. Subsequently, we propose a number of methodological approaches and report on their application for the economic valuation of an environmental improvement project designed to stop the desertification processes in an area of south eastern Spain: The Watershed Restoration and Control Erosion Project of Lubrín (Almería, Spain).

2. Discounting in Cost–Benefit Analysis: background Discounting has traditionally been a controversial subject. In the seventies, after the great oil crisis of 1973 that took place in the USA, this country and many others faced the need to invest in research for alternative energy sources. It was at that time that the subject of discounting began to arouse great interest among a small group of researchers, since they were dealing with investments whose benefits were not to take place until many years later. Thus in 1977, Resources For the Future (RFF) made a call for a conference to discuss the adequate discount rate for public investments in energy and other technologies, the seminal ideas of which took form in the well-known book “Discounting for Time and Risk in Energy Policy”, published by Robert C. Lind (1982), which was an outstanding contribution, and the basis, during the following fifteen years, of a widespread consensus on the subject of discounting. However, by the mid-nineties, the apparent consensus on discounting starts to evaporate. In 1995, a report appears on the economic and social consequences of the climatic change and the policies to pursue (IPCC, 1995), in which one chapter is dedicated to subjects related to discounting and intergenerational equity (Arrow et al., 1996). Although there are frequent references to Lind's book (and to others), a general agreement on discounting is no longer envisioned and the different approaches to discounting could justify discount rates within a wide range of possibilities. Under these circumstances, RFF once again organised an encounter in 1996. Climatic change was the example that motivated the discussion, although the conclusions in relation to discounting were meant to be generalised to all decisionmaking processes of intergenerational nature. Some of the questions openly put forward on that occasion that are central to the current debate and upon which we will focus our attention are the following: (1st) Should projects whose effects spread over hundreds of years be dealt simply as “extended versions” of projects whose main effects do not last more than 30 or 40 years? (2nd) If the answer to the previous question is yes, what is the appropriate discount rate to be applied? and, (3rd) If projects with significant intergenerational effects are to be valued in a different way, how should it be done?

3.

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Assessing discounting approaches

Many are the ethical, philosophical and economic arguments in favour of discounting future costs and benefits1 (Pearce and Turner, 1990; Broome, 1992; Lind, 1982); however, for some authors, (see, for instance, Pearce and Turner, 1990) the use of a positive Social Discount Rate is incompatible with the intergenerational equity objective. The present debate on discounting environmental benefits and costs is centred on the inconsistency of discounting with the philosophy of sustainability. In other words, discounting is paramount to undervaluing the future, which means that future generations' preferences count less than our own present ones. As we shall see further down, any discussion on discounting will be closely related to the discussions on the various theoretical conceptions of sustainability. The conclusions drawn from the previously mentioned RFF 1996 conference, which have been gathered by Portney and Weyant (1999), evidence once again the differences in opinion in relation to discounting in the scientific community and the various ethical positions held. The authors make two clear-cut case distinctions in the subject under debate: short to midterm projects (40 years and under) and projects of a lengthier time span. One issue all the authors in the book agree on, with one exception, is that of considering it appropriate — even essential — to discount future benefits and costs with some positive discounting. Regarding the short to mid-term time span (40 years and under), most authors believe that failing to discount future benefits and costs would be damaging to future generations, and that the appropriate discount rate in this case is the capital's opportunity cost. Other experts, albeit a minority, are in favour of lower discount rates in this case also. It is in regard to longer time spans than these that the authors most clearly disagree. Generally speaking, in the environmental discounting2 literature, where projects carrying an intergenerational impact receive special attention, the different authors tend to favour one of the following options: • To question the appropriateness of the Economic Welfare Theory, and consequently of the CBA technique, as the right approach in the decision making process when dealing with climate change policies, and in general with other problems bearing significant intergenerational consequences.3

1 Some of the main arguments used to justify the use of a positive social discount rate, specifically of the so-called social time preference rate (STPR), are: a) the argument based on the psychological discount caused by the individuals' short-sightedness in looking into the future, whereby any future satisfaction seems less important than that in the present; b) the decreasing social consumption marginal utility argument over time; and c) the uncertainty argument. 2 We use this denomination to refer to discounting associated with projects involving important intergenerational repercussions, usually because they have a long term impact on the environment. 3 Some of the authors that question the use of ECBA are Sagoff, 1988; Bromley, 1990; Vatn and Bromley, 1994; Munda, 1996; Goulder and Kennedy, 1997; Joubert et al., 1997; Goulder and Kennedy, 1997; Prato, 1999; Neumayer, 1999b; Martínez-Alier and Roca-Jusmet, 2000. Researchers that favour the use of ECBA are, among others, Navrud (1992) and Hanemann (1994).

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• To consider unnecessary and/or inappropriate any reduction of the traditional Social Discount Rate (SDR) due to intergenerational equity issues. • To favour the need to use discount rates (either constant or variable in time), within the interval (0, SDR). • To retain the conventional discount rate but increasing the value of the environmental good with time, as suggested by Krutilla and Fisher (1975). • To design different mechanisms to take future generations into account in the analysis (Intergenerational CBA Approach). Particularly, the most representative stances on applying discounting through the ECBA technique, and beginning with the most extreme positions of the interval (0, SDR), are embodied in the following opinions: a) The only valid discount rate is zero, since it is the only rate that is in accord with a fully intergenerational equity scenario. This is an extreme position, defended by a very small minority, and which more readily represents — in some cases — a critical position against the CBA approach in the decision making process in projects with intergenerational repercussions rather than a discount rate proposal. For instance, Ciriacy-Wantrup (1942) has suggested applying a zero discount rate or even a negative rate for certain social purposes such as public health, defence, or education. Harrod (1948) have taken the argument that “a zero discount rate would ensure intergenerational equity by preventing the present generations from ignoring the long-term environmental” and one step further by arguing that discounting is ethically indefensible and is, indeed, a “polite expression for rapacity”. More recently, Shue (1999) investigates the rights of future generations in resource and environmental policy (both property rights and the fundamental and non-marketable right of physical security) arguing that such rights should not be attenuated by discounting, let alone by application of a net present-value criterion. b) The social time preference rate (STPR)4 is the appropriate and necessary rate to evaluate intertemporal efficiency (among genera4 In practice, the STPR formula works as follows (Ramsey equation (Ramsey, 1928), referred in Pearce and Turner, 1990): STPR ¼ ce þ pwherecthe real per capita consumption rate;e=the elasticity of the consumption function's marginal utility; and p=the type of interest of pure time preference.While component p reflects impatience, parameter e reflects the utility we believe is derived from the additional consumption units and, for the sake of analytical convenience, this relationship is expressed as an elasticity, that is, the change in marginal utility that arises arise from a change in marginal consumption. The component ce, hence, represents the idea that, since it is likely that future societies will be richer, we allot a smaller weight to their earnings, and should therefore discount those future earnings. This is what is called the decreasing consumption marginal utility principle. It is a straightforward principle, that, translated, amounts to the following: the more we have of something, the lower the increase in satisfaction we derive from the addition of another unit of the same thing. Generally speaking, the better off we find ourselves, the lower the increase in satisfaction we get out of improving a little more. Thus, according to this logic, if in fifty years, judging by the historical evidence in this respect, people will be better off in terms of welfare, the damage that they will be caused when depriving them of something will be smaller than the damage that will be caused to those that are alive today, who are worse off, and have more urgent needs to meet.

tions). Lesser et al. (1997), among others, sustain that an investment project (or group of these) complies with the rule of intergenerational equity, if present generations can improve their welfare — in terms of consumption — without diminishing the welfare of future generations. Conversely, we will be unfair with regard to future generations if we leave them worse off than we could. At the foundation of this line of reasoning lies the idea that, in practice, a positive discount rate is associated with capital accumulation and to technological change, which will allow future generations to be better off. In our opinion, this reasoning could only be true if a perfect substitution capability existed between natural capital and other types of capital, which no doubt is very debatable, especially when we consider that decisions affecting the environment are often associated with irreversible changes. In other words, underlying these authors' reasoning is the concept of weak sustainability, also called “neoclassical” sustainability, a concept that has been heavily criticised, as we will comment on further down. Furthermore, assuming that one accepts the argument that the “consumption” of natural goods has placed the present generation in a position that is better off than that of past generations, we cannot apply this same reasoning to future generations. Natural capital can be considered replaceable to a certain extent by another kind of capital so long as humanity doesn't reach a certain “critical natural capital” level (Faucheux and O'Connor, 1998),5 in which damage to the environment cannot be compensated for by any amount of alternative good(s). In this sense, Solow (1991) offers a short definition for sustainability in the neoclassical sense. He affirms that our obligation towards future generations is to behave in such a way that they will have the option or the capacity of living as well as we do. According to Solow, sustainability does not entail any specific objective; what we transmit to posterity is a general capability to live as well as we do. This definition assumes perfect intersubstitution: monetary capital, labour and natural resources are interchangeable elements of capital. However, this concept of sustainability has been the object of severe criticism. As Carpenter (1997) affirms, calling it weak is the most optimistic thing that can be said about it. In our opinion, and in agreement with such authors as Simón Fernández (1995), the “flaw” in the weak sustainability point of view is that it allows for compensation among the different kinds of capital. Changes associated with the environment frequently entail irreversibility, and this is the extreme form of incapability of substitution. Moreover, once an irreversible event has taken place it is suffered by the next generation and by all following generations. c) Reductions in discount rates in favour of the environment are unnecessary if we operate with a strict no-decrease restriction on the endowment of natural capital. This is the position held by authors (see Pearce and Turner, 1990; Pearce et al., 1990; Barbier et al., 1990) who believe that adjusting the STPR after the environmental externalities have been included is wrong as it involves a double 5

Faucheux and O'Connor (1998) describe critical natural capital as a set of environmental resources which (at the prescribed geographical scale) performs important environmental functions and from which no substitute in terms of manufactured, human or other natural capital exist.

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accountancy. Acknowledging the shortcomings of the weak sustainability concept, Pearce and Turner (1990) try to make the strong or strict sustainability concept compatible with the decision evaluating process, by imposing the constraint that, no matter what the benefits and costs associated with the decision may be, the environmental capital stock must remain constant. For example, in order to back a certain project, the benefits should be greater than the costs, but there must also be a proviso requiring any environmental damage caused by this project to be compensated through restoration and rehabilitation. Since this provision would be very strict and hardly operative, these authors recommend considering a whole series of decisions on development projects and imposing on them the strong sustainability condition in the following way: the total sum of the environmental damage caused by an entire sequence of projects can be counteracted by separate projects within the set of “decisions to be made”. These corrective, or “shadow”, projects would be an attempt to compensate for the reduction in natural capital stock through the creation and deliberate increase of this stock. Shadow projects would not be required to pass any kind of test relating the costs with the benefits, since their justification would lie in their compliance with the requirement of this type of sustainability. The philosophy of strong sustainability underlying this position is not free from objections and criticism either. Rather than in its theoretical conceptualisation, the problem lies in the difficulty in making it operational.6 The point is that a CBA approach to the decision making process is only compatible, at best, with a philosophy of weak sustainability, which leads us to acknowledge a number of fundamental problems of the Cost–Benefit Analysis when it incorporates the economic valuation of environmental externalities: i) the very analytic design of this technique assumes that all goods are commensurable, ii) that, no matter how heavy the loss of any good may be, the losers, in theory, would be willing to accept a certain level of compensation, and that is not 6 Pearce et al. (1990) and Turner (1993) define strict sustainability as the need to maintain natural capital stock constant, affirming that a constant or growing stock of natural resources allows us to attain higher degrees of intergenerational equity when the sustenance of the poor is associated with the ecosystems' productivity levels. As Simón Fernández (1995) pointed out, in Pearce and Turner (1990) and in Pearce et al. (1990), the authors discuss this last question without giving a satisfactory answer: that either the physical amount of stock, the total economic value of the stock, the price of the natural resources or the flow value of the resources should remain constant are all marked as options, without opting for any one of them as indicator of natural capital constancy. In order to make strict sustainability operative, they make a distinction between renewable and non-renewable resources. They believe renewable resources can be maintained over time if the rate of their usage does not surpass the rate of their reproduction. In this way, those renewable resources would be available for future use. But if this is the rule to follow, a problem arises as far as the non-renewable resources are concerned: their stock cannot be maintained constant unless they are not consumed. These authors' position in this question is as follows: decreases in the resources' stock are to be compensated for by increases in renewable resources. That is, they assume substitution capability between renewable and non-renewable resources. However, they do not make clear what implications this assumption may bear.

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necessarily so at any given moment, and it is even less true when dealing with different time brackets. Neumayer (1999a) argues that CBA would only be consistent with “weak sustainability” if the (hypothetical) compensation in which the analysis is based was effective and not just hypothetical, at least in the case of projects with costs in the future. Thus, the “weak sustainability criterion” denies the compensation criteria in the intergenerational context. Attempts to make this tool compatible with the strong sustainability concept are also debatable, as we have seen earlier. We agree with Neumayer (1999b) that “discounting is not the issue but substitutability is” since sustainability is not a matter of efficiency but of intergenerational ethics.7 This implies accepting the limitation of ECBA as a “monocriterion” decision approach. We still consider CBA a useful valuation tool but we believe that it should be applied in a broader context jointly with other criteria, though this would not be, strictly speaking, a multi-criterion approach. Recent studies such as those of Brouwer and Van Ek (2004) and Gulli (2006) illustrate the practical relevance of this tool and, in fact, ECBA is being applied by Public Administrations, albeit its implementation in practice is not always clear-cut. For instance, the new European regulations that pertain to the application of Structural and Cohesion Funds, among others, explicitly require a Cost–Benefit Analysis for investment projects with budgets surpassing a given threshold. The CBA evaluation guide8 explicitly supports the monetary valuation of increments of environmental quality. Social Discount Rates around 5% are recommended, although projects with lower Internal Return Rate (IRR) are not automatically discarded. This implicitly acknowledges that the traditional profitability return criteria are not sufficient for the scope of application of ECBA. This is thus the practical standpoint of the work here reported. d) After outlining and briefly discussing the extreme positions of the interval (0, SDR), a group of opinions that share a common preference for coherence and which defend the need to use discount rates located within this interval, which can be constant or variable in time, are presented next. Within this group three main orientations (albeit not clearly separable in practice) are considered. d.1) Constant reduced discount rates Many authors defend the reduction in discount rates due to environmental considerations, established in a conventional manner, as a type of rational adjustment in the conventional discount rates. Thus, due to the difficulty of finding a convincing 7

Therefore, decisions that affect problems as important and irreversible as global warming, require approaches solidly based on a post-normal epistemological concept that rely on democratisation of knowledge (Funtowicz and Ravetz, 1994; Martínez-Alier et al., 1998). Such democratisation of discourse arises from the nature of the problems at hand, from their urgency, their interdisciplinarity, their uncertainty, and their irreversibility. Post-normal science proponents advocate a combination of institutional analysis and iterative public dialogue using multicriteria decision analysis as a tool to understand the structure of conflict and potential for conflict resolution (O'Conner et al., 1996; Munda, 2000) and facilitating public understanding of the decision problems at hand (Munda, 1995; De Marchi et al., 2000; Strassert and Prato, 2002). 8 European Commission (2002): Guide to cost-benefit analysis of investment projects. Available on line: http://ec.europa.eu/ regional_policy/sources/docgener/guides/cost/guide02_en.pdf.

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discount rate to apply in practice, they request a pronouncement from the public administrations regarding the rate that should be applied in public capital endowment projects (Horta, 1998; European Commission, 1998; Rabl, 1996). There are, however, a number of authors that oppose this proposition: Lind (1997) questions whether a lower discount rate guarantees intergenerational equity; others, such as Neumayer (1999b), warn that the demand for a lower discount rate may divert the debate from its central question of rightly placing it within the political decisionmaking process; Padilla (2001) claims that modifying arbitrarily discounting entails ignoring the preferences between present and future consumption, which may result in accepting projects with low social profitability; and, for Philibert (1999), most of the arguments made in favour of constant, low discount rates for the sake of future generations are weak. Also Pearce and Turner (1990) have argued that the idea of reducing discount rates due to environmental constraints is rather problematic, since there is no unique relationship between discount rates and environmental degradation. According to these authors, allowing the discount rate to determine the level of investment will have negatively influence, through the consequent depressing effect on the investment, the general pace of development. However, we believe that, as referred by O'Neill (1993), a rational planning of the future cannot be based on the application of discount rates that govern all activities, project and resources. For example, it is common practice to apply a particularly low rate to forestry projects. As rightly argued by Martínez-Alier and Roca-Jusmet (2000), and O'Neill (1993), these “ad hoc adjustments are not irrational but are rather a rational variant within an irrational procedure”. d.2) Obtaining the discount rate empirically One can find in the literature some attempts to obtain empirically the discount rate that would be necessary to apply towards the welfare of future generations. Several routes are followed. One of them consists in assessing the present generation's opinion in this respect. In other words: to ascertain what is the value attached to a change that will take place in the future (Luckert and Admowicz, 1993; Cropper et al., 1992; Benzion et al., 1989; Poper and Perry, 1989; among others). Frederick et al. (2002) reviews 34 studies that aimed at obtaining empirically discount rate values, but the time horizons considered in those studies are clearly insufficient to allow drawing conclusions at intergenerational scale.9 The use of time ranges of a few years or even months logically entails inferring very high discount rates. Indeed, in those studies, the shorter the time range applied in the experiment, the higher is the discount rate obtained. This highlights the need both for research studies more focused on the kind of resource to be valued and with coherent time range, and for gathering empirical evidence for Declining Discount Rate (DDR) approaches, which we address below. d.3) Discount rates variable in time

9 The study by Johanneson and Johanneson (1997) — the only one that encompasses a multigenerational timeframe — extends the temporal horizon to 57 years and yields a yearly discount rate between 0% and 3%.

This idea of a variable discount rate is gaining support from a growing number of studies in which individual discount rates can be inferred or observed in the present market behaviour (Hausman, 1979) or in response to hypothetical issues connected to people's attitude toward risk (Horowitz, 1991), savings behaviours (Thaler, 1981), or found in life saving government agency programs (Cropper et al., 1994). Weitzman (1994) provides a theoretical foundation for the low and declining discount rates in long-term CBA; and Azar and Sterner (1996), in which discounting in relation to the Earth's over-warming effect is analysed, believe that the discount rates used in the economic models of climatic change should be lower than those traditionally used, and that constant discount rates in time are unreasonable; instead, the discount rate should decrease over time. Henderson and Bateman (1995), following the works of Cropper et al. (1992), obtain for the discounting on human lives a form of the hyperbolic discount curve that is different from the curve generated by the classical discounting (exponential), and which they consider more realistic for projects with intergenerational implications. In the same vein, more and more authors defend applying variable discount rates in time following a decreasing hyperbolic function (Loewenstein and Prelec, 1992; Sterner, 1994; Henderson and Bateman, 1995; Azqueta, 1996; Frederick et al., 2002; among others). Decreasing functions other than the hyperbolic have been studied, such as those proposed by Weitzman (2001), who concludes that the underlying distribution of discount rates follows a Gamma distribution in a context of uncertainties about future economic conditions. Newell and Pizer (2003) tried to operationalize Weitzman's (2001) work, whereas the work of Groom et al. (2004) builds further upon this idea. The recent work of Guo et al. (2006) presents a more extensive review of the declining discount rate (DDR) approaches. A sensitive analysis presented in this paper concludes that policies on climate change are more likely to pass a CBA using DDR schemes. However, not all DDR schemes are adequate and only very few of these (the Weiztman–Gamma discounting scheme and the use of a constant STPR of 0%) would enable passing a CBA. Schemes based on hyperbolic discounting were dismissed as unrealistic because parameters in the hyperbolic function that are measured empirically imply very large initial discount rates, sometimes as high as 30–40%. Problems with declining discount rates have been addressed by Heal (1998) and Hepburn (2005), who show that declining discount rates result in “time inconsistency” (that is, “if individuals have the opportunity to revise their plans in the future, they will deviate from the decisions made in the past”). However, we do not consider this argument strong enough to discourage the growing support for the Declining Discount rates (DDR). Furthermore, there is a “political” argument in favour of the acceptance of time-varying discount rates: in one swoop this would help to resolve the long standing tension between those who believe the distant future matters and those who want to continue discounting the future in the traditional way”, as concluded by Pearce et al. (2003), who, for this rea son, predict an increasingly applicability of the method in discount schemes. In fact, the UK government has already

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recommended it for its public policies (HM Treasury, 2003, “The Green Book: Appraisal and evaluation in Central Government”). In what follows, we outline two approaches for tackling the basic conflict between CBA and the long-term environmental consequences, which differ from the previous ones in that they do not address directly in its discussion the modification of discount rates: e) The first approach is that of Fisher and Krutilla (Krutilla and Fisher, 1975; Fisher and Krutilla, 1985; Porter, 1982), which employs the traditional Social Discount Rate but increases the value of the environmental asset in time. The rationale for this is that as natural resources become scarcer in time, they become increasingly more expensive (Tol, 1994; Rabl, 1996; Hasselmann et al., 1997; Hasselmann, 1999, Philibert, 1999). Although this method may be misinterpreted as if it would apply two different discount rates, as pinpointed by Padilla (2001), it entails a different underlying principle as described below. For instance, Hasselmann (1999) uses a 2% discount rate for mitigation costs and a 0% rate for climate change costs, based on the hypothesis that a climate catastrophe can be avoided only if it is assumed that climate damage costs increase significantly in the long term relative to mitigation costs. f ) The second approach is that of the use of Intergenerational CBA, which includes future generations explicitly in the analysis. Kula (1988) was the first to introduce the idea, and subsequent works apply an intergenerational weight, which takes into account the undeniable observation that individuals do not value equally present and future (Nijkamp and Rouwendal, 1988; Bellinger, 1991; among others). Recently, Padilla (2001) and Padilla and Pascual (2002) have improved this approach by developing the concept of “Multigenerational Net Present Value”, which incorporates an intergenerational structure into the model through a method that enables to translate the individual level of “altruism” into social intergenerational weighing, thereby adding a more realistic component to the work developed initially. A number of other proposals with a different methodology but with the same rationale of including future generations into the analysis have been developed. These include that of Fearnside (2002) that proposes an alternative unified index that assigns explicit weights to the interests of future generations; and that and Sumaila and Walters (2005), which incorporate future generations into the discount rates by means of an “Intergenerational Discount Factor”. The use of Intergenerational CBA is a very interesting research line for long temporal horizons (centuries), although it still encompasses the assignment of weights (which thus entails a degree of subjective judgment) that represent the preferences of intergenerational altruism of society with regard to future generations.

4.

A proposal on environmental discounting

The central idea that we propose for intergenerational discounting is to defend the rationality of applying simultaneously in the same CBA exercise discount rates for intangible effects (e.g. environmental) that are different than those we use for tangible ones.

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We have not found in the literature specific theoretical developments postulating this approach, nor practical applications thereof, although we did find, as referred above, a few studies that use two different discount rates. However, these studies (Tol, 1994; Rabl, 1996; Hasselmann et al., 1997; Hasselmann, 1999, Philibert, 1999) are in reality only versions of the Krutilla–Fisher approach (see (e) above). The only theoretical development that we believe to be different is that of Yang (2003), which we will discuss latter. Thus, our concept — discussed previously in Almansa and Calatrava (2000, 2002a) — is based on the following reasoning: 1. Since environmental goods are not market goods, individuals have different mindsets and act differently when dealing with “merchandise” that when handling with “environmental goods”. If we consider that the most coherent Social Discount Rate that should be applied to market effects is the Social Time Preference Rate (STPR = ce + p), it is only logical to suppose that the interest rate of pure time preference (p) will be smaller in the case of environmental goods, whether it be out of an ethical “imposition” of intergenerational equity (1.a), or simply because of empirical evidence that certain studies seem to reveal in this direction (1.b). (1.a) In fact, governments carry out environmental enhancement projects that often would not pass the decision making criteria of the conventional CBA, and whose benefits will be enjoyed by future generations, from which one can infer a very low discount rate (and therefore, very low interest rate of pure time preference), as the United Kingdom does, by applying a lower-than-usual discount rate in the case of forestry projects, as a “grant for future generations.” (1.b) Kopp and Portney (1999) believe that there are no reasons for taking for granted that individuals will be willing to exchange money and the environment with the same logic. This idea is implicit in Lumeley (1997) commenting on empirical studies that link individual discount rates with practices carried out in land preservation projects, in which there does not seem to be any clear relationship between one and the other. Gintis (2000) arrives to the same conclusion. In a study already mentioned above, Luckert and Admowicz (1993), deduce different behaviours when dealing with discounting of forests and of holdings securities. Similarly, Taylor et al. (2003) obtained implicit discount rates that were different for forest benefits of distinct nature, namely timber and recreation. 2. It seems logical to think that the hypothesis of the marginal decline in utility consumption will not hold for environmental goods. If the environmental benefits or costs take place over a long period of time, the term ce of the STPR formula may decrease for this type of goods, since the hypothesis of the marginal utility consumption decline is not fulfilled. For example, if in two hundred years people are worse off in terms of “environmental welfare”, the damage caused by depriving them of an environmental good (a natural space for recreational purposes, for example) will not be slighter in any way than the damage it would cause to those that live today, as it is usually claimed. The idea that per capita consumption decreases instead of increasing with the passage of time has been held by many authors (based on the idea that future growth and natural capital stock go hand in hand), and it is one of the central themes

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in criticising discounting by many ecological economists, who are accused by others of creating pessimistic scenarios (see Azar and Sterner, 1996; Dasgupta et al., 1999; respectively). This proposal on discounting could be represented as follows (Eq. (1a)):

NPV ¼

t¼n X

Ft

t¼0

ð1 þ STPRÞt

! þ

t¼n X

N0

t¼0

ð1 þ EDRÞt

! ð1aÞ

where NPV is the Net Present Value, Ft represents the annual net financial cost or benefit (in general, the shadow price of the tangible effects), and N0 the annual environmental cost or benefit at the current time for the current generation (or, more generally, the shadow price of the intangible effects). The discount rate is the appropriate STPR (Social Time Preference Rate) value to account for the financial effects (first term), and a lower Environmental Discount Rate (EDR), for the environmental effects (second term). In what does this proposal differs from that of Krutilla–Fisher? A comparison of Eqs. (1a) and (1b) clearly shows that, despite of the similarities, our proposal differs significantly from the Krutilla–Fischer (K–F) method in that while K–F uses Nt (the value of the environmental good that increases with time as a result of its decreasing supply) in the numerator and the same STPR for the environmental and financial term; our approach explicitly considers two different discount rates by applying an EDR to the environmental term, which clearly entails a different underlying principle.

NPV ¼

t¼n X t¼0

NPV ¼

t¼n X t¼0

Ft ð1 þ STPRÞt

Ft ð1 þ STPRÞt

! þ

t¼n X t¼0

! þ

t¼n X t¼0

Nt ð1 þ STPRÞt

Nt ð1 þ EDRÞt

Table 1 – A general proposal of different STPR (Social Time Preference Rate) and EDR (Environmental Discounting Rate) depending on the time span of the project Time span b 25 years Time span that only affects the present generation

STPR = ce + p a and EDR = ce + p1 p1 b p 3% b STPR b 5% and 2% b EDR b 3% • Reasonable use of the ECBA (Extended Cost–Benefit Analysis) approach

25–100 years Reasonably short time span that affects our children, grandsons and great-grandchildren

STPR = ce + p and EDR = ce2 + p2 p2 b p and ce2 b ce 3% b STPR b 5% and 1% b EDR b 2% • Use of ECBA together with other tools and/or decisionmaking criteria • Prior strict and/or ecological sustainability restriction

100–200 years Time span that affects the less immediate generations, with a reasonable degree of uncertainty

STPR = ce + p and EDR = ce3 + p3 p3 b p and ce3 b ce 3% b STPR b 5% and 0% b EDR b 1% • Introduce hyperbolic discount rates in the sensitivity analysis • Use of ECBA together with other tools and/or decisionmaking criteria. • Prior strict and/or ecological sustainability restriction.

More than 200 years

• Use of hyperbolic discount rates • Adequate ECBA approach?

a

!

Discounting

See footnote 4.

ð1bÞ

! ð1cÞ

A combination of both equations as in (1c) (proposed by Yang, 2003) would be, in practice, difficult to implement and, importantly, it would result in double accounting, since the rationale for the use of EDR already includes the hypothesis of a declining consumption of marginal utility for environmental goods. But what specific value(s) would the EDR take on?. We can hardly give only one answer to this general question, but we have the following suggestions: (i) This environmental rate should not be the same one for all types of projects, nor resources, and will depend on the time span considered. Weitzman (1998) interviewed more than 1700 economists, and a group of 15 “experts” on their intergenerational discounting preferences, from which were derived different discount rates for certain time spans that we find quite reasonable, although we obviously need to work harder in defining these discount rates. Thus, Weitzman (1999) proposes the following discount rates for different time spans: 3–4% (the usual Social Discount Rate) for time spans of around 25 years; 2% when they are of 25–75 years; 1% when they are of 75–300 years;

and 0% for more than 300 years. Along the same line goes a recent proposal of the UK Government in its official guidance to Ministries on the appraisal of investments and policies (HM Treasury, 2003), by considering the next time-variant scheme: 3.5% for 0–30 years; 3% for 31–75 years; 2.5% for 76–125; 2% for 126–200 years; 1.5% for 201 a 300 years); and 1% for over 301 years. (ii) The idea of the hyperbolic discount factor seems to us reasonable in projects with very long time spans (several centuries). However, much remains to be done in defining the specific parameter values for this type of functions. To summarise, what we seek in discounting, can, in a very general way, be summed up in Table 1.

5.

Environmental profitability indicators

As a complement to the previous proposal, and in keeping with the established approach, two concepts have been tested (Almansa, 2006) that we consider of interest in the CBA application:

5.1.

Intergenerational Transfer Amount (ITA)

The Intergenerational Transfer Amount (ITA) is a criterion for the quantification of environmental profitability in absolute

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terms. It is defined as the difference between the Net Present Value (NPV) that is obtained using the general STPR for public investments, the NPV (STPR%), and the NPV in which an intergenerational equity adjustment has been carried out on the discount rate applied to the environmental effects, the NPV (STPR%, EDR%). See Eq. (2) where N represents the environmental flow, calculated in year 0. This indicator relates to what the actual generation passes on to the future generations, as consequence of incorporating a certain degree of intergenerational equity in the analysis. Therefore, this may be considered as an effort towards the quantification of the degree of sustainability chosen by the current generation. This value, although expressed in monetary units, is relevant not so much in absolute terms but rather as compared to other investment proposals. ITA ¼ VPNðSTPR; EDRÞ−VPNðSTPRÞ ! !! t¼n t¼n X X Ft N0 þ ¼ ð1 þ STPRÞt ð1 þ EDRÞt t¼0 ! t¼0 !! t¼n t¼n X X Ft N0 þ  ð1 þ STPRÞt ð1 þ STPRÞt t¼0 t¼0 ! !! t¼n t¼n X X N0 N0 − ¼ ð1 þ EDRÞt ð1 þ STPRÞt t¼0 t¼0

ð2Þ

Logically, this value will be higher or equal to zero, and when alternative projects of environmental restoration are compared, a higher value of ITA will indicate a higher environmental profitability of the project.10

5.2.

Critical Environmental Rate (CER)

The Critical Environmental Rate (CER) is defined as the discount rate that, applied to the environmental effects and after the market effects have been discounted from the usual STPR, makes the Net Present Value (VPN) equal to zero. The CER is obtained from Eq. (3), where STPR is a previously chosen value, Ft the annual financial flow and N0 the environmental flow in year 0. t¼n X

Ft

t¼0

ð1 þ STPRÞt

! þ

t¼n X

N0

t¼0

ð1 þ CERÞt

! ¼0

ð3Þ

It is, therefore, a criterion related to the environmental profitability of a project in relative terms. In order to interpret it, it is necessary to compare it to the Social Environmental Discount Rate (SEDR); that is, the environmental discount rate that adequately represents the level of intergenerational equity that a society is willing to assume. From this methodological perspective, it must be fulfilled that CER (STPR %) N SEDR. For example, if SEDR and STPR are 1% and 3%, respectively, projects with CER (3%) N 1% will be profitable from an

10 In the case of projects in which the environmental effects have a negative sign, that is, projects that have a positive financial flux but a negative environmental flux (e.g., the activation of a nuclear power plant where the negative effect would be given by the effect of radioactive residues), the ITV would be negative as a result of a sustainability adjustment that assigns more weight to the environmental damage for the future generations.

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environmental point of view (with adjustments for sustainability), although they need not to be so from a financial point of view (with no adjustments for sustainability), if also CER (3%) b 3%. Another way of viewing this criterion is to consider it as an indicator of “environmental profitability that the financial cost produces”.11

6. Applying different discounting approaches to the WREC Project of Almería (Spain) The Watershed Restoration and Erosion Control Project of Lubrín (De Simón Navarrete, 1993) covers an area of 8.830 ha that experiences “accelerated” or “extremely accelerated” erosion processes in 82% of its territory. There are climatic and orographic conditions which contribute to the desertification processes, but without doubt, those with the greatest impact are those of human factors, both historical (deforestation processes), and the current use of land determined by the abandonment of farming land, in a typical marginal mountain agricultural zone. The main corrective actions considered in the project are: a) maintaining farmland but improving the step slopes, b) reforesting 85% of the areas currently covered with degraded Mediterranean scrub with indigenous species and regenerating the remaining 15% of Mediterranean scrub, and c) to construct specific infrastructures of hydraulic correction. The project covers a time span of 100 years. Logically, this period was chosen by convention for the analysis, due to the long maturing period of the species.12 The implementation of corrective measures (investment) is planned within the first six years (Table 2 summarizes the net financial costs of implementation and maintenance of the project). Whereby it is deduced that, whilst the main financial costs are supported by the present generation, the environmental rewards are only seen at the medium to long term, thus affecting future generations. In order to apply the ECBA to the case study (Almansa, 2006), the following stages were carried out: (1) Identification of the positive and negative effects (economic, social and environmental) of the project. Given the multidisciplinary nature of the project, numerous experts in various relevant areas of the study were consulted. Defining, among many other matters, various future scenarios of the zone both for the hypothetical case of the project start-up and that of its non-implementation. In parallel, members of the population concerned were consulted through qualitative techniques (mainly semi-structured interviews), endeavouring to

11 As in the previous criterion, for projects with a positive financial flux but a negative environmental flux, we would rank the projects also aiming at selecting those with higher CER. In this case, a higher CER would be interpreted as a lesser environmental damage associated to the financial benefit. 12 Owing to its intrinsic interest, we did simulations of the different net environmental benefits for a larger time span (500 years) but, as the technical study and financial plan of the project done by De Simón Navarrete (1993) extends only up to 100 years, we did not calculated the Net Present Value.

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Table 2 – Net Costs of implementing the Lubrín HFR project (€) Investment costs Fictive or previous investment prior to the project (year 0) Investment year 1 Investment year 2 Investment year 3 Investment year 4 Investment year 5 Investment year 6

166,786.87 1,680,668.05 1,222,031.90 1,201,681.63 2,416,711.74 2,554,613.97 182,719.70

Maintenance costs Maintenance and repair of hydrotechnical infrastructure (year 50) Maintenance and repair of hydrotechnical infrastructure (year 100) Silvicultural treatment (clearing costs) (year 20) Silvicultural treatment (clearing costs) (year 40) Silvicultural treatment (clearing costs) (year 60)

432,794.53 433,341.45 449,915.60 518,492.38 2,880,309.51

Benefits arising from timber sales following silvicultural treatments (clearance) Silvicultural treatment (benefits after clearing) (year 20) Silvicultural treatment (benefits after clearing) (year 40) Silvicultural treatment (benefits after clearing) (year 60)

284,192.38 378,923.24 4,090,803.91

ensure representation of the different groups affected by the project. (2) Identification and application, from among the different available methods of environmental benefits valuation, the most suitable one for the case study, which led us to choose, for various reasons, a Contingent Valuation (CV) exercise on the project as a whole.13 The CV exercise was carried out in summer 2000, through personal surveys done by suitably qualified and advised interviewers. The random sample (stratified by socioeconomic profiles) size was a total of 334 individuals. The information package showed, between other information, the current situation of the zone affected by the project and the

13 The reason we did not value the different effects by distinct methods, as it is generally done, is that since the population involved is affected simultaneously by many of these effects, it would not have been possible to put into practice correctly a contingent valuation exercise designed to assess only some of the costs and benefits of the project. Therefore, the Contingent Valuation Method (CVM) was selected due to its versatility and capacity to capture both use and non-use values, and to its flexibility to be applied in a wide range of situations, non-withstanding the acknowledgement of a number of ethical and technical limitations as extensively described in literature (see Almansa and Calatrava, 2002b and Almansa, 2006, for this case study). The application of other methods of expressed preferences, such the Choice Experiment or Conjoint Analysis, which include price as a variable, was discarded because these methods postulate the interdependency of variables or, such as here, impacts to be valued, which is clearly not the case in this study.

future situation of the zone in future scenarios within 50 and 100 years, if no corrective measures were taken of an environmental nature (Fig. 1). A net annual benefit was finally obtained of around 506,797 €/year.14 (3) Calculation of the project's Economic Profitability Indicators: The Internal Return Rate (IRR) was 5.23%, which means the project surpasses the positive net present value (NPVN 0) in all cases studied, since the highest discount rate used in the sensitivity analysis was 5%. The different discount approaches applied were the following: a) Discount rates recommended by the European Union (5%), and by several experts in the specific Spanish case (3%), following a traditional approach (see Table 3.a). b) Lower discount rates than the traditional ones, following the well-founded lines of reasoning of various authors, in the 1–3% range (see Table 3.b). c) Different discount rates for tangible and intangible effects, fol-lowing the methodological approach suggested (see Table 3.c). As the respective tables show, the project's NPV variability is very large, depending on which discounting approach is used, reaching its lowest value of 303,637 € in the case of the conventional discounting, using a SDR of 5%; and its highest value of 22,004,126 € when downward adjustments of the discount rate were made for the particular case of the net environmental benefits (SDR of 5% and EDR of 1%), following our suggested approach. But, what if we consider a time horizon span of the project in the order of centuries? What will be the yearly present value at, for example, 200 or 500 years? In the following tables we calculate and compare the present value of intangible effects (environmental benefits) within 50, 100, 200 and 500 years using an exponential (see Table 4.1 and Fig. 2) and a hyperbolic discount factor (see Table 4.2 and Fig. 3). It can be observed that the maximum values for years 50 and 100 correspond to exponential discount factors (EDF) with SDR=1%, while in the case of years 200 and 500 the maximum values are represented by hyperbolic discount factors (HDF) with parameters a = b = 2r, for r = SDR = 1%. This agrees with our conclusions, as presented in the theoretical section above, regarding the advisability of using hyperbolic discount factors in the case of very long-term scenarios. This is clear from Figs. 2 and 3, which show how the exponential discounting reduces to zero

14

Value obtained from the average Willingness To Pay (WTP) by residents and non-residents (return tourists with strong ties to the municipality) as derived from the equation 1530 Residents⁎€104.04/ year/resident] + [4826 Non-residents ⁎ €72.03/year/non-resident] = €506,797/year. This is a conservative value since we considered only the population directly involved, although that is not the only one. The question format was open-ended, since it was the most appropriate as found from a pre-testing questionnaire and for specific reasons to this study. The central question of the hypothetical market was, in short: “How much would you be willing to pay, in the form of a sort of “environmental tax”, per year or month (to choose) for the implementation and maintenance of the Environmental Restoration Project in Lubrin?”.

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EC O L O G IC A L E C O N O M IC S 6 0 ( 2 0 07 ) 71 2 –7 25

Fig. 1 – Photographs of four future scenarios of the WREC Project of Lubrín.

the present value of the environmental benefit in the course of the second and third century for discount rates of 3 and 5% (reaching zero in the years 160 and 260, respectively). Table 3.a – Net Present Value of the Lubrín HFR project with the classical discounting approach Discount rate 5% 3%

Net financial cost − 10,258,177 € − 11,704,032 €

(4) Calculation of the project's Environmental Profitability Indicators: The Intergenerational Transfer Amount, ITA (3%, 1%) represents the difference between the NPV (3%) and a NPV (3%, 1%) in which an intergenerational equity adjustment was made on the discount rate used to account for the

Net environmental Net present benefit value 10,561,814 € 16,494,672 €

303,637 € 4,790,643 €

Table 4.1 – Present Value of WREC Project Benefit (506,797 € in year 0) using exponential discount factor (conventional approach of discounting) Discount rate 50 years

Table 3.b – Net Present Value of Lubrín HFR project with discounting approach “STPR downward adjustment”

44,220 € 115,604 € 308,153 €

5% 3% 1%

100 years 4€ 27,161 € 189,230 €

200 years 500 years 0€ 1€ 69,272 €

0€ 0€ 4€

Discount Net financial Net environmental Net present rate cost benefit value 3% 1%

−11,704,032 € −18,474,235 €

16,494,672 € 32,262,304 €

4,790,643 € 13,788,068 €

Table 3.c – Net Present Value of the Lubrín HFR project with the discounting approach “using different discount rates for tangible and intangible effects” Discount Net financial Net environmental Net present rate cost benefit value C(5%) and B(3%) C(3%) and B(1%) C(5%) and B(1%)

− 10,258,177 €

16,494,672 €

6,236,495 €

− 11,704,032 €

32,262,304 €

20,558,271 €

− 10,258,177 €

32,262,304 €

22,004,126 €

Table 4.2 – Present Value of WREC Project Benefit (500,787 € in year 0) using hyperbolic discount factor (*) Discount rate

50 years

100 years 200 years 500 years

FDh, (a = b = 2r) r = 5% FDh, (a = b = 2r) r = 3% FDh, (a = b = 2r) r = 1%

84,466 €

46,072 €

24,133 €

9,936 €

126,699 €

72,400 €

38,864 €

16,348 €

253,399 €

168,932 €

101,359 €

46,012 €

(⁎)The discount factors have been calculated according to the following formula, where parameters a and b have been defined as a = b = 2r, after Poulos and Whittington (2000). FDh ¼

1 ð1 þ atÞb=a

;

a; bN0

722

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Fig. 2 – Present Value of Project Environmental Benefits (time span of 500 years) using exponential discount factor (classic approach).

environmental effects. In our study we arrive at a value of 15,768 million € (as obtained from Eq. (4) below).

whilst being also socially profitable given the minimum value of social profitability represented by an STPR of 3%.

ITAð3%; 1%Þ ¼ NPVð3%; 1%Þ−NPVð3%Þ ¼ 20; 558; 271€−4; 790; 643 ¼ 15; 767; 628€

7.

ð4Þ

The value of the Critical Environmental Rate (CER) for a STPR of 3%, that is, the CER (3%) is obtained by solving Eq. (5): NPVð3%; EDR ¼ ?Þ ¼ −11; 704; 032 þ

t¼l X

N0

t¼0

ð1 þ CERÞt

! ¼0

ð5Þ

The CER (3%) value of 4.47% obtained indicates that if we set the environmental discount rate that adequately represents the intergenerational equity level at, say, 1% or 2% (for this time span) the project would be profitable from an environmental point of view (under the methodological logic considered here),

Conclusions

Extending CBA analysis to include intangible (non-market) effects, even those spanning very long periods of time, such long-term environmental impacts, demands a reassessment of the classical arguments on discounting. Attempts to justify scenarios of full intergenerational equity in the CBA analysis are hard to take on. We must not forget that this tool is based on the Economic Theory of Welfare, which is based in turn on the Theory of Utility, an admittedly anthropocentric approach. That is to say, the CBA selects, at best, our own intergenerational ethics, expressing what our present generation is willing to pass on to future generations, but we will most likely never

Fig. 3 – Present Value of Project Environmental Benefits (time span of 500 years) using hyperbolic discount factor (see Table 4.2).

EC O L O G IC A L E C O N O M IC S 6 0 ( 2 0 07 ) 71 2 –7 25

find a way to reasonably include future generations' preferences in our formulations. The controversy about whether or not to adjust the Social Discount Rate for intergenerational equity reasons stems from different concepts of sustainability. This is the reason why the various positions are almost impossible to reconcile, thus the bottom line is that the debate does not deal with technical but rather with ethical issues. If, in spite of the previous limitations, one is still to use CBA, the inclusion of a certain level of intergenerational equity, as one of the valuation criteria of a project, entails the need to use lower discount rates. Furthermore, the different logics that we adopt in managing goods with and without a market must be mirrored through the use of different discounting logics. For all these reasons, we propose the use of the common Social Discount Rate for market goods and a lower discount rate (environmental discount rate) for non-market goods, to be used simultaneously in the same CBA exercise. By quantifying and stating clearly the degree of intergenerational equity implicit in an environmental project, the indicators of environmental profitability proposed elicits more transparency, helps in reconciling the CBA technique with the objective of sustainability and may be useful in public decisionmaking. Obviously, our proposal does not claim to solve all the problems in applying CBA to projects highly irreversible and with large intergenerational impacts, which should be studied and previously decided on the basis of criteria external to the analysis. Neither is this a closed proposition since there are number of aspects that were left unaddressed. But we do argue that, as compared to the various options available and revised here, this proposal, without adding complexity to the current methodologies, does increase rationality and contributes to reconcile sustainability and discounting in Cost– Benefit Analysis.

Acknowledgements We would like to thank the collaboration of the Town Hall and residents of Lubrín. We also thank the Regional Offices of the Ministry of the Environment of Almería (Spain), and the INIA (National Institute of Agricultural Research) of Spain, both for the its human and material support. We thank the anonymous reviewers for the valuable suggestions. We acknowledge as well the FUNCAS foundation (Fundación de las Cajas de Ahorros of Spain) and its reviewers for the acceptance and publication of a preliminary version of this work (N° 231, 2005) in its series of working papers.

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