United States
Environmental Protection
Agency
Office of the
Administrator
EPA 240-R-00-003
September 2000
Guidelines for Preparing
Economic Analyses
>:
m
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for
U.S.
NOTICE
The statements in this document have been developed by the EPA solely for use as guidance for economic analysts in the Agency,
and those consultants, contractors, or other persons who perform work under Agency contract or sponsorship. In addition, publica-
tion of these Guidelines makes information on the principles, concepts, and methods used by the Agency available to all interested
members of the public. This document is not intended, nor can it be relied upon, to create any rights enforceable by any party in lit-
igation with the United States. The Agency may decide to follow the guidance provided in this document, or to act at variance with
the guidance based on its analysis of the specific facts present. This guidance may be revised without public notice to reflect changes
in the Agency's approach to preparing economic analyses, or to clarify and update text.
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Preface
The U.S. Environmental Protection Agency (EPA), Regulatory Policy Council oversees regulatory planning by the
Agency. In this capacity, the Council establishes analytical procedures on risk management issues to ensure that
high quality and consistent practices are followed in accordance with Federal and Agency regulatory procedures.
In early 1996, the conduct and consistency of economic analyses prepared in support of regulatory actions were
identified as areas in need of updated and more specific guidance than was presently available in the Agency.
The Regulatory Policy Council assembled a group economists and policy analysts serving in offices throughout
the EPA to serve on an Economic Consistency Workgroup. The Council instructed the Workgroup to develop a
series of issue papers to assess important economic analytical issues facing the Agency. After discussing the
results of the findings in the issue papers, the Council charged the Workgroup with preparing a guidance docu-
ment to assist in the preparation of economic analyses used for regulatory development and policy evaluation
conducted by the Agency.
The Guidelines for Preparing Economic Analyses (or EA Guidelines) is part of a continuing effort by the EPA
to develop improved guidance on the preparation and use of sound science in support of the decision making
process. The EA Guidelines provide guidance on analyzing the benefits, costs, and economic impacts of regula-
tions and policies. The document draws from several previously published sources, including existing econom-
ic guidelines materials prepared by the EPA in the mid-1980s, other Agency economic analyses and handbooks,
and materials prepared by the Office of Management and Budget in support of Executive Order 12866 on regu-
latory planning and analysis. It seeks to incorporate recent theoretical, empirical, and modeling advances in
environmental economics, drawing upon the considerable body of scholarly literature.
In an effort to ensure the EA Guidelines presents sound, scientific information consistent with mainstream
practices in environmental economics, the Agency's Science Advisory Board (SAB) was charged with undertak-
ing an extensive peer review of the document. The review was performed by the SAB's Environmental
Economics Advisory Committee (EEAC), comprising leading U.S. environmental economists affiliated with
major colleges, universities and economic research institutions. The EEAC provided substantial input on the
content and organization of the document, reviewing the materials for accuracy in both economic theory and
practice. In their final review report to the Agency (included as Appendix A in this document), the SAB conclud-
ed that the EA Guidelines receive an overall rating of "excellent," saying it "succeed(s) in reflecting methods
and practices that enjoy widespread acceptance in the environmental economics profession."
Constant advances in theoretical and empirical research in the field of environmental economics will require
that the Agency reexamine the EA Guidelines on a continual basis. The Agency will again enlist experts in the
field of environmental economics and engage in an open review of the scientific basis of the document when it
is reevaluated in the future.
Preface
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Table of Contents
Preface
List of Acronyms and Abbreviations vii
Acknowledgments ix
Chapter 1: Introduction 1
Chapter 2: Statutory and Executive Order Requirements for Conducting Economic Analyses 5
Chapter 3: Statement of Need for the Proposal
3.1 Introduction 9
3.2 Problem Definition 9
3.3 Reasons for Market or Institutional Failure 9
3.4 Need for Federal Action 10
Chapter 4: Regulatory and Non-Regulatory Approaches to Consider
4.1 Introduction 11
4.2 Traditional Design-Based Command and Control 11
4.3 Performance-Oriented Approaches 11
4.4 Market-Oriented Approaches 12
4.4.1 Descriptions of Market-Based Approaches 12
4.4.2 Selecting Market-Oriented Approaches 13
4.5 Non-Regulatory Approaches 14
4.6 Fine-tuning Policy Approaches 15
4.7 References 16
Chapter 5: Overview of Economic Analysis of Environmental Policy
5.1 Introduction 19
5.2 Economic Framework and Definition of Terms 19
5.3 Baseline Specification 21
5.3.1 Guiding Principles for Baseline Specification 21
5.3.2 Compliance Rate Issues and Baseline Specification 23
5.3.3 Multiple Rules or Regulations and Baseline Specification 25
5.3.4 Summary 25
5.4 Predicting Responses to a New Environmental Policy 26
5.5 Analyzing and Presenting Uncertainty 27
5.5.1 Guiding Principles for Uncertainty Analysis 27
'**•«,
s*-
r*t*
Table of
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Table of Contents
5.5.2 Performing Sensitivity Analysis 28
5.3.3 Welfare Considerations Related to Uncertainty and Risk ......................... .29
5.6 Emerging Cross-Cutting Issues ................................................. .30
5.7 References 31
Chapter 6: Analysis of Social Discounting
6.1 Introduction [[[ .33
6.2 General Considerations in Social Discounting 34
6.2.1 Social and Private Discounting 34
6.2.2 Methods for Summarizing Present and Future Costs and Benefits .................. .34
6.2.3 Sensitivity of Present Value Estimates to the Discount Rate 36
6.2.4 Distinguishing Discounting from Other Procedures 37
6.3 Approaches to Social Discounting 38
6.3.1 Intra-Generational Social Discounting ....................................... .38
6.3.2 Inter-Generational Social Discounting 48
6.4 Discounting and Non-Monetized Effects 52
6.4.1 Perspectives on Discounting Non-Monetized Effects ............................ .53
6.4.2 When Discounting Non-Monetized Effects Is Appropriate 53
6.4.3 When Discounting Non-Monetized Effects Might Not Be Appropriate 54
6.5 References 56
Chapter 7: Analyzing Benefits
7.1 Introduction to Analyzing Benefits 59
7.2 A Conceptual Framework for Benefits Analysis 60
7.2.1 Welfare Measures: Willingness to Pay and Willingness to Accept Compensation ........ .60
7.2.2 Market Goods: Using Consumer Surplus and Demand Curves .................... .61
7.2.3 Non-Market Goods 62
7.3 The Benefit Analysis Process [[[ .62
7.3.1 A General "Effect-by-Effect" Approach 62
7.3.2 Implementation Principles 65
7.4 'lypes of Benefits Associated will) Environmental Policies 66
7.4.1 Human Health: Mortality Risks .............................................68
7.4.2 Human Health: Morbidity .................................................68
7.4.3 Amenities 69
7.4.4 Ecological Benefits [[[ .69
7.4.5 Reduced Materials Damages 71
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Table of Contents
7.5-3 Stated Preference Methods 83
7.5.4 Benefit Transfer [[[ .85
7.6 Values for Major Benefit Categories .............................................. .87
7.6.1 Human Health: Mortality Risks 87
7.6.2 Human Health: Morbidity Risks 94
7.6.3 Ecological Benefit Valuation ...............................................98
7.6.4 Materials Damage 100
7.7 References 101
Chapter 8: Analyzing Social Costs
8.1 Introduction 113
8.2 The Theory of Social Cost Analysis 113
8.2.1 An Illustration of Social Costs and Externalities 114
8.3 A General Approach to Social Cost Analysis ....................................... .115
8.3.1 Estimating the Supply and Demand Equations of All the Affected Markets 115
8.3.2 Determining the Different Types of Social Costs 119
8.33 Other Issues Arising in Presentation of Social Costs ............................ .123
8.4 Modeling Tools 124
8.4.1 The Basic Framework 124
8.4.2 The Direct Compliance Cost Method ........................................124
8.4.3 Partial Equilibrium Analysis ............................................. .125
8.4.4 Multi-Market Models 126
8.4.5 General Equilibrium Analysis 126
8.5 Estimating the Social Costs of Alternative Policy Approaches ........................... .130
8.5.1 Direct (or Standards-Based) Controls 130
8.5.2 Incentive-Based Controls 131
8.5.3 Voluntary Actions [[[ .135
8.6 Summary and Conclusions [[[ .135
8.7 References 137
Chapter 9'- Distributional Analyses: Economic Impact Analyses and Equity Assessments
9.1 Introduction [[[139
9.1.1 A Process for Economic Impact Analyses and Equity Assessments ................. .141
9.2 Economic Impact Analysis 143
9.2.1 Introduction to Economic Impact Analysis ...................................143
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Table of Contents
9.2.6 Profile of Affected Entities 149
9.2.7 Impacts on Prices [[[151
9.2.8 Impacts on Production and Employment ....................................152
9.2.9 Impacts on Profitability and Plant Closures 153
9.2.10 Impacts on Related Industries and Consumers 155
9.2.11 Impacts on Innovation, Productivity, and Economic Growth .................... .155
9.2.1.2 Impacts on Industry Competitiveness 155
9-2.13 Impacts on Government Entities and Not-for-Profit Organizations 156
9-3 Equity Assessment [[[ .160
9.3.1 Introduction [[[ .160
9-3.2 Statutes and. Policies Requiring Equity Assessment and. Definitions of Sub-Populations 1.6.1
93.3 Entity Size 161
93.4 Minority Status and Income Level ......................................... .164
9.3.5 Childhood. Status 166
9-3.6 Case Specific Equity Dimensions 167
93.7 A Framework for Equity Assessment ........................................168
9.3.8 Data for Conducting Equity Assessments .....................................170
9-4 References 172
Chapter 10: Using Economic Analyses in Decision Making
10.1 Introduction [[[ .175
10.2 Communicating Assumptions and Methods 175
10.3 Presenting the Results 176
10.3.1 Results from Benefit-Cost Analysis ....................................... .177
10.3.2 Results from Economic Impacts Analysis and Equity Assessments 177
10.3.3 Results from Cost-Effectiveness Analysis 178
10.4 Use of Economic Analyses in Policy Choices ..................................... .178
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Acronyms and Abbreviations
AC
BAT
BCA
BPT
CA
CE
CEQ
CERCLA
CFG
CFR
CGE
COI
CPI
CR
cv
DALY
DOE
DOT
DWL
EA
EBIT
EEAC
EIA
EO
EPA
FINDS
FTE
GDP
I/O
IPCC
LP
MR
MFC
MSC
MSD
NAICS
NB
annualized costs
best available technology
benefit-cost analysis
best practicable technology
conjoint analysis
certainty equivalent
Council on Environmental Quality
Comprehensive Environmental Response, Compensation and Liability Act
chlorofluorocarbons
Code of Federal Regulations
computable general equilibrium
cost of illness
Consumer Price Index
contingent ranking
contingent valuation
disability-adjusted life year
Department of Energy
Department of Transportation
dead weight loss
economic analysis
earnings before interest and taxes
Environmental Economics Advisory Committee
economic impact analysis
Executive Order
Environmental Protection Agency
Facility Index Data System
full-time equivalent employment
gross domestic product
input-output
Intergovernmental Panel on Climate Change
linear programming
marginal revenue
marginal private costs
marginal social costs
marginal social damages
North American Industrial Classification System
net benefits
V
Acronyms
and
Abbreviations
VII
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Acronyms and Abbreviations
NEPA National Environmental Policy Act
NESHAP National Emission Standard for Hazardous Air Pollutant
NFV net future value
NOAA National Oceanic and Atmospheric Administration
OCC opportunity cost of capital
OECD Organization for Economic Cooperation and Development
OLS ordinary least squares
OMB Office of Management and Budget
OSHA Occupational Safety and Health Administration
PRA Paperwork Reduction Act
POTW publicly-owned (wastewater) treatment work
PVC present value of costs
QALY quality-adjusted life year
RAPIDS Rule and Policy Information Development System
RFA Regulatory Flexibility Act
RIA regulatory impact analysis
RIM random utility model
SAB Science Advisory Board
SAM social accounting matrix
S&P Standard & Poors
SBA Small Business Administration
SBREFA Small Business Regulatory Enforcement Fairness Act
SIC Standard Industrial Classification
TAMM Timber Assessment Market Model
TSLS two-stage least squares
UMRA Unfunded Mandates Reform Act
USC United States Code
VSL value of statistical life
VS.LY value of statistical life-year
WIA willingness to accept
WTP willingness to pay
VIII
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Acknowledgments
The preparation of the Guidelines for Preparing Economic Analyses (or EA Guidelines) was managed under
the direction of the Regulatory Policy Council, chaired by the Deputy Administrator of EPA. Initial work on the
EA Guidelines began in 1996 under the direction of Deputy Administrator, FredJ. Hansen during his tenure at
the Agency, and concluded in 2000 under Deputy Administrator, W Michael McCabe.
The principal manager of the Economic Consistency Workgroup was Al McGartland, Director, National Center for
Environmental Economics. The Economic Consistency Workgroup consists of staff economists and policy ana-
lysts from across the Agency, who contributed to the development and review of the materials contained in the
EA Guidelines. The primary writers/editors for the EA Guidelines were Chris Dockins and Brett Snyder.
Additional persons responsible for final preparation of the text include: Liwayway Adkins, Kathleen Bell, Jennifer
Bowen, Jared Creason, Richard Garbaccio, Richard lovanna, Robin Jenkins, Elizabeth McClelland, Nicole Owens,
Michael Podolsky, Keith Sargent, Nathalie Simon, Lanelle Wiggins and Melonie Williams.
Representatives from EPA's many different program offices contributed to development and review of the EA
Guidelines as members of the Economic Consistency Workgroup. Persons playing more active roles in the
review process included: Ghulam Ali, Rebecca K. Allen, Paul Balserak, Allen Basala, John B. Bennett, Paul Borst,
Nick Bouwes, Jennifer Bowen, Ed Chu, Matthew Clark, Gary Cole, Jim DeMocker, Mark Eads, Ron Evans, Sandy
Evelanko, Glenn Farber, John Faulkner, Leslye Fraser, Arthur Grube, Patricia Hall, Chris Herman, Bryan
Hubbell, Barnes Johnson, Robert Lee, Jonathan Libber, Mahesh Podar, John R. Powers, Elliot Rosenberg, Jean
Schumann, Ann Watkins, William Wheeler, David Widawsky and Jan Young.
In addition to EPA staff, a number of contractors developed key materials used as technical assistance in prepa-
ration of the EA Guidelines and supporting documents. They include Frank Arnold and Francis Sussman of ICF
Consulting, Inc.; Lisa Robinson, Maria Markowski, Jim Neumann and Robert Unsworth, of Industrial
Economics; Leland Deck, Ellen Post and Penny Schafer of Abt Associates; Robert Raucher, Brian Kurd, Lauraine
Chesnut, David Mills, Greg Pitts, Tom Ottom of Stratus Consulting; Richard Bishop of University of Wisconsin-
Madison; Michael Hanemann of University of California-Berkeley; David Burmaster of Alceon Corporation; and
Anna Alberini of University of Colorado-Boulder.
The Science Advisory Board (SAB) review of the EA Guidelines was supervised by Donald G. Barnes, Director of
the SAB Staff and by Dr. Joan M. Daisy, Chair of the SAB. Thomas Miller was the Designated Federal Official for
the SAB-Environmental Economics Advisory Committee (EEAC) charged with conducting the peer review of the
EA Guidelines. Dorothy Clark provided administrative management support to the SAB-EEAC.
The SAB-EEAC was chaired by Dr. Robert Stavins of the John F. Kennedy School of Government, Harvard
University. SAB-EEAC members serving on the committee during the review of the EA Guidelines included: Dr.
Nancy Bockstael of University of Maryland-College Park, Dr. Dallas Burtraw of Resources for the Future, Dr.
Trudy Cameron of University of California-Los Angeles, Dr. Maureen Cropper of the World Bank, Dr. Herman
Daly of University of Maryland-College Park, Dr. A. Myrick Freeman of Bowdoin College, Dr. Lawrence Goulder of
Stanford University, Dr. Dale Jorgenson of Harvard University, Dr. Paul Joskow of Massachusetts Institute of
Technology, Dr. Catherine Sing of Iowa State University, Dr. Charles Kolstad of University of California-Santa
Barbara, Dr. Richard Revesz of New York University School of Law, Dr. Jason Shogren of University of Wyoming,
Dr. Hilary Sigman of Rutgers University, Dr. Richard Schmalensee of Massachusetts Institute of Technology, and
Dr. V Kip Viscusi of Harvard University.
Acknowledgments
IX
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Chapter 1: Introduction
Background to the
Guidelines for
Performing Economic
Analyses
In December of 1983, the U.S. Environmental
Protection Agency issued its Guidelines for
Performing Regulatory Impact Analysis1 (RIA
Guidelines).
Since their promulgation, the original RIA Guidelines
have remained largely unaltered, experiencing only a
few modifications and additions to specific sections
during the 1980s.
Much has changed since 1983, however, so EPA has
prepared these revised and updated Guidelines for
Preparing Economic Analyses (EA Guidelines). The
revised EA Guidelines reflect the evolution of envi-
ronmental policy making and economic analysis over
the past decade and a half.
Recent years have seen an expansion of the universe
of economic and social issues that are potentially
affected by environmental policies. In 1983, the con-
tent of the analyses required for RIAs was driven
mostly by Executive Order 12291, which directed fed-
eral agencies to assess the costs, benefits, and eco-
nomic impacts of their rules, and established a for-
mal review process by the Office of Management and
Budget (OMB). This process and its goals were reaf-
firmed in 1992 with the issuance of Executive Order
12866 on regulatory planning and review. OMB sub-
sequently released the document Economic Analysis
of Federal Regulations Under Executive Order
128662 (or Best Practices), which served to illustrate
specific techniques and issues concerning the con-
duct of economic analysis in support of EO 12866.
More recently, OMB released the document
Guidelines to Standardize Measures of Costs and
Benefits and the Format of Accounting Statements^
(or OMB Guidelines) which currently serves as
guidelines to federal agencies on economic analysis.
In addition to requirements to prepare economic
analyses set forth by Executive Order, economic
assessments are also called for under various admin-
istrative statutes. For example, agencies are explicitly
directed to examine whether their policies impose
new "unfunded mandates" on state, local, and tribal
governments, and to review economic impacts on
small businesses, governments, and nonprofit enter-
prises under the Unfunded Mandates Reform Act of
1995 (PL. 104-4) and the Regulatory Flexibility Act,
as amended by the Small Business Regulatory
Enforcement Fairness Act (5 U.S.C. 601-612).
Policy makers have also extended the scope of rele-
vant effects to be considered beyond these mandatory
•Jl
1 U.S. Environmental Protection Agency, Guidelines for Performing Regulatory Impact Analyses. EPA-230-84-003, December
1983. Reprinted with Appendices in March 1991.
2 U.S. Office of Management and Budget, Economic Analysis of Federal Regulations Under Executive Order 12866, January
11, 1996. This "Best Practices" document can be found at the U.S. White House, Office of Management and Budget website:
http://www.whitehouse.gov/OMB/inforeg/riaguide.html under the section titled "Regulatory Policy" (accessed 8/28/2000).
3 U.S. Office of Management and Budget, M-00-08 Guidelines to Standardize Measures of Costs and Benefits and the
Format of Accounting Statements, March 22, 2000. The OMB Guidelines serves to implement Section 638(c) of the 1999 Omnibus
Consolidated and Emergency Supplemental Appropriations Act and Section 628(c) of the Fiscal Year 2000 Treasury and General
Government Appropriations Act. They require OMB to issue guidelines to help agencies estimate the benefits and costs of federal regula-
tions and paperwork and summarize the results of the associated analysis. The OMB Guidelines can be found at the U.S. White House,
Office of Management and Budget website: http://wwwwhitehouse.gov/OMB/memoranda/index.html under the section titled "Selected
Memorandum to Heads of Federal Departments and Agencies" (accessed 8/28/2000).
Chapter
1
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Chapter 1: Introduction
assessments. For example, the Pollution Prevention Act
was passed in 1990 and the Agency has undertaken new
initiatives that explored voluntary, non-regulatory
approaches to address past and potential future pollution
sources. Economic assessment of these types of actions
can provide useful information on the economic efficiency
of allocating society's resources in these ways.
The EA Guidelines have been updated to keep pace with
the evolving emphases policy makers place on different
economic and social concerns affected by environmental
policies. Underlying this exercise is the recognition that a
thorough and careful economic analysis is an important
component in designing sound environmental policies.
Preparing high quality economic analyses can greatly
enhance the effectiveness of environmental policies by
providing policy makers with the ability to systematically
assess the consequences of regulatory and non-regulatory
actions. An economic analysis can describe the implica-
tions of policy alternatives not just for economic efficiency
but for the magnitude and distribution of an array of
impacts. Economic analyses also serve as a mechanism
for organizing information carefully. Thus, even when data
are insufficient to support particular types of economic
analyses, the conceptual scoping exercise may provide use-
ful insights.
The RIA Guidelines focused appropriately not only on
what was required for assessing costs, benefits, and eco-
nomic impacts of policies, but also on the basic technical
procedures for doing so. Over the past 15 years, however,
economic science has developed new techniques for bene-
fits estimation, different economic models for assessing
costs and other effects, and greatly expanded data sources
and related guidance materials. These are all reflected in
this document.
As a. result of these modifications and updates, the new EA
Guidelines will continue to serve, as always, to ensure that
the EPA's economic analyses are prepared to inform its
policy making processes and satisfy OMB's requirements
for regulatory review. The new FA Guidelines also seek to
establish an interactive policy development process
between analysts and decision makers through an expand-
ed set of cost, benefit, economic impacts, and equity
effects assessments, an up-to-date encapsulation of envi-
ronmental economics theory and. practice, and an
enhanced emphasis on practical applications.
The of the EA
The focus of the M Guidelines is on the economic analy-
ses typically conducted for environmental policies using
regulatory or non-regulatory management strategies.
Other guidance documents exist for related analyses, some
of which are inputs to economic assessments. No attempt
is made here to summarize these other guidance materi-
als. Instead, their existence and content are noted in the
appropriate sections. The EA Guidelines follow generally
the outline of OMB's Best Practices and the OMB
Guidelines, except insofar as these guidelines embody
assessment principles and policy advice developed recently
by EPA for its economic analyses.
As with the previous RIA Guidelines, the presentation of
economic concepts and applications in this document
assumes the reader has some background in microeco-
nomics as applied to environmental and natural resource
policies. Thus, to fully understand and apply the
approaches and recommendations presented in the EA
Guidelines readers should be familiar with basic applied
microeconomic analysis, the concepts and measurement
of consumer and producer surplus, and the economic
foundations of benefit-cost evaluation. Persons lacking
these skills, but seeking to better understand economics,
will require an alternative presentation of the materials
contained in this document. Supplemental written materi-
al will be prepared to accompany this document, including
training materials developed to reach a wider audience of
individuals responsible for using the types of economic
tools and information described here.
The EA Guidelines are designed to provide assistance to
analysts in the economic analysis of environmental poli-
cies, but they do not provide a rigid blueprint or a "cook-
book" for all policy assessments. The most productive and
illuminating approaches for particular situations will
depend on a, variety of case-specific factors and will require
professional judgment to apply. The EA Guidelines should
be viewed as a summary of analytical methodologies,
empirical techniques, and data sources that can assist in
performing economic analyses of environmental policies.
When drawing upon these resources, there is no substitute
for reviewing the original source materials.
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Chapter 1: Introduction
In all cases, the FA Guidelines recommend adhering to
the following general principles as stated by OMB (EO
12866, Introduction):
'"Analysis of the risks, benefits, and costs associ-
ated with regulation must be guided by the prin-
ciples of full disclosure and transparency. Data,
models, inferences, and assumptions should be
identified and evaluated explicitly, together with
adequate justifications of choices made, and
assessments of the effects of these choices on the
analysis. The existence of plausible alternative
models or assumptions, and their implications,
should be identified. In the absence of adequate
valid data, properly identified assumptions are
necessary for conducting an assessment."
"Analysis of the risks, benefits, and costs associ-
ated with regulation inevitably also involves
uncertainties and requires informed professional
judgments. There should be balance between
thoroughness of analysis and practical limits to
the agency's capacity to carry out analysis. The
amount of analysis (whether scientific, statistical,
or economic) that a particular issue requires
depends on the need for more thorough analysis
because of the importance and complexity of the
issue, the need for expedition, the nature of the
statutory language and the extent of statutory dis-
cretion, and the sensitivity of net benefits to the
choice of regulatory alternatives.'"
Thus, economic analyses should always acknowledge and
characterize important uncertainties that arise throughout
the analysis. Economic analyses should clearly state the
judgments and decisions associated with these uncertain-
ties and should identify the implications of these choices.
When assumptions are necessary in order to carry out the
analysis, the reasons for those assumptions must be stated
explicitly and clearly. Further, economic analyses of envi-
ronmental policies should be flexible enough to be tailored
to the specific circumstances of a particular policy; and to
incorporate new information and advances in the theory
and practice of environmental policy analysis.
Organization of the EA Guidelines
The remainder of this document is organized into nine
main chapters as follows:
0~ Chapter 2: Statutory and Executive Order
Requirements for Conducting Economic Analyses
reviews the major statutes and other directives man-
dating certain assessments of the consequences of
policy actions;
f Chapter 3: Statement of Need for the Proposal pro-
vides guidance on procedures and analyses for clearly
identifying the environmental problem to be
addressed and for justifying federal intervention to
correct it;
0~ Chapter 4: Regulatory and Non-Regulatory
Approaches to Consider discusses the variety of regu-
latory and non-regulatory approaches analysts and
policy makers ought to consider in developing strate-
gies for environmental improvement;
f Chapter 5: Overview of Economic Analysis of
Environmental Policy provides a theoretical overview
of environmental economic analyses, as well as guid-
ance concerning baseline specification and the treat-
ment of uncertainty;
0~ Chapter 6: Analysis of Social Discounting presents a
review of discounting procedures and provides guid-
ance on social discounting in conventional contexts
and over very long time horizons;
0~ Chapter 7: Analyzing Benefits provides guidance for
assessing the benefits of environmental policies
including various techniques of valuing risk-reduction
and other benefits;
0~ Chapter 8: Analyzing Social Costs presents the basic
theoretical approach for assessing the social costs of
environmental policies and describes how this can be
applied in practice;
0~ Chapter 9: Distributional Analyses provides guidance
for performing a variety of different assessments of
the economic impacts and equity effects of environ-
mental policies; and
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Chapter 1: Introduction
f Chapter 10: Using Economic Analyses in Decision
Making concludes the main body of the FA
Guidelines with suggestions for evaluating different
policy approaches and options, and for presenting the
quantified and unqualified results of the various
economic analyses to policy makers.
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Chapter 2: Statutory and Executive
Order Requirements for Conducting
Economic Analyses
Policy makers need information on the benefits,
costs, and other effects of alternative options for
addressing a particular environmental problem in
order to make sound policy decisions. In addition,
various statutes specifically require economic analy-
ses of policy actions. General mandates may also
direct agencies to conduct specific types of economic
analyses. In some cases, agencies have established
their own requirements for certain types of assess-
ments of their policies. This chapter discusses spe-
cific requirements that apply to all of EPA's
programs.1
OMB's basic requirements for regulatory review,
including their Best Practices and OMB Guidelines
documents, have helped to shape EPA's methodologi-
cal and empirical approaches for conducting eco-
nomic analyses. Several new mandates to conduct
specific economic assessments of environmental
policies have also recently been enacted. Many of the
mandates that introduce economic analyses require-
ments of policies are briefly reviewed here.2 In each
case, citations for the relevant mandates or statutes
and references to applicable EPA guidelines are pro-
vided.3
Executive Order 12866, "Regulatory
Planning and Review" requires analysis of
benefits and costs for all significant regulatory
actions. The Regulatory Working Group has pre-
pared general guidance for complying with the
requirements of EO 12866.4 EO 12866 requires
a statement of the need for the proposed action,
examination of alternative approaches, and
analysis of social benefits and costs. Chapters 3
through 8 of this document describe methods
for meeting these requirements. EO 12866 also
states that the distributional and equity effects of
a rule should be considered. Chapter 9
describes methods for analyzing and assessing
these effects.
The Unfunded Mandates Reform Act of
1995 (EL. 104-4) directs agencies to assess the
effects of federal regulatory actions on state,
local, and tribal governments, and the private
sector. Agencies are to obtain meaningful input
from state, local, and tribal governments for
rules containing "significant federal intergovern-
mental mandates." These are federal mandates
which may result in the expenditure by state,
ilflfP™^!^!*.'-". •
1 EPA personnel seeking information on EPA's policies and guidelines applicable to rule development can be found at the fol-
lowing EPA Intranet website http://intranet.epa.gov/rapids (accessed 8/18/2000, internal EPA document). Many of the citations included
in this section can be found at this site. Note, this website and other additional websites referenced in this document are located on EPA's
Intranet website and are limited to use by EPA personnel. When cited in this document, EPA Intranet websites will be labeled as "internal
EPA document."
2 Statutory provisions that require economic analysis but that apply only to specific EPA programs are not described here.
However, analysts should carefully consider the relevant program-specific statutory requirements when designing and conducting eco-
nomic analyses, recognizing that these requirements may mandate specific economic analyses.
3 More information on some of these program-specific mandates can be found in Chapter 9 of this document.
4 U.S. Office of Management and Budget, "Memorandum for Members of the Regulatory Working Group: Economic Analysis
of Federal Regulations Under Executive Order No. 12866," January 11, 1996. The guidance also addresses the requirements of the
Unfunded Mandates Reform Act and the Regulatory Flexibility Act.
Chapter
2
-------
Chapter 2: Requirements for Conducting Economic Analyses
local, and tribal governments, in the aggregate, or by
the private sector, of $100 million or more in any one
year.5 IMRA also directs agencies to assess the effects
of federal regulatory actions that will have a signifi-
cant or unique effect on small governments. OMB
has provided general guidance on complying with
UMRA.6
Executive Order 13132, "Federalism" requires
consultation with affected state and local governments
on rules that have federalism implications—that is
regulations and policy statements "that have substan-
tial direct effects on states (and local governments),
on the relationship between the national government
and the states, or on the distribution of power and
responsibilities among the various levels of govern-
ment." EO 13132 also imposes additional consulta-
tion obligations on agencies if they promulgate regula-
tions with federalism implications that either: (1)
impose substantial direct compliance costs on state
and local governments not required by statute and do
not provide funds to cover these costs, or (2) preempt
state or local laws.7
The Regulatory Act of 1980 (5 U.S.C.
610-612) (RFA), as amended by The
Business Regulatory Enforcement Fairness Act
of 1996 (El. 96-354) requires that fed-
eral agencies determine if a regulation will have a sig-
nificant economic impact on a substantial number of
small entities (including small businesses, govern-
ments, and non-profit organizations.) If a regulation
will have such an impact, agencies must prepare a
Regulatory Flexibility Analysis and comply with a
number of procedural requirements to solicit and
consider flexible regulatory options that minimize
adverse economic impacts on small entities. EPA has
prepared Revised Guidance on complying with the
RFA and SBREFA requirements.8 Chapter 1 of that
document provides guidance on the analytical
requirements, including thresholds for determining
"significant impact," "substantial number," and
"small entities," and recommended quantitative
measures for evaluating economic impacts on small
entities.
Executive Order 12898, "Federal Actions to
Address Environmental Justice in Minority
Populations and Low-Income Populations"
requires federal agencies to identify and address, as
appropriate, disproportionately high and adverse
human health or environmental effects of its pro-
grams, policies, and activities on minority populations
and low income populations. EO 12898 also requires
the same consideration for Native American pro-
grams. EPA and the Council on Environmental
Quality (CEQ) have prepared guidance for addressing
environmental justice concerns in the context of NEPA
requirements.9 These materials provide definitions of
key phrases in the Executive Order, which draw on
draft guidance prepared by an interagency task
force.10
Executive Order 13045, "Protection of Children
from Environmental Health and Safety
Misks" requires agencies to evaluate the health or
safety effects of planned regulations on children. For
economically significant rules that are subject to EO
13045, agencies are required to explain why the
planned regulation is preferable to other potentially
5 U.S. Environmental Protection Agency, EPA Guidance - Unfunded Mandates Reform Act of 1995, Interim Guidance, March 23, 1995.
8 U.S. Office of Management and Budget, "Guidance for Implementing Title II of S.I." Memorandum from Sally Katzen, Administrator,
Office of Information and Regulatory Affaire, March 31, 1995.
7 U.S. Environmental Protection Agency, Interim Guidance on Executive Order 13132: Federalism, February 2000.
8 U.S. Environmental Protection Agency, EPA Revised Interim Guidance for EPA Rttlewriters: Regulatory Flexibility Act as amended by
the Small Business Regulatory Enforcement Fairness Act, March 29, 1999.
9 For more information see U.S. Environmental Protection Agency, Interim Final Guidance for Incorporating Environmental justice
Concerns in EPA'sNEPA Compliance Analyses, Office of Federal Activities, April 1998, and Council on Environmental Quality, Guidance for
Addressing Environmental Justice under the National Environmental Policy Act (NEPA), March 1998.
10 Interagency Working Group on Environmental Justice, Final Guidance for Federal Agencies on Key Terms in Executive Order 12898,
Augusts, 1995,
6
-------
Chapter 2: Requirements for Conducting Economic Analyses
effective and reasonably feasible alternatives consid-
ered by the agency. EPA lias prepared guidance on
compliance with EO 13045." Materials in Chapter 9
provide suggestions for the types of questions analysts
could, ask to characterize risks to children, and refers
analysts to the various EPA guidance documents on
risk assessment for information on analytic method-
ologies. While EO 13045 primarily addresses risk
rather than economic analyses, economic analyses
may be needed, to determine whether EO 13045
requirements apply to a specific rule.
Executive Order 13084, "Consultation and
Coordination with Indian Tribal Governments"
requires agencies to recognize the unique legal rela-
tionship with Indian tribal governments set forth in
the Constitution and other treaties and. documents.
The order seeks to establish a regular and meaningful
consultation and collaboration with Indian tribal gov-
ernments in the development of regulations, imposi-
tion of unfunded mandates, and process for seeking
waivers from federal requirements. The order seeks
to encourage cooperation of tribal governments in
development of regulations that significantly or
uniquely affect their communities, including use of
consensual mechanisms and. negotiated, rulemaking.
11 U.S. Environmental Protection Agency, EPA Rule Writer's Guide to Executive Order 13045: Guidance for Considering Risks to Children
During the Establishment of Public Health-Related and Risk-Related Standards, Interim Final Guidance, April 30, 1998,
-------
Chapter 3: Statement of Need
for the Proposal
3.1 Introduction
An appropriate point of departure for economic
analyses of an environmental policy is a clear state-
ment of the need for policy action. Key components
of this discussion include an examination of the
nature of the pollution problem to be addressed, an
analysis of the reasons existing legal and other insti-
tutions have failed to correct the problem, and a jus-
tification for federal intervention instead of other
alternatives. Statutory and judicial requirements that
mandate the promulgation of particular policies or
the evaluation of specific effects are also key factors
in motivating certain analyses and policy actions. In
some instances statutes prohibit the use of certain
types of analyses in policy making. In these cases,
the guidance presented in this document should be
applied selectively to be consistent with such man-
dates.
3.2 Problem Definition
The initial problem definition discussion should
briefly review the nature of the environmental prob-
lem to be addressed. The following considerations
are often relevant:
0~ primary pollutants causing the problem and
their magnitude;
0~ media through which exposures or damages
take place;
0~ private and public sector sources responsible for
creating the problem;
f human exposures involved and the health
effects due to those exposures;
non-human resources affected and the harm
that results;
expected evolution of the pollution problem over
the time horizon of the analysis;
current control and mitigation techniques; and
the amount or proportion (or both) of the envi-
ronmental problem likely to be corrected by fed-
eral action.
3.3 Reasons for
Market or Institutional
Failure
Following this concise problem definition summary
should be an examination of the reasons why the
market and other public and private sector institu-
tions have failed to correct the problem. This com-
ponent should be viewed as a key part of the process
of environmental policy development because the
underlying failure itself often suggests the most
appropriate remedy for the problem.
Four categories of "market failure" are discussed in
OMB's Best Practices in the sections titled externali-
ties, market power, natural monopoly, and informa-
tion asymmetry. For environmental conditions,
externalities are the most likely causes of the failure
of private and public sector institutions to correct
pollution damages. However, information asymme-
tries and even pre-existing government-induced dis-
tortions can also be responsible for these problems.
Externalities can occur for many reasons.
Transactions costs, for example, can make it difficult
for injured parties to use legal or other means to
iS-
%,;TBlPP*fc^\si'
, *•"
^.~ i
"H.
Chapter
3
9
-------
Chapter 3: Statement of Need
cause polluters to internalize the damages they cause. A
similar result can occur when properly rights to the media
or resources harmed are held in common or are poorly
defined. Externalities can also arise because tracing the
causal connections from activities that pose environmental
risks to the resulting damages can be very difficult and
often involve long time periods.
A comprehensive examination of the market's failure to
address a specific environmental problem involves more
than a statement that harms exist. Economic analyses
should explore, for example, why transactions costs are
high or why property rights are difficult to assign clearly.
Similar analyses are appropriate for situations in which
other factors are responsible for the failure of the market
or other public and private sector institutions to address
environmental problems.
3.4 for
The final component of this initial statement of the need
for the proposal is an analysis of why a federal remedy is
necessary instead of actions by private and other public
sector entities, such as the judicial system and. state and
local governments. Federal involvement is often required
by pollution that crosses jurisdictional boundaries, by
international environmental problems, and by statutory
and other authorities. Economic analyses should make
clear the basis for federal involvement by comparing it
with the performance of a variety of realistic alternatives
that rely on other institutions and arrangements. This dis-
cussion should also verify that the proposed action is with-
in the relevant statutory authorities and that the results of
the policy will be preferable to no action. Aspects of the
regulations being proposed and promulgated that are not
discretionary but are dictated by statutory requirements,
should be identified, as this may have an influence on the
development of the economic analysis and presentation of
the results.1
1 The reader is also referred to Executive Order 13132 on "Federalism" for the introductory statements regarding principles of federalism
and the section describing the doctrines of preemption.
10
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Chapter 4: Regulatory and
Non-Regulatory Approaches to Consider
4.1 Introduction
Once the need for federal policy action to address an
environmental problem has been established, eco-
nomic analyses should define and evaluate a range of
possible regulatory and non-regulatory approaches.
Many different approaches may help achieve efficient
environmental protection. It is largely the analyst's
responsibility to consider and characterize these
approaches and then to present feasible alternatives
for decision makers to consider early in the policy
making process. The analyst should also be cog-
nizant of constraints that may be placed on the use of
non-regulatory approaches for addressing a specific
environmental problem. Market-oriented options,
for example, may not be consistent with statutory
mandates and the best response to an environmental
problem might require action outside the authority of
the relevant statute.
This chapter briefly describes several of these
approaches, but it does not attempt to detail the rela-
tive merits of putting them into practice for particular
EPA policy initiatives. The goal here is to introduce
several of the terms and concepts to analysts and to
provide references that describe the conceptual foun-
dations of each approach.1 For some approaches,
this chapter provides references on existing applica-
tions to environmental regulatory programs. Four
general types of approaches are described below. The
chapter concludes with some notes on fine-tuning
policy approaches.
4.2 Traditional
Design-Based
Command and Control
Design-based command and control regulations have
a long history in environmental policy, generally tak-
ing the form of specifying certain technologies or
designs. These regulations usually impose the same
requirements on all sources, although new and exist-
ing sources as groups are frequently subject to differ-
ent standards.2 An advantage of the approach is its
relative ease of compliance monitoring and enforce-
ment. Nonetheless, command and control regula-
tions may be less cost-effective than other approach-
es, meaning that the same environmental protection
might be achieved at a lower cost or more environ-
mental protection might be secured for the same
cost. Also, command and control regulations may
not readily accommodate or encourage technological
innovation or may fail to provide incentives to reduce
pollution beyond what would be undertaken to com-
ply with the standard.3
4.3 Performance-
Oriented Approaches
Rather than mandating a particular technology for
compliance, performance-based standards specify a
source's maximum allowable level of pollution and
•Jl
•I:1
1 Baumol and Gates (1993), particularly Chapters 10-14, is a useful general reference on the economic foundations of many
of these approaches.
2 For a discussion on this subject and ways these types of programs lead to this result, see Helfand (1992).
3 For some theoretical analyses of this point, see Malueg (1989), Milliman and Prince (1989), and Jung et al. (1996). A
recent review of empirical literature can be found in Jaffe and Stavins (1995).
Chapter
4
11
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Chapter 4: Approaches to Consider
then allows the source to meet this target in whatever
manner it chooses (e.g., the least cosily and most flexible
manner available). This approach has the advantage of
allowing sources to effectively tailor pollution control
requirements to their particular circumstances and
encourages and accommodates technological innovation.
Often, performance-based standards provide the
opportunity to achieve the same goals more cost-effectively
than command and control approaches. However, these
approaches may place additional burdens on monitoring
to ensure compliance and do not introduce incentives to
reduce emissions or hazard levels beyond prescribed
requirements.
4.4
A wide variety of methods for environmental protection fall
under the general classification of market-oriented
approaches. In one manner or another, each of these
makes use of private sector incentives, information, and
decision making in the pursuit of environmental
improvement. Market-oriented approaches can differ
from more traditional regulatory methods with regard to
their economic efficiency and distribution of benefits and
costs within the economy. These approaches include, for
example:
f taxes, fees, or charges;
f subsidies;
f marketable permit systems;
0~ deposit-refund systems;
f offsets and bubbling;
f insurance/financial assurance requirements;
f liability rules; and
f information provision.
Some aspects to consider when choosing among these
approaches as potential regulatory options are briefly
described below4
4.4.1 Of
Taxes, fees, charges, and subsidies generally "price"
pollution and leave decisions about the level of emissions
to each source. For example, emissions of a toxic sub-
stance might be subject to an environmental charge based
on the damages these emissions cause. Sources would
individually decide how much to control these emissions
based on the costs of the control and the magnitude of the
charge. Taxes, fees, and charges have some highly desir-
able theoretic properties, including encouraging pollution
control activities. However, they also sometimes impose
substantially different burdens on pollution sources than
do other approaches. One example is the potential liability
that taxes, tees, and charges impose for residual pollution,
which other approaches allow without charge. Issues sur-
rounding the use of these approaches concern the collec-
tion of revenues and the distribution of economic "rents"
from these programs, including deciding who should col-
lect these fees (e.g., government or private sector) and
what to do with revenues raised by these mechanisms
(e.g., reduce other types of taxes on the regulated entities
or redistribute the funds to finance other public services).
Marketable permit systems provide environmental
improvements similar to those provided by taxes, fees, and
charges. They function differently, however, in that the
marketable permits approach sets the total quantity of
emissions, while taxes, fees, and charges set the effective
"price" of emitting pollutants.5 If the permits are
auctioned or otherwise sold to pollution sources, the
* This document does not go into the level of detail necessary to fully describe and provide a means of evaluating the relative merits of dif-
ferent regulatory and non-regulatory approaches. Instead, there is a growing literature on applied market-oriented approaches for environmental
protection that should be reviewed prior to considering these regulatory approaches. For example, Anderson and Lohof (1997) and Stavins (1998a,
1998b) provide recent compilations of information on the theory behind and empirical use of economic incentives systems applied to environmental
protection. Additional sources for details on incentive systems include Moore (1989), Tietenberg (1985, 1992), EPA (1991), OECD (1989, 1991), and
proceedings published under (he ''Project 88" forum sponsored by the Center for Science and International Affairs, Harvard University (Stavins (1988,
1991)). These sources, and the references they contain, should be consulted for additional information concerning the design, operation, and per-
formance of many of these instruments,
5 The U.S. Acid Rain Program established under Title IV of the 1990 Clean Air Act Amendments is a good example of a marketable permit
program. For recent economic analyses of this program see Joskow et al (1998) and Stavins (1998c). For more information on the program itself
visit EPAs Acid Rain website at http://www.epa.gov/acidrain (accessed 8/28/00).
12
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Chapter 4: Approaches to Consider
distributional consequences of this approach are similar to
those experienced when using taxes, lees, and charges.
However, if new entrants must obtain permits from
existing sources, then the distributional consequences of
permit systems will differ from those likely to arise after
the introduction of technology-based standards. The
potential to establish a barrier to entry on the basis of
limiting quantities (e.g., if "grandfathering" of current
emission sources is part of the program) can affect the
eventual distribution of revenues, expenses, and "rents"
within the economy. The ultimate distribution of "rents"
under these programs can be an important feature of
market-based approaches and, therefore, should be
considered when comparing these with more traditional
regulatory approaches.
Deposit-refund systems are like specialized forms of
taxes. The deposit operates as a tax and the refund serves
as an offsetting subsidy. Many good examples of deposit-
refund systems exist, most of which are geared toward
reducing litter and increasing the recycling rates of certain
components of municipal solid waste." Perhaps the most
prominent examples are those programs associated with
newspapers, plastic, and glass bottles.
Offsets and bubbling allow restricted forms of emissions
trading across or within sources. This approach has seen
widespread use, mostly in controlling air pollution in non-
attainment areas. An offset, for example, would allow a
new source of emissions in an airshed to negotiate with an
existing source to secure reduction in the latter's emis-
sions. This reduction would then be used to accommo-
date the emissions from the new source. Bubbling can
allow a facility to consider all sources of emissions of a
particular pollutant within the facility in achieving an over-
all target level of emission control or environmental
improvement.
Insurance and financial assurance arrangements gen-
erally require those engaged in environmentally risky activ-
ities to ensure, typically through a third party, that suffi-
cient resources will be available to remedy future dam-
ages. This arrangement harnesses the financial incentives
of private sector companies to promote and maintain envi-
ronmentally safer practices. An example of this approach
to environmental protection is the financial assurance
requirements related to closure and post-closure care for
hazardous waste treatment, storage, and disposal facilities.
Liability rules are legal tools that allow victims (or the
government) to force polluters that cause damages to pay
for those damages after they occur.7 They are typically
applied to infrequent events such as cleanup of hazardous
waste sites under CERCLA or cleanup after oil spills under
the Oil Pollution Control Act. There are a variety of types
of liability rules and in some situations these rules can
mimic the desirable properties of taxes. However, this is
not the case in all situations and even in those specific
cases proper functioning of liability rules depends on a
legal system which may not perfectly implement the rules.
Finally, information provision operates by ensuring that
production and consumption decisions are adequately
informed about the environmental and human health con-
sequences of certain choices. In some cases, shifts in
these decisions can encourage environmentally benign
activities and discourage environmentally detrimental
ones. The Toxics Release Inventory; consumer-based pro-
grams on the risks of radon in homes, and pesticide label-
ing programs are examples of efforts by EPA to implement
information-based policy approaches.
4.4.2
Approaches
The most appropriate market-oriented regulatory
approach depends on a wide variety of factors, such as the
nature of the market failure, the specific circumstances of
the pollution problem, and the ultimate goals of policy
makers.8 The choice between taxes (or fees and charges)
and marketable permits, for example, rests theoretically
on such matters as the degree of uncertainty surrounding
the estimated benefits and costs of pollution control as
8 For example, Arnold. (1995) analyses the merits of a deposit-refund system in a case study focusing on enhancing used-oil recycling and
Sigman (1995) reviews policy options to address lead recycling,
7 See Segerson (1995) for a discussion of the various types of liability rules, the efficiency properties of each type of rale, and an extensive
bibliography,
8 Helpful references that discuss aspects to consider when comparing among different approaches include EPA (1980), Halm (1990),
Halm and Stavins (1992), and OEGD (1994a, 1994b),
13
-------
Chapter 4: Approaches to Consider
well as how marginal benefits and costs change with the
stringency of the pollution control target. This choice also
depends on distributional considerations and the extent to
which policy makers are willing to allow the market to
determine exact outcomes. Marketable permits, for exam-
ple, set the total level of pollution control, but the market
determines which sources reduce emissions and to what
extent. Taxes, however, leave both the extent of control by
individual sources and the total level of control to market
determination.
Consideration should also be given to potential differences
among economic instruments that have implications for
the revenues collected under alternative mechanisms. The
opportunities to direct collected resources at reductions in
other inefficiencies introduced in markets that have conse-
quences for economic welfare will affect the assessment of
market-oriented approaches.9
The use of a particular market-oriented approach is often
suggested directly by the cause of the pollution problem
and constraints on the efficacy of other traditional policy
instruments. For example, subsidies and deposit-refund
systems place some enforcement burden on the regulated
entities. This feature makes these approaches attractive if
large numbers of small pollution sources exist and
attempts to prohibit their actions are likely to fail due to
risk of widespread noncompliance and costly enforcement.
A positive incentive in these cases can solve both the origi-
nal market failure and the enforcement problem.
Offsets and bubbles tend to be more appropriate when
policy makers seek to help sources reduce compliance
costs, while still attaining the environmental improvement
embodied in a more traditional standards-based, source-
by-source approach. Similarly insurance and financial
assurance mechanisms are useful instruments to supple-
ment existing standards and rules when there is a signifi-
cant risk that sources of future pollution might be inca-
pable of financing the required pollution control or dam-
age mitigation.
Finally, information remedies are often suggested when a
market has failed to provide information and policy mak-
ers believe that private and public sector decisionmakers
will act to address an environmental problem once the
information has been disseminated. Voluntary approaches
are closely related to information remedies and are most
useful when they bring to bear the market's knowledge
and innovation efforts on a particular environmental prob-
lem, and when direct standards-based methods would be
very time-consuming and costly to develop.
4.5
In addition to regulatory approaches, EPA has pursued a
number of non-regulatory initiatives that rely heavily on
voluntary approaches to achieve improvements in emis-
sions controls and management of environmental hazards.
Much of the foundation for these initiatives rests with the
concepts underlying a "Pollution Prevention" approach to
environmental management choices. In the Pollution
Prevention Act of 1990, Congress established as a national
policy that:
f pollution should be prevented or reduced at the
source whenever feasible;
f pollution that cannot be prevented should be recycled
in an environmentally safe manner whenever
feasible;
f pollution that cannot be prevented or recycled should
be treated in an environmentally safe manner when-
ever feasible; and
f disposal or other release into the environment should
be employed as a last resort and should be conducted
in an environmentally safe manner.
Working directly with a broad array of institutions that par-
ticipate in decisions affecting the environment (e.g., con-
sumers, regulatory agencies, industry), an effort is made
to reach "common sense" understanding of the benefits
and costs of management strategies that prevent damages
from occurring, versus strategies aimed at reacting to the
consequences of realized environmental hazards.
Furthermore, some preventive measures can be instituted
without establishing a regulatory program, but instead
through a facilitated process of identifying problems and
' For useful references on the emerging issues concerning the uses of revenues from pollution charges (e.g., applying environmental tax
revenues so as to reduce other taxes and fees in the economy) and ways to analyze these policies, see Bovenberg and de Moojii (1994), Goulder
(1996), Bovenberg and Goulder 1996), Goulder et. al. (1997), andjorgenson (1998a, 1998b).
14
-------
Chapter 4: Approaches to Consider
solutions. This can involve sharing information and expe-
riences among participants on the use of procedures,
practices, or processes that reduce or eliminate the gener-
ation of pollutants and waste at the source. Examples
within the manufacturing sector include developing and
distributing information on input substitution or modifica-
tion, product reformulation, process modifications,
improved housekeeping, and on-site closed-loop recycling.
Further, pollution prevention includes other practices that
reduce or eliminate pollutants through the protection of
material resources by conservation and increased efficien-
cy in the uses of raw materials, energy, water, or other
resources.
Examples of voluntary programs include: (1) the 33/50
toxic substances program under which many companies
have established voluntary targets for reducing the use of
various toxic chemicals, (2) the "ENERGY STAR" energy effi-
ciency labeling program, and (3) the "Design for the
Environment" program. The last of these programs seeks
to form voluntary partnerships with industry and other
stakeholders in order to develop environmentally safer
alternatives to existing products and processes that prevent
the need to cleanup pollution created as by-products in
manufacturing processes. Much of the literature devel-
oped to document these changes can be found in public
policy and industrial ecology literature sources.10
ded in new investments can often substantially reduce a.
policy's costs while sacrificing relatively few of its benefits,
especially when large-scale premature retirement of capital
equipment can be avoided.
Constraints, such as statutory provisions, can limit the
number of available regulatory and non-regulatory
approaches for addressing a specific environmental prob-
lem. Market-oriented options, for example, may not be
consistent with statutory mandates and the best response
to an environmental problem might require action outside
the authority of the relevant statute. Nevertheless, the
strategy that best informs policy makers is generally one
that adopts an expansive view of a problem's possible solu-
tions and then provides cogent and detailed economic
analysis of their benefits, costs, and other effects.
4.6
In addition to considering a wide variety of possible
approaches for environmental protection, analysts and pol-
icy makers should also examine other characteristics of
regulatory or non-regulatory policies that affect their costs
and effectiveness. For example, evaluating benefits, costs,
and other effects at different levels of stringency for a given
policy can help to determine settings that provide the
greatest net benefits to society. Similarly, tailoring pollu-
tion control requirements to account for geographical dif-
ferences in environmental effects and source differences
in pollution control costs will tend to achieve greater envi-
ronmental protection at lower costs. Finally, phasing in
policies over time to allow new requirements to be embed-
10 For more illustrations of ongoing programs and policies, the following websites offer useful information: http://www.epa.gov/opei/
(accessed 8/28/2000) and http://wwwepa.gov/p2/ (accessed 8/28/2000).
15
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Chapter 4: Approaches to Consider
4.7
Anderson, R. C. and A. Q. Lohof. 1997. The United States Experience with Economic. Incentives in Environmental
Pollution Control Policy. Environmental Law Institute, Washington, B.C.
Arnold, F. S. 1995. Economic Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons,
Inc.
Baumol, W. and ¥. Gates. 1993. The Theory of'EnvironmentalPolicy Third Edition, Englewood, NJ: Prentice Hall.
Bovenberg, A. L. and R. de Moojii. 1994. Environmental Levies and Distortionary Taxes. American Economic Review,
84(5): 1085-1089.
Bovenberg, A. L. and L. Goulder. 1996. Optimal Environmental Taxation in the Presence of Other Taxes: General
Equilibrium Analysis. American Economic Revieiv, 86(5): 985-1000.
Goulder, L. H. 1995. Environmental Taxation and the Double Dividend: A Reader's Guide. International Tax and Public
Finance, 2(2): 157-183.
Goulder, L. H., I. Parry, and D. Burtraw. 1997. Revenue-Raising Versus Other Approaches to Environmental Protection:
The Critical Significance of Preexisting Tax Distortions. RAND Journal of Economics, 28(4): 708-731.
Halm, R. W. 1990. Regulatory Constraints on Environmental Markets. Journal of Public Economics, 42: 149-175-
Hahn, R. W and R. N. Stavins. 1992. Economic Incentives for Environmental Protection: Integrating Theory and Practice.
American Economic Review, 82 (3) :464-468.
Helfand, G. E. 1991- Standards versus Standards: The Effects of Different Pollution Restriction. American Economic
Review. September, 81(4): 622-634.
Jaffe, A. B. and R. N. Stavins. 1995- Dynamic Incentives of Environmental Regulations: The Effects of Alternative Policy
Instruments on Technology Diffusion. Journal of Environmental Economics and Management, 29: S43-S63.
Jorgenson, D. W (1998a). Growth, Volume 1: Econometric General Equilibrium Modeling., Cambridge, MA: MIT Press.
Jorgenson, D. W (1998b). Growth, Volume 2: Energy, the Environment, and Economic Growth. Cambridge, MA: MIT
Press.
Joskow, R L., R. Schmalensee, and E.M. Bailey. 1998. The Market for Sulfur Dioxide Emissions. American Economic
Revieiv, September, 88(4): 669-85.
Jung, C., K. Krutilla, and R. Boyd. 1996. Incentives for Advanced Pollution Abatement Technology at the Industry Level: An
Evaluation of Policy Alternatives. Journal of "Environmental Economics and Management, 30: 95-111.
Malueg, D. 1989- Emission Credit Trading and. the Incentive to Adopt New Pollution Abatement Technology. Journal of
Environmental Economics ami Management, 16: 52-57.
Milliman, S. R. and R. Prince. 1989. Firm Incentives to Promote Technological Change in Pollution Control. Journal of
Environmental Economics and Management, 17: 247-265.
Moore, J. L., L. Parker, J. Bodgett, J. McCarthy, and D. Gushee. 1989- Using Incentives for Environmental Protection: An
Overview, U.S. Congressional Research Service, Washington, D.C.June 1989-
Organization for Economic Cooperation and Development. 1989- Economic Incentives, Options for Environmental
Protection, Paris, France.
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Chapter 4: Approaches to Consider
Organization for Economic Cooperation and Development. 1991. Environmental Polity: How to Apply Economic
Instruments, Paris, France.
Organization for Economic Cooperation and Development. 1994a. Evaluating Economic Incentives for Environmental
Policy, Paris, France.
Organization for Economic Cooperation and. Development. 19941). Managing the Environment - The Role of Economic
Instruments, Paris, France.
Segerson, K. 1995- Liability and Penally Structures in Policy Design. In The Handbook of Environmental Economics,
Daniel W Bromley, Ed, 272-294. Cambridge, MA: Blackwell Publishers.
Sigman, H. A. 1995. A Comparison of Public Policies for Lead Recycling. RAND Journal of Economics, 26(3): 452-478.
Stavins, R. N., ed. 1988. Project 88-Harnessing Market Forces to Protect Our Environment: Initiatives for the Neiv
President, A Public Policy Study, Sponsored by Senator Timothy E. Wirth, Colorado, and Senator John Heinz,
Pennsylvania. Washington, D.C.: December 1988.
Stavins, R. N., ed. 1991. Project 88 -Round II, Incentives for Action: Designing Market-Based Environmental
Strategies. A Public Policy Study, Sponsored by Senator Timothy E. Wirth, Colorado, and Senator John Heinz,
Pennsylvania. Washington, D.C.: May 1991-
Stavins, R. N. 1998a. Market Based Environmental Policies. Faculty Research Working Paper Series. R98-03, John F.
Kennedy School of Government, Harvard University, Cambridge, MA.
Stavins, R. N. 1998b. "Economic Incentives for Environmental Regulation." The New Palgrave Dictionary of Economics
and the Law, ed. E Newman. London, Great Britain: The Macmillan Press.
Stavins, R. N. 1998c. What Can We Learn from the Grand Policy Experiment? Lessons from S02 Allowance Trading.
Journal of Economic Perspectives, Summer 12(3): 69-88.
Tietenberg, T. 1985. Emissions Trading: An Exercise in Reforming Pollution Policy, Resources for the Future,
Washington, D.C.
Tietenberg, T. 1992. Environmental and Natural Resource Economics, Third Edition, New York, NY: Harper Collins
Publishers.
U.S. Environmental Protection Agency. 1980. Checklist of Regulatory Alternatives, Office of Planning and Management,
July 1980.
U.S. Environmental Protection Agency. 1991- Economic Incentives: Options for Environmental Protection, EPA/21P-
2001, Office of Policy, Planning and Evaluation, March 1991.
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Chapter5: Overview of Economic
Analysis of Environmental Policy
5.1 Introduction
This chapter provides a brief overview of several dif-
ferent analyses and assessments that are normally
conducted in the course of evaluating environmental
policies. It also presents background and guidance
on several cross-cutting methodological topics. The
suggestions in this chapter, and throughout this doc-
ument, are not intended to be rigid rules to be
applied uniformly for each and every economic
analysis. Instead, they are intended to produce a
consistent, well-reasoned, and transparent process
for framing economic analyses regardless of the spe-
cific characteristics and features of any given policy.
The next section outlines a conceptual perspective for
economic analysis and identifies the component
assessments that together form an economic analysis
in practice. This section also defines certain terms
that are used throughout this and the remaining
chapters of the EA Guidelines. The remaining sec-
tions of this chapter explore some common method-
ological elements that are shared by virtually all eco-
nomic analyses of environmental policies. The third
section of this chapter addresses the choice of analyt-
ic baseline and the fourth discusses predicting
responses to new policies. Treatment of uncertainty
is addressed in the fifth section and the final section
addresses some emerging analytical issues. Each
section first reviews the nature of the methodological
topic and its impact on the economic analyses, and
then provides general guidelines for incorporating or
addressing associated issues in practice.
5.2 Economic
Framework and
Definition of Terms
A Conceptual Perspective for Economic
Analysis
The conceptually appropriate framework for assess-
ing all the impacts of an environmental regulation is
an economic model of general equilibrium. The
starting point of such a model is to define the alloca-
tion of resources and interrelationships for an entire
economy with all its diverse components (house-
holds, firms, government). Potential regulatory alter-
natives are then modeled as economic changes that
move the economy from a state of equilibrium
absent the regulation to a new state of equilibrium
with the regulation in effect. The differences between
the old and new states—measured as changes in
prices, quantities produced and consumed, income
and other economic quantities—can be used to
characterize the net welfare changes for each affected
group identified in the model.
Analysts can rely on different outputs and conclu-
sions from the general equilibrium framework to
assess issues of both efficiency and distribution. At
EPA these issues often take the form of three distinct
questions:
f Is it theoretically possible for the "gainers" from
the policy to fully compensate the "losers" and
still remain better off?
f Who are the gainers and losers from the policy
and associated economic changes?
f And how did a particular group—especially a
group that may be considered to be disadvan-
taged—fare as a result of the policy change?
•I:1
Chapter
5
19
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Chapter 5: Overview
The first question is directed a! the measurement of effi-
ciency, and is based on \he Potential Parelo criterion.
This criterion is the foundation of benefit-cost analysis,
requiring that a policy's net benefits to society be positive.
Measuring net benefits by summing all of the welfare
changes for all groups provides an answer to this question.
The last two questions are related to the distributional
consequences of the policy. Because a general equilibrium
framework provides for the ability to estimate welfare
changes for particular groups, these questions can be
pursued, using the same approach taken to answer the
efficiency question, provided that the general equilibrium
model is developed at an appropriate level of
disaggregation.
Compromises: Cost Analysis,
Economic and
Although a general equilibrium framework can, in princi-
ple, provide the information needed to address ail three
questions, in practice analysts have limited access to the
tools and resources needed to adopt a general equilibrium
approach'. More often, EPA must resort to assembling a
set of different models to address issues of efficiency and
distribution separately. However, the limitations on
employing general equilibrium models have greatly dimin-
ished in recent years with advances in the theory, tools,
and data needed to use the approach. Chapter 8 contains
additional information on general equilibrium models.
The FA Guidelines follow more traditional practices and
adopt conventional labels to distinguish models or
approaches used to answer questions on the efficiency and
distribution of environmental regulations. For purposes of
this document, the presentation separates the concepts
and approaches into the following three general categories:
f the examination of net social benefits using a benefit-
cost analysis (BCA);
f the examination of gainers and losers using an eco-
nomic impacts analysis (EIA); and
f the examination of particular sub-populations, espe-
cially those considered, to be disadvantaged, using an
equity assessment.
This division is necessary not only because of data and
resource limitations, but because analysts often lack mod-
els that are sufficiently comprehensive to address all of
these dimensions concurrently. Within a BCA, for exam-
ple, EPA is generally unable to measure benefits with the
same models used for estimating costs, necessitating sepa-
rate treatment of costs and benefits. Further, when esti-
mating social costs there are cases in which some direct
expenditures can be identified, but data and. models are
unavailable to track the "ripple" effects of these expendi-
tures through the economy. For most practical applica-
tions, therefore, a complete economic analysis comprises a.
benefit-cost analysis, an economic impacts analysis, and
an equity assessment.
Benefit-cost analysis evaluates the favorable effects of poli-
cy actions and the associated opportunity costs of those
actions. The favorable effects are defined as benefits and
the opportunities foregone define economic costs. While
conceptually symmetric, benefits and costs must often be
evaluated separately due to practical considerations.
Analysts may even organize the analysis of benefits differ-
ently from the analysis of costs, but they should be aware
of the conceptual relationship between the two. Using esti-
mates of health and other risk-reduction effects provided
by risk assessors, benefits analyses apply a variety of eco-
nomic methodologies to estimate the value of anticipated
health improvements and other sources of environmental
benefits. Social cost analyses attempt to estimate the total
welfare costs, net of any transfers, imposed by environ-
mental policies. In most instances, these costs are meas-
ured by higher costs of consumption goods for consumers
and. lower earnings for producers and other factors of pro-
duction. Some of the findings of a social cost analysis are
inputs for benefits analyses, such as predicted changes in
the outputs of goods associated with a pollution problem.
The assumptions and. modeling framework developed for
the BCA, constrain and limit the estimation techniques
used to examine gainers and losers (in an EIA) or to
examine impacts on disadvantaged sub-populations (in an
1 The general equilibrium framework Mil at least capture all "market" benefits and costs, but may not include non-market benefits, such
as those associated with existence value. In practice, models of general equilibrium may also be unable to analyze relatively small sectors of the econ-
omy. For more on general equilibrium analysis see Chapter 8, section 4.5.
20
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Chapter 5: Overview
equity assessment). To estimate these two categories of
impacts we rely on a multiplicity of estimation techniques.
The constraints faced by these analyses as well as details
regarding estimation techniques are given by Chapter 9-
5.3
An economic analysis of a policy or regulation compares
"the world with the policy or regulation" (the policy sce-
nario) with "the world absent the policy or regulation" (the
baseline scenario). Impacts of policies or regulations are
measured by the resulting differences between these two
scenarios. Measured differences may include changes in
pollutant emissions and. ambient concentrations, changes
in usage or production of toxic substances, and incidence
rates for adverse health effects associated with exposure to
pollutants.
Specification of baseline conditions can have profound
influence on the measurement and interpretation of ana-
lytic results. The complexity of the regulatory and policy-
making stipulations may not yield a clear-cut decision on
the specification of baseline conditions. The honesty and
integrity of the analysis depend on the ability of the analyst
to provide well-defined and defensible choices in the selec-
tion and estimation of baseline conditions. Analysts
uncertain about the selection of baseline conditions are
advised to review the guiding principles listed below. In
the development of the rule, the analyst is responsible for
raising questions about baseline definitions early within
the regulatory development process, and should receive
the views of enforcement and general counsel staff. Doing
so can facilitate the consistent treatment of this issue in
EPA analyses.
5.3.1 for
Baseline specification can be thought of as having two
steps—selection and quantification. The first step is to
select a baseline that is appropriate to the question the
analysis is intended to address. The second step is to esti-
mate the values of the relevant factors in the selected base-
line scenario. Several guiding principles to assist in the
treatment of baselines in an analysis are listed, below.
Though they exhibit a common sense approach to the
issue, the analyst is advised to provide explicit statements
within the analysis on each point. Failure to do so may
result in a confusing analytic presentation, inefficient use
of time and. resources, and misinterpretation of the eco-
nomic results.
f Clearly the question the analysis Is
addressing. The type of regulatory question facing
an analyst will affect the selection of the baseline in
an analysis. A baseline definition appropriate to
many analyses will be "reality in the absence of the
regulation." However, to ensure provisions contained
in statutes or policies precipitating the regulatory
action are appropriately addressed, it is useful to
assume full compliance with regulatory requirements
in most cases.2 Clearly stating the questions to be
answered by the analysis will help not only in choos-
ing an appropriate baseline, but also in communicat-
ing this information to persons using the results of
the analysis.
f Clearly identify all aspects of the baseline condi-
tions that are uncertain and all assumptions
made in specifying the baseline. If the analyst
had complete information about current values and
perfect foresight about the future, the appropriate
baseline conditions could be characterized with cer-
tainty. This, of course, is never the case. Current val-
ues of factors are often uncertain, and future values
of factors are always uncertain. Estimates of uncer-
tain factors should be based, on actual data, to the
extent possible. Uncertainties underlying the baseline
conditions should be treated as other types of uncer-
tainties are handled throughout the analysis. If, in
the face of uncertainty, assumptions about baseline
components are made, these should be the most real-
istic assumptions possible. For example, where reli-
able projections of future economic activity and
• Analysts should refer later sections of these guidelines (Section 5.3.2) and other cited EPA documents prepared in support of implement-
ing these statutes, for more detailed guidance on the treatment of baseline definitions and compliance assumptions used for economic analyses
required under these statutes. Much of the information on EPA's policies and guidelines applicable to rule development can be found at the following
EPA Intranet website http://intranet.epa.gov/rapids (accessed 8/02/2000, internal EPA document).
21
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Chapter 5: Overview
demographics are available, this information should
be accounted for in defining the baseline. All
assumptions should be clearly stated, with particular
attention given to situations calling for more than one
baseline to be included in the analysis.
ie consistent throughout the analysis In the use
of baselines. The same baseline should be carried
through for all components of the analysis. For
example, the comparison of costs and benefits in a
benefit-cost analysis should draw upon estimates
derived using the same baseline, so that the calcula-
tion of net economic benefits yields a meaningful eco-
nomic measure. Likewise, when comparing and
ranking alternative regulatory options, the same base-
line should be used for all options under considera-
tion. When use of more than one baseline scenario is
warranted, the analyst must avoid the mistake of
combining analytic results obtained from different
baseline scenarios. To limit confusion on this point,
if multiple baseline scenarios are included in an
analysis, presentations of economic information
should clearly describe and refer to which baseline
scenario is being used.
Determine the appropriate level of effort for
baseline specification. Every analysis is limited by
finite resources. Analytical efforts should be concen-
trated on those components of the baseline that are
most important to the analysis. If several compo-
nents of the baseline are uncertain, the analysis
should concentrate its limited resources on refining
the estimates of those components that have the
greatest effect on interpretation of the results.
Clearly state the "stalling point" of baseline and
policy scenarios. A starting point of an analysis is
the point in time at which the comparison between
the baseline and policy scenarios begins. This is con-
ceptually a point in time when the two scenarios are
believed to diverge. For example, one approach is to
organize the analysis presuming that the policy sce-
nario conditions diverge from those in the baseline at
the time an enforceable requirement becomes effec-
tive. Another convenient approach is to set the start-
ing point to be coincident with promulgation of the
final rule. These dates may be appropriate to use, as
thev are clearly defined under monitored administra-
tive procedures, or represent deadlines that compli-
ance progress can be measured against.
However, where behavioral changes are motivated by
the expected outcome of the regulatory process, the
actual timing of the formal issuance of an enforceable
requirement should not be used to define differences
between the baseline and policy scenarios. Earlier
starting points, such as the date authorizing legisla-
tion is signed into law, the date the rule is first pub-
lished in a Notice of Proposed Rule Making, or other
regulatory development process milestones, may be
supported if divergence from the baseline occurs due
to anticipation of promulgation. In some instances,
parties anticipating the outcome of a regulatory initia-
tive may change their economic behavior, including
spending resources to meet expected emission or
hazard reductions prior to the compliance deadline
set by enforceable requirements. The same issues
arise in the treatment of non-regulatory programs, in
which voluntary or negotiated, environmental goals
may be established, leading parties to take steps to
achieve these goals at rates different from those
expected in the absence of the program. In these
cases, it may be appropriate to include these costs
and benefits into the analysis of the policy action, and.
not subsume these into the baseline scenario. The
dynamic aspects of market and consumer behavior,
and the many motivations leading to change, can
make it more difficult to attribute economic costs and
benefits to specific regulations. Looking at the sensi-
tivity of the outcome of the analysis to these condi-
tions and assumptions will be useful.
Let the duration of important effects of a policy
dictate the structure of the analysis and. base-
line. To consider how the benefits of a proposed pol-
icy compare with the costs of the policy, the analyst
will assemble estimates of the present discounted val-
ues of the total costs and benefits attributable to the
policy. How one defines the baseline is particularly
important in situations in which the accrual of costs
and/or benefits do not coincide due to lagged effects,
or occur over an extended period of time. For exam-
ple, the human health benefits of a policy that
reduces leachate from landfills may not be manifest
for many years, if the potential for human exposure
through contaminated groundwater may occur
22
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Chapter 5: Overview
decades after closure of the landfill. In theory, then,
the longer the lime frame, the more likely the analy-
sis will depict all the benefits and costs of the policy
that are expected to occur. However, forecasts of eco-
nomic, demographic, and technological trends neces-
sary for baseline specification must also span the
entire period of the analysis. Because the reliability of
many forecasts diminishes into the future, the analyst
must balance the advantages of structuring the analy-
sis to include a, longer time span against the disad-
vantages of the decreasing reliability of the analytic
results.
Defining the baseline and policy scenarios will often
require information and assumptions on trends in
behavior, and how these trends may be affected by
regulatory management options. For example, the
analyst may observe trends in economic activity or
pollution control technologies that occur for reasons
other than direct environmental regulations. For
example, as the purchasing power of consumer
income increases over time, demand for different
commodities can change. Demand for some com-
modities may grow at rates faster than the rate of
change in income, while demand for other goods may
decrease. Therefore, where these trends are highly
uncertain or are expected to have significant influence
on the evaluation of regulatory alternatives (including
a "no-regulatory control" alternative), the analyst
should clearly explain and identify their choices in the
analysis.
Lastly, in some cases the benefits of a policy will be
expected to increase over time. Some analyses must
therefore look far enough into the future to assure
that benefits are not substantially underestimated. For
example, suppose a policy that would greatly reduce
greenhouse gas emissions were being proposed. In
the baseline scenario, the level of greenhouse gases in
the atmosphere would steadily increase over time,
with a corresponding increase in expected human
health and welfare and ecological changes. A benefit-
cost analysis limited to the first decade after initiation
of the policy would be likely to distort the relationship
of benefits and costs associated with the policy. In
this case, the conflict between the need to consider a
long time frame and the decreasing reliability of fore-
casting far into the future may be substantial. In
most cases, primary considerations in determining
the lime horizon of the analysis will be the time span
of the physical effects that drive the benefits esti-
mates, and capital investment cycles associated with
environmental expenditures.
5.3.2
One aspect of baseline specification that is particularly
complex, and for which assumptions are typically neces-
sary, is that of compliance rates. The treatment of compli-
ance in the baseline scenario can significantly affect the
results of the analysis. Therefore, it is important to be
clear to persons using the analysis how assumptions about
compliance behavior are incorporated into the analysis,
and how sensitive the results are to the handling of com-
pliance rates.
It can be challenging to clearly demonstrate the economic
effects attributable to a new regulation or policy; while
avoiding the potential for double-counting of benefits,
costs, and impacts associated with separate existing regula-
tions. To aid in preparation of the economic analysis and
presentation of results, it is common to establish baseline
conditions so that the affected regulated entities are in full
compliance with other separate existing regulations.
Assuming full compliance with existing regulations will
enable the analysis to focus on the incremental economic
effects of the new rule or policy, the resulls of which are
used to evaluate the predicted economic changes. This
information also meets the requirements contained in
many of the statutes and administrative orders that use
economic information as evidence that further steps need
to be taken to address the effects on regulated parties
(described in Chapters 2 and 9).
Defining the baseline in this fashion may pose some
challenges to the analyst, since current observed or
reported economic behavior may represent the
consequences of either under-compliance or over-
compliance with existing regulations. For example, it is
possible to observe over-compliance by regulated entities
with enforceable standards. One can find industries whose
current effluent discharge concentrations for regulated
pollutants are measured below concentrations legally
required by existing effluent guideline regulations. On the
23
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Chapter 5: Overview
other hand, evidence for under-compliance is evident in
the resources devoted by EPA and other state and local
replatory agencies to enforce rules through orders, fines,
and negotiated settlements. As a result, it will be
important that the analysis separates the changes
associated with a new regulation from actions taken to
meet existing requirements. This is of particular
importance if actions taken to meet existing requirements
are coincident with, but not caused by, changes introduced
by the new regulation.3
For some types of analyses it is sensible to establish a
baseline of "current practice" (i.e., what is believed to be
the actual degree of compliance, rather than assumed full
compliance). For example, when a new action under
review is intended to address or "fix-up" compliance prob-
lems associated with existing policies, information on cur-
rent practices belongs in the baseline. Otherwise, defining
the baseline in a manner that disregards this behavior will
obscure the value of investigating whether further or alter-
native regulatory actions are necessary (e.g., as was the
case in a review of banning lead from gasoline, which was
precipitated in part by the noncompliance of consumers
misfueling their non-leaded gasoline automobiles (EPA,
1985)). For a deregulatory rule (e.g., a rule designed to
address potential changes in or clarity definitions of regu-
latory performance thai frees entities from enforceable
requirements contained in an existing rule), it may be
sensible to perform the analysis using both a full compli-
ance and "current practices" baseline. A full compliance
scenario in this instance introduces some added complica-
tions to the analysis, but it may be important to report on
the economic effects of failing to take the deregulatory
action.
In cases of over-compliance with existing policies, or
actions already taken in the economic interests of the
affected parties, current practices can be used to define
baseline conditions unless these practices are expected to
change or are highly uncertain in ways that are directly
associated with the rule being analyzed. For example,
observed over-compliance by a regulated entity may be the
result of choices it has made to anticipate forthcoming
more stringent federal regulatory requirements. If there
should be a decision not to follow through with the antici-
pated federal regulation, the analysis will need to establish
whether the current observed over-compliance behavior by
the regulated entity may be curtailed to meet existing (i.e.,
relatively less stringent) requirements. If the regulated
entity in this example is expected to continue to over-com-
ply despite the absence of the more stringent regulation,
then the policy scenario should not contain the costs and
benefits attributable to this behavior, and it is appropriate
to account for them in the baseline scenario that describes
the "world without the regulation." However, if the regu-
lated entity will relax its pollution control practices to meet
current requirements after the stricter regulation fails to
emerge, then the costs and benefits of the over-compliance
behavior should be attributed to the policy scenario. In
these situations, it may be useful to consider performing
the analysis with alternative baseline scenarios, and
demonstrate the potential economic consequences of dif-
ferent assumptions associated with the expected changes
in this type of behavior.
Analysts may also elect to incorporate predicted differences
in compliance rates within policy options considered for
new rules, in cases where compliance behavior is known
to vary systematically with the regulatory options being
considered (e.g., if the expected compliance rale with a
rule may differ if entities are regulated using economic
incentives as compared with prescribed control
technologies).
Despite the above possible complexities, il is prtulenl for
most analyses of regulations to develop baseline and
policy scenarios that assume full compliance with
existing and newly enacted regulations. One rationale
for adopting these assumptions is that the analytic results
will provide information on the unique role the action
under consideration is expected to have on the economy
which may be required under the authorizing statute, or
administrative laws and policies. As a practical matter,
noncomplianl behavior will need to be known, estimable,
and occurring at rates that can affect the evaluation of
policy options before totally rejecting assumptions of "full
'' For example, assigning costs between an existing and new regulation could be further complicated, if. as a result of under-compliance
with the existing regulation, the estimated ''joint" cost of meeting both regulations differs from the summed marginal costs of first meeting the exist-
ing regulation, followed by implementing the new regulation. The same concern equally applies to the attribution of benefits and economic impacts
to each regulation. Under these circumstances, the analyst should seek further directions provided by the authorizing legislation for the regulation, or
instructions contained in other operative laws and policies.
24
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Chapter 5: Overview
compliance" for existing and new policies. In the end,
assumptions on compliance behavior for current and new
requirements should be clearly presented in the
description of the analytic approach and assumption used
for the analysis. Care should be taken to describe the
importance of these assumptions when comparing
regulatory options for which social costs and benefits, and
economic impacts have been estimated.
5.3.3 or
Specification
If conditions exist where there are no other relevant
regulations, specifying a baseline is not complicated by
questions of whether other regulations are being
implemented and, if so, which regulations are responsible
for environmental improvements and can "take credit" for
reductions in risks. That is, there is no need to be
concerned with which environmental improvements are in
the baseline. Nor is it necessary to try to determine how
these other regulations affect market conditions that
directly influence the costs or the benefits associated with
the policy of interest.
But actual conditions in the regulation of environmental
risks are much more complex, and it is an unusual case
where the above holds true. There are many regulatory
agencies (i.e., federal, state, local) affecting environmental
behavior, and several forms of consumer and industrial
behavior are regulated by agencies whose agendas can
overlap with EPA's (e.g., OSIIA, DOT, DOE). Absent an
orderly sequence of events that allows attributing changes
in behavior to a unique regulatory source, in practice,
there is no non-arbitrary way to allocate the costs and the
benefits of a package of overlapping policies to each
individual policy Whether any one of these policies is "in
the baseline" of the benefit-cost analysis of another policy
is, to a large degree, a matter of choice. There is no
theoretically correct order for conducting a sequential
analysis of multiple overlapping policies that are
promulgaled simultaneously.
An idealized approach would attempt to analyze all of the
policies together when assessing the total costs and
benefits resulting from the package of policies. However,
this kind of comprehensive analysis is usually not feasible.
A practical alternative may be to consider the actual or
statutory timing of the promulgation and/or
implementation of the policies, and use this to establish a
sequence with which to analyze related rules. But even
when the temporal order of policies makes it clearer which
policies are "in the baseline" and which are not, different
depictions of the timing and impacts of pre-existing or
overlapping policies can still have a substantial effect on
the outcome of a benefit-cost analysis. An example of this,
offered by Arnold (1995), concerns regulations designed to
reduce the production of chlorofluorocarbons (CFCs) and
other ozone-depleting substances. In this case, the
impacts of multiple regulations on production decisions
were not separable or independent of the order of their
issuance, so that the costs and benefits of requirements
estimated for each regulation were dependent on which
preexisting rules were considered binding in the analysis.
A similar illustration concerning hazardous waste
regulations is also provided by Arnold (1995), wherein an
assessment of the cosls and benefits associated with
several regulations is performed, demonstrating that the
result of evaluating each individual regulation varies
significantly depending on which of the other regulations
are included in the baseline.
Therefore, the best practice is to be clear as to the baseline
selected for the analysis, and to present a justification for
making this choice. This can include providing informa-
tion on the status of other regulatory actions that may
have some effect on the baseline, and conducting sensitivi-
ty analyses that test for the implications of including or
omitting other regulations. Some regulatory actions have
attempted to directly link rules together that affect the
same industrial category (e.g., the pulp and paper effluent
guidelines and NESHAP rules (EPA, 1997)). While statuto-
ry and judicial (leadlines may inhibit the linking of rules
that fall on the same replated entities (e.g., LMR4 and
MA require analyses be performed for each rule), coordi-
nation between rulemaking groups is advocated in EPA's
regulatory development process, and sharing of data, mod-
els, and joint decisions on analytic approaches is strongly
recommended.
5.3.4
The specification of the baseline for an economic analysis
can have a profound influence on the outcome of the
25
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Chapter 5: Overview
analysis. The estimated costs and/or benefits of a
proposed policy can change by an order of magnitude
under different baseline assumptions. Careful thought in
specifying the baseline is therefore crucial to a defensible
analysis.
The first slep is to be clear about the question being asked
and therefore what baseline the analyst would like to spec-
ify. The second step is to characterize that baseline as well
as possible within the constraints of the analysis. This
involves determining which baseline parameters are most
important to the analysis, assessing the advisability of
expending resources to improve the estimates of those
parameters, and making reasonable assumptions when
necessary. In all cases, assumptions and uncertainties
should be clearly stated as part of the analysis, along with
a discussion of how alternative, plausible assumptions
would be likely to affect the outcome of the analysis.
Within the resources available, sensitivity analysis and
uncertainty analysis are valuable tools for illustrating the
potential impacts of assumptions made and quantifying, to
the degree possible, the extent of the uncertainty underly-
ing the specified baseline. Finally, the estimation of the
costs and benefits attributable to individual policies in a
package of policies is a problem for which there simply is
no "correct answer."
Many factors will affect the configuration of the baseline in
EPA's economic analyses. This means that even though
analytical choices are well-constructed and logical, the
consequences of these differences may frustrate efforts to
attain comparability of baselines across different regulatory
activities. Still, in any effort to evaluate regulatory options
and assess benefits, costs, and economic impacts attribut-
able to an individual rule, the analysis should be internally
consistent in its definition and use of baseline assump-
tions. This is imperative when more than one baseline
scenario is introduced, since this provides more possibili-
ties to erroneously compare costs and benefits across dif-
ferent baselines. A decision to include multiple baselines
into an analysis can result in a complex set of modeling
choices, and an abundance of analytic results to interpret
and communicate to decision makers. Therefore, analysts
are advised to seek clear direction from management
about baseline definitions early during the development of
a rule.
5.4
to a
It is impossible to measure an environmental policy's costs
and benefits without a clear characterization of actions
taken in response to the policy. Some policies are pre-
scriptive in specifying what actions are required—for
example, mandating the use of a specific type of pollution
control equipment. It can be difficult, however, to predict
responses to less-direct performance standards, such as
bans on the production or use of certain products or
processes, and market-based incentive programs. Analysis
should make explicit all assumptions about responses,
and should consider plausible alternative compliance
options. Alternatively, when the number of conceivable
options is essentially infinite, the analysis should at least
span the range of possibilities. Cost-effectiveness analysis
can often be used to identify and map out dominant regu-
latory options and responses. When it is not possible to
characterize compliance responses with a high degree of
certainty, the analysis should include a description of the
likely direction of bias in the estimates—whether costs
and benefits are over- or understated—if this is known.
Predicting responses starts with a comprehensive list of
possible response options. These may include the use of
different compliance technologies (if the technology is not
specified by the policy itself) or waste management
methods; changes in operations to avoid or reduce the
need for new controls or the utilization of materials whose
use is restricted by a policy (including various types of
pollution prevention); shutting down a production line or
plant to avoid, the investments required to achieve
compliance; or even noncompliance.1 Typically, parties
affected by a policy are assumed to choose the compliance
option that minimizes their costs. In some cases,
however, it may be reasonable to select a more cosily
option as the most likely response. Sometimes a higher
4 As in the case of baseline specification, most analyses will assume full compliance by all entities that continue to operate. For some poli-
cies that present significant enforcement challenges, or for options that differ in ways that are likely to affect compliance rates, it may be useful to cal-
culate how costs and benefits compare when using estimates of compliance rates less than 100 percent.
26
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Chapter 5: Overview
cost option may significantly reduce future legal liabilities,
or achieve compliance with other rules being implemented
at either the same time, or those expected to be
promulgated in the future. However, the additional costs
of compliance responses in excess of least-cost strategy
costs should be attributed to these other causes.
Estimating responses is often the most difficult for pollu-
tion prevention policies because these options are general-
ly more site- and process-specific than end-of-pipe control
technologies. Predicting the costs and environmental
effects of pollution prevention policies may require
detailed information on industrial processes. As a result,
the costs of a pollution prevention policy may be overstat-
ed and the benefits either over- or understated (depending
on the nature of the process changes involved).
Nevertheless, economic analyses should at least include
qualitative discussion of potential pollution prevention
responses and their effects on costs and benefits.
Predicting reductions in output (e.g., production line or
plant closures) in response to a policy requires analysis of
market characteristics thai determine the allocation of cost
increases among directly affected entities and their suppli-
ers, customers, and competitors. This subject is discussed
in the economic impact analysis section of Chapter 9-
5.5
This section contains guidance on dealing with uncertainty
in regulatory economic analyses, focusing on characteriz-
ing the precision of estimated economic outcomes such as
net benefits. It provides specific recommendations for
describing and presenting problems arising from uncer-
tainty; and suggestions for carrying out sensitivity analyses.
This section concludes with a discussion of the welfare
considerations related to risk and uncertainty.5 These con-
siderations are largely distinct from those associated with
characterizing precision. The use of certainty equivalents
for addressing these problems is addressed briefly, but
detailed treatment is beyond the scope of this discussion.6
Issues related to differences in risk perceptions and the
provision of information are described, and the role of
quasi-option values in decisions characterized by irre-
versible consequences is addressed briefly.
5.5.1 for
Uncertainty is inherent in economic analyses, particularly
those associated with environmental benefits for which
there are no existing markets. The issue for the analyst is
not how to avoid uncertainly, but how to account for it and
present useful conclusions to those making policy deci-
sions. Treatment of uncertainty, therefore, should be con-
sidered part of the communication process between ana-
lysts and policy makers.
Transparency and clarity of presentation are the guiding
principles for assessing and describing uncertainty in
economic analyses. Although the extent to which
uncertainty is treated and presented will vary according to
the specific needs of the economic analysis, some general
minimum requirements apply to most economic analyses.
In assessing and presenting uncertainty the analyst should,
if feasible:
f present outcomes or conclusions based on expected
or most plausible values;
f provide descriptions of all known key assumptions,
biases, and omissions;
f perform sensitivity analysis on key assumptions; and
f justify the assumptions used in the sensitivity
analysis.
The outcome of the initial assessment of uncertainty may
be sufficient to support the policy decisions. If, however,
the implications of uncertainty are not adequately cap-
tured in the initial assessment then a more sophisticated
5 Stemming from definitions given in Knight (1921) economists have distinguished risk and uncertainty according to how well one can
characterize the probabilities associated with potential outcomes. Risk applies to situations or circumstances in which a probability distribution is
known or assumed, while uncertainty applies to cases where knowledge of probabilities is absent. Note that the economic definitions for these terms
may differ from those used in other disciplines,
6 Several other issues associated with uncertainty are also beyond the scope of this brief discussion, including verification, validation, and
plausibility checks. Analysts will need to consult other sources for additional information on these topics.
27
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Chapter 5: Overview
analysis should be undertaken. The need for additional
analysis should be clearly slated, along with a description
of the other methods used for assessing uncertainty.
These methods include decision trees, Delphi-type meth-
ods7, and meta-analysis. Probabilistic methods, including
Monte Carlo analysis, can be particularly useful because
they explicitly characterize analytical uncertainty and vari-
ability. However, these methods can be difficult to imple-
ment, often requiring more data than are available to the
analyst.8
Confidence intervals are generally useful to describe the
uncertainty associated with particular variables. When
data are available to estimate confidence intervals they can
serve to characterize the precision of estimates and to
bound the values used in sensitivitv analysis.
Analysis
Most analytical base cases, or primary analyses, generally
do not address uncertainty and present expected or most
plausible outcomes. Regardless of the basis for the
primary analysis, point estimates alone do not provide
policy makers with information about the full range of
potential outcomes. Additional information is needed if
the decision-maker is to have a more complete view of the
potential impacts of the policy alternatives. It is always
useful to see how net benefit estimates or other outputs of
the economic analysis change with assumptions about
input parameters. Sensitivity analysis provides a
systematic method for making these determinations.
Keeping in mind some basic principles can enhance
sensitivity analysis.
f Focus on key variables. For most applied economic
analyses, a full sensitivity analysis that includes every
variable is not feasible. Instead the analyst must limit
the sensitivity analysis to those input parameters that
are considered to be key or particularly important. In
determining which parameters are key, the analyst
should carefully consider both the range of possible
values for input parameters and each one's functional
relationship to the output of analysis. The analyst
should specify a plausible range of values for each key
variable, including the rationale for the range of val-
ues tested.
Present the results clearly. Results of the sensitivi-
ty analysis should be presented clearly and accompa-
nied with descriptive text. The most common
approach to this sort of partial sensitivity analysis is to
estimate the change in net benefits (for a benefit-cost
analysis) or other economic outcome while varying a
single parameter, leaving other parameters at their
base value. A more complete analysis will present the
marginal changes in the economic outcome as the
input parameter takes on progressively higher or
lower values. Varying two parameters simultaneously
can often provide a richer picture of the implications
of base values and the robustness of the analysis.
Analysts should consider using graphs to present
these combined sensitivity analyses by plotting one
parameter on the x-axis, the economic outcome on
the y-axis, and treating the second parameter as a
shift variable.9
Identify switch points. "Switch point" values for
key input parameters can be very informative, espe-
cially in benefit-cost analyses. Switch points are
defined as those conditions at which the recommend-
ed policy decision changes (e.g., when the estimation
of net benefits changes sign). While switch points are
not tests of confidence in the statistical sense, they
can help provide decision-makers with an under-
standing of how robust the analysis is.
Assess the need for more detailed analysis.
Finally; sensitivity analyses can also be useful as a
screening device to determine where more extensive
treatment of uncertainty may be needed. In some
cases the plausible range of values for the parameter
may be narrowed with further research or data gath-
ering, or the analyst may be able to better character-
ize the parameter's uncertainty. If several parameters
'There a number of such techniques, but all of these methods focus on the use of eliciting and combining expert judgment to inform
analysis. See Chapter 7 of Morgan and Henrion (1990) for more detail on the use of these methods.
8 Morgan and Henrion (1990) is a useful general reference that includes descriptions of many methods to assess uncertainty,
' When the analysis contains many highly uncertain variables, presentation may be facilitated by noting the uncertainty of each in foot-
notes and carrying through the central analysis using best point estimates.
28
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Chapter 5: Overview
appear to have a large impact on the results of the
analysis then a more sophisticated treatment of
uncertainty may be necessary
5.5.3
to
So far this discussion has focused upon uncertainty as it
must be accommodated by the analyst charged with per-
forming an economic assessment and. the decision-maker
who receives this information. A separate but related issue
is how individuals affected by environmental policies
respond to uncertainty in outcomes and imperfect infor-
mation. These responses may have an impact on how
individuals respond to policy alternatives and how they
value policy outcomes. Some of these considerations are
noted here, but this treatment is not detailed or exhaus-
tive. It is important to note that analytical precision and
welfare effects are distinct concepts. Certainty equivalents,
for example, address welfare effects and are appropriate
for assessing efficiency in a benefit-cost analysis, but they
do not assess analytical precision or mitigate the useful-
ness of sensitivity analyses and bounding cases.
f Risk attitudes and certainty equivalents:
Individuals and other entities are generally not neu-
tral when faced with situations of uncertainty or risk.
In most cases related to environment and health they
are considered to be risk averse, favoring a certain
outcome to one that is uncertain even if the expected
value of the risky outcome is equal to the value of the
certain one. The theoretically preferred manner of
incorporating risk attitudes is to use certainly equiv-
alents, sometimes termed certain monetary equiva-
lents. Certainty equivalents are defined as the mini-
mum amount that an individual would be willing to
accept with certainty instead of facing the uncertain
outcomes.10
While certainty equivalents have theoretic appeal, they
are difficult to put into practice for economic analyses
of environmental policies. Estimation of certainty
equivalents requires detailed knowledge of (or
assumptions about) risk preferences, and analysts are
unlikely to have these data. To estimate certainty
equivalents one must also be able to assign probabili-
ties to the set of potential outcomes. It is often very
difficult or impossible to make these assignments.
Lay and expert risk perceptions: Lay perceptions
of risk may differ significantly from scientific assess-
ments of the same risk, and an extensive literature
has developed on the topic.11 Because individuals
respond according to their own risk perceptions, it is
important for the analyst to be attentive to situations
where there is an obvious divergence in these two
measures. In such cases, analysts should consider
evaluating policy options under both sets of informa-
tion, clearly stating the basis for economic value esti-
mates used or developed in their analysis. Because
providing information to the public may reduce differ-
ences between lay and expert perceptions of risk, and
may allay public concerns, analysts should consider
including these strategies in their analysis of potential
policy options.
Provision of information: Some policy actions
focus on providing information on risks to health and
welfare. Inasmuch as this information allows con-
sumers to make better decisions regarding their
households' welfare there is an economic benefit to
providing this information. Revealed, preference ben-
efit analyses, however, can make new information
appear to have a net negative effect on household wel-
fare because households may undertake new (and
costly) activities in response. An appropriate frame-
work for evaluating the benefits of information provi-
sion under these circumstances is to assess the costs
of sub-optimal household decisions under the less-
complete information.12 Analysts should carefully
consider these issues when they evaluate policies that
focus on information provision.
10 Some researchers have suggested risk-adjusted discount rates as an alternative device for incorporating information on the uncertainty
future benefits and costs. Most economists now conclude, however, that the discount rate should not be adjusted to account for uncertainty in bene-
fit-cost analysis.
11 Useful general sources include Slovic (1987) and Fischhoff et at. (1978).
12 Foster and Just (1989) describes this approach more fully, demonstrating that compensating surplus is an appropriate measure of will-
ingness-to-pay under these conditions. The authors illustrate this with an empirical application to food safety.
29
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Chapter 5: Overview
f Quasi-option value: Another relevant issue in deci-
sion-making under uncertainty is that of quasi-option
value as identified by Arrow and Fisher (1974). Some
environmental policies involve irreversible decisions
that must be made in the face of uncertainty. If infor-
mation that reduces this uncertainly can be expected
to develop over time, then there is a positive "quasi-
option" value to waiting until this information is avail-
able. In this case, the value originates from possess-
ing the option to hold off on making the decision
until uncertainties are resolved. Generally, it is diffi-
cult to quantitatively include quasi-option values in an
economic analysis of environmental policy, but the
concept is useful and may be highlighted qualitatively
if circumstances warrant. For more on this issue see
Freeman (1984, 1993), Fisher and Hanemann
(1987), and Cochrane and Cutler (1990).
5.6
Many other cross-cutting issues are not detailed in the EA
Guidelines. Some of these issues are difficult or impossi-
ble to incorporate fully into economic analyses at this
lime, but may become either more important or more
tractable as the economic literature develops. Although
the relevance of these considerations depends on the
specifics of the policy being considered, analysts may want
to at least consider these issues qualitatively. Three
emerging issues are identified here: tax interaction effects,
the pace of exogenous technological change, and the
effects of regulation on innovation.
f Tax Interaction effects: Although evaluations of
environmental policies typically assume a first-best
regulatory setting, preexisting taxes such as those on
labor income create a second-best setting. This dif-
ference can affect the estimated costs of policy
actions. Recent advances in applied general equilibri-
um analysis have led to generally replicable qualita-
tive results. These studies indicate that ignoring these
effects may result in underestimating the cost of com-
pliance, from a social perspective.13 However, the
magnitude of the effect—and perhaps the direc-
tion—will vary across policies. Although the analyti-
cal emphasis on this issue has been on estimating
costs, benefits analysis can conceivably suffer a simi-
lar bias.
Pace of exogenous technological change:
Economic analysis of environmental policies may be
affected by the pace of exogenous technological
change. In principal, accounting for this can either
increase or decrease marginal and. total abatement
costs, depending on the direction of change.
Generally, however, the expectation is that accounting
for exogenous technological change would decrease
estimated abatement costs. Recent analyses have
indicated that even for mature technologies the mag-
nitude of this effect can be large.14
Regulation and Innovation: More extensive
research is being developed to examine the impact of
various regulatory approaches on firms' research and
development decisions for abatement technology." As
suggested in the descriptions of alternative regulatory
approaches in Chapter 4, this impact may be positive
or negative depending on the regulatory approach and
setting. Generally, economists expect that incentive-
based instruments will provide greater incentive for
cost-reducing innovations than will command and
control regulatory approaches. Policies that provide
information to firms and consumers may also affect
technological innovation. Chapter 8 provides some
additional information on the subject of regulation,
innovation, and the implications for estimating social
costs.
" For an example see Bovenberg and Goulder (1997),
14 See, for example, Ellerman and Montero (1998) and Carlson et al (1998).
15 See, for example, Milliman and Prince (1989) and Biglaiser and Horowitz (1995).
30
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Chapter 5: Overview
5.1
Arnold, F. S. 1995. Economic. Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons,
Inc.
Arrow, K. J. and A. C. Fisher. 1974. Environmental Preservation, Uncertainty and Irreversibility, Quarterly Journal of
Economics, 88(1): 1-9.
Biglaiser, G. and J. K Horowitz. 1995. Pollution Regulation and Incentives for Pollution-Control Research, Journal of
Environmental Economics and Management, 3(4): 663-684.
Bovenberg, A. L. and L. H. Goulder. 1997. Costs of Environmentally Motivated Taxes in the Presence of Other Taxes:
General Equilibrium Analyses, National Tax Journal, 50(1): 59-87.
Carlson, C., D. Burtraw, M. Cropper, K. L. Palmer. 1998. Sulfur Dioxide Control by Electric Utilities: What are the Gains
from Trade? Resources for the Future, Discussion Paper 98-44.
Cochrane, H. and H. Cutler. 1990. The Economics of Sequential Choice Applied to Quasi-Option Value,/owr««/ of
Environmental Economics and Management, 18(3): 238-246.
Ellerman, A. D. and J.E Montero. 1998. The Declining Trend in Sulfur Dioxide Emissions: Implications for Allowance
Prices. Journal of Environmental Economics and Management, 36(1): 26-45.
Fischhoff, B. et al. 1978. How Safe is Safe Enough? A Psychometric Study of Attitudes Towards Technological Risks and
Benefits. Policy Sciences 9'. 127-152.
Fisher, A. C and W M. Ilanemann. 1987. Quasi-Option Value: Some Misconceptions Dispelled, Journal of Environmental
Economics and Management, 14(2): 183-190.
Foster, W and R. E. Just. 1989. Measuring Welfare Effects of Product Contamination with Consumer Uncertainty. Journal
of Environmental Economics and Management, 17: 266-283.
Freeman, A. M. III. 1984. The Quasi-Option Value of Irreversible Development, Journal of Environmental Economics
and Management, 11(3): 292-295.
Freeman, A. M. III. 1993- The Measurement of Environmental and Resource Values: Theory and Methods. Resources
for the Future, Washington, D.C.
Knight, F. H. 1921. Risk, Uncertainty, and Profit. Boston, MA: Houghton, Mifflin Co.
Milliman, S. R. and R. Price. 1989. Firm Incentives to Promote Technological Change in Pollution Control, Journal of
Environmental Economics and Management, 17(3): 247-265.
Morgan, M. G. and M. Henrion. 1990. Uncertainty: A Guide to Dealing with Uncertainly in Quantitative Risk and
Policy Analysis. New York, NY: Cambridge University Press.
Slovic, P 1987. Perception of Risk. Science, 30(4): 423-439-
U.S. Environmental Protection Agency. 1985. Costs and Benefits of Reducing Lead in Gasoline: Final Regulatory
Impact Analysis. EPA/230/05-85-006, Office of Policy Analysis, February 1985.
U.S. Environmental Protection Agency. 1997. Economic Analysis for the NationalEmissions Standards for Hazardous
Air Pollutants (NESHAPS) for Source Category; Pulp and Paper Production; Effluent Guidelines, Pretreatment
Standards, and New Source Performance Standards: Pulp, Paper and Paperboard Category - Phase /.
EPA/821/R-97/012, Office ofWater, October 1997.
31
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Chapter 6: Analysis of Social
Discounting
6.1 Introduction
The costs and benefits of many environmental poli-
cies are frequently paid and received at different
points over the course of sometimes long time hori-
zons. As a result, benefit-cost and related analyses
that are key components of EPA's policy development
and evaluation process must describe future effects
in terms that help present day policy makers choose
appropriate approaches for environmental protection.
One common method for doing so is called discount-
ing, which is the process whereby the values of future
effects are adjusted to render them comparable to
the values placed on current consumption, costs, and
benefits, reflecting the fact that a given amount of
future consumption is worth less than the same
amount of consumption today. Time discounting is
accomplished by multiplying the future values of a
policy's effects by discount factors that reflect both
the amount of time between the present and the
point at which these events occur and the degree to
which current consumption is more highly valued
than future consumption.
Despite the relative simplicity of the discounting con-
cept, choosing a discount rate has been one of the
most contentious and controversial aspects of EPA's
economic analyses of environmental policies. While
there are several plausible explanations for why dis-
counting in environmental policy evaluation has been
unsettled for many years, the most important is that
the theoretical and applied economics literature on
discounting from a social perspective is voluminous
and technically complex. This makes it difficult to
distill precise advice on appropriate discounting pro-
cedures for policy analysis. Moreover, in some cases
the economics literature by itself does not yield sim-
ple and robust discounting rules for practical applica-
tions because making such important social deci-
sions requires inputs from disciplines other than
economics.
Nonetheless, it is important to consider the uncer-
tainties surrounding social discounting in the broad-
er context of applied economic analysis. Benefit-cost
analysis is not a precise tool that yields firm numeri-
cal results, rather, it is a general framework for more
carefully accounting for the potential and varied
effects of government programs. Some of these
effects can be quantified, whereas others can only be
assessed qualitatively. Some may be relatively cer-
tain, whereas others may be quite speculative.
The imprecision connected with assessing benefits
and costs suggests that the controversy surrounding
the discount rate, in many circumstances, may have
more theoretical than practical significance. For
example, the effects on net benefits of alternative
assumptions made for measuring and valuing uncer-
tain effects of environmental policies can overwhelm
the effects of changes in the discount rate.
Additionally, for some government projects, benefits
and costs may have similar time profiles, or benefits
may so outweigh costs (or vice versa), that changes
in the discount rate will not influence the policy
implications of the analysis.
This review of the basics of social discounting begins
in Section 6.2 with a discussion of some general
considerations in social discounting. In Section 6.3,
various discounting procedures for environmental
policy assessment are presented and evaluated. This
detailed discussion is divided into social discounting
as applied in intra-generational contexts, where very
long time horizons involving multiple generations do
not apply, and discounting for inter-generational
Chapter
6
33
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Chapter 6: Social Discounting
circumstances involving long time horizons and unborn
generations. EPA guidance for intra-generalional social
discounting is presented in Section 6.3.1.5. EPA guidance
on inter-generational social discounting follows in Section
6.3.2.4. Finally, discounting and related procedures for
situations in which some effects are not monetized are
addressed in Section 6.4.
gest that social discounting is a very different process than
a single individual's discounting. In any event, at a mini-
mum, the term "social discounting" refers to the broad
society-as-a-whole point of view embodied in benefit-cost
and other analyses of public policies. Whether it also con-
notes procedures and rates different from private dis-
counting is a central question explored in this chapter.
6.2
in
This section reviews a few basic concepts and
considerations central to understanding the role and
importance of discounting in public policy evaluation. The
focus is mainly on describing social discounting and on
distinguishing discounting per se from other aspects of
measuring and summarizing the costs, benefits, impacts,
and other consequences of environmental policies. It also
discusses the circumstances in which discounting has a
large impact on the net social benefits of an environmental
policy.
6.2.1
Discounting
Discounting in public policy evaluation is normally
referred to as social discounting or discounting using the
social, rate of interest. The process itself—applying dis-
count factors to future flows of costs, benefits, and other
consequences of environmental and other policies—is
mechanically the same as the discounting process in pri-
vate individuals' economic and financial calculations.
What makes it "social" discounting is that it is being
applied in the context of evaluating a policy's effects from
an overall social perspective. Clearly, private and social
perspectives can yield very different conclusions concern-
ing, for example, the cost of engaging in an activity that
also generates environmental harms.
Whether social discounting also departs significantly from
private discounting, however, is less clear. Some
approaches to social discounting suggest that the proce-
dures and rates should be the same as those used in pri-
vate sector discounting. Other perspectives, however, sug-
6.2.2 for
Benefits
Most applications of social discounting in environmental
policy evaluation involve translating future values into
present ones. The conceptual foundation of discounting is
based on the fact that present consumption is valued dif-
ferently from future consumption. Discounting renders
costs and benefits that occur in different time periods
comparable by stating them all in present day terms. The
resulting net present value is at least one measure of
social value that might be used in evaluating environmen-
tal policies.
6.2.2.1 Net
In formal terms, the net present value of a projected
stream of current and future benefits and costs is found by
multiplying the benefits and costs in each year by a time-
dependent weight, dt, and adding all of the weighted values
as follows:
NPV = NB0 + d,NB, + d^B2 + - + drflBn
NBt is the net difference between benefits and costs (BfC/)
that accrue at the end of period, /, and the discounting
weights are given by:
where r is the discount rate and n is the final period in the
future in which the policy's effects are felt.
To account for inflation, either real or nominal values may
be used, as long as they are used consistently. In other
words, nominal costs and benefits require nominal
discount rates, and real costs and benefits require real
discount rates. Moreover, consistent decision making
requires that the same discount rate be used for both
34
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Chapter 6: Social Discounting
benefits and costs. Otherwise, any policy can be justified
by choosing a sufficiently low discount rate for benefits, by
choosing a sufficiently high discount rates for costs, or by
choosing a sufficiently long time horizon.
It is important to be explicit about how time periods are
designated and when, within each time period, costs and
benefits accrue. Typically, time periods are years, but
alternative time periods may prove desirable or necessary
if costs or benefits accrue at irregular or non-annual inter-
vals. The preceding formula assumes that t=0 designates
the beginning of the first period. Therefore, C0 represents
startup costs such as capital costs that occur immediately
upon implementation of the regulation. The formula fur-
ther assumes that no additional costs are incurred until
the end of the first year of regulatory compliance.1
Benefits, if any, also accrue at the end of each time period.
Therefore, the following diagram illustrates how net bene-
fits (measured in dollars) are distributed over time.
TIME'
Year/
1
0
fBn
1
1
NB,
I
2
NB2
l
3
NB,
l
4
NB4
\
... n
... NB.
costs alone, not the net benefits, is used in the calculation.
This present value is then annualized (as in calculating
mortgage payments) according to the following formula:
AC = PVC X
r X (1 + r)"
(1+r)"-l
where,
AC = annualized cost accrued at the end of each of
n periods;
PVC = present value of costs;
r = the discount rate per period; and
n = the duration of the policy.
Note that the annualized cost is the amount one would
have to pay at the end of each period t to add up to the
same cost in present value terms as the stream of costs
being annualized. There is no initial cost at t=0 in this
annualization. Such an initial cost can be incorporated
into the annualization using the slightly different formula:
AC = PVC X
r X (1 + r)"
6.2.2.2 Annualized Values
In addition to net present value, there are other proce-
dures for rendering costs and benefits that occur in more
than one time period comparable. One method is to
annualize the costs and benefits over the duration of the
policy. For example, in the absence of discount rates
(r=0), a regulation that costs $100,000 at the end of the
first year, $200,000 at the end of the second year, and
$300,000 at the end of the third year can be said to cost
$200,000 a year in annualized costs over the three year
period. Comparing annualized costs to annualized bene-
fits is equivalent to comparing the present values of costs
and benefits.
Costs and benefits each may be annualized separately by
using a two-step procedure. To annualize the costs, for
example, the present value of costs is calculated using the
NPV formula in Section 6.2.2.1, except that the stream of
This approach is also useful when analyzing non-mone-
tized benefits, such as reductions in emissions or reduc-
tions in health risks, when benefits are constant over
time. The average cost-effectiveness of a policy can be cal-
culated by dividing the annualized cost by the annual ben-
efit to produce measures of program effectiveness, such as
the cost per ton of emissions avoided.
6.2.2.3 Net Future Value
Finally, there is yet another way of rendering costs and
benefits that occur in more than one time period compa-
rable. Instead of discounting all future values back to the
present, it is possible to accumulate them forward to some
future time period — for example, to the end of the last
year of the policy's effects, n. Here, the net benefit test is
whether the accumulated net future value (NFV) is positive.
NFV =
NB
1 See EPA (1995) for an example in which operating and monitoring costs were assumed to be spread out evenly throughout each year of
compliance. While the exponential function above is the most accurate way of modeling the relationship between present value and a continuous
stream of benefits and costs, simple adjustments to the equations above can sometimes adapt them for use under alternative assumptions about how
dollar flows are distributed over time.
35
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Chapter 6: Social Discounting
NBt is the net difference between benefits and costs (Rt-Ct)
that accrue in year / and the accumulation weights, dt, are
given by
where r is the discount rate.
Each of these methods employs an interest rate to trans-
late values through or across time, so the methods are not
really different ways to determine the benefits and costs of
a policy Instead, they are different ways to express and
compare costs and benefits that occur in multiple time
periods on a consistent basis. Discounting places all costs
and benefits in the present time period, annualization
spreads them smoothly through time, and accumulation
states them all in the future. But each procedure uses the
same discount (interest) rate, so they are different ways to
describe the same underlying phenomenon.
Depending on the circumstances, one method might have
advantages over the others. For example, annualizing the
costs of two machines with different service lifetimes
might reveal that the one with the higher total cost actually
has a lower annual cost because of its longer lifetime.
Similarly discounting to the present is likely to be the
most informative procedure when analyzing a policy that
requires an immediate investment and offers a stream of
highly variable future benefits.
In general, however, these are alternative ways of translat-
ing costs and benefits through time using an interest rate.
Therefore, the analysis, discussion, and conclusions pre-
sented in this chapter apply to all methods of translating
costs, benefits, and effects through time, even though the
focus is mostly on discounting.
6.2.3 of
to the
The impact of discounting streams of costs and benefits in
public policy evaluation is sometimes large and sometimes
not, depending on the circumstances. When all effects
occur in the same period, discounting may be unnecessary
or superfluous: net benefits are positive or negative regard-
less of the discount rate used or the procedure for trans-
lating them through time. Similarly, when costs and bene-
fits of a policy are largely consta.nl over the relevant lime
frame, discounting costs and benefits will produce the
same conclusion concerning the policy as would examina-
tion of a single year's costs and benefits. Of course, higher
discount rates will reduce the present value of any future
cost or benefit. But if costs and benefits of a policy occur
simultaneously and if their relative values do not change
over time, whether the net present value of such a policy is
positive does not depend on the discount rate.
Discounting can substantially affect the present value net
benefits estimates for public policies when there is a sig-
nificant difference in the timing of costs and benefits. For
example, if the costs of a policy are incurred today, they
are not discounted at all. But if the benefits will occur 30
years from now, the present value of the benefits, and,
hence, the net present value of the policy's effects,
depends critically on the discount rate used.
Suppose the cost of some environmental policy that is
incurred entirely in the present is $1 billion and that after
30 years a benefit results that is estimated to be worth $5
billion in the future. Without discounting, a policy that
offers benefits five times its cost appears to be a very
worthwhile social investment. Discounting the $5 billion
future benefits, however, can radically alter the economic
assessment of the net present value of the policy. Five bil-
lion dollars, 30 years in the future, discounted at one per-
cent is $3.71 billion, at three percent it is worth $2.06 bil-
lion, at seven percent it is worth $657 million, and at 10
percent it is worth only $287 million. In this case, the
range of discount rates generates over an order of magni-
tude difference in the present value of benefits. And,
longer time horizons will produce even more dramatic
effects on a policy's net present value. Hence, the choice
of the discount rate largely determines whether this policy
is considered, at least on economic efficiency grounds, to
offer society positive or negative net benefits.
Thus, for government projects and. policies that require
large initial outlays or that have long delays before benefits
are realized, the selection of the discount rate can be a
major factor in determining whether the net present value
is positive. Many of EPA's policies fit these profiles. Large
investments by public or private parties are usually
required early on, whereas the benefits of those invest-
ments either accrue for many years thereafter, such as
improvements in health and environmental quality, or will
not begin for many years, such as reductions in the con-
lamination of environmental systems from hazardous
36
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Chapter 6: Social Discounting
waste, landfill facilities, and the protection of the earth's
atmosphere and climate.
count rate for each cost and benefit stream, which is gen-
erally inappropriate.
6.2.4
Discounting is only one of several components that are
necessary in order to produce comparable estimates of a
policy's costs and benefits that accrue over more than one
time period. Discounting is a technique for translating val-
ues from one time period to another in order to express
the values of a policy's consequences in consistent terms.
It is not, however, a method for actually determining the
future values of future costs and benefits. Two considera-
tions related, to determining these future values—project-
ing future values based on present ones and accounting
for risk—are closely related to discounting.
6.2.4.1 Future of
Benefits
The future value of one of an environmental policy's
effects may hinge critically on the assumed rate of growth
of wealth over lime. There may also be a connection
between increasing wealth and the discount rate for
expressing future values in present day terms.
Nevertheless, the process of determining the values of
future costs and benefits and then translating them into
present terms are two conceptually distinct procedures.
It is generally appropriate to conduct each of these tasks
separately. And, it is prudent to avoid attempting to "cor-
rect" for errors in one procedure by "adjusting" the other.
For example, it is technically possible to use a current val-
uation for a future benefit whose future value is expected
to increase, but then reduce the discount rate to reflect
that assumed rising valuation through time. Nevertheless,
this is usually unwise because the values of other conse-
quences of a policy might not follow the same rate of
increase over time. Thus, these might be over- or under-
corrected by the adjusted discount rate. The only way to
avoid that result would be to use a different adjusted dis-
6.2.4.2 the
Rate
The relationship between risk and the rate of return on
assets has been an important subject in modern finance.
Risk considerations also have played a role in the contro-
versy surrounding the selection of an appropriate discount
rate for benefit-cost analysis. For example, one recom-
mendation is that public projects with risk)7 or uncertain
future costs and benefits should be discounted at a higher
rate reflecting those risks, just as it is in the private sector.
The concept of risk is often interpreted narrowly as being
measured by the variability or range of possible outcomes
of a project. Greater variation implies more risk according
to this view. But the notion of risk should be conceptual-
ized more broadly. Rather than being taken in isolation,
the risk of a project is measured by its effect on the vari-
ability in outcomes of the entire portfolio of assets. In
general, the degree of risk associated with an asset is
measured in terms of the covariance of its returns with
those of the portfolio of assets to which it is added.2
When viewed from this broader perspective, most environ-
mental projects are either riskless or reduce risk. This is
because most environmental projects have benefits and
costs that are widely dispersed and that are uncorrelated
or negatively correlated with future measured income and
other aspects of economic welfare.
Nevertheless, the costs and benefits of some
environmental policies can be risky in this broader sense.
In these cases, it is commonly argued that the discount
rate should be adjusted upward by a risk premium to
value future uncertain returns. However, this is generally
not the correct procedure because it requires the discount
rate to reflect both the risk of future returns as well as the
length of time until they materialize. That is, if the goal is
to reduce the present value of a project's returns to reflect
their risk, the same decrease in present value will be
2 Ail assumption underlying this analysis is that the asset being acquired is a very small fraction of the portfolio of assets already held. If
this assumption is violated, the variability in returns of the asset can directly affect the variability of returns to the entire portfolio. The potential costs
and benefits of environmental policies generally are spread among large numbers of people, however, which satisfies the condition that the asset
acquired be a small portion of the portfolio of assets already held.
37
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Chapter 6: Social Discounting
produced by a. smaller increase in the discount rate the
longer the delay until the returns are received.3
Economic theory suggests using two different "instru-
ments" to accomplish the two different goals. One such
procedure to account for risk is to value a. project's uncer-
tain returns using the certain monetary equivalent or
certainty equivalent. As discussed in Chapter 5 of this
document, this is the amount risk averse individuals
would be willing to pay with certainty for the risky
prospect. The certainty equivalent should then be dis-
counted using the rate of interest individuals use to dis-
count other perfectly certain flows.
Hence, to properly account for risk in benefit-cost analy-
ses, the first step should be to evaluate whether a project is
actually risky from the broader perspective of society's
larger portfolio of assets. Many government policies are
not risky at all, so that their expected values of costs and
benefits can be discounted directly using a risk-free inter-
est rate. For projects that offer truly risky prospects, how-
ever, certain monetary equivalents for these returns
should be derived and then discounted to the present
using a risk-free rate. The discount rate should not be
"adjusted" to account for risk)7 costs and benefits.
6.3 to
This review of the basics of social discounting and the new
EPA guidance on the subject begins with discounting in
conventional or intra-generational contexts, where very
long time horizons involving multiple generations do not
apply. Next, approaches for inter-generational social dis-
counting, involving very long time horizons and unborn
generations, are presented and evaluated.
The main purpose of this discussion is to provide a broad
overview of the extensive literature on social discounting in
order to distill from it practical guidelines for environmen-
tal policy evaluation. It is not, however, a detailed review
of the literature on discounting in public project evalua-
tion, which is vast in scope and volume. Excellent sources
for summaries of the social discounting literature are Lind
(1982a), Lind (1982b), Lind (1990), Lind (1994), Lyon
(1990), Lyon (1994), Kolb and Scheraga (1990), Scheraga
(1990), IPCC (1996), Pearce and Turner (1990), and
Pearce and Ulph (1994).
6.3.1
Discounting
This section explores social discounting in conventional or
intra-generational contexts, specifically those in which
very-long-time-horizon issues are not important features.
Most of the traditional discounting literature focuses on
these circumstances. Intra-generational contexts may well
have decades-long time frames, but they do not explicitly
confront the extremely long time horizons and impacts on
unborn generations that are central to the extensions of
social discounting research into climate change, nuclear
waste disposal, and other such policy issues. The division
of the problem into intra-generational and inter-genera-
tional social discounting helps to understand the substan-
tially different contribution economic approaches can offer
in each area.
The discussion begins with a brief review of the analytical
foundations of conventional social discounting. It next
outlines the major social discounting approaches suggest-
ed in the literature. The section concludes with a review of
the concrete conclusions and advice offered by the tradi-
tional discounting literature and the new guidance devel-
oped by EPA for use in social discounting in intra-genera-
tional contexts.
6.3.1.1 of Intra-
Conventional social discounting is rooted firmly in the view
that the government is acting on behalf of its citizens in
undertaking public projects and promulgating environ-
mental and other policies. Therefore, benefit-cost analysis
of these actions should seek to estimate the costs and ben-
efits experienced by all of the affected parties, and in so
1 Note that if discount rates are adjusted to incorporate risk, the adjustment is not always upward. Risky benefits are worth less than their
expected value, so an upward adjustment of the discount rate will reduce the present value. But uncertain costs would require a downward adjust-
ment of the discount rale 1o increase the present value to reflect the fact thai risk averse individuals would pay more than the expecled value of the
costs lo avoid bearing the uncertain prospect.
38
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Chapter 6: Social Discounting
doing determine whether, in aggregate, the gainers under a
policy would be able to compensate the losers.
This foundation for social discounting has an important
implication for the choice of a social discounting method.
Just as consumer sovereignly dictates that the government
should incorporate the specific values that particular indi-
viduals place on outcomes that affect them in assessing its
actions, the government should also discount future costs
and benefits in the same way that the affected individuals
do. Strict adherence to the principles of consumer sover-
eignty is necessary in order to determine how much each
person would agree he or she is made better or worse off
by a given policy in present value terms.
The analytical and ethical foundation of the intra-genera-
tional social discounting literature thus rests on the tradi-
tional test of a "potential" Pareto improvement in social
welfare—whether gainers could compensate the losers.
This framework fundamentally casts the consequences of
government policies in terms of collections of individuals
contemplating changes in their own consumption (broadly
defined) over time. Thus, social discounting in this con-
text should seek to mimic the discounting practices of the
affected individuals.
The Paretian economics point of view, however, is not the
only ethical perspective possible in this context. As dis-
cussed in the section on inter-generational discounting,
another approach is to cast the problem in terms of maxi-
mizing a social welfare function that includes utilities of
present and future individuals and is maximized according
to an alternative set of objectives and constraints. While
alternative social welfare functions could apply to intra-
generational circumstances, it is generally confined to
inter-generational contexts. Hence, although there is noth-
ing inherent in a shorl-tinie-horizon policy that dictates
that only the Paretian perspective is appropriate for intra-
generational situations, this is the most commonly accept-
ed point of departure in the social discounting literature
for these circumstances. It is also worth considering the
two very distinct foundations for social discounting sepa-
rately because their implications for determining the social
discount rate are quite different. The Paretian economic
approach suggests that the social discount rate is to be
found by examining the preferences of affected parlies,
while the discount rate under alternative social welfare
functions is not necessarily based on the preferences of
existing individuals.4
6.3.1.2 Fundamental Procedures for
Given the reasonably precise and circumscribed objective
of social discounting as described above, the volume of lit-
erature on the topic is surprisingly diverse and complex.
This section briefly reviews the major approaches suggest-
ed in the literature and evaluates their implications for
practical social discounting in environmental policy assess-
ments. The section concludes with a summary of recom-
mended practices for social discounting in intra-genera-
tional contexts.
Consumption of Interest for Social
Discounting
The economic literature begins by pointing out that under
a variety of restrictive assumptions—no (axes, no risk,
perfect capital markets—the task of discounting effects
experienced by individuals would be straightforward.
Analysts should simply use the observable market rate of
interest that underlies the intertemporal consumption
allocation decisions of those same individuals. The rate at
which individuals are willing to exchange consumption
over time is normally referred to as the "consumption rate
of interest."
The simplifying assumptions (especially the absence of
taxes on investment returns) imply that the consumption
rate of interest equals the market interest rate, which also
equals the rate of return on private sector investments. In
this case, individuals discount future consumption at the
market rate of interest, which is also the rate at which con-
sumption can be translated through time via private sector
investments. Hence, if the government seeks to value
costs and benefits in present day terms in the same way as
the affected individuals, it also should discount using the
market rate of interest.
One of the simplifying assumptions underlying this
result—that the consumption rate of investment at which
consumers discount future consumption equals the rate of
framework
* This concept is also treated in Chapter 10 in the discussion of ways to jointly consider efficiency and equity within a single analytical
39
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Chapter 6: Social Discounting
return on private sector investment—probably does not
hold in practice. Taxes on private sector investment
returns can cause the social rate at which consumption
can be traded through time (the pre-tax rate of return) to
exceed the rate at which individuals can trade consump-
tion over time (the post-tax consumption rate of interest).
For example, suppose the market rate of interest, net of
inflation, is five percent, and that taxes on capital income
amount to 40 percent of the net return. In this case, pri-
vate investments will yield five percent, of which two per-
cent is paid in taxes to the government, with individuals
receiving the remaining three percent. From a social per-
spective, consumption can be traded from the present to
the future at a rate of five percent. But individuals effec-
tively trade consumption through lime at a. rate of three
percent because they owe taxes on investment earnings.
As a result, the consumption rate of interest is three per-
cent, which is substantially less than the five percent social
rate of return on private sector investments (also known
as the social opportunity cost of private capital).
Over several decades, a very large body of economic litera-
ture developed, analyzing the implications for social dis-
counting of divergences between the consumption rate of
interest and the social rate of return on private sector
investment. The dominant approaches in this literature
are briefly outlined here.
Consumption Price of
Capital: The Traditional View
One approach that enjoys widespread support among
economists recommends that social discounting in intra-
generational contexts should use the consumption rate of
interest to discount future costs and benefits that have
been valued in terms of future consumption. Intuitively
this procedure makes sense because the government is
assumed to be valuing future consequences of its policies
just as the affected citizens would. If individuals discount
future consumption (and the costs and benefits of a public
policy) using the consumption rate of interest, then so
should the government. So, the social rate of discount
should equal the consumption rale of interest.
But, if the costs of financing a public project or the costs of
regulatory compliance displace private investments, society
loses the total pre-tax returns from those foregone invest-
ments. Private capital investments might be displaced if,
for example, public projects are financed with government
debt and the supply of investment capital is relatively fixed.
This is the "closed economy" condition. In this case, dis-
counting costs and benefits using the consumption rate of
interest (the post-tax rate of interest) does not seem to
capture the fact that society loses the higher, social (pre-
tax) rate of return on foregone investments.
Under the consumption rate of interest-shadow price of
capital approach for social discounting, the social value of
displacing private capital investments is taken into account
prior to discounting. Under this approach, when a public
project displaces private sector investments, the correct
method for measuring the social costs and benefits
requires an adjustment of the estimated costs (and per-
haps benefits as well) prior to discounting using the con-
sumption rate of interest. This adjustment factor is
referred to as the "shadow price of capital."5
The shadow (social) price (value) of private capital is
intended to capture the fact that a unit of private capital
produces a stream of social returns at a rate greater than
the rate at which they are discounted by individuals. If the
social rate of discount is the consumption rate of interest,
then the social value of a $1 private sector investment will
be greater than $1. The investment produces a rate of
return for its owners equal to the post-tax consumption
rate of interest, plus a stream of tax revenues (considered
to be consumption) for the government.
To illustrate this simply suppose that the consumption
rate of interest is three percent, that the pre-tax rate of
return on private investments is five percent, that the net-
of-tax earnings from these investments are consumed in
each period, and that the investment exists in perpetuity
(amortization payments from the gross returns of the
investment are devoted to preserving the value of the capi-
tal intact). A $1 private investment with these characteris-
tics will produce a stream of private consumption of $0.03
per year and. tax revenues of $0.02 per year. Discounting
the private post-tax stream of consumption at the three
percent consumption rate of interest yields a present value
of $1. Discounting the stream of tax revenues at the same
rate yields a present value of about $0.67. The social value
; Lind (1982a) remains the seminal source for this approach in the social discounting literature.
40
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Chapter 6: Social Discounting
of this $1 private investment—the shadow price of capi-
tal—is thus $1.67, substantially greater than the $1 pri-
vate value that individuals place on it.
Therefore, if financing a public project displaces private
investments, this "consumption rate of interest-shadow
price of capital" approach suggests adjusting the project's
costs upward by the shadow price of capital and then dis-
counting all costs and benefits using a social rate of dis-
count equal to the consumption rate of interest. To apply
this approach, the first step is to determine whether pri-
vate investment flows will be altered by a policy. Typically
project costs are thought to displace private capital, at least
in part, although project benefits could encourage addi-
tional private sector investments. Next, all of the altered
private investment flows (positive and negative) are multi-
plied by the shadow price of capital to convert them into
consumption-equivalent units. All flows of consumption
and consumption-equivalents are then discounted using
the consumption rate of interest.
A simple example of this method is as follows. Suppose
the pre-tax rate of return from private investments is five
percent and the post-tax rate is three percent, with the dif-
ference attributable to taxation of capital income. Assume
as well that increases in government debt displace private
investments dollar-for-dollar, and that increased taxes
reduce individuals' current consumption also on a one-
for-one basis.6 Finally, assume that the $1 current cost of
a public project is financed 75 percent with government
debt and 25 percent with current taxes and that this proj-
ect produces a benefit 40 years from now thai is estimated
to be worth $5 in the future.
Using the consumption rate of interest-shadow price of
capital approach, first multiply 75 percent of the $1 cur-
rent cost (which is the amount of displaced private invest-
ment) by the shadow price of capital (assume this is the
$1.67 figure from above). This yields $1.2525, to which is
added the $0.25 amount by which the project's costs dis-
place current consumption. The total social cost is there-
fore $1.5025. This results in a net social present value of
about $0.03, which is the present value of the future $5
benefit discounted at the three percent consumption rate
of interest ($1.5328) minus the $1.5025 social cost.
Thus, under the consumption rate of interest-shadow price
of capital approach, costs are adjusted upward to reflect
the higher social costs of displacing private investments,
but discounting for time itself is accomplished using the
consumption rate of interest—consistent with how indi-
viduals trade and value consumption over time.
Variants of this approach exist. For example, the Kolb-
Scheraga (1988) approach recommends annualizing capi-
tal expenditures using the pre-tax rate and then discount-
ing all cost and benefits using the consumption rate of
interest.
Otter Social
Other approaches for social discounting in the literature
have been recommended on and off over the years. These
alternatives focus on different methods than the shadow
price of capital approach for evaluating policies that dis-
place private sector investments. However, the procedures
these approaches use will not generally produce a correct
estimate of the social present value of a policy's costs and
benefits. Some of these other methods for social discount-
ing are reviewed and evaluated below
Weighted average of pre- and. post-tax rates of
return: A major alternative approach for addressing the
divergence between the higher social rate of return on pri-
vate investments and lower consumption rate of interest is
to set the discount rate for public projects equal to a
weighted average of the two. The weights would equal the
proportions of project financing that displace private
investment and consumption, respectively. Intuitively, this
approach would set an overall project discount according
to the amount lost by displacing consumption (using the
lower consumption rate of interest) and the amount lost
by displacing investments (using the higher social rale of
return on private capital).
For example, suppose the social rate of return from private
investments is five percent and the consumption rate of
interest is three percent, as above. Suppose further that
75 percent of a public project's costs are financed using
6 The assumption that additional government borrowing crowds out private investment dollar-for-dollar is not critical to the example. If
crowding out is less than dollar-for-dollar, then the 75 percent of the project's cost that is financed by additional debt would be further divided into the
proportion of that percentage of the cost that displaces private investment, which should then be adjusted using the shadow price of capital, and the
remainder of the cost, which is drawn from consumption and therefore does not need to be adjusted.
41
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Chapter 6: Social Discounting
government debt, with the remaining 25 percent of the
costs raised through taxation. Finally, assume that
government debt crowds out private investment on a
dollar-for-dollar basis and that increased taxes reduce
individuals' current consumption also on a one-for-one
basis. The weighted average approach then suggests that
the social rate of discount should be 75 percent of five
percent plus 25 percent of three percent, or four and a
half percent. If the proportions of the project's financing
from each revenue source were reversed, however, the
weighted average discount rate would instead be 25
percent of five percent plus 75 percent of three percent, or
three and a half percent.
This approach has enjoyed considerable popularity over
the years, and is probably acceptable for similarly timed
cost and benefit flows.7 As presented, above, however, it is
technically incorrect and can produce net present value
results substantially different from the correct result
(where "correct" is defined by the consumption rate of
interest-shadow price of capital approach). The problem
with the simple weighted average approach is that it seeks
to accomplish two tasks using the social discount rate—
pure time discounting and adjusting for the displacement
of private investments that yield pre-tax social returns
higher than the consumption rate of interest.
In general, the "synthesized" discount rate based on the
social rate of return from private investments and the con-
sumption rate of interest that accomplishes both objec-
tives—and. so arrives the correct present value—depends
on the liming of the cost and benefits flows. A simple
weighted, average based only on project cost components
will not in general produce the correct result.
To understand this, consider how the weighted average dis-
count rate approach performs for the simple numerical
example discussed above. .Assume that the social rate of
return on private investments is five percent, that the con-
sumption rate of interest is three percent, that increases in
government debt displace private investments dollar-for-
dollar, that the $1 current cost of a public project is
financed 75 percent with government debt and 25 percent
with current taxes, and that the project produces a benefit
40 years from now that is estimated to be worth $5 in the
future.
The weighted average social discount rate approach would
suggest discounting the future benefit at a four and a half
percent rate (0.75 times five percent plus 0.25 times three
percent). This produces an estimated net social present
value of -$0.14, which is the present value of the future $5
benefit discounted using a four and a half percent rate
($0.86) minus the current year $1 cost. In this case, the
weighted average social discount rate approach suggests
that the project's net social present value is negative. But
earlier, the consumption rate of interest-shadow price of
capital approach was applied to exactly this scenario, con-
cluding that the net social present value is positive.
The problem with the weighted average approach is that its
method for accounting for the higher social cost of dis-
placed private investments is to "over discount" the bene-
fits. But the amount of "over discounting" necessary in
this example to adjust for the actual social costs of the
project's costs depends on the time profile of the benefit
stream—the farther in the future the benefits occur, the
less "over discounting" is needed. The source of the pro-
ject's financing is therefore insufficient to define a single
rate of social discount that will produce correct net social
present value results for any given policy.
Accordingly, to derive the weighted average discount rate
that will produce the correct net present value requires
that the consumption rate of interest-shadow price of capi-
tal method be used first to compute the net present value.
The discount rate that produces this correct present value
based on discounting costs and benefits, but not adjusting
for the shadow price of capital, can then be calculated.
There seems to be little purpose to this exercise because it
requires the net present value of a policy to be computed
using accurate procedures first before the adjusted, dis-
count rate can be derived.
Opportunity cost of capital: Another approach for social
discounting argues that the government should not invest
(or compel investment through its policies) in any project
that offers a rate of return less than the social rate of
return on private investments. Stated another way
because the citizens collectively enjoy the benefits of all
7 Lind (1982b) provides a clear exposition of the weighted average approach for estimating the social discount rate. The large literature on
this topic, spanning the 1960s through the early 1980s, has been summarized well by Lind and others.
42
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public and private investments, welfare will be higher over-
all if the government invests in projects will) the highest
rates of return.8
Critics of this social investment rule argue that the govern-
ment cannot realistically tax citizens and then invest in
private sector projects. Therefore, the issue is not what
"could" be done with the funds, but rather what "would"
be done with them. Thus, if the government obtains funds
for a project through taxation and this displaces only pri-
vate consumption, then relative to consuming the
resources today, welfare is increased as long as the project
generates future benefits that exceed those costs when dis-
counted at the consumption rate of interest. Of course, it
remains true that welfare would be further increased if the
funds were devoted to an even more valuable project.
A closely related opportunity cost-based observation is that
the government faces a menu of projects and, for whatever
reason, is not able to undertake all projects that have posi-
tive net social benefits when computed using a social rate
of discount equal to the consumption rate of interest. In
this event, the opportunity costs of funding one program
are the benefits of other programs not funded.
Proponents of this view typically conclude that the "hur-
dle" discount rate for a particular project should be equal
to the rate of return offered by other projects foregone.
Regardless of the particular point of departure, the central
point of the opportunity cost strand of the social discount-
ing literature is valid. Social welfare will be improved if
the government invests in projects that have higher values
than if it invests in lower value ones. Hence, if the net
present value of benefits of all courses of action are exam-
ined using the consumption rate of interest and the set
with the highest net benefits are pursued, social welfare
will be higher than otherwise.9 So stated, this advice is
correct.
However, it does not follow that rates of return offered by
alternative private or public projects define the level of the
social discount rate. An alternative project might produce
large benefits over the future and thus offer a. large "rate of
return." But if individuals discount these future benefits
Chapter 6: Social Discounting
using the consumption rate of interest, the correct way to
describe this project is that it offers substantial present
value net benefits. In general, the opportunity cost argu-
ment is not about the social discount rate/»er se, but
about correctly and consistently examining the social val-
ues of all alternatives. As was the case for the shadow
price of capital, an alternative project with a high rate of
return will have a high social net present value. But this
does not imply that its rate of return should become the
social rate of discount to be used for pure time discount-
ing for other projects.
Consumption of Interest-Shadow Price of
The New View
Over the years, the consumption rate of interest-shadow
price of capital approach to social discounting has gained
increasingly wide acceptance among economists. Recently,
however, a key assumption in that analysis has been ques-
tioned—the assumption that the economy is "closed" to
foreign capital flows—and an alternative hypothesis con-
cerning government crowding out of private investment
has been put forward.10 According to this new view, earlier
analyses implicitly assumed that capital flows into the
nation were either nonexistent or very insensitive to inter-
est rates, a "closed economy" assumption. Empirical evi-
dence suggests, however, that international capital flows
are quite large and very sensitive to interest rate changes.
In this case, the supply of investment funds to the U.S.
equity and debt markets is likely to be highly elastic (the
"open economy" condition) and, thus, private capital dis-
placement is much less importa.nl than it was previously
thought to be.
Under this new view, it is inappropriate to assume that
financing a public project through borrowing will result in
dollar-for-dollar crowding out of private investment. If,
instead, financing public projects results in no crowding
out of private investment, then no adjustments using the
shadow price of capital are necessary. Benefits and costs
should be discounted using the consumption rate of inter-
est alone. However, the literature to date does not ade-
quately support the assumption of zero crowding out. It is
more likely that there exists some degree of private capital
8 Many authors cite high opportunity costs of public investments. Among these are Birdsall and Steer (1993), Schelling (1995), and Lyon
(1994). On the technical issue of rates of return vs. net present values, see Lind (1990) and Cowen and Paiilt (1992).
9 Clearly such an approach cannot be followed when a particular action is mandated.
10 See Lind (1990) for this revision of the consumption rate of interest-shadow price of capital approach.
43
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Chapter 6: Social Discounting
displacement within the spectrum between zero and dol-
lar-for-dollar displacement. The degree of crowding out
will depend on the magnitude of the policy or program
being analyzed. Unfortunately, while the shadow price of
capital adjustment requires an assessment of the propor-
tion of costs that displace investment,11 the literature pro-
vides little empirical evidence as to the relationship
between project size and capital displacement.12
6.3.1.3 Applying the
of to
Policies
The extension of the consumption rate of interest-shadow
price of capital approach to the case of an economy "open"
to substantial capital flows is relatively recent. And, as is
true for most of the discounting literature, virtually all of
the discussion focuses on public project financing, rather
than on environmental policies that largely mandate that
private parties undertake certain actions or expenditures
in pursuit of social objectives. Finally, while it is intuitive
to argue that private investments are not displaced by
either additional government borrowing or mandatory pri-
vate investments for environmental protection, it is often
the gross gains and losses of the affected parties in the
economy that are the focus of economic impact analyses.
How the change in the assumption concerning the avail-
ability of investment funds to the economy translates into
these gross gains and losses is critical for conducting accu-
rate environmental policy assessments.
For all of these reasons, it is worth clarifying the capital
displacement and adjustment issue for environmental
policies that mandate capital investments in the context of
both the "open" and "closed" economy assumptions
regarding capital flows.
in a
"Closed"
To focus closely and exclusively on the shadow price of
capital adjustment issue, some simplifying assumptions
are helpful. Assume that there is no risk and uncertainty,
that all firms and. the government borrow at the interest
rate i, that taxes on investment income are levied on ail
sources of such income at a rate of t, and that the result-
ing post-tax interest rate, r (=iX (I-/)), is the rate at
which individuals discount future consumption.13
Further, assume that the net-of-tax returns from all invest-
ments are consumed in each year (to assist in making this
illustration as simple as possible). Assume, finally that
the supply of investment funds is perfectly inelastic with
respect to their price, the interest rate.
Consider, first, a public project that costs $1, is financed
through taxes on labor and other factors of production
(but not capital), and offers future environmental benefits.
Assuming that increased current taxation only reduces
consumption, the cost of the project is this amount of
reduced current consumption. Future benefits, once
valued in terms of future consumption, can be discounted
to the present using a social rate of discount equal to the
consumption rate of interest. For the remainder of this
discussion, the benefits side of the calculations will be
ignored to focus on the cost calculation considerations.
Now, consider exactly the same project, but assume that it
is financed only through government borrowing, which
crowds out an equal amount of private sector investment.
To calculate the costs of this project financing, it is helpful
to analyze the impacts on the different entities affected.
First, the private sector investors who lend $1 to the gov-
ernment instead of to private firms are indifferent. They
receive the interest rate i from either source and, there-
fore, continue to receive a stream of returns net-of-lax
equal to $lXr.
Next, consider the government, which can be thought of as
representing the interests of citizens in future years. The
foregone private investments would have generated a
stream of tax reven ues of $ 1 XIX i each year, which is lost.
But the increased public debt is taxable, so the govern-
ment regains this $lxtxi each year and the streams of
gained and lost tax revenues offset each other.
Nevertheless, the government must service this new debt
11 See footnote 5 for a descriplion of this adjustment.
n See Lind (1990) for a summary of the empirical literature in this area.
" The relevant tax rate t is the effective marginal tax rate. It is difficult to determine this rate in the aggregate with any reasonable degree
of accuracy.
44
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Chapter 6: Social Discounting
by raising future taxes each year by the amount $1 Xi
(assuming, for simplicity, that the debt is a perpetuity).
As a result, the cost of financing this public project
through government debt in a closed economy context is a
stream of decreased consumption experienced in the
future of SIX/ per year forever. The present value of mis
stream of foregone consumption computed using the con-
sumption rate of interest, r, exceeds $1. This is the
essence of the shadow price of capital adjustment ration-
ale. The value of i exceeds r in this example because of
the tax wedge between the social (pre-tax) rate of return
on investments and the (post-tax) consumption rate of
interest. This is the equivalent of observing that a taxable
investment yields a private return of r per year to the
investor and a "return" odxi to the government in the
form of tax revenues.
Assume now that the relevant investment is a private sec-
tor capital project that must be undertaken in order to
comply with an environmental policy. To estimate the
social costs of this requirement under the closed economy
assumption, two polar cases are useful to examine: no
cost shifting to consumers or other factors of production
and full cost shifting to consumers through higher product
prices.
In the case of no cosl shifting to consumers, the owners of
the firms required to make these investments either must
obtain debt or equity funds or reduce their other invest-
ment and lending activities, to comply. Wherever the
required funds originate, two facts are clear. One is that
other taxable investments of $1 will not be undertaken.
The second is that, because the price of the products or
services into which this environmental investment flows
does not rise, the mandated investment will produce no
"return" for their owners or for the government in the
form of future tax revenues. The result is that the owners
of the affected firms lose a stream of investment income,
$1 Xr, and the government loses a stream of tax revenues
of $lxtxi, because of the displaced private investment.
But since r=ix(l-t), this adds up to a stream of costs of
$1 Xi per year. Once again, this is essentially the shadow
price of capital adjustment.
Now assume that the cost of the mandated environmen-
tal investment is shifted to consumers through higher
prices, which rise by enough to provide the full social
pre-tax return of i. In this case, the owners of the firms
required to make these investments are indifferent.
Similarly, the government is indifferent—it still receives
a stream of tax revenues from the $1 investment. Here,
however, it is consumers of the affected product or serv-
ice who are not indifferent. In fact, the product price
increases they face are precisely enough to provide the
$lxi pre-tax social return on the mandated investment.
Here again, this is essentially the shadow price of capital
adjustment.
Environmentally-Mandated Private Investments in
an "Open" Economy
The central difference between the closed and open econo-
my contexts concerns the conditions of supply of invest-
ment funds. In the closed economy case, the amount of
these funds is fixed, so the total available for all projects,
private and public, is constant. Hence, the key to analyz-
ing that case lies in (racing the implications of altering the
composition of the investments undertaken with and with-
out a new public project or a new environmental policy
mandating private investments.
In the open economy context, however, what is fixed is
not the supply of investment funds, but the price at
which they may be obtained. In this case, ail invest-
ments worth undertaking without a new public project or
a new environmental policy requiring investments will
still be worth undertaking with those new policies—so
that there will be no impact on capital availability and the
level of private sector investments. This suggests that
measuring the costs of these policies in this open econo-
my context may be slightly different than in the closed
economy case.
Purely tax-financed public projects are not discussed
here because the results for that case do not depend on
the assumption concerning the supply of capital. For
debt-financed public projects, however, the results under
the closed and open economy assumptions are very dif-
ferent. In this open economy case, the government's
increased $1 of borrowing does not change the level of
U.S. private sector investment. Hence, the government
must service the debt at a cost of $1 Xi per year, but also
gains from that $\XiXt of tax revenues from these new
45
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Chapter 6: Social Discounting
taxable interest payments.14 The net cost is only
$1 X/'X(1-/), which is the stream of future reduced con-
sumption citizens will experience as the net cost of the
new public project. But because 'ix(l-f) =r, this stream
of reduced consumption is equal to $1 Xr. Discounted at
the consumption rate of interest, r, the present value cost
is $ 1. This is the rationale lor not using the shadow price of
capital adjustment.
To analyze the implications of the open economy assump-
tion for mandated private investments, the no- and full-
cost pass-through polar cases continue to be helpful. In
the case of no-cost pass-through, the results are very sim-
ple. The owners of the firms required to make the invest-
ments to comply with an environmental policy will obtain
the necessary funds either from their own resources that
would have been invested elsewhere, or from other
sources, and undertake the required investments.
Because the price of the services or products subject to the
new policy do not rise to compensate for these costs, no
return to these owners or to the government in the form of
tax revenues will result. But, because the supply of invest-
ment funds to the economy is perfectly elastic, no other
private sector investments will be foregone.
The result in this case is that the owners of the entities
required to make these investments will lose a stream of
private investment returns of $1 Xr (their net-of-tax
return on production investments) if the mandatory
investment causes them to reduce investment elsewhere.
Alternatively the owners of the affected firms may increase
their demands for investment funds in the market and
continue with their pre-policy investment plans.
Nevertheless, because i is constant, all investment projects
that were profitable before the policy is imposed will still
be profitable and these investments will be undertaken as
if the policy did not exist. Hence, the government loses no
tax revenue as a result and no shadow price of capital
adjustment is appropriate here.
Finally if the costs of the mandated private investments
are fully passed through to consumers, the owners of the
affected firms are now indifferent. The government and
the consumers of the relevant services or products, howev-
er, are not. First, the consumers of the affected sector's
output face price increases equivalent to $1 Xi, which is
the amount necessary to fully recoup the full pre-tax social
return on the invested capital. But the government gains a
stream of tax revenues associated with this mandated
investment, amounting to $1 XiXt per year. Again, all
other investments are still undertaken because of the
assumption regarding the supply of investment funds.
As a result, the net cost to society is the price increase
borne by consumers, equal to $1 Xi per year, minus the
increase government tax revenues—which represents
future reduced taxation—of $1 XiXt per year, for a net
cost of only $lXt(l-t)=$lXr. thus, the shadow price of
capital adjustment is not necessary here. But, note that
the cost increase for the firm and ils consumers is meas-
ured, by the pre-tax amount per year, $1 Xi, not the net
social cost of $1 Xr per year. The former is the relevant
measure for modeling private sector "economic impacts"
and for assessing the gross gains and losses of a policy,
while the latter represents the social perspective.
6.3.1.4 Summary of from the
Economics Literature
The vast majority of the traditional social discounting liter-
ature has focused on exploring the implications for public
project evaluation of a tew, probably very important, depar-
tures from the idealized no-other-distortions simplified
economy for which unambiguous social discounting rec-
ommendations can be made. Yet, in the development of
that literature, many matters have been addressed and are
considered by many contributors to this literature to be
somewhat settled, some of which are discussed above, and
others not (largely because they are not directly social dis-
counting issues). In particular, for infra-generational
social discounting:
^ There is reasonable agreement that the social rate of
discount ought to reflect the private rates of con-
sumption discount of the citizens affected.
0~ If social and. private returns from private investments
are different, then adjustments should be introduced
" The taxability of the interest payments on the increased amount of government debt in an open economy context is complex because of
the international nature of capital markets. Generally speaking, taxes are owed on interest earnings from government obligations to the country that
pays the interest, although there are exceptions to this rule. Hence, if U.S. citizens increase their lending to the U.S. government, the interest earnings
would clearly be taxable. If foreign investors purchase the increased U.S. government debt, normally these interest payments are taxable as U.S.
46
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Chapter 6: Social Discounting
to reflect this when and it" policies alter private invest-
ment flows.
f Uncertainty and risk should largely be addressed
through appropriate valuation of costs and benefits
(e.g., certain monetary equivalents) rather than
through modifications of the discount rate.
f Changes in the values of environmental goods and
other such factors should likewise be reflected in
direct cost and benefit measurements, not through
adjustments to the social discount rate.
f Irreversibility of consequences is an option value con-
cept and requires separate treatment in benefit-cost
analyses, but it does not provide a reason to adjust
the discount rate.
f Opportunity costs of other public and private uses for
funds should be considered in evaluating the desir-
ability of undertaking a particular public investment
or policy. That a project offers a positive present value
of net benefits when discounted using the consump-
tion rate of interest does not by itself imply that the
policy should be undertaken.
These conclusions demonstrate the significant progress
made in the theoretical social discounting literature, espe-
cially regarding the implications of divergences between
social and private rates of returns on investments.
However, exactly what numerical rale of interest to use for
social discounting in practical policy evaluations remains
somewhat unsettled.
Moreover, some recent literature questions some of the
most basic premises underlying the conventional social
discounting analysis. For example, recent studies of indi-
viduals' financial and other decision making suggest that
even a single person may appear to value and discount dif-
ferent actions, goods, and wealth components differently.
This "mental accounts" or "self-control" approach suggests
that individuals may well evaluate some aspects of the
future quite differently from other consequences. The dis-
count rate an individual might apply to a given future ben-
efit or cost, as a result, may not be observable from mar-
ket prices, interest rates, or other phenomena. This may
be especially the case if the future consequences in ques-
tion are not tradable commodities. Some recent evidence
from experimental economics also indicates that discount
rates appear to be lower the larger the magnitude of the
underlying effect being valued, higher for gains than for
losses, and tend to decline as the length of time to the
event increases.15
Despite ail of these limitations, practical economic analy-
ses must use social discounting to assist in evaluating
environmental policies. Hence, even limited guidance is
helpful in developing recommendations for practical
analyses. What is offered in the empirical literature for
choosing a social discount rate focuses on estimating the
consumption rate of interest at which individuals translate
consumption through time with reasonable certainty.
For this, historical rates of return, post-tax and after infla-
tion, on "safe" assets, such as U.S. Treasury securities, are
normally used, typically resulting in rates in the range of
one to three percent.16 Some studies have expanded this
portfolio to include other bonds, stocks, and even housing
and this generally raises the range of rates slightly. It
should be noted, that these rates are ex post rates of
return, not anticipated, and they are somewhat sensitive to
the time periods selected and the classes of assets consid-
ered.17 A recent study of the social discount rate for the
United Kingdom places the consumption rate of interest at
two to four percent, with the balance of the evidence point-
ing toward the lower end. of the range.18
15 Shefrin and Thaler (1988) and Thaler (1985) are central sources for the mental accounts idea and Lowenstein and Thaler (1989)
report numerous examples of various inconsistencies and other aspects of individual interlemporal choices.
18 Estimates of the consumption rale of interest (an individual's marginal rale of time preference) could be based on either after-tax lend-
ing or borrowing rates. Because individuals may be in different marginal tax brackets, have different levels of assets, and have different opportunities
to borrow and invest, the type of interest rate that best reflects marginal time preference will differ among individuals. Additionally, individuals rou-
tinely are observed to have several different types of savings, each possibly yielding different returns, while simultaneously borrowing at different rates
of interest. Thus, discerning an average marginal rate of time preference from observed interest rates is very difficult. However, the fact that, on net.
individuals generally accumulate assets over their working lives suggests that the after-tax returns on sayings instruments generally available to the
public will provide a reasonable estimate of the consumption rate of interest,
17 Ibbotson and Sinquefleld (1984 and annual updates) provide historical rates of return for various assets and for different holding periods,
18 Lind (1982b) offers some empirical estimates of the consumption rate of interest, Pcarcc and Ulph (1994) provide the estimates of the
consumption rate of interest for the United Kingdom, Lyon (1994) provides estimates of the shadow price of capital under a variety of assumptions.
47
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Chapter 6: Social Discounting
Finally, for the shadow price of capital, even less concrete
empirical guidance is available. This parameter depends
on the consumption rate of interest, the gross-of-tax rate
of return on private investment, and the rate of consump-
tion out of net investment returns, among other factors.
Depending on the magnitudes of these factors, shadow
prices from close to one to three, 20, 100, and infinity can
result. Lyon (1990) has an excellent review of how to cal-
culate the shadow price of capital and possible settings for
the various parameters that determine its magnitude.
Moreover, the shadow price of capital adjustment will
require an assessment of the proportion of project costs
that displace private investment. Whether or not this
adjustment is necessary appears to depend largely on
whether the economy in question is assumed to be open
or closed and on the magnitude of the intervention or pro-
gram considered relative to the flow of investment capital
from abroad.19
6.3.1.5 for Intra-
For economic analyses of intra-generational policies ana-
lysts should apply the consumption rate of interest
approach. There should be no adjustments using the
shadow price of capital unless there are strong reasons to
believe that a particular policy will affect the level of U.S.
private sector investment.20 Based on historical rates of
return on relatively risk-tree investments, adjusted for
taxes and inflation, a consumption rate of interest meas-
ured at two to three percent is justified.
OMB's own guidance on discounting21 currently recom-
mends discounting using a rate of seven percent, an esti-
mate of the average real pre-lax rale of return generated by
private sector investments. EPA economic analyses there-
fore should provide estimates of the present values of costs
and benefits using both a two to three percent rate and
OMB's guidance on discounting. In some cases, a sensitiv-
ity analysis at discount rates within this range may provide
useful information to decision makers.
In addition, all analyses should present the undiscounled
streams of benefits and costs. This is not equivalent to cal-
culating a present value using a discount rate of zero. In
other words, the flow of benefits and costs should be dis-
played rather than a summation of values.
Discounting
This section focuses on social discounting in the context of
policies with very long time horizons involving multiple
generations. Policies with potential inter-generational
impacts include global climate change, radioactive waste
disposal, groundwater pollution, and biodiversity. Because
of potentially large or catastrophic impacts on unborn gen-
erations and because policies with very long time horizons
often involve high costs imposed by current generations,
there is less agreement in the literature on the appropriate
approach to discounting over very long time horizons.
This section attempts to present a balanced discussion of
alternative points of view The discussion first focuses on
how the point of departure for inter-generational discount-
ing differs in some very fundamental ways from that of
in Ira-generational social discounting. Next, various
approaches for deciding whether and how to discount
when evaluating inter-generational policies are reviewed.
Finally, the section concludes by summarizing the advice
offered by the economics literature and EPA's new guide-
lines for inter-generational social discounting.
19 Studies suggesting that increased U.S. government borrowing does not crowd out U.S. private investment generally examine the impact
of changes in the level of government borrowing on interest rates. The lack of a significant positive correlation of government borrowing and interest
rates is the foundation of this conclusion. Because changes in yearly U.S. government borrowing during the past several decades have been in the
many billions of dollars, it is reasonable to conclude that EPA programs and policies costing a fraction of these amounts are not likely to result in sig-
nificant crowding out of U.S. private investments,
20As the estimation of the shadow price of capital can be a costly exercise, analysts should use a value-of-information approach to deter-
mine whether it is worthwhile to pursue a quantitative assessment of the effects of private capital displacement. Should a quantitative assessment be
undertaken, the analysis should include a sensitivity analysis of alternative assumptions regarding the degree of crowding out.
21 OMB Circular A-94, "Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs," October 29, 1992 (note: see updates
to cost-effectiveness rates—most recent released in January 2000, http://www.whitehouse.gov/OMB/circulars/a094/a094.html (accessed 8/28/2000))
and U.S. Office of Management and Budget, Guidelines to Standardize Measures of Costs ami Benefits ami the Format of Accounting Statements,
report M-00-08, March 22, 2000,.http:/Avww.whitehouse.gov/media/pdf/mOO-08.pd'f (accessed 8/28/2000).
48
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Chapter 6: Social Discounting
6.3.2.1 Foundation of Inter-
Social Discounting
One obvious problem with long-time-horizon policies is
that many of the people affected are not alive. Hence,
while the preferences of each affected individual are know-
able (if probably unknown in practice) for infra-genera-
tional social discounting problems, they are essentially
unknowable for those involving future generations not yet
born. This is not always a severe problem for practical
policymaking, especially when policies impose relatively
modest costs and benefits, or when the benefits begin
immediately or in the not too distant future. And most of
the time, it suffices to assume that future generations will
have preferences much like those of present generations.
The more serious challenge posed by long-time-horizon
situations arises primarily when costs and benefits of an
action or inaction are very large and are distributed asym-
metrically over vast expanses of time. Here, the crux of
the problem is that future generations are not present to
participate in making the relevant social choices. Instead,
these decisions will be made only by existing generations.
Social discounting in these cases can no longer be thought
of as a process of consulting the preferences of all affected
parties concerning their valuation today of effects they will
experience in different time periods.
Moreover, compounding interest over very long time hori-
zons can have profound impacts on the inter-generational
distribution of welfare. An extremely large cost far enough
in the future has essentially zero present value when dis-
counted at even a. low rate. But a modest sum invested
today at the same low interest rale also can grow to a stag-
gering amount given enough time. Therefore, mechanical-
ly discounting very large distant future effects of a policy
without thinking carefully about the ethical implications is
not advised.
6.3.2.2 on Inter-
The social discounting literature contains many different
perspectives on social discounting in inter-generational
contexts. This section briefly describes the major
approaches and their theoretical motivations. The focus in
this discussion is on the social discount rate itself, so such
other issues as the shadow price of capital adjustments,
while clearly still relevant under certain assumptions, are
kept in the background.
Social Planner Approach
One popular recommendation is that social discounting
for inter-generational policies should be based upon meth-
ods economists have used for many years in optimal
growth analyses. In these models, the policy maker is
understood to be maximizing the utilities of all present
and future generations using a well-defined social welfare
function.22
In optimal growth models, the social rate of discount gen-
erally equals the sum of two factors. One is a discount
rate for pure time preference, which measures the degree
to which the social planner favors the utility of current and
near future members of society over that of individuals in
the more distant future. The other is an adjustment
reflecting the fact that the marginal utility of consumption
will decline over time as consumption per capita increases
(equal to the elasticity of marginal utility multiplied by the
rate of increase of consumption over time).
If the world actually corresponded to the theoretical con-
struct of an optimal growth model and there were no taxes
or other distortions, the social discount rate as defined in
these models would be equal to the market interest rate.
And, the market rate of interest, in turn, would also be
equal to the social rate of return on private investments
and the consumption rate of interest. But because the
world contains many distortions, and is not likely to con-
form to the conditions that characterize optimal growth
models, the social rate of discount is not observable in the
economy.
Recent practical applications of this approach to very-long-
time-horizon analyses have therefore attempted to
estimate the social discount rate by constructing it from its
components. Most assume that the rate of pure time
discount is zero, adhering to the ethical precept that the
policy maker ought not to inherently favor present
generations' consumption over that of future generations.
For the other component of the social discount rate,
-- Key literature on this topic includes Arrow et al. (1996), Lind (1994), Schelling (1995), Solow (1992), Manne (1994), Toth (1994), Sen
(1982), Dasgupta (1982), and Pearce and Ulph (1994).
49
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Chapter 6: Social Discounting
hypothetical, but perhaps plausible, estimates of the
elasticity of marginal utility and the rale of growth of
consumption over time are introduced. The product of
these two factors is the implied social discount rate. This
computational procedure in essence derives an implied
social rate of discount under the assumption that future
generations will be richer than current generations, so that
the marginal utility of consumption is projected to fall over
time. Rates developed using this technique generally
range from one-half percent to three percent.23
Optimal growth modeling, however, is only one strand of
the substantial body of research and writing on intertem-
poral social welfare maximization and optimal growth.
This literature extends from the economics and ethics of
inter-personal and inter-generational wealth distribution,
to the more specific environment-growth issues raised in
the "sustainability" literature, and even to the appropriate
form of the social welfare function, e.g., utilitarianism or
Rawls1 maxi-min criterion.
Clearly, economics alone cannot provide definitive guid-
ance for selecting the "correct" social welfare function or
the social rate of time preference. Nevertheless, econom-
ics can offer a few insights concerning the implications
and consequences of alternative choices and some advice
on the appropriate and consistent use of the social welfare
function approach as a policy evaluation tool.
/Ipproacftes on
Preferences
The major alternative to the social welfare planner
approach for inter-generational discounting is to rely on
the preferences of current individuals for an appropriate
discount rate. At its core, this perspective rejects the view
that the problem is one of balancing the interests of all
humans who will live now and in the future. Instead,
according to this perspective, it is fundamentally about
individuals alive today allocating their scarce resources to
competing ends, one of which happens to be the welfare of
future generations. Several specific approaches fall into
this category.
Consumption rate of inter esl/liifiiiltely-llved
Individuals: Although not popular in theoretical
terms, in practice it is common to adopt the approach
of simply making no great distinction between inter-
generational and infra-generational social discount-
ing. Models of infinitely-lived individuals, for exam-
ple, suggest the consumption rate of interest as the
social discount rate. But the assumption that people
live forever is contrary to the fact that individuals
actually do not live long enough to experience distant
future consequences of a policy and to report today
the present values they place on those effects. As
such, models of infinitely-lived individuals essentially
ignore the fundamental problem posed in evaluations
of policies that affect distant future generations.
Inter-generational discounting vs. time dis-
counting: Mother suggestion for social discounting
in inter-generational contexts is to examine possible
differences between how current individuals evaluate
the welfare of their descendants versus how they dis-
count their own future consumption.24 It is possible
that the year-by-year exponential time discounting25
that underlies an individual's allocation of his or her
own consumption in the present and the future does
not apply to this individual's valuation of his or her
descendant's welfare. That is, a person might indeed
value future generations' consumption less than his
or her own current and future consumption, but not
as low as would be implied by standard discounting
techniques. An individual's present valuation of the
consumption of successive future generations might
decline gradually and approach some constant posi-
tive value, so that the value of a unit of consumption
by a person 10 generations from the present might be
considered to be the same as a unit of consumption
by a person 11 generations from now.
A related line of reasoning suggests that large-scale
catastrophic consequences in the future are viewed
differently than marginal changes in welfare, so that it
matters little whether these possibilities are 100 years
2!SeelPCC (1996), pp. 131-132.
2-1 Sources discussing this approach include Rothenberg (1993), Cropper et at. (1992), Shefrin and Thaler (1988), Thaler (1985), and
Cowcn and Parfit (1992).
" Exponential time discounting applies discounting factors to future values that increase as the time between the present arid the future
when those values will be experienced increases. As a result, the present value of a benefit to be enjoyed 50 years from now is much higher than the
present value of the same benefit if it accrues 100 years from now
50
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Chapter 6: Social Discounting
or 1,000 years in the future. If so, applying exponen-
tial, or year-by-year, lime discounting to such
future consequences is inappropriate.
Revealed/stated preferences for altruism:
According to this view, environmental policies that
affect distant future generations are considered 1o be
altruistic acts.26 As such, they should be valued, by-
current generations exactly the same as other acts of
altruism. Hence, the discount rate in question is not
that applied to an individual's consumption, but
instead that applicable for an individual's valuation of
the consumption or welfare of someone else.
At least some altruism is apparent from international
aid programs, private charitable giving, and bequests
within overlapping generations of families. But the
evidence suggests that the importance of other peo-
ple's welfare to an individual appears to grow weaker
with temporal, cultural, geographic, and other meas-
ures of "distance." The implied discount rates that
survey respondents appear to apply in trading off
presenl and future lives are also relevant under this
approach. One such survey (Cropper, et al., 1992)
suggests that these rates are positive on average, con-
sistent with the rates at which people discount mone-
tary outcomes, and decline as the time horizon
involved lengthens.
Opportunity cost of alternatives: A variety of per-
spectives in the inter-generational discounting litera-
ture converge on the broad notion that devoting
resources to long-time-horizon environmental proj-
ects—largely because low discount rates appear to
make these attractive in present value terms—neg-
lects numerous other social investment opportunities
with higher values.27
Advocates of this point of view point to numerous
alternative social investments that would generate far
larger benefits now and in the future, such as basic
infrastructure, education, medical assistance, and
other projects in developing nations.
Depending on the context, this point of view is often
expressed in two different ways: (1) many other
investments would be more beneficial to society and
so long-time-horizon environmental programs face
very high opportunity costs, and (2) the rates of
return offered by these alternative investments are
high and these rates ought to be used as the social
rate of discount.
As noted earlier in the context of infra-generational
social discounting, the first statement of this opportu-
nity cost argument is the correct one, the second is
somewhat problematic. The opportunity costs of
alternative government or private investment pro-
grams are appropriately measured by calculating their
present values using the social rate of discount. If
these projects have higher rates of return than the
social discount rale, their social presenl values will
also be high. But this does not imply that the social
rate of discount itself ought to be set equal to some
alternative project's rate of return. For example, an
alternative project might offer a very large rate of
return for only one year, but this should not become
the social rate of discount for very-long-time-horizon
projects and policies.
Paretlan compensation tests: One final approach
for social discounting in an inter-generational context
returns to the theoretical motivation and ethical
underpinnings of infra-generational social discount-
ing. This approach views social discounting in inter-
generational contexts as a question of whether the
distribution of wealth among many different genera-
tions could be adjusted in order to compensate the
losers under an environmental policy and still leave
the gamers better off. Whether gainers could compen-
sate losers hinges on the rate of interest at which socie-
ty (the U.S. presumably or perhaps the entire world)
can transfer wealth across hundreds of years. Some
argue that in the U.S. context, a good candidate for this
rate is the federal government's borrowing rate.
What lies at the foundation of this approach is the
goal of maintaining overall inter-generational equity.
The implicit assumption is that society starts from a
position at which the distribution of wealth across
present and future generations is "acceptable." Then
•' Schelling (1995) and Birdsall and Steer (1993) are good references for these arguments,
27 Many authors cite high opportunity costs of public investments. Among these are Birdsall and Steer (1993), Xordhaus (1993). Schelling
(1995), and Lyon (1994).
51
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Chapter 6: Social Discounting
it is discovered that some current environmental
action or inaction will impose large burdens on future
generations. To maintain inter-generational equity,
some sort of accumulation fund is necessary to pro-
vide compensation for those harms.
While this approach offers solid advice for selecting a
social discount rate for inter-generational policy
evaluation, its resolution of the many difficult social
choice problems posed by such policies rests on two
critical assumptions. One is that the initial
distribution of inter-generational wealth is socially
acceptable. If this is not the case, it is not clear that
attempting to maintain that distribution after
discovering the long-term environmental problem is
an appropriate goal.
Second, if the compensation fund is not accumulated,
then the decision not to remedy this environmental
problem is once again recast as an inter-generational
equity problem, not a question purely of economic
efficiency. There is considerable skepticism regarding
the willingness of the current generation to provide
these compensation funds and a significant concern
that intervening generations might not continue the
accumulation process. Thus, actually undertaking
the process of locking away sufficient savings for dis-
tant future generations to compensate them for envi-
ronmental harms is a very different matter than
determining the rates of interest at which such a fund
might grow.
6.3.2.3 Summary of from the
There is little consensus in the economic literature on social
discounting for inter-generational policies. In particular, the
fundamental choice of what moral perspective should guide
inter-generational social discounting—a social planner who
weighs the utilities of present and future generations, the
preferences of the current generations regarding future gen-
erations, or perhaps other approaches—cannot be made on
economic grounds alone.
It is important, however, to view this result in the proper
context. In fact, the practical effect of this lack of consen-
sus concerning social discounting for inter-generational
policies is not as profound as it at first appears. The major
problems with discounting in long-time-horizon contexts
occur in probably a few cases out of a vastly larger set, par-
ticularly where costs and benefits are inherently high and.
are substantially divorced in time. But the environmental
policies that fit this description are uncommon because
most environmental programs are relatively short in dura-
tion and reversible, with their time frames determined
largely by capital investments.
6.3.2.4 for Inter-
Based on the theoretical social discounting literature and
other considerations, economic analyses of policies with
inter-generational effects should generally include a "no
discounting" scenario by displaying the streams of costs
and benefits over lime. This is not equivalent to calculat-
ing a present value using a discount rate of zero (i.e., the
flow of benefits and costs should be displayed rather than
a summation of values).
Economic analyses should present a sensitivity analysis of
alternative discount rates, including discounting at two to
three percent and seven percent as in the intra-generational
case, as well as scenarios using rates in the interval one-half
to three percent as prescribed by optimal growth models.
The discussion of the sensitivity analysis should include
appropriate caveats regarding the state of the literature with
respect to discounting for very long time horizons.
6.4
Despite analysts' best efforts to assign monetary values to
all of the consequences of an environmental policy, there
are instances in which monetization is not feasible. This
section briefly explores social discounting when some ele-
ments are not expressed in monetary terms.28
''s Although this discussion focuses exclusively on non-monetized benefits, many cost categories are often not monetized as well. The time
costs consumers experience as a result of some policies, the financial costs of business delays that result from others, and the quality and perform-
ance impairments caused by yet other policies often are not monetized in economic analyses. Discounting policy regarding these non-monetized
effects should largely track discounting practices for monetized costs unless there are reasons for not doing so, similar to (hose described in this sec-
tion, for leaving some non-monetized benefits undiscounted.
52
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Chapter 6: Social Discounting
6.4.1 on
Effects
One strategy for addressing future non-monetized effects is
to discount them as though they had been monetized.
Some argue, however, that environmental benefits that
have not been monetized cannot—or should not—be dis-
counted and summarized together with costs in a cost-
effectiveness or benefit-cost summary. Two basic lines of
reasoning are normally offered. One is that because dis-
counting is essentially a financial process designed to eval-
uate investment decisions, it is only relevant to dollar-
denominated streams, and so benefits that are in physical
rather than dollar terms cannot be discounted.
Discounting some types of benefits, such as avoided dam-
ages to human lives or natural resources, treats these tan-
gible risk-related benefits as monetary outcomes, when
they are not in fact financial consequences.
The other line of reasoning for not discounting non-mone-
tized benefits is that it is ethically unacceptable to discount
physical units. If, for example, cancer cases that occur in
the future are discounted to the present, this effectively
asserts that a future cancer case is not really a cancer
case, but rather is only 80 percent, 20 percent, or some
other fraction of a "full" current cancer case. Discounting
therefore somehow cheapens the future effect's value or
reduces its importance and is unfair to future individuals
or generations whose lives or natural resources are at
stake. This argument is often applied not only to human
health and environmental effects that are simply enumer-
ated, but also to those that are monetized.
Evaluating these arguments requires a clear understanding
of the various reasons why benefits might not be mone-
tized in any given analysis. In some cases, benefits are not
monetized because the environmental and health impacts
may be unknown, so that only changes in emissions, pro-
duction, exposure, or other imperfect proxies for benefits,
damages, or harms, are available. Sometimes there may
be an estimated time stream of human health and envi-
ronmental impacts, but the needed valuation tools and
information on how to monetize the benefils are not—or
are only partially—available. Finally in still other cases,
physical effects have been estimated and could be mone-
tized, but this last step—converting measured physical
effects into dollar values of benefits—has simply not been
taken.
6.4.2
Is
In many cases, quantitative information on the time
streams of physical effects is available and these effects are
measured in terms of human health consequences and
ecosystem damages that correspond to endpoints that are
normally monetized. If so, then these non-monetized
benefits ought to be discounted if monetized costs and
benefits are discounted. Discounting non-monetary effects
in these cases is not inherently different from discounting
these units after attaching a unit value in dollar terms.
What is being conveyed is the notion that effects felt far-
ther in the future are worth less in today's terms than
those that occured earlier in time. Thus, if two policies
have identical current costs and. the same amount of bene-
fits in the future except that one produces these benefits
earlier in time, the policy that offers earlier benefits will
have a higher social value.
Choosing not to discount non-monetized benefits can have
perverse consequences. First, to the extent that the act of
discounting and the choice of discount rate embody a
rational investment criterion, failing to discount non-mon-
etized benefits may produce results that appear to be irra-
tional or intrinsically unappealing. Suppose, for example,
there is a policy that is estimated to save five lives in the
year it is implemented. This policy can either be imple-
mented today (Option A) or 20 years from now (Option
B), and the undiscounted costs in current dollars are the
same for both options. If the discounted costs are com-
pared with undiscounted benefits, a cost-effectiveness eval-
uation will clearly favor Option B. Thus, failing to discount
benefits can produce a situation in which society has little
motive to pursue current environmental benefits because
by investing instead, larger net environmental benefils can
be gained, in the more distant future.
Finally, surveys that examine individuals' attitudes toward
public policies with non-monetized benefits suggest that
people do appear to apply a positive discount rate to these
future effects. For example, contingent valuation studies
(Cropper el al., 1992; Carson et al., 1987; Horowitz and
Carson, 1990) that look at individuals' preferences for
53
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Chapter 6: Social Discounting
saving lives find that individuals prefer projects that save
lives in the near term over equivalent cost projects that
save lives in the future.
6.4.3
Not Be
Appropriate
While there are many cases in which non-monetized bene-
fits can and should be discounted along with all of the
other costs and benefits of environmental policies, there
are others in which benefits are not monetized for reasons
that pose more significant problems for discounting.
Specifically, sometimes the available measures of benefits
are very poor proxies for ultimate damages, making it diffi-
cult to discount them correctly.
When an analysis stops far short of the physical effects that
are good proxies for damages, the relationship between
harms and emissions—or other relevant physical meas-
ures—might be poorly understood. In the case of the
greenhouse effect, for example, the ultimate impact of a
ton of greenhouse gas emitted in a given year depends on
the subsequent change in the time paths of temperature,
sea level, and other variables, and on the physical effects
and economic impacts accompanying these changes.
Changes in temperature depend, in turn, on the magni-
tude of emissions of all greenhouse gases over time and
their radiative forcing. Further, the impacts of climate
change may depend not only on the absolute levels of
these effects, but on the rate at which they occur. Because
linking quantified physical harms to a unit of emissions is
a difficult task, discounting greenhouse gas emissions
would be a. premature and problematic step in determin-
ing the cost-effectiveness of two alternative emission
reduction strategies.
Similarly, even when benefit estimates are based on link-
ages from emissions to other physical and. biological end-
points, often these benefit measures are still not close
enough to the endpoints of ultimate concern to allow7 dis-
counting. For example, although pollution damages can
be measured in terms of species diversity, ecosystem
health, and forest productivity, the further detailed linkages
from those damages to current and future recreation, pro-
duction, non-use, or other values identified by economists
and ecologists often do not exist.
Discounting non-monetized effects is also not warranted
when doing so actually conceals information of value to
policy makers. For example, suppose a policy reduces
current and future effluent discharges to a river. Suppose
further that this river has a complex chemistry so that
interactions between the effluent reduced by this environ-
mental policy and other natural and human inputs to the
river are unknown and/or the relationship between efflu-
ent discharges and damages is nonlinear (e.g., the river is
subject to degradation only after passing some threshold).
Here, the same quantities of effluent reduction in different
time periods are not necessarily identical in their effects,
so not only is there a time element to contend with, but
also possible differences in ultimate environmental bene-
fits. In this case it might be far more useful to display the
stream of effluent reduction and probabilities of exceeding
thresholds each year, rather than to discount all of the
future effluent reduction.
In all of these examples, the problem is that analysts have
an incomplete understanding of the relationship between
emissions—and production or other physical units that
are potentially subject to control—and the actual harm to
human health or the environment that result. However, a
general preference for earlier benefits over later ones still
applies. The problem is that discounting in these cases
masks important information by implicitly assuming that a
unit of benefits in one period has an identical effect on the
ultimate benefit consequences of concern as a unit of the
same benefit in another period. When non-monetized
benefits measures are far from the human health and
other benefit categories of true concern, this assumption
often is contrary to reality.
When it is not appropriate to discount certain non-mone-
tized benefits, comparisons of costs and benefits can still
be made without directly discounting the benefits. For
example, if costs and benefits occur in each time period
over the course of a policy, and these do not change signifi-
cantly over time, net social benefits can be explored with-
out discounting by examining a representative year's costs
and benefits. Similarly, if the benefits are relatively con-
stant through time, but the costs are not, the costs can be
annualized and compared to the annual benefits using
cost effectiveness analysis. Another approach is to cumu-
late costs forward with interest to compare this future
value to the benefits, a method that is particularly suitable
when the benefits occur in onlv one future year. If none of
54
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Chapter 6: Social Discounting
these methods applies, simply presenting the streams of
costs and monetized and non-monetized benefits to policy
makers is often sufficient.
55
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Chapter 6: Social Discounting
6.5
Arrow, K. J., W R. Cline, K. G. Maler, M. Munasinghe, R. Squitieri, andj. E. Stiglitz. 1996. Intertemporal Equity,
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Carson, R. T., J. K. Horowitz, and M. J. Machina. 1987. Discounting Mortality Risks. Discussion Paper 87-25, UCSD
Department of Economics, University of California, San Diego, September 1987.
Cowen, T. and D. Parfit. 1992. Against the Social Discount Rate. In Philosophy, Politics, and Society: Series 6, Future
Generations, edited by E Lasletl and J. Fishkin. New Haven, CT: Yale University Press.
Cropper, M. L, S. K. Aydede, and V. R. Eortney. 1992. Public Preferences for Life Saving. Discussion Paper CRM 9201,
Resources for the Future, Washington, D.C.
Dasgupta, E 1982. Resource Depletion, Research and Development, and the Social Rate of Return. Chapter 8 in
Discounting for Time and Risk in Energy Policy, edited by R. C. Lind. Washington, D.C.: Resources for the Future.
Horowitz, J. K., and R. T. Carson. 1990. Discounting Statistical Lives. Journal of Risk and Uncertainty 3(4): 403-413.
Ibbotson, R. G., and R. A. Sinquefleld. 1984. Stocks, Bonds, Bills, and Inflation: The Past and the future, Financial
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IL: R.G. Ibbotson Associates, Inc.
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mid Social Dimensions of Climate Change. Contributions of Working Group III to the Second Assessment Report of the
Intergovernmental Panel on Climate Change. Melbourne, Australia: Cambridge University Press.
Kolb, J. A., and J. D. Scheraga. 1988. A Suggested Approach for Discounting the Benefits and Costs of Environmental
Regulations. Memorandum prepared by U.S. EPA. Office of Policy, Planning and Evaluation, Washington, D.C.
Kolb, J. A., and J. D. Scheraga. 1990. Discounting the Benefits and Costs of Environmental Regulations. Journal, of Policy
Analysis and Management 9: 381-390.
Lind, R. C. (ed.) 1982a. Discounting for Time and Risk in Energy Policy. Washington, D.C.: Resources for the Future.
Lind, R. C. 1982b. A Primer on the Major Issues Relating to the Discount Rate for Evaluating National Energy Options.
Chapter 2 of Discounting for Time and Risk in Energy Policy, edited by R. C. Lind. Washington, D.C.: Resources for the
Future.
Lind, R. C. 1990. Reassessing the Government's Discount Rate Policy in Light of New Theory and Data in a World
Economy with a High Degree of Capital Mobility. Journal of Environmental Economics and Management 18(2): 8-28.
Lind, R. C. 1994. Intergenerational Equity, Discounting, and the Role of Cost-Benefit Analysis in Evaluating Global Climate
Policy. In Integrative Assessment of Mitigation, Impacts, and Adaptation to Climate, edited by N. Nakicenovic, WD.
Nordhaus, R. Richels, and F.L. Toth. Laxenburg, Austria: International Institute of Applied Systems Analysis (IIASA).
Lowenstein and Thaler. 1989. Intertemporal Choice. Journal of Economic Perspectives, 3(4): 181-193.
Lyon, R. M. 1990. Federal Discount Rate Policy, the Shadow Price of Capital, and Challenges for Reforms. Journal of
Environmental Economics and Management 18(2): 29-50.
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Chapter 6: Social Discounting
Lyon, R. M. 1994. Intergenerational Equity and Discount Rates for Climate Change Analysis. Paper presented at IPCC
Working Group 111 Workshop on Equity and Social Considerations Related to Climate Change, 18-22 July, Nairobi, Kenya.
Marine, A. S. 1994. The Rate of Time Preference: Implications for the Greenhouse Debate. In Integrative Assessment of
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Environment, Baltimore, MI): The Johns Hopkins University Press.
Pearce, D. W. and D. Ulph. 1994. A Social Discount Rate for the United Kingdom. Mimeo No. 95-01, Centre for Social and
Economic Research on the Global Environment, University College London and University of East Anglia, UK.
Rothenberg, J. 1993- Economic Perspectives on Time Comparisons: Evaluation of Time Discounting. In Global Accord;
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Schelling, T. C. 1995. Intergenerational Discounting. Energy Policy 23(4/5): 395-401.
Scheraga, J. D. 1990. Perspectives on Government Discounting Policies. Journal of Environmental Economics and
Management 18(2): 65-71.
Sen, A. K. 1982. Approaches to the Choice of Discount Rates for Social Benefit-cost Analysis. Chap. 9 in Discounting for
Time and Risk in Energy Policy, edited by R. C. Lind. Washington, D.C.: Resources for the Future.
Shefrin, LI. M. and R. H. Thaler. 1988. The Behavioral Life-cycle Hypothesis. Economic Inquiry XXVI(October): 609-43.
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Thaler, R. 1985- Mental Accounting and Consumer Choice. Marketing Science 4(3): 199-214.
Toth, F. L. 1994. Discounting in Integrated Assessments of Climate Change. In Integrative Assessment of Mitigation,
Impacts, and Adaptation to Climate, edited by N. Nakicenovic, WD. Nordhaus, R. Richels, and F.L. Toth. Laxenburg,
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(accessed 8/28/2000).
57
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Chapter 7: Analyzing Benefits
7.1 Introduction to
Analyzing Benefits
At its roots, benefits analysis develops monetary val-
ues to inform the policy making process. These val-
ues are important because they allow decision mak-
ers to directly compare costs and benefits using the
same measure (i.e., dollars). A complete benefits
analysis is also useful because it makes explicit the
assumptions about the value of benefits embedded in
different policy choices. This chapter focuses on
those benefits that can be expressed in terms of dol-
lars. Chapter 10 discusses the presentation of non-
monetized benefits, those that cannot be expressed in
dollar terms.
This chapter presents information on the theory and
practice of benefits assessment for environmental
policies. The discussion focuses on the benefits pos-
sible from a "typical" EPA policy or regulation that
reduces emissions of contaminants into the environ-
ment. However, the principles discussed here apply
to other types of EPA policies, such as those that pro-
vide information or regulatory relief.
Most EPA benefits analyses face two serious chal-
lenges. First, a given policy may produce many dif-
ferent benefits, but it is seldom possible to obtain a
single, comprehensive value estimate for the collec-
tion of effects. This will often leave analysts with no
alternative but to address these effects individually,
aggregating values to generate an estimate of the total
benefits of a policy alternative. Although there are
exceptions to this "effect by effect" process for bene-
fits analysis, much of the discussion in this chapter
assumes that analysts will be forced to adopt this
approach.
The second major challenge faced by analysts is the
difficulty of conducting original valuation research in
support of specific policy actions. Because it is often
too expensive or time consuming to perform original
research, analysts will need to draw upon existing val-
uation estimates for use in benefits analysis. The
process of applying these estimates to value the con-
sequences of policy actions is called benefits
transfer. Although the benefit transfer method is
detailed in only one section, this chapter is generally
written with benefit transfer in mind. For example,
the descriptions of valuation methods in Section 7.5
include recommendations for assessing the quality of
published studies. This is done to help analysts
determine which studies deserve consideration for
use in benefit transfers.
While analysts should always seek precision, they
must make assumptions and exercise professional
judgment to face the challenges noted above, as well
as numerous others that arise in a benefits analysis.
Existing value estimates, for example, are often sub-
ject to large uncertainty bounds due to measurement
error, model uncertainty, and the inherent variability
of individual preferences. When drawing from these
studies—and when using quantitative estimates of
any kind—analysts should carefully assess the quali-
ty of the data and should clearly state the reasons for
their analytical choices. As with any analytical exer-
cise, the maxim "garbage in, garbage out" always
applies.
The next section briefly summarizes the conceptual
economic framework for benefits analysis. Section
7.3 outlines the effect-by-effect process for benefits
analysis, including some general implementation
principles. The fourth section defines and describes
the types of benefits associated with environmental
policies, followed by a review of available economic
valuation methods in Section 7.5. This chapter
•I:1
Chapter
7
59
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Chapter 7: Benefits
concludes with specific recommendations for valuing types
of beriefils that are common to many EPA policies.
7.2 A
for
This section describes the theoretical economic foundation
for valuing benefits. The theoretical discussion here
serves as a conceptual starting point for benefits estima-
tion—it is not a full and comprehensive treatment of wel-
fare economics. The section includes a discussion of will-
ingness to pay, consumer surplus, and analytical problems
arising from the lack of markets for environmental
improvements. References are provided for further read-
ing on the specific topics introduced in this section, but
useful texts for general reference include Just et al.
(1982), Braden and Kolstad (1991), and Freeman (1993).
Boardman et al. (1996), Brent (1995) and Hanley and
Spash (1993) are useful, general references for benefit-
cost analysis.
7.2.1
to Pay
to
Compensation
Economists define benefits by focusing on measures of
individual satisfaction or well-being, referred to as meas-
ures of welfare or utility. Economic theory assumes that
individuals can maintain the same level of utility while
trading-off different "bundles" of goods, services, and
money. For example, one may be equally satisfied by going
fishing or viewing a movie. The tradeoffs individuals make
reveal information about the value they place on these
goods and services.
The willingness to trade off compensation for goods or
services can be measured either as willingness to pay
(WTP) or as willingness to accept compensation (WTA).
Economists generally express WTP and WTA in monetary
terms. In the case of an environmental policy, willingness
to pay is the maximum amount of money an individual
would voluntarily exchange to obtain an improvement (or
avoid a decrement) in the environmental effects of con-
cern. Conversely, willingness to accept compensation is
the least amount of money an individual would accept to
forego the improvement (or endure the decrement).1
0~ WTP and WTA are not necessarily equal. The
amount an individual would be willing to pay to
obtain an environmental improvement is not neces-
sarily identical to the amount he or she would be will-
ing to accept to forego the improvement. One reason
for this difference is that the starting points of the two
measures differ. For environmental improvements,
WTP uses the level of utility without the improvement
as a reference point. WTA, on the other hand, uses as
its reference point the level of utility with the
improvement. Although these two measures are dis-
tinct and sometimes differ in practice, under conven-
tional assumptions economists expect that the differ-
ence between them will be small in most cases. This
result generally holds as long as the amounts in ques-
tion are a relatively small proportion of the individ-
ual's income. Nonetheless, in the case of environ-
mental goods, some additional considerations modify
this general result. Hanetnann (1990 shows that
while this result holds for price changes, it does not
strictly hold for changes in quantity or quality. Also, if
a good has no close substitutes, differences in WTP
and WTA may be large even if the effect on income is
small.
f WTP and WTA can also be with what
they Imply about property rights—whether enti-
ties have a right to pollute, so the public must pay
them not to, or whether the public has a right to a
clean environment and must be compensated for pol-
lution. For example, in the case of a policy that
would reduce existing pollution levels, the use of WTP
measures to value benefits implicitly assumes that the
properly right rests with the polluting firm.
1 In the case of environmental improvements, WTP is identified as the compensating variation measure of welfare change, while WTA in
this case is identified as the equivalent variation measure. For environmental decrements, these associations are reversed. For a more detailed
treatment of welfare measures that includes these issues see Just et al. (1982), Freeman (1993), and Hanley and Spash (1993).
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Chapter 7: Benefits
In practice, WTP is generally used to value benefits
because it is often easier to measure and estimate. To
simplify the presentation, we use the term "willingness to
pay" (or WTP) throughout this chapter to refer to the
underlying economic principles behind both WTA and WTE
Aggregating Individual Willingness to Pay
Measures
The benefits of a policy are the sum total of each affected
individual's WTP for the policy. Because benefit-cost analy-
sis assesses only the efficiency of policy choices, each indi-
vidual's WTP must be given the same weight in the sum-
mation. This means that no individual or group of individ-
uals is given preferential treatment in assessing the effi-
ciency of the program except to the degree that they are
willing to pay for it. .As described in Chapter 9, equity
assessments and impact analyses can be used to describe
the effects of policies on populations of concern.
Altruism
While benefits are generally calculated by summing each
individual's WTP for his or her own welfare, there are con-
ditions under which it is appropriate to include altruistic
values, or individuals' WTP for the welfare of others.
Economic theory concludes that if one cares about a
neighbor but respects the neighbor's preferences, and if
the neighbor would have to pay for the policy action being
analyzed, then altruistic benefits should not be counted in
a benefit-cost analysis. The intuition behind this result is
that, if one respects the neighbor's preferences, one cares
about both the benefits and the costs the neighbor faces.
It is therefore inappropriate to add the value one attaches
to the neighbor's benefits without considering the cost
implications of doing so. Comparing individual benefits
and costs in this case is the appropriate decision rule.
Altruistic benefits may be counted either when altruism
toward one's neighbor is paternalistic or when one will in
fact bear the costs of the project but the neighbor will not.
In the first case (paternalistic altruism), one cares about
the benefits the neighbor will enjoy e.g., from a health or
safety project, but not about the costs the project will
impose on him. An example of the second case would be
a project whose costs are borne entirely by the current
generation; i.e., the project imposes no costs on future
generations. In this case, altruism toward future genera-
tions by the current generation could legitimately be
counted as a benefit.
7.2.2
Curves
Willingness to pay is closely related to the concept of con-
sumer surplus, which is both an individual and an aggre-
gate concept. An individual demand curve indicates the
maximum amount an individual would be willing to pay to
acquire an additional unit of good. These individual
demand curves can then be aggregated into a market
demand curve that provides the cumulative WTP for addi-
tional units. Consumer surplus is derived from market
estimates of how much of the good is demanded in the
aggregate at each price and can be easier to estimate than
individual WTP.
A market demand, curve for a given good or service traces
out the amounts that consumers will purchase at different
price levels; i.e., their collective WTP for the good or serv-
ice. Consumer surplus is the excess amount that pur-
chasers are willing to spend on a good or service over and
above that required by the market price (i.e., the area
under the demand curve but above the price line). This
surplus serves as a measure of the social benefits of pro-
ducing the good. Policies that affect market conditions in
ways that decrease prices will generally increase consumer
surplus. This increase can be used to measure the bene-
fits of the policy.2
The use of demand curves and consumer surplus high-
lights the importance of assessing how individuals will
respond to changes in market conditions. For example, if
a policy affects the price or availability of a commodity
traded in a market (e.g., if it leads to increases in the com-
mercial fish harvest), multiplying the increased quantity
by current prices generally will not provide an accurate
2 Technically, consumer surplus serves as a precise measure of benefits only if the demand curve represents a compensated or Hicksim,
demand function. However, Willig (1976) shows that ordinary, or MarshaUian. demand curves can often be used to derive an approximate measure
of welfare. The difference in Ihese Iwo types of demand curves is that Ihe former holds utility constant while the latler holds income constant More
background on the theoretic basis for welfare measures can be found in several texts including Freeman (1993), Johansson (1993), Just et al. (1982),
andVarian (1992).
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Chapter 7: Benefits
measure of benefits. Depending on the elasticity of the
demand curve, a one percent price increase may lead to
more (or less) than a one percent increase in the quantity
demanded, affecting the change in consumer surplus.3
While not detailed here, supply curves also vary in elastici-
ty and have an analogous effect on producer surplus.
Information on the elasticity of the supply and demand
curves is needed to estimate benefits in the form of
increases in consumer (and/or producer) surplus.4
7.2.3
One challenge facing analysts of environmental policies is
the lack of a market for most environmental improve-
ments. Because "cleaner air" or "cleaner water" is not
normally bought or sold, market data are generally not
available for benefit valuation. Economists have therefore
developed other methods for eliciting values for these
types of effects. These methods rely either on information
from the markets for related goods (revealed preference
methods) or on direct information on people's preferences
(stated preference methods). Individual WTP values esti-
mated in these studies can be aggregated (or an average
value multiplied by the total number of affected individu-
als) to produce an estimate of the total benefit for a good
or policy. Section 7.5 provides more information on the
economic foundations of specific methods, and Section 7.6
details how these methods have been—or can be—
applied in benefits analysis.
7.3
From the perspective of economic theory, an appropriate
measure of a policy's benefits is the sum of individual WTP
estimates for that policy. While it may be possible in some
circumstances to obtain individual WTP estimates for the
entirety of a. policy decision, in practice, analysts must
often use an "effect-by-effect" approach for benefit valua-
tion. This section discusses this approach to benefits
analysis, concluding with some general principles to keep
in mind when implementing this approach.
A
Approach
The most widely used approach for estimating the benefits
of a policy option is to evaluate separately the major effects
of a given policy and then sum these individual measures
to arrive at total benefits. This general approach usually
involves describing the physical effects of the pollutants
(e.g., various types of damages to human health and eco-
logical systems) and assessing each type of effect separate-
ly. In some cases, it may be desirable and feasible to
diverge from this approach. For example, contingent valu-
ation or other methods could be used to develop estimates
of WTP for the combined effects of the policy change,
reducing the need to identify, quantity and value each
effect separately A comprehensive value estimate for the
entire set of effects from a policy change can also be useful
as an indication of the upper bound expected from the
sum of values developed with the effect-by-effect
approach.5 However, because it is difficult to develop esti-
mates of the total value of the pollution reduction and
decision makers are often interested in information on
individual benefit categories, an effect-by-effect valuation
approach is most often used by EPA in economic analyses
of regulations.
The general effect-by-effect approach for assessing the
benefits of environmental policies includes three
components:
f Identify potentially affected benefit categories by
developing an inventory of the physical effects that
may be averted by the policies.
1 Elasticity is a measure of relative change. For a given demand curve, price elasticity is defined as the percentage change in quantity
demanded divided by the percentage change in price. Where this value is less than one in absolute value, demand is considered to be "inelastic."
Elasticity values greater than one (in absolute value) indicate that demand is "elastic,"
* It is important to keep in mind that elasticity is a local concept. Generally, one can expect the elasticity of supply and demand curves to
vary along their respective lengths. This means that elasticities measured at a particular point on these curves may not be appropriate for estimating
large changes or changes elsewhere on the curve. In these cases, it may be necessary to characterize the demand and supply functions in the rele-
vant range of prices and quantities.
5 Randall (1991) presents a framework for comparing total value and "independent valuation and summation" and reviews many issues
associated with estimating total values.
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Chapter 7: Benefits
f Quantify significant physical effects to the extent
possible working with managers, risk assessors, ecolo-
gists, physical scientists, and other experts.
f Estimate the values of these effects using studies
that focus on the effects of concern or transferring
estimates from studies of similar impacts.
These steps may be implemented using an iterative
process. For example, analysts can begin by conducting
screening analyses using available data and relatively sim-
ple assumptions, then collect additional data and refine
the analysis as needed to better inform decision-making.
Each step in this approach is discussed in more detail
below; focusing on the actions that are generally undertak-
en when conducting benefits analyses for typical EPA poli-
cies. However, this guidance is intended to be flexible.
Analysts will need to determine on a case-by-case basis
whether this framework is appropriate for assessing a spe-
cific policy, given the effects particular to that policy and
the information needed for related decision-making.
Stepf; Potentially
Categories
The first step in the benefits assessment is to determine
the types of benefits most likely to be associated with the
particular policy. Section 4 of this chapter contains a
detailed presentation of the categories of benefits typically
associated with environmental policies and regulations. To
identify benefit categories, analysts should, to the extent
feasible, do several things:
0~ Develop an initial understanding of policy
options of interest by working with cost analysts
and policy makers. Information should also be col-
lected on the likely range of emissions levels associat-
ed with the baseline and with implementation of each
of the policy options. At the outset of the analysis, the
range of options and associated emissions levels con-
sidered may be very broad because emissions levels
and preferred policy options can change significantly
in the course of the policy making process.
0~ Research the physical effects of the pollutants
on human health, welfare, and the environment.
This can be done by reviewing the literature and, if
necessary, meeting with other experts. This step
requires considering the transport of the pollutant
through the environment along a variety of pathways,
including movement through the air, surface water
and groundwater, deposition in soils, and ingestion or
uptake by plants and animals (including humans).
Along these pathways, the pollutant may have detri-
mental effects on natural resources (e.g., affecting oxy-
gen availability in surface water or reducing crop
yields) as well as direct or indirect effects on human
health (e.g., affecting cancer incidence through direct
inhalation or through ingestion of contaminated food).
f Consider the potential change in these effects as
a result of possible policy options. If policy options
differ only in their level of stringency, then each
option may have an impact on all identified physical
effects. In other cases, however, some effects may be
reduced while others remain unchanged under a spe-
cific policy option. Evaluating how physical effects
change under each policy option requires evaluation
of how the pathways differ in the "post-policy" world.
f Evaluate which effects are likely to be significant
in the overall benefit analysis according to at least
three criteria:
— whether there are likely to be observable changes
in the benefits category when comparing the poli-
cy options to each other and to the baseline;
— whether the benefits category is likely to account
for a major proportion of the total benefits of the
policy; and
— whether stakeholders or decision makers are
likely to need information on the benefits catego-
ry, even if its magnitude is relatively small.6
The outcome of this initial step in the benefits analysis can
be summarized in a list or matrix that describes the physi-
cal effects of the pollutant, identifies the benefits categories
associated with these effects, and an initial ranking of
which effects may be significant enough to warrant further
investigation.
Initially, the list of benefit categories may be lengthy and
include all effects that reasonably can be associated with
6 This criteria relates to equity considerations detailed in Chapter 9.
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Chapter 7: Benefits
the policy options under consideration. Analysts should
preserve arid refine this list of benefit categories as the
analysis proceeds, and the effects that are not assessed in
detail should be discussed qualitatively when presenting
analytic results. In some cases, it may not be feasible to
assess some of the more significant impacts, either
because of insufficient scientific data (e.g., data are lacking
on the effects of changes in pollution levels on the benefit
category of concern) or because the time or resources
needed, to assess the effect are high compared to the sig-
nificance of the benefits category in the decision-making
process. These issues should be discussed when present-
ing the results of the benefits analysis. The discussion
should address (1) the criteria used to exclude selected
benefit categories from detailed quantitative analysis, (2)
the likely magnitude of the non-quantified benefits, and
(3) the extent to which these effects are or are not impor-
tant considerations for the decision-making process.
2;
The second step is to quantify the physical impacts related
to each category. Data are usually needed on the extent,
timing, age distribution of the affected population, and
severity of the effects. The focus should be on the changes
attributable to each policy option in comparison to the
baseline. For example, if the risk of lung cancer is one of
the effects of concern, data may be needed on the changes
in risk associated with each option, the timing of the risk
reductions, the age distribution of those experiencing the
risk reductions, and the percentage of cases likely to be
fatal. If visibility is a concern, data may be needed on the
geographical areas affected and the change in visibility lev-
els attributable to each policy option.
f Work closely with analysts In other fields.
Estimating these impacts is largely, but not complete-
ly the domain of other scientists, including risk asses-
sors, ecologists, and other experts. These experts are
generally responsible for evaluating the likely trans-
port of the pollutant through the environment and its
potential effects on humans, ecological systems, and
manufactured materials under the baseline and each
policy option. The principal role of the economist is
to communicate with these experts in order to ensure
that the information provided is adequate to support
the benefits analysis, including information on the
uncertainty associated with the estimates of physical
impacts. However, economists may also be able to
provide insights, information, and analysis on behav-
ioral changes that can affect the results of the risk
assessment.
f Try to match the risk assessment economic
endpeints. A key consideration in this interaction is
that the endpoints quantified and described in the
risk assessment match well the effects for which eco-
nomic valuation is feasible. Effects that are described
too broadly or that cannot be associated with econom-
ic welfare will limit the ability of the analysis to cap-
ture the full range of benefits associated with policy
options. H is difficult, for example, to produce an
economic measure of the benefits associated with a
reduction in the number of persons exposed to a con-
taminant at a particular level. If, however, the risk
assessment can produce an estimate of the reduction
in the number and type of adverse health effects from
exposure, then the economic valuation exercise is much
more feasible. This means that the analyst must be
aware of the available economic data and tools when
working will) risk assessors and other scientists.
f Describe qualitatively effects that cannot be
quantified. It will not be possible to quantify all of
the significant physical impacts for all policies. For
example, animal studies may suggest that a contami-
nant causes severe illnesses in humans, but the data
available may not be adequate to determine the num-
ber of expected cases associated with different human
exposure levels. Likewise, it is often not possible to
quantify all the ways in which an ecosystem may
change as a result of an environmental policy. In
these situations, the effect should be described quali-
tatively when presenting the results of the benefits
analysis. Analysts should also assess the implications
of not being able to include this effect in quantitative
benefits estimates.
EPA has developed extensive guidance on the assessment
of human health and ecological risks and analysts should
refer to those documents and the offices responsible for
their production and implementation for further
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Chapter 7: Benefits
guidance.7 No specific guidance exists for assessing changes
in materials damages or amenity effects. Analysis should
consult relevant experts and existing literature to determine
the "best practices" appropriate for this type of analysis.
Step 3: the
Once information on the physical effects of the pollutant is
available, the next step is to assess the value of related
benefits based on estimates of individual WTE As dis-
cussed earlier, no market exists for many of the types of
benefits anticipated from environmental regulation. In
most cases, analysts will need to rely upon the results of
other methods for estimating economic values. Details on
these methods and examples of how they may be applied
can be found in Sections 7.5 and 7.6, respectively.
0~ Consider using more than one method to
estimate benefits. Different methods often address
different subsets of total benefits and the use of
multiple methods allows for comparison of alternative
measure of value. Double-counting is a significant
concern when applying more than one method,
however, and. any overlap should, be noted, in
presenting the results. In addition, some
components of the total value of benefits may not be
amenable to valuation and will need to be described
in other terms when presenting the analytic results.
The discussion of benefit transfer in Section 7.5
describes many of the issues involved in applying
values from one study to another situation.
0~ Describe the source of estimates and. confidence
in those sources. Valuation estimates always con-
tain a degree of uncertainty. Using them in a context
other than the one in which they were initially esti-
mated can only increase that uncertainty. If many
high-quality studies of the same effect have produced
comparable values, analysts can have more confi-
dence in using these estimates in their benefits calcu-
lations. Some specific benefit transfer methods
described in Section 7.5 provide a systematic manner
of combining multiple estimates. In other cases, ana-
lysis may have only a. single study—or even no direct-
ly comparable study—to draw from. In all cases, the
presentation of the benefits analysis should clearly
describe the sources of any values used, along with
some assessment of the confidence associated with
those sources.
7.3.2
When applying this framework to assess the benefits of
specific policies, analysts should keep in mind the follow-
ing general principles:
0~ Focus on key Issues. Resources should be focused
on benefit categories that are likely to influence policy
decisions. To use time and resources effectively ana-
lysts must weigh the costs of conducting additional
analysis against the usefulness of the additional infor-
mation provided for decision-making. The analysis
should devote significant time and resources to careful-
ly assessing those benefits categories that are likely to
influence the selection among policy options. In some
cases, relatively simple screening analyses may provide
adequate information on these benefits. Additional
data collection may not be warranted because it is
unlikely to lead to significant changes in the conclu-
sions of the analysis. For example, screening using a
broad range of values for selected effects may indicate
that a policy is clearly worth pursuing and analysts may
conclude that any possible refinements to the analysis
are likely to simply reinforce this conclusion. In this
case, the analyst should discuss the approach taken and
note that the benefits estimate may represent a lower
bound. Likewise, some categories of benefits may not
be assessed either because they are expected to be
small or because the costs or time needed to quantify
them far exceed the time or resource levels appropriate
for analysis of the particular policy
Applying this approach to benefits assessment
involves first conducting scoping analyses to collect
available information on the potential benefits of the
policies and using this information to develop
7 In September 1986, EPA published final risk assessment guidelines for a number of health effects, including Guidelines for Carcinogen
Risk Assessment, which are currently under revision. Many other risk-related guidelines have been published, revised, and updated since 1986,
Recent additions include Guidelines for Exposure Assessment (EPA, 1992) and Guidelines for Reproductive Toxicity Risk Assessment (EPA, 1996),
More information on these and other guidelines, as well as electronic copies of the documents themselves, can be found on the home page of EPA's
National Center for Environmental Assessment at http://'wwwepa.gownceawwwl/'raf/'rafguid,htm (accessed 8/28/2000).
65
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Chapter 7: Benefits
preliminary estimates (see, for example, Morgan and
Henrion,1990). The results from this initial
screening analysis can then be used to inform the
early stages of the policy development process and to
focus future research on those areas most in need of
further assessment. In many cases, it may be useful
to use benefits transfer techniques in the initial stages
of the analysis, as discussed later in this chapter.
Coordinate frequently with others Involved in
developing the policies. Ongoing coordination with
the analysts responsible for assessing costs and eco-
nomic impacts, and with the work group considering
policy options is crucial to ensure consistency as the
policy options and analyses evolve. This coordination
should begin in the planning stages of the analysis, and
should continue throughout the development process.
Successful efforts often involve informal conversations
among lead analysts several times each week, supple-
mented by larger and more formal periodic meetings
to report on progress and discuss next steps.
Coordination will help ensure thai the cost and bene-
fit results are comparable and based on consistent
baseline and policy assumptions. In addition, infor-
mation from the cost analysis is often needed for the
analysis of benefits and vice versa. For example, if a
policy requires firms to install new pollution controls,
benefits analysis requires information on the number
of facilities likely to install each type of control and
the associated reduction in emissions. On the other
hand, where a performance standard is being consid-
ered, the cost analysis may need data from the risk
models in considering which controls are likely to
meet the standard.
Consider changes in behavior. The use of an
effect-by-effect approach does not necessarily mean
that one should simply value benefits by estimating
the physical changes attributable to changes in pollu-
tion emission levels (e.g., increases in the fish popu-
lation) then assigning a unit value to these changes
(e.g., the price of the fish). Such a limited analysis
will be inappropriate in many cases because it leaves
out the effects of changes in behavior attributable to
changes in environmental quality. For example,
increased fish populations may cause commercial
prices to drop, in which case consumers may
increase their purchases. Commercial fisheries may
also respond to changes in pollution levels by altering
their production processes. While it may not be pos-
sible in practice to capture all of these types of
responses in the analysis, those that are likely to be
significant should be addressed.
Guard against double-counting benefits. If
there is significant overlap across the values used for
estimating the benefits of different effects, summing
values across these effects could substantially
overstate expected benefits. For example, property
value studies may estimate people's WTP for all
perceived effects. This would overlap with values
estimated separately for any one of these effects, such
as reduced risk, so simply adding these two values to
estimate benefits would be inappropriate. Analysis
should also take care to ensure that important effects
of the policy have not been omitted in the benefits
analysis, as this will lead to significant underestimates
of total benefits.
Explicitly address uncertainty and non-mone-
tized effects. Benefits assessments for environmen-
tal policies often involve significant uncertainty.
Sometimes this uncertainty cannot be reduced (or
better characterized) given the need to regulate in a
timely manner and the resources available for the
analysis. These uncertainties should, be clearly com-
municated when presenting the results of the analy-
sis, focusing on the implications for decision-making.
For example, if benefits may be significantly overstat-
ed due to the conservatism inherent in the risk esti-
mates, then the materials summarizing the analysis
should state this explicitly. Guiding principles for
addressing and presenting uncertainty are presented
in Chapter 5 of this guidance. The relative signifi-
cance of benefits categories that are not quantified, or
quantified but not monetized, should also be
described, as discussed in Chapter 10.
7.4 of
This section describes the types of benefits that are
typically associated with environ menial policies. These
66
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Chapter 7: Benefits
descriptions are provided with an understanding that it is
desirable to quantify and monetize these benefits.
Available valuation techniques are described in Section 7.5.
Benefits from environmental policies can be broadly clas-
sified into those that directly affect humans and human
welfare and those that affect human welfare through systems
or processes. The former category includes human health
improvements such as reduced mortality rates, decreased inci-
dence of nonfatal cancers, chronic conditions and other ill-
nesses, and reduced adverse reproductive or developmental
effects. Improved amenities are another type of benefit experi-
enced directly by humans. Improved taste and odor of tap
water resulting from treatment requirements are an example
of direct amenity benefits.
Benefits that affect human welfare through systems or
processes include reduced materials damages and
numerous other effects collectively termed ecological
benefits. EPA policies may result in ecological impacts that
affect the human use of natural resources (e.g., improving
commercial fishing, increasing agricultural yields,
enhancing recreational opportunities.) Ecological effects
may also provide passive use (or "non-use") benefits that
arise from a variety of motives including, for example,
one's own utility in knowing that clean resources exist or
the desire to preserve clean resources for future
generations. In some cases, environmental policies also
reduce damages to manufactured materials or improve a
resource's aesthetic qualities. Reducing air pollution may
decrease damages to building exteriors or improve
visibility. Exhibit 7-1 illustrates this categorization scheme
Exhibit 7-1 Examples of Benefit Categories, Service Flows, and
Commonly-Used Valuation Methods
Benefit Category
Human Health
Mortality Risks
Morbidity Risks
Amenities
Ecological Benefits
Market: products
Non-market:
recreation and
aesthetics
Indirect: ecosystem
services
Non-use: existence
and bequest values
Materials Damage
Examples of Service Flows
Reduced risk of
• Cancer fatality
• Acute fatality
Reduced risk of
• Cancer
• Asthma
• Nausea
• Taste
• Odor
• Visibility
Provision of
• Food • Market
• Fuel • Timber
• Fiber • Fur, eather
Provision of
• Recreational opportunities,
e.g., viewing, fishing, boating,
swimming, hiking
• Scenic vistas
• Climate moderation • Pollination by wild species
• Flood moderation • Biodiversity, genetic library
• Groundwater recharge • Water filtration
• Sediment trapping • Soil fertilization
• Soil retention • Pest control
• Nutrient cycling
No associated services
Commonly-Used
Valuation Methods
Averting behaviors
Hedonics
Stated preference
Averting behaviors
Cost of illness
Hedonics
Stated preference
Averting behaviors
Hedonics
Stated preference
• Market
• Production function
• Averting behaviors
• Hedonics
• Recreation demand
• Stated preference
• Production function
• Averting behaviors
• Stated preference
• Stated preference
• Averting behaviors
• Market
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Chapter 7: Benefits
and suggests commonly-used techniques for estimating
their values, although the list is not exhaustive.8 A detailed
discussion of valuation techniques is presented in the next
section of this chapter. The remainder of this section
describes each of these categories briefly and notes issues
associated with quantification.
7.4.1
Risks
Some EPA policies are designed to decrease the risks of
contracting potentially fatal health effects, such as some
cancers. Reducing these risks of premature fatality pro-
vides welfare increases to those individuals affected by the
policy. It is important to keep in mind that policies gener-
ally provide marginal changes in relatively small risks.
That is, most policies do not provide assurance that one
will not prematurely die of environmental causes, they
only marginally reduce the probability of such an event.
f Reduced mortality risks are often measured in
terms of "statistical lives." This measure is the
aggregation of many small risks over an exposed pop-
ulation. Suppose, for example, that a policy affects
100,000 people and reduces the risk of premature mor-
tality by one in 10,000 for each individual. Summing
lliese individual risk reductions across the entire affed-
ed population results in the policy saving 10 statistical
lives. It is unknown who these ten people might be—
everyone faces some risk of being affected—but the
policy can be expected to prevent premature fatality for
10 individuals in the population.
f Alternative measurements may include "statisti-
cal life years." A somewhat more refined approach
to measuring reduced mortality risks includes the
degree of life extension in the estimate. This is usual-
ly done by looking not just at the reduced probability
of a premature fatality, but also at the expected life
span of those enjoying the risk reduction. A risk
reduction of one in 10,000 experienced by a popula-
tion of 100,000 people with an expected remaining
life span of 50 years each, for example, would save 10
"statistical lives" or 500 "statistical life years."
Measuring mortality risk reduction in terms of statis-
tical life years provides more information about the
expected benefits of a policy, but requires risk esti-
mates for specific age groups.9 Often these risk esti-
mates are not available.
7.4.2
Effects
This benefits category consists of reductions in the risk of
non-fatal health effects ranging from mild illnesses such
as headache and nausea to very serious illnesses such as
cancer. A complete list of morbidity effects is beyond the
scope of this document, but the presumption for all of
these effects is that the illness will not generally result in
premature fatality.
f Morbidity effects can generally be characterized
by their duration and severity. For duration of ill-
ness, the primary distinction is between acute effects
and chronic effects. Acute effects are discrete
episodes usually lasting only a few days, while chronic
effects last much longer and are generally associated
with long-term illness. Severity defines the degree of
impairment associated with the illness and may be
measured in terms of "restricted activity days," "bed
disability days," or "lost work days."10 Severity may
also be described in terms of health state indices that
may combine multiple dimensions of health into a
single quantity, or index. The difference in the index
8 This classification scheme is offered here to facilitate discussion in this document. It is similar in many respects to one ottered in
Freeman (1993), but olher researchers have offered alternatives. Freeman (1993) describes some general characteristics of these alternatives. The
list of techniques for each benefit category is riot intended to be comprehensive or exclusive
' Additional refinements to account for quality of life or health status are often employed in the public health and health economics.
Existing measures include "quality adjusted life years" (QALYs) and "disability adjusted life years:' These measures have not been fully integrated
with the literature on benefits analysis for environmental policies. More information on QALYs can be found in Gold et al. (1996) and additional
information on DALYs can be found in Murray (1994).
10 As Cropper and Freeman (1991) note, these descriptions are essentially characterizations of a behavioral response to the illness. Lost
workdays, for example, in some cases requires a decision on an individual's part not to go to work due to illness. Such a response may depend upon
various socioeconomic factors as well as the physical effect of the illness.
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Chapter 7: Benefits
value reflects the relative difference in disutility asso-
ciated will) symptoms or illnesses." Morbidity effects
can be further characterized by the set of symptoms
associated with an illness.
Morbidity effects are usually quantified In terms
of the number of expected cases of a particular
Illness. Given the risks faced by each individual and
the number of persons exposed to this risk, an esti-
mate of "statistical cases" can be defined analogously
to "statistical lives" described above. Alternatively,
morbidity effects may be described according to the
expected number and duration of particular symp-
toms associated with the illness. These estimates of
"symptom days" may be used in benefits analysis
when appropriate estimates of economic value are
available.
7.4.3
Direct amenities include improvements in aesthetic attrib-
utes associated with environmental commodities. This
includes improvements in taste, odor, appearance, or visi-
bility. In short, these benefits are determined by how the
senses are affected and how individual's welfare is changed
as a result. This class of benefits is unique in that the
focus is on the sensory experience and not on a physical
or material effect.
Despite this conceptual distinction, aesthetic benefits are
often intertwined with other benefit categories such as
health and recreation. A policy that improves air quality,
for example, might simultaneously improve visibility and
reduce mortality risks associated with airborne
contaminants. New treatments for drinking water might
reduce health risks as well as alter the taste and odor of
tap water. These relationships may make it extremely
difficult to separately quantity and value improvements in
aesthetic qualities.
Many types of policies can be expected to have some
impact on these kinds of amenities and they may be the
focus of a given policy. Amenity improvements may be
major component of total expected benefits. Improved vis-
ibility from belter air quality is one example that has been
the subject of several empirical studies.12
7.4.4
Ecosystems provide services that benefit humans. For
example, a freshwater lake may provide recreational and
boating sites; a wetland provides a service by being a
breeding ground for fish and fowl. Although ecosystems
have a profound impact upon human well-being, the
quantitative assessment of ecological benefits presents a
formidable challenge for several reasons. First, natural
systems are inherently complex. The many services they
provide and how they provide them may be poorly under-
stood by even the scientific community. Second, ecological
risks vary widely in terms of persistence (e.g., eutrophica-
tion versus species extinction), geographic extent (e.g.,
toxic contamination versus global climate change), and the
degree to which the overall threat can be predicted (e.g.,
effects of ozone on crops versus developmental and behav-
ioral effects of chemicals on wildlife populations). Third,
many of the less tangible benefits are not readily amenable
to monetary valuation.
Section 7.3 discussed generally the three steps involved in
assessing the benefits of environmental policies. However,
some issues associated with identifying and quantifying
ecological benefits are particularly complex and warrant
more detailed treatment.
Identifying Ecological
The first step in assessing ecological benefits is to identify
those relevant to policy options under consideration,
focusing on service flows that are likely to change as a con-
sequence of guidance or regulatory action. In general,
these ecological benefits may be thought of as flows of
services from the natural asset in question. These can be
categorized by how directly they are experienced and
where they fall along a private good/public good continu-
um. Exhibit 7-2 illustrates how the categories relate to
one another. Not only is it useful as a conceptual tool, this
11 These indices may be constructed in a number of ways, but consistency with welfare economics requires affected individuals to define
these relative tradeoffs for themselves rather than having them determined by health experts. Several economic analyses have employed some form
of health state index. Recent examples include Desvousges el at (1998) and Magal el al. (1996).
12 Examples of these studies include Rae (1983), Johnson el. al. (1983), Schuke et al. (1983), Cheslnul and Rowe (1990), Crocker and
Shogren (1991), and McClelland et al. (1993).
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Chapter 7: Benefits
Exhibit 7-2 Ecological Benefits Classification Scheme
Ecological
Benefits
Use
Non-Use
Direct
Indirect
Market
Non-Market
Private Goods
Public Goods i
categorization helps direct analysts to suitable valuation
methods.13
f Market benefits: Direct market benefits are some of
the most readily identified service flows provided by
ecosystems. These typically relate to primary prod-
ucts that can be bought and sold competitively as fac-
tors of production or final consumption products.
Although they may be managed to a high degree, agri-
cultural systems are nevertheless predicated on eco-
logical processes. As a consequence, increased pro-
ductivity of farmland and rangeland may provide sig-
nificant market benefits. Other products include
commercial fish species and timber. When access is
controlled and appropriate user charges levied, recre-
ational opportunities may also be considered direct,
market benefits.
f Non-market benefits: Recreational opportunities
and aesthetic qualities provided by ecosystems are
also experienced directly by individuals, albeit in a
non-market setting. Non-market benefits include
both consumptive uses (e.g., recreational fishing and
hunting) and non-consumptive uses (e.g., scenic vis-
tas, wildlife viewing, hiking, and boating). These serv-
ices are typically provided by natural assets held in
common (e.g., public lands). They have public goods
characteristics—since access is not or cannot be con-
trolled, consumption is not exclusive. On the other
hand, like private goods, they are rival in consumption
because excessive use by others (i.e., congestion) tends
to diminish one's own enjoyment of these services.
Indirect benefits: Ecosystem services that do not
directly provide some good or opportunity to individu-
als may be valued because they support off-site eco-
logical resources or maintain the biological and bio-
chemical processes required for life support. These
indirect benefits tend to be purely public in nature—
access to or use of the service is not exclusive and a
virtually unlimited number of individuals can share
in the benefits without reducing the average benefit
accruing to each. Each type of ecosystem provides
various indirect benefits. Wetlands recharge ground-
water, mitigate flooding, and trap sediments. Forests
sequester carbon, anchor soil, and maintain microcli-
mates. Estuaries protect adolescent fish. Terrestrial
ecosystems provide habitat for natural pollinators. All
of these systems support biodiversity.
Non-use benefits: Some benefits are not associated
with any direct use by either individuals or mankind.
13 A more detailed discussion of these concepts is also found in EPA's Conceptual Framework for Assessing Ecological Costs or Benefits
(EPA, 1999b). A draft is available at http://intranet.epa.gov/oerrinet/ecoweb/index2.htm (accessed 8/29/2000).
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Chapter 7: Benefits
Rather, they result because individuals might value an
ecological resource without using or even intending to
use it. Non-use values, also referred to as passive use
values, are those associated with the knowledge the
resource exists in an improved state, bequest values
for future generations and altruistic values for others'
enjoyment of the resource. An individual's commit-
ment to environmental stewardship may also be the
source of existence value. The commitment of some
groups to particular animals or ecosystems provides
an example of this.14
Quantifying Ecological
The second step in the analysis of ecological benefits is to
estimate the physical effects of each policy option, compar-
ing the flow of services with and without the policy. It falls
upon ecologists and environmental lexicologists to conduct
the ecological risk assessments to estimate the expected
adverse ecological effect of a particular stressor.15
Ecological risk assessments can be either narrow in scope,
with inquiry limited to a single species or population (e.g.,
the effect of chemical exposure on an endangered bird
species) or focus broadly on an entire ecosystem. Further
information on ecological risk assessment can be found in
Ecological Risk Assessment Guidelines (EPA, 1998).
The results of an ecological risk assessment generally
include the effect's magnitude (expressed in such metrics
as hazard quotients or percent change in population),
duration, spatial distribution, and time period of recovery.
The analysis of ecological risks may be highly uncertain.
Limited availability of data and models, and imperfect
understanding of key issues, hampers our ability to
describe ecological effects.
7.4.5
Damages
The materials damages benefit category includes welfare
impacts thai arise from changes in the provision of service
flows from the "material" environment. The "material"
environment is distinguished from the natural environ-
ment discussed in the ecological benefits section and
includes constructed or highly-managed physical systems.
Changes in the stock and quality of these material environ-
mental resources are assessed in a similar fashion to their
natural environment counterparts. Analytically, benefits
assessment for materials improvements parallels thai for
managed ecosystems such as agriculture or forestry, with
most benefits arising from direct, market effects or use
values. For example, effects from changes in air quality on
the provision of the service flows from physical resources
such as buildings, bridges, or roads are handled in a simi-
lar fashion to the effects from changes in air quality on
crops or commercial timber stocks. The most common
empirical applications involve air pollution damages and
the soiling of structures and other property.
7.5 for
Economists have developed a. number of methodologies to
measure (lie benefits of environmental improvements.
0~ Market methods can be used when direct markets
for environmental goods and services exist. The ben-
efits of a change in quantity of a good, are estimated
using data on these market transactions. By knowing
how the good, was bought and sold, economists can
infer directly how people appear to value that good.
Unfortunately, direct markets for environmental goods
and services do not often exist. In the absence of these
markets, environmental and. natural resource econo-
mists must rely upon alternative methodologies to
measure the benefits of environmental improvements.
^ Revealed preference methods (or indirect
approaches) allow economists to infer the value
placed on environmental goods using data on actual
choices made by individuals in related markets.
Revealed preference methods include recreational
demand models, hedonic wage and hedonic property
models, and averting behavior models.
14 Even though it does not involve use. non-use value still falls under the rubric of welfare economics. It emanates from human interest,
alone, and does not encompass any rights or ethics-based justification for preservation (see Kopp, 1992 and Mazzotta and Kline, 1995).
15 Other types of frameworks for ecological assessment include injury assessments undertaken as part of natural resource damage assess-
ments (!EG, 1995 and Huguenin et at., 1996) and environmental assessments undertaken to meet the requirements of NEPA,
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Chapter 7: Benefits
f Stated preference methods (or direct approaches)
allow economists to estimate the value placed on
environmental goods using data on hypothetical
choices made by individuals responding to a survey.
Stated preference methods include contingent valua-
tion, conjoint analysis, and contingent ranking.
Specific approaches that fall under these two broad cate-
gories are presented below This presentation includes an
overview of each method, a description of its general appli-
cation to environmental benefits assessment, and a discus-
sion of issues involved in interpreting and understanding
studies using the method. This information is primarily
designed to help analysts evaluate existing studies being
considered for benefit transfer, but it can also assist ana-
lysts in assessing the feasibility of employing these meth-
ods. The discussion below concludes with a separate
overview of benefit transfer methodology in general. It is
important to keep in mind that research on all of these
methods is ongoing, sometimes at a rapid pace. The limi-
tations and qualifications described here are meant to
characterize the slate of the science at the lime these
guidelines are published. Analysts should consult addi-
tional resources as they become available.
7.5.1
Economic
Market methods are used to value environmental goods
and services that are directly traded as market commodi-
ties. Market methods are used, for example, to examine
the effects of air quality improvements on agriculture and
commercial timber industries and the effects of water
quality improvements on commercial fisheries.
Market methods apply when environmental goods are fac-
tor inputs. Changes in the quality or stock of an environ-
mental good can affect production costs, which can then
alter the price and quantity of output and the returns to
other factor inputs. In turn, these market responses affect
the decisions and welfare of consumers and producers.
Changes in the prices of marketed goods consumers face
and changes in the income of the owners of the factor
inputs reveal information about the welfare of consumers
and producers. For example, the benefits of an environ-
mental improvement are often realized as increases in
consumer and producer surplus that arise from lower
costs and prices and increases in the quantity of the mar-
keted good. For more detailed discussion of the economic
foundation of market methods, see Just et al.(1982) or
Freeman (1993).
to
When applying market methods to assess the benefits of
environmental improvements, two types of market
responses are important: the impacts of the environmental
change on the relevant marketed good (e.g., factor) and
the response of producers and consumers to this change.
When examining these responses, it is important to con-
sider the range of market responses available to producers
and consumers. Overlooking market adjustments can bias
benefits assessment. For instance, the damage function
approach, which derives benefits by applying a unit price
to a physical measure of damage or loss, ignores con-
sumer responses to market adjustments.16 Measures of
price-elasticities, cross-price elasticities, and substitution
possibilities indicate the extent to which market adjust-
ments are likely to occur.
In practice, characterizing the market response to a
change in environmental quality can be difficult. Two
techniques that rely on observations of direct market
behavior, cost and production function approaches, facili-
tate the measurement of consumer and producer surplus
changes, but one must assume optimizing behavior on the
part of producers and consumers. A different approach
for benefits assessment is to use optimization models that
simulate behavior. All three of these approaches require
considerable information and data on the relevant market
participants.
Benefits estimation using market methods varies with the
types of markets affected by the environmental improve-
ment. The nature of firms affected on the producer side
(e.g., single-product firms or multi-product firms), the
market structure (e.g., vertically linked markets), and the
presence of market distortions (e.g., monopoly power,
price supports) influence the complexity of benefits
assessment. Freeman (1993) singles out two cases where
18 Although the damage function approach does not account for market adjustments, it may be a useful screening tool when time and
resources are limited.
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Chapter 7: Benefits
benefits assessment is relatively straightforward. The first
case is one in which the environmental good or quality is a
perfect substitute for another input. Here, the benefits of
an environmental improvement can be calculated by esti-
mating the reduction in input costs caused by substituting
away from the other input, as long as the change in total
costs does not affect marginal costs or output. The second.
case is where observable market data (e.g., cost, demand,
and market structure) imply that benefits from an envi-
ronmental improvement will accrue to owners of fixed fac-
tors. Here, benefits can take the form of increased pro-
ductivity and are realized as profit or quasi-rents. One
such case would be where the producer affected by the
environmental improvement is small relative to the mar-
ket, and variable prices for factors and products are not
affected by the environmental improvement.
Empirical applications of market methods are diverse.
Among other topics, the empirical literature has addressed
the effects of air quality changes on agriculture and com-
mercial timber industries. It has also assessed the effects
of water quality changes on water supply treatment costs
and on the production costs of industry processors, irriga-
tion operations, and commercial fisheries. Refer to Adams
el al. (1986), Kopp and Krupnick (1987), Taylor (1993),
and EPA (1997) for empirical examples.
Considerations in and understanding
Issues to consider when interpreting the results of market
studies include:
0~ Data requirements and Implications: Employing
market methods requires information on the effect of
the environmental resource on production costs, sup-
ply conditions for output, demand curve for final
good, and factor supplies.
0~ The model for estimation: Data availability plays a
large role in the selection of a modeling approach and
the structure of the model. Production function, cost
function, and simulation optimization models are all
options for understanding the market response to
environmental improvements.
7.5.2
Methods
In the absence of market data on the value of environmen-
tal improvements, WTP may be estimated by looking at
related goods thai are traded in markets. Methods that
employ this general approach are referred to as "revealed
preference" methods because people's behavior in associ-
ated markets reveals the value they place on the environ-
mental improvements. For example, if pollution levels
affect the use of a lake for recreational fishing, individual
WTP to travel to a substitute site can be used to estimate
the value of averting the damages to the lake of concern.
Four distinct revealed preference methods have been wide-
ly used by economists: recreation demand models (includ-
ing travel cost and discrete choice models), hedonic pric-
ing models, averting behavior models, and cosl-of-illness
studies.
7.5.2.1
Improvements in environmental quality may enhance
recreation opportunities at one or more sites in a region.
For example, policies that control the level of toxics in sur-
face water bodies might result in a reduction in the num-
ber of lakes and streams subject to fish consumption advi-
sories, thereby enhancing recreational angling opportuni-
ties. Recreation improvements constitute a potentially
large class of environmental benefits, but measurement of
these values is complicated by the fact that access to recre-
ation activities are only partially regulated by observable
market mechanisms. Recreation demand models,
including the travel cost model, the random utility model
(RIM), and other approaches, may be used to assess non-
market benefits associated with recreation activities.
Economic Foundation of Recreation Demand
Models
Recreation demand models focus on the choice of trips or
visits to sites for recreational purposes. The basic trade off
to be considered is between the satisfaction gained from
participating in an activity at a site and the value of money
and time given up. The fundamental assumption is that
people may weigh the money and time costs of travel to a
site in the same way as an admission fee. Thus, by exam-
ining the patterns of travel to particular sites, one may
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Chapter 7: Benefits
inter how individuals value the site or particular aspects of
the site such as environmental quality.
As with other economic studies, recreation demand mod-
els rely on individual perceptions. While it is possible to
value changes in environmental quality that have an obvi-
ous effect on popular recreation activities, recreation
demand methods may not be appropriate for valuing
changes in environmental quality that are difficult for peo-
ple to observe or only indirectly affect well-known species.
f Travel cost models: The simplest recreation
demand model involves trips to a single site. User
surveys provide data on visitors and trip origins and
the data is organized by distance to the site.
Generally an inverse relation between distance trav-
eled and the number of visits emerges. The distance
variable may be converted to cost by including factors
for the dollar per mile cost of vehicle travel as well as
the cost of travel times and, the relationship among
the variables may be interpreted as a demand func-
tion, with the number of trips from a particular area
as a function of the travel costs of reaching the site.
The single-site travel cost model may be extended to
multiple sites, usually by estimating a system of
demand equations, with the number of trips to a
given site taken to be a function of the cost of visiting
that site as well as the costs of visiting other available
sites. A number of extensions to the simple travel
cost model are described in Freeman (1993).
Travel cost models are most appropriate for estimat-
ing changes in the number of trips over a given peri-
od of time, also known as participation. They are lim-
ited, however, in their ability to model the recreation-
ist's choice among competing sites. A separate but
related body of literature has developed around mod-
els that directly address the decision of "where to go"
and estimate welfare changes associated with this
alternative theoretical framework.
f Discrete choice models: For analyses focusing on
the role of environmental quality variables, changes
in social welfare may best be estimated through dis-
crete choice models (also referred to as RUMs).
Discrete choice models focus on the decision to recre-
ate a! a specific site as compared to alternative substi-
tute sites. The model considers travel cost and envi-
ronmental quality variables associated with all com-
peting sites. Detailed treatments of the discrete
choice model include Bockstael et al. (1986) and
Bockstaeletal. (1991).
Although well suited for analyzing welfare effects of
changes in site quality per visit, the discrete choice
model is less useful for predicting the number of trips
over a period and measuring seasonal welfare
changes. Most recreation demand studies use either
variations on the discrete choice model or combina-
tions of travel cost and discrete choice approaches to
estimate changes in social welfare.
Considerations in and
There are several issues that must be confronted in a
recreation demand model:
0~ Definition of a site: Ideally, one could estimate a
recreation demand model in which sites are defined
as specific points, such as launch ramps, campsites,
etc., but the data requirements of detailed models are
large. Similarly, for a given site, the range of alterna-
tive sites may vary by individual. Ultimately, every
recreation demand study strikes a compromise in
defining sites, balancing data needs and availability,
costs, and time.
f Opportunity cost of time: Part of the cost of taking
a recreation trip is the value of recreation time, which
varies with respondent's income and work schedules.
Recreation demand models typically use some frac-
tion of the wage rate in calculating travel costs, but
the tradeoffs between work hours and leisure time
involve complex theoretical and methodological
issues. Furthermore, it is presupposed that travel
time detracts from the overall satisfaction of a recre-
ation trip, but this assumption may not always hold.
Other time-related issues include the treatment of on-
site time, which varies from case to case but is often
ignored altogether.
0~ Multiple site or multipurpose trips: Recreation
demand models assume that the particular recreation
activity being studied is the sole purpose for a given
trip. Visits to multiple sites or multipurpose trips con-
found attempts to measure social welfare changes.
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Chapter 7: Benefits
7.5.2.2
Hedonic wage studies draw on the framework of hedonic
pricing methods. This section describes the hedonic wage
method, but first provides some general background on
hedonic pricing methods in general. Property value stud-
ies, another large area of research based upon this frame-
work, is described in Section 7.5-2.3.
on Pricing in
General
Hedonic pricing methods apply to heterogeneous goods
and services. Heterogeneous goods and services consist of
"bundles" of attributes and are differentiated from each
other by the quantity and quality of these attributes. Job
opportunities, housing units, computers, and cars are
common examples of heterogeneous goods. Hedonic pric-
ing methods explain variations in price using information
on attributes. For example, determinants of wages are
expected to include worker characteristics (e.g., level of
education, tenure, age) and job characteristics (e.g., risk of
fatal injury). Determinants of housing prices may include
structural attributes (e.g., number of bedrooms and age of
house), neighborhood attributes (e.g., population demo-
graphics, crime, and school quality), and environmental
attributes (e.g., air quality and proximity to hazardous
waste sites).
The economic theory underlying hedonic pricing methods
extends from a model of market equilibrium, where sup-
pliers and demanders of heterogeneous goods interact
under conditions of perfect information and zero transac-
tions costs. Consumers derive utility from the attributes of
the heterogeneous goods and adjust purchases in response
to differences in these attributes. Producers or sellers of
goods and services incur costs that vary with the range of
attributes offered. An equilibrium price schedule develops
from the market interactions of consumers and suppliers.
The foundation of the hedonic pricing method as it relates
to job opportunities is analogous, with workers and
employers interacting in the labor market. The equilibri-
um price schedule is termed the hedonic price function
and forms the basis for benefits assessment using hedonic
pricing methods. Rosen (1974) is the seminal article on
the economic theory of hedonic methods.
Empirical hedonic pricing research typically concentrates
on the hedonic price function and the decisions of con-
sumers or workers. The hedonic price function is approxi-
mated by regressing price on measures of attributes and
the estimated coefficients represent the marginal WTP for
the associated attribute. Applications of hedonic methods
to labor wages and property values have been used to
characterize the benefits of environmental improve-
ments.17 These are known as hedonic wage studies and
hedonic property value studies, respectively. Each is con-
sidered separately below.
Economic foundation of Hedonic
Hedonic wage studies, sometimes known as wage-risk or
compensating wage studies, are based on the premise that
individuals make tradeoffs between higher wages and
increased occupational risks of death or injury. Essentially;
higher risk jobs are expected to pay higher wages, all else
held constant. Hedonic wage studies use statistical regres-
sion and data from labor markets to isolate the increment
in wages associated with higher job risks. The outcome of
these models is an estimated value of small changes in
mortality risks. Some models also attempt to estimate the
value of small changes in morbidity, or non-fatal risks.
The key to an effective hedonic wage study lies in separat-
ing the portion of compensation associated with occupa-
tional health risks from other job characteristics, including
supervisory responsibility, job security; and similar factors.
The wage rate is also affected by the industry in which the
individual is employed, characteristics of the location and
the personal characteristics of the workers (e.g., age, edu-
cation, experience). All of these data are needed to disen-
tangle the effects of worker characteristics from those of
job attributes in determining wages paid.
In hedonic wage studies, workers' perceptions of risk levels
across jobs are assumed to match actual risk levels. If
perceived risks do not match actual risks faced by the
workers, then the resulting estimates of compensation
required to accept additional risk will be biased. Most
17 Palrnquisl (1991) Mid Freeman (1993) contain current discussions of the use of hedonic methods for characterizing the demand for
environmental quality and benefits assessment. See Palmquist (1982) for a discussion of a benefits assessment method related to hedonic property
value studies known as repeat sales analysis.
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Chapter 7: Benefits
analysts believe that this potential bias is small, but others
argue thai workers generally underestimate on-the-job
risks. If the latter is true, hedonic wage studies will
understate the additional compensation required for
bearing risks. Some studies attempt to account for
workers' perceived risks, but the results of these studies
are not markedly different from those that do not.
Another assumption employed in hedonic wage studies is
the existence of perfect labor markets in which workers
are freely mobile and there is perfect information about
jobs and job risks. Hedonic wage studies will not produce
accurate estimates of the wage-risk tradeoff in imperfect
markets where workers are unable to move freely between
jobs or in which only union members have sufficient
information and market power to receive higher wages for
higher risk jobs. Since in reality labor markets are some-
what imperfect, many studies attempt to control for union
membership and similar factors that might influence wage
rates.
Hedonic wage models are limited to estimating values for
relatively small risk changes. The observed wage and the
estimated increment, or "premium," to accept higher risks
represents the market equilibrium price for the entire set
of workers in the study. This estimate is not necessarily
the value that any particular worker would require to
accept a risk increase, but for small changes in risk, it is
very close.
A thorough treatment of the hedonic wage model that
includes all of these considerations can be found in Viscusi
(1992,1993).
of Hedonic to
Because they are narrowly focused on labor market trade-
offs, hedonic wage studies are not generally well-suited to
measure the benefits of environmental regulation directly.
That is, it is not usually feasible to perform a hedonic wage
study to estimate the benefits that would accrue from a
specific environmental policy action. Nonetheless, these
studies have yielded consistent estimates of how groups of
workers appear to value small risk changes.
Environmental benefits assessments can draw upon these
studies to estimate the value of reductions in environmen-
tal mortality risks.18 Such an application is essentially an
exercise in benefits transfer, which is described in greater
detail later in this chapter.
Analysis should be aware that, although hedonic wage
studies currently provide the most reliable and consistent
estimates of the value of mortality risks, there are impor-
tant differences in the types of risks captured in an hedo-
nic wage study and the types of risks that are affected by
environmental regulation. For instance, hedonic wage
studies tend to focus on accidental deaths occurring
among prime-aged males while deaths associated with
environmental risk often occur among the elderly and may
involve an extended latency period. Furthermore, elevated
risks in hedonic wage studies are voluntarily accepted
while environmental risks are often involuntarily borne.
The nature and importance of these and other differences
are detailed in Section 6 of this chapter.
Estimates of the value of changes in fatal risks are general-
ly more relevant for environmental benefits assessment
than are those for job-related non-fatal injuries. This is
because these injuries are usually quite different from the
non-fatal health risks associated with environmental policy
actions.
Hedonic wage models have also used wage differentials
across geographic areas to estimate values for environ-
mental quality differences.'9 Theoretically, jobs in areas
with poor environmental quality should pay less than iden-
tical jobs in areas with high environmental quality, again
holding all else equal. There are a number of difficulties
with employing hedonic wage models in this manner,
including integrating wage and housing choices, and the
need to assess in Ira-city variation in amenities. The major-
ity of hedonic wage studies relevant for most EPA policies
have focused on estimating values for health risks.
Considerations in Evaluating and Understanding
0~ Data requirements and implications: Hedonic
wage studies require large sets of data on labor
18 Values of mortality risk have also been estimated using hedonic studies of automobile prices. While these studies produce values of life
in a similar range, most environmental risk assessments rely on hedonic wage studies. For information on the automobile price literature, see
Dreyfus and Viscusi (1996) and Viscusi (1992).
ls This should nol be confused with attempts 1o control for wage differentials across broad regions found in most existing wage-risk studies.
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Chapter 7: Benefits
market behavior. Data on worker and job
characteristics are generally collected using survey
techniques. Risk information, however, is frequently
retrieved from published sources reported at the
occupation or industry level. These risk measures are
then matched to the worker in the sample using
information provided by the respondent on his or her
job. The risk data used in most studies, however, are
not complete. For example, although accidental, on-
the-job (and almost immediate) deaths are generally
reported, occupational diseases such as cancer are
not accurately captured in most data.
The estimated wage-risk tradeoff can vary consider-
ably across data sets and across methodologies. In
particular, studies that draw upon data from high-risk
jobs will generally provide valuations of risk that are
lower than those that rely upon data from lower-risk
jobs. This is due to a sample selection problem.
Study results reflect the value to the sample popula-
tion. High risk jobs tend to attract those who are less
averse to taking risks and therefore require less com-
pensation to face them.
Controlling for other risks: If the study seeks to
estimate values for fatal risks, it is important that the
study control adequately for non-fatal risks in order to
obtain an unbiased wage-risk estimate for mortality.
Conversely, when values for non-fatal risk are being
estimated, mortality risks should be considered in the
wage-risk equation.
The scope of the risk measures: Some labor mar-
ket studies use actuarial data to determine the risk
levels faced by workers. However, these data are not
limited to occupational risks. They include all types
of fatality risks faced by the individual boll) on and off
the job. The degree to which these risks are correlat-
ed with job risks is unclear, but they would not be
reflected in job-related compensation. These studies
generally should be excluded from use in policy
analysis since this problem will cause the tradeoffs
they estimate to be biased downwards by an unknown
amount.
The model for estimation: Some labor market
studies attempt to determine the value of a life year
and the implicit discount rate workers apply to this
value. While attractive in theory, the complexity of the
structural models used in these studies leads to less
robust estimates of the value of risk reduction than
studies using conventional wage-risk estimation pro-
cedures. Such studies should be viewed as less reli-
able for use in valuing lifesaving programs.
7.5.2.3
Studies
Hedonic property value studies are applications of the
hedonic pricing method. The introduction to Section
7.5.2.2 (Hedonic Wage Studies) provides background on
hedonic pricing methods in general.
Economic Foundation of Property Value Studies
Hedonic property value studies assert that individuals
perceive housing units as bundles of attributes and derive
different levels of utility from different combinations of
these attributes. When transaction decisions are made,
individuals make tradeoffs between money and attributes.
These tradeoffs reveal the marginal values of these
attributes and are central to hedonic property value
studies. Hedonic property value studies use statistical
regression methods and data from real estate markets to
examine the increments in property values associated with
different attributes.20
Structural attributes (e.g., number of bedrooms and age of
house), neighborhood attributes (e.g., population
demographics, crime, and school quality), and
environmental attributes (e.g., air quality and proximity to
hazardous waste sites) may influence property values.
When assessing an environmental improvement, it is
essential to separate the effect of the relevant
environmental attribute on the price of a housing unit
from the effects of other attributes. While deriving
measures of marginal WTP using hedonic methods is
straightforward, estimating measures of WTP for
substantial or discrete (non-marginal) improvements in
environmental quality is difficult. The use of hedonic
property value studies for benefits assessment rests on
careful interpretation of the hedonic price function and its
relevance to the policy scenario being considered. Barlik
20 To simplify the discussion, housing units are consistently used as examples, Hedonic property value studies are also completed on
vacant land parcels.
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Chapter 7: Benefits
(1988b) and Palmquist (1991, 1988) provide excellent,
detailed discussions of benefits assessment using hedonic
methods.
When using hedonic property value studies for benefits
assessment, the measurement of the environmental attrib-
ute is central to the analysis. If the measurement of the
environmental attribute does not match individuals' per-
ceptions, then the results of the analysis may be biased.
The hedonic price function for housing units represents
an equilibrium that results from the interaction of suppli-
ers and. demanders of housing in a market with full infor-
mation. When this assumption is not met, the results of
an hedonic analysis will not provide an exact representa-
tion of the tradeoffs individuals make across housing
attributes and the marginal values associated with these
different attributes.
General Application of Hedonic Property Value
to
Benefits assessment applications of hedonic property value
studies focus on the relationship between property values
and environmental attributes such as air quality water
quality, proximity to hazardous waste sites, and landscape
characteristics. Hedonic property value studies are not
widely used in environmental benefits assessments
because of the limited transferability of hedonic results
and the difficulties of using hedonic methods to describe
the benefits associated with discrete (non-marginal) envi-
ronmental improvements.
Using data on a sample of transactions, price is regressed
on measures of the observable attributes and an hedonic
price function is estimated. The coefficient on the envi-
ronmental attribute reveals the marginal WTP for that
attribute. Therefore, if the policy scenario considered
results in a marginal environmental improvement, the
estimated hedonic is well-suited to measure benefits.
However, if the policy scenario considered results in a dis-
crete improvement that affects numerous properties, addi-
tional information on preferences and the hedonic price
function is required for assessing the true benefits of the
environmental improvement.21 When larger changes in
environmental quality are considered, the analytical
requirements increase because the hedonic price function
and the level of utility of individuals may change.
The hedonic price function does not typically provide gen-
eral information on individuals' WTP for the different
attributes. Methods for identifying demand (or WTP)
functions for the different attributes (e.g., using data from
multiple markets or imposing assumptions about the
functional form of the hedonic and/or the utility functions
of individuals) exist, but they often rely on restrictive
assumptions.22 Furthermore, identifying WTP functions
does not ensure the ability to measure the welfare gain
from a discrete environmental improvement because mar-
kets intervene and prices change. As a result of these diffi-
culties, approximations of welfare gains based on the
hedonic price function are sometimes employed to assess
benefits. See Palmquist (1991, 1988) and Bartik (1988b)
for a detailed discussion of benefits assessment using
hedonic methods, including guidance on developing lower
and upper bound measures of benefits.
Considerations in Evaluating and Understanding
Property Value
0~ Data, requirements and implications: Property
value studies require large amounts of disaggregated
data. Market transaction prices on individual parcels
or housing units are preferred to aggregated data
such as census tract information on average housing
units because aggregation problems can be avoided.
Data on attributes may include housing characteris-
tics, sale dates, neighborhood amenities such as
schools and parks, neighborhood demographic char-
acteristics such as income, age, and race, and envi-
ronmental quality.
f Errors in variables: Problems may arise from error
in measuring prices (aggregated data) and errors in
measuring product characteristics (particularly those
related to the neighborhood and the environment).
In addition, omitted variable bias problems may
occur if relevant data are not available.
0~ The measurement of environmental attributes:
The measurement of the environmental attribute
included in the hedonic price function is central to
" There are cases when the hedonic price function can alone be used to measure welfare effects from a non-marginal change in the envi-
ronmental attribute. For example, this holds if few properties are affected and the hedonic price function is not expected to shift.
22 See Palmquist (1991) for a detailed discussion of identification issues.
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Chapter 7: Benefits
the assessment of benefits. Researchers often use
information available from the scientific community
such as air or water quality monitoring data and then
must determine how to assign the data to the individ-
ual houses in the data set. However, there may be
differences between how these attributes are meas-
ured by scientists and how they are perceived, by indi-
viduals. If this difference is large, the hedonic price
function will not accurately represent the values of
these attributes. Individual perceptions of environ-
mental attributes are central to this type of analysis.23
Mother issue to consider is the timing of the effect
from the environmental improvement. Some effects
from environmental improvements change over time.
Others may be understood differently over time
depending on available information (e.g., hazardous
waste sites). The choice of when and how to measure
the environmental attribute for a given transaction
price is complicated. Refer to Eel and McClain
(1995) for a discussion of price responses over time.
The model for estimation: There are numerous
statistical or econometric issues associated with
applying hedonic methods to property value studies.
These include the choice of functional form, the defi-
nition of the extent of the market, identification, and
endogeneity. A brief overview of the first two estima-
tion issues is presented below. Refer to Palmquist
(1991) for a thorough treatment of the econometric
issues associated with hedonic property value studies.
Because economic theory offers limited guidance on
the functional form of an hedonic price function,
researchers often try several forms when estimating
hedonic functions (e.g., semilogarithmic, inverse
semilogarithmic, log-linear, or quadratic Box Cox).
However, it is important to note that the choice of
functional form has implications for benefits assess-
ment. See Graves et al. (1988) and Cropper, Deck,
and McConnell (1988) for discussions of issues relat-
ed to the choice of functional form.
The choice of data also has an effect on estimation.
The extent of the market is defined by the scope of
housing market data, collected. Questions have been
raised about how to define the extent of housing mar-
kets. Empirically; it is important to note that if the
market is defined to be too big, the resulting coeffi-
cients of the hedonic price function may be biased.
Conversely, if the market is defined too narrowly, the
coefficients of the hedonic price function are less effi-
cient. Refer to Michaels and Smith (1990) for infor-
mation on defining the extent of the market.
f Assessing the results an empirical study: Two
simple ways to assess the quality of a property value
study are noted here. First, a review of the empirical
work is informative. This involves assessing the quali-
ty of the data collected, the framing of the policy
problem, the measurement of environmental attrib-
utes, and the statistical regression analysis. Second,
the existing literature on hedonic methods is a valu-
able resource. Comparing data, modeling assump-
tions, and results across studies is a useful exercise.
While variation is expected across studies, especially
between those completed on different areas, some
factors such as the sips of particular coefficients may
be consistently reported.
7.5.2.4
The averting behavior method infers values from observa-
tions of how people change defensive behavior in response
to changes in environmental quality. Defensive behaviors
are usually defined as actions taken to reduce the risk of
suffering environmental damages, as well as actions taken
to mitigate the impact of environmental damages. The
former category includes behaviors such as the use of air
filters or boiling water prior to drinking it, while the latter
includes the purchase of medical care or treatment. Faced
with a given level of environmental risk, the averting
behavior method assumes that individuals engage in these
defensive behaviors to achieve an optimal level of health.
By analyzing the expenditures associated with these defen-
sive behaviors economists can attempt to estimate the
value individuals place on small changes in risk.2'1
"' For example, hedonic property value studies that address water quality often use measures such as water clarity because these are
observable characteristics. In contrast, standard scientific measures such as BOD or pH may not be readily perceived by individuals,
24 As Desvousges et al. (1998) note, the term "averting behavior study" has been used to describe at least three somewhat different
approaches: attempts to estimate WTP for environmental quality; attempts to estimate WTP for health effects or other specific impacts; and simple
summation of observed expenses.
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Chapter 7: Benefits
Economic Foundation ofAwerting Behawior Method
The economic theory underlying the averting behavior
method rests on a model of household production. In
these models, households produce health benefits by com-
bining an exogenous level of environmental quality with
inputs such as defensive behaviors. The underlying theory
predicts that a person will continue to take protective
action as long as the perceived benefit exceeds the cost of
doing so. If there is a continuous relationship between
defensive actions and reductions in health risks, then the
individual will continue to avert until the cost just equals
his or her WTP for these reductions. Thus, the benefit for
a small reduction in health, or health risk, is estimated
from two primary pieces of information (1) the cost of the
averting behavior or good and (2) its effectiveness, as per-
ceived by the individual, in offsetting the loss in environ-
mental quality.
Averting behaviors methods can provide theoretically cor-
rect measures of WTP to avoid a decline in environmental
quality or an increase in environmental risks. To do so,
however, they require a great deal of data and particular
assumptions about consumer preferences. In practice, it
has proven difficult to meet these requirements. More
detail on the difficulties inherent in applying the averting
behavior model can be found in Cropper and Freeman
(1991).
One approach to estimation is to use observable expendi-
tures on averting and mitigating activities to generate val-
ues that may be interpreted as a lower bound on WTE
Harrington and Portney (1987) demonstrate this by show-
ing that WTP for small changes in environmental quality
can be expressed as the sum of the values of four compo-
nents: lost time, changes in averting expenditures, changes
in mitigating expenditures, and the loss of utility from pain
and suffering. The first three terms of this expression are
observable, in principle, and can be approximated by
using changes in these expenditures observed after a
change in environmental quality. The resulting estimate
can be interpreted as a lower bound, on WTP that may be
used in benefits analysis. These estimates can be an
improvement over eost-of-illness estimates alone, because
the latter usually captures only mitigating expenditures
and lost lime.25
Averting behavior results cannot always be interpreted as
lower bounds on WTP, however, because conclusions may
depend critically upon modeling conditions. For example,
Shogren and Crocker (1991) use a theoretical model to
show that the impact of changes in risk on defensive
expenditures is ambiguous and that these expenditures
need not be a lower bound value. Using the same model
Quiggin (1992) imposes restrictions under which defen-
sive expenditures will increase in response to increases in
risk, providing support for self-protection expenditures as
a method for benefits valuation. Recently, Shogren and
Crocker (1999) show that averting behavior need not be a
lower bound on value when both private and collective risk
reduction strategies are considered.
Large, or non-marginal, changes in environmental quality
require a somewhat different valuation strategy. Generally
it is not possible to obtain exact estimates of WTP for these
changes. However, Bartik (1988a) details the conditions
under which upper and lower bounds on WTP may be esti-
mated in this circumstance. These bounds effectively
bracket WTE
Finally, analysis should remember that consumers base
their actions on perceived benefits from defensive behav-
iors. If these perceptions differ from objective estimates
of, for example, risk changes, the analysis will produce
biased WTP estimates for a given change in objective risk.
Surveys may be necessary in order to determine the bene-
fits individuals perceive they are receiving when engaging
in defensive activities. These perceived benefits can then
be used as the object of the valuation estimates.
ofAwerting to
The averting behavior method can, in theory, provide WTP
estimates for a wide range of environmental benefits,
including changes in mortality risks, morbidity risks, and
damage to materials. Most recent research, however, has
focused on health risk changes.
Mortality risks can be estimated with the averting behavior
method by observing purchases of items that reduce the
" Cropper and Freeman (1991) note that the full costs of medical expenditures and lost work time may not be borne by individuals mak-
ing these decisions due to insurance and paid sick leave. An analysis of social benefits would need to include the costs that have been shifted from
the consumer to others.
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Chapter 7: Benefits
risks of dying in an accident. These applications are
sometimes known as consumer market studies. One of
the difficulties with the use of averting behavior methods
in this context is that many of the risk reduction actions
are discrete rather than continuous, leading to estimates
that are likely to understate the value of risk reduction to
the average purchaser. These studies can also be sensitive
to assumptions about unobserved costs such as the time
required for employing or maintaining the risk-reducing
good.
The most common focus of averting behavior models has
been the estimation of values for non-fatal health (mor-
bidity) risk changes. There have been many analyses of
observable averting and mitigating expenditures. Some of
these studies focus on behaviors that prevent or mitigate
the impact of particular symptoms (e.g., shortness of
breath, headaches), while others have examined averting
expenditures in response to specific episodes of contami-
nation (e.g., groundwater contamination). The difference
in these endpoints is important. Because many contami-
nants can produce similar symptoms, studies that esti-
mate values for symptoms may be more amenable to ben-
efit transfer than those that are episode-specific. The latter
may be more useful, however, if assessing the benefits of a.
regulation expected to reduce the probability of similar
contamination episodes.
Considerations in Evaluating and Understanding
0~ Data requirements and Implications: Cropper
and. Freeman (1991) describe the data required, for
estimating WTP using the averting behavior method.
These requirements are quite burdensome and
include information detailing the severity, frequency,
and duration of symptoms; exposure to environmen-
tal contaminants; actions taken to avert or mitigate
damages; the costs of those behaviors and activities;
and other variables that affect health outcomes (e.g.,
age, health status, chronic conditions).
Often, data, availability will limit the analysis to an
examination of observed defensive expenditures.
These results can be cautiously interpreted as a lower
bound on WTB Analysts should note that costs asso-
ciated with pain and suffering will not be included in
the estimate.
0~ Separability of other benefits: Many defensive
behaviors not only avert or mitigate against environ-
mental damages, but also provide other benefits. For
example, air conditioners obviously provide cooling in
addition to air filtering, and bottled water may not
only reduce health risks, but may also be better tast-
ing. The degree to which individuals engage in avert-
ing behaviors to obtain these benefits provides evi-
dence of the value of these qualities, but disentangling
the value of different components is not an easy task
In order to accurately produce estimates of WIT for a
risk change, for example, averting behaviors studies
must isolate the value for the effect of interest from
the value of the other benefits conferred by the defen-
sive activity. It is also possible that the averting behav-
ior may have negative effects on utility. For example,
wearing helmets when riding bicycles or motorcycles
may be uncomfortable. Failure to account for "other"
benefits and disutilities associated with averting
behaviors will result in biased estimates ofWT.fi
Analysts should exercise caution in interpreting the
results of studies that focus on goods in which there
may be significant interrelated costs and benefits.
0~ Modeling assumptions: As noted above, restrictive
assumptions are sometimes needed to make averting
behavior models tractable. For example, assuming
that the economy and the environment are additively
separable may lead to unambiguous results, but it
may be plausible only in particular circumstances.
Shogren and Crocker (1999) note this fact and sug-
gest thai this assumption be justified whenever
invoked. Analysts drawing upon averting behavior
studies will need to review and assess the implications
of these assumptions for the valuation estimates.
7.5.2.5
The health economics literature relies heavily upon the
cost-of-illness method to value morbidity changes. The
cost-of-illness method does not estimate VCTE, but rather
estimates the change in explicit market costs resulting
from a change in the incidence of a given illness. Two
types of costs measured in a typical cost-of-illness study
are direct costs (such as diagnosis, treatment, rehabilita-
tion, and accommodation) and indirect costs (including
loss of work time).
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Chapter 7: Benefits
Economic Foundation of Cost-of-IIIness
The theoretical basis for the cost-of-illness method relies
on two major assumptions (1) direct costs of morbidity
reflect the economic value of goods and services used to
treat illness and (2) a person's earnings reflect the eco-
nomic value of lost production. Because of distortions in
medical and labor markets, an argument could be made
about whether these assumptions hold, but they are
broadly consistent with neoclassical economics.
It is important to note that the cost of illness is not a
measure of WTE The cost-of-illness approach simply
measures ex post costs and does not attempt to measure
the loss in utility due to pain and suffering or the costs of
any averting behaviors thai individuals have taken to avoid
the illness altogether (see Section 7.5-2.3 on averting
behaviors). However, the cost-of-illness estimate may be
considered a lower bound estimate of WTP (Harrington
and Portney, 1987; Berger et al., 1987). The main reason
that the cost of illness understates total WTP is the failure
to account for many effects of disease. It ipores pain and
suffering, defensive expenditures, lost leisure time, and
any potential altruistic benefits. As a simple hypothetical
example, if an individual spends five dollars on pain med-
ication to treat a headache, and. does not miss any time
from work due to the headache, his or her cost of illness is
five dollars. The individual's actual WTP to avoid the
headache is likely to be greater than five dollars, assuming
he experiences disutility from the pain the headache caus-
es prior to taking the pain medication. Available compar-
isons of cost-of-illness and total WTP estimates suggest
that the difference can be large (Rowe et al., 1995).
However, this difference varies greatly across health effects
and across individuals.
Most existing cost-of-illness studies estimate indirect costs
based on the typical hours lost from a work schedule or
home production, evaluated at an average hourly wage.
The direct medical costs of illness are generally derived in
one of two ways. The empirical approach uses a database
of actual costs incurred for patients with the illness to esti-
mate the total medical costs of the disease. The theoreti-
cal approach uses a panel of physicians to develop a gener-
ic treatment profile for the illness. Illness costs are esti-
mated by multiplying the probability of a patient receiving
a treatment by the cost of the treatment. For any particu-
lar application, the preferred approach will depend on
availability of reliable actual cost data as well as character-
istics of the illness under study.
Detailed descriptions of the cost-of-illness approach can be
found in Cooper and Mice (1976), Hartunian et al. (1981),
Hu and Sandifer (1981), Rice (1966), Rice et al. (1985)
and EPA's Cost of Illness Handbook (EPA, forthcoming).
General Application of Cost-of-IIIness to
Because the cost-of-illness approach does not rely on elab-
orate econometric models, and data are often readily avail-
able, implementation of this approach is relatively straight-
forward. For these same reasons, the approach is easy to
explain to policy makers and the general public and tends
to be less resource intensive than other approaches to
health valuation. The method is generally suited for ill-
nesses such as non-fatal cancers and other incidents of
morbidity.
Cost-of-illness measures will understate WTP because they
do not capture the disutility associated with anxiety, pain
and suffering, or averting costs. On the other hand, some
WTP estimates may understate social costs because they
are unlikely to account for health care costs passed on to
third parties (e.g., health insurance companies or hospi-
tals in the case of direct medical expenses, and employers
who offer sick leave in the case of time/productivity loss).
Considerations in Evaluating and Understanding
Cost-of-IIIness
0~ Ex post vs. ex ante measure: As noted above, the
cost-of-illness measures ex post costs of an illness
rather than WTF to avoid the illness. Although the
approach may account for costs shifted from the indi-
vidual experiencing the illness to third parties, it fails
to account for the disutility of pain and suffering, or
any costs that may have been incurred in order to
avoid the illness. Also, ex post measures cannot cap-
ture any value associated with risk attitudes. These
attitudes may have a significant effect on WTP to
reduce risks of more severe illnesses.
It is also important to keep in mind that this measure
captures the costs of choices that individuals make.
Individuals generally choose when and how often to
go to the doctor and when and for how long to stay
home from work. These choices may be affected by
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Chapter 7: Benefits
the existence of health insurance, sick leave, and
socioeconomic status.
Technological change: Medical treatment technolo-
gies and methods are constantly changing, and this
could push the true cost estimate for a given illness
either higher or lower. When using previous cost-of-
illness studies, the analyst should be sure to research
whether and how the generally accepted treatment
has changed from the time of the study
Measuring the value of lost productivity: Several
issues arise in the indirect cost portion of a cosl-of-ill-
ness study. Simply valuing the actual lost work time
due to an illness may not capture the full loss of an
individual's productivity in the case of a long-term
chronic illness. Chronic illness may force an individ-
ual to work less than a full-time schedule, take a job
at a lower pay rate than he or she would otherwise
qualify7 for as a healthy person, or drop out of the
labor force altogether. A second issue involved with
estimating the value of lost productivity is the choice
of wage rate. Even if the direct medical costs are esti-
mated using individual actual cost data, it is highly
unlikely that the individual data will include wages.
Therefore, the wage rate chosen should reflect the
demographic distribution of the illness under study.
Furthermore, the value of lost time should include
the productivity of those persons not involved in paid
jobs. Ilomemakers' household upkeep and childcare
services, retired persons' volunteering efforts, and
students' time in school all directly or indirectly con-
tribute to the productivity of society. Finally, the value
of lost leisure time to an individual and his family is
not included in most cost-of-illness studies.
7.5.3
Methods
Stated preference approaches attempt to measure Wl'P val-
ues directly. Unlike the revealed preference methods that
infer values for environmental goods and services from
observed behavior, stated preference methods rely on data
from surveys that directly question respondents about
their preferences to measure the value of environmental
goods and services. This class of methods comprises sev-
eral related techniques, including contingent valuation
(CV), stated, choice or conjoint analysis (CA), and. less fre-
quently, contingent ranking (CR). 'Hie common feature of
these methods is direct questioning of members of a pop-
ulation about their likely choices in a hypothetical market.
These three techniques are discussed below.
Economic Foundation of Preference
There are some situations in which data on actual behav-
ior and choices cannot be used to derive estimates of the
value of environmental goods and services. Stated prefer-
ence methods rely on survey data rather than on date, on
observed behavior, therefore, they can be used to measure
the value of environmental goods and services in most sit-
uations. The responses elicited from the surveys, if truth-
ful, are either direct expressions of WTP or can be used to
estimate WTP for the good in question.
0~ Contingent Valuation: Contingent valuation (CV) is
the most well developed of the stated preference
methods. CV surveys either ask respondents if they
would pay a specified amount for a described hypo-
thetical commodity or ask their highest WTP for it (for
a good overview of the method see Ilanemann, 1991;
Mitchell and Carson, 1989; Carson, 2000; or Kopp et
al. 1997). Concerns about the reliability of value esti-
mates that come from CV studies have dominated
debates about the methodology, since research has
shown that bias can be introduced easily into these
studies, especially if they are not carefully done. In
particular, the concern that CV surveys do not require
respondents to make actual payments has led critics
to argue that responses to CV surveys are biased
because of the hypothetical nature of the good.
Reliability tests on the data that conform to expecta-
tions from both economic and psychological theory
can enhance the credibility of a. CV survey. Surveys
without these tests should be suspect; surveys whose
results fail the tests may be discredited.
The result of the debates about the reliability of the
CV method has been an infusion of methods and the-
ory, particularly from the disciplines of psychology
and survey research, to enhance questionnaire design
to mitigate these concerns (Krosnick, 1991; Fischhoff,
1997). In addition, the National Oceanic and.
Atmospheric Administration (NOAA) convened a panel
of well-known economists to review and evaluate the
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Chapter 7: Benefits
methodology in 1993. The panel devised a set of
"best practices" recommendations for the method,
particularly as it relates to natural resource damage
assessments (NOAA, 1993). EPA subsequently pre-
pared comments on the panel recommendations and
regulations NOAA proposed that drew upon the
panel's report (EPA, 1994).
f Conjoint Analysis and Contingent Ranking:
Conjoint analysis (CA) and contingent ranking (CR)
studies ask respondents to make choices between two
or more (in the case of CA), or rank several (in the
case of CR), similar commodities with different attrib-
utes and prices, in order to tease out the marginal
value of particular attributes of the commodity of
interest (Johnson et al., 1994). These methods are a
variation on stated preference methods that aim to
evaluate marginal tradeoffs rather than the total value
for a described change that is evaluated in CV studies.
Arising out of the marketing discipline, these methods
rely on respondents' ability to make choices between
commodities whose attributes differ in relation to one
another. These methods often present respondents
with a series of binary choice questions (e.g., "Given
the descriptions of A and B, would you prefer A or
B?") or multiple choice questions that ask respon-
dents to make tradeoffs between prices and other fea-
tures of commodities that are presented to them.
General Application of Stated Preference
to
More than 2,000 stated preference studies have been
undertaken since the early 1970's. Among other things,
these have been used to value changes in visibility
(Chestnut and Rowe, 1990; Tolley et al. 1985), changes in
surface water quality (Mitchell and Carson, 1984, 1986b),
groundwater protection (McClelland el al., 1992), recre-
ation services (Cameron and James, 1987; Bishop and
Heberlien, 1979) and changes in health effects attributable
to pollution (Krupnick and Cropper, 1989; Mitchell and
Carson, 1986a; Viscusi et al., 1991).
Currently, contingent valuation is the only established
method capable of estimating non-use values; however,
most CV studies are designed to elicit respondents' total
value for a given commodity. A number of researchers
have attempted to disaggregate WTP values into "use" and
"non-use" components. Examples of studies where non-
use values have been specifically evaluated include
McClelland et al. (1992) and Schulze el al. (1993). A
more practical approach is to represent non-use values by
employing the total WTP amounts given by persons who do
not use the resource. The downside to this convenience is
that there might be significant differences between those
who use the resource and those who do not. Applying
non-use values from the latter population to the former
one may result in biased estimates.
In the context of environmental valuation, the commodity
being purchased is usually a described change in environ-
mental quality. This is a Ilicksian measure, since it asks
respondents to state the amount of income that they
would be willing to forgo in order to have the described
commodity, while making them as well off as they were
without it and the payment. Similarly; they might be asked
how much they would be willing to accept to put up with a
nuisance or a loss. However, willingness to accept applica-
tions of CVare much more problematic because, unlike
the case of WTP, there is no upper limit on the size of the
opportunity set available to the respondent. This results in
a strong potential for respondents to overstate the amount
they would need to receive to compensate them for a loss.
While conjoint analysis (CA) has been used in marketing
for some time, its application to environmental valuation
began in the late 1.980's. To date, it has not been subject
to the level of testing and scrutiny that CV has had, so
much less is known about the reliability (and how to
enhance it) of these studies. The main methodological
concerns thai arise with CA studies are the viability of dis-
aggregating the good in question into attributes that can be
separately traded off in respondents' minds, and the prob-
lem that many respondents display intransitive preferences
over the numerous, and often complex, set of choices. .As
a result of this complexity, heteroskedasticity is a pervasive
problem with these methods.
An important limitation to using contingent valuation and
other stated preference techniques is that it is expensive
and time-consuming to survey the public about their
preferences. Samples must be drawn, questionnaires
developed, surveys administered either by mail, telephone
or in person, and results coded and analyzed. In-person
interviews are most expensive, but in some contexts are
unavoidable due to the need to present complicated
information to respondents or when they are required as
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Chapter 7: Benefits
criterion for legal evidence. Mail and phone surveys carry
much lower costs and are often sufficient for use in the
analysis of EPA policies.
in
Studies
Accurately measuring WTP for environmental goods and
services using contingent valuation depends on the relia-
bility and validity of the data collected. There are several
issues to consider when evaluating study quality.
0~ Content validity: To evaluate a survey instrument
itself, the analyst should look for a number of
features that the researchers should have
incorporated into the survey scenario. First, the
commodity being valued must be clearly and
concisely defined. A detailed explanation of the
salient features of the environmental change being
valued (the "commodity") begins with a careful
exposition of the conditions in the baseline case and
how these would be expected to change over time if
no action were taken. Next, the action (policy
change) should be described, including an illustration
of how and when the policy action would affect
aspects of the environment that people might care
about. Finally the way the payment will be made
(e.g., through taxes, user fees, etc.) may have large
implications for the outcome, so careful attention
should be paid to the rationale given for the choice of
payment mechanism. Respondent attitudes about the
provider and the implied property rights of the survey
scenario can be used to evaluate the appropriateness
of these features of the commodity description
(Fischhoff and Furby, 1988). Questions that probe for
respondent comprehension and acceptance of the
commodity scenario can offer important indications
about the potential for the study to be reliable.
0~ Construct validity: In CV studies, the main indica-
tors of study quality are tests of internal validity that
can be incorporated into study design. Internal validi-
ty is supported when variables thai are expected by
theory to be important determinants of preferences
actually are statistically significant with the correct
sign. For example, with normal goods, price is
expected to have a negative effect on demand for a
good, while household income is expected to have a
positive effect, all else equal. Thus, respondents with
higher income are expected to demand more of the
good than respondents with low income. Familiarity
with the good or its context can also be an important
indicator of internal validity. One would intuitively
expect that someone who fishes would know more
about, and be willing to pay more for, a commodity
that improves conditions for fishing than someone
who never engages in outdoor recreation. Tests of
sensitivity to scope, where the amount of the com-
modity is varied randomly over different sub-samples
of survey respondents, can increase confidence in the
results where the findings are consistent with theoret-
ical expectations (Carson et al., 1993).
0~ Criterion validity: In order to assess criterion valid-
ity, the analyst needs to have an indicator of true
value against which to evaluate values from contin-
gent valuation studies. Given the lack of actual mar-
ket prices, it is often impossible to conduct criterion
validity tests. However, the quality of a CV study can
also be gauged by comparing valuation estimates
obtained using CV with those obtained using other
techniques. At least one study that has compared CV
valuation estimates with estimates derived using other
valuation techniques has shown that, where the CV
study was carefully designed, CV estimates are not
inflated relative to the other estimates for the same
commodity (Carson, 1996).
In conclusion, because of the issues raised here, among
other factors, there is a divergence of views within the eco-
nomic profession concerning whether stated preference
methods can provide useful information on economic val-
ues and on validity of individuals' responses to hypotheti-
cal questions. Nonetheless, for goods providing non-use
value, stated preference methods may provide the only
analytic method currently available for benefits estimation.
7.5.4
Benefit transfer can be a feasible alternative to using one
of the primary stated or revealed preference research
methods described in previous sections. Rather than
collecting primary data, the benefit transfer approach
relies on information from existing studies that have
applied other methods. More precisely Boyle and
Bergstrom (1992) define benefit transfer as "the transfer
of existing estimates of nonmarket values to a new study
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Chapter 7: Benefits
which is different from the study for which the values were
originally estimated." The case for which the existing
estimates were obtained is often referred to as the "study
case," while the case under consideration for a new policy
is termed, the "policy case."
Existing applications of benefit transfer often focus on
recreation demand. For an example of such a study, see
Walsh et al. (1992). Applications of benefit transfer to
value health effects have also been completed. See, for
example, EPA's retrospective and prospective reports on
the benefits and costs of the Clean Air Act (EPA, 1997a;
EPA 1999a). Here, ranges of values for multiple-symptom
health effects were calculated by combining results of
studies that valued individual health effects. More infor-
mation on benefit transfer in general and some of the
issues discussed below can be found in EPA (1993) and a
special issue of Water Resources Research (1992, Volume
28, Number 3) dedicated to the topic. More recently,
Desvousges et al. (1998) discusses transfer studies in gen-
eral, not only for valuation purposes. The authors illus-
trate the transfer method with a case-study estimating
externalities associated with electric utility generation.
Is Transfer the Appropriate Technique?
The advantages to benefit transfer are clear. Original stud-
ies are time consuming and expensive; benefit transfer can
reduce both the time and financial resources needed to
develop benefits estimates of a proposed policy Given the
demands of the regulatory process, these considerations
may be extremely important. Additionally, while the quali-
ty of primary research is unknown in advance, the analyst
performing a benefit transfer is able to gauge the quality of
existing studies prior to conducting the transfer exercise.
However, benefit transfer is not without drawbacks. Most
important, estimates derived using benefit transfer tech-
niques are unlikely to be as accurate as primary research
tailored specifically to the new policy case. Of concern to
the analyst is whether more accurate benefits information
make a difference in the decision-making process. There
are many situations in which a benefit transfer may pro-
vide adequate information. For example, if the entire
range of benefits estimates from the transfer exercise falls
well above or below the costs of the policy being consid-
ered, more accurate estimates will probably not alter the
efficiency conclusion.
Other factors to consider when deciding whether to con-
duct a benefit transfer include the availability of relevant,
high-quality existing studies and the degree to which addi-
tional primary research would reduce the uncertainty of
the current benefits estimate.
Considerations in Evaluating and Understanding
Transfer
Currently, a systematic process for conducting benefit
transfer does not exist. There are, however, well-accepted
steps involved in the process. When conducting a benefit
transfer, one should make certain that each of the follow-
ing steps are carried out carefully:
^ Describe the policy case. The first step in a benefit
transfer is to describe the policy case so that its char-
acteristics and consequences are understood. It is
equally important to describe the population impact-
ed by the proposed policy. As part of this step, it is
important to determine whether effects of the policy
will be felt by the general population or by specific
subsets of individuals (e.g., users of a particular
recreation site or children). Information on the
affected population will generally be used to convert
per person (or household) values to an aggregate
benefits estimate.
0~ Identify existing, relevant studies. Existing, rele-
vant studies are identified by conducting a literature
search. This literature search should, ideally, include
searches of published literature, reviews of survey
articles, examination of databases, and consultation
with researchers to identify government publications,
unpublished research, works in progress, and other
"gray literature."
^ Review available studies for quality applica-
bility. In the third step, the analyst should review
and assess the studies identified in the literature
review for their quality and applicability to the policy
case. The quality of the study case estimates will, in
part, determine the quality of the benefit transfer.
Indicators of quality will generally depend on the
method used. See the previous discussions on each
of the primary research methods for more informa-
tion on assessing the quality of studies. Assessing
studies for applicability involves determining whether
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Chapter 7: Benefits
available studies are comparable to the policy case.
Specifically:
— the basic commodities must be essentially
equivalent;
— the baseline and extent of the change should be
similar; and
— the affected populations should be similar.
The analyst should also determine whether adjust-
ments can be made for important differences between
the policy case and the study case. In some cases, it
may prove enlightening to discuss your interpretation
and intended use of the study case with the original
authors. See Desvousges et al. (1992) for additional
information on criteria used to determine quality and
applicability. For more information on applicability as
related to specific benefit categories, see the draft
Handbook for Non-Cancer Valuation (EPA, 1999c),
the Children's Health Valuation Handbook (EPA,
forthcoming), and Desvousges et al. (1998).
Transfer the benefit estimates. This step involves
the actual transfer. There are four types of benefit
transfer studies: point estimate, benefit function,
meta-analysis, and Bayesian techniques. The point
estimate approach involves taking the mean value (or
range of values) from the study case and applying it
directly to the policy case. As it is rare that a. policy
case and study case will be identical, this approach is
not generally recommended. Rather than directly
using existing values, analysts will often adjust point
estimates based on judged differences between the
study and policy cases. Judgments of this type should
be based on economic theory, empirical evidence, and
experience (Brookshire and Neill, 1992). The benefit
function transfer approach is more refined but also
more complex. If the study case provides a WTP
function, valuation estimates can be updated by sub-
stituting applicable values of key variables, such as
baseline risk and population characteristics (e.g.,
mean or median income, racial or age distribution)
from the policy case into the benefit function. The
most rigorous benefit transfer exercise uses meta-
analysis. Meta-analysis is a statistical method of com-
bining a number of valuation estimates thai allows
the analyst to systematically explore variation in exist-
ing value estimates across studies. As with the benefit
function transfer approach, key variables from the
policy case are inserted into the resulting benefit
function. An alternative to the meta-analytic
approach is the Bayesian approach. These techniques
provide a systematic way of incorporating study case
information with policy case information. Studies
that have explored these concepts include Atkinson et
al. (1992) and Boyle et al. (1994). A discussion of
Bayesian approaches appears in Desvousges et al.
(1998). Regardless of the procedure used, estimates
are generally aggregated over the affected population
to compute an overall benefits estimate.
0~ Address uncertainty. Benefit transfer involves
judgements and assumptions. Throughout the analy-
sis, the researcher should clearly describe all judge-
ments and assumptions and their potential impact on
final estimates, as well as any other sources of uncer-
tainty inherent in the analysis.
7.6 for
As noted earlier, EPA policies may reduce the risk of pre-
mature death, typically measured as the number of statis-
tical lives "saved" as a result of the policy action. The ben-
efits of these risk reductions are usually measured using
the concept of the "value of a statistical life" (VSL). VSL
estimates are derived from aggregated estimates of individ-
ual values for small changes in mortality risks. If 10,000
individuals are each willing to pay, for example, $500 for a
reduction in risk of 1/10,000, then the value of saving one
statistical lite equals $500 times 10,000—or $5 million.
This does not mean that any identifiable life is valued at
this amount, but rather that the aggregate value of reduc-
ing a collection of small individual risks is worth $5 mil-
lion in this case.
7.6.1
Risks
EPA policies reduce a wide array of mortality risks. Some
risks are experienced by young persons and others by
older persons. Some risks result in death shortly after
exposure, while others take years to manifest. For benefits
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Chapter 7: Benefits
analysis, mortality risks can generally be classified across
two broad dimensions: the characteristics of the affected
population and the characteristics of the risk itself, such as
timing. These dimensions can be expected to affect the
value of reducing mortality risks.
An ideal value estimate for fatal risk reduction would
account for all of these demographic and risk characteris-
tics. It would be derived from the preferences of the popu-
lation affected by the policy, based on the type of risk that
the policy is expected to reduce. For example, if a policy
were designed to remove carcinogens at a suburban haz-
ardous waste site, the ideal measure would represent the
preferences for reduced cancer risks for the typical subur-
ban dweller in the area. Unfortunately, it is simply too
expensive and lime-consuming to obtain such unique risk
value estimates for each EPA policy.
Because original research is usually infeasible, analysts at
EPA will need to draw from existing VSL estimates that
have been obtained using well-established methods.
However, virtually all available applications of these meth-
ods focus on risks that differ from environmental risks in
a number of ways. Applying existing VSL estimates found
in the economics literature is an exercise in benefit trans-
fer and raises a number of issues associated with this
technique.
This section characterizes and assesses these issues, recog-
nizing that there are limitations to how effectively analysts
can make adjustments in the benefit transfer process. The
discussion is sometimes necessarily broad, given that
there are a variety of different types of mortality risks
affected by EPA policies. First, this section briefly reviews
relevant economic valuation methods and the VSL esti-
mates they provide. Then the bulk of this section high-
lights key considerations when considering and transfer-
ring these values for use in EPA benefits analysis. In order
to focus the discussion, this section emphasizes those con-
siderations that may be unique to benefit transfer in the
context of mortality risk changes. Benefit transfer consid-
erations that are common to all applications, including
most demographic characteristics of the study and policy
populations, are described in the section of the benefit
transfer method itself.
7.6.1.1 for
Mortality
The value of small changes in mortality risk is well-stud-
ied, although researchers generally acknowledge that there
are formidable difficulties in measuring risk-dollar trade-
offs. Economists have developed three broad methods to
estimate a value of mortality risk reduction, each of which
is described below. When using any of these methods,
researchers encounter uncertainties not only in isolating
the amount of compensation received for assuming higher
mortality risk, but also in estimating the actual and per-
ceived risk increment inherent in the transaction.
f Wage-risk analysis: This method is well-established
and the economics literature contains at least twenty
high-quality wage-risk studies. The resulting VSL esti-
mates range from about $0.7 million to more than
$16 million (1997$) and are included in Exhibit 7-3.
Wage-risk studies have been performed in a number
of different industries and countries and their esti-
mates appear to be somewhat sensitive to the data
and econometric model used.26 Workplace mortality
risks, which tend to be dominated by deaths associat-
ed with accidents or other immediate causes, form
the basis for VSL estimates from these studies.
Environmental risks affected by EPA policies often dif-
fer from these types of risk in a number of ways.
f Contingent valuation: There are at least five high-
quality published estimates of VSL based on the con-
tingent valuation method. These estimates are broad-
ly consistent with those generated by the wage-risk
method and are included in Exhibit 7-3. These stud-
ies have not employed a fatal risk scenario involving
an environmental cause and, therefore, suffer from
some of the same "risk context" differences as wage-
risk studies when transferred for use in EPA policy
analyses. Recently, however, researchers have exhibit-
ed renewed interest in using the contingent valuation
method to explore how particular factors affect WTP
to reduce risks.27
f Averting behavior studies: The published litera-
ture contains several examples of averting behavior
M Viscusi (1992, 1993) discusses the implications of different specifications and data sets.
27 Johannesson and Johansson (1996), for example, attempt to value extensions to life expectancy. The design of this study has, however,
received some criticism (Krupnicketal, 1999).
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Chapter 7: Benefits
Exhibit 7-3 Value of Statistcal Life Estimates (mean values in 1997 dollars)
Study
Kneisner and Leeth (1991 - U.S.)
Smith and Gilbert (1984)
Dillingham (1985)
Butler (1983)
Miller and Guria (1991)
Moore and Viscusi (1988)
Viscusi, Magat and Huber (1991)
Marin and Psacharopoulos (1982)
Gegax et al. (1985)
Kneisner and Leeth (1991 - Australia)
Gerking, de Haan and Schulze (1988)
Cousineau, Lecroix and Girard (1988)
Jones-Lee (1989)
Dillingham (1985)
Viscusi (1978, 1979)
R.S. Smith (1976)
VK. Smith (1976)
Olson (1981)
Viscusi (1981)
R.S. Smith (1974)
Moore and Viscusi (1988)
Kneisner and Leeth (1991 -Japan)
Herzog and Schlottman (1987)
Leigh and Folsom (1984)
Leigh (1987)
Garen (1988)
Derived from EPA (1997) and Viscusi (1992).
Method
Labor Market
Labor Market
Labor Market
Labor Market
Contingent Valuation
Labor Market
Contingent Valuation
Labor Market
Contingent Valuation
Labor Market
Contingent Valuation
Labor Market
Contingent Valuation
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Labor Market
Value of Statistical Life
$0.7 million
$0.8 million
$1.1 million
$1.3 million
$1.5 million
$3.0 million
$3.3 million
$3.4 million
$4.0 million
$4.0 million
$4.1 million
$4.4 million
$4.6 million
$4.7 million
$5.0 million
$5.6 million
$5.7 million
$6.3 million
$7.9 million
$8.7 million
$8.8 million
$9.2 million
$11.0 million
$11. 7 million
$12. 6 million
$16.3 million
studies, also known as "consumer market studies."
Consumer market studies have examined risk-dollar
tradeoffs associated with highway speed (Ghosh et al.,
1975), seatbelt use (Blomquist, 1979), use of smoke
detectors (Dardis, 1980; Garbacz, 1989), and the use
of child safety seats (Carlin and Sandy, 1991). All of
these studies suffer from problems in estimating the
full costs of consumer actions to reduce risks. For
28 These criticisms include Fisher et al. (1989) and Viscusi (1992).
example, it is difficult to quantify the added expense
and "cost of time" involved in purchasing, installing,
and maintaining a smoke detector. Further, these
studies cannot generally control for reductions in
non-fatal risks that are associated with the averting
action. Some researchers argue that these and other
limitations lead consumer market studies to produce
downwardly biased VSL estimates.28
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Chapter 7: Benefits
No clear consensus establishes one of these three methods
or any particular study as exhibiting superior features for
use in regulatory analyses. However, the relative abun-
dance of available VSL estimates from wage-risk studies
provides a range of broadly applicable values for reduced
mortality risk. As in other benefit transfer exercises, a
range or distribution of values serves as a starting point
when seeking to identify values appropriated for a particu-
lar policy context.
7.6.1.2 Of Of
Life
Literature surveys found in Viscusi (1993) and Fisher
(1989) represent the best starting points for VSL estimates.
In both cases, the authors' goals included presenting a
broadly applicable range of values rather than a point esti-
mate. Viscusi (1993) is more recent and includes some
studies not considered by Fisher.29
Drawing from these reviews, EPA identified 26 policy-rele-
vant risk VSL studies as part of an extensive assessment
titled The Benefits and, Costs of the Clean Air Act, 1970 to
1990 (EPA, 1997a).30 These are summarized in Exhibit 7-3
(1'Ec 1992, 1993a, 1993b). Five of the 26 studies are con-
tingent valuation studies, the rest are wage-risk studies. To
allow for probabilistic modeling of mortality risk reduction
benefits, the analysts reviewed a number of common dis-
tributions to determine which best fit the distribution of
mean values from the studies. AWeibull distribution was
selected with a central tendency (or mean) of $5.8 million
(1997$).
Although these studies are generally of high-quality; the
$5.8 million measure of central tendency does not account
for variation in study-specific factors underlying these VSL
estimates. Further research on synthesizing the results of
these and other studies, including the use of m eta-analy-
sis, may provide estimates better suited for benefit transfer
to environmental policies.
7.6.1.3 Transfer Considerations
for VSL
Exhibit 7-3 contains the best range of estimates available
at this time. For use in benefits analyses, EPA recom-
mends a central estimate of $4.8 million (1990$), updated
to the base year of the analysis. For example, updating
this figure for inflation produces an estimate of $6.1 mil-
lion in 1999 dollars.31
However, as with any benefit transfer exercise, it is impor-
tant to consider differences in the nature of the base and
policy cases. As noted earlier, for fatal risks these differ-
ences fall into two major categories:
^ differences in the characteristics of the population;
and
§C differences in the characteristics of the risks being
valued.
Particular differences in these categories are detailed
below. Following this presentation is a summary assess-
ment of how analysts might assess the impact of these
population and risk dimensions. Generally, policy analysts
considering mortality-related benefits should, include at
least a qualitative discussion of the potential impact of
these factors on the overall results. It is important to rec-
ognize that the ultimate objective of the benefit transfer
exercise is to adjust or correct for all of the factors that sig-
nificantly affect the value of mortality risk reduction in the
context of the policy. Analysts should carefully consider
the implications of making adjustments for some relevant
factors, but not for others.
29 A third literature survey, Miller (1990), reviews a broad range of value of life studies, including estimates from averting behavior studies
that others forcefully argue are not appropriate for environmental policy purposes. In addition, Miller's results are dependent on adjustments he
makes to wage-risk data. These adjustments are the subject of debate among economists and may be difficult to defend in environmental contexts.
30 This approach for valuing mortality risks was subject to extensive external peer review during the development process of this report.
Since the report's release, this approach has been adopted in other EPA benefit analyses. Peer reviewers have recently confirmed the approach for use
in a prospective analysis of the Clean Air Act (EPA, 1999a).
°' This was estimated using the Consumer Price Index (OPT) for all goods and services. Many economists prefer to use the Gross Domestic
Product (GDP) Deflator inflation index in some applications. The key issue for EPA analysts is that the chosen index be used consistently throughout
the analvsis.
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Chapter 7: Benefits
Factors Associated with Demographic
f Age (longevity): Several authors have attempted to
address potential differences in the value of statistical
life due to differences in the average age of the affect-
ed population or the average age at which an effect is
experienced.32 In the case of reductions in mortality
risks, a young person is assumed to experience a
greater expected benefit in total lifetime utility than
an older person. This hypothesis may be confounded
by the finding that older persons reveal a greater
demand for reducing mortality risks and hence have
a greater implicit value of a life year (Ehrlich and
Chuma, 1990). Though few in number, empirical
studies and theoretic models suggest that the value of
a life follows a consistent "inverted-U" life-cycle, peak-
ing in the region of mean age.33
Two alternative adjustment techniques have been
derived from this literature. The first, valuation of
statistical life-years, is based on the concept of statis-
tical lite years introduced in Section 7.4.1. The most
common application of this approach is illustrated in
Moore and Vlscusi (1988) and presumes that 1) the
value of statistical life equals the sum of discounted
values for each life year and 2) each life year has the
same value. This method was applied as an alterna-
tive case in an effort to evaluate the sensitivity of the
benefits estimates prepared for EPA's retrospective
study of the costs and benefits of the Clean Air Act
(EPA 1997). A second technique is to apply a distinct
value or suite of values for mortality risk reduction
depending on the age of incidence. However, there is
relatively little available literature upon which to base
such adjustments.34
0~ Health status: Individual health status also appears
to affect VCTP for mortality risk reduction. This is a
relevant factor for valuation of environmental risks
because individuals with impaired health are often
the most vulnerable to mortality risks from environ-
mental causes (for example, particulate air pollution
appears to disproportionately affect individuals in an
already impaired state of health). Health status is dis-
tinct from age (a "quality versus quantity" distinction)
but the two factors are clearly correlated and there-
fore must be addressed jointly when considering the
need for an adjustment. At least one pilot study has
found that WTP for increased longevity decreases with
a declining baseline health state (Desvousges et al.,
1996).35
Factors Associated with Characteristics of Risk
and Other Considerations
iT Risk characteristics appear to affect the value that
people place on risk reduction. A large body of work
identifies eight dimensions of risk that affect human
risk perception:36
— voluntary/involuntary;
— ordinary/catastrophic;
— delayed/immediate;
— natural/man-made;
— old/new;
— controllable/uncontrollable;
— necessary/unnecessary; and
— occasional/continuous.
'" See, for example, Cropper and Sussman (1990) and Moore and Vlscusi (1988).
"" Jones-Lee et al. (1985) reach this conclusion empirically, considering both remaining years of life and the value of a life year. This con-
clusion supports theoretical predictions by Shepard and Zeckhauser (1982),
* This second approach was illustrated in one EPA study (EPA, 1995) for valuation of air pollution mortality risks, drawing upon adjust-
ments measured in Jones-Lee et al. (1985).
35 The fields of health economics and public health often account for health status through the use of quality adjusted life years (QALYs) or
disability adjusted life years (DALYs). These measures have their place in evaluating the cost effectiveness of medical interventions and other policy
contexts, but have not been fully integrated into the welfare economic literature on risk valuation. More information on QALYs can be found in Gold
et al. (1996) and additional information on DALYs can be found in Murray (1994).
M A review of issues in risk perception is found in Slovic (1987). Other informative sources include Rowe (1977), Otway (1977), and
Fischhoffetal. (1978).
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Chapter 7: Benefits
Transferring VSL estimates between these categories
may introduce bias.37 There have been some recent
efforts attempting to quantitatively assess these
sources of bias. These studies generally conclude
that voluntariness, control, and responsibility affect
individual values for safety, although the direction and
magnitude of these effects are somewhat uncertain.
Environmental risks may differ from those that form
the basis of VSL estimates in many of these dimen-
sions. Occupational risks, for example, are generally
considered to be more voluntary in nature than are
environmental risks, and may be more controllable.
Latency periods: Many environmental policies are
targeted at reducing the risk of effects such as cancer,
where there may be an extended period of latency
between the time of exposure and eventual death
from the disease.33 While the benefit of a reduction in
exposure is an immediate reduction in the risk of the
associated health endpoint, latency periods between
exposure and manifestation may affect the value of
that risk reduction. Existing VSL estimates are based
upon risks of relatively immediate fatalities, making
them an imperfect fit for a benefits analysis of many
policies. Economic theory suggests that reducing the
risk of a delayed health effect will be valued less than
reducing the risk of a more immediate one, when
controlling for other factors.
A simple ad hoc approach to adjusting existing VSL
estimates is to apply a financial discount rate over the
expected latency period. However, defining latency
periods with existing risk assessment methods may be
difficult and empirical estimates may be highly
uncertain. Further, the underlying assumptions
supporting this procedure may oversimplify how
individuals appear to consider delayed health effects.39
Cropper and Sussman (1990) develop an alternative
procedure to account for the influence of time on
fatal risk reduction values, but their demonstration is
data-intensive, requiring detailed life tables and age-
specific VSL estimates.
f Altruism: The existing VSL literature focuses on
individual risk tradeoffs, but there is evidence that
people are willing to pay to reduce risks incurred by
others. Although the literature on altruism is limited,
several studies suggest that these values may be sig-
nificant.40 Other analysts advocate caution in attempt-
ing to inflate value of life estimates to reflect altruism,
primarily because of concerns over the potential for
double-counting.'11
7.6.1.4 Summary of from the
It is important to recognize the limitations of a single VSL
point estimate and to consider whether any of the factors
discussed above may have a significant impact on the ben-
efits estimated for mortality risk reductions from environ-
mental policies. In any given policy context, there may be
several components that are both relevant and important
and that could act to increase or decrease the appropriate
risk reduction value used to estimate benefits.
Adjustments for each these factors may offset one another
to some extent.12 Analysts should exercise caution in
accounting for some important risk and population char-
acteristics when unable to account for others.
" Examples include Mendeloff and Kaplan (1990), McDaniels et al. (1992), Savage (1993), Jones-Lee and Loonies (1994, 1995, 1996),
and Covey et al. (1995).
" Although latency is defined here as the time between exposure and fatality from illness, alternative definitions may be used in other con-
texts. For example, 'latency'1 may refer to the time between exposure and the onset of symptoms. These symptoms may be experienced for an
extended period of time before ultimately resulting in fatality,
°' See, for example, the choice of discount rate discussion in Horowitz et al. (1990) and Rowlalt et al. (1998).
'" In a sludy that included willingness to pay to reduce others' risk of illness from insecticides, Viscusi el al. (1988) found evidence of sig-
nificant altruistic values. Jones-Lee et al (1985) suggests an adjustment to value of statistical life estimates of about one-third to account for people's
concern for the safety of others.
41 Examples include Bergstrom (1982) and Viscusi (1992).
42 Sometimes this might mean that very different risks will be valued similarly. There are relatively few studies that assess responses to
different types of risk in an individual choice framework. A notable exception is Magat et al. (1996), which finds individuals indifferent between mor-
tality risks from an automobile accident and those from fatal lymph cancer.
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Chapter 7: Benefits
Because of the inherent uncertainty in any analysis, how-
ever, analysts should consider qualitative evaluations of
these factors and explore where sensitivity analysis can sat-
isfactorily address some of these concerns. The impor-
tance and relevance of each of the risk and demographic
characteristics need to be considered. Depending upon
specific policy context, there may be multiple alternatives
for supplemental analysis.
For example, when policies do not affect the entire popula-
tion equally, a sensitivity analysis may show the cost per
life saved. In some contexts these values may provide use-
ful information to decision makers on the relative merits
of alternative policy options. However, cost-pcr-lifc-savcd
measures implicitly assume that all costs are associated
with mortality reduction. For policies that provide other
types of benefits, cost-per-life-saved measures may be mis-
leading unless the value of those benefits are first deduct-
ed from cost estimates, but it is impossible to make these
deductions when some benefits are either non-quantified
or non-monetized. Because of these shortcomings, ana-
lysts will need to assess the usefulness of cost-per-life-
saved measures on a case-by-case basis.
In general, the decision to perform sensitivity analysis will
also depend upon the relative importance of mortality val-
ues in the overall benefits estimates and upon having
sound theoretical and. empirical economic literature upon
which to structure the analysis. Parameter values used to
formulate the sensitivity analyses must also be supported
by the underlying risk assessment data.
What support does the economics literature currently offer
for making these potential adjustments? Existing, feasible
methods for age (or longevity) adjustments have signifi-
cant limitations. Age adjustments may be desirable from a
theoretical standpoint, but the relationship between the
value of risk reductions and expected remaining life span
is complex. Application of existing valuation of statistical
life years approaches implicitly assumes a linear relation-
ship in which each discounted life year is valued equally.
As OMB (1996) notes, although "there are theoretical
advantages to using a value of statistical life-year-extended
(VSLY) approach, current research does not provide a.
definitive way of developing estimates of VSLY that are sen-
sitive to such factors as current age, latency of effect, life
years remaining, and social valuation of different risk
reductions." The second alternative, applying a suite of
values for these risks, lacks broad empirical support in the
economics literature. However, the potential importance
of this benefit transfer factor suggests that analysts consid-
er sensitivity analysis when risk data—essentially risk esti-
mates for specific age groups—are available. Emerging
literature on the value of life expectancy extensions, based
primarily on stated preference techniques, is beginning to
help establish a basis for valuation in cases where the
mortality risk reduction involves relatively short extensions
of life.43
A small body of literature on the quantitative impact of risk
characteristics on risk valuation exists. Although there is
some qualitative consistency in the results of these studies,
the risk valuation literature is not sufficiently robust to
support quantitative adjustments for these factors at this
time. Considerations associated with risk characteristics
may deserve qualitative discussion in some policy contexts.
Both of the procedures available for accounting for latency
have potentially serious shortcomings. For example, nei-
ther procedure addresses the dread of death or the mor-
bidity that occurs prior to fatality from protracted, diseases,
such as that experienced with many cancers. As noted
earlier, the simple "discounted VSL" approach may also
oversimplify how individuals consider latency in their
expressed WTP for reduced mortality risks. This literature
does, however, suggest one alternative for conducting sen-
sitivity analysis on this benefit transfer component.
7.6.1.5 Conclusion
In summary, these guidelines recognize the theoretically
ideal measure of mortality risk reduction benefits and this
section has discussed the many variables affecting such a
measure. Due to current limitations in the existing
economic literature, these guidelines conclude that an
appropriate default approach for valuing these benefits is
a It should be noted that many observers have expressed reservations over adjusting the value of mortality risk reduction on the basis of
population characteristics such as age. One of the ethical bases for these reservations is a concern that adjustments for population characteristics
may imply support for variation in protection from environmental risks. Another consideration is that existing economic methods may not capture
social willingness 1o pay to reduce health risks. Chapter 9 details how some these considerations may be informed by a separate assessment of equity.
Chapter 10 describes the potential for efficiency and equity considerations to be considered together in a social welfare function.
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Chapter 7: Benefits
provided by the central VSL estimate described earlier.
However, analysts should carefully present the limitations
of this estimate. Economic analyses should also fully
characterize the nature of the risk and populations
affected by the policy action and. should confirm that these
parameters are within the scope of the situations
considered in these guidelines. While a qualitative
discussion of these issues is generally warranted in EPA
economic analyses, analysts should also consider a variety
of quantitative sensitivity analyses on a case-by-case basis
as data allow. The analytical goal is to characterize the
impact of key attributes that differ between the policy and
study cases. These attributes, and the degree to which
they affect the value of risk reduction, may vary with each
benefit transfer exercise, but analysts should consider the
characteristics described above (e.g., age, health status,
voluntariness of risk, latency) and values arising from
altruism.
As the economic literature in this area evolves, WTP esti-
mates for mortality risk reductions that more closely
resemble those from environmental hazards may support
more precise benefit transfers. Literature on the specific
methods available to account for individual benefit transfer
considerations will also continue to develop. EPA will con-
tinue to conduct annual reviews of the risk valuation liter-
ature and will reconsider and revise the recommendations
in these guidelines accordingly. EPA will seek advice from
the Science Advisory Board as guidance recommendations
are revised.44
Despite the limitations described in this section, analysis
should remember that mortality risk valuation remains
one of the most studied benefit categories for environmen-
tal policies. Wage-risk studies, while not without limita-
tions, nonetheless provide revealed preference estimates
based on a well-tested method. Estimating mortality relat-
ed benefits will often be relatively straightforward to imple-
ment, while other benefit categories will require more time
and attention.
Risks
Morbidity valuation, or the valuation of non-fatal health
effects, often requires addressing a more diverse set of
issues than mortality valuation. First, there is a tremen-
dous variety in the health endpoints considered, for valua-
tion. These endpoints vary will) respect to their severity
including the degree to which other activities can be pur-
sued and the degree of discomfort or pain associated with
the ailment. The duration of the effect also varies consid-
erably, from short term effects to those that may be per-
manently debilitating. Non-fatal health effects differ con-
siderably with respect to the availability of existing value
estimates. Some of these health effects have been valued
multiple times with different methods, while others have
not been the subject of any valuation studies.
Willingness to pay to reduce the risk of experiencing an ill-
ness is the preferred measure of value for morbidity
effects. This measure includes several components.
Illness imposes direct costs, such as expenses for medical
care and medication, and indirect costs, such as lost time
from paid work, maintaining a home, and pursuing leisure
activities. Illness also imposes less easily measured, but
equally real costs of discomfort, anxiety, pain, and suffer-
ing. Methods used to estimate WTP vary in the extent to
which they capture these components.
A commonly used alternative to WTP is the avoided costs
of illness (€01). For a given health effect, the COI
approach will generally understate true WTP. By focusing
on market measures of the value of health effects, it leaves
out important components such as the value of avoiding
pain and suffering. By focusing on ex post costs, it also
does not capture the risk attitudes associated with ex ante
WTP measures. However, for many effects, estimates of
WIT are not currently available or are highly uncertain.
Where estimates of WTP are not available, the potential
44 A second review on this subject was recently completed by the Science Advisory Board (SAB), the results of which can be found in "An
SAB Report: on EPA's White Paper Valuing the Benefits of Fata! Cancer Risk Reductions," EPA-SAB-EEAC-00-013, July 27. 2000 (website address
http://www.epa.gov/sab/eeacffll3.pdf, accessed 8/28/00). The SAB review elaborates further on using the wage-risk literature for valuing mortality
risk reductions, concluding that among the demographic and risk factors that might affect VSL estimates, the current literature can only support
empirical adjustments related to the timing of the risk First, the review supports adjusting willingness-to-pay estimates to account for higher future
income levels, though not for cross-sectional differences in income. The second time-related adjustment recommended is to discount for risk reduc-
tions that are brought about in the future by current policy initiatives (that is, after a latency period), using the same rates used to discount other
future benefits and costs. More information on the SAB review and its implications for the Guidelines will be released in a forthcoming supplement
to this document.
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Chapter 7: Benefits
bias inherent in relying on cost-of-illness estimates should,
at minimum, be discussed qualitatively.
Time and resources will often not allow for original mor-
bidity valuation research to support specific benefit analy-
ses. As with other types of benefits, analysts will then need
to look for estimates available from existing sources, and
apply these values to the policy case using benefit transfer
techniques. The discussion here is presented with this
benefit transfer exercise in mind. The remaining parts of
this section present a summary of methods commonly
used to value reductions in morbidity, useful references for
obtaining existing values, and issues that arise in transfer-
ring existing values to the analysis of EPA policies.
7.6.2.1 for
Morbidity
Researchers use a wide range of methods to value changes
in morbidity risks. Some available methods measure the
theoretically-preferred value of individual WTP to avoid a
health effect, while others provide useful data but are less
well-grounded in economic theory. Methods also differ in
the perspective from which valuation is measured (e.g.,
before or after the incidence of morbidity) and the degree
to which they account for all of the components of total
WTR
The three primary research methods used most often to
value environmental morbidity are cost of illness, contin-
gent valuation, and averting behavior, as described earlier.
Several other primary valuation methods have been used.
less frequently to value morbidity from environmental
causes: hedonic methods, risk-risk tradeoffs, health-state
indexes, and studies of jury awards. However, these meth-
ods often do not provide monetary estimates of WTP or
suffer from other methodological flaws, and are generally
less useful for policy analysis.
f Cost-of-illness: The cost-of-illness method is
straightforward to implement and explain to policy
makers and has a number of other advantages. It has
been applied for many years, is well-developed, and
measures of direct and indirect costs are easily
explained without reference to complex economic
theory. Collection of additional data is often less
expensive than for other methods, perhaps making it
feasible to develop original cost-of-illness estimates in
support of a specific policy or set of policies.
Estimates for many illnesses are available from exist-
ing studies and span a wide range of health effects.
EPA's Cost of Illness Handbook (EPA, forthcoming)
contains an extensive collection of cost-of-illness esti-
mates. .4s noted earlier, however, the cost-of-illness
method has several shortcomings and its theoretical
basis is quite limited. Generally, cost-of-illness esti-
mates should be considered lower bounds on WTR
Averting behavior: In the case of morbidity valua-
tion, the averting behavior method can provide WTP
estimates based on actual behavior. These measures
can account for all of the effects of health on individ-
ual well-being, including altruism toward other
household members if averting actions are taken
jointly (e.g., if everyone in the household drinks bot-
tled water). However, the method has several weak-
nesses, as described in Section 7.5. Existing studies
vary in their analytical approach. Some existing stud-
ies have attempted to estimate WTP for particular sets
of illnesses (Gerking and Stanley, 1986; Dickie and
Gerking, 1991; Bresnahan and Dickie, 1995). Others
do not attempt to estimate ex ante WTR, but focus
instead on actual household expenditures in response
to a particular contamination episode or event
(Harrington et al, 1989; Abdallah, 1990). In prac-
tice, most averting behavior estimates should be
interpreted cautiously as a lower-bound estimate on
WTR Also, because behaviors generally avert a range
of symptoms (e.g., a water filter removes contami-
nants with several potential health effects), it is diffi-
cult to isolate the value of avoiding those individual
health effects that may be attributable to a particular
EPA policy. Indiscriminate use of this method may
raise significant problems with double counting or
overestimation.
Stated preference methods: Contingent valuation
and other stated preference methods can be used to
account for all the effects of illness on individual well-
being, including pain and suffering. These methods
appear to be the only ones capable of eliciting dollar
values for altruism toward persons outside the house-
hold. Unlike the averting behavior or cost-of-illness
methods, these can be applied to value the risks of ill-
ness lacking any connection to market transactions.
Stated preference methods have been used to value a
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Chapter 7: Benefits
number of different health outcomes including acci-
dental poisoning (Viscusi and Magal, 1987; Viscusi el
al., 1988); coughing, congestion, and other minor
symptoms (Berger et al., 1987); chronic bronchitis
(Viscusi et al., 1991; Krupnickand Cropper, 1992);
and nonfatal nerve disease (Magat et al., 1996).
Some economists, however, express concerns about
the hypothetical nature of the transaction and the dif-
ficulties inherent in ensuring that respondents under-
stand the change in health status they are being asked
to value/0
7.6.2.2 for
Morbidity
Analysts have a number of resources available for obtain-
ing information on morbidity values. While these refer-
ences provide valuable information, they are not substi-
tutes for careful evaluation of original studies when con-
sidering a benefit transfer. Useful general references for
valuing non-fatal health effects include Tolley et al. (1994)
and Johanneson (1995). Both of these books provide ref-
erences to many existing health valuation studies and dis-
cuss issues associated with using these estimates for policy
valuation. Desvousges et al. (1998) assess a number of
existing studies in the context of performing a benefit
transfer for a benefits analysis of improved air quality.
Another good starting point for reviewing available esti-
mates is EPA's Handbook for Non-Cancer Valuation (EPA,
1999c). This report will provide available, published esti-
mates for many illnesses and reproductive and develop-
mental effects.
Because estimates of WTP will not always be available for
particular health effects, another useful resource is EPA's
Cost of Illness Handbook (EPA, forthcoming). This hand-
book includes cost-of-illness estimates for many cancers,
developmental illnesses and disabilities, and other illness-
es. Work on the handbook is ongoing and new estimates
will be included as they become available.46
Existing EPA economic analyses may also provide useful
insights. For example, the Benefits mid Costs of the
Clean Air Act (EPA, 1997a) draws upon a number of exist-
ing studies to obtain values for reductions of a variety of
health effects. The report describes the central estimates
used in the analysis, how these estimates were derived,
and attempts to quantify the uncertainty associated with
using the estimates.
7.6.2.3 Transfer
Benefit transfer was detailed earlier in this chapter; howev-
er, there are issues associated, with benefit transfer particu-
lar to morbidity valuation. As with any benefit transfer,
analysts should:
^ carefully describe the policy case;
^" assess the quality of the studies and their applicability
to the policy case;
^~ evaluate the plausibility of the findings;
^ consider possible adjustments for differences between
the subject of the study and the policy case; and
§C explicitly address uncertainty.
m^ Handbook for Non-Cancer Valuation (EPA, 1999c)
contains additional information on this subject.
the to the Policy
0~ Assessing applicability: A key element in evaluat-
ing the applicability of a study is the correspondence
between the health effect valued in the study and the
health effect influenced by the policy. An assessment
of this correspondence must consider the set of
symptoms covered in the study. The analyst should
consider whether the study case consists of a larger or
smaller set of symptoms than the policy case. The
severity of the symptoms should also be commensu-
rate, including the degree to which the illness limits
activities and the extent of any discomfort, pain and
suffering. Analysts should also assess whether the
duration of the base and policy cases are similar.
A second key factor is the similarity between the pop-
ulation examined in the study and the population
affected, by the policy Key considerations include the
*s See, for example, Mitchell and Carson, 1989; Cummings et al., 1986; NOAA, 1993; Bjomstad and Kahn, 1996; NRDA, 1994; Diamond
and Hausman, 1994.
* The Cost of Illness Handbook will be available online.The website will be continuously updated as additional COI estimates are completed.
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Chapter 7: Benefits
baseline health status of the populations, the age of the
populations, arid other demographic characteristics.
f Evaluating plausibility: The analyst should con-
duct sonic initial checks to evaluate whether the study
case values are plausible or reasonable. For example,
if the estimated value of avoiding an acute, reversible
effect exceeds other reasonable estimated values for
avoiding long-term, chronic effects, then the value for
the acute effect is probably too large and will be diffi-
cult to defend. On the other hand, WTP values that
are less than cost-of-illness values for the same effect
are probably too low, particularly if the effect clearly
results in pain or otherwise impairs activity.
f Using the results of multiple studies: After
reviewing the quality and applicability of available
studies, the analyst can apply the valuation estimates
to the data on cases averted by each policy option.
Because the value of morbidity avoidance is difficult
to quantify precisely it is useful where possible to
apply estimates from more than one valuation tech-
nique. Where multiple studies are available that pro-
vide differing estimates, the range of values should be
presented with a discussion of the advantages and
limitations of the studies used. Estimates based sole-
ly on cost-of-illness values should be flagged as poten-
tially understating total values. WTP studies of health
effects that are similar in severity and duration may
be used as a point of comparison.
Addressing Uncertainty and Concerns
Available estimates of non-fatal effects may suffer from
several limitations. They may be derived from cost-of-ill-
ness methods that do not fully measure WTP to avoid the
effect or may be transferred from studies of effects that are
similar, but not identical to, the effect of concern. The
extent to which adjustments or new research are needed
to address these concerns will depend largely on the value
of new information to the decision-making process. If
morbidity values are a small component of total benefits
and unlikely to influence the choice among policy options,
then a qualitative discussion of uncertainly may be appro-
priate. Where morbidity values are a significant concern,
quantified sensitivity analysis and additional data collection
may be desired.
Some of the major sources of uncertainty are described
below. Because of the diversity of the health effects of con-
cern and of the studies used to value morbidity effects, this
discussion is relatively general. The limitations and poten-
tial adjustments or analyses of uncertainty that are appro-
priate will vary greatly depending on the approach used for
a particular policy analysis. More information on these
issues is provided in EPA's Non-Cancer Valuation
Handbook (EPA, 1999c).
0~ Ex and ex post valuation estimates:
Environmental contamination will generally not cause
an adverse health effect with certainty, but rather will
increase the probability that the effect occurs,
increase its severity given that it occurs, or both.
People are likely to value these changes in risk differ-
ently than they would value certain changes in health
status. While contingent valuation and other methods
can adopt an ex ante perspective and obtain esti-
mates for risk changes, many available studies pro-
vide ex post value estimates for morbidity effects. For
minor health effects this difference in perspective
may not be important, but for severe health effects
the difference may be significant and ex post esti-
mates may understate the benefits of a policy action.
Analysts should address this issue at least qualitatively
in these cases.
f Incomplete estimates of willingness to pay: The
widespread availability of health insurance and paid
sick leave shift the costs of illness from individuals to
others. While this cost-shifting can be addressed
explicitly in cosl-of-illness studies, it may lead to
problems in estimating total WTP through contingent
valuation surveys. If the researcher does not ade-
quately address these concerns, respondents may
understate their WTP, assuming that some related
costs will be borne by others.
f Timing of health effects: Environmental contami-
nation may cause immediate or delayed health effects
and the value of avoiding a given health effect likely
depends on whether it occurs now or in the future.
Recent empirical research confirms that workers dis-
count future risks of fatal injuries on the job; that is,
they are willing to pay less to reduce a future risk
than a present risk of equal magnitude (Viscusi and
Moore, 1989). In addition, a separate study conclud-
ed that individuals value policies that yield health
benefits in the present more highly than policies that
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Chapter 7: Benefits
yield the same benefits in the future (Cropper et al.,
1994).
7.6.2.4
Morbidity benefits valuation can be a difficult process,
often requiring careful judgment decisions by the analyst.
Whether the analyst is conducting original research that
supports the policy action or is drawing upon existing
studies, clarity and transparency in the analysis is vital.
When employing benefits transfer, some shortcomings in
the "fit" of the study case to the policy case is to be expect-
ed. Addressing these shortcomings explicitly, conducting
appropriate sensitivity analysis, and clearly stating assump-
tions can greatly enhance the credibility of the benefits
analysis.
7.6.3
Valuation
In estimating ecological benefits, one is generally forced to
value individual ecological service flows separately and
then sum these estimates rather than constructing prices
for changes in the structure and function of entire ecosys-
tems. Alternative approaches that estimate the total value
of ecosystems based on the replacement cost of the entire
ecosystem or its embodied energy (e.g., Costanza et al.,
1997; Ehrlich and Ehrlich, 1997; Pearce, 1998; Pimentel
el al., 1997) have received considerable attention as of
late. However, the results of these studies should not be
incorporated into benefit assessments. The methods
adopted in these studies are not well grounded in econom-
ic theory nor are they typically applicable to policy analysis.
Pearce (1998) contains a critical review of the total value
approach, as does Bockstael et al. (2000).
Although the economics literature is replete with benefit
studies, the coverage is patchy considering the broad range
of services and stressors addressed by EPA programs.
Especially rare in the literature are examples of wide-scale
changes, very small changes, or the consequences of long
term ecological and economic change. Ongoing research
has begun to address these data limitations. Examples
include recent contingent valuation studies undertaken for
purposes of natural resource damage assessments that
attempt to elicit WTP for marginal changes in long-term
environmental quality (Kopp et al., 1994). In addition,
Layton and Brown (1997) attempt to elicit from respon-
dents the value of one attribute of the long-term ecological
changes expected to be associated with climate change.
Awailable Methods for Estimating Ecological
Economists have employed a variety of methods to esti-
mate the benefits of improved ecological conditions.
Issues particular to their implementation for this benefit
category are discussed below.
f Market models: The benefit of changes in commer-
cial crop, timber, or fish harvests can be estimated
using a variety of available market models. Several
studies have assessed the social welfare implications
of changes in yields for a number of crop species.
For example, Taylor el al. (1993) apply the
Agricultural Sector Model and Kopp et al. (1985)
apply the Regional Model Farm Agricultural Benefits
Assessment Model to estimate welfare impacts of agri-
cultural yield changes. Adams et al. (1997) use the
Agricultural Simulation Model to estimate the eco-
nomic effects associated with yield changes resulting
from climate change.
When dealing with timber or fisheries, bioeconomic
models are designed to deal explicitly with time to
account for the fact that environmental and market
changes are not coincident. EPA has used the Timber
Assessment Market Model (TAMM) to estimate ozone
effects on commercial timber harvesting. The welfare
impacts of changes in commercial fish harvests have
also been examined, e.g., Alaskan king crab in
Greenberg et al. (1994); herring in Mendelsohn
(1993); and lobster in Wang and Kellogg (1988).
If changes in service flows are small, current market
prices can be used as a proxy for expected benefit.
For example, a change in the commercial fish catch
might be valued using the market price for the affect-
ed species. This approach can only be used in cases
where fishing effort and price are unlikely to be affect-
ed by the policies. If these conditions do not hold, a
market model should be applied to assess the effects
of increased catch rates on supply conditions and
market price, as discussed earlier in the section on
consumer and producer surplus.
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Chapter 7: Benefits
Production function approach: Values for indirect,
non-market benefits can be estimated when their
contribution to production processes are expressed
explicitly in a production function. As service flows
increase, the welfare gain is essentially the marginal
product of the service for small changes or is reflect-
ed by the shift in the marginal cost curve. Several
studies have examined the relationship between envi-
ronmental quality and crop production, such as
measurement of ozone impacts by Heck et al. (1983).
Moreover, researchers have applied this approach
using household production functions to examine
ecosystem services that benefit individuals directly or
to establish the link between some services and their
off-site benefits. Bell (1997) values wetland contribu-
tions to recreational fishing and Barbier (1994) val-
ues a range of indirect wetland benefits. Smith et al.
(1993) estimate the impact of nitrogen and pesticide
loadings on coastal water recreational fishing.
Averting behaviors approaches: One such
approach, the replacement cost method, uses pur-
chases of market goods to infer the value of indirect,
non-market services. Willingness to pay is revealed
by efforts made to substitute for services provided by
ecosystems. For example, since water treatment
infrastructure replaces wetland functions, investment
and operations and maintenance costs provide an
estimate of the value of the water filtration service
provided by wetlands. This method is justified only
when individuals are proven willing to incur such
replacement costs, through either their voluntary pur-
chases or their support for public works projects. If
so, the value of the service is at least as much as the
replacement cost.
Another variation on this theme applies to actions
that reduce the cost of complying with existing poli-
cies. For example, a reduction in atmospheric nitro-
gen deposition in the watershed of an estuary may
ultimately reduce the costs incurred, in reducing other
sources of nitrogen to the system, such as added con-
trols on POTWs. This approach is generally useful in
situations satisfying two criteria: alternative pollution
control methods are prescribed through existing poli-
cies and the new policies under consideration would
provide a lower cost method for achieving the desired
level of environmental protection.
Hedonic methods: Hedonic property models can
isolate the relationship between environmental quality
and housing prices from the effects of variation in
other attributes such as size, location, and security.
This method is often used to use to value regional dif-
ference in air quality. Smith and Huang (1995) con-
duct a meta-analysis to examine how well the models
perform in this context and discern a statistically sig-
nificant relationship between housing prices and air
quality measures in general. Hedonic models have
also been used, to estimate the impact of landfill clo-
sure (Kohlhase, 1991), nuisances from odors
(Palmquist et al., 1997), and the existence and reme-
diation of toxic contaminated sites (Eel, 1995) on
nearby properly values. Oilier applications have
addressed the costs of land-use restrictions (Parsons,
1992) and the benefits of water quality improvements
(Rich and Moffitt, 1982). A promising development
involves the application of hedonic methods in a
model of land-use change to explore the ecological
and economic consequences of landscape alteration
(Bockstael, 1996). In addition, Geoghegan et al.
(1997) estimate the impact of land uses adjacent to
and near one's home.
Recreation demand models: Recreation demand
models are discussed in detail in Section 5.2.1 of this
chapter. Recreation demand models are based on the
tradeoff between travel expense and environmental
quality. While early travel cost models dealt will) sin-
gle sites, did. not consider environmental quality, and
suffered from a range of limitations and biases, more
recent efforts overcome these problems. For exam-
ple, a travel cost model was used to estimate the WTP
by Chesapeake Bay beach users for a 20 percent
improvement in water quality as measured by nitrogen
and phosphorous loadings (Bockstael et al., 1989).
Random utility models have been used in a wide
variety of studies to estimate the recreational fishing
benefit of fresh water quality improvements.
Montgomery and Needelman (1997) apply a random
utility model to fishing behavior and estimate the
benefits of eliminating toxic contamination from New
York lakes and ponds. Recreation demand models
also have been used in the context of forest
management (Englin and Mendelsohn, 1991; Dwyer
et al., 1983). the ecological effects of natural resource
99
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Chapter 7: Benefits
damages (Bailsman et al., 1995; Morey and Rowe,
1995), health risks associated with fish advisories
(fakus et. al., 1997), and non-point source pollution
controls in estuaries (Kaoru et al., 1995).
f Stated preference approaches: As discussed earli-
er, stated preference methods represent the only
means of obtaining a value for non-use benefits. For
instance, research has tried to measure how much
better people feel that various wildlife species are alive
and well (Stevens et al., 1991). Individuals have also
expressed a willingness to pay to protect visibility in
national parks, whether or not they plan to visit these
parks (Crocker and Shogren, 1991). Contingent valu-
ation has been applied to the other ecological benefit
categories as well. EPA has regularly used the results
of one such study to value water quality improve-
ments in fresh water (Mitchell and Carson, 1986b).
in EPA (1997b) for an example that employs a. reduced
form economic model relating defensive expenditures to
ambient pollutant levels.
7.6.4
Market methods are the primary technique used to quanti-
fy benefits falling in this category Materials damages can
include changes in both the quantity of the materials and
in the quality. Linking changes in environmental quality
with the provision of service flows from materials can be
difficult because of the limited understanding of the physi-
cal effects (e.g., scientific information), the timing of some
effects (e.g., long-term), and risk responses of producers
and consumers of these service flows. When feasible,
assessment typically involves combining the output of an
environmental model with stressor-response function
and/or price information to estimate the impact of the
change in environmental quality on production (inputs) or
consumption (output) of the material service flows. The
market response to this impact serves as the basis for the
welfare change and benefits assessment. In practice, these
market methods may be implemented as reduced from
economic models that relate averting or mitigating expen-
ditures to ambient pollutant levels. The degree to which
behavioral adjustments are considered when measuring
the market response are important and models that incor-
porate behavioral responses are preferred to those that do
not. Refer to Adams and Crocker (1991) for a detailed dis-
cussion of this and other features of materials-damages-
benefits assessment. See the analysis of household soiling
100
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Chapter 7: Benefits
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Chapter 8: Analyzing Social Costs
8.1 Introduction
The goal of a benefit-cost analysis is to determine the
net change in social welfare brought about by a new
environmental policy, as measured by changes in the
producer and consumer surpluses. In general, the
economic effects of a new environmental policy
result in many different people and firms being
affected, both positively and negatively. The previous
chapter looked at the positive effects (or social bene-
fits). This chapter considers the negative effects (or
social costs). It is the sum of these changes, when
combined with the social benefits, that yield a meas-
ure of the net changes in social welfare.
As with social benefits, when computing the social
cost of a policy (i.e., the negative impact on social
welfare), monetary sums that measure changes in
individuals' welfare are all weighted equally in bene-
fit-cost analysis. Other methods for evaluating the
welfare consequences of policies on particular indi-
viduals, groups, or sectors should be examined using
either economic impact analysis, equity assessment
techniques, or social welfare functions (all described
in Chapter 9).
This chapter is organized into four major sections
followed by a concluding section. Section 8.2 reviews
the theoretical foundations of social cost estimation
for environmental policies. Section 8.3 discusses
how to estimate and model total social cost.1 Next,
four types of models for estimating social cost are
examined in Section 8.4. Then the estimation of the
costs of specific regulatory approaches is reviewed in
Section 8.5. Finally, Section 8.6 provides a discussion
of the choice of tools for each type of policy
8.2 The Theory of
Social Cost Analysis
The total social cost is the sum of the opportunity
costs incurred by society because of a new regulatory
policy; the opportunity costs are the value of the
goods and services lost by society resulting from the
use of resources to comply with and implement the
regulation, and from reductions in output. These
costs, however, do not take into account any of the
health, environmental, safety, or other benefits which
offset the social welfare costs.
The five basic components of total social costs are
listed here in the general order of relative ease of
estimation, and hence inclusion, in most social cost
analyses of environmental policies. They include:
f Real-resource compliance costs: These
direct costs are the principal component of total
social costs and are associated with: (1) pur-
chasing, installing, and operating new pollution
control equipment, (2) changing the production
process by using different inputs or different
mixtures of inputs, or (3) capturing the waste
products and selling or reusing them. (The last
two options can actually result in negative com-
pliance costs.)
These real-resource costs should also include
unpriced resources that have opportunity costs
associated with them, such as unpaid labor
diverted from other productive uses, and extra
administrative costs associated with compliance.
However, the pre-tax compliance costs do not
include any transfers, such as emissions taxes,
licensing fees, or subsidies (which are included
in the firm's private costs).
1 Several texts on applied microeconomics and policy evaluation provide substantially more theoretical depth and examples
than the overview presented in this chapter, such as Arnold (1995), Gramlich (1981), and Just et al. (1982).
Chapter
8
113
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Chapter 8: Social Costs
Government regulatory costs: These include the
monitoring, administrative, and enforcement costs
associated with new regulations. This also includes
the cost of setting up a new market when incentive-
based regulations are established, such as tradable
permits.
Social welfare losses: These are the losses in con-
sumer and producer surpluses associated with the
rise in the price (or decreases in the output) of goods
and services that occurs as a result of an environ-
mental policy.
Transitional costs: These include the value of
resources that are displaced because of regulation-
induced reductions in production, and the private
real-resource costs of reallocating those resources.
Offsetting these costs, in theory, are regulation-
induced increases in resource use in both primary
and related markets (e.g., more workers and equip-
ment are needed for pollution control).
Indirect costs: These other costs include the
adverse effects policies may have on product quality,
productivity, innovation, and changes in markets indi-
rectly affected by the environmental policy, all of
which may have impacts on net levels of measured
consumer and producer surplus.
8.2.1 An Illustration of Social
Costs and Externalities
Exhibit 8-1 illustrates an externality (pollution) associated
with the production of a good or service (Q). In this
figure:
f MR is marginal revenue from selling the good;
f MFC is the marginal private real-resource cost of
production;
f MSD is the marginal social damage from pollution
associated with production; and
f MSC is the total marginal social cost of supplying the
good.
The producer operates where marginal revenue (MR)
equals marginal private real-resource costs (MFC), so it
produces Qx items at a price of Pj per item. In this exam-
ple, the producer also is assumed to impose a social cost
on society due to pollution associated with its production
of Q. Here the actual pre-policy total social cost of supply-
ing the good is measured by the marginal private real-
resource cost (MFC) plus the marginal social damage
(MSD, also known as an externality) caused by pollution.
Together the MFC plus the MSD gives the true marginal
social cost (MSC) of supplying the good.
Exhibit 8-1 Producer and Consumer Surplus with an External Cost
MSC
MPC
Quantity
114
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Chapter 8: Social Costs
The producer surplus is indicated by the area, of triangle
PjGPj and the consumer surplus is measured as the area
of triangle P^P^ but the total social damage is indicated
by the area of P3GF P2. Therefore, the deadweight loss to
society (DWL) is equal to the area of triangle EFG. If pro-
ducers have to pay for the damage caused by the pollution,
their producer surplus is reduced to area of triangle P2HPi
minus the area of triangle IIGF. In this case the firm
would be making negative profits since the area of triangle
HGF is larger than their producer surplus. Net social wel-
fare in this case would be the area of triangle P2EP,j less
the area of triangle EFG (the deadweight loss).
If, however, the optimal amount of the product is pro-
duced (i.e., where MR equals MSC), then the firm's output
is Q* at a price of F*. In this case, consumer surplus is
equal to the area, of triangle P4EP* and producer surplus
is the area of triangle P2EP*. Since there is no deadweight
loss to society; net social welfare has increased and is
equal to the area of triangle P2EP4-
Suppose that producers can do nothing to reduce the pol-
lution damages other than decrease the amount of output
supplied. If the government places a tax equal to the MSB
on each unit of pollution, this would increase private pro-
duction costs (but not private real-resource costs) by the
amount of the MSD, which would cause a rise in con-
sumer (taxpayer) welfare. This occurs because of the
reduction in adverse health effects. Depending on the rev-
enue policy of the government, it could lead to a possible
reduction in consumer taxes, since producers are now
paying an additional tax (the double-dividend hypothesis,
which is described, in greater detail later in this chapter).
Although there is a decrease in the producer surplus (and
the obvious consumer surplus), the overall social welfare
has increased because of the reduction in the externality
costs.2 Adding all of these surplus changes together, and
subtracting the transfers to the government (i.e., taxes),
yields the net social cost of the policy.
If instead of an emissions tax, a firm is required to install
pollution control devices, the private compliance costs will
raise the firm's supply curve (or MPC) up by the amount
spent on the new equipment. Under a permit system.
where a set number of permits are issued for each unit of
pollution, and. firms are allowed to buy and sell these per-
mits, then each firm will consider buying permits if the
private cost of a permit is less than the unit cost of reduc-
ing pollution. Conversely, a firm that can reduce its pollu-
tion by less than the cost of a permit will consider selling
its "extra." permits. In both cases, the firms' MPC curves
will shift up by the price of the permits, just as it did in the
case of an emissions tax.
8.3 A
to
The challenge in developing an estimate of the social cost
of an environmental policy is to consider the market(s)
being affected by the policy, assess the available data and
analytic methods, and adopt an analytic approach that will
yield an estimate suitable for use in the benefit-cost analy-
sis. An important requirement in measuring social costs
is to characterize the supply and. demand, equations of the
regulated market or behavior. This section briefly reviews
the estimation of supply and demand equations and their
relevance to social cost, but concentrates on the variety of
social costs that may be encountered from different types
of environmental policies: (1) direct social costs, (2) tran-
sitional costs, and (3) indirect costs. Finally, some other
issues that arise in characterizing and presenting social
costs are examined, including discounting, difficulties in
monetizing costs, consideration of sensitivity analyses, and.
simplifying market effects.
the
of AH the
Empirical estimates of the supply and demand curves for
each market are usually needed to calculate the social
cos Is of proposed regulations and. policies. In addition to
private sources, government reports and academic studies
can provide useful information needed to estimate the
2 If the regulation causes social cosls to be greater than (he MSD, then net social welfare may adually fall because of the new regulation;
one cause being the diversion of investment capital to excess pollution control and away from its highest valued use.
115
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Chapter 8: Social Costs
supply and demand equations.3 Solving these equations
will yield equilibrium quantities and prices in each market
that approximate the baseline figures.
In most situations, the supply and demand functions can
be derived based on engineering cost estimates. For exam-
ple, a step-function demand curve for a particular good
can be computed based on the prices at which various seg-
ments of the market will turn to substitute goods. This
technique is relatively more successful for products that
are used as inputs to other processes and consumer goods
that have well-defined alternatives. Similarly, an estimate
of producer surplus can be derived based on the value of
plant and equipment dedicated to supplying a particular
good, and the ease or difficulty with which this capital can
be deployed in other markets to supply different goods. In
the long run, the supply curve is often assumed to be hor-
izontal.
Information on the elasticity of demand is available for the
aggregate output of most industries. When such informa-
tion is unavailable, as is often the case for intermediate
goods, the elasticity of demand may be quantitatively or
qualitatively assessed. Econometric techniques, such as
multiple regression, can be used to estimate a demand
curve when sufficient data are available. For example,
when dealing with intermediate products, econometric
models can be constructed using engineering cost data to
estimate both the supply and demand curves. In general,
econometric tools are frequently used to estimate supply
and demand equations and the factors that influence
them.
Information on the availability of product or service substi-
tutes, the impact of price increases on final goods (where
the product or service is an intermediate good), the
amount of a person's income devoted to the good or serv-
ice, and the necessity of the final product or service can be
used to qualitatively assess demand elasticities. The esti-
mate selected for the point elasticity should be consistent
with the equilibrium point (the time allowed for adjust-
ments to occur) used in the analysis.
Estimating the equations that govern market supply and
demand may be time and resource intensive, in addition
to the formidable tasks of developing the means to struc-
ture and compute the considered models. While many
types of markets have been researched in detail by the aca-
demic community, others may be too new to have much
information available. It may be difficult to obtain data
from the affected firms or industries because of confiden-
tiality provisions or the proprietary nature of some data
and models. Achieving sufficiently reliable results will
often depend on the quality of the data, and overcoming
problems with data will be a primary hurdle in many
social cost analyses.
8.3.1.1 Definition of
In general, economists use the term "elasticity" to refer to
the sensitivity of one variable to changes in another vari-
able.4 The price elasticity of demand (or supply) refers to
changes in the quantity demanded (or supplied) that
would result from a change in the price of a good or serv-
ice. Changes are measured assuming all other things,
such as incomes and tastes, remain constant. Demand
and supply elasticities are rarely constant and often change
depending on the quantity of the good. Therefore, when
calculating elasticities, it is important to state the price and
quantity of the good.
"Elastic" demand (or supply) indicates that a small per-
centage increase in price results in a larger percentage
decrease in quantity demanded (or supplied). How much
of the price increase that will be passed on to consumers
is determined by the elasticity of demand relative to supply
(as well as the degree of competition within the industry
and existing price controls). Ml other things equal, an
industry lacing a relatively elastic demand is less likely to
pass on costs to the consumer because increasing prices
will result in reduced revenues.
3 Sources can include trade publications, financial studies, and data collected through surveys administered in support of the regulation
(e.g.. Section 308 surveys administered under the Clean "Wkter Act for promulgation of effluent discharge limitations). Government agencies and the
private sector also publish data and studies on the economic activity of the public and private sector and households, A more complete listing of
examples is provided in Exhibit 9-3 on sources used to prepare economic profiles of industries. Additional illustrations can be found in existing EPA
economic reports, several of which are referenced later in this chapter,
* Own price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price,
Own price elasticity of supply is defined as the ratio of the percentage change in quantity supplied divided by the percentage change in price.
116
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Chapter 8: Social Costs
8.3.1.2 Of
Elasticity
Among the many variables that affect the elasticity of
demand are: (1) the availability of close substitutes, (2)
the percentage of income a consumer spends on the good,
(3) how necessary the good is for the consumer, (4) the
amount of lime available to the consumer to locale substi-
tutes, (5) the level of aggregation used, in the study, and
(6) the expected future price of the good. In this section,
only the first four will be discussed.
f The availability of close substitutes is one of the
most important factors that determine demand
elasticities. A product with close substitutes tends to
have an elastic demand, because consumers can
readily switch to substitutes rather than paying a
higher price. Therefore, a company is less likely to be
able to pass through costs if there are many close
substitutes for its product.
f Whether the affected product represents a
substantial or necessary portion of customers'
costs or budgets is another factor that affects
demand elasticities. When price increases occur for
products that represent a substantial portion of
downstream producers' costs or consumers' budgets,
these producers or consumers may be more likely to
seek alternatives. Where the product subject to the
price increase is less important in customers'
budgets, customers may be less motivated to use
substitutes (even if they are available) or to forego
consumption entirely. A similar issue concerns the
type of final good involved. Reductions in demand.
may be more likely to occur when prices increase for
"luxuries" or optional purchases than for basic
requirements.
f The time frame considered is a third important
factor in determining elasticity. Elasticities tend to
increase over time, as firms and customers have
more time to respond to changes in prices. A
company facing an inelastic demand curve in the
short run may experience greater losses in demand in
the long run, as customers have time to make
adjustments that allow use of substitutes or as new
substitutes are developed.
It is important to keep in mind that elasticities differ
at the firm versus the industry level. For example, if
twenty companies are producing pesticide formula-
tions that are equally effective, each firm may face an
elastic demand, curve because of competition within
the industry, although the industry as a whole may
face an inelastic demand curve for its products as a
group. In this example, it would not be appropriate
to use an industry-level elasticity to estimate the abili-
ty of only one firm to pass on compliance costs when
its competitors are not subject to the same costs.
8.3.1.3 of
Elasticities
The elasticity of supply depends, in part, on how quickly
costs per unit rise as firms increase their output. Among
the many variables that influence this rise in cost are:
f the availability of close input substitutes;
f the amount of time available to adjust production to
changing conditions;
f the degree of market concentration among producers;
f the expected future price of the product;
f the price of related inputs and related outputs; and
f the speed, of technological advances in production
that can lower costs.
Supply elasticities will tend to increase over time as firms
have more opportunities to renegotiate contracts and
change production technologies.
Characteristics of supply in the industries affected by a reg-
ulation can be as important as demand characteristics in
determining the economic impacts of a rule. For highly
elastic supply curves, it is likely that costs will be passed
through to consumers. The main determinants of indus-
try supply curves are the structure of costs and. the time
period of the analysis. Industry supply curves are defined
as the aggregation of the supply curves of individual firms
within an industry.
If detailed financial profiles of individual establishments or
categories of establishments and production data are avail-
able, they can be used to define an industry supply curve.
Explicit information on the cost structure of an industry is
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Chapter 8: Social Costs
very useful in predicting impacts more precisely than is
possible using industry average data. A given firm may
experience significant impacts if it is already a relatively
high cost producer. Such firms would be more vulnerable
to closure if subjected to high compliance costs.
8.3.1.4 Obtaining Supply
Elasticities
Elasticity estimates may be obtained from existing litera-
ture or from original research. The use of published esti-
mates avoids the time and expense of gathering the neces-
sary data. Sources for published estimates include previ-
ous agency rule makings or relevant studies found in the
economics literature. The analyst will have to employ
careful judgement in deciding whether and how to use
elasticity estimates from previous studies. Estimates
should be drawn from studies based on:
0~ similar market structure and level of aggregation;
f sensitivity to potential differences in regional elasticity
estimates;
f current economic conditions; and
f appropriate time horizon (i.e., short or long run).
This is not an exhaustive list of issues which must be con-
sidered in applying existing estimates to new analyses.
There are a. number of statistical and technical issues that
may influence the quality of elasticity estimates. Relevant
texts cited below should be consulted and technical assis-
tance sought when necessary.
New or original estimates of elasticities are derived from
demand and supply functions for goods or services that
have been estimated using econometric methods.
Econometrics is the use of statistical analysis in applied
economic research. For example, the demand for a good
or service is often estimated as a function of its price, the
price of related goods (substitutes and complements),
consumer demographic characteristics, as well as variables
that may represent institutional or technological character-
istics of a. market. Supply and demand elasticities may be
derived from a variety of functional forms that embody
various assumptions about the relationships between the
data. Methods of calculating elasticity estimates differ
according to the specification of the function. The analyst
should consult relevant texts and seek technical assistance.
The availability of sufficient data, both in terms of quantity
and quality, is the first threshold that determines whether
econometric tools can be used. Only with sufficient data
can elasticity estimates be considered reliable. The analyst
should carefully document data sources. Once the deci-
sion to employ econometrics is made, there are a number
of issues which the analyst must address, including the
choice of an appropriate modeling technique, proper func-
tional form, and ensuring that the mathematical proper-
ties required for the chosen technique to yield proper
results are achieved. For example, ordinary least squares
(OLS) requires that:
f values of independent variables are non-stochastic or
fixed;
0~ expected mean value of the error term is zero;
0~ expected value of the variance of the error term is
constant;
0~ no correlation exists between error terms; and
f no correlation exists between error terms and
independent variables.
If any of these conditions are violated, the analyst will have
to make a corrective adjustment to the OLS or consider an
alternative econometric technique. For example, if one of
the independent variables is endogenous, the first and last
condition will be violated, resulting in a biased and ineffi-
cient coefficient estimate. In the context of estimating a
demand function, the price variable is likely to be endoge-
nous, which would render the coefficient estimate and
derived elasticity incorrect. A method known as two-stage
least squares (TSLS) represents one means of accounting
for endogeneity. The number of potential econometric
approaches, mathematical requirements, and corrective
measures is beyond the scope of this guidance document.
.Analysts should consult relevant texts for a more thorough
discussion of all of these issues.5
' For detailed review of econometric modeling and technical issues see Greene (1996), Maddala (1992), or Pindyck and Rubinfeld (1991).
Kennedy (1998) provides a more intuitive discussion in the main text with detailed technical notes provided in appendices.
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Chapter 8: Social Costs
8.3.1.5
A "Uses and Substitutes Analysis" may provide useful infor-
mation on the characteristics of demand as a supplement
to or substitute for elasticity estimates.6 This is "...an in-
depth examination of each significant use of the substance
in question, and an assessment of the costs, performance,
and useful life of substitutes, on a product-by-product
basis."7 A "Uses and Substitutes Analysis" includes four
steps:
1) define markets and segments of markets that are rel-
atively homogeneous;
2) assess the cost and performance characteristics of the
products in question;
3) identify the most appropriate substitutes; and
4) estimate the incremental costs and performance
characteristics of the substitutes in each specific
application.
The results of the analysis can then be used, to generate
demand functions, based on the price at which substitute
products become economical for different uses. This
analysis can be time and information intensive and may
produce relatively crude results. 11 is nonetheless a useful
alternative to estimating demand functions when elastici-
ties are not available.
the
of
Having established measures of supply and demand, the
analysis then considers how equilibrium price and quanti-
ties will change from measured baseline conditions.
Social cost changes in each of the affected markets are
assessed by examining the direct, indirect, and transitional
effects that occur as a result of the new policy. The types
of social costs that need to be examined to determine how
the supply and demand equations change are summa-
rized, with examples in Exhibit 8-2. A short description of
direct costs, which include private and public compliance
costs, government regulatory costs, and other types of
social costs, is presented. Other social costs less routinely
included in empirical analyses of social costs, including
indirect costs and the transitional costs, are then reviewed.
8.3.2.1
The direct social costs of a new environmental policy arise
from: (1) changes in the private real-resource compliance
costs, (2) additional government regulatory costs, (3)
social welfare losses, and (4) transitional social costs. The
largest fraction of direct social costs arises from the real-
resource compliance costs due to the new regulation.
These new compliance costs arise from the installation,
operation, and maintenance of new capital equipment, or
are a result of changes in the production process that raise
the price of producing the good.
The additional compliance costs can be used to estimate
the new equilibrium price and quantity in the affected
markets which will change social welfare. However, these
changes will affect other markets, resulting in further price
and quantity changes in other goods, giving rise to addi-
tional changes in social welfare. The significance of the
changes in other markets will influence the type of model
necessary for the economic analysis (see Section 8.4,
"Modeling Tools"). Changes in social welfare also result
from increased government regulatory costs and transi-
tional costs from plant closures and unemployment.
f Private real-resource compliance costs can arise
from: (1) the capital costs associated with the
purchase, installation, operation, and maintenance of
new pollution control equipment, (2) changes in the
inputs or mixtures used, in the production process, or
(3) the capture of waste products that can either be
disposed of, sold, or reused.
Real-resource costs are theoretically straightforward
to calculate if they arise from the purchase of new
pollution control equipment. For example, having
information on the number of factories and the price
of purchasing and operating new equipment required
to meet a policy would provide a means of estimating
the compliance costs for the industry. However, since
all factories are not identical, costs may be estimated
based on cost studies of representative factories
' Uses and substitutes analysis is described in Arnold (1995).
'Ibid., p, 21.
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Chapter 8: Social Costs
chosen by random sampling procedures, which can
be extrapolated to the universe of affected factories.
Additional costs involve the operating expenses, main-
tenance, and training associated with the new equip-
ment. Further costs may occur from maintenance
changes in other equipment. Also, additional admin-
istrative costs may be associated with obtaining per-
mits and preparing required monitoring reports.8
In the two other methods of compliance, the private
costs may actually be negative and thus need to be
included for an accurate estimate of social costs.
When waste products are captured and then disposed
of, sold, or reused, the cost calculation is also
straightforward. Disposal charges are easily deter-
mined and the selling price of the waste product (if it
is used as an input for other goods) can also be
obtained. However, if the production process is
changed so that different inputs are used or the mix-
ture of the inputs is altered, the costs involved will be
difficult to determine before the change takes place.
In addition, the changes may be considered propri-
etary information.
Government regulatory costs are incurred by
federal, state, or local governments to administer and
enforce new policies. Government regulatory costs
include: administration, training, monitoring/reporting
(if they are not included in compliance costs),
enforcement, litigation, and the cost of developing and
distributing permits. These incremental costs must be
financed through additional taxation or other
governmental financing mechanisms.
Because they are hard to translate into producer and
consumer surplus terms, governmental administra-
tion and enforcement costs are typically examined in
terms of their dollar costs and staffing requirements
(expressed as full-time equivalent employment
(FTEs)). Ultimately, these costs are borne by taxpay-
ers unless other administrative costs are reduced to
accommodate a new policy. Since government costs
are usually small compared to the explicit compliance
costs, they are not usually included in partial
Exhibit 8-2 Examples of Social Cost Categories
Social Cost Category
Real-resource Compliance Costs
Government Sector Regulatory Costs
Social Welfare Losses
Transitional Social Costs
Examples
Capital costs of new equipment
Operation and maintenance of new equipment
Waste capture and disposal, selling, or reuse
Change in production processes or inputs
Maintenance changes in other equipment
Training/administration
M o n ito ri ng/re po rti ng
Enforcement/litigation
Permitting
Higher consumer and producer prices
Legal/administrative costs
Unemployment
Firm closings
Resource shifts to other markets
Transaction costs
Disrupted production
Source: Adapted from Harrington et al. (1999).
8 A good recent illustration of the measurement of compliance costs can be found in EPA (1997), Economic Analysis for the NESHAPSfor
Source Categories: Pulp & Paper Production; Effluent Limitations Guidelines, Pretreatment Standards: Pulp, Paper, and Paperboard Category,
Phase I. For useful empirical presentations on engineering approaches, see Vatavuk (1990) for air pollution controls and EPA (1984) for a wider vari-
ety of pollution control technologies.
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Chapter 8: Social Costs
equilibrium models. However, if they are significant,
they should be estimated separately and added to the
surplus-based social cost estimates.
Monitoring and enforcement costs, incurred by the
government, can be either (1) the opportunity costs
of other activities that are discontinued because of
fixed government budgets, or (2) the private costs
imposed on taxpayers to support the increased gov-
ernment expenditure necessary for the program. The
costs of government monitoring and enforcement
efforts are normally based on the cost of necessary
administrative activities.9
Social welfare losses occur when real-resource
compliance costs result in higher prices for the good
or service and. when additional government regulatory
costs result in higher taxes passed on to the
consumer. New regulations may lead to increased
legal and administrative costs for the government, as
well as for the regulated entities. The change in social
welfare resulting from an increase in taxes or fees
assessed in order to pay for government regulatory
costs will typically be small relative to social welfare
losses attributable to the real-resource compliance
costs.
If the imposition of real-resource compliance costs
leads to an increase in the price of the good, this will
lead consumers to either buy less or switch to substi-
tutes, thereby leading to a fall in the consumer sur-
plus. The amount of the private costs passed through
to the consumer is determined by the market struc-
ture, and the elasticities of demand, supply and
income. Once the prices, quantities, and elasticities
are known, the process of calculating changes in pro-
ducer and consumer surpluses is also theoretically
straightforward.10
Transitional effects vary depending on the length of
the time period examined; therefore, social cost
analyses should be explicit about the time frame
being studied. In the short run, the private
annualized costs of compliance, both for consumers
and producers, will be higher relative to the
annualized long-run costs. This is because the short-
run analysis will not provide for possible adjustments
in the production process, or allow consumers to find
substitutes. Some workers may become unemployed
in the short run, but will almost certainly find other
jobs in the long run.
However, over time the impact of a policy can easily
spread out to a variety of markets and result in a
number of unanticipated adverse effects. Therefore,
it is not always appropriate to assume that social costs
arising in the short run as a consequence of transi-
tional effects will be resolved in the long run. For EPA
economic analyses, the four transitional effects most
frequently considered include: (1) plant closings and
resultant unemployment, (2) resources shifting to
other markets, (3) transactions costs associated with
setting up incentive-based programs, and (4) disrup-
tions in production.
Firm closings and unemployment: In the simplest
static models, the lime frame is assumed to be a peri-
od of time in the near future (e.g., the first year after
a new policy is promulgated). Surplus-based meas-
ures of social cost are therefore short-run estimates.
But as time passes, adjustments are likely to occur.
Workers who suffer transitional unemployment will
usually find new jobs, and new plant and equipment
installed in the future might require relatively less
costly pollution control. These long-run changes
should be considered as the yearly social costs of a
policy are calculated into the future.
In most cases, involuntary unemployment and plant
closings are consequences that are difficult to model
using a conventional partial equilibrium framework
(which will be discussed in the following section on
modeling tools). Predicting these specific conse-
quences would require far more detailed analysis and
data than are usually available for practical assess-
ments. Unemployment rates for each group of work-
ers, the duration of unemployment, and the cost of
job training programs are just some of the factors that
" A useful illustration of the measure of government regulatory costs for a rale can by found in EPA (1995a), Economic Analysis of the
Title IV Requirements of the Clean Air Act Ammdments.
10 An example of the steps taken to estimate the measurement of social welfare losses from a rule is EPA (1998), Economic Analysis of
Effluent Limitation Guidelines and Standards for the Centralized, Waste Treatment Industry.
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Chapter 8: Social Costs
need to be taken into account when estimating how
the transitional costs decline over lime.
These temporary effects are typically assessed and
reported as part of an "economic impact" of the poli-
cy, and. are incorporated into the development of the
social cost section of an economic analysis. Chapter
9 of this document reviews such methods to assist in
detecting situations in which a policy's private costs
are sufficiently large to induce social costs from
occurring as a consequence of business closures,
reduced employment, or other such impacts.
Shifts of resources to other markets: These shifts
occur when the payments to factors of production
(labor, land, and capital) are reduced. These shifts
are partly responsible for the decreased output level
of the product or service. Those that remain earn
less than before, at least in the short run, which is
reflected in the lower net price received by producers
for the good or service. Some of the resources no
longer employed in producing this good or service
might even become unemployed for a while, such as
labor, or be permanently and prematurely scrapped,
such as plant and equipment. These and other real-
world phenomena can change the position and slope
of the supply functions in other markets. Likewise,
consumers of the product either pay more for the
same good or purchase substitutes that are less suit-
able or more costly, which can change the position
and slope of several demand functions. The analysis
of these types of effects is also treated more fully in
Chapter 9-
Transaction costs: These costs are encountered with
incentive-based policies, such as with a tradable per-
mits program. A market must be established so that
the efficiency gains from trading permits are maxi-
mized, and rules for trading are developed that
enable the market to function under the rules of per-
fect competition. Therefore, initial short-run costs
associated with setting up the market will be high, but
are expected to diminish over time as the created
market begins to function with less government over-
sight. The private cost of buying and selling permits
will then become similar to the purchase of any other
resource needed to produce a good or service.
Disruptions in production: This may take place when
new equipment is installed or new production
processes or inputs are applied. These costs can be
estimated as the amount of time the production line
is stopped or slowed down to allow for the necessary
changes to comply with the new policy regulations.
However, if the changes are made during previously
scheduled down-time or required maintenance, then
downward adjustments should be made to the esti-
mated costs to reflect this.
To conclude, in many cases transitional costs are consid-
ered to be small enough that their inclusion in the overall
social cost estimate would not appreciably alter the quanti-
tative conclusions. However, when these are expected to
be significant, the cosls should be estimated. For example,
lost wages and job search costs during the time workers
are unemployed can be used as a prow for this transition-
al social cost. Similarly, the value of prematurely retired
plant and equipment can be calculated and added to the
surplus-based social cost estimates to capture this transi-
tional effect, as long as this is not reflected already in the
supply and demand framework.
8.3.2.2 Equilibrium (Indirect)
Effects
Other possible components of social costs, such as effects
on product quality productivity; innovation, and market
structure, can require fairly complex dynamic models to
quantify. Although most individual regulatory policies will
not have such dramatic effects, these costs can be quite
significant in certain instances, such as when a policy's
requirements delay industrial projects or affect new prod-
uct development. Such policy effects have implications for
future social costs but are difficult to measure and express
in social cost terms. However, an effort should be made to
qualitatively describe these factors and look at approaches
that can quantify7 these effects when data and resources
can support this level of detailed analysis of social costs.
f Changes In market structure may occur if the
expense of pollution control is sufficiently high that it
drives out enough firms to cause changes in the
market concentration and competitiveness of firms
remaining in the industry. Such a change often
results in shifts of both firm and industry supply
curves, which can lead to changes in output and
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Chapter 8: Social Costs
prices in several markets affecting both producer and
consumer surpluses.
Labor and capital productivity may decrease
under new regulations. For example, the
administrative costs of monitoring emissions and
filing reports will) regulatory agencies may require
firms to hire more workers whose labor does not
increase productivity (as measured by labor employed
relative to produced output). Pollution control
devices or restrictions on the use of products may
cause lower levels of output relative to unconstrained
production processes. For example, placing
restrictions on pesticide use may reduce the yield of
crops susceptible to pest damage, holding other
factors of production (e.g., labor, fertilizer) constant.
In each case, however, private costs are captured by
changes in the supply and demand curves of the
product, and therefore care should be taken to insure
that social costs associated with productivity losses are
not double counted with other social cost estimates.
Discouraged investment may occur if research and
development funds are reallocated to meet additional
compliance costs. This may result in decreases in
technological innovation and product quality. The
latter can be modeled as the reduced amount
consumers are willing to pay for the low quality good,
relative to what they were willing to pay for the
original, higher quality good. In practice, changes in
technological innovations are not commonly analyzed
in most economic models used in benefit-cost
analyses of individual regulations and policies.
8.3.3 in
of
Four additional issues to note arise in the organization and
presentation of social costs, several of which have also
been raised earlier in this document in connection with
the measurement of social benefits. These issues dis-
cussed here on social costs include: (1) discounting, (2)
difficulties valuing some social cost categories, (3) con-
ducting sensitivity analyses, and (4) simplifying market
effects.
f Discounting: Social discounting procedures for
economic analyses are reviewed in considerable detail
in Chapter 6. For purposes of computing the social
costs of environmental policies, costs should be
discounted using the methods and social discount
rates discussed in that chapter. This is the case
regardless of the methods used to estimate social
costs. Social costs can be estimated in detail year-by-
year, or estimated using growth rates, or merely
assumed to be constant. These streams of social
costs can then be adjusted to yield: (1) discounted
present value, (2) future value, or (3) the annualized
cost of the policy. All three approaches are different
ways to express the same concept and choosing which
method to present the results will depend on the
method that most effectively allows comparisons
among the options and the measurement of net
benefits."
f Difficulties of valuing social costs: Some
consequences of environmental policies are difficult
to represent in the definitive, quantitative terms of
conventional social cost analysis. Irreversible
environmental impacts, substantial changes in
economic opportunities for certain segments of the
population, social costs that span very long time
horizons, socioeconomic effects on communities, and
poorly understood effects on large-scale ecosystems
are difficult to summarize in a quantitative benefit-
cost analysis. Some alternative techniques for
measuring and presenting these effects to policy
makers are reviewed in section 7.6.3 of the benefits
chapter that discusses measuring ecological benefits.
The relative significance of social cost categories that
are not quantified—or are quantified but not
valued—should be described in the analysis.
f Sensitivity analysis: The estimates in the social cost
analysis will not be known with certainty. In fact,
some data and models will likely introduce
substantial uncertainties into the estimations of social
costs. Numerous assumptions are made in regard to
" Many EPA analyses typically prepare an annualized cost estimate, since ttiis measure is one of several used, to determine whether rules
require additional review and oversight, and is used to help establish the scope of the economic analysis to be conducted (e.g., the social cost thresh-
old of $ 100 million in annual costs is used to identify rules that require a benefit-cost analysis under the provisions of EO 12866).
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Chapter 8: Social Costs
the baseline, predicting responses to policy, and the
number of affected markets. Therefore, the
conclusions drawn in the benefit-cost analysis will be
sensitive to the degree of uncertainty present and the
assumptions that were made. Reporting the
uncertainty of the data, the assumptions used, and
how the uncertainty and assumptions affect the
results are important components of the presentation
of social cost. Section 5-5 outlines the process of
analyzing and presenting uncertainty.
f Simplifying market effects: Given the complexity
of modern economies, measuring and predicting all
of the consequences of a particular action would
involve a significant effort. The central question
explored in this section is whether some or all
markets indirectly affected by a policy must be
analyzed to obtain a measure of social costs suitable
for a benefit-cost analysis, or whether the calculation
of social costs can be limited to an assessment of the
directly affected markets without introducing
unacceptable biases and errors into the analysis.
In general, the social cost of a policy can be measured
exclusively by changes that occur in the markets directly
targeted, by a policy as long as significant net changes in
social welfare are not generated in indirectly affected mar-
kets. If price changes in other markets generate both
gainers and losers among the producers and consumers,
then they may offset each other in a social cost analysis as
transfers.12 However, if there are strong reasons to believe
that conditions in other related markets might generate
important net social welfare consequences, these should
be examined. If a policy indirectly increases or decreases
the quantity of a good that is consumed, whose production
or consumption involves an externality, then this results in
net social welfare effects that may be worth considering
when calculating total social costs (and benefits).
8.4
The following section first focuses on the basic framework
common to all models used to estimate social costs, while
the remaining sections examine the models commonly
used: (1) direct compliance cost methods, (2) partial
equilibrium models, (3) multi-market models, and (4)
computable general equilibrium models.
8.4.1 The
Benefit-cost models must predict what actions firms are
likely to choose when attempting to comply with a new
policy and what the compliance costs of those actions will
be. Normally, these are based on engineering or process
cost models that examine firms' alternative compliance
methods. Engineering cost estimates typically specify the
capital, operating, and maintenance costs that are likely to
occur in adopting different pollution control strategies.
When possible, these initial engineering cost estimates
should include the expected level of compliance costs, as
well as reasonable lower and upper bounds for purposes
of sensitivity analysis.
In addition to the preliminary engineering or other esti-
mates of the social costs of various compliance strategies,
other costs may be significant, As noted earlier, for some
market-based approaches, transaction costs can often be
substantial. For example, when setting up the market for
a permit trading system, determining how many permits
to purchase or sell can involve detailed, cost modeling and
forecasting, in addition to the social costs associated with
operating the trading system. When these costs are likely
to be significant, they should be estimated in addition to
the basic private real-resource costs of capital and the
operating costs of alternative compliance methods.
In some cases, social costs are estimated using the direct
compliance cost method. This is the simplest approach
used in estimating social costs. Under this approach, the
social cost for a policy is simply set equal to the initial
engineering or other compliance cost estimates for the
compliance options the firms are likely to adopt; no addi-
tional modeling is undertaken. If only compliance costs
are calculated, the private (compliance) costs are likely to
12 This conclusion regarding the net social welfare implications of price changes in related markets requires some qualification. Even
when non-zero welfare effects are produced by price changes in related markets, they are likely to be small relative to the estimated producer and
consumer welfare effects in the directly affected markets. See Arnold (1995) for more discussion of related markets and welfare measurement.
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Chapter 8: Social Costs
be overestimated. This is because private costs are com-
puted for the pre-policy level of output under the implicit
assumption that there is no substitution away from the
affected products or activities into other relatively less
expensive ones. That is, firms do not make any capital or
labor adjustments in their production processes. In addi-
tion, when the resulting changes in consumer surplus are
calculated at the new higher prices, consumer welfare
losses are also likely to be overestimated since changes in
consumer behavior will not be taken into account.
Nevertheless, using direct compliance costs as an approxi-
mation of actual social costs may be reasonable for a poli-
cy when price and quantity changes are small, and there
are tew indirect effects. However, if consumers can easily
switch to substitute goods, this adjustment will make the
actual social cost of the policy significantly less than indi-
cated by the direct compliance cost estimates. Likewise, if
firms can find less costly substitutes for their inputs or
production processes, which have been made more expen-
sive by the new regulations, then compliance costs will be
an overestimate of the actual social costs.
8.4.3
Because of the limitations of using direct compliance costs
as a measure of social costs, an alternative approach is to
model the economic effects of these compliance costs on
producers and consumers using & partial equilibrium
supply and. demand model of the affected, markets. This
allows for a more complete analysis of social costs and
their incidence. "Partial" equilibrium refers to the fact
that the supply and demand functions are modeled for
just one or a tew isolated markets and that conditions in
other markets are assumed either to be unaffected by a
policy or unimportant for social cost estimation.
For example, it" using a partial equilibrium supply and
demand framework, a new environmental policy that
increases production costs will cause a change in the sup-
ply function. 'Hie demand function, the old and new sup-
ply functions, prices, and quantities can then be used to
compute changes in producer and consumer surpluses. If
the relevant markets are evolving over time, this technique
can be applied in each future time period using new sup-
ply and demand functions. This makes it possible to esti-
mate the changing distribution of social costs over time.
The practical difference between the results of the partial
equilibrium supply and demand-based modeling and the
direct compliance costs approach depends on the nature
of the policy and the magnitude of its effects. For small
compliance costs, price and quantity movements are likely
to be minimal, so the social cost estimates derived from
the partial equilibrium model framework will not be signif-
icantly different from the results obtained from the direct
compliance cost method.
For policies with larger compliance costs, price and quan-
tity movements could be more substantial. The estimated
social costs using the supply and demand framework in
these cases may be considerably less than those suggested
by the simpler direct compliance cost approach.
Moreover, policies that effectively ban products or activities
cause the loss of all producer and consumer surpluses in
these markets. Therefore, it is difficult to calculate social
cos Is of these policies without an explicit supply and
demand framework.
Analyzing the effects of a policy using a partial equilibrium
model of the directly affected markets is appropriate when
the ramifications in indirectly affected markels do not gen-
erate net social costs. It is also a. reasonable framework as
long as the social costs imposed by a policy are small and
do not significantly alter other markets or produce meas-
urable macroeconomic effects (e.g., changes in national
unemployment levels).
In most cases, a conventional partial equilibrium frame-
work comparing the pre-policy baseline with the expected
results of a new environmental policy will suffice for an
economic analysis. For analyzing environmental policies
that pose very large consequences for the economy, com-
putable general equilibrium modeling is an alternative
technique that is particularly useful and is discussed later
in this chapter.13
The partial equilibrium framework is a commonly used
theoretical tool for modeling and measuring the social
costs of environmental policies. In theory, a variety of
" Useful recent illustrations of partial equilibrium analyses prepared in support of environmental policies include EPA (1998) Economic
Analysis of Effluent Guidelines and Standards for the Centralized Waste Treatment Industry, and EPA (1996) Economic Impact Analysis of
Proposed NESHAPfor FlexiblePofyurethane Foam.
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Chapter 8: Social Costs
social costs can be observed and calculated using this
technique. Even transitional effects that result in short-
run social costs, such as premature capital equipment
retirement and relatively brief spells of involuntary unem-
ployment, can be modeled and estimated using this
framework. Thus, the approach offers a theoretically
sound, if limited, method for conceptualizing the conse-
quences of an environmental policy and measuring their
social costs.
Deriving the supply and demand functions is the founda-
tion of benefit-cost analysis and is necessary in all eco-
nomic models used to analyze social costs and benefits.
However, because of its importance and the uncertainties
associated with estimating supply and demand functions,
it may be useful to evaluate key assumptions with sensitiv-
ity analyses and develop a range of estimated social costs.
The typical analysis is performed assuming a competitive
market, although unusual circumstances may require
relaxing this assumption. Even should competitive market
conditions fail to hold, partial equilibrium analysis can be
adapted to analyze varying market conditions that may
more closely reflect real-world conditions. It is useful to
indicate when social benefits or social costs have been
overestimated or underestimated because of biases caused
by market distortions. However, the principles underlying
partial equilibrium analysis can serve as a useful model to
evaluate the real-resource costs of many of EPA's regula-
tions and policies.
As previously discussed in Section 5.6, "Emerging Cross-
Cutting Issues," environmental policies usually can be ana-
lyzed assuming a first-best regulatory setting, although
actual conditions reflect a second-best world in light of
taxes placed on a variety of goods and services. Therefore,
it is conceivable that a regulatory policy in one sector may
have effects in labor markets and other sectors of the
economy. Thus, examining costs in only the final
goods market may cause costs (or even benefits) to be
underestimated.
The scope of the regulatory program is likely to be propor-
tional to the effects experienced in oilier sectors of the
economy. Therefore, the larger the program, the more
important it is to examine several markets to accurately
estimate costs and determine (1) tax interaction effects,
(2) changes in technology, and (3) the effects on firms'
research and development decisions. Thus, multi-market
models are needed for regulatory policies that may have
large economic effects on several sectors of the economy.
Multi-market models go beyond partial equilibrium analy-
sis by extending the inquiry to more than just a single
market. Multi-market analysis attempts to capture at least
some of the interactions between markets. However,
unlike the general equilibrium models discussed in the
next section, multi-market models do not attempt to
incorporate a representation of the entire economy
An example of the use of a multi-market model for envi-
ronmental policy analysis is contained in a report prepared
for EPA on the regulatory impact of controls on asbestos
and asbestos products (EPA 1989). The model developed
for the study describes the interactions between the
asbestos fiber market and markets for the goods that use
the fiber as an intermediate input. The collective demands
for final goods that use asbestos create a derived demand
for asbestos fiber. The price of the fiber is determined
through the interaction between the demand and supply
schedules for asbestos. Changes in this price in turn influ-
ence the prices and demands for the downstream goods.
The specification of the links between the input and output
markets is especially important for simulating alternative
regulatory policies, including interventions in both the
input market (caps on the usage of asbestos fiber) and in
the output market (bans on some of the goods that use
asbestos as an input), as well as combinations of the two.
The model was then used to compare the efficiency losses
under various regulatory scenarios.
8.4.5
Analysis
Although the use of a partial equilibrium or multi-market
model may be appropriate when policies are likely to affect
a limited number of markets, they are not able to capture
interactions between a large number of sectors. Many
environmental policies, such as energy taxes, can be
expected to impact a large number of sectors both directly
where the policy is applied, and indirectly through
spillover and feedback effects on those and other sectors.
A strength of general equilibrium models is their ability to
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account consistently for the linkages between all sectors of
the economy. Three types of general equilibrium models
that have been used for the analysis of social costs are
input-output models, linear programming models, and
computable general equilibrium (CGE) models.
8.4.5.1 (I/O)
The central idea underlying I/O analysis is that in modern
economies, production activities are closely interrelated.
An input-output table represents the flow of goods and
services through the economy, usually measured as trans-
actions occurring over the course of a year. In addition to
the primary factors of capital, labor, and land, most pro-
ductive sectors use many different intermediate inputs. In
an 1/0 table, the column associated with a particular sec-
tor lists the value of the individual intermediate and pri-
mary inputs consumed by that sector. The row associated
with an individual sector lists the value of that sector's out-
put purchased as both intermediate inputs and final
demand. For each sector in a table, the column sum rep-
resents the total costs of production and the row sum rep-
resents total expenditure on that sector's output. A key
feature of I/O tables is that, by definition, for every sector,
total costs must equal total expenditures during the year."
An I/O table can be turned into a simple linear model
through a series of matrix operations. The intermediate
inputs matrix defines a matrix of technical coefficients,
based on the assumption that inputs to production are
consumed in fixed, proportions to output and. that there
are constant returns to scale. The model is manipulated
by making exogenous changes to the vector of final
demands. The model will then calculate how much of
each of the intermediate goods is required to produce the
new final demand vector. The sum of the intermediate
inputs required plus final demand, is equal to total output
for the year.
I/O models have a long history in environmental policy
analysis. Leontief (1970) showed how it was possible to
augment the basic I/O model with an additional set of
coefficients for pollution generation and/or abatement.
When a set of pollution coefficients has been defined, an
I/O model can then produce an estimate of the quantity of
pollution that would be generated along with a given
amount of final demand or total output. The quantity of
pollution generated may be specified, in either monetary
terms (as damages) or in physical units.
Some economic research firms use I/O models to provide
upper bound estimates on price effects. Others use I/O
models to look at the related markets and their potential
significance prior to adopting a partial or general equilibri-
um model. The I/O approach has also been extended fur-
ther to include non-market, ecological commodities such
as ecosystem services."
Although I/O models can be a useful as a consistency
check or a first-order approximation, they have a number
of shortcomings that limit their applicability as a predictive
tool:
f Given that prices are normally assumed to be fixed
and do not adjust to indicate scarcity, there is nothing
to ensure that the total demands generated by
manipulation of the model are consistent with the
actual productive capacity of the economy.
f The fixed coefficients assumption leaves no scope for
substitution of inputs in production.
f Since there is no producer or consumer behavior
built into 1/0 models, simulation of policy
interventions that would affect those agents is of
limited value.
f Because the construction of an input-output table is a.
costly and time-consuming process, usually requiring
a specialized survey the application of input-output
analysis to environmental policy making will normally
only be possible when an appropriate table already
exists. More importantly, since input-output tables
are used, in linear programming and computable
general equilibrium models, this last shortcoming is
shared by these models as well.
14 A general reference on input-output models is Miller and Blair (1985),
'' A discussion of the application of input-output models to environmental policy analysis, with a number of examples, is provided in
Chapter 7 of Miller and Blair (1985), Another example applied to the environmental protection industry is EPA (1995b), The U.S. Environmental
Protection Industry: A Proposed Framework for Assessment.
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Chapter 8: Social Costs
8.4.5.2 (LP)
Models
1/0 models are driven by exogenous changes in final
demand. Since they do not contain an objective function,
I/O models are difficult to use for decision making among
multiple alternatives. However, it is possible to extend the
basic I/O model into a LP model by incorporating an
explicit objective function and a set of inequality con-
straints.10
In addition to the usual economic variables, the objective
function may be specified to include a number of environ-
mental variables, such as the discharge of air or water pol-
lutants. The specification of multiple inequality con-
straints allows for a great deal of flexibility in the applica-
tion of LP model (because of this flexibility, EPA's Office of
Air and Radiation has used linear programming models
for many years). Shadow prices generated in the dual
form of LP models have a limited relationship to market
prices and may sometimes be useful as indicators of the
importance of the individual constraints. Sensitivity analy-
sis can be conducted by varying key parameters in the
model.17
The flexibility in the specification of LP models is also
something of a liability of the approach. The problem is
that the selection of the constraints used is often ad hoc
and may influence the model solution. As with many lin-
ear models, there is often a tendency towards unrealistic
solutions, such as excessive specialization in production or
trade. Finally, the lack of realistic consumer and producer
behavior is carried over from I/O models.
8.4.5.3
Equilibrium (CGE)
As discussed in the previous sections on I/O and LP mod-
els, these approaches have shortcomings that make them
less than ideal tools for policy analysis in modern market
economies. In particular, in both I/O and LP models, the
behavior of producers and consumers does not reflect the
independent optimizing behavior that is usually assumed
to be a characteristic of agents in a market economy.
Without the specification of realistic producer and con-
sumer behavior, model-based policy simulations will be
unable to correctly account for the reactions agents may
have to policies that impact them. Computable general
equilibrium (CGE) models incorporate more realistic
behavioral specifications of the agents into the model and
are thus able to provide a better laboratory for many types
of policy analysis. CGE models have been used to analyze
a wide variety of policy interventions, including issues in
public finance, international trade, development, and
increasingly, the environment.18
Most policies meanl to protect the environment, ranging
from those relying on market-based instruments, such as
effluent taxes, to command and control regulations,
induce changes in the behavior of consumers and produc-
ers. These changes may occur directly where the interven-
tion takes place or indirectly as the effects of the interven-
tion are passed through the economy. Because they focus
on both trying to model more accurately the expected
reactions of consumers and producers to policy interven-
tions and on the interactions between various actors in the
economy for some problems CGE models may be the
most appropriate tool for the analysis of social costs. CGE
models are particularly good at examining questions of
static resource allocation, such as the effects the imposi-
tion of a tax may have on sectoral output, income, and
employment. Under certain specifications, CGE models
may also be useful for assessing impacts on overall meas-
ures of economic performance, such as aggregate output,
employment, and various measures of welfare.
In almost all cases, CGE models start from the framework
and data of an input-output table, which provides a basic-
set of accounting identities for the production sectors.
Producers are assumed to maximize their profits through
their choice of productive inputs, typically labor, capital,
and intermediate goods, and sometimes land. Consumers,
16 The term linear programming actually refers to any applied mathematical programming exercise where an objective function is either
maximized or minimized subject to a set of inequality constraints and where all of the equations are linear. In this section, only general equilibrium
applications (i.e., those based on an input-output table) are discussed.
17 Linear programming models are discussed in Denis et at. (1982). A number of examples of the application of linear programming
models to environmental problems are given in Hufschmidt et al. (1983).
18 General references on CGE models include Denis et al. (1982) and Ginsburgh and Keyser (1997). Applications to environmental policy
are discussed in Wajsman (1995).
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Chapter 8: Social Costs
or in many cases a. representative consumer, are assumed
to maximize their utility by choosing their consumption
bundles, subject to a budget constraint. Although not usual-
ly specified as an optimizing agent, most CGE models also
include a government sector that collects a variety of taxes to
pay for its purchases of goods and services. The domestic
demand for imports and the supply of exports are determined
based on the relative prices of domestic and foreign goods.
CGE models may be categorized across a number of
dimensions. These can include (1) the method by which
the parameters of the model are specified (through cali-
bration or econometric estimation), (2) the time horizon
of the model (static or dynamic), and (3) the scope of the
model (single- or multi-country). Most CGE models are
calibrated to a single base year, which is assumed to be in
equilibrium. After the specification of a subset of elastici-
ties and other data obtained through a literature search
(or using informed judgments) the rest of the parameters
can be determined by working backward from a social
accounting matrix (SAM) for the base year.19 An alternative
to the calibration approach is econometric estimation.20
General equilibrium econometric estimation allows mod-
els to incorporate the representation of more sophisticated
producer and consumer behavior man would normally be
possible through calibration. However, econometric esti-
mation requires a consistent set of multi-sector time-
series data and this data is usually not available for devel-
oping countries.
CGE models can also be differentiated by the time horizon
of the analysis. The majority of CGE models are "static,"
meaning that no explicit dynamics are incorporated and
the time frame for the attainment of a new equilibrium
following a policy or external shock is indeterminate. In
conducting simulations, an exogenous shock is introduced
or a variable, such as a tax rate, is altered. The model is
then allowed to search for a solution until a new set of
prices is found which again equilibrates the system. The
new prices in turn determine a new set of factor demands,
outputs, and incomes. The values from mis new solution
are then compared with the values from the original equi-
librium. Dynamic models, on the other hand, incorporate
an explicit updating of lime dependent variables, such as
the labor supply, capital stock, technology; and demand
patterns. In conducting a simulation, a baseline case is
first run with a given set of assumptions about the time-
dependent variables. Next, an alternative or counterfactual
simulation is run with the same set of assumptions, but
with a policy or external shock. The values resulting from
the alternative solution are then compared with the origi-
nal baseline. These values may be compared at different
points in lime or discounted to estimate present values, or
to evaluate changes in welfare.
Mother dimension along which CGE models may be clas-
sified is by scope: (1) single country or single region mod-
els, (2) multi-country or multi-region models, and (3)
global models encompassing all countries and regions.
Although models representing a single country or region
are the most common, multi-country or multi-region
models are being developed in increasing numbers.
Because trade is inherently a multi-country phenomenon,
multi-country models are generally the best suited for
examining issues that involve the flow of goods, services,
and capital across national boundaries.
CGE models have been applied to an expanding array of
environmental policy issues. Most recently, they have been
used for the analysis of policies designed to avert or slow
global climate change, such as those proposed in the Kyoto
Protocol. Both single country and multi-country CGE
models have been used for these simulations, with multi-
country models able to assess policies like global emis-
sions trading. Because they are able to incorporate taxes
and other existing distortions, CGE models have been used
to explore the potential for a "double dividend"—a reduc-
tion in pollution plus a reduction in the inefficiencies of
the tax system—from substituting taxes on pollutants for
pre-existing taxes on output, income, or wages. In addi-
tion, CGE models have been used to perform retrospective
analyses of the economic costs of a number of environ-
mental regulations.21
19 References on social accounting matrices include Pyatt and Round (1985) and Chapter 10 of Sadoulet and de Janvry (1995).
20 This approach has been pioneered by Dale Jorgenson and a number of his collaborators. See in particular the papers collected in
Jorgenson (1998a, 1998b). Mother example of the use of the econometric approach is Hazilla and Kopp (1990).
21 For example, the Jorgenson-Wilcoxen dynamic CGE model of the U.S. was used to estimate compliance costs between 1970 and 1990 for
EPA's retrospective study of the benefits and costs of the Clean Air Act (EPA, 19971)). A previous CGE-based study by Hazilla and Kopp (1990) looked
at the costs of both the Clean Air and Clean Water Acts.
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Chapter 8: Social Costs
While CGE models have a number of advantages as tools
for policy analysis, they also have serious drawbacks:
f Although the costs have been reduced in recent years,
the construction of a CGE model can be still be time
consuming and expensive.
f In addition to an appropriate input-output table, a
considerable amount of data on national accounts,
trade, elasticities, and environmental externalities
must be collected and made consistent with the
sectors chosen to be part of the analysis.
f Dynamic models also require that forecasts be made
for many exogenous variables.
f Many environmental policies only affect a small part
of what may be a highly aggregated sector in an input-
output table. Sometimes it will be possible to
separate these smaller sectors out, but sufficient data
is often not available at that level of detail.
8.5
of
This section discusses the methods of estimating the social
costs for several alternative regulatory and nonregulatory
policy approaches, which are divided into three categories:
(1) direct controls, (2) incentive-based controls, and (3)
voluntary actions taken to reduce environmental risks.
The discussion focuses on the significant features of each
regulatory approach that must be examined in either par-
tial equilibrium, multi-market, or CGE models. In addi-
tion to the private compliance costs, transactions costs
may be significant. Therefore, the associated changes in
the prices of goods and services will alter producer and
consumer surplus and must be calculated to estimate the
total social costs.
Independent of the method used, the social cost analysis
should explain how the uncertainties and assumptions in
the data and models affect the results. Since much of the
data used is not known with certainty and many assump-
tions must be made to develop the necessary analytical
models, social cost estimates can never be known with
total certainty. Another difficulty is that private (compli-
ance) cost bounds in one project may be based on the
intuition of a single engineer, but the private cost bounds
in another sector may be developed based on adequate
data permitting the estimation of confidence intervals.
Aggregating these into a single study may conceal impor-
tant uncertainties rather than enlightening the decision
making process.22
8.5.1 (or
In general, direct or standards-based controls rely on dif-
ferent types of standards that mandate a level of perform-
ance intended to acheive an environmental objective.
8.5.1.1 Technology
Estimating the private compliance costs of standards-based
regulations is relatively straightforward compared to incen-
tive-based approaches. Technology standards often require
Best Available Technology (BAT) or Best Practicable
Technology (BPT). Since these technologies already exist,
their costs and the number of firms required to use them
are often well documented. Additional compliance costs
include expenditures on maintenance and training costs
associated with installing and. operating the equipment.
However, estimating the private compliance costs is not
always simple, especially for proposed regulations. For
example, unanticipated scaling effects, as well as unfore-
seen bottlenecks in construction and implementation may
occur, resulting in differences between the anticipated bids
for a project, the bids received, and. the actual construction
cost.
The private real-resource costs, when discounted over
time, correspond to the sum of investment costs and dis-
counted annual costs (operating and maintenance and.
other annual regulatory costs) that will be incurred by
firms to comply with the regulation. Thus, the real-
resource costs of regulation can be approximated, in most
instances, by methodologies routinely used by other EPA
'•' Another reason for variability of the compliance cost estimates for pollution control may be due to the way emission rates are character-
ized, their method of transport, and chemical transformation rather than variations in the price of pollution control equipment and labor costs.
130
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Chapter 8: Social Costs
program offices to evaluate compliance costs.
Furthermore, the supply and demand curves thai implicit-
ly lie behind such calculations need not be formally esti-
mated unless the effects of the regulation on price and
output are expected to be significant.
8.5.1.2
Regulations that limit emissions are usually targeted at
particular point sources or geographic regions, but there
also exist national standards such as ambient air and
water quality standards. For point sources, private compli-
ance cost estimates are usually based on the cost to pur-
chase and operate regulatory equipment needed to comply
with the regulations. This equipment will be similar to
that needed to meet technology standards. Since it may be
prohibitive to examine in detail each area and all its pollu-
tion sources, private social and compliance cost estimates
can be based upon random samples of representative
areas and industries. The survey should accurately reflect
the expected compliance costs for different categories and
sizes of industries in each area. In each of the three cases,
additional social costs are involved with monitoring and
enforcement of the regulations.
8.5.1.3 Production
The prohibition of a product or service results in shut-
downs, causing short- and, sometimes, long-term unem-
ployment, as well as the loss or premature retirement of
capital equipment. Therefore, adjustment costs should
include: (1) the value of wages temporarily or permanent-
ly foregone because of reductions in production levels in
the directly affected markets23 and (2) the social cost of re-
employing displaced workers (including the administrative
cost for transfer payment programs, but excluding the pay-
ment itself). Moreover, policies that effectively ban prod-
ucts or activities cause the loss of all producer and con-
sumer surpluses in these markets. Regulations also may
substantially affect secondary or linked markets. CGE and
multi-market models will account for these effects, but
partial equilibrium models will not do so unless a separate
model is used.
Some policies, although not explicitly banning production,
may be so stringent that the effect on production is the
same. In this case, the concept of compliance cost is less
applicable. For example, if the mandated environmental
protection controls would be so costly that the new equilib-
rium level of output is zero (because the consumers of the
good shift completely to substitutes and producers of the
good exit this market to produce other outputs), then it is
not possible to use compliance costs as an estimate of
social costs. A ban on producing this good would produce
a similar result.
In the case of an effective ban on production, the social
cost of the new policy is measured by the complete loss of
all producer and consumer surpluses in this market. The
real-resource cost in this case might be conceptualized as
the welfare change associated with the additional expense
and lower quality of the oilier goods that consumers pur-
chase as substitutes for their previous use of the product.
The appeal of incentive-based approaches is their potential
ability to achieve environmental improvement goals more
cost effectively than traditional standards-based methods.
The approaches examined here include: marketable per-
mits, emission taxes, bubbles and offsets, user charges,
product charges, subsidies for pollution reduction, govern-
ment cost sharing, refundable deposits, pollution indemni-
ty, and information and labeling rules. In many cases, sig-
nificant transfers will occur between private parties and
the government, but in most cases, these policies achieve
their greater economic efficiency through mechanisms
that encourage private parties to use information known to
them but not to the environmental authorities. Such
information may include differences in emission control
costs among different firms. Analyses of the social costs of
incentive-based approaches may require different informa-
tion and tools than those used to analvze more traditional
21 Lost wages, rather than lost production, is suggested as a proxy for (he value of displaced resources. In most cases, lost wages will cap-
ture most of the value of displaced resources because it is likely that inputs other than labor will be reallocated to other sectors of the economy fairly
quickly and at little cost.
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Chapter 8: Social Costs
policies. The task of calculating the exact compliance costs
of these policies is therefore more difficult.24
8.5.2.1
Permits are usually denominated in the amount of emis-
sions allowed and the number and denomination of per-
mits issued determines the aggregate amount of emis-
sions.25 Marketable permits establish the aggregate quanti-
ty of pollution allowed and allow the price of those entitle-
ments to vary. Since different polluters incur different pri-
vate costs to control emissions, they will be willing to pay
different amounts for permits. The price of permits, in
theory, will be established by the unit cost of control of the
marginal polluter. Marketable permits are traded between
emission sources, giving rise to a transfer among private
parties but not social costs.
In contrast to technology standards, incentive-based
approaches (taxes or permits) do not require any particu-
lar firm to install particular pollution control devices.
Therefore, it is usually necessary to predict what technolo-
gy will be used by the firms to meet the new regulations to
estimate costs. Under a marketable permit system, the
private costs of pollution control are estimated following a
three-step process:
f Calculate the demand and supply functions for the
permits (these demand and supply functions are
based on the costs of different sources' pollution
control options). Polluters will be willing to pay
prices for the permits up to the unit cost of reducing
emissions.
0" Estimate the equilibrium price for permits. This
price will determine which firms will install pollution
control measures and those which will purchase
additional permits.
f Calculate the real-resource cost of the regulation by
summing the investment costs and the present value
of operating and maintenance costs incurred to
reduce emissions. (The cost of the permits purchased
by firms is classified as an income transfer between
firms, not a social cost.)
Marketable permits may be sold at auction initially, in
which case the prices bid for the newly issued permits
again represent income transfers to the government.
Alternatively, permits may be allocated to sources by some
rule, in which case no private costs are imposed at the
outset. In neither case is the private cost of a permit
counted as part of the social cost, since it is not a real-
resource cost, but rather a transfer from one firm to
another or a transfer from a firm to the government. The
act of establishing the permit system and assigning proper-
ty rights to the distributed permits may result in some type
of "wealth transfer" taking place, which should be account-
ed for in the equity assessment of the benefit-cost analysis.
.As described earlier, the marketable permit systems
requires the creation of a functioning market. This results
in administrative costs and also additional enforcement
costs since it is necessary to ensure that emissions do not
exceed, the levels for which permits are held. Both need to
be added to the social cost estimate.
8.5.2.2
Estimates of the social costs of pollution control under
emissions taxes are virtually the same as those under mar-
ketable permits. Here however, the unit price of pollution
will be known (since it is set by the regulation) and does
not have to be calculated. Because the private cost of pol-
lution control varies among firms, firms with the highest
private costs of pollution control are expected to cut back
production and pay the tax on the remaining emissions,
rather than install required pollution control equipment.
Most often, firms will choose some combination of cut-
backs in production, installation of pollution control
equipment, and payment of the tax. However, as in the
case of most regulations, real-world limitations may
reduce the possible selection of cost-minimizing alterna-
tives chosen or firms may simply decide to engage in litiga-
tion to delay the regulation, which adds an additional cost.
•* However, after the policy is passed, compliance costs are much easier to calculate. In the case of emission taxes, cost-minimizing pol-
luters, in theory, will reduce emissions up to the point where the marginal cost of control equals the tax. Of course, these conclusions rest upon the
assumptions of perfectly competitive markets, low transactions costs, and complete information.
25 Permits may also be weighted based on the impact the pollutant has on air or water quality.
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Chapter 8: Social Costs
After the supply (or abatement cost) function for each firm
is estimated, then the equilibrium amount of pollution
generated can be determined. The new production levels
can then be calculated for each firm along with how much
pollution control equipment will be installed. Finally, the
real-resource costs and private costs are calculated as is
done above for marketable permits. However, here the
pollution taxes or charges may involve transfers of tax rev-
enues from the private sector to the government, but
because such fees accrue to the government, they are
again income transfers and should not be included in total
social costs.
8.5.2.3 and
Bubbles and offsets allow emissions to be averaged among
specific regions or among different sources within a partic-
ular facility. The resulting level of emission control must
be equivalent to or better than that required by existing
regulations. If "banking" is allowed, pollution credits can
be traded, across time—with potential offsets created, in
one period to be used in later periods. Bubbles and offsets
create incentives to reduce emissions in firms where the
private costs of control are relatively low. Compared with
direct controls, bubbles and offsets usually result in lower
compliance costs (relative to costs incurred, under technol-
ogy and emission standards).
Additional social costs associated with bubbles and offsets
are similar to those encountered with marketable permits.
Initial administrative costs may be significant and. some
additional enforcement costs for monitoring emission lev-
els also may be incurred. The private cost of the offsets
traded in a formal market are transfers between the cre-
ator and the user of the offset and are not social costs.
However, the transactions costs incurred to arrange the
trade, both private and public, are part of total social costs.
8.5.2.4
Charges may be imposed directly on users of publicly
operated facilities. Such charges have been imposed on
firms that discharge waste to municipal wastewater treat-
ment facilities and on non-hazardous solid wastes dis-
posed of in publicly operated landfills. User charges are
usually set at a level sufficient to recover the private costs
of operating the public system, rather than to create incen-
tives for reducing pollution. Measuring the total social cost
imposed by user charges is similar in concept to measur-
ing the social costs of emission charges, but is not always
based on a per unit charge of the pollutant.
8.5.2.5
Charges may be imposed, on intermediate or final products
whose use or disposal pollutes the environment. The pri-
vate and social costs imposed by product charges depend
on the extent to which users switch to substitutes, reduce
the rate at which the product is used by recycling or other
process changes, or continue to use the regulated prod-
ucts. Predicting responses and estimating compliance
costs is difficult and requires analysis of the social costs
and effectiveness of substitute products as well as the
social costs of recycling and reuse. Any charges paid, as a
result of continuing use represent private costs, but are
not social costs because these are borne by the consumer
who buys less of the more expensive product.
8.5.2.6 for Pollution
Reduction
Subsidies paid to polluters based, on their reductions in
pollution have the same general effect on behavior as
charges on pollution. Sources may reduce pollution up to
the point where the private costs of control equal the sub-
sidy. Using subsidies instead of charges shifts private costs
to the government. This may result in more sources con-
tinuing to operate than if a charge system were used.
Thus, subsidies and charges may not have the same aggre-
gate social costs or the same degree of pollution control.
Measuring the social costs resulting from a system of pol-
lution subsidies is similar in concept to measuring the
social costs resulting from pollution charges, except that
private costs are reduced by the amount of the subsidy,
rather than being increased by the amount of the fee.
Again, the subsidies themselves are income transfers and do
not constitute a social cost. Therefore, private real-resource
costs should be computed excluding the subsidies.
8.5.2.7
In addition to issuing the regulations described above, the
government may take actions to lower the private costs of
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Chapter 8: Social Costs
specific actions—most notably, by subsidizing investments
in pollution control equipment. These subsidies may take
the form of reduced interest rates, accelerated deprecia-
tion, direct capital grants, and loan assistance or guaran-
tees for pollution control investments. Such policies may
not by themselves induce changes in private behavior.
However, in conjunction with direct controls, pollution
fees, or other regulatory mechanisms, they may influence
the nature of private responses and the distribution of the
cost burden. In particular, such subsidies may encourage
investment in pollution control equipment, rather than
other responses that do not require capital investments
(e.g., changes in operating practices or recycling and
reuse).
Government cost-sharing subsidies reduce the private
costs associated with the resulting private investments.
However, social costs may arise if cost-sharing programs
lead to resource misallocations. Additional social costs will
result from administration of the subsidy program, but are
likely to be minor if the incentives are provided, through
the existing tax system. However, they may be significant if
new administrative structures are required.
8.5.2.8
Refundable deposits create economic incentives to return
a. product for reuse or for proper disposal, providing that
the deposit exceeds the private cost of returning the prod-
uct. Therefore, to predict the rates of return, the private
cost of returning products must be estimated.
Under a. refundable deposit system, compliance costs con-
sist of the resources (labor, equipment, and transporta-
tion) required to return the regulated product, and the pri-
vate cost of preparing products for reuse (if required), less
the cost of new products replaced by recycled products.
The private administrative costs of a. deposit system vary,
depending on where in the production-consumption cycle
they occur and from whom the deposits are collected.
Record-keeping requirements may also be a cost compo-
nent. For those that participate in a recycling/refund pro-
gram, the opportunity cost of the time spent sorting trash
is an important component, and the analysis must address
whether other behavior changes may be expected to take
place (e.g., whether consumers may adjust their con-
sumption of products marketed in recyclable containers).
The deposits themselves represent transfers from one
point in the production-consumption cycle to another and,
hence, are not social costs. These transfers are temporary
if the deposit is reclaimed, but permanent if it is not.
Enforcement costs are minimal since no standards have
been set and no laws are broken if the product is not
returned.
A government "buy-back" constitutes another type of
refundable deposit. Under this system, the government
either directly pays a fee for the return of a product or
subsidizes firms that purchase recycled materials. They
are equivalent to product deposits, except that the govern-
ment, rather than the purchaser, provides the deposit.
The government subsidy represents a transfer from the
government to the private sector, which offsets the private
costs of recycling products.
8.5.2.9 Pollution
Regulations that impose stricter liability on polluters for
the health and. environmental damage caused by their pol-
lution may reduce the transaction cosls of legal actions
brought by affected parties. Such regulations do not
impose additional social costs, but only shift the costs
from one party to another. However, this may induce pol-
luters to alter their behavior and expend real resources to
reduce their probability of being required to reimburse
other parties for pollution damages. For example, they
may reduce pollution, dispose of waste products more
safely, install pollution control devices, reduce output, or
invest in added legal counsel.
Other regulations may require firms to demonstrate finan-
cial ability to compensate damaged parties by posting per-
formance bonds that are forfeited in the event of damages,
by obtaining liability insurance, or by contributing to a
pool of funds to compensate victims. The administrative
and enforcement costs imposed by such requirements
represent the use of economic resources but are not
counted as part of the social costs because the funds used
to pay damages do not represent a use of resources, but
are transfers among private parties (between polluters,
insurers, and victims of pollution). Again, however, these
requirements are likely to alter private behavior and lead
to increased, outlays of real resources to reduce the proba-
bility of accidents, or reduce the probability of having to
pay using any of the methods cited above.
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Chapter 8: Social Costs
8.5.2.10 Information
Rules
Information or labeling rules may be applied to specific
substances or to certain contaminated locations. For
example, warning labels may be required for hazardous
substances that describe safe-handling procedures or
describe the risks posed by the product. Purchasers may
then switch to less damaging substitutes for some or all
uses or handlers of hazardous substances may be better
able to prevent damages. Posting information on contami-
nated locations gives potentially exposed parties the oppor-
tunity to avoid hazards—for example, contaminated dump
sites or drinking water aquifers.
Calculating the private costs of complying with information
and labeling requirements for particular cases is straight-
forward. Compliance costs include the cost of developing
the required information (analyzing the composition of
substances, monitoring and testing of sites, testing for
health damages, etc.) and the cost of disseminating infor-
mation (printing and applying labels, maintaining and
publishing information on sites).
Similarly, the direct costs of enforcing and administering
the requirements (including government review and
approval of labels) can be calculated directly. Calculating
aggregate private costs may be more difficult, however, if
the number of containers requiring labels or the number
of facilities affected is unknown. In addition, it is difficult
to predict responses by the recipients of the information
and, hence, the social cost of avoidance.
While there can be social costs associated with voluntary
actions taken to mitigate environmental polluting behavior,
it may be difficult to establish the relation between deci-
sions made by firms or individuals and the role EPA and
other regulatory agencies may play in inducing or con-
tributing to the adoption of these practices. EPA and other
regulatory agencies are looking to alternative nonregulato-
ry approaches in an effort to change behavior thai con-
tributes to health and environmental risks. Examples of
EPA programs of this type include the 33/50 program for
reduction of toxic pollutant discharges and energy conser-
vation and greenhouse gas mitigation measures, such as
ENERGY STAR and Climate Wise programs.26
A basic premise underlying social cost analyses is the
assumption that profit-maximizing firms undertake invest-
ment decisions, voluntary or otherwise, when it is in their
private interests to do so (i.e., where private benefits are
greater than private costs). If actions would not have
occurred absent EPA's involvement in these programs,
then there may be social costs (beyond those costs
incurred by EPA) that are associated with actions taken by
participants in the programs. Social costs may arise, for
example, from firms exhibiting strategic behavior in their
investment decision that incorporates expectations that
voluntarily participating in nonregulatory programs may
serve to reduce or delay promulgation of future, potentially
more stringent enforceable compliance standards.
Without some assessment of costs, it is difficult to estab-
lish whether a particular voluntary program is cost-effec-
tive in comparison with other policy actions. As a conse-
quence, it is useful to investigate the social costs associat-
ed with nonregulatory programs—quantifying how they
affect economic markets, and evaluating the relative eco-
nomic efficiency of these approaches as compared with
regulatory policies.
8.6
This chapter has reviewed the theoretical foundations of
social cost assessments as well as practical methods for
measuring the social costs of environmental policies.
Several key conclusions reached in this discussion are
worth reiterating.
First, in most cases, the social costs of an environmental
policy or other action can be measured with sufficient
accuracy by limiting the analysis to the directly affected
markets. This allows the analysis to focus on the sectors
that must comply with a policy. In these cases, the distur-
bances thai ripple outward from the directly affected mar-
kets to numerous other markets should have a minimal
effect on the estimation of social costs.
'" More information on the operations and objectives of these types of programs can be found in publications prepared by EPA's Office of
Reinvention and at the following website http://wwwepa.gov/reinvent/ (accessed 8/28/2000).
135
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Chapter 8: Social Costs
Second, a. conventional partial equilibrium depiction and
modeling of the directly affected markets will often be suf-
ficient to measure social costs. The detail and precision of
applying this approach in practice will depend on the avail-
ability of information, the resources devoted to the evalua-
tion, and the value to policy makers of improved accuracy
of the results.
Finally, other modeling techniques, such as CGE, are often
used to measure a variety of indirect costs, the many tran-
sitional effects of environmental policies, and, when they
are significant, transactions costs borne by private sector
entities. Nevertheless, the majority of the economic analy-
sis of environmental policies can employ the conventional
partial equilibrium modeling approach to evaluate social
costs of EPA policies and programs.
136
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Chapter 8: Social Costs
8.1
Arnold, F.S. 1995. Economic Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons, Inc.
Denis, K, J. de Melo, and S. Robinson. 1982. General Equilibrium Models for Development Policy. New York, NY:
Cambridge University Press.
Friedman, L. E. 1984. Microeconomic Policy Analysis.: New York, NY: McGraw-Hill.
Ginsburgh, V and M. Keyser. 1997. 'Ihe Structure of Applied General Equilibrium Models. Cambridge, MA: MIT Press.
Goulder, L. II. 1995. Effects of Carbon Taxes in an Economy with Prior Tax Distortions: An Intertemporal General
Equilibrium Analysis. Journal of Environmental Economics and Management 29: 271-297.
Gramlich, E. M. 1981. Cost-Benefit Analysis of Government Programs. Englewood Cliffs, NJ: Prentice-Hall, Inc.
Greene, W. H. Econometric Analysis. 1996. 3rd edition. New York, NY: Macmillian.
Harrington, W, R. Morgenstern and E Nelson. 1999- On the Accuracy of Regulatory Cost Estimates, Discussion Paper
99-18. Resources for the Future, Washington, D.C.
Hazilla, M. and R. J. Kopp. 1990. Social cost of environmental quality regulations: a general equilibrium analysis. Journal
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Hufschmidt, M. M, D. E.James, A. D. Meister, B. T. Bower, andj. A. Dixon. 1983- Environment, Natural Systems, and
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Press.
Just, R. E., D. L. Hueth, and A. Schmitz. 1982. Applied Welfare Economics and Public Policy, Englewood Cliffs, NJ:
Prentice-Hall, Inc.
Kennedy, E 1998. A Guide to Econometrics. 4th edition. Cambridge, MA: MIT Press.
Leontief, W 1970. Environmental Repercussions and the Economic Structure: An Input-Output Approach. Review; of
Economics and Statistics, (52)3.
Maddala, G. J. 1992. Introduction to Econometrics. 2nd ed. Englewood Cliffs, NJ: Prentice Hall.
McKibbin, W'J. and P J. Wilcoxen. 1995. The Theoretical and Empirical Structure of the G-Cubed Model. Brookings
Discussion Papers in International Economics, no. 118 (December).
Miller, R. E. and E I). Blair. 1985. Input-Output Analysis: Foundations and Extensions. Englewood Cliffs, NJ: Prentice-
Hall.
Morgenstern, R. D. 1997. Economic Analysis at EPA: Assessing Regulatory Impact. Resources for the Future,
Washington, D.C.
Nestor, D. V, and C. A. Pasurka, Jr. 1995. CGE Model of Pollution Abatement Processes for Assessing the Economics
Effects of Environmental Policy, Economic Modeling 12(1): 53-59-
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Chapter 8: Social Costs
Pindyck, R. S. and D. L Rubinfeld. 1991- Econometric Methods mid Economic Forecasts. 3rd edition. New York, NY:
McGraw Hill.
Sadoulet, E., aod A. dejanvry. 1995. Quantitative Development Policy Analysis. Baltimore, MI): The Johns Hopkins
University Press.
U.S. Environmental Protection Agency. 1984. The Cost Digest: Cost Summaries of Selected Environmental Control
Technologies. EPA/600/8-84-010, Office of Research and. Development.
U.S. Environmental Protection Agency. 1989- Regulatory Impact- Analysis of Controls on Asbestos and Asbestos
Products: Final Report. Prepared by the Office of Pesticides and Toxic Substances.
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U.S. Environmental Protection Agency. 1995b. The U.S. Environmental Protection. Industry: A Proposed Framework for
Assessment. EPA/230/R-95-011, Office of Policy, Planning and Evaluation.
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the Office of Air and Radiation and Office of Policy, Planning and Evaluation.
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Centralized Waste Treatment Industry. EPA/82 l/R-98-019, Office of Water.
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Chapter 9: Distributional Analyses:
Economic Impact Analyses and Equity
Assessments
9.1 Introduction
In an effort to fully understand a regulation's impact
and make an informed judgement regarding its
desirability, policy makers study many different regu-
latory consequences. Economic information is
important to the evaluation of at least two conse-
quences—a regulation's efficiency and its distribu-
tional consequences. In principle, both types of con-
sequences could be estimated simultaneously by a
general equilibrium model. In practice, for reasons
discussed in Chapter 5, they are usually estimated
separately.
A benefit-cost analysis (BCA) calculates the social
benefits and costs of an environmental policy and
answers the question of whether the benefits are suf-
ficient for the gainers to potentially compensate the
losers, leaving everyone at least as well off as before
the policy. Its calculation of net benefits helps ascer-
tain the economic efficiency of a regulation. Two
other ways to express economic information—an
economic impact analysis (EIA) and an equity assess-
ment—assess changes in social welfare by examining
the distributive effects of a regulation. An EIA focuses
on traditional classifications of affected populations1
(e.g., industrial sector classifications). Under the
heading of equity assessment analysts can address
broad concerns such as changes in the national dis-
tribution of income or wealth. In addition, an equity
assessment can provide information to decision mak-
ers on how policies affect specific sub-populations.
Disadvantaged or vulnerable sub-populations (e.g.,
low income households) may be of particular concern.
Economic Impact Analysis (EIA)
An EIA helps answer the questions, "Who are the los-
ers and gainers from a policy?" and "By how much
do they lose or gain?" Traditionally, EIAs have
focused on the losers and the negative impacts of an
environmental regulation. This focus is in response
to existing legislative and administrative statutes and
policies which direct analysts to examine the distribu-
tion of negative regulatory impacts or costs.
Currently, several of these same statutes and policies
call for a similar examination of the positive impacts
of a regulation.
Unlike a BCA which rests its conclusions exclusively
on comparisons of social benefits and costs, an EIA
examines the distribution of many different econom-
ic impacts. Conventional impacts include monetized
effects such as changes in profitability or in govern-
ment revenues, as well as non-monetized effects
such as increases in unemployment rates or num-
bers of plant closures. An EIA will often examine and
report on regulatory outcomes that a BCA would not.
For example, when measuring impacts on private
ilflfP™^!^!*.'-". •
1 The term "affected" is applied throughout the chapter in its most general use as an economic term. Analysts should be
aware of how the authorizing statute for the rule, as well as other applicable statutes and administrative orders noted in this chapter,
make more specific use of this term. For example, the Regulatory Flexibility Act includes the clause "subject to the requirements of the
rule" when quantifying economic impacts. This results in analyzing entities that are directly affected, so that conclusions can be drawn
as to the significance of impacts of the rule. Alternatively, provisions in UMRA and EO 12866 address both direct and indirect impacts, so
that the affected population of entities may be more inclusive than only those "subject to the requirements of the rule." For more infor-
mation, Chapter 8, Section 3 on "Social Cost Analysis" covers the economic concepts and terminology relevant to direct and indirect
impacts.
Chapter
9
139
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Chapter 9: Distributional Analyses
businesses, an EIA will include changes in transfer pay-
ments from firms to the public sector whereas a BCA
would not. Transfer payments become important when
analyzing the distributional consequences of a regulation.
To achieve the objective of an EIA and educate policy mak-
ers about who will lose or gain as a result of a particular
regulation, analysts have traditionally relied upon the
assortment of impacts described in Section 9.2 below.
Equity
Generally, assessments of equity examine a regulation's
impact on the distribution of national income or wealth.
Decision makers may use this information in conjunction
with economic efficiency measures as captured in a bene-
fit-cost analysis to evaluate tradeoffs between equity and
efficiency. For the most unified treatment, both equity and
efficiency issues can be addressed in a computable general
equilibrium model.2 In practice, data constraints will limit
analysts to undertake distributional analyses independently
from benefit-cost analyses.
As is true for an EIA, an equity assessment is generally
more concerned with sub-populations who experience net
costs or other negative impacts than with those who expe-
rience net benefits or positive impacts. An equity assess-
ment may consider effects on any sub-population, but it
should always consider the economic effects of a regula-
tion on disadvantaged or vulnerable sub-populations;
specifically, sub-populations who are physically susceptible
to environmental contamination, are less than fully capa-
ble of representing their own interests, or are economically
disadvantaged or vulnerable. Examples include children,
low-income or minority communities, and small business-
es, governments, and not-for-profit organizations. For
many of these sub-populations, EPA has been directed by
statute or policy to examine the effects of its rules when
they are expected to have a "disproportionate," "significant
and substantial," or other such impact.
An equity assessment draws on information and analytic
tools used in BCA and may report on impacts using meas-
ures found in an EIA. Therefore, an early step in an equity
assessment is to identify sub-populations likely to be
affected by a regulation. Once identified, if data permits,
the social costs and benefits estimated for the BCA can be
disaggregated and net benefits for the sub-population (s) or
the distribution of net benefits among sub-populations,
can be examined. An equity assessment may also examine
economic impacts, such as increases in rates of unem-
ployment or other traditional impact measures, for the
identified sub-population (s).
Consistency BCA and Distributional
Ensuring consistency in analytic design and interpretation
of results for the BCA, EIA and equity assessment support-
ing a particular regulation is essential. All three examine
impacts that, in principle, could, be estimated, by a. single
general equilibrium model (see Section 5.2). Both an EIA
and an equity assessment must be conducted following the
principles that frame a BCA, even if the formal preparation
of BCA is not undertaken. When a BCA is undertaken, to
the extent possible, both distributive analyses should adopt
the same set of assumptions used in the BCA. For exam-
ple, all three should rely upon the same set of baseline
assumptions and all three should assume the same values
for relevant elasticities. However, because all the informa-
tion needed to estimate distributive outcomes is often not
integral to the calculations performed in a BCA, in many
cases further assumptions must be developed specifically
for the EIA or the equity assessment. For example, new
assumptions regarding definitions of sub-populations must
be developed and there might be good reason to assume
different elasticities for different sub-populations. Even in
these cases, analysts should ensure that the implications,
if any of the added assumptions for the outcome of the
BCA are understood and made manifest to policy makers.
Using a Social We/fare Function to Evaluate
Efficiency-Equity
Potentially, a regulation's effects on distribution, analyzed
by its EIA and/or equity assessment, and its effects on
efficiency, analyzed by its BCA, can be incorporated into a
single social welfare function. A social welfare function
establishes criteria under which efficiency and equity
outcomes are transformed into a single metric, making
them directly comparable. A potential output of such a.
function is a ranking of policy outcomes that have different
aggregate levels and distributions of net benefits. A social
welfare function can provide empirical evidence that a
policy alternative yielding higher net benefits, but a less
1 Computable general equilibrium models are discussed in section 8.4.5.
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Chapter 9: Distributional Analyses
equitable distribution of wealth, is better or worse than a.
less efficient alternative with more egalitarian
distributional consequences.3
In practice, developing a universally acceptable social wel-
fare function is difficult because it requires explicit deci-
sions to be made about society's preferences for the distri-
bution of resources. Nonetheless, future research may
result in some feasible practical alternatives.1 These guide-
lines do not suggest a particular social welfare function or
that analysts attempt to use this approach at this time, but
the approach may merit further consideration as addition-
al research and applications develop.
This chapter begins with a brief discussion of an iterative
process between analysts and management to facilitate
thorough consideration of the output from distributional
analyses. The bulk of the chapter occurs in Section 9-2 on
Economic Impact Analysis which, after reviewing statutes
and policies that require examination of economic
impacts, describes methods for estimating economic
impacts that are relevant for both EIAs and equity assess-
ments. The final section of this chapter discusses the rela-
tively new distributional analysis, equity assessment.
Statutes and policies that require equity assessment, defi-
nitions of sub-populations, and a general framework for
conducting an equity assessment, including possible data
sources, are reviewed.
9.1.1 A for
Assessments
This section describes an iterative process between EPA
analysts and senior management5 as an integral part of an
EIA and an equity assessment. At several points of the reg-
ulatory development process, senior analysts should report
the results of distributional analyses to senior manage-
ment and receive feedback. Only through such ongoing
communication can senior management remain suffi-
ciently informed so that potential economic effects of pro-
posed environmental regulations receive proper attention
within the regulatory development process.
As discussed above, ensuring consistency between the EIA,
equity assessment, and BCA is critical. The methods and
results of an EIA and an equity assessment are inherently
linked to their corresponding BCA. Consequently con-
cerns regarding distributional outcomes that arise through
the iterative process that necessitate a change in the regu-
latory approach will also require adjustments to the
assessment of social benefits and costs.
This iterative process is not expected to add significant
additional administrative procedures to the current EPA
regulatory development process. Rather, its objective is to
bring greater attention to opportunities for the workgroup
and senior management to have ongoing communication
related to potential economic impacts and equity dimen-
sions of proposed environmental regulations. Frequent
and timely exchanges of information between senior man-
agement and the workgroup will focus greater attention on
affected sectors of the economy as well as affected sub-
populations and may influence the final regulatory alterna-
tive selected.
Information contained in Exhibit 9-1 illustrates such a
process. Its contents are consistent with the procedures
outlined in the document, Regulation Development in
EPA (EPA, 1997) and with the process for promulgating a
regulation illustrated by the flow chart in Guidance for
Analytic Blueprints (EPA, 1994). There are two key com-
ponents of Exhibit 9-1 that are designed to institutionalize
the iterative process between the workgroup and senior
management for EIAs and equity assessments. The first
component is an explicit incorporation of the identification
and analysis of economic impacts and equity dimensions
such as those listed in Exhibits 9-2 and 9-5 into the regu-
latory development process. The second component,
depicted by the arrows, is a process for initiating multiple
1 For more on the use of social welfare functions in policy analysis sec Sen (1970), Arrow (1977), andjorgcnson (1997). An empirical
application of this approach can be found in Norland and Ninassi (1998).
4 For a recent description of potential alternatives see Farrow (1998),
5 Senior management is used as shorthand for persons responsible for authorizing and using these forms of analysis. Most often, these
persons will include the Assistant or Regional Administrator of the lead office or region that is considering the regulation or other upper management
within that office or region.
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Chapter 9: Distributional Analyses
re-evaluations of a regulation during the development
process. This process includes three key tasks.
f Identify potentially important economic impacts
and equity dimensions for senior management
to help determine which may be of concern. This
should be done as part of the analytical blueprint
process. The analytic blueprint provides an opportu-
nity for early identification of important issues in
order to enhance the quality of information provided
to senior management to assist in decisions for a par-
ticular regulation or policy. While required for Tier 1
and 2 regulations, analytic blueprints are encouraged
for Tier 3 regulations as well.
f Conduct a preliminary analysis of these eco-
nomic impacts and equity dimensions once sen-
ior management has approved the analytic blueprint.
This is the second point where the iterative process
affects a regulation's development. Analysts should
share the results with senior management who
should then determine whether to proceed to a more
detailed analysis or to revisit the preliminary analysis.
Senior management may even decide to alter the
overall regulatory approach being considered which
could require revising the BCA as well as the analytic
blueprint. The potential need to revise the analytic
blueprint is consistent with the idea that it is a living
document.6
Develop options and prepare detailed economic
analysis after the preliminary analysis is complete.
Data and information developed as part of this effort
will provide input for conducting distributional analy-
ses for the impacts and dimensions identified earlier.
Here is the third point where the iterative process
comes into play. It is recommended that input from
senior management be sought once more before pro-
ceeding to closure. Additional economic impact and
Exhibit 9-1 Flow Chart: A Process for Economic Impact Analyses and Equity Assessments
Tier Assigned &
Workgroup Members
Identified
Non-approval
Non-approval
Early Guidance
from
Senior Management
Workgroup Prepares
Analytic Blueprint and
Identifies Potential
Economic Impacts and
Equity Dimensions
Senior Management
Reviews Analytic
Blueprint
Approval
Workgroup Conducts
Preliminary Analysis and
Analyzes Economic
Impacts and Equity
Dimensions
Senior Management
Reviews Preliminary
Analysis
Approval
Non-approval
Workgroup Develops
Regulatory Options and
Analyzes Economic
Impacts and Equity
Dimensions
Senior Management
Reviews Detailed
Analyses
Approval
Alternatives Selection
Workgroup Prepares
Rule, Draft Policy, etc.
Workgroup Closure
OMB Review
Administrator's Signature
Federal Register
Publication
' For a detailed discussion of the concept of the analytic blueprint as a living document and more information on the "Tiering" of rules,
see pp. 12-13 Guidance for Analytic Blueprints (EPA, 1994) and see section 5, p. 31 Regulation Development in EPA (EPA, 1997).
142
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Chapter 9: Distributional Analyses
equity analysis may be warranted for a variety of rea-
sons including new insights gathered from the regula-
tory review process.
9.2
9.2.1 to
As discussed in Chapter 5 above, a BCA calculates the total
social benefits and total social costs associated with an
environmental policy and measures the change in overall
economic efficiency. As part of the effort to inform policy
makers, it is important to not only understand the change
in economic efficiency, but to understand the distribution
of negative and positive impacts associated with this
change. An EIA contributes to this understanding. It iden-
tifies losers and gainers from a policy and estimates the
magnitude of their gains and losses. An EIA does this by
studying the economic changes occurring across broadly
defined economic sectors of society such as industry, gov-
ernment, not-for-profit organizations, and consumers. In
addition to these broad categories, an EIA will examine
more narrowly defined sectors within these broad cate-
gories such as the solid waste industry or an individual
solid waste company. Traditionally, EIAs have focused on
the losers and the negative impacts of an environmental
regulation, although at least two general directives (see
Exhibit 9-2) suggest that the positive impacts be examined
as well.
EIAs measure impacts in different ways, from direct
impacts on private business—including individual plants,
whole firms, and industrial sectors—to indirect impacts
on customers and suppliers. EIAs also measure direct and
indirect impacts on governments and not-for-profit entities
such as schools or hospitals. Impacts include changes in
profitability, employment, prices paid by consumers, gov-
ernment revenues or expenditures, trade balances, and
other changes of interest to policy makers.
Ensuring consistency of the EIA with the BCA for a particu-
lar regulation is essential. For consistency, an EIA must be
conducted within the analytical bounds of its correspon-
ding BCA. To the extent possible, the EIA should adopt the
same set of assumptions used by the BCA. Adjustments or
additions to these assumptions or to the overall modeling
framework used for the BCA should be made only when
they help bridge the difference between social and private
perspectives, such as the difference between the social cost
of a regulation and private compliance costs.
EPA's programs and regulations vary greatly in the types of
parties affected and the nature of economic impacts that
may be important. The data, available for analysis vary
widely as well. Thus, while specific methods for estimating
impacts are reviewed, it is expected that every EIA will
focus on the particular issues associated with the set of
regulations under review. The general methods outlined
here should be adapted to fit the needs of a particular
analysis.
The remainder of this section is divided into twelve sub-
sections. The first outlines the statutes and policies that
direct EPA, and other government agencies, to study the
distribution of positive and negative impacts. The second
gives a broad overview of models for estimating social
costs and how such models might relate to distributional
analyses. In the third section, we begin explaining how to
assess economic impacts. We begin with the first step,
which is to calculate compliance costs. The next steps—
how to screen for significant impacts and how to profile
affected entities—are outlined in the fourth and fifth sec-
tions. Finally, beginning in Section 9-2.7, we review meth-
ods for estimating specific impacts, in the following order:
impacts on prices; impacts on production and employ-
ment; impacts on profitability and plant closures; impacts
on related industries and consumers; aggregate impacts
on innovation, productivity, and economic growth; impacts
on industry competitiveness; and impacts on governments
and not-for-profit organizations.
and
of
There are at least two general administrative laws or orders
that direct analysts to examine economic impacts; each is
reviewed below. Some parts of environmental statutes also
require consideration of economic impacts. Relevant quo-
tations from a selection of these are presented.
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Chapter 9: Distributional Analyses
9.2.2.1 or
Orders
At least one statute—The Unfunded Mandates Reform Act
of 1995 (UMRA)—and one executive order--EO 12866,
"Regulatory Planning and Review"—require agencies to
analyze various economic impacts of regulatory actions.7
These directives require analysts to report on economic
information that does not directly concern the net benefits
tests for efficiency in a BCA. The first calls for analysts to
examine the distribution of benefits and costs across dif-
ferent sectors of the economy. The second, directs that cer-
tain outcomes be examined, such as changes in unem-
ployment rates. For each policy Exhibit 9-2 gives the
dimensions for which impacts are to be analyzed and the
corresponding analytical requirements. A discussion of
these requirements follow the table.
As outlined by Exhibit 9-2, UMRA requires analysts to
examine the costs, benefits, and budgetary effects of regu-
latory actions as experienced by state, local, and tribal gov-
ernments; regions; urban or rural or other types of com-
munities; or particular segments of the private sector. For
the national economy, UMRA suggests many impacts that
must be examined, including effects on productivity, eco-
nomic growth, full employment, creation of jobs, and
international competitiveness. These requirements apply
only to rules that include federal mandates "which may
result in the expenditure by state, local, and tribal govern-
ments, in the aggregate, or by the private sector, of $100
million or more in anv one year."8
Exhibit 9-2 also briefly summarizes relevant parts of guid-
ance from the Office of Management and Budget for EO
12866" (OMB, 1996 or Best Practices) and Guidelines to
Standardize Measures of Costs mid Benefits and the
Format of Accounting Statements'0 (OMB, 2000 or OMB
Guidelines), The Best Practices suggests that analysts
examine the distribution of impacts across various sectors
of the economy: "Information on distributional impacts
related to the (regulatory) alternatives should accompany
the analysis of aggregate benefits and costs."11 In the OMB
Guidelines, the focus for a distributional analysis is placed
on those sectors that are likely to feel substantial impacts:
"If these distributive effects are important, you should
describe the effects of various regulatory alternatives quan-
titatively to the extent possible, including their magnitude,
likelihood, and incidence of effects on particular groups."12
The Best Practices also states, "The term 'distributional
effects' refers to the description of the net effects of a regu-
latory alternative across the population and economy,
divided up in various ways .. ."" This clearly suggests thai
both positive and negative impacts are relevant.
OMB cautions analysts conducting distributional analyses
to recognize that transfer payments will become relevant,
to avoid double-counting even when mixing monetized and
physical effects, and to describe distributional effects with-
out judging their fairness.
"Since generally accepted principles do not exist
for determining when one distribution of net
benefits is more equitable than another, you
should describe distributional effects without
7 EO 13132, Federalism which took effect on November 2, 1999, and EO 13084, Consultation and Coordination With Indian Tribal
Governments which took effect on August 12, 1998, both support (he objectives of UMRA.
8 UMRA § 202.
' U.S. Office of Management and Budget's Economic Analysis of Federal Regulations Under Executive Order 12866, January 11, 1996,
This "Best Practices" document can be found at the U.S. White House, Office of Management and Budget website:
http://www.whitehouse.gov/OMB/inforeg/riaguide.html under the section titled "Regulatory Policy" (accessed 8/28/2000).
10 U.S. Office of Management arid Budget's M-00-08 Guidelines to Standardize Measures of Costs and Benefits and the Format of
Accounting Statements, March 22, 2000. The OMB Guidelines serves to implement Section 638(c) of the 1999 Omnibus Consolidated and
Emergency Supplemental Appropriations Act and Section 628(c) of the Fiscal Year 2000 Treasury and General Government Appropriations Act. They
require OMB to issue guidelines to help agencies estimate the benefits and costs of Federal regulations and paperwork and summarize the results of
the associated analysis. The OMB Guidelines can be found at the U.S. White House, Office of Management and Budget website: http://www.white-
house.gov/OMB/memoranda/index.html under the section titled "Selected Memorandum to Heads of Federal Departments and Agencies" (accessed
8/28/2000).
" Best Practices, p. 10.
12 OMB Guidelines, p. 16.
13 Best Practices, p.23.
144
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Chapter 9: Distributional Analyses
Exhibit 9-2 Economic Impacts Required by General Administrative Law or Order14'15
General Administrative
Law or Order
Dimension
Analytical Requirements
UMRA
State, local, and tribal
governments; the
private sector
Qualitative and quantitative assessment of anticipated
costs and benefits of the federal mandate, including costs
and benefits to state, local, and tribal governments or the
private sector.
Geographic location
Estimates of any disproportionate budgetary effects of the
Federal mandate upon any particular regions of the nation
or particular state, local, or tribal governments; urban or
rural or other types of communities; or particular
segments of the private sector.
National economy
Estimates of the effect of the federal mandate on the
national economy, such as the effect on productivity,
economic growth, full employment, creation of productive
jobs, and international competitiveness of U.S. goods and
services.
OMB Guidance for
EO 12866 and
Accounting Statements
Population and
economy, divided
up in various ways
(e.g., income groups,
race, sex, industrial
sector)
An economic analysis (EA) should describe the net effects
of a regulatory alternative across the population and
economy.
"Irrespective of the presentation of monetized
benefits and costs, the EA should present available
physical or other quantitative measure of the effects of
the alternative actions to help decision makers
understand the full effects of alternative actions."16
judging their fairness. You should describe these
effects broadly, focusing on large groups with
small effects per capita, as well as on small
groups experiencing large effects per capita. You
should also note any equity issues not related to
the distribution of policy effects if they are impor-
tant, and describe them quantitatively to the
extent you can."17
9.2.3 Models for Assessing
Economic Impacts
As noted above, the analytic methods used for a distribu-
tional analysis of a particular regulation should be consis-
tent with those used for the corresponding BCA. This sec-
tion returns to the four methods for estimating social costs
covered in Chapter 8, adding more insights on their appli-
cation to distributional impacts.18 The most sophisticated
method—computable general equilibrium (CGE)—is
14 Exhibit 9-2 does not include a discussion of The Regulatory Flexibility Act of 1980 (RFA), as amended by the Small Business Regulatory
Enforcement Fairness Act of 1996 (SBREFA), as they are discussed below in Section 9.3, "Equity Assessment."
15 The Office of Regulatory Management and Information's Rule and Policy Information Development System (RAPIDS)
http://intranet.epa.gov/rapids (accessed 8/18/2000, internal EPA document) is a resource for EPA personnel who wish to read relevant statutes, execu-
tive orders or Agency policy documents in their entirety or to acquire copies.
16 Best Practices, p. 23.
17 OMB Guidelines, p. 16.
18 For additional information regarding the four methods for estimating social costs see Section 3 of Chapter 8.
145
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Chapter 9: Distributional Analyses
treated first and moves to less complex approaches, con-
cluding with direct compliance costs.
9.2.3.1
Equilibrium
A CGE framework can be used to describe the effect of a
particular policy on overall measures of economic per-
formance, such as aggregate output, welfare, and the level
of employment. CGE models are particularly effective in
assessing static resource allocation and welfare distribu-
tion effects. These include the allocation of resources
across sectors (e.g., employment by sector), the distribu-
tion of sectoral output, the distribution of income among
factors, and the distribution of welfare across different
consumer groups, whole regions, and countries. By con-
struction, the basic capacity to describe and evaluate these
sorts of distributional impacts exists to some extent within
every CGE model. More detailed impacts, or impacts of a
particular kind, will require a more complex and/or tai-
lored model formulation (and the data to support it).
The simplest CGE models generally include a single, repre-
sentative consumer, a few production sectors, and a gov-
ernment sector, all within a single-country, static frame-
work. Complexities may be specified for the model in a
variety of ways. Consumers may be divided into different
groups along the lines of income, occupation, or other
socioeconomic criteria. Producers may be disaggregated
into dozens, or even hundreds, of sectors, each producing
a unique commodity. The government, in addition to
implementing a variety of taxes and other policy instru-
ments, may produce public sector outputs, provide a pub-
lic good, or run a deficit. CGE models may be internation-
al in scope, consisting of many countries or regions linked
by international flows of goods and capital. The behavioral
equations that characterize economic decisions may take
on simple or complex functional forms. The model may
be solved dynamically over a long time horizon, incorpo-
rating inter-temporal decision-making on the part of con-
sumers or firms. This will have implications for the treat-
ment of savings, investment, and the long-term profile of
consumption and capital accumulation.
9.2.3.2
CGE modeling captures multiple effects of a given policy
change throughout an entire economy and can provide
comprehensive distributional information across economic
sectors (e.g., employment by sector). A CGE model may
not be feasible or practical to use as a consequence of lim-
ited data and resources or when the scope of expected sig-
nificant market interactions is limited to a subset of eco-
nomic sectors. In such instances a multi-market analysis
can be adopted as an alternative to a CGE model." Multi-
market analysis considers the interactions between a regu-
lated market and. other important related, markets (out-
puts and inputs), requiring estimates of elasticities of
demand and supply for these markets as well as cross-
price-elasticities also found in CGE models. Multi-market
models are best used when potential economic impacts
and equity effects on related markets might be consider-
able, but more complete modeling using a CGE framework
would offer a negligible improvement on the quality of
information produced.
9.2.3.3 Equilibrium
Unlike multi-market and CGE models, a. partial equilibri-
um framework limits a distributional analysis to consider-
ing impacts on entities associated with the directly affected
output markets only. Distributional consequences for
other output markets and input markets are not estimated
using these models. As discussed in Chapter 8, a partial
equilibrium framework requires knowledge of demand
and supply functions for directly affected markets only.
If information is required for distributional outcomes that
this method is not designed to address, it may be possible
to adopt further assumptions and acquire additional data
to approximate distributional consequences of concern.
These new assumptions should be consistent with those
used for the corresponding BCA.
9.2.3.4 of
A relatively unsophisticated distributional analysis exam-
ines the direct costs of compliance paid by regulated enti-
ties. Often these analyses simply assume that the quantity
of output and state of technology in the regulated industry
' For a detailed discussion of multi-market analysis see Chapter 9 in Just et at. (1982).
146
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Chapter 9: Distributional Analyses
remain unchanged after the regulation becomes effective.
Ail analyst could disaggregate compliance costs for regulat-
ed industries or sectors or geographic regions.
9.2.4
Costs
The first step in assessing impacts is to estimate and verify
the costs of compliance. This step is necessary regardless
of whether the entities affected are for-proflt, governmen-
tal, communities, or not-for-profit entities. Compliance
costs include annual costs (such as operation and mainte-
nance of pollution control equipment or increased produc-
tion cost) and any capital costs. In certain situations it
may be appropriate to estimate the costs year by year,
especially in cases where the costs are expected to vary
over time. Depending on the nature of the analysis, these
costs may be annualized, so that they can be compared to
average annual income and other measures of financial
strength.20
Verifying the compliance cost estimates entails two steps.
First, the full range of responses to the rule needs to be
identified, including pollution prevention alternatives.
Second, the costs for each response need to be checked to
determine if all elements are included and the costs are
consistent with a given base year. Either a general infla-
tion factor, such as the Gross Domestic Product (GDP)
implicit price deflator, or various cost indices specific to
the type of project can be used.21 The base year and index-
ing procedure should be stated clearly. Implicit costs that
do not represent direct outlays may be important. The
cost estimates should include such elements as produc-
tion lost during installation, training of operators, and edu-
cation of users and citizens (for example, for programs
involving recycling of household wastes). The cost of
acquiring a permit is not so much the permit fee as it is
the lost opportunities during the approval process.
Likewise, the cost of having a car's emissions inspected is
not so much the fee as it is the value of registrant's lime.
EIAs and BCAs use different concepts of cost. BCA relies
on estimates of the social costs of a regulation. EIA costs
are the private costs needed to predict compliance
responses and assess economic impacts in several ways.
Social costs represent costs to society as a. whole, whereas
private costs reflect costs as they are experienced by the
affected parties. Often, the same basic engineering com-
pliance cost estimates are used as the basis for developing
both social and private cost estimates and are adjusted to
provide the required costs.
There are several issues analysts must consider when esti-
mating the private costs of environmental polices. These
include:
f Before- versus after-tax costs: The costs of com-
plying with regulations are generally deductible as
expenses for income tax purposes. The effective bur-
den of compliance costs is reduced for taxable entities
because they can reduce their taxable income by the
amount of the compliance costs. The effect of a regu-
lation on profits is therefore measured by after-tax
compliance costs. Different components of engineer-
ing cost estimates should be adjusted based on their
specific impact on taxes, to provide the inputs needed
for an EIA.22 Operating costs are generally fully
deductible as expenses in the year incurred. Capital
investments associated with compliance must gener-
ally be depreciated over some number of years.23
In most cases, communities, not-for-profits, and gov-
ernments do not benefit from reduced income taxes
that can offset compliance costs. Therefore, adjust-
ments to cost estimates, annualization formulas, and
cost of capital calculations required to calculate after-
tax costs should not be used in analyses of impacts
on governments and not-for-profits.
20 As previously discussed, the discount rate used should be specific to the task. The rate used to annualize costs is dependent on the enti-
ty's cost of capital and, thus, the sources of financing used as well as the credit rating of the borrower. When calculating the present value of a stream
of future social costs (or benefits), the social rate of time preference is (he appropriate discount rale. See Chapter 6 fora complete discussion of dis-
count rates.
21 The GDP implicit price deflator is reported by the U.S. Department of Commerce, Bureau of Economic Analysis in its Survey of Current
Business. The annual Economic Report of the President, Office of the President, is another convenient source for the GDP deflator time series.
22 Engineering costs can often be used in their before-tax form to calculate social costs. Adjustments may be required, however, if the
available compliance cost estimates do not reflect the social cost of the resources used.
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Chapter 9: Distributional Analyses
Transfers: Social costs reflect the real value of eco-
nomic resources—labor, equipment, supplies—used
to achieve compliance. However, some types of com-
pliance costs incurred by the regulated parties may
represent transfers among parties. Transfers, such as
payments for insurance or payments for marketable
permits do not reflect use of economic resources.
Private cost estimates used in the EIA should include
such transfers, but these transfers should be excluded
when calculating social costs for the benefit-cost
analysis.
Discounting: Compliance costs often vary over lime,
perhaps requiring initial capital investments and then
annual operating costs. To estimate impacts, the
stream of costs is generally discounted to provide a.
Present Value of Costs (PVC) that reflects the time
value of money.24 In contrast to social costs and bene-
fits, which are discounted using a social discount rate,
private costs are discounted using a rate that reflects
the regulated entity's cost of capital.25 The private dis-
count rale used will generally exceed the social dis-
count rate by an amount that reflects the risk associ-
ated with the regulated entity in question.26 For firms,
their cost of capital may also be determined by their
ability to deduct debt from their tax liability.
Annuallzed costs: Annualizing costs involves calcu-
lating the annualized equivalent of the stream of cash
flows associated with compliance. It provides a single
annual cost number that reflects the various compo-
nents of compliance costs incurred over some select-
ed time period (e.g., 15 or 30 years).27 The annual
value is the amount that, if incurred each year over
the selected time period, would have the same pres-
ent value as the actual stream of compliance expendi-
tures. Annualized costs are therefore a convenient
compliance cost metric that can be compared with
annual revenues and profits. It is important to
remember that using annualized costs masks the tim-
ing of actual compliance outlays. For some purposes,
using the underlying compliance costs may be more
appropriate. For example, when assessing the avail-
ability of financing for capital investments, it is impor-
tant to consider the actual timing of capital outlays.
Fixed versus variable costs: Some types of compli-
ance costs vary with the size of the regulated enter-
prise (e.g., in proportion to production). Other com-
ponents of cost may be fixed with respect to produc-
tion, such as the costs involved in reading and under-
standing regulatory requirements.28 Requirements
that impose high fixed costs will impose a higher cost
per unit of production on smaller firms than on larg-
er firms. It is important that the effects of any
"economies of scale" be reflected in the compliance
costs used to analyze economic impacts.29 Using the
same average annualized cost per unit of production
may mask the importance of such fked costs and
understate impacts on small entities.
for
A comprehensive analysis of all aspects of economic
impacts associated with a rule can be highly resource
intensive. Detailed and explicit analysis of impacts may
not be justified in all cases, if a preliminary analysis
21 Current federal and state income tax rates can be obtained from the Federation of Tax Administrators in Washington, D.G, FT.4, State Tax
Rates & Structure, available from http:/Avwwtaxadmin.org/fta/rate/tax_stru.html (accessed 8/28/2000).
'* This Present Value of Costs may then be annualized to provide an annual equivalent of the uneven compliance cost stream, as described
" While the discount rate differs, the formula used to discount private costs is the same as used for social costs. See Chapter 6.
26 Risk adjusted rates for different industries can be obtained from the Ibbotsen Associates Handbook or for specific firms from the Value
Line Investment Survey.
27 Annualized costs are also discussed in Chapter 6 on social discounting. The formula for calculating annualized costs is presented in
Section 6.2,
•E Note that fixed versus variable costs is not the same thing as capital versus operating costs. Capital costs may be fixed or variable with
respect to the size of the operation, as may operating costs. This distinction between capital and operating costs is important for calculating after-tax
costs.
29 Economies of scale characterize costs that decline on a per unit basis as the scale of an operation increases.
148
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Chapter 9: Distributional Analyses
suggests that economic impacts will be minor. Screening
analyses provide a way to focus attention and analytic
resources on the areas where economic impacts are most
likely to be significant. These screening analyses generally
use simplifying assumptions about market outcomes (e.g.,
the alternative no-cost-pass-through and full-cost-pass-
through assumptions) or simple tests of financial impacts
(e.g., a ratio of compliance costs to sales or to profits) to
screen for potentially significant impacts.
It is important to keep in mind the limitations in screen-
ing analyses when interpreting and presenting their
results. They typically identify cases of potentially signifi-
cant impacts. More detailed investigation beyond the
screening analysis is usually needed to reach a reliable
conclusion about the likelihood ofsignifica.nl impacts.
In addition, screening analysis criteria should be chosen to
balance the risk of identifying "false positives" versus "false
negatives." That is to say, using too low a threshold will do
little to distinguish true differences in potential impacts
(false positives), while using too high a threshold, runs the
risk of missing some sectors thai may be significantly
affected (false negatives).
Finally, when screening analyses are based on alternative
assumptions about market responses, it is important to
note in presenting the results that they represent extreme
assumptions that in practice cannot occur simultaneously.
For example, worst case impacts on profits cannot occur
simultaneously with worst case impacts on prices.30
Of
9.2.6.1 an Profile
The impact of a regulation on business profitability and
other economic outcomes depends on the magnitude of
the compliance costs associated with the rule, on the dis-
tribution of compliance costs across firms, and on the eco-
nomic and financial characteristics of the affected firms
and industries.31 A substantial portion of an EIA involves
characterizing the affected firms and. industries as a. basis
for evaluating economic impacts. The following are
important inputs to an EIA:
f Standard Industrial Classification (SIC)
North American Industrial Classification System
(NAICS) industry codes: These definitions can be
developed, by working with engineering analysts, the
EPA project team and workgroups, industry roundta-
bles and industry specialists at the Department of
Commerce. The SIC codes and their definitions
appear in the Standard Industrial Classification
Manual: 1987, available from the Government
Printing Office (OMB, 1987). This industry classifica-
tion system is being replaced by the North American
Industry Classification System (NAICS), which will be
reflected, in the forthcoming data, series (OMB, 1998).
A regulated entity that is a small part of a larger
industry may require fractional multipliers in order to
estimate the regulated category's share of the larger
industry.
f Compilation of summary statistics: Data regard-
ing total employment, revenue, number of establish-
ments, and number of firms are available from the
economic censuses and. interim updates (e.g.,
Department of Commerce Annual Survey of
Manufactures, for non-manufacturers, the
Department of Commerce County Business Patterns,
and Agricultural Statistics from the Department of
Agriculture). The profile should, also define the
industry and its products, describe major production
technologies, and discuss important business and
regulatory trends.
f The level and distribution of compliance costs:
Estimates of compliance costs reflect predicted
responses to the rule and. are often developed based.
on engineering estimates. It is important to know
how costs are distributed among plants and firms in
the same industry, since firms that are not affected by
the rule or that incur lower compliance costs than
their competitors may gain competitive advantage as a
result of the rule. If only a few producers in an
industry incur added costs, they are less likely to be
30 A more detailed treatment of the considerations in the conduct of sensitivity analysis is presented in Chapter 5.
" Generally, analysts should presume a perfectly competitive market structure. The purpose of developing an industry profile is to confirm
this presumption or discover evidence to the contrary.
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Chapter 9: Distributional Analyses
able to raise their prices to recover costs. In contrast,
a rule that affects ail industry participants equally is
more likely to result in price increases and less likely
to change the competitive structure of the industry.
In addition, some rules impose different require-
ments and costs on new versus existing sources.
Such rules may affect industry competition, growth,
and innovation by raising barriers to new entry.
f Baseline Industry growth and financial
condition: Industries and firms that are relatively
profitable in the baseline will be better able to absorb
new compliance costs without experiencing financial
distress. Industries that are enjoying strong growth
may be better able to recover increased costs through
price increases than they would have been had there
been no demand growth. Section 9-2.9 provides
suggestions for using specific ratios to assess the
significance of economic impacts on a firm's financial
condition.
f Baseline Industry structure: Industry-level
impacts depend on the competitive structure and
organization of the industry and the industry's rela-
tionship to other economic entities. In addition, the
number and size distribution of firms and facilities
and the degree of vertical integration are important
aspects of industry structure that affect the economic
impacts of regulations.
f Characteristics of supply demand: Assessing
the likelihood of changes in production and prices
requires information on the characteristics of supply
and demand in the affected industries. The relevant
characteristics are reflected in price elasticities of sup-
ply and demand, which, if available, allow direct
quantitative analysis of changes in prices and produc-
tion. Often, reliable estimates of elasticities are not
available, and the analysis of industry-level adjust-
ments must rely on simplifying assumptions and
qualitative assessments.
The industry profile provides a general understanding of
an industry or industries affected by a regulatory action
and characterizes their ability to absorb compliance costs.
This information provides the basis for assumptions cen-
tral to the impact analysis, as well as information needed
for some of the special analyses such as Regulatory
Flexibility Analyses.
Of
Entities
Careful consideration needs to be given to the question of
whether or not a particular rule will affect government
entities,32 not-for-profit organizations,33 or households. For
example, air pollution regulations that apply to power
plants may affect municipally owned electric companies;
air regulations that apply to vehicles may affect municipal
bus companies, as well as other municipal vehicles such
as police cars and public works vehicles; effluent guide-
lines for machinery repairing activities may affect munici-
pal garages. Thus, the first step is to identity7 all the gov-
ernment entities that may be affected.
Relevant characteristics of government entities may
include:
f the community's size (number of people living in the
community);
f household income levels (both median and some
measure of the income range);
f number of children (since education is frequently the
major service provided by local governments);
f number of elderly residents (who frequently have
fixed incomes);
f unemployment rate;
f revenue amounts by source; and
f the credit or bond rating of the community.
If the property tax is the major revenue source, then the
assessed value of properly in the community and the per-
centage of this assessed value represented by residential
versus commercial and industrial property should be
determined. If the government entity serves multiple
communities, such as a regional water or sewer authority,
w Government entities that may be affected by a program include states, cities, counties, towns, townships, water authorities, villages,
Indian Tribes, special districts, military bases, etc.
" Examples of not-for-profits include non-profit hospitals, colleges, universities, and research institutions.
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Chapter 9: Distributional Analyses
then this information needs to be collected for all the
communities covered by the entity.
Data on community size, income, number of children and
elderly, and unemployment levels are available from the
U.S. Bureau of Census. Data, on property values, amount
of revenue collected from each revenue source, and credit
rating will need to be collected directly from the communi-
ty or state finance agencies. If the regulated activity is pro-
vided by an "Enterprise Fund" then revenue and cost
information will need to be obtained directly from the
fund.34 Depending on the number of communities affect-
ed and the level of detail warranted, the analysis may rely
on generally available data only. In other cases, a survey of
affected communities may be necessary However, in
cases where a. survey is needed, (here will be a need to
comply with the requirements of the Paperwork Reduction
Act (PKA).
Relevant characteristics of not-for-profit entities include
their size, the goods or services they provide, their operat-
ing costs, and. the amount and sources of their revenue. If
the entity is raising its revenues through user fees or in
other ways charging a price for its goods/services (such as
university tuition), then the income levels of its clientele
are relevant. If the entity relies on contributions, then it
would be helpful to know the financial and demographic
characteristics of its contributors. If it relies on govern-
ment funding (such as Medicaid) then possible future
changes in these programs should be identified.
Relevant features of households are standard socioeco-
nomic and demographic characteristics. These character-
istics include, for example, their income level, size, age
distribution, education level, and ethnic group.
9.2.6.3
Profiles generally draw from at least two types of informa-
tion: 1) literature from economic journals, dissertations,
and industry trade publications, and 2) quantitative data
describing the characteristics of the industry. The relevant
literature can be useful in characterizing the industry
activities and markets as well as regulations affecting the
industry. Identification of relevant literature is most effi-
ciently performed through a computerized search using
on-line services such as Dialog, BBS/Search Services, or
Dow Jones News/Retrieval. These on-line services contain
more than 800 databases covering business, economic,
and scientific topic areas. Exhibit 9-3 lists some common-
ly used sources.
The industry profile may also identify those situations
where sufficient data for an EIA cannot be obtained
through published and commercial sources. These situa-
tions arise particularly when the affected industry is one of
many product lines or other activities of identified facili-
ties; in addition, for some industries, identification of the
appropriate SIC or NAICS code for ail the firms or facilities
included in the industry may be difficult if the industry
can be categorized in a variety of ways. In these cases, and
particularly if facility-level data are required to estimate
economic impacts, a survey of either a statistical sample
or a census of affected facilities may be required to provide
sufficient data for analysis.
9.2.7 on
Predicting impacts on prices is the basis for determining
how the burden of compliance costs will be shared
between the directly-affected firms and their customers
and suppliers in a typical market. At one extreme, regulat-
ed firms may not be able to raise their prices at all and
they will bear the entire burden of the added costs in the
form of reduced profits. Reduced profits may result from
reduced earnings on continuing production, lost profits on
products or services that are no longer produced, or some
combination of the two. At another extreme, firms may be
able to raise prices enough to recover costs fully. In this
case, there will be no impacts on the profitability of the
directly-affected firms but their customers will bear the
burden of increased prices. Another possible outcome is
that suppliers to the directly-affected firms will bear some
of the burden in lost earnings if the regulation results in a
decline in demand for particular products.35
34 Public services that are funded entirely by fees charged to users are referred to as "enterprises'" and their revenues are referred to as
"Enterprise Funds."
" Regulations limiting sulfur emissions may result in reduced demand for high-sulfur coal, for example, which will result in a fall in the
price of such coal and lost profits for its producers.
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Chapter 9: Distributional Analyses
Exhibit 9-3 Frequently Used Profile Sources
Source
Trade Publications
U.S. Department of Commerce,
Economic Censuses36
U.S. Department of Commerce,
U.S. Industry & Trade Outlook
United Nations,
International Trade Statistics
Yearbook
Robert Morris Associates,
Annual Statement Studies
Dun & Bradstreet,
Information Services
Standard & Poor's
Standard & Poor's,
Research Reports
Securities and Exchange
Commission 10k Filings,
EDGAR System Database
Value Line Industry Reports
FINDS database
Data
Market and technological trends, sales, location, regulatory events, ownership
changes.
Total revenue by 4-SIC (generally); payroll; quantity and value of products shipped
and materials consumed; value added; capital expenditures, assets, inventories,
employment, and geographic area, distribution by size, kind of business.
Description of industry, trends, international competitiveness, regulatory events.
Foreign trade volumes for selected commodities, major trading partners
Income statement and balance sheet summaries, profitability, debt burden and
other financial ratios, all expressed in quartiles and available for recent years.
Based on loan applicants only.
Type of establishment, SIC code, address, facility and parent firm revenues and
employment.
Publicly held firms, at 4-digit SIC level. Prices, dividends, and earnings,
line-of-business and geographic segment information, S&P's ratings. Quarterly
History (10 years): income statement, ratio, cash flow, and balance sheet analyses
and trends.
Industry profiles, competitors for selected firms. Firm Level Data:
(publicly traded companies) company background, stock prices, major
competitors, description of business organization, summary financial data.
Income statement and balance sheet, working capital, cost of capital,
employment, outlook, regulatory history, foreign competition, lines of business,
ownership and subsidiaries, mergers and acquisitions.
Industry overviews, company descriptions and outlook, performance measures.
Facility SIC, latitude and longitude, zip code, size, ownership structure.
In general, the likelihood that price increases will occur
can be evaluated by considering whether competitive con-
ditions will allow the affected facilities to pass on their
costs. The methods used to conduct the analysis of the
directly-affected markets will depend on the availability of
appropriate estimates of supply and demand elasticities.
In many cases, reliable estimates of elasticities will not be
available.37 In these cases, the analyst will need to rely on a
more basic investigation of the characteristics of supply
and demand in the affected market to reach a judgment
about the likelihood of full or partial pass-through of costs
via price increases.
9.2.8 Impacts on Production and
Employment
Regulations may raise the cost of doing business sufficient-
ly to make some or all production unprofitable or may
reduce the quantity demanded as producers raise their
prices to maintain profitability. The associated reductions
in output may result from lower operating rates at existing
plants, closure of some plants, or reduced future growth in
production relative to what would have occurred in the
baseline. Losses in employment are typically associated
with reductions in output.
36 Economic Censuses include: Census of Manufacturers, Census of Construction Industries, Census of Mineral Industries, Census of
Retail Trade, Census of Service Industries, Census of Transportation, and Census of'Wholesale Trade.
" See Chapter 8 for a more complete discussion of costs and elasticity.
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Chapter 9: Distributional Analyses
EPA has used a. variety of methods to assess reductions in
production and employment. In some cases, demand and
supply elasticities are used directly to calculate changes in
output and prices that would result from a shift upward in
the supply curve associated, with compliance costs. Often
estimates of the shape of the supply curve are not available
and assumptions are made about its shape in the region of
interest to allow use of demand elasticity estimates to pre-
dict output and price adjustments.
In other cases, analysts may assess the impacts of rules on
the profitability of specific firms or industry segments, and
identify potential line or plant closures based on a finan-
cial analysis.38 If partial or full plant closures are project-
ed, it is important to consider whether the production lost
at the affected facilities will be shifted to other existing
plants or to new sources or will simply no longer be pro-
duced. If there is excess capacity in the industry in the
baseline and some plants with excess capacity can operate
profitably in compliance with the rule, they may expand
production to meet the demand for products no longer
produced at plants that can no longer operate profitably.39
Even if total production does not decline but is simply
shifted from higher-cost plants to more efficient competi-
tors and even if total employment does not change, local-
ized changes in employment may interest policy makers.
This is especially the case for rules that may have a strong
regional impact. For example, UMRA § 202 requires such
an analysis as an element of the UMRA cost analysis. Data
on the ratio of production or sales to employment can
help predict the number of jobs lost as a result of reduc-
tions in production. The regional distribution of job losses
can be calculated based on plant locations.
on
The availability of financial information used to assess
profitability varies greatly; depending on the industry in
question and the extent to which EPA is able to collect new
information by surveying the affected entities. With limit-
ed exceptions, detailed financial information is not gener-
ally available for individual plants or for privately-held
companies from published sources. Financial data, for
publicly-held companies may be too aggregated to allow
analysis of the specific business practices affected by the
rule. In the absence of new data collection by EPA, ana-
lysts may need to rely on financial profiles constructed for
model plants, or on industry-average data provided by the
Census Bureau and other sources.40 In some cases, finan-
cial profiles used in the analysis of a previous rule-making
might be adapted and updated to analyze the impacts of
the rule in question.
Analysis is conducted by determining how the added costs
of compliance will affect the financial strength of the firm.
As with predicting price increases, it may be worthwhile to
start with a screening analysis based on an extreme
assumption about the incidence of costs—in this case,
that no costs can be recovered through price increases.
This assumption provides a worst case estimate of impacts
on profits, potential closures, and employment reductions
in the directly-affected market. Where firms in an indus-
try do not appear to experience financial distress under
the no-cost-pass-through scenario, more detailed analyses
to predict actual market adjustments and. price increases
are not needed.
The severity of financial impacts to firms from a rule can
range from no impact (if all costs are recovered, through
price increases, for example) to a modest reduction in
profits, closure of a production line or plant, to bankruptcy
of the firm. Criteria for assessing the degree of financial
distress and for predicting when a production line or plant
would be shut-down are not clear-cut.41 If detailed finan-
cial profiles can be developed, including revenues, costs,
income statements, and balance sheets, a variety of finan-
cial tests can be used to assess the likelihood of financial
distress or closure. These tests address the following
issues:
18 Analysis of impacts on profitability and plant closures are discussed later in this section.
" Some surviving plants could experience increases in production, capacity utilization, and profits even though subjected to regulatory
requirements, if their competitors face even greater cost increases.
10 Sources of financial data are listed in Exhibit 9-3.
41 This section assumes a perfectly competitive market, which in practice does not always correctly characterize the market structure being
analyzed. In these cases, this section should be adapted to the relevant market structure.
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Chapter 9: Distributional Analyses
f Do the costs of the regulation result in a, negative dis-
counted after-tax cash flow?42
f Does the facility or firm's profitability fall below
acceptable levels?
f Is the facility or firm's ability to finance its operations
and pay its obligations jeopardized?
Establishments that fail the first test are potentially at risk
for closure.13
Closure Decisions
A variety of considerations affect a firm's decision to close
a production line or a plant.
f The profitability of the plant itself provides
insight into whether the operation will be contined if
the plant represents a stand-alone business. This
also assumes that it is possible to construct a. finan-
cial profile of that business.
^~ The role the plant plays in a larger operation
may influence closure decisions. For example, some
plants may be part of a vertically or horizontally inte-
grated operation. Such plants might not be viable as
a stand-alone operation but may continue to operate
based on its contribution to the business line as a
whole. In general, however, the analysis should
assume that an operation will be closed if compliance
with the rule would increase costs to the point where
continued operation is no longer profitable.
f A negative discounted flow indicates that
returns are below the rate of return required to pro-
vide the required return on equity and payment of
interest. Closures in the short run are likely to occur
if earnings do not cover variable costs plus the cost of
compliance. Disinvestment and closures will occur
over the longer term if earnings are not sufficient to
justify investment in plant and equipment as well.
Where closures and reduced production are likely for
some but not all plants, firms may face complex decisions
about which plants to close. These decisions reflect relative
operating costs, age of equipment, tax and other incentives
offered by local communities and states to retain business,
and logistical considerations. Analyses of plant closures
should include caveats stating that the analysis identifies
candidates for closure, rather than providing reliable pre-
dictions of which specific plants will close. The available
information on plant-level operating costs and contribu-
tions to earnings is generally too uncertain to allow more
precise prediction of plant closures.
Financial of Closure
Short of closure, financial distress may occur. Financial
distress measures a continuum from mild, to severe finan-
cial weakness and may result in difficulties obtaining
financing and attracting capital.'1'1 Although in practice,
analysts may use a variety of measures of financial dis-
tress, use of specific financial ratios has the advantage that
it mirrors analyses that investment and lending institu-
tions perform to evaluate industries and businesses.
Particular measures include:
0~ Measures of Impacts on profitability, e.g., pre-tax
return on assets (net operating income divided by
total assets) or return on equity. These measures
reflect the profit performance of a firm's capital
assets. If returns are reduced to unacceptable levels
when compliance costs are included, the firm may
have difficulty financing new investment or attracting
capital even if it is not earning negative returns.
0~ Measures of impacts on liquidity, e.g., interest
coverage ratio (cash operating income divided by
interest expense), times-interest-earned (earnings
before interest and taxes divided by interest expense),
and the current ratio (current assets divided by cur-
rent liabilities.) These measures reflect the firm's
42 If after-tax cash flow is negative under baseline conditions (before considering compliance costs), the facility is a likely candidate for clo-
sure even in the absence of additional compliance costs. These closures should not be attributed to the rule, but rather should be classified as base-
line closures.
'" If il is possible 1o estimate plant liquidation values, another test can be added to assess the likelihood of closure. Plants may be predict-
ed to close if the value of continuing to operate is less than the liquidation value.
" Researchers have developed various composite measures that are designed to assess the potential for bankruptcy The most commonly
cited is the ZETA model or "Z-score" developed by Altaian et at. (1993). This model uses a weighted average of five variables to predict potential for
bankruptcy The ratios include working capital/total assets, retained earnings/total assets, earnings before interest and taxes (EBIT)/total assets, mar-
ket value of equity/par value of debt, and sales/total assets. The model includes levels for this composite score that represent clear potential for bank-
ruptcy, low or no potential for bankruptcy, and an uncertain grey area.
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Chapter 9: Distributional Analyses
ability to meet its financial obligations out of current,
on-going operations. If operating cash flow does not
comfortably exceed its payment obligations, the firm
may have to use resources required for on-going
operations to pay contractual obligations and its cred-
itworthiness will suffer.
on
The economic and financial impacts of regulatory actions
propagate to industries and communities that are linked to
the regulated industries, resulting in indirect business
impacts. These indirect impacts may include employment
and income losses, as well as changes in the competitive-
ness and efficiency of related markets. Compliance-related
industries, on the other hand, may yield offsetting gains in
employment and income when a regulated industry pur-
chases equipment, facilities or labor in order to comply
with a regulation.
Although, in principle, every economic entity can be
thought of as having a connection with every other entity
practical considerations usually require an analysis of indi-
rect impacts to be performed or presented for a manage-
able subset of economic entities that are most strongly
linked to the regulated entity. In addition to considering
major customers and specialized suppliers of the affected
industry, it is also important to consider less obvious but
potentially significant links, for example, basic suppliers
such as electricity generators.
For this reason, the analysis of linkages should use a
framework that thoroughly measures indirect as well as
direct linkages. Whatever the approach, the goal of the
analysis is to measure—given a certain amount of
employment and income change in a regulated market—how
employment and income will likely change in related entities.
9.2.11 on
Growth
While regulatory interventions can theoretically lead to
macroeconomic impacts, such as growth and technical
efficiency such impacts may be impossible to measure or
observe.15 In some cases, however, it may be feasible to
use macroeconomic models to evaluate the regulatory
impact on gross national product (i.e., including trade
effects and plant location decisions), factor payments,
inflation, and aggregate employment.
For programs or rules that are expected to have significant
impacts in a particular region, use of regional models—
either general equilibrium or more limited models—may
be valuable.
Some macroeconomic regulatory effects are beyond the
capacity of the typical regulatory impact analysis to quanti-
fy. For example, price changes induced by a regulation can
lead to technical inefficiency because firms are not choos-
ing the production techniques that minimize the use of
labor and other resources in the long run. Instead, firms
will tend to overuse resources whose prices are artificially
depressed by the regulation compared to the resources'
true cost to society.
Additional anecdotal, theoretical and limited empirical lit-
erature are available that point to possible macroeconomic
impacts.46
9.2.12 on
Competitiveness
Regulatory actions that substantially change the structure
or conduct of firms can produce indirect impacts by
changing the competitiveness of the regulated industry, as
well as that of linked industries. An analysis of impacts on
competitiveness begins by examining barriers to entry and
market concentration and by answering two key questions.
45 OMB states that macroeconomic effects are likely to be measurable only if the impact of the regulation exceeds 0.25 to 0,5 percent of
GDE See OMB (1995),
"s See Jaffe et al, (1995) and Gray and Shadbegian (1997),
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Chapter 9: Distributional Analyses
Will the regulation erect entry barriers that
might reduce innovation by impeding new
entrants into the market? High sunk costs associ-
ated with capital costs of compliance or compliance
determination and familiarization would be an entry
barrier attributable to the regulation. Sunk costs are
fixed costs that cannot be recovered in liquidation;
they can be calculated by subtracting the liquidation
value of assets from the acquisition cost of assets fac-
ing a new entrant, on an after-tax basis.47 Lack of
access to debt or equity markets to finance fixed costs
of entering the market can also present entry barri-
ers, even if none of the fixed costs are sunk costs.
However, if financing is available and fixed costs are
recoverable in liquidation, the magnitude of fixed
costs alone should not present any barrier to entry.
Will the regulation tend to create or enhance
market power and reduce the economic efficien-
cy of the market? The tools presented in the sec-
tion describing how to create an economic profile also
address Ibis question. The most important of these
tools include measures of horizontal and vertical inte-
gration (i.e., concentration), among both buyers and
sellers, in the baseline compared to post-compliance
cases. Closely related to concentration, product dif-
ferentiation may occasionally be either increased or
decreased by a regulatory action. For a hypothetical
example, certain labeling restrictions might reduce
the ability of firms to segment their market by differ-
entiating an essentially uniform product with packag-
ing. In such a hypothetical baseline, firms might
enjoy effectively higher concentration ratios and less
competition after imposition of a uniform labeling
policy.
on
Organizations
Section 9-2.9 of this chapter discussed ways of measuring
the impact of regulations and requirements on private
entities, such as firms and manufacturing facilities. When
dealing with private entities, the primary focus is on meas-
ures that assess changes in profits. This section describes
impact measures for situations where profits and prof-
itability are not relevant — where the regulations affect gov-
ernment entities and/or not-for-profit organizations. Many
of the same questions, however, apply:
f Which entities are affected and what are their charac-
teristics?
f How much will the regulation increase operating
costs?
f What impact will the regulation have on operating
procedures?
f Will this change the amount and/or quality of the
goods and services provided?
f Can the entity raise the necessary capital and will this
change its ability to raise capital for oilier projects?
The major difference is that instead of ultimately
measuring the regulation's impact on profit levels, when
government entities are involved, the ultimate measure is
the ability of its citizens to pay for the requirements.
Likewise, in the case of a not-for-profit, the measure is the
reduction in the organization's ability to provide its goods
and services.
9.2.13.1 of Government
Impacts
EPA regulations can affect governments in at least three
ways. They can directly impose requirements on the gov-
ernmental entity, such as water pollution requirements for
publicly-owned wastewater treatment works (POTWs) or
air pollution restrictions that affect municipal bus systems
or power plants. Second, they can involve costs for govern-
ments to implement and enforce regulations imposed on
other parties. Finally they can impose indirect costs on
government entities, such as increased unemployment in
a community because an EPA regulation has resulted in
reduced production (or even closure) at a factory in the
community. Keep in mind that some of the impacts may
reduce the community's financial resources and thus its
ability to pay for the requirements. For example, the
47 Sunk costs are sometimes referred, to as exil barriers. Without exit barriers, there can be no entry barriers, as long as there are no liq-
uidity constraints.
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Chapter 9: Distributional Analyses
closure of a facility may increase the drain on social serv-
ices at the same time that tax revenues are declining.
of Programs That Directly Affect
and Not-for-Profit
The direct impact measures can be divided into two cate-
gories, (1) those that measure the impact itself in terms of
the relative size of the costs and the burden they place on
citizens and (2) those that measure the economic and
financial conditions of the entity that affect its ability to pay
for the requirements. For each category, there are several
types of measures that can be used either as alternatives,
or jointly, to illuminate various aspects of the question.
Measuring the relative cost burden of the regu-
lations. There are three commonly used approaches to
measuring the burden of the rule; ail involve calculating
the annualized costs of complying with the regulation. For
government entities, the three approaches are:
0~ Annualized compliance costs as a percentage of
annual costs for the service included: This meas-
ure tries to define the impact as narrowly as possible
and is particularly appropriate when the service or
activity to be regulated is provided by a single-purpose
entity. For example, if the regulated activity is sewage
treatment, the POTW may not be able to draw on gen-
eral government revenues to cover its increased cost.
Thus the appropriate comparison would be to esti-
mate the resulting increase in its costs. Even if the
affected entities are not able to draw on general gov-
ernment revenues, it is useful to know how the rule
affects the cost of the activity in question. In practice,
EPA has often used the condition that if compliance
costs are less than one percent of the current annual
costs of the activity, it is usually assumed that the
compliance costs are placing a small burden on the
entity.
0~ Annualized compliance costs as a percentage of
annual revenues of the governmental unit: The
second measure corresponds to the commonly used
private-sector measure of annualized compliance
costs as a percentage of sales. Referred to as the
"Revenue Test," it is one of the measures suggested in
EPA Revised Interim Guidance for EPA Ruleimiters:
Regulatory Flexibility Act as amended by the Small
Business Regulatory Enforcement Fairness Act (EPA,
1999).48 This differs from the prior measure in that it
compares annualized compliance costs to the total
revenues of the entity (which usually is multi-purpose
in nature). If compliance costs are less than one per-
cent of revenues, then the requirements are usually
considered to be affordable. Compliance costs in the
range of one to three percent of government revenues
are less easily interpreted. If all affected communities
fall in this range, then further thought should be
given to lowering annual compliance costs, if only a
small percentage of communities fall into this range
and the rest tall below one percent, then the require-
ments can probably be considered affordable.
Compliance-cost-to-revenue ratios of greater than
three percent indicate thai the requirements are plac-
ing a heavy burden on the community.
Per household (or per capita) annualized com-
pliance costs as a percentage of median house-
hold (or per capita) income: The third measure
compares the annualized costs to the ability of resi-
dents to pay for the cost increase. Commonly
referred to as the "Income Test," it is described in the
Revised Interim Guidance (EPA, 1999) and EPA's
Office of Water Interim Economic Guidance for
Water Quality Standards. Workbook (EPA, 1995a).4°
Costs can be compared to either median household
or median per capita income. In calculating the per
household or per person costs, the actual allocation
of costs needs to be considered. If the costs are
entirely paid through property taxes, and the commu-
nity is predominately residential, then an average per
household cost is probably appropriate. If, however,
some or all of the costs are allocated to users (e.g.,
fares paid by bus riders or fees paid by users for
sewer, water, or electricity supplied by municipal utili-
ties), then this needs to be taken into account. In
addition, if some of the costs are borne by local firms,
48 See Section 9.3 for a discussion of the analytic and procedural requirements under SBREFA.
49 For example, materials presented in the water guidance and other EPA Office of Water analyses are; less than one percent indicates little
impact, over two percent indicates a large impact, with the range from one to two percent being a gray area of indeterminate impact.
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Chapter 9: Distributional Analyses
then that portion of the costs needs to be handled
separately.
Two commonly used impact measures for not-for-profit
entities are: (1) annualized compliance costs as a percent-
age of annual operating costs and (2) annualized compli-
ance costs as a percentage of total assets. 'Hie first is
equivalent to the first of the impact measures described
for government entities, measuring the percentage
increase in costs that would result from the regulation
being analyzed. The second is a more severe test, measur-
ing the impacts if the annualized costs were paid for out of
the assets of the institution. As presented in EPA's Revised
Interim Guidelines, the guidelines for annualized compli-
ance costs as a percentage of annual operating costs are:
annualized compliance costs less than 1 percent of operat-
ing costs indicate that the rule does not represent a. bur-
den, annualized compliance costs between one and three
percent of operating costs indicates that the rule may
impose a burden, and annualized compliance costs that
are more than three percent of operating costs indicates
that the rule may impose a heavy burden.
Measuring the economic and financial health of the
community: This second category of impact measures
looks at the economic and financial health of the commu-
nity involved, since these will affect its ability to finance
expenditures required by a program or rule. A given cost
may place a much heavier burden on a poor community
than on a wealthy one of the same size. As with the
impact measures described above, there are three cate-
gories of economic and financial condition measures:
0" Indicators of the community's debt situation:
Debt indicators are important because they measure
both the ability of the community to absorb additional
debt (to pay for any capital requirements of the rule)
and the general financial condition of the community.
While several indicators have been developed and
used, this section describes two. One measure is the
governmental entity's bond rating. Awarded by com-
panies such as Moody's and Standard & Poor's, bond
ratings summarize their assessment of a community's
credit capacity and thus reflect the current financial
conditions of the governmental body. A second fre-
quently used measure is the ratio of overall net debt
(the debt to be repaid by property taxes) to the full
market value of taxable property in the community.
Overall net debt should include the debt of overlap-
ping districts. For example, a household may be part
of a town, a regional school district, and a county
sewer and water district, all of which have debt that
the household is helping to pay off.50 See Exhibit 9-4
for interpretations of the values for these measures.
Neither of these two debt measures will always be
appropriate. Some communities, especially small
ones, may not have a bond rating. This does not nec-
essarily mean that they are not creditworthy, it may
only mean that they have not had an occasion recent-
ly to borrow money in the bond market. Second, if
the government entity does not rely on property taxes,
as may be the case for a state government or an
enterprise district, then the ratio of debt to full mar-
ket value may not be relevant. Information on debt
and assessed property values are available from the
financial statement of each community. The state's
auditor's office is likely to have this information for all
communities within the state.
Indicators of the economic/financial condition of
the households in the community: There are a
wide variety of household economic and financial
indicators. Two commonly used ones are: the unem-
ployment rate and median household income. Both
measure the financial well-being of households.
Unemployment rates are available from the U.S.
Bureau of Labor Statistics. Median household
income is available from the U.S. Census and some
steles maintain more up-to-date databases on income
levels. Benchmark values for these two measures are
presented in Exhibit 9-4.
Financial management indicators: This category
consists of indicators measuring the general financial
health of the community as an entity, as opposed to
the general financial health of the residents. Since
50 An alternative to the net debt as percent of full market value of taxable property is the net debt per capita. Commonly used benchmarks
for this measure are:
Net debt per capita: less than $ 1,000 = strong financial condition
Net debt per capita: $1,000 and $3,000 = mid-range or gray area
Net debt per capita: greater than $3,000 = weak financial condition
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Chapter 9: Distributional Analyses
Exhibit 9-4 Indicators of Economic and Financial Well-Being of Government Entities
Indicator
Bond Rating
Overall Net Debt as
Percent of Full Market
Value of Taxable Property
Unemployment Rate
Median Household
Income
Property Tax as Percent
of Full Market Value of
Taxable Property
Property Tax
Collection Rate
Weak
Below BBB (S&P)
Below Baa (Moody's)
Above 5%
More than 1 percentage
point above national
average
More than 10%
below the state median
Above 4%
Less than 94%
Mid-Range
BBB (S&P)
Baa (Moody's)
2% to 5%
Within 1 percentage
point of national
average
Within 10% of the
state median
2% to 4%
94% to 98%
Strong
Above BBB (S&P)
Above Baa (Moody's)
Below 2%
More than 1 percentage
point below national
average
More than 10%
above the state median
Below 2%
More than 98%
most local communities rely on the property tax as
their major source of revenues, two indicators of
property tax health are presented here. One meas-
ures the burden property taxes are placing on the
community in terms of property tax revenues as a
percent of full market value of taxable property. The
second indicator measures the efficiency with which
the community's finances are managed, and indirect-
ly, whether the tax burden may already be excessive,
in terms of the property tax collection rate. As the
property tax burden on tax payers increases, they are
more likely to not pay their taxes or pay them late.
Measuring the financial strength of not-for-profit entities
includes assessing (1) how much reserve the entity has,
(2) how much debt the entity already has and how its
annual debt service compares to its annual revenues, and
(3) how the entity's fees or user charges compare with the
fees and user charges of similar institutions. Again, this
part of the analysis is meant to judge whether the entity is
in a strong or weak financial position to absorb additional
costs.
Impacts of Programs That Place Administrative and
Enforcement Burdens on Governments
Many EPA programs require effort on the part of different
levels of government for administration and/or enforce-
ment. These costs must be considered to comply with
UMRA and to calculate the full social costs of a program or
rule. EPA is currently investigating methods for estimating
and evaluating the impacts of such costs. Revisions to this
guidance document will be made in the future to incorpo-
rate the results of that work.
Impacts of Programs That Indirectly Affect
Government Entities
The previous section describes how to measure the impact
of regulations that directly affect the provision of goods or
services by government or not-for-profit entities. This sec-
tion addresses the indirect or induced impacts on govern-
ment entities. For example, a manufacturing facility may
reduce or suspend production in response to an EPA regu-
lation, thus reducing the income levels of its employees.
In turn, these reductions will propagate through the econ-
omy by means of changes in household expenditures.
These induced impacts include the familiar multiplier
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Chapter 9: Distributional Analyses
effect, in which loss of income in one household results in
less spending by that household and, therefore, less
income in households and firms associated with goods
previously purchased by the first household. Unlike pro-
duction-based linkages, income-based linkages tend to be
more geographically localized, with the strength of the
linkage typically decreasing as geographic distance increas-
es (although the number of linked economic entities
increases with distance).
Decreased household and business income can affect the
government sector by reducing tax revenues and increas-
ing expenditures on income security programs (the auto-
matic stabilizer effect), employment training, food and
housing subsidies, and other fiscal line items. Due to wide
variation in these programs and in lax structures, estimat-
ing public sector impacts for a large number of govern-
ment jurisdictions can be prohibitively difficult.
On the other hand, compliance expenditures increase
income for businesses and employees that provide compli-
ance-related goods and services. These income gains also
have a multiplier effect, offsetting some of the induced
losses in tax revenue and increases in government expen-
ditures identified above.
9.3
9.3.1
In the context of an EPA economic analysis, an equity
assessment is an important type of distribution analysis.
An equity assessment examines the accrual of a regula-
tion's net costs, net benefits, or other economic impacts to
a specific sub-population(s) and/or examines the distribu-
tion of these costs, benefits, and impacts among sub-popu-
lation (s). This examination includes the possibility of ana-
lyzing a regulation's impact on the distribution of national
income or wealth.
Generally, cost bearers and beneficiaries belong to one of
four populations: individuals, businesses, not-for-profit
organizations, or governments. Within each of these pop-
ulations are sub-populations whose particular circum-
stances EPA wishes to belter understand, either because
the sub-population is more physically susceptible to envi-
ronmental contamination, is less than fully capable of rep-
resenting its own interests, or is economically disadvan-
taged or vulnerable. For many of these sub-populations,
the EPA has been directed by statute, executive order, or
agency policy to examine the effects of its rules when they
are expected to have a "disproportionate," "significant and
substantial," or other such impact on a particular sub-
population. An equity assessment gives rule makers a bet-
ter understanding of the economic effects of the EPA's
rules on these sub-populations and, for comparison or
other purposes, on oilier specific sub-populations as well.
An equity assessment examines the magnitude as well as
the distribution of effects on sub-populations.
There are several considerations to keep in mind when
performing an equity assessment. Each of these points
will be detailed in this chapter.
f There are specific equity dimensions that must
always be considered, but there are none that
must always be analyzed when assessing the
impact of environmental regulations. Generally
speaking, the regulation under review, and the specific
issues associated with it, will determine which equity
dimensions are relevant and in need of an equity
assessment.
f The methods used by a regulation's BCA and EIA
should guide the methodology used by an equity
assessment Neither this chapter nor OMB's Best-
Practices and OMB Guidelines outline a specific
methodology for conducting an equity assessment.
However, the models and assumptions developed for
these other two analyses should not conflict with
those used by an equity assessment.
An equity assessment may draw on the information
compiled for its corresponding BCA as well as include
measures of impact similar to those in its correspon-
ding EIA. An early step in an equity assessment is to
identify sub-populations likely to be affected by a reg-
ulation. Once identified, if data permits, the social
costs and benefits estimated for the BCA can be disag-
gregated and net benefits examined for the sub-popu-
lation (s). An equity assessment also examines other
economic impacts, such as increases in rates of
unemployment or other traditional impact measures,
for the identified sub-populations (s).
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Chapter 9: Distributional Analyses
f An equity assessment Is not an Independent
form of economic analysis, but is a. reflection of
decisions made on many of the other analytic issues
arising in the benefit, cost, and economic impact sec-
tions of this guidance. For example, the analysis of
distributions over long time horizons can be greatly
affected by the analyst's treatment of uncertainty or
choice of a discount rate. Baseline issues are impor-
tant in the determination of net benefits expected to
accrue to specific sub-populations. When making
decisions on these and other relevant issues, the ana-
lyst should keep in mind the ramifications borne by
the equity assessment.
Many of the instructions offered in the preceding sections
on estimating economic impacts will be directly applicable
to an equity assessment. The difference will be extending
the analysis or presentation of results to describe sub-pop-
ulation (s) for which impacts are estimated. Whereas an
EIA focuses on traditional classifications of affected popu-
lations (like industrial classifications), an equity assess-
ment often focuses on "disadvanlaged or vulnerable" sub-
populations (like low income households) but, for com-
parison or other purposes, can also focus on other rele-
vant sub-populations (like upper income households). In
this section, we outline a general framework for conduct-
ing an equity assessment but refer the reader to Sections
5, 6, and 9-2 for approaches used to estimate specific
impacts. As is true for an EIA, generally speaking, an equi-
ty assessment is more concerned with sub-populations
experiencing net costs or other negative impacts than
those experiencing net benefits or positive impacts.
The following parts of this section accomplish three objec-
tives. First, the existing environmental and administrative
statutes, executive orders, and agency policies which direct
analysts to consider specific sub-populations when assess-
ing the economic effects of EPA's regulations are reviewed.
The statutes and policies are enumerated, the relevant
sub-populations are identified, and definitions are estab-
lished for these sub-populations. Second, a broad frame-
work for conducting an equity assessment is outlined.
This section concludes with a review of general sources of
data for assessing equity impacts.
9.3.2
Of
Equity issues are at the heart of two existing statutes—The
Regulatory Flexibility Act of 1980 (RFA), as amended by
the Small Business Regulatory Enforcement Fairness Act of
1996 (SBREFA), and The Unfunded Mandates Reform Act
of 1995 (IMR4)5'—and two executive orders^EO 12898,
"Federal Actions to Address Environmental Justice in
Minority Populations and Low-Income Populations" and
EO 13045, "Protection of Children From Environmental
Health Risks and Safety Risks,"—all of which require
agencies to consider a regulation's distributional impact on
various entities or sub-populations.52 These administrative
laws or orders suggest several equity dimensions; in partic-
ular, entity size, minority status, income level, and child-
hood status. Exhibit 9-5 lists these equity dimensions and
links each to the relevant statute or order, to a population,
and to at least one established definition of sub-populations.
A second executive order—EO 12866, "Regulatory
Planning and Review" has multiple objectives regarding
regulatory planning and review, many that have nothing to
do with improvements in equity. It does, however, include
a specific directive for agencies to consider distributive
impacts and equity when designing regulations. Thus,
Exhibit 9-5 lists the equity dimensions suggested by the
OMB's Best Practices for EO 12866 and noted in its OMB
Guidelines for economic analyses. The equity dimensions
are discussed in more detail below.
The RFA as amended by SBREFA and UMM require agen-
cies to consider economic effects on small entities—
specifically, small businesses, small governmental
in UMRA,
51 EO 13132, Federalism, and EO 13084, Consultation and Coordination With Indian Tribal Governments, both support some objectives
52 The Office of Regulatory Management and Information's Rule and Policy Information Development System (R4PIDS)
http://intranet.epa.gov/rapids (accessed 4/05/2000, internal EPA document) is a resource for those who wish to read relevant statutes, executive
orders or Agency policy documents in their entirety or to acquire copies.
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Chapter 9: Distributional Analyses
Exhibit 9-5 Equity Dimensions Potentially Relevant to Environmental Policy Analyses5
Equity Dimension
Administrative Law
or Order
Population
Definitions of Sub-Populations
Entitv Size
RFA; UMRA; OMB Guidance
to EO 12866
Businesses,
Governmental
Jurisdictions,
Not-for-Profit
Organizations
The RFA references the Small Business Act
definition of small business which defines
small business using SIC codes. Definitions
sometimes depend on number of employees
and other times depend on annual receipts.
The RFA defines small governmental
jurisdiction as the government of a city,
county, town, school district, or special
district with a population of less than 50,000.
The RFA defines a small not-for-profit
organization as an enterprise which is
independently owned and operated and is not
dominant in its field.54
UMRA defines small government jurisdiction,
similar to the RFA, as the government of a
city, county, town, school district, or special
district with a population of less than 50,000,
and any tribal government.
Minority Status
E.G. 12898; OMB
Guidance to EO
12866; EO 13084
for Indian tribal
communities only
Individuals or
Households
Minority population of the affected area
exceeds 50 percent or minority population
percentage of the affected area is meaning-
fully greater than the minority population
percentage in the general population or other
appropriate unit of geographic analysis.
(Minorities are those individuals classified by
OMB Directive No. 15 as Black/African
American, Hispanic, Asian and Pacific
Islander, American Indian, Eskimo, Aleut,
and other non-white persons.)
"Indian tribe" means an Indian or Alaska
Native tribe, band, nation, pueblo, village, or
community that the Secretary of the Interior
acknowledges to exist as an Indian tribe
pursuant to the Federally Recognized Indian
Tribe List Act of 1994, 25 U.S.C. 479a. (See
EO 13084.)
Income Level
EO 12898; OMB
Guidance to EO 12866
Individuals or
Households
Annual statistical poverty thresholds from
the U.S. Bureau of the Census' Current
Population Reports, Series P-60 on Income
and Poverty. Consumers grouped according
to consumption expenditures (e.g., into
deciles).
5i Some environmental statutes may also identify sub-populations that merit additional consideration, but this document is limited to
those with broad coverage.
54 The RFA also allows agencies to establish an alternative definition of small entity after notice-and-comment, and for small businesses
only, after consultation with the Small Business Administration (SBA).
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Chapter 9: Distributional Analyses
Exhibit 9-5 Equity Dimensions Potentially Relevant to Environmental Policy Analyses
(Continued)
Equity Dimension
Childhood Status,
Age
Gender
Time
Physical Sensitivity
Administrative Law
or Order
EO 13045, OMB
Guidance to EO 12866
OMB Guidance to
EO 12866
OMB Guidance to
EO 12866
OMB Guidance to
EO 12866
Population
Individuals or
Households
Individuals
Individuals or
Households
Individuals or
Households
Definitions of Sub-Populations
EPA's Office of Children's Health Protection
does not adhere to a single definition of
"child." It suggests that the definition will
vary depending upon the issue (s) of
concern.
U.S. Bureau of the Census reports statistics
by age in five-year age groups and for the
following special age categories: 16 years
and over; 18 years and over; 15 to 44 years;
65 years and over; 85 years and over.
Male/Female
Current/Future Generations
Varies according to the rule under review.
For example, a rule that controls an air
pollutant might define a physically sensitive
sub-population as individuals with asthma.
jurisdictions, and/or small not-for-profit organizations.
Definitions of "small" for each of these entities are consid-
ered below. For guidance as to when it will be necessary to
examine the economic effects of a regulation under the
RFA, analysts should consult EPA guidelines on these
administrative laws.55 These guidelines include the types
of economic effects that must be considered and establish-
ment of the baseline for purposes of determining if a rule
may have a significant economic impact on a substantial
number of small entities. Further, these guidelines
explain the requirements in the event the rule is found to
have a significant economic impact on a substantial num-
ber of small entities. Note that the RFA only applies to
rules for which notice-and-comment rulemaking is
required.
9.3.3.1 Small Business
The RFA requires agencies to begin with the definition of
small business that is contained in the SBA's small busi-
ness size standard regulations.56 The SBA defines small
business by category of business using SIC codes, and in
the case of manufacturing, generally defines small busi-
ness as a business having 500 or fewer employees. For
some types of manufacturing, however, the SBA's size stan-
dards define small business as a business having up to
750, 1000, or 1500 employees, depending on the particu-
lar type of business. In the case of agriculture, mining,
and electric, gas, and sanitary services, the SBA size stan-
dards generally define small business with respect to
annual receipts (from $0.5 million for crops to $25 mil-
lion for certain types of pipelines).
55 U.S. Environmental Protection Agency, Revised Interim Guidance for EPA Rulewriters: Regulatory Flexibility Act as Amended by the
Small Business Regulatory Enforcement Fairness Act, dated March 29, 1999.
56 5 U.S.G. § 601; see also the SBA's "Small Business Size Regulations" are contained in the Code of Federal Regulations at 13 CFR 121 and
in the Federal Acquisition Regulation 46 CFR 19. The SBA reviews and reissues the size standards every year. The current version can be viewed at:
http://www.sbaonline.sba.gov/gopher/Financial-Assistance/Size-Standards/ (accessed on 8/28/2000).
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Chapter 9: Distributional Analyses
The RFA also authorizes any agency to adopt and apply an
alternative definition of small business "where appropriate
to the activities of the agency" after consulting with the
Chief Counsel for Advocacy of the SBA and after opportuni-
ty for public comment. The agency must publish any
alternative definition in the Federal Register.57
9.3.3.2
Jurisdiction
The RFA defines a small governmental jurisdiction as the
government of a city, county, town, school district, or spe-
cial district with a population of less than 50,000. Similar
to the definition of small business, the RFA authorizes
agencies to establish alternative definitions of small gov-
ernment after opportunity for public comment (consulta-
tion with the SBA is not required). Any alternative defini-
tion must be "appropriate to the activity of the agency" and
"based on such factors as location in rural or sparsely pop-
ulated areas or limited revenues due to the population of
such jurisdiction." Any alternative definition must be pub-
lished in the Federal Register.58
Section 202 of UMRA directs agencies to obtain meaningful
input from state, local, and tribal governments for each
proposed and final rule "containing significant federal
intergovernmental mandates." More specifically this
requirement is for rules that include federal mandates
"which may result in the expenditure by state, local, and
tribal governments, in the aggregate, or by the private sec-
tor, of $100 million or more in any one year."59 Section
203 of UMRA requires that agencies assess whether its
rules "might significantly or uniquely affect small govern-
ments" so as to consider the need for a compliance plan.
Small governments are defined in the paragraph immedi-
ately above. The phrase "small towns" refers to very small
governments with populations of under 2,500 citizens. .As
part of the "Small Government Agency Plan" required
under UMRA, EPA evaluates such factors as whether small
governments will experience higher per-capita costs due to
economies of scale, whether they would need to hire pro-
fessional staff or consultants for implementation, or if they
would be required to purchase and operate expensive or
sophisticated equipment.60
9.3.3.3 Not-for-Profit
Organization
The RFA defines a small not-for-profit organization as an
"enterprise which is independently owned and operated
and is not dominant in its field." Examples might include
private hospitals or educational institutions. Here again,
agencies are authorized to establish alternative definitions
"appropriate to the activities of the agency" after providing
an opportunity for public comment (consultation with the
SBA is not required). Any alternative definition must be
published in the Federal Register.61
9.3.4
Level
Executive Order 12898, "Federal Actions to Address
Environmental Justice in Minority Populations and Low-
Income Populations" and its accompanying memorandum
have the primary purpose of ensuring that "each federal
agency shall make achieving environmental justice part of
its mission by identifying and addressing, as appropriate,
disproportionately high and adverse human health or envi-
ronmental effects of its programs, policies, and activities
on minority populations and low income populations... ."
57 U.S. Environmental Protection Agency, Revised Interim Guidance/or EPA Ralewriters: Regulatory Flexibility Act as Amended, by the
Small Business Regulatory Enforcement Fairness Act, dated March 29, 1999.
58 Ibid,
59 U.S. Environmental Protection Agency, Interim Guidance an the Unfunded Mandates Reform Act of 1995, memorandum from Office
of General Counsel, March 23, 1995b.
"° Ibid. p. 4,
61 U.S. Environmental Protection Agency, Revised Interim Guidance for FPA Rttlewriters: Regulatory Flexibility Act as Amended, by the
Small Business Regulatory Enforcement Fairness Act, dated March 29, 1999.
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Chapter 9: Distributional Analyses
The Executive Order also explicitly calls for the application
of equal consideration for Native American programs.62
EPA's Interim Final Guidance for Incorporating
Environmental Justice Concerns in EPA's NEPA
Compliance Analyses (EPA, 1998), discusses the meaning
of key terms arid phrases contained in EO 12898. Their
conclusions regarding four key phrases: "minority popula-
tion," "low-income population," "disproportionately high
and adverse human health effects," and "disproportionate-
ly high and adverse environmental effects" are summa-
rized below.
9.3.4.1 Minority
Minority individuals are those classified by Office of
Management and Budget Directive No. 15 as Black/African
American, Hispanic, Asian and Pacific Islander, American
Indian, Eskimo, Aleut, and other non-white persons. A
minority population should be identified where either (1)
the minority population of the affected area exceeds 50
percent or (2) the minority population percentage of the
affected area is meaningfully greater than its correspon-
ding percentage in the general population (or other appro-
priate unit of geographic analysis). A minority population
also exists if there is more than one minority group pres-
ent and the percentage calculated by aggregating all minor-
ity persons meets one of these thresholds. In identifying
minority communities, the Agency may consider as a com-
munity either: (1) a group of individuals living in geo-
graphic proximity to one another or (2) a geographically
dispersed/transient set of individuals (such as migrant
workers or American Indians), where either type of group
experiences common conditions of environmental expo-
sure or effect. The selection of the appropriate unit of geo-
graphic analysis may be a governing body's jurisdiction, a
neighborhood, census tract, or other similar unit that is to
be chosen so as to not artificially dilute or inflate the
affected minority population. The selection of the appro-
priate unit of geographic analysis may also be influenced
by the accuracy and precision of environmental quality
models.
9.3.4.2 Low-Income Population
Low income populations in an affected area can be identi-
fied with the annual statistical poverty thresholds from the
U.S. Bureau of the Census' Current Population Reports,
Series P-60 on Income and Poverty, In conjunction with
census data, the analysis should also consider state and
regional low-income and poverty definitions as appropri-
ate. In identifying low-income populations, the Agency
may consider as a community either a group of individuals
living in geographic proximity to one another or a geo-
graphically dispersed/transient set of individuals (such as
migrant workers or American Indians), where either type
of group experiences common conditions of environmen-
tal exposure or effects.63
One alternative to measuring annual incomes is to exam-
ine expected lifetime incomes. Generally, consumption is
better than annual income at tracking households' expect-
ed lifetime incomes. For example, an analyst might divide
the population by consumption deciles and see how the
lowest deciles fere. These data will be harder to access as
the Census does not contain consumption data.
9.3.4.3
Human
When determining whether human health effects are dis-
proportionately high and adverse, the Agency is to consider
the following three factors to the extent practicable:
f Whether the health effects, which may be measured
in risks and rales, are significant, unacceptable, or
above generally accepted norms. Adverse health
62 In addition, EO 13084, Consultation and Coordination with Indian Tribal Governments, requires regulations that "significantly or
uniquely1' affect Ihe communities of Indian tribal governments and that impose substantial direct compliance costs on such communities to either
refund the direct costs incurred or to consult with elected officials and other representatives of the Indian tribal governments and to provide a
description of the consultation and/or communication to the Office of Management and Budget.
"'' Two additional tests available for identifying low-income populations in an affected area are: (1) the U.S. Department of Health and
Human Services poverty guidelines or (2) the U.S. Department of Housing and Urban Development statutory definition for very low-income for the
purposes of housing benefits programs. Information on these and other tests can be found in the CEQ report Environmental Justice: Guidelines for
National Environmental Policy Act (CEQ, 1997) and Ihe Interim Final Guidance for Incorporating Environmental Justice Concerns in EPA's
NEPA Compliance (EPA, 1998).
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Chapter 9: Distributional Analyses
effects may include bodily impairment, infirmity, ill-
ness, or death;04 and
f Whether the risk or rate of hazard exposure by a
minority population or low-income population to an
environmental hazard is significant and appreciably
exceeds or is likely to appreciably exceed the risk or
rate to the general population or other appropriate
comparison group;65 and
f Whether health effects occur in a minority or low-
income population affected by cumulative or multiple
adverse exposures from environmental hazards.
9.3.4.4
Environmental
When determining whether environmental effects are
adverse and disproportionately high, the Agency is to con-
sider the following three factors to the extent practicable:
0~ Whether there is or will be an impact on the natural
or physical environment that significantly and
adversely affects a minority or low-income population.
Such effects may include ecological, cultural, human
health, economic, or social impacts on minority com-
munities or low-income communities, when those
impacts are interrelated with impacts on the natural
or physical environment; and
f Whether environmental effects are significant and are
or may be having an adverse impact on minority pop-
ulations or low-income populations that appreciably
exceeds, or is likely to appreciably exceed, those on
the general population or other appropriate compari-
son group; and
Whether the environmental effects occur or would
occur in a minority population or low-income popula-
tion affected by cumulative or multiple adverse expo-
sures from environmental hazards.
EO 13045, Protection of Children Prom Environmental
Health Risks and Safety Risks states that:
"A growing body of scientific knowledge demon-
strates that children may suffer disproportionate-
ly from environmental health risks and safety
risks. .. . Therefore, to the extent permitted by
law and appropriate, and consistent with the
agency's mission, each Federal agency: (a) shall
make it a high priority to identify and assess envi-
ronmental health risks and safety risks that may
disproportionately affect children; and (b) shall
ensure that its policies, programs, activities, and
standards address disproportionate risks to chil-
dren thai result from environmental health risks
or safety risks."06
The order also states that each "covered regulatory
action"07 submitted to OMB, unless prohibited by law,
should be accompanied by "...an evaluation of the environ-
mental health or safety effects of the planned regulation
on children."08 The term "children" is not defined. EPA's
Office of Children's Health Protection, established in
response to this order, does not use a single definition of
"child." They suggest that the definition will vary depend-
ing upon the issue(s) of concern. See Exhibit 9-5 for age
classifications reported by the U.S. Bureau of the Census.
EPA is currently developing a practical guide for valuing
children's health effects.
'** The definition of adverse health effects contained in specific environmental statues, under whose authority a regulation is being devel-
oped, may also guide (he consideration of adverse health effects in conducting equity assessments.
"'' The definition of risk or rate of hazard exposure contained in specific environmental statues under whose authority a regulation is being
developed may also guide the consideration of risk or rate of hazard exposure in conducting equity assessments,
66 EO 13045, Protection, of Children, From Environmental Health Risks and Sa/ety Risks effective April 21, 1997,
67 A "covered regulatory action" is any substantive action in a rale making that is likely to result in a rule that may (a) be economically sig-
nificant (have an annual effect on the economy of $ 100 million or more or would adversely affect in a material way the economy, a sector of the econ-
omy, the environment, and so on) and (b) concern an environmental health risk that an agency has reason to believe may disproportionately affect
children,
68 EO 13045,
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Dimensions
EO 12866, Regulatory Planning and Review has several
requirements that contribute to the preparation of eco-
nomic information, including a specific directive for agen-
cies to consider distributive impacts and equity when
designing regulations. The OMB Guidelines (OMB, 2000)
also makes note of several specific equity dimensions.
But, unlike the laws and orders mentioned above, it does
not suggest that analysts must always consider these
dimensions. Rather, the suggestion is that the regulation
under review should determine which equity dimensions
are relevant.
"Those who bear the costs of a regulation and
those who enjoy its benefits often are not the
same people. Regulations have 'distributional
effects' that affect different segments of the popu-
lation and economy in various ways: by income
groups, race, sex, industrial sector, and others.
Regulations often distribute benefits and costs
unevenly over time, perhaps spanning several
generations... . If these distributive effects are
important, you should describe the effects of var-
ious regulatory alternatives quantitatively to the
extent possible, including their magnitude, likeli-
hood, and incidence of effects on particular
groups. You should carefully analyze regulations
that significantly affect outcomes for different
groups."69
OMB seems to be offering a general directive to study dis-
tributive effects on any grouping of sub-populations when
those effects are expected to be significant, without requir-
ing agencies to always consider a predetermined set of
equity dimensions.
9.3.6.1 Equity
In its general directive, OMB specifically mentions gender
as a way to divide effects. Certain regulations may be found
to have differential impacts on males and females. Thus,
we add gender to the equity dimensions in Exhibit 9-5-
" OMB Guidelines, p. 16.
70 Ibid, p. 8.
71 Ibid,, p. 8.
Chapter 9: Distributional Analyses
Later in the OMB Guidelines it states, "The economic
analysis should also present information on the streams of
benefits and costs over time in order to provide a basis for
judging intertemporal distributional consequences, partic-
ularly where intergenerational effects are concerned."70
This leans more towards being a directive and suggests
that time is an important equity dimension. The OMB
Guidelines give some suggestions for conducting an inter-
generational analysis including:
"Special approaches may also be appropriate
when comparing benefits and costs across gener-
ations. One approach is to follow the discounting
method discussed above, and address the inter-
generational equity and fairness issues explicitly,
instead of modifying the discount rale."
"One alternative approach is based on the per-
spective that this generation is concerned about
the welfare of future generations and, in fact, is
willing to defer consumption and invest or pre-
serve resources for future use at a discount rate
that is less than the discount rale used in making
decisions within a generation. For this purpose,
you could use as a discount rate a special rate of
time preference based on the growth of per capita
consumption. Again, check with us if you plan to
use such an approach."71
Both OMB and EPA recognize that inter-generational equity
issues are potentially addressed by applying a discounting
procedure. In the quotation above, OMB offers some ana-
lytical approaches to inter-generational discounting.
Chapter 6 of this document provides information on alter-
native methods of discounting in this context and discuss-
es when such discounting is, and is not, appropriate.
When discussing risk assessment, the Best Practices men-
tions that,
"Exposures and sensitivities to risks may vary
considerably across the affected population.
These difficulties can lead; for example, to a
range of quantitative estimates of risk in health
and ecological risk assessments that can span
167
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Chapter 9: Distributional Analyses
several orders of magnitude... . All of these con-
cerns should be reflected in the uncertainties
about outcomes that should be incorporated in
the analysis."72
Hence, we include physical sensitivity as an important
equity dimension. The definition of who precisely is physi-
cally sensitive will vary according to the rule being devel-
oped. For example, a rule that controls an air pollutant
might have a large impact on individuals with asthma. Or,
a rule that diminishes the quantity of a hazardous sub-
stance that winds up in soils near residential areas, might
have a large impact on children with pica (a disorder that
results in an urge to eat non-food substances such as
dirt).
The Best Practices is not the only source directing atten-
tion to physical sensitivity. There are sections of environ-
mental statutes which require EPA to address sensitive
populations, analyze effects, and take actions to avert or
mitigate adverse impacts. For example, the Clean Air Act
section 108(f)(1)(C) requires the Administrator to publish
and make available "information on other measures which
may be employed to reduce the impact on public health or
protect the health of sensitive or susceptible individuals or
groups... ."
Finally, the Best Practices mentions that economic analy-
ses might need to consider different age categories.
"The literature identifies certain attributes of risk
that affect value. These attributes include the
baseline risk, the extent to which the risk is vol-
untarily or involuntarily assumed, and features
(such as age) of the population exposed to risk.
For regulations affecting some segments of the
population (e.g., infants) more than those groups
which have served as the basis for most of the
information used to estimates (sic.) values of a
statistical life (e.g., working-age adults), the use
of values of a statistical life from the literature
may not be appropriate."73
Age is clearly the issue in EO 13045, though its specific
focus is on childhood status. Thus, Exhibit 9-5 lists child-
hood status and age as two aspects of a single equity
dimension and cites the Best Practices and OMB
Guidelines, as well as EO 13045. The next three entries of
Exhibit 9-5 list the other equity dimensions suggested by
the Best Practices and OMB Guidelines and links each to
a population and at least one established definition of sub-
populations.
While directing agencies to consider the differential impact
of a regulation on relevant sub-populations, the OMB
Guidelines state that an economic analysis should focus
on the distribution of the costs and benefits of complying
with a regulation rather than on the financial well-being of
regulated entities.
"Since generally accepted principles do not exist
for determining when one distribution of net
benefits is more equitable than another, you
should describe distributional effects without
judging their fairness. You should describe these
effects broadly, focusing on large groups with
small effects per capita, as well as on small
groups experiencing large effects per capita. You
should also note any equity issues not related to
the distribution of policy effects if they are impor-
tant, and describe them quantitatively to the
extent you can."7'1
OMB cautions analysts conducting distributional analyses
to recognize that transfer payments will become relevant;
to avoid double-counting even when mixing monetized and
physical effects and to describe distributional effects with-
out judging their fairness.
9.3.7 A for
Assessment
What follows is a very general three-step framework to
guide analysts conducting equity assessments.
Instructions for estimating particular impacts on sub-pop-
ulations are given above in the section on EIA. Whether
disaggregating benefits and costs or estimating economic
impacts, the primary purpose of an equity assessment is
" Best Practices, p. 15.
71 Ibid, p, 29.
" OMB Guidelines, p. 16,
168
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Chapter 9: Distributional Analyses
to examine regulatory consequences for specific sub-popu-
lations of concern. Thus, the framework developed here
offers an approach on how to identify a sub-population to
be analyzed.
For each step, choosing to measure the equity-related con-
sequences of a regulation involves balancing costs of data
acquisition and analysis against the value of improved
accuracy. The framework attempts to conserve resources
by screening out situations for which any of the variety of
equity impacts probably will not occur. This permits more
extensive analytical and empirical efforts to focus on cir-
cumstances with a higher probability of creating significant
equity-related effects. The three steps should not be
viewed as necessarily sequential. Instead, at the outset of
a particular regulatory analysis, all aspects of the suggested
approach should be considered. This will help to ensure
that the data gathered and the analyses performed will be
well suited to measuring the equity impacts of concern.
9.3.7.1 1:
Analysis
This first step consists of several tasks described here in
sequential order.
f Determine which populations listed in Exhibit
9-5 are within the scope of the analysis or exist
relevant markets. In certain cases, some of the
populations might not be connected closely enough to
the regulation to be meaningfully affected. For exam-
ple, governmental entities might not be involved in
the activities that would be affected by a regulation. If
so, then no further analysis is necessary for these
populations. It will be useful to make this determina-
tion early so that resources may be used in the most
effective manner possible.
^~ Determine whether the rule or regulatory alter-
native imposes costs, offers benefits, or results
In other economic effects too small to warrant
further analysis. When considering the cost side of
the analysis, it might be possible to argue that incre-
mental unemployment and plant or firm closures
resulting from even small regulatory costs cannot be
distinguished from changes that would probably be
triggered by the underlying economic viability of these
activities. This step also applies when a. regulation
imposes one burden on an entity!, but reduces anoth-
er on the same entity, so that the net effect is small.
Although some equity impacts might be dismissed on
this basis, others will probably require further analy-
sis beyond this initial de minimis screen.
Identify which equity dimensions from Exhibit
9-5 are relevant If further analysis Is required.
Negative impacts on small entities, low income popu-
lations, minority populations, and children are
important to consider in all cases because of statutory
and. other mandates (see Section 9-3.2). For exam-
ple, rules requiring additional safeguards against con-
tamination of groundwater by landfills clearly benefit
communities where landfills are sited. There is a
long-standing concern among the environmental jus-
tice movement that locally unwanted facilities, includ-
ing landfills, are sited disproportionately in poor
and/or minority neighborhoods. Thus, for regulations
affecting siting and management of landfills, wealth
and. race are equity dimensions of concern. Rules
requiring additional safeguards are likely to have a
positive impact on neighborhoods hosting landfills.
This positive impact should be noted and possibly
estimated. For other rules, it is likely that concern for
other equity dimensions will naturally arise.
In addition to those equity dimensions that must
always be considered for distributional analysis, the
other dimensions listed by Exhibit 9-5 should be con-
sidered as part of the effort to identify which are rele-
vant. In attempting to decide for a particular case
whether some of the less obvious dimensions matter,
analysts should collect readily accessible information
on the characteristics of affected entities and popula-
tions. Attention should be paid to who is expected to
receive the benefits of the regulation as well as who
will pay the costs. Negative net benefits or net costs
are ultimately what should trigger concern. Financial,
health, and other non-monetary benefits and costs
should be included.
Prioritize relevant equity dimensions. Assuming
there is more than one relevant equity dimension,
they should be prioritized according to which dimen-
sion seems to warrant greatest concern. The level of
concern should be determined by how strongly
analysts expect a regulation to affect a particular
sub-population.
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Chapter 9: Distributional Analyses
9.3.7.2 2:
for the Equity of
Concern
The next step is to define distributional variables associat-
ed with the equity dimensions from Step 1. For example,
if one were concerned about a regulation's potential
impact on poor neighborhoods, then a classification sys-
tem for "poor" versus "not-poor" neighborhoods should be
developed. The established definitions reviewed in Section
93.2 above could be used or alternatives developed.
Referring again to the landfill example where one of the
relevant equity dimensions is race, analysts would need to
establish a rule for defining what qualifies as an African-
American neighborhood or a minority neighborhood. In
this case, one could rely on the established definitions pre-
sented in Section 9-3.2.
9.3.7.3 3: Equity
Consequences
The next step is to begin to measure specific economic
effects across the distributional variables. In some cases,
estimating the equity-related effects of a regulation will
involve disaggregating existing costs and benefits and tabu-
lating or otherwise accounting for their distribution across
the distributional variables defined in Step 2. This process
would subject the equity assessment to the same set of
assumptions applied to the benefit-cost analysis.
In other cases, an equity assessment will examine oilier
impacts, such as increases in unemployment, for identi-
fied sub-populations. The section above on EIA reviews
these other impacts and outlines how to estimate them.
Any assumptions, for example those concerning elasticities
of demand, used in the EIA, should also be applied to the
Equity Assessment unless there are specific reasons for
why the assumptions are inappropriate for the identified
sub-population (s).
A thorough equity assessment, when resources permit,
might include a disaggregation of benefits and costs from
the BCAas well as an examination of economic impacts
for the identified sub-population (s).
for
Assessments
The discussion in the preceding sections suggests several
types of data that would be useful for estimating the distri-
bution of impacts of environmental policy options. This
section presents some of the data sources for each catego-
ry of data needed. This is not an exhaustive list of data
sources, but is presented to provide initial guidance for
this information.
9.3.8.1 on
Not-For-Prof it
Organizations
Two specific Internet sites provide access to some of the
most commonly needed data. The first is the SBA's Office
of Advocacy website.75 Data provided on this website
include the number of firms, number of establishments,
employment, annual payroll, and. estimated receipts. The
data are available by employment size categories. Data
may be viewed and downloaded for the U.S., by state or by
metropolitan statistical area. A second website that ana-
lysts may find useful is the home page of the U.S. Bureau
of the Census, Office of Statistics.76 Here a variety of rele-
vant data may be accessed including information pub-
lished in the County Business Patterns and other pub-
lished data series on population characteristics, including
income and age distributions.
9.3.8.2
The U.S. Bureau of the Census collects household data and
aggregates them in forms that may be useful for environ-
mental justice mailers. Data are available on population
distributions by race and household income at the state,
county, metropolitan statistical area, or census tract level.
An additional. Census website allows one to view a map of
any part of the U.S., at the desired scale, that shows data
on population distributions by family income or a specified
race (e.g., percent white or percent black).77 In addition,
income data collected bv the Internal Revenue Service and
75 The address for this site is http://wwwsba,g0y/ADVO/stats/ (accessed 8/28/2000, internal EPA document).
" The address for this site is http://wwwcensus.gov (accessed 8/28/2000).
" The address for this site is http://wwwcensus.gov/geo/www/tiger/index.html (accessed 8/28/2000).
170
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Chapter 9: Distributional Analyses
made available in aggregated form on the Internet may be
useful for some analyses.78
9.3.8.3
Sources
There is a range of other sources that may provide useful
data on other factors potentially relevant to equity analy-
ses. For example, import and export data are available
from the Bureau of the Census publication, The U.S.
Merchandise Trade: Exports, General Imports, and
Imports for Consumption. The U.S. Department of
Commerce may also have data that would be useful for
estimating changes in demand as a result of regulatory
costs, or the turnover rate for capital equipment in various
industrial sectors.
78 The address of the website providing these data is http://trac.syr.edu/tracirs/. Note that a user ID and password are necessary to access
the data. Registration is available at http://trac.syr.edu/registcr/rcgistration.html (accessed 8/28/2000).
171
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Chapter 9: Distributional Analyses
9.4
Altaian, E. I. et al. 1993. Corporate Financial DMress and Bankruptcy, 2nd Ed., New York: John Wiley and Sons.
Arrow, K. J. 1977. Extended Sympathy and the Possibility of Social Choice. American Economic Review, Vol 67, No. 1,
February. 219-225.
Dun &Bradstreet Information Services, Industry Norms &Key Business Ratios, New York, NY: (annual).
Econotnic Report of the President, transmitted to the Congress, February (annual). Washington, D.C.: US Government
Printing Office.
Farrow, S. 1998. Environmental Equity and Sustainability: Rejecting the Kaldor-Hicks Criteria. Ecological Economics,
27(2): 183-188.
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(accessed 8/28/2000).
Gray W and R. Shadbegian. 1997. Environmental Regulation, Investment Timing, and Technology Choice. National
Bureau of Economic Research, Working Paper 6036, May.
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Jaffee, A. et. al. 1995- Environmental Regulation and the Competitiveness of U.S. Manufacturing: What Does the Evidence
Tell Us? Journal of Economic Literature, 32(1): 132-163.
Jorgenson, D. W 1997. Welfare: Volume 2 - Measuring Social Welfare. Cambridge, MA: MIT Press.
Just R. E., D. L. Hueth, and A. Schmitz. 1982. Applied Welfare Economics and Public Policy, Englewood, NJ: Prentice-
Hall.
Norland, D. L. and K. Y. Ninassi. 1998. Price It Right: Energy Pricing and Fundamental Tax Reform. Report to the
Alliance to Save Energy-, Washington, DC.
Robert Morris Associates, Annual Statement Studies, Philadelphia, PA (annual).
Sen, A. K. 1970. Collective Choice and Social Welfare. San Francisco, CA: Holden-Day.
Standard & Poor's Corp., Industry Surveys, (loose-leaf, updated weekly).
United Nations, Statistical Office, 'International Trade Statistics Yearbook, New York, NY (2 volumes).
U.S. Council on Environmental Quality. 1997. Environmental Justice. Guidance under the National Environmental
Policy Act.
U.S. Department of Agriculture, Agricultural Statistics. Annual reports, Washington, D.C.: U.S. Government Printing
Office.
U.S. Department of Commerce, Bureau of the Census, Annual Survey of Manufacturers. Annual reports. Washington,
B.C.: U.S. Government Printing Office.
U.S. Department of Commerce, Bureau of the Census, Census of Construction Industries. Published every five years, with
most recent data for 1997 published in 1999- Washington, D.C.: U.S. Government Printing Office.
U.S. Department of Commerce, Bureau of the Census, Census of Governments. Published every five years, with most
recent data for 1997 published in 1999- Washington, D.C.: U.S. Government Printing Office.
172
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Chapter 9: Distributional Analyses
U.S. Department of Commerce, Bureau of the Census, Cens-us of Manufacturers. Published every five years. Washington,
B.C.: U.S. Government Printing Office.
U.S. Department of Commerce, Bureau of the Census, Census of Mineral Industries. Published every five years, with
most recent data for 1997 published in 1999- Washington, B.C.: U.S. Government Printing Office.
U.S. Department of Commerce, Bureau of the Census, Census of Population. Published every five years with most recent
data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.
U.S. Department of Commerce, Bureau of the Census, Census of Retail Trade. Published every five years, with most
recent data for 1997 published in 1999- Washington, B.C.: U.S. Government Printing Office.
U.S. Department of Commerce, Bureau of the Census, Census of Service Industries. Published every five years, with most
recent data for 1997 published in 1999- Washington, D.C.: U.S. Government Printing Office.
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Chapter 9: Distributional Analyses
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Chapter 10: Using Economic
Analyses in Decision Making
10.1 Introduction
This chapter provides some general rules for present-
ing analytical results to policy makers and others
interested in environmental policy development. As
emphasized several times in these EA Guidelines,
especially by the flowchart and discussion of equity
assessments in Chapter 9, economic analyses play an
important role throughout the policy development
process. From the initial, preliminary evaluation of
potential options and their consequences through the
preparation of the final economic analysis document,
economic analysts participate in an interactive
process with policy makers. The fundamental goal of
this process is to refine the information available for
making policy choices.
Hence, this guidance for presenting inputs, analyses,
and results applies at all stages of this process, not
only for the final document embodying the complet-
ed economic analysis. In particular, reporting ranges
of uncertainty, critical assumptions, and key unquan-
tified effects to decision makers as they weigh various
options and alternatives is as critical as including
these in a final economic analysis document at the
conclusion of the policy development process.
This chapter first reviews some important features of
economic analyses of environmental policies to
include or describe in all presentations of analyses
and results. Following this is some general guidance
on what types of results are most useful to report and
useful formats for presenting them. Some brief com-
ments on the relationship between economic analy-
ses and environmental policy making conclude the
chapter. All of the recommendations in this chapter
are, of course, subject to resource availability and
statutory prohibitions.
10.2 Communicating
Assumptions and
Methods
All economic analyses of environmental policies must
balance the goals of accuracy and completeness
against the costs of data acquisition, detailed
modeling, and valuation of consequences. Hence,
the results of applied economic analyses inevitably
contain uncertainties in particular areas,
assumptions in the place of data that are not
available, and effects that cannot be quantified or
monetized. Analysts should highlight these
limitations when presenting the inputs, modeling,
and results of economic analyses.
Some general guidelines for communicating these
considerations include the following:
f Clarity and transparency: Presentations of
economic analyses should strive for maximum
clarity and transparency of all aspects of the
assessments. An analysis whose conclusions
can withstand close scrutiny of all of its facets is
more likely to provide policy makers with the
information they need to develop the best envi-
ronmental policies. In addition, if a rule is later
challenged, the more clear, transparent and
thorough analysis is, the easier it is to defend
the agency's regulatory approach.
f Delineation of data and assumptions:
Economic analyses should clearly describe all
important data sources and references used, as
well as key assumptions and their justifications.
All of these inputs should be available to policy
makers, and other researchers and policy ana-
lysts, to the extent that these data are not
•I:1
Chapter
10
175
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Chapter 10: Decision Making
confidential business information or some other form
of private data.
Exposition of modeling techniques: Although
modeling frameworks for many economic analyses
can be complex, it is important to convey at least the
basic framework used for modeling a policy's conse-
quences. The presentation should highlight the key
elements or drivers that dominate the framework and
its results.
Ranges for inputs and. results: At a minimum,
uncertainties should be explored through the use of
expected values supplemented by upper and lower
bounds for important inputs, assumptions, and
results. Sensitivity analyses using these ranges gener-
ally enhance the credibility of environmental policy
assessments. If key elements for an economic analy-
sis are extremely uncertain, these should be clearly
indicated. Analysts should explore how resolving
these uncertainties affects the conclusions of the
analysis.
Monetizing a policy's effects: To the extent feasible
and warranted by their contribution to the results, as
many of the effects of a policy as possible should be
monetized. This enhances the value of the conclu-
sions to policy makers weighing the many often dis-
parate consequences of different policy options and
alternatives.
Highlighting non-monetized and unquantified
effects: Economic analyses should present and high-
light non?monetized effects when these are important
for policy decisions. Reasons why these conse-
quences cannot be valued in monetary terms are
important to communicate as well. Unquantified, but
potentially significant, consequences of a policy also
should be highlighted, especially when these could be
important enough in magnitude to affect the broad
conclusions of an economic analysis of different poli-
cy options and alternatives.
Presenting and disaggregated results:
Finally, the analytic framework should be organized to
provide information on the separate economic conse-
quences of important individual programs or compo-
nent parts identified with the regulation. This can be
particularly challenging when the underlying physical
science and engineering information needed by the
economist to prepare the economic analysis may not
be amenable to a simple separation of the individual
contributions of pollution control choices (e.g.,
installed, emission control devices) to changes in risks
from pollutants. Further, some economic values used
in analyses represent a quantified aggregate value for
a set of environmental goods (e.g., a consumer bene-
fit measure for total improvements to surface water),
and it is unknown how to divide the value among the
individual attributes thai comprise this reported
value. Nevertheless, it is valuable to describe disag-
gregate information on the costs and benefits attribut-
able to individual policies whenever possible, given
the frequent necessity to package or link regulatory
actions or evaluations together into a single analysis.
The results of economic analyses of environmental policies
should generally be presented in three clusters:
f Results from benefit-cost analysis: Estimates of
the net social benefits should be presented based on
the benefits and costs for which dollar values can be
assigned, and a. discussion of non-monetizable or
unquantiflable benefits and costs should be provided;
f Results from economic impact analysis and
equity assessment: Results of the economic
impacts analysis and equity assessments should be
reported, including predicted effects on prices, profits,
plant closures, employment, and other effects, and
findings concerning the distribution of effects for
particular groups of concern, such as small entities,
governments, and disadvantaged and vulnerable
populations.
f Results from cost-effectiveness analysis: This
policy evaluation technique is used when many bene-
fits are not easily monetized and when the statutes or
other authorities dictate specific regulatory objectives.
Results of these analyses should also be presented
when these analyses are conducted.
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Chapter 10: Decision Making
The relative importance of these three clusters will depend
upon the policy and statutory context of the decision.
Generally, analyses leading to these findings normally
should be conducted simultaneously and the results
should, be presented together as different ways to examine
a policy's social consequences.1
10.3.1
Analysis
The net social benefits of each major alternative is estimat-
ed by subtracting the present value of monetary social
costs from the present value of monetary social benefits
(as defined in Chapter 6). For this calculation the same
baseline must be used in both the benefit and cost analy-
ses. Plausible upper- and lower-bound estimates of net
benefits should be provided, the "best" or most-likely esti-
mate should be identified and the sensitivity of the net
benefits estimate to variations in uncertain parameters
should be examined.
Other considerations for presenting and summarizing the
results from benefit-cost analyses include the following:
f Discounting benefits and costs Is the preferred
method for summarizing benefits and costs that
accrue over several years. The conditions for dis-
counting in benefit-cost analysis are outlined in
Chapter 6. Alternatives to discounting include annu-
alizing costs and benefits, comparing those figures,
and accumulating costs and benefits through time to
a future year. When both traditional discounting and
these alternatives are not feasible or advisable, it is
appropriate to display the streams of costs and bene-
fits over time for policy makers to consider.
f Present and evaluate non-monetized and non-
quantified effects. The net social benefit estimate
should be carefully evaluated in light of all the effects
that have been excluded because they cannot be val-
ued in monetary terms. Thus, immediately following
a net benefit calculation, there should be a presenta-
tion and evaluation of all benefits and costs that can
only be quantified but not valued, as well as all bene-
fits and costs that can be only qualitatively described.
Present the incremental benefits, costs, and net
benefits of moving from one regulatory alterna-
tive to more stringent ones. This presentation
should be done both globally and by sub-population.
This should include a discussion of incremental
changes in quantified and qualitatively described ben-
efits and costs. It is sometimes necessary to evaluate
all combinations of options and alternatives when key
sources of benefits and costs of a policy are affected
by more than one option. In these cases, identifying
the combination of alternatives with the highest net
social benefits cannot rely only on the incremental
benefits and costs of each individual option when
added to other prePexisting options.
Discuss other potential costs and benefits that
may be by-products of the proposed action.
These include transfers of the pollutant problem from
one exposure medium or program office jurisdiction
to another or possible exacerbation of exposures for
specific groups (e.g., sensitive sub-populations, maxi-
mum exposure groups, or specific types of workers)
not captured already in the economic impacts analy-
sis and equity assessment.
Assessment
Economic impact analyses and equity assessments focus
on distributional outcomes. Therefore, the presentation of
these results should focus on disaggregating effects to
show impacts separately for the groups and sectors of
interest. If costs and/or benefits vary significantly among
the sectors affected by the policy, then both costs and ben-
efits should be shown separately for the different sectors.
Presenting results in disaggregated form will provide
important information to policy makers that may help
them tailor the rule to improve its efficiency and equity
outcomes.
1 There are other, more limited types of economic analysis that can inform policy decisions. One example is health-health analysis (some-
times known as risk-risk analysis) thai assesses the health risks introduced by diverting 1o regulation resources otherwise available for individual
health care. Although limited, health-health analysis may be useful in contexts where benefit-cost analysis is infeasible. The method has been
employed by several researchers (Viscusi, 1994; Keeney, 1997), but is not without criticism (Portney and Stavins, 1994).
177
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Chapter 10: Decision Making
The results of the economic impact analyses should also
be reported for iniporta.nl sectors within the affected com-
munity—identifying specific segments of industries,
regions of the country, or types of firms that may experi-
ence significant impacts or plant closures and losses in
employment.
Reporting the results of equity assessments may include
the distribution of benefits, costs, or both for specific sub-
populations including those highlighted in the various
mandates. These include minorities, low-income popula-
tions, small businesses, governments, and non-profits, and
sensitive and vulnerable populations (including children).
Where these mandates specify requirements that depend
on the outcomes of the distributional analyses (such as
the Regulatory Flexibility Act), the presentation of the
results should conform to the criteria specified by the
mandate.
10.3.3
When many benefits cannot easily be monetized, or when
statutes or other authorities set forth a specific policy
objective, economic analyses should present the results of
a cost-effectiveness analysis. This will provide useful infor-
mation to policy makers and it conforms to the general
principle of minimizing the cost of achieving particular
policy goals.
The cost-effectiveness of a policy option is calculated by
dividing the annualized cost of the option by non-mone-
tary benefit measures. Such natural units measures range
from the amount of the reduction in pollution measured
in physical terms, to the ultimate improvements in human
health or the environment measured in terms of specific
effects and damages avoided.
Cost-effectiveness analysis does not necessarily reveal what
level of control is reasonable, nor can it be used to directly
compare situations with different benefit streams.
Moreover, other criteria, such as statutory requirements,
enforcement problems, technological feasibility or quantity
and location of total emissions abated, may preclude
selecting the least-cost solution in a regulatory decision.
However, where not prohibited by statute, cost-effective-
ness analysis can indicate which control measures or poli-
cies are inferior options.
of
in
The primary purpose of conducting economic analysis is
to provide policy makers and others with detailed informa-
tion on wide variety of consequences of environmental
policies. One important element these analyses have tra-
ditionally provided to the policy-making process is esti-
mates of social benefits and costs—the economic efficien-
cy of a policy Hence, the EA Guidelines reflect updated
information regarding procedures for calculating benefits
and costs, monetizing benefits estimates, and selecting
particular inputs and assumptions.
Determining which regulatory options are best even on the
restrictive terms of economic efficiency, however, often is
made difficult by uncertainties in data and by the presence
of benefits and costs that can be quantified but not mone-
tized or that can only be qualitatively assessed. Thus, even
if the criterion of economic efficiency were the sole guide
to policy decisions, social benefit and cost estimates alone
would not be sufficient to define the best policies.
A large number of social goals and statutory and judicial
mandates motivate and shape environmental policy. For
this and other reasons, the EA Guidelines contain infor-
mation concerning procedures for conducting analyses of
other consequences of environmental policies, such as
economic impacts and equity effects. This is consistent
with the fact that economic efficiency is not the sole crite-
rion for developing good public policies.
Even the most comprehensive economic analyses are but
part of a larger policy development process, one in which
no individual analytical feature or empirical finding domi-
nates. The role of economic analysis is to organize infor-
mation and comprehensively assess the economic conse-
quences of alternative actions—benefits, costs, economic
impacts, and equity effects—and the tradeoffs among
them. These results serve as important inputs for this
broader policy-making process along with other analyses
and considerations.
178
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Chapter 10: Decision Making
Jorgensoii, D. W 1997. Welfare, Volume 2: Measuring Social Welfare. Cambridge, MA: MIT Press.
Keeney, R. L. 1997. Estimating Fatalities Induced by the Economic Costs of Regulations. Journal of Risk and
Uncertainty, 14(1): 5-23.
Portney, P R. and R.N. Stavins. 1994. Regulatory Review of Environmental Policy: The Potential Role of Health-Health
Analysis. Journal of Risk and Uncertainty, 8(1): 11-122.
Viscusi, W K. 1994. Risk-Risk Analysis. Journal of Risk and Uncertainty, 8(1): 5-17.
179
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Chapter 10: Decision Making
180
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Appendix A: An SAB Report on
the EPA Guidelines for Preparing
Economic Analysis
Appendix A
181
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United States Science Advisory EPA-SAB-EEAC-99-020
Environmental Board (1400) September 1999
Protection Agency Washington DC ivww.epa.gov/sab
&EPA AN SAB REPORT ON THE
EPA GUIDELINES FOR
PREPARING ECONOMIC
ANALYSES
A Review by the Environmental
Economics Advisory Committee
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UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
WASHINGTON, D.C. 20460
September 30, 1999
OFFICE OF THE ADMINISTRATOR
SCIENCE ADVISORY BOARD
EPA-SAB-EEAC-99-020
The Honorable Carol Browner
Administrator
United States Environmental Protection Agency
401 M Street, SW
Washington, DC 20460
Subject:
An SAB Report on the EPA Guidelines for Preparing Economic
Analyses
Dear Ms. Browner:
This Report on the Environmental Protection Agency's (EPA's) revised Guidelines for
Preparing Economic Analyses was developed by the Environmental Economics Advisory
Committee (EEAC) of the Science Advisory Board (SAB) in response to a charge received from
the Deputy Administrator on August 4, 1998 (attached). The review was carried out in a series of
meetings with the Agency's Office of Policy, beginning in August 1998, and ending with a
telephone conference on July 27, 1999.
As is described in detail in the full report, the Committee's general conclusion is that the
Guidelines succeed in reflecting methods and practices that enjoy widespread acceptance in the
environmental economics profession. Although some concerns remain about particular parts of
the Guidelines, our overall assessment is that the Guidelines are excellent. It is our hope that the
Guidelines demonstrate EPA's commitment to credible and consistent economic analyses in
support of the policy process.
The best analytical tools of environmental economics are constantly changing, as
experience with applications of existing tools and as new theoretical and empirical techniques
appear in the scholarly literature. As a result, it is important that EPA carry out new reviews of
the Guidelines every two to three years to reflect these developments in environmental economics.
The Committee looks forward to working with EPA to strengthen this document in the years
ahead.
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The iterative process that the EEAC employed with EPA for this review represents a
departure from the end-of-pipe assessments that are more typical of SAB practice. It was
consistent, however, with the Mission Statement of the EEAC prepared by the Deputy
Administrator, and was consistent with the SAB Executive Committee's previously expressed
aims. Although this approach will not necessarily be appropriate for all SAB reviews, it may be a
useful model in selected cases. Therefore, we briefly describe the procedure in the full report.
Finally, Dr. Albert McGartland and his staff in the Office of Economy and Environment
should be commended for the professionalism they brought to this process. The excellence of the
revised Guidelines is testimony to the dedication of the talented team of Agency economists and
analysts who worked on this project. It was, as always, a pleasure for the EEAC to interact with
Dr. McGartland and his staff. We anticipate that you and everyone involved will be proud of the
quality of the new Guidelines for Preparing Economic Analyses, and we look forward to your
questions and your response to our Report.
Sincerely,
/s/ /s/
Dr. Joan M. Daisey, Chair Dr. Robert N. Stavins
Science Advisory Board Environmental Economics Advisory
Committee
Science Advisory Board
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NOTICE
This report has been written as part of the activities of the Science Advisory Board, a
public advisory group providing extramural scientific information and advice to the Administrator
and other officials of the Environmental Protection Agency. The Board is structured to provide
balanced, expert assessment of scientific matters related to problems facing the Agency. This
report has not been reviewed for approval by the Agency and, hence, the contents of this report
do not necessarily represent the views and policies of the Environmental Protection Agency, nor
of other agencies in the Executive Branch of the Federal government, nor does mention of trade
names or commercial products constitute a recommendation for use.
Distribution and Availability: This Science Advisory Board report is provided to the EPA
Administrator, senior Agency management, appropriate program staff, interested members of the
public, and is posted on the SAB website (www.epa.gov/sab). Information on its availability is
also provided in the SAB's monthly newsletter {Happenings at the Science Advisory Board).
Additional copies and further information are available from the SAB staff.
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U.S. Environmental Protection Agency
Science Advisory Board
Environmental Economics Advisory Committee
Panel for Review of the Economic Analysis Guidelines
CHAIRMAN
Dr. Robert N. Stavins, Albert Pratt Professor of Business and Government, John F. Kennedy
School of Government, Harvard University, Cambridge, MA
MEMBERS
Dr. Nancy E. Bockstael Professor, Department of Agricultural & Resource Economics,
University of Maryland, College Park, MD
Dr. Dallas Burtraw, Fellow, Resources for the Future, Washington, DC
Dr. Trudy Ann Cameron, Professor, Department of Economics, University of California, Los
Angeles, CA
Dr. Maureen L. Cropper, Senior Economist, The World Bank, Washington, DC
Dr. Herman E. Daly, Senior Research Scholar, School of Public Affairs, University of Maryland,
College Park, MD
Dr. A. Myrick Freeman, Professor, Department of Economics, Bowdoin College, Brunswick,
ME
Dr. Dale W. Jorgenson, Frederic Eaton Abbe Professor of Economics, Department of
Economics, and JFK School of Government, Harvard University, Cambridge, MA
Dr. Paul L. Joskow, Elizabeth and James Killian Professor of Economics, Massachusetts
Institute of Technology, Cambridge, MA
Dr. Catherine Kling, Professor, Department of Economics, Iowa State University, Ames, IA
Dr. Richard L. Revesz, Professor of Law, New York University School of Law,
New York, NY
Dr. Jason F. Shogren, Stroock Distinguished Professor of Law and Economics, Department of
Economics and Finance; University of Wyoming, Laramie, WY.
Dr. Hilary A. Sigman, Assistant Professor, Department of Economics, Rutgers University, New
Brunswick, NJ.
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SCIENCE ADVISORY BOARD STAFF
Mr. Thomas O. Miller,Designated Federal Officer, Science Advisory Board (1400), U.S.
Environmental Protection Agency, Washington, DC
Mrs. Dorothy M. Clark,Management Assistant, Science Advisory Board (1400), U.S.
Environmental Protection Agency, Washington, DC
in
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TABLE OF CONTENTS
1. Executive Summary and Conclusions 1
2. Introduction 2
3. Specific Responses to Charge Questions 3
3.1. Discounting 3
3.2. Quantifying and Valuing Human Fatalities 4
3.3. Certainly Equivalents 5
3.4. Valuation Approaches for Human Morbidity and Improved Ecological
Conditions 5
3.5. Economic Impact and Net Social Benefits 6
3.6. Computable General Equilibrium 6
3.7. Economic Impacts to the Private Sector, Public Sector, and Households 7
3.8. Equity 8
3.9. Altruism 8
References R-l
Appendix A A-l
IV
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1. EXECUTIVE SUMMARY AND CONCLUSIONS
The Environmental Economics Advisory Committee (EEAC) of the EPA Science
Advisory Board (SAB) reviewed the Agency's draft Guidelines for Preparing Economic
Analyses (EPA, 1999) during a series of meetings extending from August 1998 to July 1999, in
response to a request received from EPA to perform a full and complete review. This is EPA's
first major overhaul of these guidelines in more than a decade. Because the Guidelines are to be
used by all parts of the Agency for carrying out regulatory analyses, it is important that they
reflect "methods and practices that enjoy widespread acceptance in the environmental economics
profession," as specified in the charge to the EEAC received from the EPA Deputy Administrator.
The draft Guidelines have been revised and improved as a result of the interactions between the
Committee and EPA staff in several public meetings over the past year. The EEAC's general
conclusion is that the Guidelines reflect best methods and practices that enjoy widespread
acceptance in the environmental economics profession, notwithstanding the several EEAC
concerns that remain about particular parts of the Guidelines. The Committee hopes that the
Guidelines demonstrate EPA's commitment to credible and consistent economic analysis in
support of the policy process.
The fundamental ingredients of an economic analysis of a proposed or existing
environmental policy or program are well covered in the Guidelines, and key conceptual, analytic,
and empirical issues are highlighted. The Guidelines acknowledge the practical limitations facing
EPA analysts in terms of time, resources, and expertise, and hence provide flexibility to analysts.
The Guidelines are just that — guidelines for analysis, not a rigid (or simplistic) cook book.
Economics, like any scholarly discipline, is constantly changing. Environmental
economics, a relatively young branch of the discipline, has experienced particularly rapid growth.
New areas of the literature continue to emerge, and existing areas change and expand. Hence,
despite the Committee's generally positive assessment of the revised Guidelines, we urge EPA to
carry out new reviews every two to three years. The time investments that will be required for
such periodic reviews — both on the part of EPA staff and on the part of the EEAC — will be
much less than was required for this first revision in ten years.
The interactive process that the EEAC employed with EPA for this review was something
of a departure from the end-of-pipe assessments that are more typical of SAB practice. It was
consistent, however, with the Mission Statement of the EEAC prepared by the Deputy
Administrator, and, moreover, was consistent with the SAB Executive Committee's previously
expressed interest in early involvement with the Agency on important issues. Although this
approach will not necessarily be appropriate for all SAB reviews, it may be a useful model in
selected cases. Therefore, we briefly describe the procedure here.
During the past twelve months, the EEAC held three one-day meetings in Washington,
D.C., devoted primarily to our review of EPA's revised Guidelines for Preparing Economic
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Analyses, plus a fourth meeting via teleconference. Each of the meetings was attended by Dr.
Albert McGartland, Director of the Office of Economy and Environment, and many members of
his staff. Intensive and extensive substantive discussions at these meetings provided an effective
forum in which EEAC members and the Committee as a whole could pose questions, describe
concerns, and express views, and for Agency representatives to explain the thinking behind their
drafts. Each of the first three meetings led to a subsequently revised draft, which in every case
addressed the general and specific concerns expressed by the EEAC at the previous meeting, and
thereby represented a significantly improved draft document. Dr. McGartland and his staff should
be commended for the openness, professionalism, and lack of defensiveness which they brought to
this process.
2. INTRODUCTION
The Environmental Economics Advisory Committee was requested to perform a full and
complete review of the Guidelines for Preparing Economic Analyses (EAGs or the Guidelines).
EPA asked for comments on all aspects of the guidance document and written documentation,
when applicable, on recommendations from the Committee for alternative methodologies,
assumptions and data sources to improve the presentation of issues addressed in the guidance
document.
The stated intent of the Guidelines is to:
a) Represent EPA policy on preparing economic analyses under a variety of
authorizing statutes and administrative requirements, each of which can influence
the conduct and use of analyses by different EPA offices;
b) Demonstrate EPA's commitment to credible/consistent economic analyses in
support of the policy making process;
c) Emphasize the need for analytic efforts commensurate with the value of that
information in the EPA policy making process;
d) Reflect mainstream economic science/methods that are well demonstrated and
relatively straightforward to apply to particular environmental issues;
e) Cover a number of principles and practices that virtually all economic analyses
should follow and clarify, for a number of identified analytic issues, the process
that analysts are to follow as they organize and conduct the analysis;
f) Account for some of the practical limitations on time and resources that EPA
analysts must contend with when preparing economic analyses; and
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g) Provide some flexibility to analysts to permit them to "customize" analyses to
conform to administrative and legal procedures.
The document embodying the Guidelines is not intended to be a text on the theory and
methods of applying economic analysis to EPA regulations and policies nor do they preclude new
or path breaking forms of analysis. EPA intends to regularly and frequently review and revise
parts of the Guidelines to reflect and report on significant changes in the literature used to support
EPA analyses, as well as changes in administrative and legal requirements that affect the conduct
of economics at the EPA.
3. SPECIFIC RESPONSES TO CHARGE QUESTIONS
The Committee's specific comments on the Guidelines are organized into nine sections,
the first eight of which address, respectively, questions posed in EPA's charge to the Committee.
The last section includes the Committee's advice on the topic of altruistic benefits.
3.1 Discounting
Charge Question 1. Does the published economic theory and empirical literature
support the statements in the guidance document on the treatment of discounting benefits
and costs in the following circumstances: a) private and public costs for use in an
economic impact analysis, b) social benefits and costs in an intragenerational context; c)
social benefits and costs in an inter generational context; and d) social benefit and cost
information that is reported in nonmonetary terms?
The guidance document is consistent with published theoretical and empirical analysis on
the use of discounting for (a) private and public costs in an economic impact analysis, and for (d)
social benefit and cost information expressed in non-monetary terms. The current literature also
supports the discussion of issue (b), discounting social benefits and costs in an intragenerational
context. In this context, the document should encourage the use of a discount rate in the middle
of its recommended range, in addition to the values currently mentioned, to reflect common
practice.
The proper application of discounting in an intergenerational context (issue (c)) remains
controversial in the published literature. The guidance document lays out the positions in this
debate clearly. Reflecting the disagreement within the economics profession, there is diversity of
opinion within the EEAC on this issue. Some members believe that the guidance document is
more critical than the published literature of the view that intergenerational discounting should not
differ from other discounting, while other members support the document's current emphasis.
The final quantitative recommendations for discount rate values in the intergenerational context
are broad enough to be uncontroversial.
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3.2 Quantifying and Valuing Human Fatalities
Charge Question 2. Does the published economic theory and empirical literature
support the statements in the guidance document on quantifying and valuing the social
benefits of reducing fatal human health risks?
The guidance document recommends that the mean value of a statistical life (VSL) based
on 26 published studies be used as the default value in Agency analyses. It urges that a
qualitative discussion of the appropriateness of this estimate to the population and risks analyzed
accompany the use of the central tendency estimate.
The EEAC encourages the use of value of a statistical life (VSL) estimates in benefit
valuation and in providing guidance for policy. Moreover, it believes that the general magnitude
of the benefit value suggested in the Guidelines is in a reasonable range for broad population
groups. However, these estimates could be refined, particularly when certain segments of the
population are affected, such as children or persons over the age of 65.
One refinement that EPA could undertake now is to narrow the set of VSL studies to the
most reliable estimates for the U.S. population, rather than taking the mean value from a set of
studies of varying quality and with different statistical controls and with populations from various
countries.
Hedonic studies based on market tradeoffs give values reflected in actual market
decisions. Such studies have focused primarily on the labor market, but some have considered
implicit values of life reflected in car safety and in housing price responses to hazardous wastes
and pollution. Contingent valuation studies can also prove useful with respect to variations due to
age, health status, and other factors not readily estimated using market data.
Care should be taken to avoid conveying the impression that $5.8 million (in 1997 dollars)
is always and everywhere the correct figure to use for the value of a statistical life. Footnote 29 in
Section 7.6.1.2 attaches some important caveats to the $5.8 million figure cited in the document.
These caveats should be placed more prominently, so that casual readers do not come away with
the notion that $5.8 million is "the" value of a statistical life. It is, of course, simply the central
tendency of a number of estimates of the VSL for some rather narrowly defined subpopulations.
The individual study values from which this number is derived range from $0.7 million to $16.3
million, indicating considerable heterogeneity across different contexts.
In some cases, it may be desirable to use a VSL estimate specific to particular populations.
The most prominent possible variation is with respect to age, but characteristics such as gender
and income could also be influential. How and whether these differences should affect policy
benefit assessment is more controversial. However, as a first step, EPA should show the age
distribution of the lives saved, or the quantity of life at risk. In addition, when policies do not
affect the entire population equally, a sensitivity analysis can show both the cost per life saved and
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the cost per discounted life year. Policymakers can then be better able to assess the efficacy of the
policy.
Clearly, any re-evaluation of the literature will take time. In the interim, if the mean VSL
cited in the Guidelines is to be used, the limitations of the estimate should be described. In cases
where the estimate is to be applied to populations whose age differs significantly from the average
age of the populations in the 26 studies, a quantitative sensitivity analysis should be performed,
such as that used in The Benefits and Costs of the Clean Air Act, 1970-1990 (EPA, 1997).
3.3 Certainty Equivalents
Charge Question 3. Does the published economic theory and empirical literature
support the statements in the guidance document on the treatment of certainty
equivalents in the assessment of social benefits and costs of environmental policies?
The discussion of principles for uncertainty analysis in the Guidelines highlights the
important distinction between the analyst's uncertainty and individuals' uncertainty about future
outcomes. The latter relates to assessing the effects of environmental changes on individuals'
welfare under uncertainty. In this regard, the Guidelines are consistent with mainstream economic
theory and the empirical literature in that they recognize the importance of taking account of
individual attitudes towards risk and suggest certainly equivalents as one way of incorporating
risk aversion into the assessment of social benefits and costs of environmental policies. However,
the Guidelines recognize that information on risk attitudes may be difficult to obtain. The
Guidelines also recognize that experts' and lay individuals' risk perceptions may differ. Because
the latter affect individuals' behavior, it is important for the analyst to consider both types of risk
assessments. The Guidelines are also consistent with current literature in recognizing the
important role information plays in welfare evaluation in an uncertain world.
3.4 Valuation Approaches for Human Morbidity and Improved Ecological Conditions
Charge Question 4. Does the published economic theory and empirical literature
support the statements in the guidance document on the merits and limitations of
different valuation approaches to the measurement of social benefits from reductions in
human morbidity risks and improvements in ecological conditions attributable to
environmental policies?
Overall, Chapter 7 does a very good job of explaining the state-of-the-art in the
measurement of environmental benefits. This literature continues to evolve, and so frequent
updates are likely to be necessary for this chapter. All currently relevant methods appear to be
represented and sufficient caveats have generally been offered. Four concerns, however, should
be highlighted.
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First, care should be taken to avoid creating the impression that the benefits or costs
associated with a proposed regulation are being misrepresented. Socially efficient policy-making
is not well served by exaggeration or understatement of the benefits or costs of alternative policy
choices. When benefits are uncertain, expected values should be emphasized. However, an
assessment should be made concerning the sensitivity of the policy conclusions to the full range of
possible benefits estimates.
Second, the claim that averting expenditures can reliably be used as a lower bound on
environmental benefits is too strong. The draft overstates the idea that averting behavior is a
generic lower bound on ex ante economic value for morbidity and mortality. The theoretical
literature reveals that averting behavior need not be a lower bound on value when both private
and collective risk reduction strategies are considered. Private actions to reduce risk mixed with
collective actions yield ambiguous results. Further discussion is available in Shogren and Crocker
(1999).
Third, the treatment of altruistic benefits should be clearer. Circumstances wherein
altruistic benefits should, and should not, be included as a separate component of total social
benefits should be highlighted. It is important to avoid double-counting of benefits and costs in
assessing proposed policies. This issue is taken up, below, in Section 3.9.
3.5 Economic Impact and Net Social Benefits
Charge Question 5. Does the published economic theory and empirical literature
support the statements in the guidance document on the relationships and distinctions
between the measurement of economic impacts and net social benefits?
The guidance document makes it clear that in order to make informed policy judgements it
is important to study a variety of consequences of environmental policies, including impacts on
particular industries, regions, and demographic groups (as well as other impacts whose analyses
are mandated by statute) to complement conventional benefit-cost analysis. The relationship
between conventional benefit-cost analysis and the analysis of the broad and diverse distributional
impacts of environmental policies are discussed clearly and the relationships between these
complementary policy analyses is consistent with the published economics literature.
3.6 Computable General Equilibrium Models
Charge Question 6. Does the guidance document contain an objective and reasonable
presentation on the published economic theory, empirical literature, and analytic tools
associated with computable general equilibrium (CGE) models, and description of their
relevance for economic analyses performed by the EPA?
The use of general equilibrium analysis, both as a conceptual and a numerical tool, is
gaining expanded use in economics. The Guidelines provide a useful discussion of the current
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uses and limitations of computable general equilibrium (CGE) models in Chapter 8. This is a
rapidly developing area in economics, and so for the Guidelines to remain relevant, the Agency
will need to commit to ongoing review of new tools and applications that broaden the applicability
of CGE models, and that provide new intellectual insights that can guide benefit-cost analysis.
One area where new insights are proliferating is the interaction of environmental
regulations with pre-existing economic distortions (that is, the deadweight loss due to existing
taxes). Of particular relevance in this regard is the role of pre-existing taxes. Recent literature in
economics indicates that the costs and benefits of regulations can be substantially different than
indicated by partial equilibrium analysis. In addition, the relative cost-effectiveness of different
policy instruments (technology standards, tradable permits, etc.) can be affected by these
interactions.
The Guidelines address the issue of interactions of regulations with pre-existing economic
distortions in a paragraph near the end of Chapter 5, under the label "Emerging Cross-Cutting
Issues." This is appropriate because the issue is both rapidly emerging and broadly cross-cutting.
But the issue is not mentioned in Chapter 8 ("Analyzing Social Costs"), where general equilibrium
analysis is discussed in detail. The exclusion of the issue from Chapter 8 is unfortunate: (a)
because of the potential magnitude associated with "interactions" and (b) because general
equilibrium tools provide the method for considering these "interactions." Hence, one of the most
compelling reasons to use CGE models is to develop an understanding of, and to estimate the
magnitude of, this potential influence. While in most regards, the discussion of CGE models is
objective and reasonable, the failure to integrate a discussion of tax interactions undermines the
presentation.
3.7 Economic Impacts to the Private Sector, Public Sector, and Households
Charge Question 7. Does the guidance document contain an objective and reasonable
presentation on the measurement of economic impacts, including approaches suitable to
estimate impacts of environmental regulations on the private sector, public sector and
households? This includes, for example, the measurement of changes in market prices,
profits, facility closure and bankruptcy rates, employment, market structure, innovation
and economic growth, regional economies, and foreign trade.
The guidance document provides an objective and reasonable presentation of these topics.
3.8 Equity
Charge Question 8. Does the guidance document contain a reasonable presentation and
set of recommendations on the selection of economic variables and data sources used to
measure the equity dimensions identified as potentially relevant to environmental policy
analysis?
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Conventional, primary dictionary definitions of equity refer to concepts such as fairness,
impartiality, and justice. Thus, equity is typically treated as a normative concept in everyday
parlance. The Guidelines, in keeping with mainstream practice in economics, however, seek
merely to supply statistical measures of the distribution of costs and benefits, leaving it to citizens
to judge whether the described distributions are fair or equitable. In this way, the document
provides positive information that is relevant to making normative judgments, but offers no
explicit discussion of norms. At the same time, however, since market prices and willingness-to-
pay criteria are employed in the Guidelines, and because they are based on the existing
distributions of income and wealth, those existing distributions are implicitly accorded normative
status. Some may object to taking the existing distribution as the norm for equity assessments,
especially as that distribution has become more concentrated in recent decades. This issue is
noted, but in accord with mainstream practice, is not considered further in the document.
The Guidelines contain a reasonable presentation and set of recommendations on the
selection of economic variables and data sources that can be used to measure the distributional
consequences of environmental policies, both on the benefit side and the cost side.
3.9 Altruism
The Guidelines would benefit from a discussion of when it is appropriate to include
altruistic benefits in a benefit-cost analysis. Economic theory is quite clear on this point (Jones-
Lee, 1991). If I care about my neighbor and respect his preferences, and if my neighbor would
have to pay for the program or project being analyzed, then altruistic benefits should not be
counted in a benefit-cost analysis. The intuition behind this result is that, if I respect my
neighbor's preferences, although I value the benefits he will receive from the project, I also care
about the costs it will impose on him. It is, therefore, inappropriate to add the value I attach to
his benefits without considering the cost implications of doing this. Comparing individual benefits
and costs in this case is the appropriate decision rule.
Altruistic benefits may be counted either when my altruism toward my neighbor is
paternalistic, or when I will in fact bear the costs of the project but he will not. In the first case
(paternalistic altruism), I care about the benefits my neighbor will enjoy, e.g., from a health or
safety project, but not about the costs the project will impose on him. An example of the second
case would be a project whose costs are borne entirely by the current generation; i.e., the project
imposes no costs on future generations. In this case, altruism toward future generations by the
current generation could legitimately be counted as a benefit.
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REFERENCES
Jones-Lee, M. W. (1991). "Altruism and the Value of Other People's Safety." Journal of Risk
and Uncertainty, 4, pp. 213-219.
Shogren, Jason F., and Thomas D. Crocker (1999). "Risk and Its Consequences," Journal of
Environmental Economics and Management, 37, 44-51.
U.S. Environmental Protection Agency (1997). The Benefits and Costs of the Clean Air Act,
1970 to 1990. Submitted to Congress pursuant to Section 812, Clean Air Act
Amendments of 1990. Washington: U.S. EPA Office of Administration and Resources
Management/Office of Policy, Planning, and Evaluation. October, 1997.
U.S. Environmental Protection Agency (1999). Guidelines for Preparing Economic Analyses.
US EPA/OP, Office of Economy and Environment. June 11, 1999. Draft.
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APPENDIX A
CHARGE TO THE COMMITTEE
August 4, 1998
Dr. Robert Stavins
Professor of Public Policy and Faculty Chair
John F. Kennedy School of Government
Harvard University
79 John F. Kennedy Street, Room L-313
Cambridge, Massachusetts 02138
Dear Dr. Stavins:
The Science Advisory Board, Environmental Economics Advisory Committee (EEAC or
the Committee) is requested to perform an advisory review of a revised guidance document
prepared for the Environmental Protection Agency (EPA) on the conduct of economic analysis.
The document, titled "Guidelines for Preparing Economic Analyses," is the product of a
deliberative Agency-wide process initiated at my direction and managed by the EPA's Regulatory
Policy Council. The document is designed to represent Agency policy on the preparation of
economic analysis called for under applicable legislative and administrative requirements,
including, but not limited to Executive Order 12866 on regulatory planning and review. The
revisions to the guidance document should embody sound economic thinking so that its
application will continue to demonstrate the EPA's commitment to make credible and consistent
economic analytic decisions in support of the regulatory and policy making process. The Agency
is seeking external peer review of the guidance documents because of the pervasive influence of
the documents on the conduct of agency-wide economic analysis.
Background
The decision to prepare a revised document is based on a number of events and factors.
The current EPA operating guidance on performing economic analysis was written over the
period 1983-1986. Since that time, there have been numerous advances in the economic
literature. Because the guidance document is primarily intended to serve as a source for technical
information on the conduct of economic analysis, it is important that the document reflect the
most recent economics literature.
The original EPA guidance document was also written to support the administrative
process for using economic information when developing regulations set forth in Executive Order
(E.O.) 12291 on Regulatory Planning and Review (released in 1981). The Office of Management
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and Budget (OMB) issued its own federal guidelines for performing economic analysis following
the release of E.O. 12291. The EPA elected to issue its own guidance document in an effort to
elaborate on the materials described in the OMB guidance, and provide additional source material
to assist in the application of the OMB analytic principles to analyses prepared by the EPA. The
issuance of an updated Order on the federal regulatory development process (E.O. 12866 released
in 1993) led OMB to revise its federal guidelines for performing economic analysis in early 1996.
The new OMB guidance drew heavily on the previous document, but developed additional details
on several aspects of conducting economic analysis that reflected advances in the economic
literature, and added information on several administrative measures and policy objectives
receiving additional emphasis included in E.O. 12866. The new EPA economic guidance
document seeks to accomplish the same objective, but in a manner that meets the distinctive needs
of EPA staff working on economic analyses.
Other administrative and legislative requirements were issued since the mid-1980s that
now affect the development and conduct of economic analysis at the EPA. Most are not directed
exclusively at EPA regulatory activities, but their addition has led to some modifications to the
preparation of economic analyses by the EPA. Some examples include legislation to consider
unfunded mandates on non-federal governments, and the assessment of economic impacts on
small entities. The revised EPA economic guidance document seeks to update and make
reference to existing and anticipated guidance on these Congressional mandates and executive
orders.
One major goal of the new guidance document is to provide more assistance to EPA
analysts in the adoption of a consistent set of procedures used to formulate its economic analyses.
The responsibility for preparing economic analyses at the EPA rests in many different offices in
the Agency. As a consequence of differences in the authorizing statutes they operate under, the
conduct and use of economic analysis can vary across documents prepared by these offices.
Despite these differences, there are a number of guiding principles and practices that the EPA
proposes to follow to aid in the consistent development of economic information. The new
economic guidance document has been written to make clear, for a number of identified analytic
issues, the process that EPA analysts are to follow as they organize and perform their economic
analyses. One of the objectives in revising the guidance document was to adopt a process
whereby the Agency's economic analytic staff participated as a group in the review and revision
of the document. Because these offices have greater authority and responsibility for the content
and quality of their economic analysis, the process provided a productive forum for raising
common and critical issues that arise in the conduct of economic analysis.
The current guidance document's publication date of 1983 belies the fact that work has
been undertaken by EPA since that time to support advances in the development and use of
economic tools and information in its economic analyses. The Agency draws upon the results of
new research and participates in professional workshops (e.g., events supported by the
Association of Environmental and Resource Economists) to be current with the state of economic
knowledge. EPA also uses materials produced by other government agencies (e.g., General
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Accounting Office reviews, reports by the Presidential/Congressional Commission on Risk
Assessment/Risk Management), incorporating new information and thinking into its economic
analyses. Recognizing that the previous process resulted in development of a "static" EPA
economic guidance document, this effort is viewed as the first of a series of more regular and
frequent actions to continually review and revise component parts of the documents. The
development and release of materials will follow a schedule that reflects and reports on significant
changes in the literature used to support EPA analyses, as well as changes in administrative and
legal requirements that affect the conduct of economics at the EPA.
The materials to be submitted to the SAB-EEAC for an advisory review at this time
include a complete draft of the revised guidance document. The document consists of a main
document and five separate appendices. Each appendix provides greater detail on subjects treated
in the main document. The appendices are organized into major component parts of economic
analyses produced by the EPA, or treat an analytic topic that merits significant attention. As of
this revision, the guidance document contains appendices on the analysis of economic benefits,
social costs, economic impacts, equity effects, and discounting future benefits and costs.
Charge to the Committee:
The charge to the Committee is to undertake an advisory review of the draft materials and
provide advice to the Agency pursuant to a series of questions concerning the preparation of
economic analyses by the EPA. The EPA guidance directly refers to methods and practices that
enjoy widespread acceptance in the environmental economics profession. The guidance document
does not intend to preclude new or path breaking forms of analysis, but to provide EPA analysts
with a reasonably concise and thorough treatment of mainstream thinking on important technical
issues that arise in the conduct of economic analysis. The guidance accounts for some of the
practical limitations on time and resources that EPA analysts must contend with when preparing
economic analyses. It also is shaped by administrative and statutory requirements that contain
direct references to the development of economic information in the formulation of regulations
(e.g., evaluations of economic achievability). As a result, the guidance is not written to resemble
a text on the theory and methods of applying economic analysis to EPA regulations and policies.
Some of the language in the guidance was chosen for the express purpose of providing some
flexibility to analysts that should enable them to "customize" the analysis to be as complex and
complete as is necessary to conform to administrative and legal procedures. The document also
emphasizes the need for the EPA analyst to ensure that their analytic efforts are commensurate
with the value the information will provide to the regulatory and policy making process at the
EPA. The document covers a number of principles and practices that virtually all economic
analyses should follow, and it is these items to which the Committee is asked to devote the
greatest attention in its review.
In general, we believe the Guidance should reflect mainstream economic science and
methods that are well demonstrated and relatively straightforward to apply to particular
environmental issues. Ideally, these methods should be general enough that EPA program
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analysts can use them consistently across all of EPA's programs. Thus, while EPA recognizes that
this document needs to provide pragmatic guidance, we have also attempted to reflect the state
of the economic science. In some cases, our goal of making this useable has meant that we had to
shorten or simplify the document. Your views about whether there are any important omissions
or oversimplifications are critical.
The review questions to the Committee are as follows:
1. Do the published economic theory and empirical literature support the statements in the
guidance document on the treatment of discounting benefits and costs in the following
circumstances:
la. Discounting private and public costs for use in an economic impact analysis?
Ib. Discounting social benefits and costs in an intragenerational context?
Ic. Discounting social benefits and costs in an intergenerational context?
Id. Discounting social benefit and cost information that is reported in nonmonetary terms?
2. Do the published economic theory and empirical literature support the statements in the
guidance document on quantifying and valuing the social benefits of reducing fatal human health
risks?
3. Do the published economic theory and empirical literature support the statements in the
guidance document on the treatment of certainty equivalents in the assessment of social benefits
and costs of environmental policies?
4. Do the published economic theory and empirical literature support the statements in the
guidance document on the merits and limitations of different valuation approaches to the
measurement of social benefits from reductions in human morbidity risks and improvements in
ecological conditions attributable to environmental policies?
5. Do the published economic theory and empirical literature support the statements in the
guidance document on the relationships and distinctions between the measurement of economic
impacts and net social benefits?
6. Does the guidance document contain an objective and reasonable presentation on the published
economic theory, empirical literature, and analytic tools associated with computable general
equilibrium (CGE) models, and description of their relevance for economic analyses performed by
the EPA?
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7. Does the guidance document contain an objective and reasonable presentation on the
measurement of economic impacts, including approaches suitable to estimate impacts of
environmental regulations on the private sector, public sector and households? This includes, for
example, the measurement of changes in market prices, profits, facility closure and bankruptcy
rates, employment, market structure, innovation and economic growth, regional economies, and
foreign trade.
8. Does the guidance document contain a reasonable presentation and set of recommendations on
the selection of economic variables and data sources used to measure the equity dimensions
identified as potentially relevant to environmental policy analysis?
The EPA requests that the Committee provide written review and documentation, when
applicable, to support recommended changes to the guidance document. Our intention is that the
Committee conduct a full and complete review. Although the specific questions identified above
are those EPA believes are the most appropriate for the Committee to consider, EPA seeks
comments on all aspects of the guidance document. The EPA also seeks recommendations from
the Committee on alternative methodologies, assumptions and data sources that will improve the
presentation of economic issues addressed in the guidance document. We would like the
Committee to conclude its review by the end of October.
Review materials
The first attachment to this memorandum is to both the Designated Federal Official and
Chairman to the Environmental Economics Advisory Committee. The memorandum lists the
publicly available documents supporting the "Guidelines for Preparing Economic Analyses." This
memorandum contains a list of the documents which are to be submitted to the Committee to
assist in their review of the guidance document. The other attachments are the documents.
Please direct any inquiries regarding the review materials to me at 202-260-3354, or by e-
mail at mcgartland.al(q),epa.gov. Thank you for your assistance.
Sincerely,
/S/
Fred Hansen,
Deputy Administrator
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ABSTRACT
The Environmental Economics Advisory Committee (EEAC) of the EPA Science
Advisory Board (SAB) reviewed the Agency's draft Guidelines for Preparing Economic
Analyses during a series of meetings extending from August 1998 to July 1999, in response to a
request received from EPA to perform a full and complete review. The draft Guidelines have
been revised and greatly improved as a result of the interactions between the EEAC and EPA staff
during the public meetings over the past year. The EEAC's general conclusion is that the
Guidelines now succeed in reflecting methods and practices that enjoy widespread acceptance in
the environmental economics profession, notwithstanding the concerns that remain with several
particular parts of the Guidelines.
Keywords: benefit-cost analysis; economic efficiency; cost effectiveness; regulatory impact
analysis
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Appendix B: EPA's Response to
SAB Review
Appendix B
205
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\ UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
I WASHINGTON, D.C. 20460
December 21,2000
OFFICE OF
THE ADMINISTRATOR
Dr. Robert N. Stavins
Chairman, Environmental Economics Advisory Committee
Science Advisory Board (A-101)
Environmental Protection Agency
Ariel Rios Building
1200 Pennsylvania Avenue, N.W.
Washington, D.C. 20460
Dear Dr. Stavins:
Thank you for your letter to Administrator Browner and the report An SAB Report on the
EPA Guidelines for Preparing Economic Analyses: A Review by the Environmental Economics
Advisory Committee (EPA-SAB-EEAC-99-20, September 30, 1999). Before I respond to the
specifics of your review, allow me to thank the Board for the sustained and intensive level of effort
devoted by the SAB's Environmental Economic Advisory Committee (EEAC) to the development
and review of the Agency's economic analysis guidelines. By incorporating the "best
mainstream" economics into our guidelines and analyses, the overall credibility of our work will
be sustained, the Agency's decisions will be better informed, and public discourse on
environmental policy will be enhanced. The SAB report contains a thorough review of our
Guidelines for Preparing Economic Analyses (or EA Guidelines), and provides many useful
recommendations that the Agency has taken under consideration in revising the document. Other
suggestions in the review help illuminate larger issues that the Agency continues to explore and
consider.
Given the importance of economic assessments to the Agency, it is imperative that they are
conducted as consistently and accurately as possible. The best way to ensure that analyses meet
these goals is to provide Agency analysts with a clear set of guidelines and recommendations that
have a solid foundation in the current state of economic science. As your letter notes, evolution of
analytical tools and practices requires that such guidelines be reviewed every few years. The
Agency is committed to undertaking regular reviews of the materials contained in the EA
Guidelines, and looks forward to receiving further recommendations from the Science Advisory
Board's Environmental Economics Advisory Committee (EEAC) that will strengthen and improve
the EA Guidelines in the years ahead.
Recycled/Recyclable
Printed with Soy/Canola Ink on paper that
contains at least 50% recycled fiber
-------
As you also note in your letter and report, the process employed by the EEAC and the Agency in
the review of the EA Guidelines is unique. The Agency agrees that this departure from the
standard practice was of great benefit in preparing the document. Not only did early involvement
by the EEAC ultimately result in a much stronger document, but the open exchange between
EEAC members, the Committee as a whole, and Agency personnel served to clarify a number of
issues that may have been difficult to address otherwise. The Agency is hopeful that a similar
process may prove useful in other contexts.
The EA Guidelines serve as a set of principles, consistent with current economic thinking,
for analysts to draw upon in performing economic analyses. Section Three of the SAB report
provides specific recommendations for the application of these principles. The Agency's
responses to the main recommendations included in the SAB report, including references to
sections in the EA Guidelines where resulting changes or additions to the document can be found,
are enclosed.
Finally, I would like to again thank the Board for its thoughtful comments provided in the
report, and the extensive feedback offered by the membership of the committee during the public
meetings on the EA Guidelines. The Agency sincerely appreciates the time and effort of the SAB
as a whole and of the individual members of the EEAC.
Sincerely,
/s/
W. Michael McCabe
Deputy Administrator
Enclosure
cc: Assistant Administrators
Associate Administrators
Regional Administrators
Regulatory Policy Council
Science Advisory Board
bcc: Economic Consistency Workgroup members
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UNITED STATES ENVIRONMENTAL PROTECTION AGENCY
WASHINGTON, D.C. 20460
December 21,2000
OFFICE OF
THE ADMINISTRATOR
Dr. Morton Lippmann
Interim Chairman, Executive Committee
Science Advisory Board (A-101)
Environmental Protection Agency
Ariel Rios Building
1200 Pennsylvania Avenue, N.W.
Washington, D.C. 20460
Dear Dr. Lippmann:
Thank you for your letter to Administrator Browner and the report An SAB Report on the
EPA Guidelines for Preparing Economic Analyses: A Review by the Environmental Economics
Advisory Committee (EPA-SAB-EEAC-99-20, September 30, 1999). Before I respond to the
specifics of your review, allow me to thank the Board for the sustained and intensive level of effort
devoted by the SAB's Environmental Economic Advisory Committee (EEAC) to the development
and review of the Agency's economic analysis guidelines. By incorporating the "best
mainstream" economics into our guidelines and analyses, the overall credibility of our work will
be sustained, the Agency's decisions will be better informed, and public discourse on
environmental policy will be enhanced. The SAB report contains a thorough review of our
Guidelines for Preparing Economic Analyses (or EA Guidelines), and provides many useful
recommendations that the Agency has taken under consideration in revising the document. Other
suggestions in the review help illuminate larger issues that the Agency continues to explore and
consider.
Given the importance of economic assessments to the Agency, it is imperative that they are
conducted as consistently and accurately as possible. The best way to ensure that analyses meet
these goals is to provide Agency analysts with a clear set of guidelines and recommendations that
have a solid foundation in the current state of economic science. As your letter notes, evolution of
analytical tools and practices requires that such guidelines be reviewed every few years. The
Agency is committed to undertaking regular reviews of the materials contained in the EA
Guidelines, and looks forward to receiving further recommendations from the Science Advisory
Board's Environmental Economics Advisory Committee (EEAC) that will strengthen and improve
the EA Guidelines in the years ahead.
. Recycled/Recyclable
^X t\) Printed with Soy/Canola Ink on paper that
KZKZ7 contains at least 50% recycled fiber
-------
As you also note in your letter and report, the process employed by the EEAC and the Agency in
the review of the EA Guidelines is unique. The Agency agrees that this departure from the
standard practice was of great benefit in preparing the document. Not only did early involvement
by the EEAC ultimately result in a much stronger document, but the open exchange between
EEAC members, the Committee as a whole, and Agency personnel served to clarify a number of
issues that may have been difficult to address otherwise. The Agency is hopeful that a similar
process may prove useful in other contexts.
The EA Guidelines serve as a set of principles, consistent with current economic thinking,
for analysts to draw upon in performing economic analyses. Section Three of the SAB report
provides specific recommendations for the application of these principles. The Agency's
responses to the main recommendations included in the SAB report, including references to
sections in the EA Guidelines where resulting changes or additions to the document can be found,
is enclosed.
Finally, I would like to again thank the Board for its thoughtful comments provided in the
report, and the extensive feedback offered by the membership of the committee during the public
meetings on the EA Guidelines. The Agency sincerely appreciates the time and effort of the SAB
as a whole and of the individual members of the EEAC.
Sincerely,
/s/
W. Michael McCabe
Deputy Administrator
Enclosure
cc: Assistant Administrators
Associate Administrators
Regional Administrators
Regulatory Policy Council
Science Advisory Board
bcc: Economic Consistency Workgroup members
-------
Enclosure to the Deputy Administrator's Response to
SAB Report on the EPA Guidelines for Preparing Economic Analyses: A Review by the
Environmental Economics Committee
On the subject of discounting, the Agency appreciates the recommendation that, to reflect
common practice, the EA Guidelines should encourage the use of a discount rate between
the range specified in the review draft of the document. Chapter Six, Section 6.3.1 in the
final EA Guidelines includes a recommendation for analysts to employ such a rate in
addition to the other rates specified, if it is believed the additional information would be
useful to decision makers. One reason analysts may include such a rate is because its use
is routinely practiced for the specific type of analysis being performed. An example would
be the recent analyses prepared by the Agency on the benefits and costs of the Clean Air
Act and its 1990 Amendments. Other economic analyses have found it sufficient for
decision making purposes to rely on presentations
of economic information using the range alone. The Agency views both presentations to
be supported by the EA Guidelines and in accord with the position taken on discounting by
the SAB in the report.
Estimating the value of reductions in fatality risks remains one of the more difficult aspects
of benefit-cost analysis, and the Agency appreciates the attention given this issue in the
SAB report. Since receiving the SAB report on the draft EA Guidelines, the Agency has
received additional SAB recommendations on the subject of valuing reductions in fatal
cancer risks (SAB report EPA-SAB-EEAC-00-013, dated July 27, 2000). As noted in
Chapter Seven, Section 7.6.1 of the final document, the Agency will release a supplement
to the EA Guidelines on this topic once it has more thoroughly considered the July 27 SAB
report on valuing fatal cancer risks.
The Agency agrees with the SAB that the limitations associated with the concepts and
empirical studies available to use in quantifying a value of a statistical life (VSL) should be
described in detail whenever VSL estimates are introduced in a benefit-cost analysis. The
final EA Guidelines specifically require analysts to carefully present these limitations in
their analyses. The document also advises analysts to fully characterize the nature of the
risk and the populations affected as they relate to the choice of available literature used in a
benefits analysis, as well as the presentation of uncertainties associated with such
estimates. Some important considerations noted by the SAB report have resulted in an
expanded discussion in the document, including recognition of how demographic
characteristics (e.g., age) of the population at risk compare with those same characteristics
of the population studied in the underlying economic literature used to derive benefit
values. The final EA Guidelines continues to make reference to the numeric VSL range
found to be reasonable by the SAB, and the Agency agrees with the SAB on the merits of
improving and refining measures of this benefit category through reasoned use of the
existing relevant literature. Analysts are further encouraged to consider quantitative
sensitivity analyses as data allow, recognizing that the need for such analyses and the
ability to perform them may vary with each benefit transfer exercise. The SAB report also
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notes that measures of cost-effectiveness may be employed as a sensitivity analysis, which
is now included in the final document.
The SAB report raises several issues related to valuation for morbidity and
ecological effects. The Agency agrees with the SAB that the benefits of a policy should be
neither understated nor exaggerated, and has revised the EA Guidelines to inform analysts
of these hazards and to encourage explicit consideration of uncertainty. Benefits will
always be uncertain to some extent and the Agency agrees that expected values should be
emphasized, as noted in Chapter Five, Section 5.5 in the expanded discussion of
uncertainty.
The final EA Guidelines also contains a revised discussion of averting expenditures
as a measure of benefits. This discussion recognizes that averting behavior is not always a
lower bound on an ex ante economic value for health improvements because of the
presence of private and collective risk reduction strategies. The reference on this subject
suggested by the Committee is now included in Chapter Seven, Section 7.5.1 in the final
EA Guidelines.
The Agency agrees with the SAB that computable general equilibrium (CGE)
analysis is growing in use as an analytical tool. The Agency is committed to an ongoing
review of tools that broaden the applicability of CGE models and is enthusiastic about their
implications for benefit-cost analysis. The discussion of CGE models in the Chapter
Eight, Section 8.4.5 of the final EA Guidelines has been expanded to include "tax
interaction" effects as recommended in the SAB report.
The SAB notes that the document would benefit from a more detailed discussion of
the role of altruism in benefit-cost analysis. The Agency agrees with the SAB and has
expanded the discussion of altruism in Chapter Seven in order to clarify when altruistic
benefits may and may not be included in a benefit-cost analysis. The expanded discussion
is found in Chapter Seven, Section 7.2.1 of the final EA Guidelines and draws, in part,
from the language in the SAB report.
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