CPR Perspective: Cost-Benefit Analysis
Pricing the Priceless: Cost-Benefit Analysis of Health, Safety, and Environmental Protection
by Frank Ackerman and then-Member Scholar Lisa Heinzerling
Background
|
The Issue |
Conservative economists and other policymakers have long questioned the wisdom of protective health, safety, and environmental regulation, arguing that the "free market" will provide the level of protection that people are willing to support and that the government should interfere with the market only in limited circumstances. This campaign to cut back on regulation has as its centerpiece the use of "cost-benefit analysis," performed by economists as a supposedly neutral, mathematically precise way of determining whether protections should be initiated or continued.
Cost-benefit analysis seeks to translate all relevant considerations into monetary terms. Economists “monetize” both the costs of regulation, such as the money spent to install a scrubber on a power plant to reduce air pollution, and the benefits of regulation, such as saving human lives and preventing disease. When benefits of regulation will happen in the future, the economists first quantify those benefits in dollars. Then they “discount” their value to reflect how much we would have to invest today to have that much money when the benefit is delivered. To see the drastic effects discounting can have, look at our easy calculator, "Honey, I Shrunk the Future." (Excel file download.)
The consideration of the costs of environmental protection is not unique to cost-benefit analysis. Development of environmental regulations has almost always involved consideration of economic costs, with or without formal cost-benefit techniques. What is unique to cost-benefit analysis, and far more problematic, is the other side of the balance – the monetary valuation of life, health, and nature itself.
Cost-benefit analysis sets out to do for government what the market does for business: add up the benefits of a public policy and compare them to the costs. The two sides of the ledger, however, raise very different issues.
The first step in a cost-benefit analysis is to calculate the costs of a public policy. The costs of protecting human health and the environment through the use of pollution control devices and other approaches are, by their very nature, measured in dollars. Thus, at least in theory, the cost side of cost-benefit analysis is relatively straightforward. (In practice, it is not quite that simple, and often costs are dramatically overstated in advance of regulation; see CPR's Perspectives on Estimating Regulatory Costs for more detailed discussion.
More problematic is the second step in the analysis: monetizing the benefits achieved by the regulation. Since there are no natural prices for a healthy environment, cost-benefit analysis requires the creation of artificial ones. Economists create artificial prices for health and environmental benefits by studying what people would be willing to pay for them. One popular method, called "contingent valuation," is essentially a form of opinion poll. Researchers ask a cross-section of the affected population how much they would be willing to pay to preserve or protect something that can't be bought in a store.
An alternative method of attaching prices to unpriced things infers what people are willing to pay from observation of their behavior in other markets. To assign a dollar value to risks to human life, for example, economists usually calculate the extra wage - or "wage premium" - that is paid to some workers who accept more risky jobs. If workers understand the risk and voluntarily accept a more dangerous job, then they are implicitly setting a price on risk by accepting the increased risk of death in exchange for increased wages. What does this indirect inference about wages say about the value of a life? A common estimate in recent cost-benefit analyses is that avoiding a risk that would lead, on average, to one death is worth roughly $6.3 million. (Some estimates are much lower than this, and go as low as $1 million or less; some are much higher, reaching $10 million or more.)
Finally, costs and benefits of a policy frequently occur at different times. Often, costs are incurred today, or in the near future, to prevent harm in the more remote future. When the analysis spans a number of years, future costs and benefits are discounted, or treated as equivalent to smaller amounts of money in today’s dollars.
Discounting is a procedure developed by economists to evaluate investments that produce future income. The case for discounting begins with the observation that $100, say, received today is worth more than $100 received next year, even in the absence of inflation. For one thing, you could put your money in the bank today and earn a little interest by next year. Suppose that your bank account earns 3 percent interest. In that case, if you received the $100 today rather than next year, you would earn $3 in interest, giving you a total of $103 next year. Likewise, in order to get $100 next year you only need to deposit $97 today. So, at a 3% discount rate, economists would say that $100 next year has a present value of $97 in today’s dollars.
This application of discounting is essential, and indeed commonplace, for many practical financial decisions. If offered a choice of investment opportunities with payoffs at different times in the future, you can (and should) discount the future payoffs to the present in order to compare them to each other. The important issue for environmental policy is whether this logic also applies to outcomes far in the future, and to opportunities – like long life and good health – that are not naturally stated in dollar terms.
What People Are Fighting About
Ever since Newt Gingrich’s “Contract With America” threatened to impose a cost-benefit standard on federal regulation, particularly environmental regulation, debates over federal regulation have featured a battle between those who favor the existing system for setting regulatory standards and those who favor fundamentally reworking that system to impose a narrow economic test on regulations that protect health, safety, and the environment.
Proponents of cost-benefit analysis make two basic arguments in its favor. First, use of cost-benefit analysis ostensibly leads to more “efficient” allocation of society’s resources by better identifying which potential regulatory actions are worth undertaking and in what fashion.
|
What's At Stake |
Yet how do we know that greater regulatory efficiency is needed? For many economists, this is an article of faith: greater efficiency is always a top priority, in regulation or elsewhere. But many advocates also raise a more specific argument, imbued with a greater sense of urgency. The government, it is said, often issues rules that are insanely expensive, out of all proportion to their benefits – a problem that could be solved by the use of cost-benefit analysis to screen proposed regulations. Thus much of the case for cost-benefit analysis depends on the case against current regulation.
The literature on risk regulation is filled with lengthy tables listing the costs per life saved of various federal regulations. The numbers on such tables are fantastic: according to these lists, we are often spending hundreds of millions, and sometimes billions, of dollars for every single human life, or even year of life, we save through regulation.
Numbers like these have been used to argue that current regulatory costs are not only chaotically variable but also unacceptably high. They have even been relied upon to claim that the existing regulatory system actually kills people by imposing some very costly life-saving requirements while other, less expensive and more effective life-saving possibilities remain untouched. Indeed, one often-cited study concluded that we could save as many as 60,000 more lives every year with no increase in costs, if we simply spent our money on the least rather than most expensive opportunities for saving lives.
However, when one looks behind these tables and carefully sorts through the data upon which they are based, one learns that such claims are not only extravagant, but false. Many of the highest costs per life saved were found for regulations that agencies never promulgated, yet the tables are used to show that the government has already run amok. In addition, all of the studies showing outlandishly high costs per life saved discounted future lives saved, producing a built-in bias against future-oriented regulation.
A second important set of arguments holds that cost-benefit analysis would produce a better regulatory process – more objective and more transparent, and thus more accountable to the public. Cost-benefit analysis has been offered as a means of preventing an agency from just doing anything it wants or, more invidiously, from benefiting politically favored groups through its decisions.
Another important goal, said to be promoted by cost-benefit analysis, is transparency of administrative procedures. Decisions about environmental protection are notoriously complex. They reflect the input of biologists, toxicologists, epidemiologists, economists, engineers, lawyers, and other experts whose work is complicated and arcane. In order for the public to be part of the process of decision making about the environment, these judgments must be offered and debated in language accessible to people who are not experts. Many advocates of cost-benefit analysis believe that their methodology provides such a language.
In fact, cost-benefit analysis is incapable of delivering what its proponents promise. First, cost-benefit analysis cannot produce more efficient decisions because the process of reducing life, health, and the natural world to monetary values is inherently flawed.
Efforts to value life illustrate the basic problems. Cost-benefit analysis implicitly equates the risk of death with death itself, when in fact they are quite different and should be accounted for separately in considering the benefits of regulatory actions. Cost-benefit analysis also ignores the fact that citizens are concerned about risks to their families and others as well as themselves, ignores the fact that market decisions are often very different from political decisions, and ignores the incomparability of many different types of risks to human life. The same kinds of problems arise in attempting to define in monetary terms the benefits of protecting human health and the environment.
Second, the use of discounting systematically and improperly downgrades the importance of environmental regulation. While discounting makes sense in comparing alternative financial investments, it cannot reasonably be used to make a choice between preventing harms to present generations and preventing similar harms to future generations. Nor can discounting reasonably be used even to make a choice between harms to the current generation; choosing between preventing an automobile fatality and a cancer death does not turn on prevailing rates of return on financial investments. In addition, discounting tends to trivialize long-term environmental risks, minimizing the very real threat our society faces from potential catastrophes and irreversible environmental harms, such as those posed by global warming and nuclear waste. Significantly, all of the studies suggesting that regulation kills people because it is so expensive employed discounting, which caused regulatory benefits to appear to shrink and regulatory costs to grow.
Third, cost-benefit analysis ignores the question of who suffers as a result of environmental problems and, therefore, threatens to reinforce existing patterns of economic and social inequality. Cost-benefit analysis treats questions about equity as, at best, side issues, contradicting the widely shared view that equity should count in public policy. In fact, poor countries, communities, and individuals are likely to express less "willingness to pay" to avoid environmental harms, simply because they have fewer resources. Therefore, cost-benefit analysis would justify imposing greater environmental burdens on them than on their wealthier counterparts. With this kind of analysis, the poor get poorer.
Finally, cost-benefit analysis fails to produce the greater objectivity and transparency promised by its proponents. Cost-benefit analysis rests on a series of assumptions and value judgments that cannot remotely be described as objective. Moreover, the highly complex, resource-intensive, and expert-driven nature of this method makes it extremely difficult for the public to understand and participate in the process. Thus, in practice, cost-benefit analysis is anything but transparent.
|
Decisions on the Table |
Beyond these inherent flaws, cost-benefit analysis suffers from serious defects in practical implementation. Many benefits of public health and environmental protection have not been quantified and cannot easily be quantified given the limits on time and resources; thus, in practice, cost-benefit analysis is often akin to shooting in the dark. Even when the data gaps are supposedly acknowledged, public discussion tends to focus on the misleading numeric values produced by cost-benefit analysis while relevant but non-monetized factors are simply ignored. Finally, the cost side of cost-benefit analysis is frequently exaggerated, because analysts routinely fail to account for the economies that can be achieved through innovative efforts to meet new environmental standards.
Real-world examples of cost-benefit analysis demonstrate the strange lengths to which this flawed method can be taken. For example, the consulting group Arthur D. Little, in a study for the Czech Republic, concluded that encouraging smoking among Czech citizens was beneficial to the government because it caused citizens to die earlier and thus reduced government expenditures on pensions, housing, and health care. In another study, analysts calculated the value of children’s lives saved by car seats, by estimating the amount of time required to fasten the seats correctly and then assigning a value to the time based on the mothers’ actual or imputed hourly wage. These studies are not the work of some lunatic fringe; on the contrary, they apply methodologies that are perfectly conventional within the cost-benefit framework.
CPR's Perspective
Two features of cost-benefit analysis distinguish it from other approaches to evaluating the advantages and disadvantages of environmentally protective regulations: the translation of lives, health, and the natural environment into monetary terms, and the discounting of harms to human health and the environment that are expected to occur in the future. CPR believes that these features of cost-benefit analysis make it a terrible way to make decisions about environmental protection, for both intrinsic and practical reasons.
CPR also believes that it is not useful to keep cost-benefit analysis around as a kind of regulatory tag-along, providing information that regulators may find useful even if not decisive. Cost-benefit analysis is exceedingly time- and resource-intensive, and its flaws are so deep and so large that this time and these resources are wasted on it. Moreover, given the intrinsic conflict between cost-benefit analysis and the principles of fairness that animate, or should animate, our national policy toward protecting people from being hurt by other people, the results of cost-benefit analysis cannot simply be “given some weight” along with other factors, without undermining the fundamental equality of all citizens – rich and poor, young and old, healthy and sick.
In developing policies to protect human health and the environment without relying on cost-benefit analysis, CPR believes that it is useful to distinguish between decisions about means and decisions about ends. CPR believes that it has sometimes proved useful to consult economic analysis in order to develop the most cost-effective means for carrying out a predetermined regulatory policy. Emissions trading programs, for example, came about in this way. (See CPR Perspective Emissions Trading for more detail.) CPR does not, however, believe that it is useful to try to set the ends of environmental policy through economic analysis. Trying to do so is what leads to the endless and unproductive battles over, for example, the monetary value of life, which we have described. Moreover, while economic costs should ordinarily play a role in developing regulatory policy, CPR believes that reliance on costs should be moderated by three other important principles: the precautionary principle; a desire for technological innovation; and a desire for fairness.
Interested in Learning More?
A more detailed discussion of the issues explored here can be found in Frank Ackerman and Lisa Heinzerling, "Pricing the Priceless: Cost-Benefit Analysis of Environmental Protection" (Georgetown Environmental Law & Policy Institute 2002), available here.
