Environmental 3: CBA Flashcards
How can we use an SWF in CBA?
We can use U(Ct) instead of Bt-Ct to attach nonlinear utility returns to consumption. Note that the utility discount rate rho is now used instead of the consumption discount rate r.
How can CBA be used to find a lower bound on environmental valuations?
Suppose we have data on the non-environmental benefits and costs of a project, such as the capital costs and the expected benefits from development. Calculate the NPV sum excluding the non-environmental benefits. Then, if this is positive, this value is a lower bound on the environmental value that would imply that the project should not go ahead. This can be a useful way of valuing the environment without having to come to a final number - we can agree that the Great Barrier Reef is worth more than $100, for example, even if we cannot agree on an exact number.
What is the Ramsey discounting formula? Where does it come from?
If consumption grows by g each period, and we have CRRA preferences, then the consumption discount rate 1+r can be shown to equal 1+rho+eta*g in continuous time.
Therefore, r = rho+eta*g
What are the consequences of different values of η?
η=0 implies that the marginal utility of income does not change with income.
η =1 implies logarithmic utility. This implies that proportionate changes in income are seen similarly across people. Therefore, even though these reflect different amounts of money, a doubling in income is seen equally by all people.
Consider one person earning $36000 per year (A), and another consuming just $360 (B). η =2 implies that a 50% reduction in income for A has the same utility effect as a 1% reduction for B.
η =3 implies that a 93% reduction in income for A has the same utility effect as a 1% reduction for B. We should prefer to take 92% of A’s income than 1% of B’s.
Why does Weitzman claim that discount rates should start at the mean and decline to the minimum?
The outcome with the lowest discount rate becomes overwhelmingly larger than all others after enough time passes, such that this drives the value of the mean.
Does reducing the discount rate always make environmental projects less likely to go ahead?
No. Reducing the discount rate increases the relative importance of costs and benefits in the further future. Although some of these costs will be environmental, a lower discount rate may also magnify some increased development benefits, since private net costs tend to be high initially and then fall to make a profit.
Why do Krutilla and Fisher argue for a lower discount rate for environmental goods?
Standard CBA assumes that the environment is perfectly substitutable with consumption goods. If it is not, the benefits of environmental preservation may grow over time. K&F justify this by appealing to income elasticity of demand for environmental quality, technical progress in economic development, or limited substitutability between E and C. Therefore, the benefits of preservation can be modelled as P_t=Pe^{at} implying a discount rate r-a for environmental costs and benefits.
What is option value?
Equal to the risk premium
Why does the Arrow-Lind theorem not apply to risky environmental projects?
Environmental projects are on public goods, so cannot be diversified across investors. The result therefore does not hold.
What is radical uncertainty?
We face risk when future states are unknown, and each could occur with probability p. We face uncertainty when we do not know these probabilities; in many cases we may not even know the possible future states. This last outcome is radical uncertainty.
How might we respond to radical uncertainty?
Conservative responses to radical uncertainty involve precautionary principles or safe minimum standards. Threats of serious or irreversible damage imply rejection of all projects, regardless of possible benefits.
An alternative response is the use of environmental performance bonds. Firms wishing to develop deposit a bond of $x with the EA. If the damage does not occur, they get this back at the end of the project with some proportion of the interest. If the damage happens, the fund is used to deal with the damage.
What is the social cost of carbon? Why does it equal the optimal carbon tax?
The marginal effect of one more ton of CO2 on welfare, in terms of present money. We should be careful to note that this varies according to the presence or absence of emissions abatement policy; the SCC today is much higher if no climate policy is to take place in the future. If not otherwise stated, ‘the’ social cost of carbon is the cost where the savings rate and emissions pathway are optimised.
This is the marginal external cost of emissions; so, the optimal Pigouvian tax internalises it by setting t=MEC(q). Note that this is the SCC on the efficient pathway as discussed above.
