Question

The main problem with the benefit-cost analysis is to determine which interest rate we need to choose in order to take a fair decision related with an environmental issue. What do you think?. What interest rate from the market would be the most appropriate?

Answer 1

Cost–benefit analysis (CBA), sometimes called benefit costs analysis (BCA).A cost-benefit analysis is a process businesses use to analyze decisions.A CBA may be used to compare potential (or completed) courses of actions, or to estimate (or evaluate) the value against the cost of a decision, project, or policy. It is commonly used in commercial transactions, business or policy decisions (particularly public policy), and project investments.

The environment often displays the characteristics of a public good. These public goods aspects of the environment are obvious sources of social utility.

In evaluating a project or policy, the environment can be treated as a free factor of production, even though real costs may be involved.There are two key points that emerge:

(a) Both the true value of the environmental services provided, and the external costs imposed on others, have to be counted in an economic CBA; and

(b) The values mentioned above have to be included without any double counting

. The costs of the Environmental Approach appear in the financial CBA. The aim of CBA is to present the lifetime costs and benefits of a project as a single number that can be compared to either the interest rate prevailing (e.g. using the internal rate of return), or the costs and benefits of other (competing) projects (to give either a net present value or a benefit/cost ratio).

Decisions are made through CBA by comparing the net present value (NPV) of the programme or project’s costs with the net present value of its benefits. Decisions are based on whether there is a net benefit or cost to the approach, i.e. total benefits less total costs. Costs and benefits that occur in the future have less weight attached to them in a cost-benefit analysis. To account for this, it is necessary to ‘discount’ or reduce the value of future costs or benefits to place them on a par with costs and benefits incurred today. The ‘discount rate’ will vary depending on the sector or industry, but public sector activity generally uses a discount rate of 5-6%. The sum of the discounted benefits of an option minus the sum of the discounted costs, all discounted to the same base date, is the ‘net present value’ of the option.

Cost-benefit analysis (CBA) is traditionally based on conventional welfare economics, which provides a utilitarian account of value which relies on individual self-interest.

The aim of CBA is to present the lifetime costs and benefits of a project as a single number that can be compared to either the interest rate prevailing (e.g. using the internal rate of return), or the costs and benefits of other (competing) projects (to give either a net present value or a benefit/cost ratio). To do this, net benefits (benefits minus costs) is discounted.

The lower the discount rate / interest rate, the higher the return value of the project’s future costs and benefits. Conversely, the higher the discount/ interest rates the lower the future return value will be. (A discount rate is a number that is usually reported in percentage terms that  means how much someone prefers resources now instead of in the future. The larger the discount rate, the higher the preference for consuming goods and services now.)

So we need to choose discount rate for cost benefit analysis with in an environmental issue to take fair decision making.

Market interest rates determine the opportunity cost of any capital used by the Government’s regulatory proposal— that is, what it would have produced in its alternative use.