Conceptual foundations and applications of cost-benefit analysis in energy economics

Energy Economics

Cost and benefit analysis is an analytical process, which is used to measure that whether the benefits or advantages associated with an activity is greater than its costs or not. It is one of the commonly used and formal tools for the assessment of efficiency. Efficiency assessment can be defined as a process in which scarce resources are examined critically so that the ways in which they can be used most efficiently can be determined. Efficiency assessment basically provides us with ways through which maximum benefits can be acquired from scarce resources. The technique of cost and benefit analysis is based on welfare economics. ("Cost-benefit analysis" 2009)[footnoteRef:2] [2: Cost-benefit analysis, (Brussels: European Commission, 2009)http://ec.europa.eu/transport/road_safety/specialist/knowledge/pdf/cost_benefit_analysis.pdf (accessed May 25, 2013), 4.]

Advantages of Cost and Benefit Analysis

Cost and benefit analysis benefits an organization in many ways. It reduces the operating costs and enhances efficiency. The major benefits of cost and benefit analysis are discussed below;

Return on Investment

Cost and benefit analysis enables the organization to analyze the return on various investments as it critically scrutinize the current and future cash flows by using different techniques such as, compounding and discounting. ("Cost Benefits analysis" 2005)[footnoteRef:3] [3: Cost Benefits analysis, (Manchester: Manchester Metropolitan University (MMU), 2005)http://www.mmu.ac.uk/bit/docs/Cost-Benefit-analysis-toolkit-v2.pdf (accessed May 25, 2013), 1. ]

Improved Performance

As the organization operates more efficiently and tries to invest in the most beneficial projects, the performance of the organization improves significantly. ("Cost Benefits analysis" 2005)[footnoteRef:4] [4: Cost Benefits analysis, (Manchester: Manchester Metropolitan University (MMU), 2005)http://www.mmu.ac.uk/bit/docs/Cost-Benefit-analysis-toolkit-v2.pdf (accessed May 25, 2013), 1.]

Better Customer Satisfaction

When the information available to the customers portrays that the organization is investing in profitable projects and its prospects for growth are very high then the customers become satisfied with the performance of the organization and they invest more in the organization. ("Cost Benefits analysis" 2005)[footnoteRef:5] [5: Cost Benefits analysis, (Manchester: Manchester Metropolitan University (MMU), 2005)http://www.mmu.ac.uk/bit/docs/Cost-Benefit-analysis-toolkit-v2.pdf (accessed May 25, 2013), 1.]

Conceptual Foundations of Cost-Benefit Analysis

The basic conceptual framework underlying the cost and benefit analysis is 'allocative efficiency'. Apart from allocative there are other conceptual frameworks, such as 'Pareto Efficiency', which also underlie the concept of cost and benefit analysis. (MacGeorge 2009)[footnoteRef:6] The major conceptual foundations that underlie the process of cost and benefit analysis are listed below; [6: Richard MacGeorge, THE CONCEPTUAL FOUNDATIONS OF BENEFIT-COST ANALYSIS AND THE USEFULNESS OF THIS TECHNIQUE IN THE AREA OF ENERGY ECONOMICS., (Christchurch: Ridgway Capital Projects, 2009)http://www.ridgway.co.nz/files/cba-energy.pdf (accessed May 25, 2013), 1-2.]

Allocative Efficiency

It can be defined as the process of allocating the scarce resources in such a way that maximum benefits can be reaped from them. This concept guides us to create a proper mix between unlimited wants and limited resources. As cost and benefit analysis is generally related with the efficient management of resources and cost efficiency. And the amount spent on the resources is directly related to both of these concepts, therefore, allocative efficiency is the fundamental conceptual framework that underlies the cost and benefit analysis. (MacGeorge 2009)[footnoteRef:7] [7: Richard MacGeorge, THE CONCEPTUAL FOUNDATIONS OF BENEFIT-COST ANALYSIS AND THE USEFULNESS OF THIS TECHNIQUE IN THE AREA OF ENERGY ECONOMICS., (Christchurch: Ridgway Capital Projects, 2009)http://www.ridgway.co.nz/files/cba-energy.pdf (accessed May 25, 2013), 1-2.]

Pareto Efficiency

This is another major concept that underlies the cost and benefit analysis. If the resources are allocated in such a way that a new or alternative allocation can make at least one person better off without making any other person worst off then this allocation of resources is 'pareto efficient. ("Conceptual Foundations of Cost-Benefit" 2007)[footnoteRef:8] [8: CONCEPTUAL FOUNDATIONS OF COST-BENEFIT, (Bangkok: National Institute of Development Administration, 2007)http://gspa.grade.nida.ac.th/pdf/Dr_Nutta/PA.640nattha_MPA_3-49/2. Efficiency/2.2.2Boardman, A. Cost Benefit Analysis Concept and practice chapter2.pdf (accessed May 25, 2013), 28-30]

The Link between Pareto Efficiency and Net Benefits

The link between Pareto efficiency is very clear and straight forward. If a policy includes positive net benefits then it has the tendency to have side payments or conditions that can make one person better off without making any other person worst off. In order to understand the link between Pareto efficiency and net benefits it is necessary to understand the following concepts; ("Conceptual Foundations of Cost-Benefit" 2007)[footnoteRef:9] [9: CONCEPTUAL FOUNDATIONS OF COST-BENEFIT, (Bangkok: National Institute of Development Administration, 2007)http://gspa.grade.nida.ac.th/pdf/Dr_Nutta/PA.640nattha_MPA_3-49/2. Efficiency/2.2.2Boardman, A. Cost Benefit Analysis Concept and practice chapter2.pdf (accessed May 25, 2013), 28-30]

Willingness to Pay (WTP)

It is the amount that the individual would be willing to pay or receive under a policy so that one may become indifferent in relation to the status quo and the policy payments. The algebraic sum of different willingness to pay (WTP) values is one of the most appropriate measures of the net benefits of a policy. The policy can be a Pareto improvement over the status quo if and only if the net benefits of the policy, which are being calculated by the willingness to pay of the individuals affected by the policy, are positive. It is then possible for a policy to have a set of contributions or payments that might make one person better off without making any other person worst off. ("Conceptual Foundations of Cost-Benefit" 2007)[footnoteRef:10] [10: CONCEPTUAL FOUNDATIONS OF COST-BENEFIT, (Bangkok: National Institute of Development Administration, 2007)http://gspa.grade.nida.ac.th/pdf/Dr_Nutta/PA.640nattha_MPA_3-49/2. Efficiency/2.2.2Boardman, A. Cost Benefit Analysis Concept and practice chapter2.pdf (accessed May 25, 2013), 28-30]

Opportunity Cost

The implementation of any policy requires the use of input that could have been used in other processes to manufacture other goods and services. For example, a policy implementation may require time, money, labor and machine and all of these could have been used in other processes. The opportunity cost can be defined as the dollar value that the resources might have earned in their best possible alternative use. This concept basically measures the opportunity that the society must forgo in order to use the input in the implementation of policy. ("Conceptual Foundations of Cost-Benefit" 2007)[footnoteRef:11] [11: CONCEPTUAL FOUNDATIONS OF COST-BENEFIT, (Bangkok: National Institute of Development Administration, 2007)http://gspa.grade.nida.ac.th/pdf/Dr_Nutta/PA.640nattha_MPA_3-49/2. Efficiency/2.2.2Boardman, A. Cost Benefit Analysis Concept and practice chapter2.pdf (accessed May 25, 2013), 28-30]

For a policy to be efficient it must compensate all the people who are bearing some opportunity cost because of the policy. If the policy is not compensating all such people then it is not efficient and it cannot be Pareto improving. ("Conceptual Foundations of Cost-Benefit" 2007)[footnoteRef:12] [12: CONCEPTUAL FOUNDATIONS OF COST-BENEFIT, (Bangkok: National Institute of Development Administration, 2007)http://gspa.grade.nida.ac.th/pdf/Dr_Nutta/PA.640nattha_MPA_3-49/2. Efficiency/2.2.2Boardman, A. Cost Benefit Analysis Concept and practice chapter2.pdf (accessed May 25, 2013), 28-30.]

Payment Mechanisms

While calculating economic surplus, the amount of money associated with demand and supply of various products or the amount of money that the people would be willing to pay or willing to accept depends on certain hypothetical assumptions. The analysts, however, by studying the trends of demand and supply over a period of time, give a somewhat accurate picture of these amounts. (Sugden 2009)[footnoteRef:13] [13: Robert Sugden, "Conceptual foundations of cost-benefit analysis: a minimalist account." (unpublished master., University of East Anglia, 2009), University of East Anglia, http://www.iccr-international.org/trans-talk/docs/ws2-sugden.pdf.]

However, the calculation of surplus for the goods that are not traded in the market is more hypothetical than that of the goods which are traded in the market. In order to calculate the effectiveness and surplus of a non-marketable good, say a road project, which gives everyone a free access the authorities would use payment mechanisms such as an access charge per day or per year, toll levied per trip or an increase in the amount of paid local tax. Such payment mechanisms represent the cost that an individual is willing to tolerate, to use the facilities provided by a project that cannot be traded in the market. (Sugden 2009)[footnoteRef:14] [14: Robert Sugden, "Conceptual foundations of cost-benefit analysis: a minimalist account." (unpublished master., University of East Anglia, 2009), University of East Anglia, http://www.iccr-international.org/trans-talk/docs/ws2-sugden.pdf.]

Cost and Benefit Analysis as Decision Making Model - A Theoretical Consideration

The conceptual foundation that the willingness to pay (WTP), willingness to accept (WTA) and opportunity costs can be used as a way to make the policy Pareto efficient is impractical as; the burden to collect information, regarding the willingness to pay, willingness to accept and opportunity cost, would be very high. In addition to that, the administrative costs related to the provision of required amounts would be extremely high. Moreover, there is a probability that the people will understate benefits and overstate costs as they will be provided with compensation for the latter one.

Economics of Energy

It is the field of study that analyzes the use of energy resources by the human beings and the effects of this utilization. In physical terms energy is defined as 'the ability of doing work'. In economics, the word energy encompasses all the energy resources and commodities. These energy resources contain large amounts of physical energy and hence they make various things work. The examples of energy resources are; natural gas, crude oil, fuels etcetera. (Sweeney 2007)[footnoteRef:15] [15: James Sweeney, "Economics of Energy." (master., Stanford University, 2007), Stanford University, http://www.localenergy.org/pdfs/Document Library/Energy Economics.pdf.]

Composition of Cost Related to Energy Economics

There are various capital, maintenance and operational costs associated with the energy economics projects. The capital cost associated with energy economics are; sunk, site specific, site non-specific and fixed. (Rothschild 2008)[footnoteRef:16] [16: Bob Rothschild, "Cost Benefit Analysis." (unpublished lecture., Lancaster University, 2008), Lancaster University, http://www.engineering.lancs.ac.uk/lureg/nwhrm/project/Joule Centre conf 08/rothschild.pdf.]

[footnoteRef:17] [17: Bob Rothschild, "Cost Benefit Analysis." (unpublished lecture., Lancaster University, 2008), Lancaster University, http://www.engineering.lancs.ac.uk/lureg/nwhrm/project/Joule Centre conf 08/rothschild.pdf.]

The above diagram shows the share of various costs in energy economics projects.

Cost and Benefit Applied to Energy Products

Cost and benefit applied to the energy economics can be defined as an appraisal of all the costs and benefits associated with a particular energy project or policy. This project might be marketable or non-marketable. This type of cost includes both the present and future costs and benefits. And both the costs and the benefits are represented in the common unit of value. (Clinch 2003)[footnoteRef:18] [18: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16. ]

As discussed in the above definition, all the costs and benefits associated with a project must be included in the cost and benefit analysis regardless of the fact that whether these costs and benefits are marketed or not. This point enables the cost and benefit analysis related to the energy economics to include some wider social and environmental issues in it. The common unit of value, which is being used in the above discussed cost and benefit analysis, is money. As the social and environmental issues are non-monetary, therefore, the costs and benefits associated with them are also non-monetary. These costs and benefits are then converted into monetary value so that they can be compared to other costs and benefits easily. (Clinch 2003)[footnoteRef:19] [19: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]

In most of the cases related to energy economics, the costs and benefits occur at different points in time. This happens, especially, in such projects, where all the consequences are unpredictable and environmental factors may have an influential impact of the policies and projects. In such cases various costs and benefits occur at different points in time. To compare the future costs and benefits with the present costs and benefits, the technique of discounting is used. This technique discounts the costs and benefits of future to the present and determines the present value of such costs and benefits. After the determination of the present, the comparison is done between the present values. (Clinch 2003)[footnoteRef:20] [20: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]

In addition to that costs and benefit analysis is also used to determine and analyze various environmental costs associated with different energy economic projects. It analyses the net benefits of using various sources of energy, the benefits of using renewable modes of energy, the benefits of using alternate modes of transports, the benefits of employing different energy efficiency policies etcetera. (Clinch 2003)[footnoteRef:21] [21: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]

Uses of Cost and Benefit Analysis in Energy Economics

The basic reason behind the use of cost and benefit analysis in the energy economics is market failure. If there would not have been any market failures and all the energy economic institutions would have been privately owned then there would not have been any need of the cost and benefit analysis. The cost and benefit analysis is used in the following areas in the field of energy economics. (Clinch 2003)[footnoteRef:22] [22: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]

Energy Externalities

One of the major environmental problems persisting today is the environmental hazards associated with the fossil fuels that generate energy, especially greenhouse gasses. Many of the damaging gasses are emitted by the energy economic sector and transport sector. These gasses have negative impacts on the local, national and international environments. (Clinch 2003)[footnoteRef:23] [23: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]

The energy externalities can be defined by a simple example, if an organization is producing products that emit SO2 in the environment and this SO2 leads to acid rain and deteriorates buildings and forests then, in the free market, such costs are not reflected in the price of the product and hence the price prevailing in the energy market does not represent the total cost of the product. The costs that do not impact the organization or people who incur it are known as external costs. By the use of cost and benefit analysis and the environmental valuation associated with it, the organizations can include such costs in their overall price. (Clinch 2003)[footnoteRef:24] [24: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]

Formation of Policies Related to Externalities

Unless these external costs are converted into internal costs, the organizations will continue to exploit and over use the scarce economic resources. This calls for the intervention of government and the formulation of policies. The cost and benefit analysis provides the tools which are required for the tradeoff between policies and externalities. (Clinch 2003)[footnoteRef:25] [25: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]

Sustainability Assessment and Green National Accounting

Cost and benefit analysis enables the organization to assess its sustainability. By using this tool the organization can answer the questions such as, 'what is the current value of our resources?' 'Are our resources being used productively and efficiently?' And 'Is the man made capital that is replacing the resources, equal to the resources?' etcetera. The green house accounting on the other hand enables the organizations and the government to adjust various environmental and social costs in the Net Income, Gross Domestic Product (GDP) and Gross National Product (GNP) etcetera. (Clinch 2003)[footnoteRef:26] [26: Peter Clinch, Cost-Benefit Analysis Applied To Energy, (University College Dublin: Dublin, 2003)http://www.ucd.ie/gpep/publications/archivedworkingpapers/2003/03-04.pdf (accessed May 25, 2013), 4-16.]