Introduction • All impacts in money terms • No impacts in monetary terms • Some impacts in money terms • Risk & uncertainty

All impacts in money terms

Aggregating benefits

Where all impacts can be estimated in money terms, they can also be aggregated (by adding them together) to give an overall indication of the level of damages (or benefits) predicted. However, it is important that all of the benefits are calculated over the same time span. For example, some benefits may be one-off and may occur immediately, but others may be annual or may occur just once, but not until some time in the future. At a project level, the application of Cost-Benefit Analysis (CBA) techniques (including benefits transfer) requires that all future costs and benefits are converted into comparable units of value in present day terms. The means of achieving this is known as discounting. This allows the future stream of costs and benefits to be aggregated over time to give a total estimate of the net present value for a project or action.

The discounting procedure is based on the principle that more importance is placed on costs and benefits that occur now, than those that arise in the future. When discounting is applied to specific assets (machinery, etc.), it provides a means of taking into account the opportunity costs of capital investments and is a widely accepted and non-controversial technique. When applied to non-market goods and services, such as the environment, discounting is used to reflect the social rate of time preference (placing more importance on now than on the future). This process can be controversial and whether or not such a time preference exists towards the environment remains the subject of debate.

For all government related CBAs, the standard discount rate set by the Treasury should be used. This rate is currently 3.5% (but reduces in year 31 to 3% and in year 76 to 2.5%).

There are some important implications of discounting in the analysis of environmental impacts, which should be understood. The higher the discount rate used, the lower the importance placed on future costs and benefits. At any positive discount rate, costs or benefits which accrue more than 50 years into the future will have a very small present value. For example, at a rate of 3.5%, costs and benefits occurring in 25 years time will have only 42% of the value of those occurring today. Hence, activities with environmental benefits occurring well into the future are less likely to be favoured than those with near-term benefits; similarly, activities with high future environmental costs, but which yield near-term benefits, are more likely to be favoured than those with lower near-term benefits, but also lower future costs.

Once benefits and costs have been ‘monetised’ for a particular year, these are normally discounted across the number of years that those costs and benefits are expected to accrue. Discounting consists of calculating the present value (PV) of costs and benefits (this being required because a unit of money now is considered to have a different value to the same unit of money sometime in the future). The formula for calculating the PV is as follows:

PV = 1/ (1+r)ⁿ * monetary value per year of costs and/or benefits , where

r = interest rate; and
n = year in which benefits and/or costs accrue.

Comparing options

Once the benefits have all been converted into comparable units, they can be aggregated to give total benefits. These can then be compared with the costs to give an indication of the economic worthiness of the project. There are a number of calculations that are used to help determine which option should be preferred:

• Net Present Value (NPV): calculated as the benefits minus the costs. A project is considered worthwhile if the NPV is greater than zero. The preferred option could also be the option with the highest NPV, although this is usually only the case where there are unlimited funds; and
• Benefit-Cost ratio (B:C): calculated as benefits divided by costs. A project is considered worthwhile if the B:C is greater than one. The preferred option is often identified as that with the highest B:C ratio.

When all impacts are presented in money terms (and where these impacts have been discounted and aggregated), the selection of the preferred option is based on (i) which option has the highest benefit-cost ratio and (ii), if the benefit-cost ratios of two (or more) options are the same (or very similar), which has the highest NPV.