Economics of Global Warming - Cost-benefit Analysis

Cost-benefit Analysis

Standard cost-benefit analysis (CBA) (also referred to as a monetized cost-benefit framework) can be applied to the problem of climate change. This requires (1) the valuation of costs and benefits using willingness to pay (WTP) or willingness to accept (WTA) compensation as a measure of value, and (2) a criterion for accepting or rejecting proposals:

For (1), in CBA where WTP/WTA is used, climate change impacts are aggregated into a monetary value, with environmental impacts converted into consumption equivalents, and risk accounted for using certainty equivalents. Values over time are then discounted to produce their equivalent present values.

The valuation of costs and benefits of climate change can be controversial because some climate change impacts are difficult to assign a value to, e.g., ecosystems and human health. It is also impossible to know the preferences of future generations, which affects the valuation of costs and benefits. Another difficulty is quantifying the risks of future climate change.

For (2), the standard criterion is the (Kaldor-Hicks) compensation principle. According to the compensation principle, so long as those benefiting from a particular project compensate the losers, and there is still something left over, then the result is an unambiguous gain in welfare. If there are no mechanisms allowing compensation to be paid, then it is necessary to assign weights to particular individuals.

One of the mechanisms for compensation is impossible for this problem: mitigation might benefit future generations at the expense of current generations, but there is no way that future generations can compensate current generations for the costs of mitigation. On the other hand, should future generations bear most of the costs of climate change, compensation to them would not be possible. Another transfer for compensation exists between regions and populations. If, for example, some countries were to benefit from future climate change but others lose out, there is no guarantee that the winners would compensate the losers; similarly, if some countries were to benefit from reducing climate change but others lose out, there would likewise be no guarantee that the winners would compensate the losers.