Guidelines for Preparing

Economic Analyses

U.S. Environmental Protection Agency

September 2000

NOTICE

The statements in this document have been developed by the EPA solely for use as guidance for economic analysts in the Agency,

and those consultants, contractors, or other persons who perform work under Agency contract or sponsorship. In addition, publication of these Guidelines makes information on the principles, concepts, and methods used by the Agency available to all interested

members of the public. This document is not intended, nor can it be relied upon, to create any rights enforceable by any party in litigation with the United States. The Agency may decide to follow the guidance provided in this document, or to act at variance with

the guidance based on its analysis of the specific facts present. This guidance may be revised without public notice to reflect changes

in the Agency’s approach to preparing economic analyses, or to clarify and update text.

i

Preface

The U.S. Environmental Protection Agency (EPA), Regulatory Policy Council oversees regulatory planning by the

Agency. In this capacity, the Council establishes analytical procedures on risk management issues to ensure that

high quality and consistent practices are followed in accordance with Federal and Agency regulatory procedures.

In early 1996, the conduct and consistency of economic analyses prepared in support of regulatory actions were

identified as areas in need of updated and more specific guidance than was presently available in the Agency.

The Regulatory Policy Council assembled a group economists and policy analysts serving in offices throughout

the EPA to serve on an Economic Consistency Workgroup. The Council instructed the Workgroup to develop a

series of issue papers to assess important economic analytical issues facing the Agency. After discussing the

results of the findings in the issue papers, the Council charged the Workgroup with preparing a guidance document to assist in the preparation of economic analyses used for regulatory development and policy evaluation

conducted by the Agency.

The Guidelines for Preparing Economic Analyses (or EA Guidelines) is part of a continuing effort by the EPA

to develop improved guidance on the preparation and use of sound science in support of the decision making

process. The EA Guidelines provide guidance on analyzing the benefits, costs, and economic impacts of regulations and policies. The document draws from several previously published sources, including existing economic guidelines materials prepared by the EPA in the mid-1980s, other Agency economic analyses and handbooks,

and materials prepared by the Office of Management and Budget in support of Executive Order 12866 on regulatory planning and analysis. It seeks to incorporate recent theoretical, empirical, and modeling advances in

environmental economics, drawing upon the considerable body of scholarly literature.

In an effort to ensure the EA Guidelines presents sound, scientific information consistent with mainstream

practices in environmental economics, the Agency's Science Advisory Board (SAB) was charged with undertaking an extensive peer review of the document. The review was performed by the SAB's Environmental

Economics Advisory Committee (EEAC), comprising leading U.S. environmental economists affiliated with

major colleges, universities and economic research institutions. The EEAC provided substantial input on the

content and organization of the document, reviewing the materials for accuracy in both economic theory and

practice. In their final review report to the Agency (included as Appendix A in this document), the SAB concluded that the EA Guidelines receive an overall rating of "excellent," saying it "succeed(s) in reflecting methods

and practices that enjoy widespread acceptance in the environmental economics profession."

Constant advances in theoretical and empirical research in the field of environmental economics will require

that the Agency reexamine the EA Guidelines on a continual basis. The Agency will again enlist experts in the

field of environmental economics and engage in an open review of the scientific basis of the document when it

is reevaluated in the future.

Preface
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Preface
Table of 

Contents

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Table of Contents

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .i

List of Acronyms and Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .vii

Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .ix

Chapter 1: Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1

Chapter 2: Statutory and Executive Order Requirements for Conducting Economic Analyses . . . . . . . . . . . . .5

Chapter 3: Statement of Need for the Proposal

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

3.2 Problem Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

3.3 Reasons for Market or Institutional Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9

3.4 Need for Federal Action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10

Chapter 4: Regulatory and Non-Regulatory Approaches to Consider

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

4.2 Traditional Design-Based Command and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

4.3 Performance-Oriented Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

4.4 Market-Oriented Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

4.4.1 Descriptions of Market-Based Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12

4.4.2 Selecting Market-Oriented Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13

4.5 Non-Regulatory Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

4.6 Fine-tuning Policy Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

4.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16

Chapter 5: Overview of Economic Analysis of Environmental Policy

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

5.2 Economic Framework and Definition of Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19

5.3 Baseline Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

5.3.1 Guiding Principles for Baseline Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21

5.3.2 Compliance Rate Issues and Baseline Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

5.3.3 Multiple Rules or Regulations and Baseline Specification . . . . . . . . . . . . . . . . . . . . . . . . .25

5.3.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25

5.4 Predicting Responses to a New Environmental Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

5.5 Analyzing and Presenting Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27

5.5.1 Guiding Principles for Uncertainty Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27
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5.5.2 Performing Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

5.5.3 Welfare Considerations Related to Uncertainty and Risk . . . . . . . . . . . . . . . . . . . . . . . . . .29

5.6 Emerging Cross-Cutting Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30

5.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31

Chapter 6: Analysis of Social Discounting

6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

6.2 General Considerations in Social Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

6.2.1 Social and Private Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

6.2.2 Methods for Summarizing Present and Future Costs and Benefits . . . . . . . . . . . . . . . . . . .34

6.2.3 Sensitivity of Present Value Estimates to the Discount Rate . . . . . . . . . . . . . . . . . . . . . . . .36

6.2.4 Distinguishing Discounting from Other Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

6.3 Approaches to Social Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38

6.3.1 Intra-Generational Social Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .38

6.3.2 Inter-Generational Social Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

6.4 Discounting and Non-Monetized Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52

6.4.1 Perspectives on Discounting Non-Monetized Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . .53

6.4.2 When Discounting Non-Monetized Effects Is Appropriate . . . . . . . . . . . . . . . . . . . . . . . . .53

6.4.3 When Discounting Non-Monetized Effects Might Not Be Appropriate . . . . . . . . . . . . . . . . .54

6.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .56

Chapter 7: Analyzing Benefits

7.1 Introduction to Analyzing Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .59

7.2 A Conceptual Framework for Benefits Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .60

7.2.1 Welfare Measures: Willingness to Pay and Willingness to Accept Compensation . . . . . . . . .60

7.2.2 Market Goods: Using Consumer Surplus and Demand Curves . . . . . . . . . . . . . . . . . . . . .61

7.2.3 Non-Market Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62

7.3 The Benefit Analysis Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62

7.3.1 A General "Effect-by-Effect" Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62

7.3.2 Implementation Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .65

7.4 Types of Benefits Associated with Environmental Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .66

7.4.1 Human Health: Mortality Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68

7.4.2 Human Health: Morbidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .68

7.4.3 Amenities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69

7.4.4 Ecological Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .69

7.4.5 Reduced Materials Damages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71

7.5 Methods for Benefits Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .71

7.5.1 Market Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72

7.5.2 Revealed Preference Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .73
7.5.3 Stated Preference Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .83

7.5.4 Benefit Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

7.6 Values for Major Benefit Categories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

7.6.1 Human Health: Mortality Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .87

7.6.2 Human Health: Morbidity Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .94

7.6.3 Ecological Benefit Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .98

7.6.4 Materials Damage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100

7.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .101

Chapter 8: Analyzing Social Costs

8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .113

8.2 The Theory of Social Cost Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .113

8.2.1 An Illustration of Social Costs and Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .114

8.3 A General Approach to Social Cost Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .115

8.3.1 Estimating the Supply and Demand Equations of All the Affected Markets . . . . . . . . . . . .115

8.3.2 Determining the Different Types of Social Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .119

8.3.3 Other Issues Arising in Presentation of Social Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . .123

8.4 Modeling Tools . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .124

8.4.1 The Basic Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .124

8.4.2 The Direct Compliance Cost Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .124

8.4.3 Partial Equilibrium Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .125

8.4.4 Multi-Market Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .126

8.4.5 General Equilibrium Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .126

8.5 Estimating the Social Costs of Alternative Policy Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . .130

8.5.1 Direct (or Standards-Based) Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .130

8.5.2 Incentive-Based Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .131

8.5.3 Voluntary Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .135

8.6 Summary and Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .135

8.7 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137

Chapter 9: Distributional Analyses: Economic Impact Analyses and Equity Assessments

9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .139

9.1.1 A Process for Economic Impact Analyses and Equity Assessments . . . . . . . . . . . . . . . . . .141

9.2 Economic Impact Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143

9.2.1 Introduction to Economic Impact Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .143

9.2.2 Statutes and Policies Requiring Examination of Economic Impacts . . . . . . . . . . . . . . . .143

9.2.3 Models for Assessing Economic Impacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .145

9.2.4 Calculating Compliance Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .147

9.2.5 Screening for Potentially Significant Impacts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .148

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9.2.6 Profile of Affected Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .149

9.2.7 Impacts on Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .151

9.2.8 Impacts on Production and Employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .152

9.2.9 Impacts on Profitability and Plant Closures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .153

9.2.10 Impacts on Related Industries and Consumers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .155

9.2.11 Impacts on Innovation, Productivity, and Economic Growth . . . . . . . . . . . . . . . . . . . . .155

9.2.12 Impacts on Industry Competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .155

9.2.13 Impacts on Government Entities and Not-for-Profit Organizations . . . . . . . . . . . . . . . . .156

9.3 Equity Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160

9.3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .160

9.3.2 Statutes and Policies Requiring Equity Assessment and Definitions of Sub-Populations . . . . .161

9.3.3 Entity Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .161

9.3.4 Minority Status and Income Level . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .164

9.3.5 Childhood Status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .166

9.3.6 Case Specific Equity Dimensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .167

9.3.7 A Framework for Equity Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .168

9.3.8 Data for Conducting Equity Assessments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .170

9.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .172

Chapter 10: Using Economic Analyses in Decision Making

10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175

10.2 Communicating Assumptions and Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .175

10.3 Presenting the Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176

10.3.1 Results from Benefit-Cost Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .177

10.3.2 Results from Economic Impacts Analysis and Equity Assessments . . . . . . . . . . . . . . . .177

10.3.3 Results from Cost-Effectiveness Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178

10.4 Use of Economic Analyses in Policy Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178

10.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .179

Appendices

A. An SAB Report on the EPA Guidelines for Preparing Economic Analysis . . . . . . . . . . . . . . . . . . . .181

B. EPA’s Response to SAB Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .205

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Acronyms 

and

Abbreviations

vii

AC annualized costs

BAT best available technology

BCA benefit-cost analysis

BPT best practicable technology

CA conjoint analysis

CE certainty equivalent

CEQ Council on Environmental Quality

CERCLA Comprehensive Environmental Response, Compensation and Liability Act

CFC chlorofluorocarbons

CFR Code of Federal Regulations

CGE computable general equilibrium

COI cost of illness

CPI Consumer Price Index

CR contingent ranking

CV contingent valuation

DALY disability-adjusted life year

DOE Department of Energy

DOT Department of Transportation

DWL dead weight loss

EA economic analysis

EBIT earnings before interest and taxes

EEAC Environmental Economics Advisory Committee

EIA economic impact analysis

EO Executive Order

EPA Environmental Protection Agency

FINDS Facility Index Data System

FTE full-time equivalent employment

GDP gross domestic product

I/O input-output

IPCC Intergovernmental Panel on Climate Change

LP linear programming

MR marginal revenue

MPC marginal private costs

MSC marginal social costs

MSD marginal social damages

NAICS North American Industrial Classification System

NB net benefits

Acronyms and Abbreviations
viii

Acronyms and Abbreviations

NEPA National Environmental Policy Act

NESHAP National Emission Standard for Hazardous Air Pollutant

NFV net future value

NOAA National Oceanic and Atmospheric Administration

OCC opportunity cost of capital

OECD Organization for Economic Cooperation and Development

OLS ordinary least squares

OMB Office of Management and Budget

OSHA Occupational Safety and Health Administration

PRA Paperwork Reduction Act

POTW publicly-owned (wastewater) treatment work

PVC present value of costs

QALY quality-adjusted life year

RAPIDS Rule and Policy Information Development System

RFA Regulatory Flexibility Act

RIA regulatory impact analysis

RUM random utility model

SAB Science Advisory Board

SAM social accounting matrix

S&P Standard & Poors

SBA Small Business Administration

SBREFA Small Business Regulatory Enforcement Fairness Act 

SIC Standard Industrial Classification

TAMM Timber Assessment Market Model

TSLS two-stage least squares

UMRA Unfunded Mandates Reform Act

USC United States Code

VSL value of statistical life

VSLY value of statistical life-year

WTA willingness to accept

WTP willingness to pay
Acknowledgments

ix

The preparation of the Guidelines for Preparing Economic Analyses (or EA Guidelines) was managed under

the direction of the Regulatory Policy Council, chaired by the Deputy Administrator of EPA. Initial work on the

EA Guidelines began in 1996 under the direction of Deputy Administrator, Fred J. Hansen during his tenure at

the Agency, and concluded in 2000 under Deputy Administrator, W. Michael McCabe. 

The principal manager of the Economic Consistency Workgroup was Al McGartland, Director, National Center for

Environmental Economics. The Economic Consistency Workgroup consists of staff economists and policy analysts from across the Agency, who contributed to the development and review of the materials contained in the

EA Guidelines. The primary writers/editors for the EA Guidelines were Chris Dockins and Brett Snyder.

Additional persons responsible for final preparation of the text include: Liwayway Adkins, Kathleen Bell, Jennifer

Bowen, Jared Creason, Richard Garbaccio, Richard Iovanna, Robin Jenkins, Elizabeth McClelland, Nicole Owens,

Michael Podolsky, Keith Sargent, Nathalie Simon, Lanelle Wiggins and Melonie Williams. 

Representatives from EPA's many different program offices contributed to development and review of the EA

Guidelines as members of the Economic Consistency Workgroup. Persons playing more active roles in the

review process included: Ghulam Ali, Rebecca K. Allen, Paul Balserak, Allen Basala, John B. Bennett, Paul Borst,

Nick Bouwes, Jennifer Bowen, Ed Chu, Matthew Clark, Gary Cole, Jim DeMocker, Mark Eads, Ron Evans, Sandy

Evelanko, Glenn Farber, John Faulkner, Leslye Fraser, Arthur Grube, Patricia Hall, Chris Herman, Bryan

Hubbell, Barnes Johnson, Robert Lee, Jonathan Libber, Mahesh Podar, John R. Powers, Elliot Rosenberg, Jean

Schumann, Ann Watkins, William Wheeler, David Widawsky and Jan Young.

In addition to EPA staff, a number of contractors developed key materials used as technical assistance in preparation of the EA Guidelines and supporting documents. They include Frank Arnold and Francis Sussman of ICF

Consulting, Inc.; Lisa Robinson, Marla Markowski, Jim Neumann and Robert Unsworth, of Industrial

Economics; Leland Deck, Ellen Post and Penny Schafer of Abt Associates; Robert Raucher, Brian Hurd, Lauraine

Chesnut, David Mills, Greg Pitts, Tom Ottom of Stratus Consulting; Richard Bishop of University of WisconsinMadison; Michael Hanemann of University of California-Berkeley; David Burmaster of Alceon Corporation; and

Anna Alberini of University of Colorado-Boulder.

The Science Advisory Board (SAB) review of the EA Guidelines was supervised by Donald G. Barnes, Director of

the SAB Staff and by Dr. Joan M. Daisy, Chair of the SAB. Thomas Miller was the Designated Federal Official for

the SAB-Environmental Economics Advisory Committee (EEAC) charged with conducting the peer review of the

EA Guidelines. Dorothy Clark provided administrative management support to the SAB-EEAC.

The SAB-EEAC was chaired by Dr. Robert Stavins of the John F. Kennedy School of Government, Harvard

University. SAB-EEAC members serving on the committee during the review of the EA Guidelines included: Dr.

Nancy Bockstael of University of Maryland-College Park, Dr. Dallas Burtraw of Resources for the Future, Dr.

Trudy Cameron of University of California-Los Angeles, Dr. Maureen Cropper of the World Bank, Dr. Herman

Daly of University of Maryland-College Park, Dr. A. Myrick Freeman of Bowdoin College, Dr. Lawrence Goulder of

Stanford University, Dr. Dale Jorgenson of Harvard University, Dr. Paul Joskow of Massachusetts Institute of

Technology, Dr. Catherine Kling of Iowa State University, Dr. Charles Kolstad of University of California-Santa

Barbara, Dr. Richard Revesz of New York University School of Law, Dr. Jason Shogren of University of Wyoming,

Dr. Hilary Sigman of Rutgers University, Dr. Richard Schmalensee of Massachusetts Institute of Technology, and

Dr. V. Kip Viscusi of Harvard University.

Acknowledgments
x

Acknowledgments
Background to the

Guidelines for

Performing Economic

Analyses

In December of 1983, the U.S. Environmental

Protection Agency issued its Guidelines for

Performing Regulatory Impact Analysis1 (RIA

Guidelines). 

Since their promulgation, the original RIA Guidelines

have remained largely unaltered, experiencing only a

few modifications and additions to specific sections

during the 1980s. 

Much has changed since 1983, however, so EPA has

prepared these revised and updated Guidelines for

Preparing Economic Analyses (EA Guidelines). The

revised EA Guidelines reflect the evolution of environmental policy making and economic analysis over

the past decade and a half.

Recent years have seen an expansion of the universe

of economic and social issues that are potentially

affected by environmental policies. In 1983, the content of the analyses required for RIAs was driven

mostly by Executive Order 12291, which directed federal agencies to assess the costs, benefits, and economic impacts of their rules, and established a formal review process by the Office of Management and

Budget (OMB). This process and its goals were reaffirmed in 1992 with the issuance of Executive Order

12866 on regulatory planning and review. OMB subsequently released the document Economic Analysis

of Federal Regulations Under Executive Order

128662 (or Best Practices), which served to illustrate

specific techniques and issues concerning the conduct of economic analysis in support of EO 12866.

More recently, OMB released the document

Guidelines to Standardize Measures of Costs and

Benefits and the Format of Accounting Statements3

(or OMB Guidelines) which currently serves as

guidelines to federal agencies on economic analysis.

In addition to requirements to prepare economic

analyses set forth by Executive Order, economic

assessments are also called for under various administrative statutes. For example, agencies are explicitly

directed to examine whether their policies impose

new "unfunded mandates" on state, local, and tribal

governments, and to review economic impacts on

small businesses, governments, and nonprofit enterprises under the Unfunded Mandates Reform Act of

1995 (P.L. 104-4) and the Regulatory Flexibility Act,

as amended by the Small Business Regulatory

Enforcement Fairness Act (5 U.S.C. 601-612).

Policy makers have also extended the scope of relevant effects to be considered beyond these mandatory

1

Chapter 

1

Chapter 1: Introduction

1 U.S. Environmental Protection Agency, Guidelines for Performing Regulatory Impact Analyses. EPA-230-84-003, December

1983. Reprinted with Appendices in March 1991.

2 U.S. Office of Management and Budget, Economic Analysis of Federal Regulations Under Executive Order 12866, January

11, 1996. This "Best Practices" document can be found at the U.S. White House, Office of Management and Budget website:

http://www.whitehouse.gov/OMB/inforeg/riaguide.html under the section titled "Regulatory Policy" (accessed 8/28/2000).

3 U.S. Office of Management and Budget, M-00-08 Guidelines to Standardize Measures of Costs and Benefits and the

Format of Accounting Statements, March 22, 2000. The OMB Guidelines serves to implement Section 638(c) of the 1999 Omnibus

Consolidated and Emergency Supplemental Appropriations Act and Section 628(c) of the Fiscal Year 2000 Treasury and General

Government Appropriations Act. They require OMB to issue guidelines to help agencies estimate the benefits and costs of federal regulations and paperwork and summarize the results of the associated analysis. The OMB Guidelines can be found at the U.S. White House,

Office of Management and Budget website: http://www.whitehouse.gov/OMB/memoranda/index.html under the section titled "Selected

Memorandum to Heads of Federal Departments and Agencies" (accessed 8/28/2000).
assessments. For example, the Pollution Prevention Act

was passed in 1990 and the Agency has undertaken new

initiatives that explored voluntary, non-regulatory

approaches to address past and potential future pollution

sources. Economic assessment of these types of actions

can provide useful information on the economic efficiency

of allocating society's resources in these ways. 

The EA Guidelines have been updated to keep pace with

the evolving emphases policy makers place on different

economic and social concerns affected by environmental

policies. Underlying this exercise is the recognition that a

thorough and careful economic analysis is an important

component in designing sound environmental policies.

Preparing high quality economic analyses can greatly

enhance the effectiveness of environmental policies by

providing policy makers with the ability to systematically

assess the consequences of regulatory and non-regulatory

actions. An economic analysis can describe the implications of policy alternatives not just for economic efficiency,

but for the magnitude and distribution of an array of

impacts. Economic analyses also serve as a mechanism

for organizing information carefully. Thus, even when data

are insufficient to support particular types of economic

analyses, the conceptual scoping exercise may provide useful insights.

The RIA Guidelines focused appropriately not only on

what was required for assessing costs, benefits, and economic impacts of policies, but also on the basic technical

procedures for doing so. Over the past 15 years, however,

economic science has developed new techniques for benefits estimation, different economic models for assessing

costs and other effects, and greatly expanded data sources

and related guidance materials. These are all reflected in

this document.

As a result of these modifications and updates, the new EA

Guidelines will continue to serve, as always, to ensure that

the EPA's economic analyses are prepared to inform its

policy making processes and satisfy OMB's requirements

for regulatory review. The new EA Guidelines also seek to

establish an interactive policy development process

between analysts and decision makers through an expanded set of cost, benefit, economic impacts, and equity

effects assessments, an up-to-date encapsulation of environmental economics theory and practice, and an

enhanced emphasis on practical applications.

The Scope of the EA Guidelines

The focus of the EA Guidelines is on the economic analyses typically conducted for environmental policies using

regulatory or non-regulatory management strategies.

Other guidance documents exist for related analyses, some

of which are inputs to economic assessments. No attempt

is made here to summarize these other guidance materials. Instead, their existence and content are noted in the

appropriate sections. The EA Guidelines follow generally

the outline of OMB's Best Practices and the OMB

Guidelines, except insofar as these guidelines embody

assessment principles and policy advice developed recently

by EPA for its economic analyses.

As with the previous RIA Guidelines, the presentation of

economic concepts and applications in this document

assumes the reader has some background in microeconomics as applied to environmental and natural resource

policies. Thus, to fully understand and apply the

approaches and recommendations presented in the EA

Guidelines readers should be familiar with basic applied

microeconomic analysis, the concepts and measurement

of consumer and producer surplus, and the economic

foundations of benefit-cost evaluation. Persons lacking

these skills, but seeking to better understand economics,

will require an alternative presentation of the materials

contained in this document. Supplemental written material will be prepared to accompany this document, including

training materials developed to reach a wider audience of

individuals responsible for using the types of economic

tools and information described here.

The EA Guidelines are designed to provide assistance to

analysts in the economic analysis of environmental policies, but they do not provide a rigid blueprint or a "cookbook" for all policy assessments. The most productive and

illuminating approaches for particular situations will

depend on a variety of case-specific factors and will require

professional judgment to apply. The EA Guidelines should

be viewed as a summary of analytical methodologies,

empirical techniques, and data sources that can assist in

performing economic analyses of environmental policies.

When drawing upon these resources, there is no substitute

for reviewing the original source materials.

2

Chapter 1: Introduction
In all cases, the EA Guidelines recommend adhering to

the following general principles as stated by OMB (EO

12866, Introduction):

"'Analysis of the risks, benefits, and costs associated with regulation must be guided by the principles of full disclosure and transparency. Data,

models, inferences, and assumptions should be

identified and evaluated explicitly, together with

adequate justifications of choices made, and

assessments of the effects of these choices on the

analysis. The existence of plausible alternative

models or assumptions, and their implications,

should be identified. In the absence of adequate

valid data, properly identified assumptions are

necessary for conducting an assessment."

"Analysis of the risks, benefits, and costs associated with regulation inevitably also involves

uncertainties and requires informed professional

judgments. There should be balance between

thoroughness of analysis and practical limits to

the agency's capacity to carry out analysis. The

amount of analysis (whether scientific, statistical,

or economic) that a particular issue requires

depends on the need for more thorough analysis

because of the importance and complexity of the

issue, the need for expedition, the nature of the

statutory language and the extent of statutory discretion, and the sensitivity of net benefits to the

choice of regulatory alternatives."'

Thus, economic analyses should always acknowledge and

characterize important uncertainties that arise throughout

the analysis. Economic analyses should clearly state the

judgments and decisions associated with these uncertainties and should identify the implications of these choices.

When assumptions are necessary in order to carry out the

analysis, the reasons for those assumptions must be stated

explicitly and clearly. Further, economic analyses of environmental policies should be flexible enough to be tailored

to the specific circumstances of a particular policy, and to

incorporate new information and advances in the theory

and practice of environmental policy analysis.

Organization of the EA Guidelines

The remainder of this document is organized into nine

main chapters as follows:

Chapter 2: Statutory and Executive Order

Requirements for Conducting Economic Analyses

reviews the major statutes and other directives mandating certain assessments of the consequences of

policy actions;

Chapter 3: Statement of Need for the Proposal provides guidance on procedures and analyses for clearly

identifying the environmental problem to be

addressed and for justifying federal intervention to

correct it;

Chapter 4: Regulatory and Non-Regulatory

Approaches to Consider discusses the variety of regulatory and non-regulatory approaches analysts and

policy makers ought to consider in developing strategies for environmental improvement;

Chapter 5: Overview of Economic Analysis of

Environmental Policy provides a theoretical overview

of environmental economic analyses, as well as guidance concerning baseline specification and the treatment of uncertainty;

Chapter 6: Analysis of Social Discounting presents a

review of discounting procedures and provides guidance on social discounting in conventional contexts

and over very long time horizons;

Chapter 7: Analyzing Benefits provides guidance for

assessing the benefits of environmental policies

including various techniques of valuing risk-reduction

and other benefits;

Chapter 8: Analyzing Social Costs presents the basic

theoretical approach for assessing the social costs of

environmental policies and describes how this can be

applied in practice;

Chapter 9: Distributional Analyses provides guidance

for performing a variety of different assessments of

the economic impacts and equity effects of environmental policies; and

3

Chapter 1: Introduction
Chapter 1: Introduction

4

Chapter 10: Using Economic Analyses in Decision

Making concludes the main body of the EA

Guidelines with suggestions for evaluating different

policy approaches and options, and for presenting the

quantified and unquantified results of the various

economic analyses to policy makers.
Policy makers need information on the benefits,

costs, and other effects of alternative options for

addressing a particular environmental problem in

order to make sound policy decisions. In addition,

various statutes specifically require economic analyses of policy actions. General mandates may also

direct agencies to conduct specific types of economic

analyses. In some cases, agencies have established

their own requirements for certain types of assessments of their policies. This chapter discusses specific requirements that apply to all of EPA's

programs.1

OMB's basic requirements for regulatory review,

including their Best Practices and OMB Guidelines

documents, have helped to shape EPA's methodological and empirical approaches for conducting economic analyses. Several new mandates to conduct

specific economic assessments of environmental

policies have also recently been enacted. Many of the

mandates that introduce economic analyses requirements of policies are briefly reviewed here.2 In each

case, citations for the relevant mandates or statutes

and references to applicable EPA guidelines are provided.3

Executive Order 12866, "Regulatory

Planning and Review" requires analysis of

benefits and costs for all significant regulatory

actions. The Regulatory Working Group has prepared general guidance for complying with the

requirements of EO 12866.4 EO 12866 requires

a statement of the need for the proposed action,

examination of alternative approaches, and

analysis of social benefits and costs. Chapters 3

through 8 of this document describe methods

for meeting these requirements. EO 12866 also

states that the distributional and equity effects of

a rule should be considered. Chapter 9

describes methods for analyzing and assessing

these effects.

The Unfunded Mandates Reform Act of

1995 (P.L. 104-4) directs agencies to assess the

effects of federal regulatory actions on state,

local, and tribal governments, and the private

sector. Agencies are to obtain meaningful input

from state, local, and tribal governments for

rules containing "significant federal intergovernmental mandates." These are federal mandates

which may result in the expenditure by state,

5

Chapter 

2

Chapter 2: Statutory and Executive

Order Requirements for Conducting

Economic Analyses

1 EPA personnel seeking information on EPA’s policies and guidelines applicable to rule development can be found at the following EPA Intranet website http://intranet.epa.gov/rapids (accessed 8/18/2000, internal EPA document). Many of the citations included

in this section can be found at this site. Note, this website and other additional websites referenced in this document are located on EPA’s

Intranet website and are limited to use by EPA personnel. When cited in this document, EPA Intranet websites will be labeled as “internal

EPA document.”

2 Statutory provisions that require economic analysis but that apply only to specific EPA programs are not described here.

However, analysts should carefully consider the relevant program-specific statutory requirements when designing and conducting economic analyses, recognizing that these requirements may mandate specific economic analyses. 

3 More information on some of these program-specific mandates can be found in Chapter 9 of this document.

4 U.S. Office of Management and Budget, "Memorandum for Members of the Regulatory Working Group: Economic Analysis

of Federal Regulations Under Executive Order No. 12866," January 11, 1996. The guidance also addresses the requirements of the

Unfunded Mandates Reform Act and the Regulatory Flexibility Act.
local, and tribal governments, in the aggregate, or by

the private sector, of $100 million or more in any one

year.5 UMRA also directs agencies to assess the effects

of federal regulatory actions that will have a significant or unique effect on small governments. OMB

has provided general guidance on complying with

UMRA.6

Executive Order 13132, "Federalism" requires

consultation with affected state and local governments

on rules that have federalism implications—that is

regulations and policy statements "that have substantial direct effects on states (and local governments),

on the relationship between the national government

and the states, or on the distribution of power and

responsibilities among the various levels of government." EO 13132 also imposes additional consultation obligations on agencies if they promulgate regulations with federalism implications that either: (1)

impose substantial direct compliance costs on state

and local governments not required by statute and do

not provide funds to cover these costs, or (2) preempt

state or local laws.7

The Regulatory Flexibility Act of 1980 (5 U.S.C.

610-612) (RFA), as amended by The Small

Business Regulatory Enforcement Fairness Act

of 1996 (P.L. 96-354) (SBREFA) requires that federal agencies determine if a regulation will have a significant economic impact on a substantial number of

small entities (including small businesses, governments, and non-profit organizations.) If a regulation

will have such an impact, agencies must prepare a

Regulatory Flexibility Analysis and comply with a

number of procedural requirements to solicit and

consider flexible regulatory options that minimize

adverse economic impacts on small entities. EPA has

prepared Revised Guidance on complying with the

RFA and SBREFA requirements.8 Chapter 1 of that

document provides guidance on the analytical

requirements, including thresholds for determining

"significant impact," "substantial number," and

"small entities," and recommended quantitative

measures for evaluating economic impacts on small

entities.

Executive Order 12898, "Federal Actions to

Address Environmental Justice in Minority

Populations and Low-Income Populations"

requires federal agencies to identify and address, as

appropriate, disproportionately high and adverse

human health or environmental effects of its programs, policies, and activities on minority populations

and low income populations. EO 12898 also requires

the same consideration for Native American programs. EPA and the Council on Environmental

Quality (CEQ) have prepared guidance for addressing

environmental justice concerns in the context of NEPA

requirements.9 These materials provide definitions of

key phrases in the Executive Order, which draw on

draft guidance prepared by an interagency task

force.10

Executive Order 13045, "Protection of Children

from Environmental Health Risks and Safety

Risks" requires agencies to evaluate the health or

safety effects of planned regulations on children. For

economically significant rules that are subject to EO

13045, agencies are required to explain why the

planned regulation is preferable to other potentially

6

Chapter 2: Requirements for Conducting Economic Analyses 

5 U.S. Environmental Protection Agency, EPA Guidance - Unfunded Mandates Reform Act of 1995, Interim Guidance, March 23, 1995.

6 U.S. Office of Management and Budget, "Guidance for Implementing Title II of S.1." Memorandum from Sally Katzen, Administrator,

Office of Information and Regulatory Affairs, March 31, 1995.

7 U.S. Environmental Protection Agency, Interim Guidance on Executive Order 13132: Federalism, February 2000.

8 U.S. Environmental Protection Agency, EPA Revised Interim Guidance for EPA Rulewriters: Regulatory Flexibility Act as amended by

the Small Business Regulatory Enforcement Fairness Act, March 29, 1999.

9 For more information see U.S. Environmental Protection Agency, Interim Final Guidance for Incorporating Environmental Justice

Concerns in EPA’s NEPA Compliance Analyses, Office of Federal Activities, April 1998, and Council on Environmental Quality, Guidance for

Addressing Environmental Justice under the National Environmental Policy Act (NEPA), March 1998.

10 Interagency Working Group on Environmental Justice, Final Guidance for Federal Agencies on Key Terms in Executive Order 12898,

August 8, 1995. 
effective and reasonably feasible alternatives considered by the agency. EPA has prepared guidance on

compliance with EO 13045.11 Materials in Chapter 9

provide suggestions for the types of questions analysts

could ask to characterize risks to children, and refers

analysts to the various EPA guidance documents on

risk assessment for information on analytic methodologies. While EO 13045 primarily addresses risk

rather than economic analyses, economic analyses

may be needed to determine whether EO 13045

requirements apply to a specific rule.

Executive Order 13084, "Consultation and

Coordination with Indian Tribal Governments"

requires agencies to recognize the unique legal relationship with Indian tribal governments set forth in

the Constitution and other treaties and documents.

The order seeks to establish a regular and meaningful

consultation and collaboration with Indian tribal governments in the development of regulations, imposition of unfunded mandates, and process for seeking

waivers from federal requirements. The order seeks

to encourage cooperation of tribal governments in

development of regulations that significantly or

uniquely affect their communities, including use of

consensual mechanisms and negotiated rulemaking.

7

Chapter 2: Requirements for Conducting Economic Analyses 

11 U.S. Environmental Protection Agency, EPA Rule Writer’s Guide to Executive Order 13045: Guidance for Considering Risks to Children

During the Establishment of Public Health-Related and Risk-Related Standards, Interim Final Guidance, April 30, 1998.
Chapter 2: Requirements for Conducting Economic Analyses 

8
3.1 Introduction

An appropriate point of departure for economic

analyses of an environmental policy is a clear statement of the need for policy action. Key components

of this discussion include an examination of the

nature of the pollution problem to be addressed, an

analysis of the reasons existing legal and other institutions have failed to correct the problem, and a justification for federal intervention instead of other

alternatives. Statutory and judicial requirements that

mandate the promulgation of particular policies or

the evaluation of specific effects are also key factors

in motivating certain analyses and policy actions. In

some instances statutes prohibit the use of certain

types of analyses in policy making. In these cases,

the guidance presented in this document should be

applied selectively to be consistent with such mandates.

3.2 Problem Definition

The initial problem definition discussion should

briefly review the nature of the environmental problem to be addressed. The following considerations

are often relevant:

primary pollutants causing the problem and

their magnitude;

media through which exposures or damages

take place;

private and public sector sources responsible for

creating the problem;

human exposures involved and the health

effects due to those exposures;

non-human resources affected and the harm

that results;

expected evolution of the pollution problem over

the time horizon of the analysis;

current control and mitigation techniques; and

the amount or proportion (or both) of the environmental problem likely to be corrected by federal action.

3.3 Reasons for

Market or Institutional

Failure

Following this concise problem definition summary

should be an examination of the reasons why the

market and other public and private sector institutions have failed to correct the problem. This component should be viewed as a key part of the process

of environmental policy development because the

underlying failure itself often suggests the most

appropriate remedy for the problem. 

Four categories of "market failure" are discussed in

OMB's Best Practices in the sections titled externalities, market power, natural monopoly, and information asymmetry. For environmental conditions,

externalities are the most likely causes of the failure

of private and public sector institutions to correct

pollution damages. However, information asymmetries and even pre-existing government-induced distortions can also be responsible for these problems.

Externalities can occur for many reasons.

Transactions costs, for example, can make it difficult

for injured parties to use legal or other means to

9

Chapter 

3

Chapter 3: Statement of Need

for the Proposal
cause polluters to internalize the damages they cause. A

similar result can occur when property rights to the media

or resources harmed are held in common or are poorly

defined. Externalities can also arise because tracing the

causal connections from activities that pose environmental

risks to the resulting damages can be very difficult and

often involve long time periods.

A comprehensive examination of the market's failure to

address a specific environmental problem involves more

than a statement that harms exist. Economic analyses

should explore, for example, why transactions costs are

high or why property rights are difficult to assign clearly.

Similar analyses are appropriate for situations in which

other factors are responsible for the failure of the market

or other public and private sector institutions to address

environmental problems.

3.4 Need for Federal

Action

The final component of this initial statement of the need

for the proposal is an analysis of why a federal remedy is

necessary instead of actions by private and other public

sector entities, such as the judicial system and state and

local governments. Federal involvement is often required

by pollution that crosses jurisdictional boundaries, by

international environmental problems, and by statutory

and other authorities. Economic analyses should make

clear the basis for federal involvement by comparing it

with the performance of a variety of realistic alternatives

that rely on other institutions and arrangements. This discussion should also verify that the proposed action is within the relevant statutory authorities and that the results of

the policy will be preferable to no action. Aspects of the

regulations being proposed and promulgated that are not

discretionary, but are dictated by statutory requirements,

should be identified, as this may have an influence on the

development of the economic analysis and presentation of

the results.1

10

Chapter 3: Statement of Need

1 The reader is also referred to Executive Order 13132 on "Federalism" for the introductory statements regarding principles of federalism

and the section describing the doctrines of preemption.
4.1 Introduction

Once the need for federal policy action to address an

environmental problem has been established, economic analyses should define and evaluate a range of

possible regulatory and non-regulatory approaches.

Many different approaches may help achieve efficient

environmental protection. It is largely the analyst's

responsibility to consider and characterize these

approaches and then to present feasible alternatives

for decision makers to consider early in the policy

making process. The analyst should also be cognizant of constraints that may be placed on the use of

non-regulatory approaches for addressing a specific

environmental problem. Market-oriented options,

for example, may not be consistent with statutory

mandates and the best response to an environmental

problem might require action outside the authority of

the relevant statute.

This chapter briefly describes several of these

approaches, but it does not attempt to detail the relative merits of putting them into practice for particular

EPA policy initiatives. The goal here is to introduce

several of the terms and concepts to analysts and to

provide references that describe the conceptual foundations of each approach.1 For some approaches,

this chapter provides references on existing applications to environmental regulatory programs. Four

general types of approaches are described below. The

chapter concludes with some notes on fine-tuning

policy approaches.

4.2 Traditional

Design-Based

Command and Control

Design-based command and control regulations have

a long history in environmental policy, generally taking the form of specifying certain technologies or

designs. These regulations usually impose the same

requirements on all sources, although new and existing sources as groups are frequently subject to different standards.2 An advantage of the approach is its

relative ease of compliance monitoring and enforcement. Nonetheless, command and control regulations may be less cost-effective than other approaches, meaning that the same environmental protection

might be achieved at a lower cost or more environmental protection might be secured for the same

cost. Also, command and control regulations may

not readily accommodate or encourage technological

innovation or may fail to provide incentives to reduce

pollution beyond what would be undertaken to comply with the standard.3

4.3 PerformanceOriented Approaches

Rather than mandating a particular technology for

compliance, performance-based standards specify a

source's maximum allowable level of pollution and

11

Chapter 

4

Chapter 4: Regulatory and

Non-Regulatory Approaches to Consider

1 Baumol and Oates (1993), particularly Chapters 10-14, is a useful general reference on the economic foundations of many

of these approaches.

2 For a discussion on this subject and ways these types of programs lead to this result, see Helfand (1992).

3 For some theoretical analyses of this point, see Malueg (1989), Milliman and Prince (1989), and Jung et al. (1996). A

recent review of empirical literature can be found in Jaffe and Stavins (1995).
then allows the source to meet this target in whatever

manner it chooses (e.g., the least costly and most flexible

manner available). This approach has the advantage of

allowing sources to effectively tailor pollution control

requirements to their particular circumstances and

encourages and accommodates technological innovation.

Often, performance-based standards provide the

opportunity to achieve the same goals more cost-effectively

than command and control approaches. However, these

approaches may place additional burdens on monitoring

to ensure compliance and do not introduce incentives to

reduce emissions or hazard levels beyond prescribed

requirements.

4.4 Market-Oriented

Approaches

A wide variety of methods for environmental protection fall

under the general classification of market-oriented

approaches. In one manner or another, each of these

makes use of private sector incentives, information, and

decision making in the pursuit of environmental

improvement. Market-oriented approaches can differ

from more traditional regulatory methods with regard to

their economic efficiency and distribution of benefits and

costs within the economy. These approaches include, for

example:

taxes, fees, or charges;

subsidies;

marketable permit systems;

deposit-refund systems;

offsets and bubbling;

insurance/financial assurance requirements;

liability rules; and

information provision.

Some aspects to consider when choosing among these

approaches as potential regulatory options are briefly

described below.4

4.4.1 Descriptions of MarketBased Approaches

Taxes, fees, charges, and subsidies generally "price"

pollution and leave decisions about the level of emissions

to each source. For example, emissions of a toxic substance might be subject to an environmental charge based

on the damages these emissions cause. Sources would

individually decide how much to control these emissions

based on the costs of the control and the magnitude of the

charge. Taxes, fees, and charges have some highly desirable theoretic properties, including encouraging pollution

control activities. However, they also sometimes impose

substantially different burdens on pollution sources than

do other approaches. One example is the potential liability

that taxes, fees, and charges impose for residual pollution,

which other approaches allow without charge. Issues surrounding the use of these approaches concern the collection of revenues and the distribution of economic "rents"

from these programs, including deciding who should collect these fees (e.g., government or private sector) and

what to do with revenues raised by these mechanisms

(e.g., reduce other types of taxes on the regulated entities

or redistribute the funds to finance other public services).

Marketable permit systems provide environmental

improvements similar to those provided by taxes, fees, and

charges. They function differently, however, in that the

marketable permits approach sets the total quantity of

emissions, while taxes, fees, and charges set the effective

"price" of emitting pollutants.5 If the permits are

auctioned or otherwise sold to pollution sources, the

12

Chapter 4: Approaches to Consider

4 This document does not go into the level of detail necessary to fully describe and provide a means of evaluating the relative merits of different regulatory and non-regulatory approaches. Instead, there is a growing literature on applied market-oriented approaches for environmental

protection that should be reviewed prior to considering these regulatory approaches. For example, Anderson and Lohof (1997) and Stavins (1998a,

1998b) provide recent compilations of information on the theory behind and empirical use of economic incentives systems applied to environmental

protection. Additional sources for details on incentive systems include Moore (1989), Tietenberg (1985, 1992), EPA (1991), OECD (1989, 1991), and

proceedings published under the “Project 88” forum sponsored by the Center for Science and International Affairs, Harvard University (Stavins (1988,

1991)). These sources, and the references they contain, should be consulted for additional information concerning the design, operation, and performance of many of these instruments.

5 The U.S. Acid Rain Program established under Title IV of the 1990 Clean Air Act Amendments is a good example of a marketable permit

program. For recent economic analyses of this program see Joskow et al (1998) and Stavins (1998c). For more information on the program itself

visit EPA’s Acid Rain website at http://www.epa.gov/acidrain (accessed 8/28/00). 
distributional consequences of this approach are similar to

those experienced when using taxes, fees, and charges.

However, if new entrants must obtain permits from

existing sources, then the distributional consequences of

permit systems will differ from those likely to arise after

the introduction of technology-based standards. The

potential to establish a barrier to entry on the basis of

limiting quantities (e.g., if "grandfathering" of current

emission sources is part of the program) can affect the

eventual distribution of revenues, expenses, and "rents"

within the economy. The ultimate distribution of "rents"

under these programs can be an important feature of

market-based approaches and, therefore, should be

considered when comparing these with more traditional

regulatory approaches.

Deposit-refund systems are like specialized forms of

taxes. The deposit operates as a tax and the refund serves

as an offsetting subsidy. Many good examples of depositrefund systems exist, most of which are geared toward

reducing litter and increasing the recycling rates of certain

components of municipal solid waste.6 Perhaps the most

prominent examples are those programs associated with

newspapers, plastic, and glass bottles.

Offsets and bubbling allow restricted forms of emissions

trading across or within sources. This approach has seen

widespread use, mostly in controlling air pollution in nonattainment areas. An offset, for example, would allow a

new source of emissions in an airshed to negotiate with an

existing source to secure reduction in the latter's emissions. This reduction would then be used to accommodate the emissions from the new source. Bubbling can

allow a facility to consider all sources of emissions of a

particular pollutant within the facility in achieving an overall target level of emission control or environmental

improvement.

Insurance and financial assurance arrangements generally require those engaged in environmentally risky activities to ensure, typically through a third party, that sufficient resources will be available to remedy future damages. This arrangement harnesses the financial incentives

of private sector companies to promote and maintain environmentally safer practices. An example of this approach

to environmental protection is the financial assurance

requirements related to closure and post-closure care for

hazardous waste treatment, storage, and disposal facilities.

Liability rules are legal tools that allow victims (or the

government) to force polluters that cause damages to pay

for those damages after they occur.7 They are typically

applied to infrequent events such as cleanup of hazardous

waste sites under CERCLA or cleanup after oil spills under

the Oil Pollution Control Act. There are a variety of types

of liability rules and in some situations these rules can

mimic the desirable properties of taxes. However, this is

not the case in all situations and even in those specific

cases proper functioning of liability rules depends on a

legal system which may not perfectly implement the rules.

Finally, information provision operates by ensuring that

production and consumption decisions are adequately

informed about the environmental and human health consequences of certain choices. In some cases, shifts in

these decisions can encourage environmentally benign

activities and discourage environmentally detrimental

ones. The Toxics Release Inventory, consumer-based programs on the risks of radon in homes, and pesticide labeling programs are examples of efforts by EPA to implement

information-based policy approaches.

4.4.2 Selecting Market-Oriented

Approaches

The most appropriate market-oriented regulatory

approach depends on a wide variety of factors, such as the

nature of the market failure, the specific circumstances of

the pollution problem, and the ultimate goals of policy

makers.8 The choice between taxes (or fees and charges)

and marketable permits, for example, rests theoretically

on such matters as the degree of uncertainty surrounding

the estimated benefits and costs of pollution control as

13

Chapter 4: Approaches to Consider

6 For example, Arnold (1995) analyses the merits of a deposit-refund system in a case study focusing on enhancing used-oil recycling and

Sigman (1995) reviews policy options to address lead recycling.

7 See Segerson (1995) for a discussion of the various types of liability rules, the efficiency properties of each type of rule, and an extensive

bibliography.

8 Helpful references that discuss aspects to consider when comparing among different approaches include EPA (1980), Hahn (1990),

Hahn and Stavins (1992), and OECD (1994a, 1994b).
14

Chapter 4: Approaches to Consider

well as how marginal benefits and costs change with the

stringency of the pollution control target. This choice also

depends on distributional considerations and the extent to

which policy makers are willing to allow the market to

determine exact outcomes. Marketable permits, for example, set the total level of pollution control, but the market

determines which sources reduce emissions and to what

extent. Taxes, however, leave both the extent of control by

individual sources and the total level of control to market

determination. 

Consideration should also be given to potential differences

among economic instruments that have implications for

the revenues collected under alternative mechanisms. The

opportunities to direct collected resources at reductions in

other inefficiencies introduced in markets that have consequences for economic welfare will affect the assessment of

market-oriented approaches.9

The use of a particular market-oriented approach is often

suggested directly by the cause of the pollution problem

and constraints on the efficacy of other traditional policy

instruments. For example, subsidies and deposit-refund

systems place some enforcement burden on the regulated

entities. This feature makes these approaches attractive if

large numbers of small pollution sources exist and

attempts to prohibit their actions are likely to fail due to

risk of widespread noncompliance and costly enforcement.

A positive incentive in these cases can solve both the original market failure and the enforcement problem.

Offsets and bubbles tend to be more appropriate when

policy makers seek to help sources reduce compliance

costs, while still attaining the environmental improvement

embodied in a more traditional standards-based, sourceby-source approach. Similarly, insurance and financial

assurance mechanisms are useful instruments to supplement existing standards and rules when there is a significant risk that sources of future pollution might be incapable of financing the required pollution control or damage mitigation.

Finally, information remedies are often suggested when a

market has failed to provide information and policy makers believe that private and public sector decisionmakers

will act to address an environmental problem once the

information has been disseminated. Voluntary approaches

are closely related to information remedies and are most

useful when they bring to bear the market's knowledge

and innovation efforts on a particular environmental problem, and when direct standards-based methods would be

very time-consuming and costly to develop.

4.5 Non-Regulatory

Approaches

In addition to regulatory approaches, EPA has pursued a

number of non-regulatory initiatives that rely heavily on

voluntary approaches to achieve improvements in emissions controls and management of environmental hazards.

Much of the foundation for these initiatives rests with the

concepts underlying a "Pollution Prevention" approach to

environmental management choices. In the Pollution

Prevention Act of 1990, Congress established as a national

policy that:

pollution should be prevented or reduced at the

source whenever feasible;

pollution that cannot be prevented should be recycled

in an environmentally safe manner whenever

feasible;

pollution that cannot be prevented or recycled should

be treated in an environmentally safe manner whenever feasible; and 

disposal or other release into the environment should

be employed as a last resort and should be conducted

in an environmentally safe manner.

Working directly with a broad array of institutions that participate in decisions affecting the environment (e.g., consumers, regulatory agencies, industry), an effort is made

to reach "common sense" understanding of the benefits

and costs of management strategies that prevent damages

from occurring, versus strategies aimed at reacting to the

consequences of realized environmental hazards.

Furthermore, some preventive measures can be instituted

without establishing a regulatory program, but instead

through a facilitated process of identifying problems and

9 For useful references on the emerging issues concerning the uses of revenues from pollution charges (e.g., applying environmental tax

revenues so as to reduce other taxes and fees in the economy) and ways to analyze these policies, see Bovenberg and de Moojii (1994), Goulder

(1996), Bovenberg and Goulder 1996), Goulder et. al. (1997), and Jorgenson (1998a, 1998b).
solutions. This can involve sharing information and experiences among participants on the use of procedures,

practices, or processes that reduce or eliminate the generation of pollutants and waste at the source. Examples

within the manufacturing sector include developing and

distributing information on input substitution or modification, product reformulation, process modifications,

improved housekeeping, and on-site closed-loop recycling.

Further, pollution prevention includes other practices that

reduce or eliminate pollutants through the protection of

material resources by conservation and increased efficiency in the uses of raw materials, energy, water, or other

resources.

Examples of voluntary programs include: (1) the 33/50

toxic substances program under which many companies

have established voluntary targets for reducing the use of

various toxic chemicals, (2) the "ENERGY STAR" energy efficiency labeling program, and (3) the "Design for the

Environment" program. The last of these programs seeks

to form voluntary partnerships with industry and other

stakeholders in order to develop environmentally safer

alternatives to existing products and processes that prevent

the need to cleanup pollution created as by-products in

manufacturing processes. Much of the literature developed to document these changes can be found in public

policy and industrial ecology literature sources.10

4.6 Fine-Tuning Policy

Approaches

In addition to considering a wide variety of possible

approaches for environmental protection, analysts and policy makers should also examine other characteristics of

regulatory or non-regulatory policies that affect their costs

and effectiveness. For example, evaluating benefits, costs,

and other effects at different levels of stringency for a given

policy can help to determine settings that provide the

greatest net benefits to society. Similarly, tailoring pollution control requirements to account for geographical differences in environmental effects and source differences

in pollution control costs will tend to achieve greater environmental protection at lower costs. Finally, phasing in

policies over time to allow new requirements to be embedded in new investments can often substantially reduce a

policy's costs while sacrificing relatively few of its benefits,

especially when large-scale premature retirement of capital

equipment can be avoided.

Constraints, such as statutory provisions, can limit the

number of available regulatory and non-regulatory

approaches for addressing a specific environmental problem. Market-oriented options, for example, may not be

consistent with statutory mandates and the best response

to an environmental problem might require action outside

the authority of the relevant statute. Nevertheless, the

strategy that best informs policy makers is generally one

that adopts an expansive view of a problem's possible solutions and then provides cogent and detailed economic

analysis of their benefits, costs, and other effects.

15

Chapter 4: Approaches to Consider

10 For more illustrations of ongoing programs and policies, the following websites offer useful information: http://www.epa.gov/opei/

(accessed 8/28/2000) and http://www.epa.gov/p2/ (accessed 8/28/2000).
4.7 References

Anderson, R. C. and A. Q. Lohof. 1997. The United States Experience with Economic Incentives in Environmental

Pollution Control Policy. Environmental Law Institute, Washington, D.C.

Arnold, F. S. 1995. Economic Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons,

Inc.

Baumol, W. and W. Oates. 1993. The Theory of Environmental Policy Third Edition, Englewood, NJ: Prentice Hall.

Bovenberg, A. L. and R. de Moojii. 1994. Environmental Levies and Distortionary Taxes. American Economic Review,

84(5): 1085-1089.

Bovenberg, A. L. and L. Goulder. 1996. Optimal Environmental Taxation in the Presence of Other Taxes: General

Equilibrium Analysis. American Economic Review, 86(5): 985-1000.

Goulder, L. H. 1995. Environmental Taxation and the Double Dividend: A Reader's Guide. International Tax and Public

Finance, 2(2): 157-183.

Goulder, L. H., I. Parry, and D. Burtraw. 1997. Revenue-Raising Versus Other Approaches to Environmental Protection:

The Critical Significance of Preexisting Tax Distortions. RAND Journal of Economics, 28(4): 708-731.

Hahn, R. W. 1990. Regulatory Constraints on Environmental Markets. Journal of Public Economics, 42: 149-175.

Hahn, R. W. and R. N. Stavins. 1992. Economic Incentives for Environmental Protection: Integrating Theory and Practice.

American Economic Review, 82(3):464-468.

Helfand, G. E. 1991. Standards versus Standards: The Effects of Different Pollution Restriction. American Economic

Review. September, 81(4): 622-634.

Jaffe, A. B. and R. N. Stavins. 1995. Dynamic Incentives of Environmental Regulations: The Effects of Alternative Policy

Instruments on Technology Diffusion. Journal of Environmental Economics and Management, 29: S43-S63. 

Jorgenson, D. W. (1998a). Growth, Volume 1: Econometric General Equilibrium Modeling., Cambridge, MA: MIT Press.

Jorgenson, D. W. (1998b). Growth, Volume 2: Energy, the Environment, and Economic Growth. Cambridge, MA: MIT

Press.

Joskow, P. L., R. Schmalensee, and E.M. Bailey. 1998. The Market for Sulfur Dioxide Emissions. American Economic

Review, September, 88(4): 669-85.

Jung, C., K. Krutilla, and R. Boyd. 1996. Incentives for Advanced Pollution Abatement Technology at the Industry Level: An

Evaluation of Policy Alternatives. Journal of Environmental Economics and Management, 30: 95-111.

Malueg, D. 1989. Emission Credit Trading and the Incentive to Adopt New Pollution Abatement Technology. Journal of

Environmental Economics and Management, 16: 52-57.

Milliman, S. R. and R. Prince. 1989. Firm Incentives to Promote Technological Change in Pollution Control. Journal of

Environmental Economics and Management, 17: 247-265.

Moore, J. L., L. Parker, J. Bodgett, J. McCarthy, and D. Gushee. 1989. Using Incentives for Environmental Protection: An

Overview, U.S. Congressional Research Service, Washington, D.C., June 1989.

Organization for Economic Cooperation and Development. 1989. Economic Incentives, Options for Environmental

Protection, Paris, France.

16

Chapter 4: Approaches to Consider
Organization for Economic Cooperation and Development. 1991. Environmental Policy: How to Apply Economic

Instruments, Paris, France.

Organization for Economic Cooperation and Development. 1994a. Evaluating Economic Incentives for Environmental

Policy, Paris, France.

Organization for Economic Cooperation and Development. 1994b. Managing the Environment - The Role of Economic

Instruments, Paris, France.

Segerson, K. 1995. Liability and Penalty Structures in Policy Design. In The Handbook of Environmental Economics,

Daniel W. Bromley, Ed., 272-294. Cambridge, MA: Blackwell Publishers.

Sigman, H. A. 1995. A Comparison of Public Policies for Lead Recycling. RAND Journal of Economics, 26(3): 452-478.

Stavins, R. N., ed. 1988. Project 88-Harnessing Market Forces to Protect Our Environment: Initiatives for the New

President. A Public Policy Study, Sponsored by Senator Timothy E. Wirth, Colorado, and Senator John Heinz,

Pennsylvania. Washington, D.C.: December 1988.

Stavins, R. N., ed. 1991. Project 88 -Round II, Incentives for Action: Designing Market-Based Environmental

Strategies. A Public Policy Study, Sponsored by Senator Timothy E. Wirth, Colorado, and Senator John Heinz,

Pennsylvania. Washington, D.C.: May 1991.

Stavins, R. N. 1998a. Market Based Environmental Policies. Faculty Research Working Paper Series. R98-03, John F.

Kennedy School of Government, Harvard University, Cambridge, MA.

Stavins, R. N. 1998b. "Economic Incentives for Environmental Regulation." The New Palgrave Dictionary of Economics

and the Law, ed. P. Newman. London, Great Britain: The Macmillan Press.

Stavins, R. N. 1998c. What Can We Learn from the Grand Policy Experiment? Lessons from SO2 Allowance Trading.

Journal of Economic Perspectives, Summer 12(3): 69-88.

Tietenberg, T. 1985. Emissions Trading: An Exercise in Reforming Pollution Policy, Resources for the Future,

Washington, D.C.

Tietenberg, T. 1992. Environmental and Natural Resource Economics, Third Edition, New York, NY: Harper Collins

Publishers.

U.S. Environmental Protection Agency. 1980. Checklist of Regulatory Alternatives, Office of Planning and Management,

July 1980.

U.S. Environmental Protection Agency. 1991. Economic Incentives: Options for Environmental Protection, EPA/21P2001, Office of Policy, Planning and Evaluation, March 1991.

17

Chapter 4: Approaches to Consider
18

Chapter 4: Approaches to Consider
5.1 Introduction

This chapter provides a brief overview of several different analyses and assessments that are normally

conducted in the course of evaluating environmental

policies. It also presents background and guidance

on several cross-cutting methodological topics. The

suggestions in this chapter, and throughout this document, are not intended to be rigid rules to be

applied uniformly for each and every economic

analysis. Instead, they are intended to produce a

consistent, well-reasoned, and transparent process

for framing economic analyses regardless of the specific characteristics and features of any given policy.

The next section outlines a conceptual perspective for

economic analysis and identifies the component

assessments that together form an economic analysis

in practice. This section also defines certain terms

that are used throughout this and the remaining

chapters of the EA Guidelines. The remaining sections of this chapter explore some common methodological elements that are shared by virtually all economic analyses of environmental policies. The third

section of this chapter addresses the choice of analytic baseline and the fourth discusses predicting

responses to new policies. Treatment of uncertainty

is addressed in the fifth section and the final section

addresses some emerging analytical issues. Each

section first reviews the nature of the methodological

topic and its impact on the economic analyses, and

then provides general guidelines for incorporating or

addressing associated issues in practice.

5.2 Economic

Framework and

Definition of Terms

A Conceptual Perspective for Economic

Analysis

The conceptually appropriate framework for assessing all the impacts of an environmental regulation is

an economic model of general equilibrium. The

starting point of such a model is to define the allocation of resources and interrelationships for an entire

economy with all its diverse components (households, firms, government). Potential regulatory alternatives are then modeled as economic changes that

move the economy from a state of equilibrium

absent the regulation to a new state of equilibrium

with the regulation in effect. The differences between

the old and new states—measured as changes in

prices, quantities produced and consumed, income

and other economic quantities—can be used to

characterize the net welfare changes for each affected

group identified in the model. 

Analysts can rely on different outputs and conclusions from the general equilibrium framework to

assess issues of both efficiency and distribution. At

EPA these issues often take the form of three distinct

questions:

Is it theoretically possible for the "gainers" from

the policy to fully compensate the "losers" and

still remain better off?

Who are the gainers and losers from the policy

and associated economic changes?

And how did a particular group—especially a

group that may be considered to be disadvantaged—fare as a result of the policy change?

19

Chapter 

5

Chapter 5: Overview of Economic

Analysis of Environmental Policy
The first question is directed at the measurement of efficiency, and is based on the Potential Pareto criterion.

This criterion is the foundation of benefit-cost analysis,

requiring that a policy's net benefits to society be positive.

Measuring net benefits by summing all of the welfare

changes for all groups provides an answer to this question.

The last two questions are related to the distributional

consequences of the policy. Because a general equilibrium

framework provides for the ability to estimate welfare

changes for particular groups, these questions can be

pursued using the same approach taken to answer the

efficiency question, provided that the general equilibrium

model is developed at an appropriate level of

disaggregation.

Practical Compromises: Benefit Cost Analysis,

Economic Impacts Analysis, and Equity

Assessments

Although a general equilibrium framework can, in principle, provide the information needed to address all three

questions, in practice analysts have limited access to the

tools and resources needed to adopt a general equilibrium

approach1

. More often, EPA must resort to assembling a

set of different models to address issues of efficiency and

distribution separately. However, the limitations on

employing general equilibrium models have greatly diminished in recent years with advances in the theory, tools,

and data needed to use the approach. Chapter 8 contains

additional information on general equilibrium models.

The EA Guidelines follow more traditional practices and

adopt conventional labels to distinguish models or

approaches used to answer questions on the efficiency and

distribution of environmental regulations. For purposes of

this document, the presentation separates the concepts

and approaches into the following three general categories: 

the examination of net social benefits using a benefitcost analysis (BCA); 

the examination of gainers and losers using an economic impacts analysis (EIA); and 

the examination of particular sub-populations, especially those considered to be disadvantaged, using an

equity assessment.

This division is necessary not only because of data and

resource limitations, but because analysts often lack models that are sufficiently comprehensive to address all of

these dimensions concurrently. Within a BCA, for example, EPA is generally unable to measure benefits with the

same models used for estimating costs, necessitating separate treatment of costs and benefits. Further, when estimating social costs there are cases in which some direct

expenditures can be identified, but data and models are

unavailable to track the "ripple" effects of these expenditures through the economy. For most practical applications, therefore, a complete economic analysis comprises a

benefit-cost analysis, an economic impacts analysis, and

an equity assessment.

Benefit-cost analysis evaluates the favorable effects of policy actions and the associated opportunity costs of those

actions. The favorable effects are defined as benefits and

the opportunities foregone define economic costs. While

conceptually symmetric, benefits and costs must often be

evaluated separately due to practical considerations.

Analysts may even organize the analysis of benefits differently from the analysis of costs, but they should be aware

of the conceptual relationship between the two. Using estimates of health and other risk-reduction effects provided

by risk assessors, benefits analyses apply a variety of economic methodologies to estimate the value of anticipated

health improvements and other sources of environmental

benefits. Social cost analyses attempt to estimate the total

welfare costs, net of any transfers, imposed by environmental policies. In most instances, these costs are measured by higher costs of consumption goods for consumers

and lower earnings for producers and other factors of production. Some of the findings of a social cost analysis are

inputs for benefits analyses, such as predicted changes in

the outputs of goods associated with a pollution problem.

The assumptions and modeling framework developed for

the BCA, constrain and limit the estimation techniques

used to examine gainers and losers (in an EIA) or to

examine impacts on disadvantaged sub-populations (in an

20

Chapter 5: Overview

1 The general equilibrium framework will at least capture all “market” benefits and costs, but may not include non-market benefits, such

as those associated with existence value. In practice, models of general equilibrium may also be unable to analyze relatively small sectors of the economy. For more on general equilibrium analysis see Chapter 8, section 4.5.
equity assessment). To estimate these two categories of

impacts we rely on a multiplicity of estimation techniques.

The constraints faced by these analyses as well as details

regarding estimation techniques are given by Chapter 9.

5.3 Baseline

Specification

An economic analysis of a policy or regulation compares

"the world with the policy or regulation" (the policy scenario) with "the world absent the policy or regulation" (the

baseline scenario). Impacts of policies or regulations are

measured by the resulting differences between these two

scenarios. Measured differences may include changes in

pollutant emissions and ambient concentrations, changes

in usage or production of toxic substances, and incidence

rates for adverse health effects associated with exposure to

pollutants. 

Specification of baseline conditions can have profound

influence on the measurement and interpretation of analytic results. The complexity of the regulatory and policymaking stipulations may not yield a clear-cut decision on

the specification of baseline conditions. The honesty and

integrity of the analysis depend on the ability of the analyst

to provide well-defined and defensible choices in the selection and estimation of baseline conditions. Analysts

uncertain about the selection of baseline conditions are

advised to review the guiding principles listed below. In

the development of the rule, the analyst is responsible for

raising questions about baseline definitions early within

the regulatory development process, and should receive

the views of enforcement and general counsel staff. Doing

so can facilitate the consistent treatment of this issue in

EPA analyses.

5.3.1 Guiding Principles for

Baseline Specification

Baseline specification can be thought of as having two

steps—selection and quantification. The first step is to

select a baseline that is appropriate to the question the

analysis is intended to address. The second step is to estimate the values of the relevant factors in the selected baseline scenario. Several guiding principles to assist in the

treatment of baselines in an analysis are listed below.

Though they exhibit a common sense approach to the

issue, the analyst is advised to provide explicit statements

within the analysis on each point. Failure to do so may

result in a confusing analytic presentation, inefficient use

of time and resources, and misinterpretation of the economic results.

Clearly state the question the analysis is

addressing. The type of regulatory question facing

an analyst will affect the selection of the baseline in

an analysis. A baseline definition appropriate to

many analyses will be "reality in the absence of the

regulation." However, to ensure provisions contained

in statutes or policies precipitating the regulatory

action are appropriately addressed, it is useful to

assume full compliance with regulatory requirements

in most cases.2 Clearly stating the questions to be

answered by the analysis will help not only in choosing an appropriate baseline, but also in communicating this information to persons using the results of

the analysis.

Clearly identify all aspects of the baseline conditions that are uncertain and all assumptions

made in specifying the baseline. If the analyst

had complete information about current values and

perfect foresight about the future, the appropriate

baseline conditions could be characterized with certainty. This, of course, is never the case. Current values of factors are often uncertain, and future values

of factors are always uncertain. Estimates of uncertain factors should be based on actual data, to the

extent possible. Uncertainties underlying the baseline

conditions should be treated as other types of uncertainties are handled throughout the analysis. If, in

the face of uncertainty, assumptions about baseline

components are made, these should be the most realistic assumptions possible. For example, where reliable projections of future economic activity and

21

Chapter 5: Overview

2 Analysts should refer later sections of these guidelines (Section 5.3.2) and other cited EPA documents prepared in support of implementing these statutes, for more detailed guidance on the treatment of baseline definitions and compliance assumptions used for economic analyses

required under these statutes. Much of the information on EPA’s policies and guidelines applicable to rule development can be found at the following

EPA Intranet website http://intranet.epa.gov/rapids (accessed 8/02/2000, internal EPA document).
demographics are available, this information should

be accounted for in defining the baseline. All

assumptions should be clearly stated, with particular

attention given to situations calling for more than one

baseline to be included in the analysis.

Be consistent throughout the analysis in the use

of baselines. The same baseline should be carried

through for all components of the analysis. For

example, the comparison of costs and benefits in a

benefit-cost analysis should draw upon estimates

derived using the same baseline, so that the calculation of net economic benefits yields a meaningful economic measure. Likewise, when comparing and

ranking alternative regulatory options, the same baseline should be used for all options under consideration. When use of more than one baseline scenario is

warranted, the analyst must avoid the mistake of

combining analytic results obtained from different

baseline scenarios. To limit confusion on this point,

if multiple baseline scenarios are included in an

analysis, presentations of economic information

should clearly describe and refer to which baseline

scenario is being used.

Determine the appropriate level of effort for

baseline specification. Every analysis is limited by

finite resources. Analytical efforts should be concentrated on those components of the baseline that are

most important to the analysis. If several components of the baseline are uncertain, the analysis

should concentrate its limited resources on refining

the estimates of those components that have the

greatest effect on interpretation of the results.

Clearly state the "starting point" of baseline and

policy scenarios. A starting point of an analysis is

the point in time at which the comparison between

the baseline and policy scenarios begins. This is conceptually a point in time when the two scenarios are

believed to diverge. For example, one approach is to

organize the analysis presuming that the policy scenario conditions diverge from those in the baseline at

the time an enforceable requirement becomes effective. Another convenient approach is to set the starting point to be coincident with promulgation of the

final rule. These dates may be appropriate to use, as

they are clearly defined under monitored administrative procedures, or represent deadlines that compliance progress can be measured against.

However, where behavioral changes are motivated by

the expected outcome of the regulatory process, the

actual timing of the formal issuance of an enforceable

requirement should not be used to define differences

between the baseline and policy scenarios. Earlier

starting points, such as the date authorizing legislation is signed into law, the date the rule is first published in a Notice of Proposed Rule Making, or other

regulatory development process milestones, may be

supported if divergence from the baseline occurs due

to anticipation of promulgation. In some instances,

parties anticipating the outcome of a regulatory initiative may change their economic behavior, including

spending resources to meet expected emission or

hazard reductions prior to the compliance deadline

set by enforceable requirements. The same issues

arise in the treatment of non-regulatory programs, in

which voluntary or negotiated environmental goals

may be established, leading parties to take steps to

achieve these goals at rates different from those

expected in the absence of the program. In these

cases, it may be appropriate to include these costs

and benefits into the analysis of the policy action, and

not subsume these into the baseline scenario. The

dynamic aspects of market and consumer behavior,

and the many motivations leading to change, can

make it more difficult to attribute economic costs and

benefits to specific regulations. Looking at the sensitivity of the outcome of the analysis to these conditions and assumptions will be useful.

Let the duration of important effects of a policy

dictate the structure of the analysis and baseline. To consider how the benefits of a proposed policy compare with the costs of the policy, the analyst

will assemble estimates of the present discounted values of the total costs and benefits attributable to the

policy. How one defines the baseline is particularly

important in situations in which the accrual of costs

and/or benefits do not coincide due to lagged effects,

or occur over an extended period of time. For example, the human health benefits of a policy that

reduces leachate from landfills may not be manifest

for many years, if the potential for human exposure

through contaminated groundwater may occur

22

Chapter 5: Overview
decades after closure of the landfill. In theory, then,

the longer the time frame, the more likely the analysis will depict all the benefits and costs of the policy

that are expected to occur. However, forecasts of economic, demographic, and technological trends necessary for baseline specification must also span the

entire period of the analysis. Because the reliability of

many forecasts diminishes into the future, the analyst

must balance the advantages of structuring the analysis to include a longer time span against the disadvantages of the decreasing reliability of the analytic

results.

Defining the baseline and policy scenarios will often

require information and assumptions on trends in

behavior, and how these trends may be affected by

regulatory management options. For example, the

analyst may observe trends in economic activity or

pollution control technologies that occur for reasons

other than direct environmental regulations. For

example, as the purchasing power of consumer

income increases over time, demand for different

commodities can change. Demand for some commodities may grow at rates faster than the rate of

change in income, while demand for other goods may

decrease. Therefore, where these trends are highly

uncertain or are expected to have significant influence

on the evaluation of regulatory alternatives (including

a "no-regulatory control" alternative), the analyst

should clearly explain and identify their choices in the

analysis.

Lastly, in some cases the benefits of a policy will be

expected to increase over time. Some analyses must

therefore look far enough into the future to assure

that benefits are not substantially underestimated. For

example, suppose a policy that would greatly reduce

greenhouse gas emissions were being proposed. In

the baseline scenario, the level of greenhouse gases in

the atmosphere would steadily increase over time,

with a corresponding increase in expected human

health and welfare and ecological changes. A benefitcost analysis limited to the first decade after initiation

of the policy would be likely to distort the relationship

of benefits and costs associated with the policy. In

this case, the conflict between the need to consider a

long time frame and the decreasing reliability of forecasting far into the future may be substantial. In

most cases, primary considerations in determining

the time horizon of the analysis will be the time span

of the physical effects that drive the benefits estimates, and capital investment cycles associated with

environmental expenditures.

5.3.2 Compliance Rate Issues

and Baseline Specification

One aspect of baseline specification that is particularly

complex, and for which assumptions are typically necessary, is that of compliance rates. The treatment of compliance in the baseline scenario can significantly affect the

results of the analysis. Therefore, it is important to be

clear to persons using the analysis how assumptions about

compliance behavior are incorporated into the analysis,

and how sensitive the results are to the handling of compliance rates.

It can be challenging to clearly demonstrate the economic

effects attributable to a new regulation or policy, while

avoiding the potential for double-counting of benefits,

costs, and impacts associated with separate existing regulations. To aid in preparation of the economic analysis and

presentation of results, it is common to establish baseline

conditions so that the affected regulated entities are in full

compliance with other separate existing regulations.

Assuming full compliance with existing regulations will

enable the analysis to focus on the incremental economic

effects of the new rule or policy, the results of which are

used to evaluate the predicted economic changes. This

information also meets the requirements contained in

many of the statutes and administrative orders that use

economic information as evidence that further steps need

to be taken to address the effects on regulated parties

(described in Chapters 2 and 9).

Defining the baseline in this fashion may pose some

challenges to the analyst, since current observed or

reported economic behavior may represent the

consequences of either under-compliance or overcompliance with existing regulations. For example, it is

possible to observe over-compliance by regulated entities

with enforceable standards. One can find industries whose

current effluent discharge concentrations for regulated

pollutants are measured below concentrations legally

required by existing effluent guideline regulations. On the

23

Chapter 5: Overview
Chapter 5: Overview

24

other hand, evidence for under-compliance is evident in

the resources devoted by EPA and other state and local

regulatory agencies to enforce rules through orders, fines,

and negotiated settlements. As a result, it will be

important that the analysis separates the changes

associated with a new regulation from actions taken to

meet existing requirements. This is of particular

importance if actions taken to meet existing requirements

are coincident with, but not caused by, changes introduced

by the new regulation.3

For some types of analyses it is sensible to establish a

baseline of "current practice" (i.e., what is believed to be

the actual degree of compliance, rather than assumed full

compliance). For example, when a new action under

review is intended to address or "fix-up" compliance problems associated with existing policies, information on current practices belongs in the baseline. Otherwise, defining

the baseline in a manner that disregards this behavior will

obscure the value of investigating whether further or alternative regulatory actions are necessary (e.g., as was the

case in a review of banning lead from gasoline, which was

precipitated in part by the noncompliance of consumers

misfueling their non-leaded gasoline automobiles (EPA,

1985)). For a deregulatory rule (e.g., a rule designed to

address potential changes in or clarify definitions of regulatory performance that frees entities from enforceable

requirements contained in an existing rule), it may be

sensible to perform the analysis using both a full compliance and "current practices" baseline. A full compliance

scenario in this instance introduces some added complications to the analysis, but it may be important to report on

the economic effects of failing to take the deregulatory

action.

In cases of over-compliance with existing policies, or

actions already taken in the economic interests of the

affected parties, current practices can be used to define

baseline conditions unless these practices are expected to

change or are highly uncertain in ways that are directly

associated with the rule being analyzed. For example,

observed over-compliance by a regulated entity may be the

result of choices it has made to anticipate forthcoming

more stringent federal regulatory requirements. If there

should be a decision not to follow through with the anticipated federal regulation, the analysis will need to establish

whether the current observed over-compliance behavior by

the regulated entity may be curtailed to meet existing (i.e.,

relatively less stringent) requirements. If the regulated

entity in this example is expected to continue to over-comply despite the absence of the more stringent regulation,

then the policy scenario should not contain the costs and

benefits attributable to this behavior, and it is appropriate

to account for them in the baseline scenario that describes

the "world without the regulation." However, if the regulated entity will relax its pollution control practices to meet

current requirements after the stricter regulation fails to

emerge, then the costs and benefits of the over-compliance

behavior should be attributed to the policy scenario. In

these situations, it may be useful to consider performing

the analysis with alternative baseline scenarios, and

demonstrate the potential economic consequences of different assumptions associated with the expected changes

in this type of behavior.

Analysts may also elect to incorporate predicted differences

in compliance rates within policy options considered for

new rules, in cases where compliance behavior is known

to vary systematically with the regulatory options being

considered (e.g., if the expected compliance rate with a

rule may differ if entities are regulated using economic

incentives as compared with prescribed control

technologies).

Despite the above possible complexities, it is prudent for

most analyses of regulations to develop baseline and

policy scenarios that assume full compliance with

existing and newly enacted regulations. One rationale

for adopting these assumptions is that the analytic results

will provide information on the unique role the action

under consideration is expected to have on the economy,

which may be required under the authorizing statute, or

administrative laws and policies. As a practical matter,

noncompliant behavior will need to be known, estimable,

and occurring at rates that can affect the evaluation of

policy options before totally rejecting assumptions of "full

3 For example, assigning costs between an existing and new regulation could be further complicated, if, as a result of under-compliance

with the existing regulation, the estimated “joint” cost of meeting both regulations differs from the summed marginal costs of first meeting the existing regulation, followed by implementing the new regulation. The same concern equally applies to the attribution of benefits and economic impacts

to each regulation. Under these circumstances, the analyst should seek further directions provided by the authorizing legislation for the regulation, or

instructions contained in other operative laws and policies.
compliance" for existing and new policies. In the end,

assumptions on compliance behavior for current and new

requirements should be clearly presented in the

description of the analytic approach and assumption used

for the analysis. Care should be taken to describe the

importance of these assumptions when comparing

regulatory options for which social costs and benefits, and

economic impacts have been estimated.

5.3.3 Multiple Rules or

Regulations and Baseline

Specification

If conditions exist where there are no other relevant

regulations, specifying a baseline is not complicated by

questions of whether other regulations are being

implemented and, if so, which regulations are responsible

for environmental improvements and can "take credit" for

reductions in risks. That is, there is no need to be

concerned with which environmental improvements are in

the baseline. Nor is it necessary to try to determine how

these other regulations affect market conditions that

directly influence the costs or the benefits associated with

the policy of interest.

But actual conditions in the regulation of environmental

risks are much more complex, and it is an unusual case

where the above holds true. There are many regulatory

agencies (i.e., federal, state, local) affecting environmental

behavior, and several forms of consumer and industrial

behavior are regulated by agencies whose agendas can

overlap with EPA's (e.g., OSHA, DOT, DOE). Absent an

orderly sequence of events that allows attributing changes

in behavior to a unique regulatory source, in practice,

there is no non-arbitrary way to allocate the costs and the

benefits of a package of overlapping policies to each

individual policy. Whether any one of these policies is "in

the baseline" of the benefit-cost analysis of another policy

is, to a large degree, a matter of choice. There is no

theoretically correct order for conducting a sequential

analysis of multiple overlapping policies that are

promulgated simultaneously.

An idealized approach would attempt to analyze all of the

policies together when assessing the total costs and

benefits resulting from the package of policies. However,

this kind of comprehensive analysis is usually not feasible.

A practical alternative may be to consider the actual or

statutory timing of the promulgation and/or

implementation of the policies, and use this to establish a

sequence with which to analyze related rules. But even

when the temporal order of policies makes it clearer which

policies are "in the baseline" and which are not, different

depictions of the timing and impacts of pre-existing or

overlapping policies can still have a substantial effect on

the outcome of a benefit-cost analysis. An example of this,

offered by Arnold (1995), concerns regulations designed to

reduce the production of chlorofluorocarbons (CFCs) and

other ozone-depleting substances. In this case, the

impacts of multiple regulations on production decisions

were not separable or independent of the order of their

issuance, so that the costs and benefits of requirements

estimated for each regulation were dependent on which

preexisting rules were considered binding in the analysis.

A similar illustration concerning hazardous waste

regulations is also provided by Arnold (1995), wherein an

assessment of the costs and benefits associated with

several regulations is performed, demonstrating that the

result of evaluating each individual regulation varies

significantly depending on which of the other regulations

are included in the baseline.

Therefore, the best practice is to be clear as to the baseline

selected for the analysis, and to present a justification for

making this choice. This can include providing information on the status of other regulatory actions that may

have some effect on the baseline, and conducting sensitivity analyses that test for the implications of including or

omitting other regulations. Some regulatory actions have

attempted to directly link rules together that affect the

same industrial category (e.g., the pulp and paper effluent

guidelines and NESHAP rules (EPA, 1997)). While statutory and judicial deadlines may inhibit the linking of rules

that fall on the same regulated entities (e.g., UMRA and

RFA require analyses be performed for each rule), coordination between rulemaking groups is advocated in EPA's

regulatory development process, and sharing of data, models, and joint decisions on analytic approaches is strongly

recommended.

5.3.4 Summary

The specification of the baseline for an economic analysis

can have a profound influence on the outcome of the

25

Chapter 5: Overview
analysis. The estimated costs and/or benefits of a

proposed policy can change by an order of magnitude

under different baseline assumptions. Careful thought in

specifying the baseline is therefore crucial to a defensible

analysis. 

The first step is to be clear about the question being asked

and therefore what baseline the analyst would like to specify. The second step is to characterize that baseline as well

as possible within the constraints of the analysis. This

involves determining which baseline parameters are most

important to the analysis, assessing the advisability of

expending resources to improve the estimates of those

parameters, and making reasonable assumptions when

necessary. In all cases, assumptions and uncertainties

should be clearly stated as part of the analysis, along with

a discussion of how alternative, plausible assumptions

would be likely to affect the outcome of the analysis.

Within the resources available, sensitivity analysis and

uncertainty analysis are valuable tools for illustrating the

potential impacts of assumptions made and quantifying, to

the degree possible, the extent of the uncertainty underlying the specified baseline. Finally, the estimation of the

costs and benefits attributable to individual policies in a

package of policies is a problem for which there simply is

no "correct answer."

Many factors will affect the configuration of the baseline in

EPA's economic analyses. This means that even though

analytical choices are well-constructed and logical, the

consequences of these differences may frustrate efforts to

attain comparability of baselines across different regulatory

activities. Still, in any effort to evaluate regulatory options

and assess benefits, costs, and economic impacts attributable to an individual rule, the analysis should be internally

consistent in its definition and use of baseline assumptions. This is imperative when more than one baseline

scenario is introduced, since this provides more possibilities to erroneously compare costs and benefits across different baselines. A decision to include multiple baselines

into an analysis can result in a complex set of modeling

choices, and an abundance of analytic results to interpret

and communicate to decision makers. Therefore, analysts

are advised to seek clear direction from management

about baseline definitions early during the development of

a rule.

5.4 Predicting

Responses to a New

Environmental Policy

It is impossible to measure an environmental policy's costs

and benefits without a clear characterization of actions

taken in response to the policy. Some policies are prescriptive in specifying what actions are required—for

example, mandating the use of a specific type of pollution

control equipment. It can be difficult, however, to predict

responses to less-direct performance standards, such as

bans on the production or use of certain products or

processes, and market-based incentive programs. Analysts

should make explicit all assumptions about responses,

and should consider plausible alternative compliance

options. Alternatively, when the number of conceivable

options is essentially infinite, the analysis should at least

span the range of possibilities. Cost-effectiveness analysis

can often be used to identify and map out dominant regulatory options and responses. When it is not possible to

characterize compliance responses with a high degree of

certainty, the analysis should include a description of the

likely direction of bias in the estimates—whether costs

and benefits are over- or understated—if this is known.

Predicting responses starts with a comprehensive list of

possible response options. These may include the use of

different compliance technologies (if the technology is not

specified by the policy itself) or waste management

methods; changes in operations to avoid or reduce the

need for new controls or the utilization of materials whose

use is restricted by a policy (including various types of

pollution prevention); shutting down a production line or

plant to avoid the investments required to achieve

compliance; or even noncompliance.4 Typically, parties

affected by a policy are assumed to choose the compliance

option that minimizes their costs. In some cases,

however, it may be reasonable to select a more costly

option as the most likely response. Sometimes a higher

26

Chapter 5: Overview

4 As in the case of baseline specification, most analyses will assume full compliance by all entities that continue to operate. For some policies that present significant enforcement challenges, or for options that differ in ways that are likely to affect compliance rates, it may be useful to calculate how costs and benefits compare when using estimates of compliance rates less than 100 percent.
cost option may significantly reduce future legal liabilities,

or achieve compliance with other rules being implemented

at either the same time, or those expected to be

promulgated in the future. However, the additional costs

of compliance responses in excess of least-cost strategy

costs should be attributed to these other causes.

Estimating responses is often the most difficult for pollution prevention policies because these options are generally more site- and process-specific than end-of-pipe control

technologies. Predicting the costs and environmental

effects of pollution prevention policies may require

detailed information on industrial processes. As a result,

the costs of a pollution prevention policy may be overstated and the benefits either over- or understated (depending

on the nature of the process changes involved).

Nevertheless, economic analyses should at least include

qualitative discussion of potential pollution prevention

responses and their effects on costs and benefits. 

Predicting reductions in output (e.g., production line or

plant closures) in response to a policy requires analysis of

market characteristics that determine the allocation of cost

increases among directly affected entities and their suppliers, customers, and competitors. This subject is discussed

in the economic impact analysis section of Chapter 9.

5.5 Analyzing and

Presenting Uncertainty

This section contains guidance on dealing with uncertainty

in regulatory economic analyses, focusing on characterizing the precision of estimated economic outcomes such as

net benefits. It provides specific recommendations for

describing and presenting problems arising from uncertainty, and suggestions for carrying out sensitivity analyses.

This section concludes with a discussion of the welfare

considerations related to risk and uncertainty.5 These considerations are largely distinct from those associated with

characterizing precision. The use of certainty equivalents

for addressing these problems is addressed briefly, but

detailed treatment is beyond the scope of this discussion.6

Issues related to differences in risk perceptions and the

provision of information are described, and the role of

quasi-option values in decisions characterized by irreversible consequences is addressed briefly.

5.5.1 Guiding Principles for

Uncertainty Analysis

Uncertainty is inherent in economic analyses, particularly

those associated with environmental benefits for which

there are no existing markets. The issue for the analyst is

not how to avoid uncertainty, but how to account for it and

present useful conclusions to those making policy decisions. Treatment of uncertainty, therefore, should be considered part of the communication process between analysts and policy makers.

Transparency and clarity of presentation are the guiding

principles for assessing and describing uncertainty in

economic analyses. Although the extent to which

uncertainty is treated and presented will vary according to

the specific needs of the economic analysis, some general

minimum requirements apply to most economic analyses.

In assessing and presenting uncertainty the analyst should,

if feasible:

present outcomes or conclusions based on expected

or most plausible values;

provide descriptions of all known key assumptions,

biases, and omissions;

perform sensitivity analysis on key assumptions; and

justify the assumptions used in the sensitivity

analysis.

The outcome of the initial assessment of uncertainty may

be sufficient to support the policy decisions. If, however,

the implications of uncertainty are not adequately captured in the initial assessment then a more sophisticated

27

Chapter 5: Overview

5 Stemming from definitions given in Knight (1921) economists have distinguished risk and uncertainty according to how well one can

characterize the probabilities associated with potential outcomes. Risk applies to situations or circumstances in which a probability distribution is

known or assumed, while uncertainty applies to cases where knowledge of probabilities is absent. Note that the economic definitions for these terms

may differ from those used in other disciplines.

6 Several other issues associated with uncertainty are also beyond the scope of this brief discussion, including verification, validation, and

plausibility checks. Analysts will need to consult other sources for additional information on these topics.
analysis should be undertaken. The need for additional

analysis should be clearly stated, along with a description

of the other methods used for assessing uncertainty.

These methods include decision trees, Delphi-type methods7

, and meta-analysis. Probabilistic methods, including

Monte Carlo analysis, can be particularly useful because

they explicitly characterize analytical uncertainty and variability. However, these methods can be difficult to implement, often requiring more data than are available to the

analyst.8

Confidence intervals are generally useful to describe the

uncertainty associated with particular variables. When

data are available to estimate confidence intervals they can

serve to characterize the precision of estimates and to

bound the values used in sensitivity analysis.

5.5.2 Performing Sensitivity

Analysis

Most analytical base cases, or primary analyses, generally

do not address uncertainty and present expected or most

plausible outcomes. Regardless of the basis for the

primary analysis, point estimates alone do not provide

policy makers with information about the full range of

potential outcomes. Additional information is needed if

the decision-maker is to have a more complete view of the

potential impacts of the policy alternatives. It is always

useful to see how net benefit estimates or other outputs of

the economic analysis change with assumptions about

input parameters. Sensitivity analysis provides a

systematic method for making these determinations.

Keeping in mind some basic principles can enhance

sensitivity analysis.

Focus on key variables. For most applied economic

analyses, a full sensitivity analysis that includes every

variable is not feasible. Instead the analyst must limit

the sensitivity analysis to those input parameters that

are considered to be key or particularly important. In

determining which parameters are key, the analyst

should carefully consider both the range of possible

values for input parameters and each one's functional

relationship to the output of analysis. The analyst

should specify a plausible range of values for each key

variable, including the rationale for the range of values tested.

Present the results clearly. Results of the sensitivity analysis should be presented clearly and accompanied with descriptive text. The most common

approach to this sort of partial sensitivity analysis is to

estimate the change in net benefits (for a benefit-cost

analysis) or other economic outcome while varying a

single parameter, leaving other parameters at their

base value. A more complete analysis will present the

marginal changes in the economic outcome as the

input parameter takes on progressively higher or

lower values. Varying two parameters simultaneously

can often provide a richer picture of the implications

of base values and the robustness of the analysis.

Analysts should consider using graphs to present

these combined sensitivity analyses by plotting one

parameter on the x-axis, the economic outcome on

the y-axis, and treating the second parameter as a

shift variable.9

Identify switch points. "Switch point" values for

key input parameters can be very informative, especially in benefit-cost analyses. Switch points are

defined as those conditions at which the recommended policy decision changes (e.g., when the estimation

of net benefits changes sign). While switch points are

not tests of confidence in the statistical sense, they

can help provide decision-makers with an understanding of how robust the analysis is.

Assess the need for more detailed analysis.

Finally, sensitivity analyses can also be useful as a

screening device to determine where more extensive

treatment of uncertainty may be needed. In some

cases the plausible range of values for the parameter

may be narrowed with further research or data gathering, or the analyst may be able to better characterize the parameter's uncertainty. If several parameters

28

Chapter 5: Overview

7 There a number of such techniques, but all of these methods focus on the use of eliciting and combining expert judgment to inform

analysis. See Chapter 7 of Morgan and Henrion (1990) for more detail on the use of these methods.

8 Morgan and Henrion (1990) is a useful general reference that includes descriptions of many methods to assess uncertainty.

9 When the analysis contains many highly uncertain variables, presentation may be facilitated by noting the uncertainty of each in footnotes and carrying through the central analysis using best point estimates.
appear to have a large impact on the results of the

analysis then a more sophisticated treatment of

uncertainty may be necessary.

5.5.3 Welfare Considerations

Related to Uncertainty and Risk 

So far this discussion has focused upon uncertainty as it

must be accommodated by the analyst charged with performing an economic assessment and the decision-maker

who receives this information. A separate but related issue

is how individuals affected by environmental policies

respond to uncertainty in outcomes and imperfect information. These responses may have an impact on how

individuals respond to policy alternatives and how they

value policy outcomes. Some of these considerations are

noted here, but this treatment is not detailed or exhaustive. It is important to note that analytical precision and

welfare effects are distinct concepts. Certainty equivalents,

for example, address welfare effects and are appropriate

for assessing efficiency in a benefit-cost analysis, but they

do not assess analytical precision or mitigate the usefulness of sensitivity analyses and bounding cases.

Risk attitudes and certainty equivalents:

Individuals and other entities are generally not neutral when faced with situations of uncertainty or risk.

In most cases related to environment and health they

are considered to be risk averse, favoring a certain

outcome to one that is uncertain even if the expected

value of the risky outcome is equal to the value of the

certain one. The theoretically preferred manner of

incorporating risk attitudes is to use certainty equivalents, sometimes termed certain monetary equivalents. Certainty equivalents are defined as the minimum amount that an individual would be willing to

accept with certainty instead of facing the uncertain

outcomes.10

While certainty equivalents have theoretic appeal, they

are difficult to put into practice for economic analyses

of environmental policies. Estimation of certainty

equivalents requires detailed knowledge of (or

assumptions about) risk preferences, and analysts are

unlikely to have these data. To estimate certainty

equivalents one must also be able to assign probabilities to the set of potential outcomes. It is often very

difficult or impossible to make these assignments. 

Lay and expert risk perceptions: Lay perceptions

of risk may differ significantly from scientific assessments of the same risk, and an extensive literature

has developed on the topic.11 Because individuals

respond according to their own risk perceptions, it is

important for the analyst to be attentive to situations

where there is an obvious divergence in these two

measures. In such cases, analysts should consider

evaluating policy options under both sets of information, clearly stating the basis for economic value estimates used or developed in their analysis. Because

providing information to the public may reduce differences between lay and expert perceptions of risk, and

may allay public concerns, analysts should consider

including these strategies in their analysis of potential

policy options.

Provision of information: Some policy actions

focus on providing information on risks to health and

welfare. Inasmuch as this information allows consumers to make better decisions regarding their

households' welfare there is an economic benefit to

providing this information. Revealed preference benefit analyses, however, can make new information

appear to have a net negative effect on household welfare because households may undertake new (and

costly) activities in response. An appropriate framework for evaluating the benefits of information provision under these circumstances is to assess the costs

of sub-optimal household decisions under the lesscomplete information.12 Analysts should carefully

consider these issues when they evaluate policies that

focus on information provision.

29

Chapter 5: Overview

10 Some researchers have suggested risk-adjusted discount rates as an alternative device for incorporating information on the uncertainty

future benefits and costs. Most economists now conclude, however, that the discount rate should not be adjusted to account for uncertainty in benefit-cost analysis.

11 Useful general sources include Slovic (1987) and Fischhoff et al. (1978).

12 Foster and Just (1989) describes this approach more fully, demonstrating that compensating surplus is an appropriate measure of willingness-to-pay under these conditions. The authors illustrate this with an empirical application to food safety.
Quasi-option value: Another relevant issue in decision-making under uncertainty is that of quasi-option

value as identified by Arrow and Fisher (1974). Some

environmental policies involve irreversible decisions

that must be made in the face of uncertainty. If information that reduces this uncertainty can be expected

to develop over time, then there is a positive "quasioption" value to waiting until this information is available. In this case, the value originates from possessing the option to hold off on making the decision

until uncertainties are resolved. Generally, it is difficult to quantitatively include quasi-option values in an

economic analysis of environmental policy, but the

concept is useful and may be highlighted qualitatively

if circumstances warrant. For more on this issue see

Freeman (1984, 1993), Fisher and Hanemann

(1987), and Cochrane and Cutler (1990).

5.6 Emerging CrossCutting Issues

Many other cross-cutting issues are not detailed in the EA

Guidelines. Some of these issues are difficult or impossible to incorporate fully into economic analyses at this

time, but may become either more important or more

tractable as the economic literature develops. Although

the relevance of these considerations depends on the

specifics of the policy being considered, analysts may want

to at least consider these issues qualitatively. Three

emerging issues are identified here: tax interaction effects,

the pace of exogenous technological change, and the

effects of regulation on innovation.

Tax Interaction effects: Although evaluations of

environmental policies typically assume a first-best

regulatory setting, preexisting taxes such as those on

labor income create a second-best setting. This difference can affect the estimated costs of policy

actions. Recent advances in applied general equilibrium analysis have led to generally replicable qualitative results. These studies indicate that ignoring these

effects may result in underestimating the cost of compliance, from a social perspective.13 However, the

magnitude of the effect—and perhaps the direction—will vary across policies. Although the analytical emphasis on this issue has been on estimating

costs, benefits analysis can conceivably suffer a similar bias.

Pace of exogenous technological change:

Economic analysis of environmental policies may be

affected by the pace of exogenous technological

change. In principal, accounting for this can either

increase or decrease marginal and total abatement

costs, depending on the direction of change.

Generally, however, the expectation is that accounting

for exogenous technological change would decrease

estimated abatement costs. Recent analyses have

indicated that even for mature technologies the magnitude of this effect can be large.14

Regulation and innovation: More extensive

research is being developed to examine the impact of

various regulatory approaches on firms' research and

development decisions for abatement technology.15 As

suggested in the descriptions of alternative regulatory

approaches in Chapter 4, this impact may be positive

or negative depending on the regulatory approach and

setting. Generally, economists expect that incentivebased instruments will provide greater incentive for

cost-reducing innovations than will command and

control regulatory approaches. Policies that provide

information to firms and consumers may also affect

technological innovation. Chapter 8 provides some

additional information on the subject of regulation,

innovation, and the implications for estimating social

costs.

30

Chapter 5: Overview

13 For an example see Bovenberg and Goulder (1997).

14 See, for example, Ellerman and Montero (1998) and Carlson et al (1998).

15 See, for example, Milliman and Prince (1989) and Biglaiser and Horowitz (1995).
5.7 References

Arnold, F. S. 1995. Economic Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons,

Inc.

Arrow, K. J. and A. C. Fisher. 1974. Environmental Preservation, Uncertainty and Irreversibility, Quarterly Journal of

Economics, 88(1): 1-9.

Biglaiser, G. and J. K. Horowitz. 1995. Pollution Regulation and Incentives for Pollution-Control Research, Journal of

Environmental Economics and Management, 3(4): 663-684.

Bovenberg, A. L. and L. H. Goulder. 1997. Costs of Environmentally Motivated Taxes in the Presence of Other Taxes:

General Equilibrium Analyses, National Tax Journal, 50(1): 59-87.

Carlson, C., D. Burtraw, M. Cropper, K. L. Palmer. 1998. Sulfur Dioxide Control by Electric Utilities: What are the Gains

from Trade? Resources for the Future, Discussion Paper 98-44.

Cochrane, H. and H. Cutler. 1990. The Economics of Sequential Choice Applied to Quasi-Option Value, Journal of

Environmental Economics and Management, 18(3): 238-246.

Ellerman, A. D. and J.P. Montero. 1998. The Declining Trend in Sulfur Dioxide Emissions: Implications for Allowance

Prices. Journal of Environmental Economics and Management. 36(1): 26-45.

Fischhoff, B. et al. 1978. How Safe is Safe Enough? A Psychometric Study of Attitudes Towards Technological Risks and

Benefits. Policy Sciences 9: 127-152.

Fisher, A. C and W. M. Hanemann. 1987. Quasi-Option Value: Some Misconceptions Dispelled, Journal of Environmental

Economics and Management, 14(2): 183-190.

Foster, W. and R. E. Just. 1989. Measuring Welfare Effects of Product Contamination with Consumer Uncertainty. Journal

of Environmental Economics and Management, 17: 266-283.

Freeman, A. M. III. 1984. The Quasi-Option Value of Irreversible Development, Journal of Environmental Economics

and Management, 11(3): 292-295.

Freeman, A. M. III. 1993. The Measurement of Environmental and Resource Values: Theory and Methods. Resources

for the Future, Washington, D.C.

Knight, F. H. 1921. Risk, Uncertainty, and Profit. Boston, MA: Houghton, Mifflin Co.

Milliman, S. R. and R. Price. 1989. Firm Incentives to Promote Technological Change in Pollution Control, Journal of

Environmental Economics and Management, 17(3): 247-265.

Morgan, M. G. and M. Henrion. 1990. Uncertainty: A Guide to Dealing with Uncertainty in Quantitative Risk and

Policy Analysis. New York, NY: Cambridge University Press.

Slovic, P. 1987. Perception of Risk. Science, 30(4): 423-439.

U.S. Environmental Protection Agency. 1985. Costs and Benefits of Reducing Lead in Gasoline: Final Regulatory

Impact Analysis. EPA/230/05-85-006, Office of Policy Analysis, February 1985.

U.S. Environmental Protection Agency. 1997. Economic Analysis for the National Emissions Standards for Hazardous

Air Pollutants (NESHAPS) for Source Category; Pulp and Paper Production; Effluent Guidelines, Pretreatment

Standards, and New Source Performance Standards: Pulp, Paper and Paperboard Category - Phase 1.

EPA/821/R-97/012, Office of Water, October 1997.

31

Chapter 5: Overview
32

Chapter 5: Overview
6.1 Introduction

The costs and benefits of many environmental policies are frequently paid and received at different

points over the course of sometimes long time horizons. As a result, benefit-cost and related analyses

that are key components of EPA's policy development

and evaluation process must describe future effects

in terms that help present day policy makers choose

appropriate approaches for environmental protection.

One common method for doing so is called discounting, which is the process whereby the values of future

effects are adjusted to render them comparable to

the values placed on current consumption, costs, and

benefits, reflecting the fact that a given amount of

future consumption is worth less than the same

amount of consumption today. Time discounting is

accomplished by multiplying the future values of a

policy's effects by discount factors that reflect both

the amount of time between the present and the

point at which these events occur and the degree to

which current consumption is more highly valued

than future consumption.

Despite the relative simplicity of the discounting concept, choosing a discount rate has been one of the

most contentious and controversial aspects of EPA's

economic analyses of environmental policies. While

there are several plausible explanations for why discounting in environmental policy evaluation has been

unsettled for many years, the most important is that

the theoretical and applied economics literature on

discounting from a social perspective is voluminous

and technically complex. This makes it difficult to

distill precise advice on appropriate discounting procedures for policy analysis. Moreover, in some cases

the economics literature by itself does not yield simple and robust discounting rules for practical applications because making such important social decisions requires inputs from disciplines other than

economics.

Nonetheless, it is important to consider the uncertainties surrounding social discounting in the broader context of applied economic analysis. Benefit-cost

analysis is not a precise tool that yields firm numerical results, rather, it is a general framework for more

carefully accounting for the potential and varied

effects of government programs. Some of these

effects can be quantified, whereas others can only be

assessed qualitatively. Some may be relatively certain, whereas others may be quite speculative.

The imprecision connected with assessing benefits

and costs suggests that the controversy surrounding

the discount rate, in many circumstances, may have

more theoretical than practical significance. For

example, the effects on net benefits of alternative

assumptions made for measuring and valuing uncertain effects of environmental policies can overwhelm

the effects of changes in the discount rate.

Additionally, for some government projects, benefits

and costs may have similar time profiles, or benefits

may so outweigh costs (or vice versa), that changes

in the discount rate will not influence the policy

implications of the analysis.

This review of the basics of social discounting begins

in Section 6.2 with a discussion of some general

considerations in social discounting. In Section 6.3,

various discounting procedures for environmental

policy assessment are presented and evaluated. This

detailed discussion is divided into social discounting

as applied in intra-generational contexts, where very

long time horizons involving multiple generations do

not apply, and discounting for inter-generational

33

Chapter 

6

Chapter 6: Analysis of Social

Discounting
circumstances involving long time horizons and unborn

generations. EPA guidance for intra-generational social

discounting is presented in Section 6.3.1.5. EPA guidance

on inter-generational social discounting follows in Section

6.3.2.4. Finally, discounting and related procedures for

situations in which some effects are not monetized are

addressed in Section 6.4.

6.2 General

Considerations in Social

Discounting

This section reviews a few basic concepts and

considerations central to understanding the role and

importance of discounting in public policy evaluation. The

focus is mainly on describing social discounting and on

distinguishing discounting per se from other aspects of

measuring and summarizing the costs, benefits, impacts,

and other consequences of environmental policies. It also

discusses the circumstances in which discounting has a

large impact on the net social benefits of an environmental

policy.

6.2.1 Social and Private

Discounting

Discounting in public policy evaluation is normally

referred to as social discounting or discounting using the

social rate of interest. The process itself—applying discount factors to future flows of costs, benefits, and other

consequences of environmental and other policies—is

mechanically the same as the discounting process in private individuals' economic and financial calculations.

What makes it "social" discounting is that it is being

applied in the context of evaluating a policy's effects from

an overall social perspective. Clearly, private and social

perspectives can yield very different conclusions concerning, for example, the cost of engaging in an activity that

also generates environmental harms.

Whether social discounting also departs significantly from

private discounting, however, is less clear. Some

approaches to social discounting suggest that the procedures and rates should be the same as those used in private sector discounting. Other perspectives, however, suggest that social discounting is a very different process than

a single individual's discounting. In any event, at a minimum, the term "social discounting" refers to the broad

society-as-a-whole point of view embodied in benefit-cost

and other analyses of public policies. Whether it also connotes procedures and rates different from private discounting is a central question explored in this chapter.

6.2.2 Methods for Summarizing

Present and Future Costs and

Benefits

Most applications of social discounting in environmental

policy evaluation involve translating future values into

present ones. The conceptual foundation of discounting is

based on the fact that present consumption is valued differently from future consumption. Discounting renders

costs and benefits that occur in different time periods

comparable by stating them all in present day terms. The

resulting net present value is at least one measure of

social value that might be used in evaluating environmental policies.

6.2.2.1 Net Present Value

In formal terms, the net present value of a projected

stream of current and future benefits and costs is found by

multiplying the benefits and costs in each year by a timedependent weight, dt

, and adding all of the weighted values

as follows:

NPV = NB0 + d1NB1 + d2NB2 + ... + dnNBn

NBt is the net difference between benefits and costs (Bt-Ct)

that accrue at the end of period, t, and the discounting

weights are given by:

dt = l/(l+r)t

where r is the discount rate and n is the final period in the

future in which the policy's effects are felt.

To account for inflation, either real or nominal values may

be used, as long as they are used consistently. In other

words, nominal costs and benefits require nominal

discount rates, and real costs and benefits require real

discount rates. Moreover, consistent decision making

requires that the same discount rate be used for both

34

Chapter 6: Social Discounting
benefits and costs. Otherwise, any policy can be justified

by choosing a sufficiently low discount rate for benefits, by

choosing a sufficiently high discount rates for costs, or by

choosing a sufficiently long time horizon.

It is important to be explicit about how time periods are

designated and when, within each time period, costs and

benefits accrue. Typically, time periods are years, but

alternative time periods may prove desirable or necessary

if costs or benefits accrue at irregular or non-annual intervals. The preceding formula assumes that t=0 designates

the beginning of the first period. Therefore, C0 represents

startup costs such as capital costs that occur immediately

upon implementation of the regulation. The formula further assumes that no additional costs are incurred until

the end of the first year of regulatory compliance.1

Benefits, if any, also accrue at the end of each time period.

Therefore, the following diagram illustrates how net benefits (measured in dollars) are distributed over time.

6.2.2.2 Annualized Values

In addition to net present value, there are other procedures for rendering costs and benefits that occur in more

than one time period comparable. One method is to

annualize the costs and benefits over the duration of the

policy. For example, in the absence of discount rates

(r=0), a regulation that costs $100,000 at the end of the

first year, $200,000 at the end of the second year, and

$300,000 at the end of the third year can be said to cost

$200,000 a year in annualized costs over the three year

period. Comparing annualized costs to annualized benefits is equivalent to comparing the present values of costs

and benefits.

Costs and benefits each may be annualized separately by

using a two-step procedure. To annualize the costs, for

example, the present value of costs is calculated using the

NPV formula in Section 6.2.2.1, except that the stream of

costs alone, not the net benefits, is used in the calculation.

This present value is then annualized (as in calculating

mortgage payments) according to the following formula:

where,

AC = annualized cost accrued at the end of each of

n periods;

PVC = present value of costs;

r = the discount rate per period; and

n = the duration of the policy.

Note that the annualized cost is the amount one would

have to pay at the end of each period t to add up to the

same cost in present value terms as the stream of costs

being annualized. There is no initial cost at t=0 in this

annualization. Such an initial cost can be incorporated

into the annualization using the slightly different formula:

This approach is also useful when analyzing non-monetized benefits, such as reductions in emissions or reductions in health risks, when benefits are constant over

time. The average cost-effectiveness of a policy can be calculated by dividing the annualized cost by the annual benefit to produce measures of program effectiveness, such as

the cost per ton of emissions avoided.

6.2.2.3 Net Future Value

Finally, there is yet another way of rendering costs and

benefits that occur in more than one time period comparable. Instead of discounting all future values back to the

present, it is possible to accumulate them forward to some

future time period—for example, to the end of the last

year of the policy's effects, n. Here, the net benefit test is

whether the accumulated net future value (NFV) is positive.

NFV = d0NB0 + d1NB1 + d2NB2 + ... + dn-1NBn-1 + NBn

35

Chapter 6: Social Discounting

1 See EPA (1995) for an example in which operating and monitoring costs were assumed to be spread out evenly throughout each year of

compliance. While the exponential function above is the most accurate way of modeling the relationship between present value and a continuous

stream of benefits and costs, simple adjustments to the equations above can sometimes adapt them for use under alternative assumptions about how

dollar flows are distributed over time.

TIME 

Year t 0 1 2 3 4 ... n

$ NB0 NB1 NB2 NB3 NB4 ... NBn

AC = PVC ×

r × (1 + r)n

(1+r)n - 1

AC = PVC ×

r × (1 + r)n

(1+r)(n+1) - 1
Chapter 6: Social Discounting

36

NBt is the net difference between benefits and costs (Bt-Ct)

that accrue in year t and the accumulation weights, dt

, are

given by 

dt = (l+r)(n-t)

where r is the discount rate.

Each of these methods employs an interest rate to translate values through or across time, so the methods are not

really different ways to determine the benefits and costs of

a policy. Instead, they are different ways to express and

compare costs and benefits that occur in multiple time

periods on a consistent basis. Discounting places all costs

and benefits in the present time period, annualization

spreads them smoothly through time, and accumulation

states them all in the future. But each procedure uses the

same discount (interest) rate, so they are different ways to

describe the same underlying phenomenon.

Depending on the circumstances, one method might have

advantages over the others. For example, annualizing the

costs of two machines with different service lifetimes

might reveal that the one with the higher total cost actually

has a lower annual cost because of its longer lifetime.

Similarly, discounting to the present is likely to be the

most informative procedure when analyzing a policy that

requires an immediate investment and offers a stream of

highly variable future benefits.

In general, however, these are alternative ways of translating costs and benefits through time using an interest rate.

Therefore, the analysis, discussion, and conclusions presented in this chapter apply to all methods of translating

costs, benefits, and effects through time, even though the

focus is mostly on discounting.

6.2.3 Sensitivity of Present Value

Estimates to the Discount Rate

The impact of discounting streams of costs and benefits in

public policy evaluation is sometimes large and sometimes

not, depending on the circumstances. When all effects

occur in the same period, discounting may be unnecessary

or superfluous: net benefits are positive or negative regardless of the discount rate used or the procedure for translating them through time. Similarly, when costs and benefits of a policy are largely constant over the relevant time

frame, discounting costs and benefits will produce the

same conclusion concerning the policy as would examination of a single year's costs and benefits. Of course, higher

discount rates will reduce the present value of any future

cost or benefit. But if costs and benefits of a policy occur

simultaneously and if their relative values do not change

over time, whether the net present value of such a policy is

positive does not depend on the discount rate.

Discounting can substantially affect the present value net

benefits estimates for public policies when there is a significant difference in the timing of costs and benefits. For

example, if the costs of a policy are incurred today, they

are not discounted at all. But if the benefits will occur 30

years from now, the present value of the benefits, and,

hence, the net present value of the policy's effects,

depends critically on the discount rate used.

Suppose the cost of some environmental policy that is

incurred entirely in the present is $1 billion and that after

30 years a benefit results that is estimated to be worth $5

billion in the future. Without discounting, a policy that

offers benefits five times its cost appears to be a very

worthwhile social investment. Discounting the $5 billion

future benefits, however, can radically alter the economic

assessment of the net present value of the policy. Five billion dollars, 30 years in the future, discounted at one percent is $3.71 billion, at three percent it is worth $2.06 billion, at seven percent it is worth $657 million, and at 10

percent it is worth only $287 million. In this case, the

range of discount rates generates over an order of magnitude difference in the present value of benefits. And,

longer time horizons will produce even more dramatic

effects on a policy's net present value. Hence, the choice

of the discount rate largely determines whether this policy

is considered, at least on economic efficiency grounds, to

offer society positive or negative net benefits.

Thus, for government projects and policies that require

large initial outlays or that have long delays before benefits

are realized, the selection of the discount rate can be a

major factor in determining whether the net present value

is positive. Many of EPA's policies fit these profiles. Large

investments by public or private parties are usually

required early on, whereas the benefits of those investments either accrue for many years thereafter, such as

improvements in health and environmental quality, or will

not begin for many years, such as reductions in the contamination of environmental systems from hazardous
waste, landfill facilities, and the protection of the earth's

atmosphere and climate.

6.2.4 Distinguishing Discounting

from Other Procedures

Discounting is only one of several components that are

necessary in order to produce comparable estimates of a

policy's costs and benefits that accrue over more than one

time period. Discounting is a technique for translating values from one time period to another in order to express

the values of a policy's consequences in consistent terms.

It is not, however, a method for actually determining the

future values of future costs and benefits. Two considerations related to determining these future values—projecting future values based on present ones and accounting

for risk—are closely related to discounting.

6.2.4.1 Future Values of Costs and

Benefits

The future value of one of an environmental policy's

effects may hinge critically on the assumed rate of growth

of wealth over time. There may also be a connection

between increasing wealth and the discount rate for

expressing future values in present day terms.

Nevertheless, the process of determining the values of

future costs and benefits and then translating them into

present terms are two conceptually distinct procedures.

It is generally appropriate to conduct each of these tasks

separately. And, it is prudent to avoid attempting to "correct" for errors in one procedure by "adjusting" the other.

For example, it is technically possible to use a current valuation for a future benefit whose future value is expected

to increase, but then reduce the discount rate to reflect

that assumed rising valuation through time. Nevertheless,

this is usually unwise because the values of other consequences of a policy might not follow the same rate of

increase over time. Thus, these might be over- or undercorrected by the adjusted discount rate. The only way to

avoid that result would be to use a different adjusted discount rate for each cost and benefit stream, which is generally inappropriate.

6.2.4.2 Risk and the Social Discount

Rate

The relationship between risk and the rate of return on

assets has been an important subject in modern finance.

Risk considerations also have played a role in the controversy surrounding the selection of an appropriate discount

rate for benefit-cost analysis. For example, one recommendation is that public projects with risky or uncertain

future costs and benefits should be discounted at a higher

rate reflecting those risks, just as it is in the private sector. 

The concept of risk is often interpreted narrowly as being

measured by the variability or range of possible outcomes

of a project. Greater variation implies more risk according

to this view. But the notion of risk should be conceptualized more broadly. Rather than being taken in isolation,

the risk of a project is measured by its effect on the variability in outcomes of the entire portfolio of assets. In

general, the degree of risk associated with an asset is

measured in terms of the covariance of its returns with

those of the portfolio of assets to which it is added.2

When viewed from this broader perspective, most environmental projects are either riskless or reduce risk. This is

because most environmental projects have benefits and

costs that are widely dispersed and that are uncorrelated

or negatively correlated with future measured income and

other aspects of economic welfare.

Nevertheless, the costs and benefits of some

environmental policies can be risky in this broader sense.

In these cases, it is commonly argued that the discount

rate should be adjusted upward by a risk premium to

value future uncertain returns. However, this is generally

not the correct procedure because it requires the discount

rate to reflect both the risk of future returns as well as the

length of time until they materialize. That is, if the goal is

to reduce the present value of a project's returns to reflect

their risk, the same decrease in present value will be

37

Chapter 6: Social Discounting

2 An assumption underlying this analysis is that the asset being acquired is a very small fraction of the portfolio of assets already held. If

this assumption is violated, the variability in returns of the asset can directly affect the variability of returns to the entire portfolio. The potential costs

and benefits of environmental policies generally are spread among large numbers of people, however, which satisfies the condition that the asset

acquired be a small portion of the portfolio of assets already held.
produced by a smaller increase in the discount rate the

longer the delay until the returns are received.3

Economic theory suggests using two different "instruments" to accomplish the two different goals. One such

procedure to account for risk is to value a project's uncertain returns using the certain monetary equivalent or

certainty equivalent. As discussed in Chapter 5 of this

document, this is the amount risk averse individuals

would be willing to pay with certainty for the risky

prospect. The certainty equivalent should then be discounted using the rate of interest individuals use to discount other perfectly certain flows. 

Hence, to properly account for risk in benefit-cost analyses, the first step should be to evaluate whether a project is

actually risky from the broader perspective of society's

larger portfolio of assets. Many government policies are

not risky at all, so that their expected values of costs and

benefits can be discounted directly using a risk-free interest rate. For projects that offer truly risky prospects, however, certain monetary equivalents for these returns

should be derived and then discounted to the present

using a risk-free rate. The discount rate should not be

"adjusted" to account for risky costs and benefits.

6.3 Approaches to

Social Discounting

This review of the basics of social discounting and the new

EPA guidance on the subject begins with discounting in

conventional or intra-generational contexts, where very

long time horizons involving multiple generations do not

apply. Next, approaches for inter-generational social discounting, involving very long time horizons and unborn

generations, are presented and evaluated. 

The main purpose of this discussion is to provide a broad

overview of the extensive literature on social discounting in

order to distill from it practical guidelines for environmental policy evaluation. It is not, however, a detailed review

of the literature on discounting in public project evaluation, which is vast in scope and volume. Excellent sources

for summaries of the social discounting literature are Lind

(1982a), Lind (1982b), Lind (1990), Lind (1994), Lyon

(1990), Lyon (1994), Kolb and Scheraga (1990), Scheraga

(1990), IPCC (1996), Pearce and Turner (1990), and

Pearce and Ulph (1994).

6.3.1 Intra-Generational Social

Discounting

This section explores social discounting in conventional or

intra-generational contexts, specifically those in which

very-long-time-horizon issues are not important features.

Most of the traditional discounting literature focuses on

these circumstances. Intra-generational contexts may well

have decades-long time frames, but they do not explicitly

confront the extremely long time horizons and impacts on

unborn generations that are central to the extensions of

social discounting research into climate change, nuclear

waste disposal, and other such policy issues. The division

of the problem into intra-generational and inter-generational social discounting helps to understand the substantially different contribution economic approaches can offer

in each area.

The discussion begins with a brief review of the analytical

foundations of conventional social discounting. It next

outlines the major social discounting approaches suggested in the literature. The section concludes with a review of

the concrete conclusions and advice offered by the traditional discounting literature and the new guidance developed by EPA for use in social discounting in intra-generational contexts.

6.3.1.1 Analytical Foundation of IntraGenerational Social Discounting

Conventional social discounting is rooted firmly in the view

that the government is acting on behalf of its citizens in

undertaking public projects and promulgating environmental and other policies. Therefore, benefit-cost analysis

of these actions should seek to estimate the costs and benefits experienced by all of the affected parties, and in so

38

Chapter 6: Social Discounting

3 Note that if discount rates are adjusted to incorporate risk, the adjustment is not always upward. Risky benefits are worth less than their

expected value, so an upward adjustment of the discount rate will reduce the present value. But uncertain costs would require a downward adjustment of the discount rate to increase the present value to reflect the fact that risk averse individuals would pay more than the expected value of the

costs to avoid bearing the uncertain prospect.
doing determine whether, in aggregate, the gainers under a

policy would be able to compensate the losers.

This foundation for social discounting has an important

implication for the choice of a social discounting method.

Just as consumer sovereignty dictates that the government

should incorporate the specific values that particular individuals place on outcomes that affect them in assessing its

actions, the government should also discount future costs

and benefits in the same way that the affected individuals

do. Strict adherence to the principles of consumer sovereignty is necessary in order to determine how much each

person would agree he or she is made better or worse off

by a given policy in present value terms.

The analytical and ethical foundation of the intra-generational social discounting literature thus rests on the traditional test of a "potential" Pareto improvement in social

welfare—whether gainers could compensate the losers.

This framework fundamentally casts the consequences of

government policies in terms of collections of individuals

contemplating changes in their own consumption (broadly

defined) over time. Thus, social discounting in this context should seek to mimic the discounting practices of the

affected individuals.

The Paretian economics point of view, however, is not the

only ethical perspective possible in this context. As discussed in the section on inter-generational discounting,

another approach is to cast the problem in terms of maximizing a social welfare function that includes utilities of

present and future individuals and is maximized according

to an alternative set of objectives and constraints. While

alternative social welfare functions could apply to intragenerational circumstances, it is generally confined to

inter-generational contexts. Hence, although there is nothing inherent in a short-time-horizon policy that dictates

that only the Paretian perspective is appropriate for intragenerational situations, this is the most commonly accepted point of departure in the social discounting literature

for these circumstances. It is also worth considering the

two very distinct foundations for social discounting separately because their implications for determining the social

discount rate are quite different. The Paretian economic

approach suggests that the social discount rate is to be

found by examining the preferences of affected parties,

while the discount rate under alternative social welfare

functions is not necessarily based on the preferences of

existing individuals.4

6.3.1.2 Fundamental Procedures for

Intra-Generational Social Discounting

Given the reasonably precise and circumscribed objective

of social discounting as described above, the volume of literature on the topic is surprisingly diverse and complex.

This section briefly reviews the major approaches suggested in the literature and evaluates their implications for

practical social discounting in environmental policy assessments. The section concludes with a summary of recommended practices for social discounting in intra-generational contexts.

Consumption Rate of Interest Approach for Social

Discounting

The economic literature begins by pointing out that under

a variety of restrictive assumptions—no taxes, no risk,

perfect capital markets—the task of discounting effects

experienced by individuals would be straightforward.

Analysts should simply use the observable market rate of

interest that underlies the intertemporal consumption

allocation decisions of those same individuals. The rate at

which individuals are willing to exchange consumption

over time is normally referred to as the "consumption rate

of interest."

The simplifying assumptions (especially the absence of

taxes on investment returns) imply that the consumption

rate of interest equals the market interest rate, which also

equals the rate of return on private sector investments. In

this case, individuals discount future consumption at the

market rate of interest, which is also the rate at which consumption can be translated through time via private sector

investments. Hence, if the government seeks to value

costs and benefits in present day terms in the same way as

the affected individuals, it also should discount using the

market rate of interest.

One of the simplifying assumptions underlying this

result—that the consumption rate of investment at which

consumers discount future consumption equals the rate of

39

Chapter 6: Social Discounting

4 This concept is also treated in Chapter 10 in the discussion of ways to jointly consider efficiency and equity within a single analytical

framework.
return on private sector investment—probably does not

hold in practice. Taxes on private sector investment

returns can cause the social rate at which consumption

can be traded through time (the pre-tax rate of return) to

exceed the rate at which individuals can trade consumption over time (the post-tax consumption rate of interest).

For example, suppose the market rate of interest, net of

inflation, is five percent, and that taxes on capital income

amount to 40 percent of the net return. In this case, private investments will yield five percent, of which two percent is paid in taxes to the government, with individuals

receiving the remaining three percent. From a social perspective, consumption can be traded from the present to

the future at a rate of five percent. But individuals effectively trade consumption through time at a rate of three

percent because they owe taxes on investment earnings.

As a result, the consumption rate of interest is three percent, which is substantially less than the five percent social

rate of return on private sector investments (also known

as the social opportunity cost of private capital).

Over several decades, a very large body of economic literature developed, analyzing the implications for social discounting of divergences between the consumption rate of

interest and the social rate of return on private sector

investment. The dominant approaches in this literature

are briefly outlined here.

Consumption Rate of Interest-Shadow Price of

Capital: The Traditional View

One approach that enjoys widespread support among

economists recommends that social discounting in intragenerational contexts should use the consumption rate of

interest to discount future costs and benefits that have

been valued in terms of future consumption. Intuitively,

this procedure makes sense because the government is

assumed to be valuing future consequences of its policies

just as the affected citizens would. If individuals discount

future consumption (and the costs and benefits of a public

policy) using the consumption rate of interest, then so

should the government. So, the social rate of discount

should equal the consumption rate of interest.

But, if the costs of financing a public project or the costs of

regulatory compliance displace private investments, society

loses the total pre-tax returns from those foregone investments. Private capital investments might be displaced if,

for example, public projects are financed with government

debt and the supply of investment capital is relatively fixed.

This is the "closed economy" condition. In this case, discounting costs and benefits using the consumption rate of

interest (the post-tax rate of interest) does not seem to

capture the fact that society loses the higher, social (pretax) rate of return on foregone investments.

Under the consumption rate of interest-shadow price of

capital approach for social discounting, the social value of

displacing private capital investments is taken into account

prior to discounting. Under this approach, when a public

project displaces private sector investments, the correct

method for measuring the social costs and benefits

requires an adjustment of the estimated costs (and perhaps benefits as well) prior to discounting using the consumption rate of interest. This adjustment factor is

referred to as the "shadow price of capital."5

The shadow (social) price (value) of private capital is

intended to capture the fact that a unit of private capital

produces a stream of social returns at a rate greater than

the rate at which they are discounted by individuals. If the

social rate of discount is the consumption rate of interest,

then the social value of a $1 private sector investment will

be greater than $1. The investment produces a rate of

return for its owners equal to the post-tax consumption

rate of interest, plus a stream of tax revenues (considered

to be consumption) for the government.

To illustrate this simply, suppose that the consumption

rate of interest is three percent, that the pre-tax rate of

return on private investments is five percent, that the netof-tax earnings from these investments are consumed in

each period, and that the investment exists in perpetuity

(amortization payments from the gross returns of the

investment are devoted to preserving the value of the capital intact). A $1 private investment with these characteristics will produce a stream of private consumption of $0.03

per year and tax revenues of $0.02 per year. Discounting

the private post-tax stream of consumption at the three

percent consumption rate of interest yields a present value

of $1. Discounting the stream of tax revenues at the same

rate yields a present value of about $0.67. The social value

40

Chapter 6: Social Discounting

5 Lind (1982a) remains the seminal source for this approach in the social discounting literature.
of this $1 private investment—the shadow price of capital—is thus $1.67, substantially greater than the $1 private value that individuals place on it.

Therefore, if financing a public project displaces private

investments, this "consumption rate of interest-shadow

price of capital" approach suggests adjusting the project's

costs upward by the shadow price of capital and then discounting all costs and benefits using a social rate of discount equal to the consumption rate of interest. To apply

this approach, the first step is to determine whether private investment flows will be altered by a policy. Typically,

project costs are thought to displace private capital, at least

in part, although project benefits could encourage additional private sector investments. Next, all of the altered

private investment flows (positive and negative) are multiplied by the shadow price of capital to convert them into

consumption-equivalent units. All flows of consumption

and consumption-equivalents are then discounted using

the consumption rate of interest.

A simple example of this method is as follows. Suppose

the pre-tax rate of return from private investments is five

percent and the post-tax rate is three percent, with the difference attributable to taxation of capital income. Assume

as well that increases in government debt displace private

investments dollar-for-dollar, and that increased taxes

reduce individuals' current consumption also on a onefor-one basis.6 Finally, assume that the $1 current cost of

a public project is financed 75 percent with government

debt and 25 percent with current taxes and that this project produces a benefit 40 years from now that is estimated

to be worth $5 in the future.

Using the consumption rate of interest-shadow price of

capital approach, first multiply 75 percent of the $1 current cost (which is the amount of displaced private investment) by the shadow price of capital (assume this is the

$1.67 figure from above). This yields $1.2525, to which is

added the $0.25 amount by which the project's costs displace current consumption. The total social cost is therefore $1.5025. This results in a net social present value of

about $0.03, which is the present value of the future $5

benefit discounted at the three percent consumption rate

of interest ($1.5328) minus the $1.5025 social cost.

Thus, under the consumption rate of interest-shadow price

of capital approach, costs are adjusted upward to reflect

the higher social costs of displacing private investments,

but discounting for time itself is accomplished using the

consumption rate of interest—consistent with how individuals trade and value consumption over time.

Variants of this approach exist. For example, the KolbScheraga (1988) approach recommends annualizing capital expenditures using the pre-tax rate and then discounting all cost and benefits using the consumption rate of

interest.

Other Social Discounting Approaches

Other approaches for social discounting in the literature

have been recommended on and off over the years. These

alternatives focus on different methods than the shadow

price of capital approach for evaluating policies that displace private sector investments. However, the procedures

these approaches use will not generally produce a correct

estimate of the social present value of a policy's costs and

benefits. Some of these other methods for social discounting are reviewed and evaluated below.

Weighted average of pre- and post-tax rates of

return: A major alternative approach for addressing the

divergence between the higher social rate of return on private investments and lower consumption rate of interest is

to set the discount rate for public projects equal to a

weighted average of the two. The weights would equal the

proportions of project financing that displace private

investment and consumption, respectively. Intuitively, this

approach would set an overall project discount according

to the amount lost by displacing consumption (using the

lower consumption rate of interest) and the amount lost

by displacing investments (using the higher social rate of

return on private capital).

For example, suppose the social rate of return from private

investments is five percent and the consumption rate of

interest is three percent, as above. Suppose further that

75 percent of a public project's costs are financed using

41

Chapter 6: Social Discounting

6 The assumption that additional government borrowing crowds out private investment dollar-for-dollar is not critical to the example. If

crowding out is less than dollar-for-dollar, then the 75 percent of the project's cost that is financed by additional debt would be further divided into the

proportion of that percentage of the cost that displaces private investment, which should then be adjusted using the shadow price of capital, and the

remainder of the cost, which is drawn from consumption and therefore does not need to be adjusted.
government debt, with the remaining 25 percent of the

costs raised through taxation. Finally, assume that

government debt crowds out private investment on a

dollar-for-dollar basis and that increased taxes reduce

individuals' current consumption also on a one-for-one

basis. The weighted average approach then suggests that

the social rate of discount should be 75 percent of five

percent plus 25 percent of three percent, or four and a

half percent. If the proportions of the project's financing

from each revenue source were reversed, however, the

weighted average discount rate would instead be 25

percent of five percent plus 75 percent of three percent, or

three and a half percent.

This approach has enjoyed considerable popularity over

the years, and is probably acceptable for similarly timed

cost and benefit flows.7 As presented above, however, it is

technically incorrect and can produce net present value

results substantially different from the correct result

(where "correct" is defined by the consumption rate of

interest-shadow price of capital approach). The problem

with the simple weighted average approach is that it seeks

to accomplish two tasks using the social discount rate—

pure time discounting and adjusting for the displacement

of private investments that yield pre-tax social returns

higher than the consumption rate of interest.

In general, the "synthesized" discount rate based on the

social rate of return from private investments and the consumption rate of interest that accomplishes both objectives—and so arrives the correct present value—depends

on the timing of the cost and benefits flows. A simple

weighted average based only on project cost components

will not in general produce the correct result.

To understand this, consider how the weighted average discount rate approach performs for the simple numerical

example discussed above. Assume that the social rate of

return on private investments is five percent, that the consumption rate of interest is three percent, that increases in

government debt displace private investments dollar-fordollar, that the $1 current cost of a public project is

financed 75 percent with government debt and 25 percent

with current taxes, and that the project produces a benefit

40 years from now that is estimated to be worth $5 in the

future.

The weighted average social discount rate approach would

suggest discounting the future benefit at a four and a half

percent rate (0.75 times five percent plus 0.25 times three

percent). This produces an estimated net social present

value of -$0.14, which is the present value of the future $5

benefit discounted using a four and a half percent rate

($0.86) minus the current year $1 cost. In this case, the

weighted average social discount rate approach suggests

that the project's net social present value is negative. But

earlier, the consumption rate of interest-shadow price of

capital approach was applied to exactly this scenario, concluding that the net social present value is positive.

The problem with the weighted average approach is that its

method for accounting for the higher social cost of displaced private investments is to "over discount" the benefits. But the amount of "over discounting" necessary in

this example to adjust for the actual social costs of the

project's costs depends on the time profile of the benefit

stream—the farther in the future the benefits occur, the

less "over discounting" is needed. The source of the project's financing is therefore insufficient to define a single

rate of social discount that will produce correct net social

present value results for any given policy.

Accordingly, to derive the weighted average discount rate

that will produce the correct net present value requires

that the consumption rate of interest-shadow price of capital method be used first to compute the net present value.

The discount rate that produces this correct present value

based on discounting costs and benefits, but not adjusting

for the shadow price of capital, can then be calculated.

There seems to be little purpose to this exercise because it

requires the net present value of a policy to be computed

using accurate procedures first before the adjusted discount rate can be derived.

Opportunity cost of capital: Another approach for social

discounting argues that the government should not invest

(or compel investment through its policies) in any project

that offers a rate of return less than the social rate of

return on private investments. Stated another way,

because the citizens collectively enjoy the benefits of all

42

Chapter 6: Social Discounting

7 Lind (1982b) provides a clear exposition of the weighted average approach for estimating the social discount rate. The large literature on

this topic, spanning the 1960s through the early 1980s, has been summarized well by Lind and others.
public and private investments, welfare will be higher overall if the government invests in projects with the highest

rates of return.8

Critics of this social investment rule argue that the government cannot realistically tax citizens and then invest in

private sector projects. Therefore, the issue is not what

"could" be done with the funds, but rather what "would"

be done with them. Thus, if the government obtains funds

for a project through taxation and this displaces only private consumption, then relative to consuming the

resources today, welfare is increased as long as the project

generates future benefits that exceed those costs when discounted at the consumption rate of interest. Of course, it

remains true that welfare would be further increased if the

funds were devoted to an even more valuable project.

A closely related opportunity cost-based observation is that

the government faces a menu of projects and, for whatever

reason, is not able to undertake all projects that have positive net social benefits when computed using a social rate

of discount equal to the consumption rate of interest. In

this event, the opportunity costs of funding one program

are the benefits of other programs not funded.

Proponents of this view typically conclude that the "hurdle" discount rate for a particular project should be equal

to the rate of return offered by other projects foregone.

Regardless of the particular point of departure, the central

point of the opportunity cost strand of the social discounting literature is valid. Social welfare will be improved if

the government invests in projects that have higher values

than if it invests in lower value ones. Hence, if the net

present value of benefits of all courses of action are examined using the consumption rate of interest and the set

with the highest net benefits are pursued, social welfare

will be higher than otherwise.9 So stated, this advice is

correct.

However, it does not follow that rates of return offered by

alternative private or public projects define the level of the

social discount rate. An alternative project might produce

large benefits over the future and thus offer a large "rate of

return." But if individuals discount these future benefits

using the consumption rate of interest, the correct way to

describe this project is that it offers substantial present

value net benefits. In general, the opportunity cost argument is not about the social discount rate per se, but

about correctly and consistently examining the social values of all alternatives. As was the case for the shadow

price of capital, an alternative project with a high rate of

return will have a high social net present value. But this

does not imply that its rate of return should become the

social rate of discount to be used for pure time discounting for other projects.

Consumption Rate of Interest-Shadow Price of

Capital: The New View

Over the years, the consumption rate of interest-shadow

price of capital approach to social discounting has gained

increasingly wide acceptance among economists. Recently,

however, a key assumption in that analysis has been questioned—the assumption that the economy is "closed" to

foreign capital flows—and an alternative hypothesis concerning government crowding out of private investment

has been put forward.10 According to this new view, earlier

analyses implicitly assumed that capital flows into the

nation were either nonexistent or very insensitive to interest rates, a "closed economy" assumption. Empirical evidence suggests, however, that international capital flows

are quite large and very sensitive to interest rate changes.

In this case, the supply of investment funds to the U.S.

equity and debt markets is likely to be highly elastic (the

"open economy" condition) and, thus, private capital displacement is much less important than it was previously

thought to be. 

Under this new view, it is inappropriate to assume that

financing a public project through borrowing will result in

dollar-for-dollar crowding out of private investment. If,

instead, financing public projects results in no crowding

out of private investment, then no adjustments using the

shadow price of capital are necessary. Benefits and costs

should be discounted using the consumption rate of interest alone. However, the literature to date does not adequately support the assumption of zero crowding out. It is

more likely that there exists some degree of private capital

43

Chapter 6: Social Discounting

8 Many authors cite high opportunity costs of public investments. Among these are Birdsall and Steer (1993), Schelling (1995), and Lyon

(1994). On the technical issue of rates of return vs. net present values, see Lind (1990) and Cowen and Parfit (1992).

9 Clearly, such an approach cannot be followed when a particular action is mandated.

10 See Lind (1990) for this revision of the consumption rate of interest-shadow price of capital approach.
displacement within the spectrum between zero and dollar-for-dollar displacement. The degree of crowding out

will depend on the magnitude of the policy or program

being analyzed. Unfortunately, while the shadow price of

capital adjustment requires an assessment of the proportion of costs that displace investment,11 the literature provides little empirical evidence as to the relationship

between project size and capital displacement.12

6.3.1.3 Applying the Consumption Rate

of Interest Approach to Environmental

Policies

The extension of the consumption rate of interest-shadow

price of capital approach to the case of an economy "open"

to substantial capital flows is relatively recent. And, as is

true for most of the discounting literature, virtually all of

the discussion focuses on public project financing, rather

than on environmental policies that largely mandate that

private parties undertake certain actions or expenditures

in pursuit of social objectives. Finally, while it is intuitive

to argue that private investments are not displaced by

either additional government borrowing or mandatory private investments for environmental protection, it is often

the gross gains and losses of the affected parties in the

economy that are the focus of economic impact analyses.

How the change in the assumption concerning the availability of investment funds to the economy translates into

these gross gains and losses is critical for conducting accurate environmental policy assessments.

For all of these reasons, it is worth clarifying the capital

displacement and adjustment issue for environmental

policies that mandate capital investments in the context of

both the "open" and "closed" economy assumptions

regarding capital flows.

Environmentally-Mandated Private Investments in a

"Closed" Economy

To focus closely and exclusively on the shadow price of

capital adjustment issue, some simplifying assumptions

are helpful. Assume that there is no risk and uncertainty,

that all firms and the government borrow at the interest

rate i, that taxes on investment income are levied on all

sources of such income at a rate of t, and that the resulting post-tax interest rate, r (=i×(1-t)), is the rate at

which individuals discount future consumption.13

Further, assume that the net-of-tax returns from all investments are consumed in each year (to assist in making this

illustration as simple as possible). Assume, finally, that

the supply of investment funds is perfectly inelastic with

respect to their price, the interest rate.

Consider, first, a public project that costs $1, is financed

through taxes on labor and other factors of production

(but not capital), and offers future environmental benefits.

Assuming that increased current taxation only reduces

consumption, the cost of the project is this amount of

reduced current consumption. Future benefits, once

valued in terms of future consumption, can be discounted

to the present using a social rate of discount equal to the

consumption rate of interest. For the remainder of this

discussion, the benefits side of the calculations will be

ignored to focus on the cost calculation considerations.

Now, consider exactly the same project, but assume that it

is financed only through government borrowing, which

crowds out an equal amount of private sector investment.

To calculate the costs of this project financing, it is helpful

to analyze the impacts on the different entities affected.

First, the private sector investors who lend $1 to the government instead of to private firms are indifferent. They

receive the interest rate i from either source and, therefore, continue to receive a stream of returns net-of-tax

equal to $1×r.

Next, consider the government, which can be thought of as

representing the interests of citizens in future years. The

foregone private investments would have generated a

stream of tax revenues of $1×t×i each year, which is lost.

But the increased public debt is taxable, so the government regains this $1×t×i each year and the streams of

gained and lost tax revenues offset each other.

Nevertheless, the government must service this new debt

44

Chapter 6: Social Discounting

11 See footnote 5 for a description of this adjustment.

12 See Lind (1990) for a summary of the empirical literature in this area.

13 The relevant tax rate t is the effective marginal tax rate. It is difficult to determine this rate in the aggregate with any reasonable degree

of accuracy.
by raising future taxes each year by the amount $1×i

(assuming, for simplicity, that the debt is a perpetuity).

As a result, the cost of financing this public project

through government debt in a closed economy context is a

stream of decreased consumption experienced in the

future of $1×i per year forever. The present value of this

stream of foregone consumption computed using the consumption rate of interest, r, exceeds $1. This is the

essence of the shadow price of capital adjustment rationale. The value of i exceeds r in this example because of

the tax wedge between the social (pre-tax) rate of return

on investments and the (post-tax) consumption rate of

interest. This is the equivalent of observing that a taxable

investment yields a private return of r per year to the

investor and a "return" of t×i to the government in the

form of tax revenues.

Assume now that the relevant investment is a private sector capital project that must be undertaken in order to

comply with an environmental policy. To estimate the

social costs of this requirement under the closed economy

assumption, two polar cases are useful to examine: no

cost shifting to consumers or other factors of production

and full cost shifting to consumers through higher product

prices.

In the case of no cost shifting to consumers, the owners of

the firms required to make these investments either must

obtain debt or equity funds or reduce their other investment and lending activities, to comply. Wherever the

required funds originate, two facts are clear. One is that

other taxable investments of $1 will not be undertaken.

The second is that, because the price of the products or

services into which this environmental investment flows

does not rise, the mandated investment will produce no

"return" for their owners or for the government in the

form of future tax revenues. The result is that the owners

of the affected firms lose a stream of investment income,

$1×r, and the government loses a stream of tax revenues

of $1×t×i, because of the displaced private investment.

But since r=i×(1-t), this adds up to a stream of costs of

$1×i per year. Once again, this is essentially the shadow

price of capital adjustment.

Now assume that the cost of the mandated environmental investment is shifted to consumers through higher

prices, which rise by enough to provide the full social

pre-tax return of i. In this case, the owners of the firms

required to make these investments are indifferent.

Similarly, the government is indifferent—it still receives

a stream of tax revenues from the $1 investment. Here,

however, it is consumers of the affected product or service who are not indifferent. In fact, the product price

increases they face are precisely enough to provide the

$1×i pre-tax social return on the mandated investment.

Here again, this is essentially the shadow price of capital

adjustment.

Environmentally-Mandated Private Investments in

an "Open" Economy

The central difference between the closed and open economy contexts concerns the conditions of supply of investment funds. In the closed economy case, the amount of

these funds is fixed, so the total available for all projects,

private and public, is constant. Hence, the key to analyzing that case lies in tracing the implications of altering the

composition of the investments undertaken with and without a new public project or a new environmental policy

mandating private investments.

In the open economy context, however, what is fixed is

not the supply of investment funds, but the price at

which they may be obtained. In this case, all investments worth undertaking without a new public project or

a new environmental policy requiring investments will

still be worth undertaking with those new policies—so

that there will be no impact on capital availability and the

level of private sector investments. This suggests that

measuring the costs of these policies in this open economy context may be slightly different than in the closed

economy case.

Purely tax-financed public projects are not discussed

here because the results for that case do not depend on

the assumption concerning the supply of capital. For

debt-financed public projects, however, the results under

the closed and open economy assumptions are very different. In this open economy case, the government's

increased $1 of borrowing does not change the level of

U.S. private sector investment. Hence, the government

must service the debt at a cost of $1×i per year, but also

gains from that $1×i×t of tax revenues from these new

45

Chapter 6: Social Discounting
taxable interest payments.14 The net cost is only

$1×i×(1-t), which is the stream of future reduced consumption citizens will experience as the net cost of the

new public project. But because i×(1-t)=r, this stream

of reduced consumption is equal to $1×r. Discounted at

the consumption rate of interest, r, the present value cost

is $1. This is the rationale for not using the shadow price of

capital adjustment.

To analyze the implications of the open economy assumption for mandated private investments, the no- and fullcost pass-through polar cases continue to be helpful. In

the case of no-cost pass-through, the results are very simple. The owners of the firms required to make the investments to comply with an environmental policy will obtain

the necessary funds either from their own resources that

would have been invested elsewhere, or from other

sources, and undertake the required investments.

Because the price of the services or products subject to the

new policy do not rise to compensate for these costs, no

return to these owners or to the government in the form of

tax revenues will result. But, because the supply of investment funds to the economy is perfectly elastic, no other

private sector investments will be foregone.

The result in this case is that the owners of the entities

required to make these investments will lose a stream of

private investment returns of $1×r (their net-of-tax

return on production investments) if the mandatory

investment causes them to reduce investment elsewhere.

Alternatively, the owners of the affected firms may increase

their demands for investment funds in the market and

continue with their pre-policy investment plans.

Nevertheless, because i is constant, all investment projects

that were profitable before the policy is imposed will still

be profitable and these investments will be undertaken as

if the policy did not exist. Hence, the government loses no

tax revenue as a result and no shadow price of capital

adjustment is appropriate here.

Finally, if the costs of the mandated private investments

are fully passed through to consumers, the owners of the

affected firms are now indifferent. The government and

the consumers of the relevant services or products, however, are not. First, the consumers of the affected sector's

output face price increases equivalent to $1×i, which is

the amount necessary to fully recoup the full pre-tax social

return on the invested capital. But the government gains a

stream of tax revenues associated with this mandated

investment, amounting to $1×i×t per year. Again, all

other investments are still undertaken because of the

assumption regarding the supply of investment funds.

As a result, the net cost to society is the price increase

borne by consumers, equal to $1×i per year, minus the

increase government tax revenues—which represents

future reduced taxation—of $1×i×t per year, for a net

cost of only $1×i(1-t)=$1×r. Thus, the shadow price of

capital adjustment is not necessary here. But, note that

the cost increase for the firm and its consumers is measured by the pre-tax amount per year, $1×i, not the net

social cost of $1×r per year. The former is the relevant

measure for modeling private sector "economic impacts"

and for assessing the gross gains and losses of a policy,

while the latter represents the social perspective.

6.3.1.4 Summary of Advice from the

Economics Literature

The vast majority of the traditional social discounting literature has focused on exploring the implications for public

project evaluation of a few, probably very important, departures from the idealized no-other-distortions simplified

economy for which unambiguous social discounting recommendations can be made. Yet, in the development of

that literature, many matters have been addressed and are

considered by many contributors to this literature to be

somewhat settled, some of which are discussed above, and

others not (largely because they are not directly social discounting issues). In particular, for intra-generational

social discounting:

There is reasonable agreement that the social rate of

discount ought to reflect the private rates of consumption discount of the citizens affected.

If social and private returns from private investments

are different, then adjustments should be introduced

46

Chapter 6: Social Discounting

14 The taxability of the interest payments on the increased amount of government debt in an open economy context is complex because of

the international nature of capital markets. Generally speaking, taxes are owed on interest earnings from government obligations to the country that

pays the interest, although there are exceptions to this rule. Hence, if U.S. citizens increase their lending to the U.S. government, the interest earnings

would clearly be taxable. If foreign investors purchase the increased U.S. government debt, normally these interest payments are taxable as U.S.

income.
to reflect this when and if policies alter private investment flows.

Uncertainty and risk should largely be addressed

through appropriate valuation of costs and benefits

(e.g., certain monetary equivalents) rather than

through modifications of the discount rate.

Changes in the values of environmental goods and

other such factors should likewise be reflected in

direct cost and benefit measurements, not through

adjustments to the social discount rate.

Irreversibility of consequences is an option value concept and requires separate treatment in benefit-cost

analyses, but it does not provide a reason to adjust

the discount rate.

Opportunity costs of other public and private uses for

funds should be considered in evaluating the desirability of undertaking a particular public investment

or policy. That a project offers a positive present value

of net benefits when discounted using the consumption rate of interest does not by itself imply that the

policy should be undertaken.

These conclusions demonstrate the significant progress

made in the theoretical social discounting literature, especially regarding the implications of divergences between

social and private rates of returns on investments.

However, exactly what numerical rate of interest to use for

social discounting in practical policy evaluations remains

somewhat unsettled.

Moreover, some recent literature questions some of the

most basic premises underlying the conventional social

discounting analysis. For example, recent studies of individuals' financial and other decision making suggest that

even a single person may appear to value and discount different actions, goods, and wealth components differently.

This "mental accounts" or "self-control" approach suggests

that individuals may well evaluate some aspects of the

future quite differently from other consequences. The discount rate an individual might apply to a given future benefit or cost, as a result, may not be observable from market prices, interest rates, or other phenomena. This may

be especially the case if the future consequences in question are not tradable commodities. Some recent evidence

from experimental economics also indicates that discount

rates appear to be lower the larger the magnitude of the

underlying effect being valued, higher for gains than for

losses, and tend to decline as the length of time to the

event increases.15

Despite all of these limitations, practical economic analyses must use social discounting to assist in evaluating

environmental policies. Hence, even limited guidance is

helpful in developing recommendations for practical

analyses. What is offered in the empirical literature for

choosing a social discount rate focuses on estimating the

consumption rate of interest at which individuals translate

consumption through time with reasonable certainty.

For this, historical rates of return, post-tax and after inflation, on "safe" assets, such as U.S. Treasury securities, are

normally used, typically resulting in rates in the range of

one to three percent.16 Some studies have expanded this

portfolio to include other bonds, stocks, and even housing

and this generally raises the range of rates slightly. It

should be noted that these rates are ex post rates of

return, not anticipated, and they are somewhat sensitive to

the time periods selected and the classes of assets considered.17 A recent study of the social discount rate for the

United Kingdom places the consumption rate of interest at

two to four percent, with the balance of the evidence pointing toward the lower end of the range.18

47

Chapter 6: Social Discounting

15 Shefrin and Thaler (1988) and Thaler (1985) are central sources for the mental accounts idea and Lowenstein and Thaler (1989)

report numerous examples of various inconsistencies and other aspects of individual intertemporal choices.

16 Estimates of the consumption rate of interest (an individual's marginal rate of time preference) could be based on either after-tax lending or borrowing rates. Because individuals may be in different marginal tax brackets, have different levels of assets, and have different opportunities

to borrow and invest, the type of interest rate that best reflects marginal time preference will differ among individuals. Additionally, individuals routinely are observed to have several different types of savings, each possibly yielding different returns, while simultaneously borrowing at different rates

of interest. Thus, discerning an average marginal rate of time preference from observed interest rates is very difficult. However, the fact that, on net,

individuals generally accumulate assets over their working lives suggests that the after-tax returns on savings instruments generally available to the

public will provide a reasonable estimate of the consumption rate of interest.

17 Ibbotson and Sinquefield (1984 and annual updates) provide historical rates of return for various assets and for different holding periods.

18 Lind (1982b) offers some empirical estimates of the consumption rate of interest. Pearce and Ulph (1994) provide the estimates of the

consumption rate of interest for the United Kingdom. Lyon (1994) provides estimates of the shadow price of capital under a variety of assumptions.
Finally, for the shadow price of capital, even less concrete

empirical guidance is available. This parameter depends

on the consumption rate of interest, the gross-of-tax rate

of return on private investment, and the rate of consumption out of net investment returns, among other factors.

Depending on the magnitudes of these factors, shadow

prices from close to one to three, 20, 100, and infinity can

result. Lyon (1990) has an excellent review of how to calculate the shadow price of capital and possible settings for

the various parameters that determine its magnitude.

Moreover, the shadow price of capital adjustment will

require an assessment of the proportion of project costs

that displace private investment. Whether or not this

adjustment is necessary appears to depend largely on

whether the economy in question is assumed to be open

or closed and on the magnitude of the intervention or program considered relative to the flow of investment capital

from abroad.19

6.3.1.5 Guidance for IntraGenerational Social Discounting

For economic analyses of intra-generational policies analysts should apply the consumption rate of interest

approach. There should be no adjustments using the

shadow price of capital unless there are strong reasons to

believe that a particular policy will affect the level of U.S.

private sector investment.20 Based on historical rates of

return on relatively risk-free investments, adjusted for

taxes and inflation, a consumption rate of interest measured at two to three percent is justified.

OMB's own guidance on discounting21 currently recommends discounting using a rate of seven percent, an estimate of the average real pre-tax rate of return generated by

private sector investments. EPA economic analyses therefore should provide estimates of the present values of costs

and benefits using both a two to three percent rate and

OMB's guidance on discounting. In some cases, a sensitivity analysis at discount rates within this range may provide

useful information to decision makers. 

In addition, all analyses should present the undiscounted

streams of benefits and costs. This is not equivalent to calculating a present value using a discount rate of zero. In

other words, the flow of benefits and costs should be displayed rather than a summation of values.

6.3.2 Inter-Generational Social

Discounting

This section focuses on social discounting in the context of

policies with very long time horizons involving multiple

generations. Policies with potential inter-generational

impacts include global climate change, radioactive waste

disposal, groundwater pollution, and biodiversity. Because

of potentially large or catastrophic impacts on unborn generations and because policies with very long time horizons

often involve high costs imposed by current generations,

there is less agreement in the literature on the appropriate

approach to discounting over very long time horizons.

This section attempts to present a balanced discussion of

alternative points of view. The discussion first focuses on

how the point of departure for inter-generational discounting differs in some very fundamental ways from that of

intra-generational social discounting. Next, various

approaches for deciding whether and how to discount

when evaluating inter-generational policies are reviewed.

Finally, the section concludes by summarizing the advice

offered by the economics literature and EPA's new guidelines for inter-generational social discounting.

48

Chapter 6: Social Discounting

19 Studies suggesting that increased U.S. government borrowing does not crowd out U.S. private investment generally examine the impact

of changes in the level of government borrowing on interest rates. The lack of a significant positive correlation of government borrowing and interest

rates is the foundation of this conclusion. Because changes in yearly U.S. government borrowing during the past several decades have been in the

many billions of dollars, it is reasonable to conclude that EPA programs and policies costing a fraction of these amounts are not likely to result in significant crowding out of U.S. private investments.

20 As the estimation of the shadow price of capital can be a costly exercise, analysts should use a value-of-information approach to determine whether it is worthwhile to pursue a quantitative assessment of the effects of private capital displacement. Should a quantitative assessment be

undertaken, the analysis should include a sensitivity analysis of alternative assumptions regarding the degree of crowding out.

21 OMB Circular A-94, "Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs," October 29, 1992 (note: see updates

to cost-effectiveness rates—most recent released in January 2000, http://www.whitehouse.gov/OMB/circulars/a094/a094.html (accessed 8/28/2000))

and U.S. Office of Management and Budget, Guidelines to Standardize Measures of Costs and Benefits and the Format of Accounting Statements,

report M-00-08, March 22, 2000,.http://www.whitehouse.gov/media/pdf/m00-08.pdf (accessed 8/28/2000).
6.3.2.1 Analytical Foundation of InterGenerational Social Discounting

One obvious problem with long-time-horizon policies is

that many of the people affected are not alive. Hence,

while the preferences of each affected individual are knowable (if probably unknown in practice) for intra-generational social discounting problems, they are essentially

unknowable for those involving future generations not yet

born. This is not always a severe problem for practical

policymaking, especially when policies impose relatively

modest costs and benefits, or when the benefits begin

immediately, or in the not too distant future. And most of

the time, it suffices to assume that future generations will

have preferences much like those of present generations.

The more serious challenge posed by long-time-horizon

situations arises primarily when costs and benefits of an

action or inaction are very large and are distributed asymmetrically over vast expanses of time. Here, the crux of

the problem is that future generations are not present to

participate in making the relevant social choices. Instead,

these decisions will be made only by existing generations.

Social discounting in these cases can no longer be thought

of as a process of consulting the preferences of all affected

parties concerning their valuation today of effects they will

experience in different time periods.

Moreover, compounding interest over very long time horizons can have profound impacts on the inter-generational

distribution of welfare. An extremely large cost far enough

in the future has essentially zero present value when discounted at even a low rate. But a modest sum invested

today at the same low interest rate also can grow to a staggering amount given enough time. Therefore, mechanically discounting very large distant future effects of a policy

without thinking carefully about the ethical implications is

not advised.

6.3.2.2 Perspectives on InterGenerational Social Discounting

The social discounting literature contains many different

perspectives on social discounting in inter-generational

contexts. This section briefly describes the major

approaches and their theoretical motivations. The focus in

this discussion is on the social discount rate itself, so such

other issues as the shadow price of capital adjustments,

while clearly still relevant under certain assumptions, are

kept in the background.

Social Welfare Planner Approach

One popular recommendation is that social discounting

for inter-generational policies should be based upon methods economists have used for many years in optimal

growth analyses. In these models, the policy maker is

understood to be maximizing the utilities of all present

and future generations using a well-defined social welfare

function.22

In optimal growth models, the social rate of discount generally equals the sum of two factors. One is a discount

rate for pure time preference, which measures the degree

to which the social planner favors the utility of current and

near future members of society over that of individuals in

the more distant future. The other is an adjustment

reflecting the fact that the marginal utility of consumption

will decline over time as consumption per capita increases

(equal to the elasticity of marginal utility multiplied by the

rate of increase of consumption over time).

If the world actually corresponded to the theoretical construct of an optimal growth model and there were no taxes

or other distortions, the social discount rate as defined in

these models would be equal to the market interest rate.

And, the market rate of interest, in turn, would also be

equal to the social rate of return on private investments

and the consumption rate of interest. But because the

world contains many distortions, and is not likely to conform to the conditions that characterize optimal growth

models, the social rate of discount is not observable in the

economy.

Recent practical applications of this approach to very-longtime-horizon analyses have therefore attempted to

estimate the social discount rate by constructing it from its

components. Most assume that the rate of pure time

discount is zero, adhering to the ethical precept that the

policy maker ought not to inherently favor present

generations' consumption over that of future generations.

For the other component of the social discount rate,

49

Chapter 6: Social Discounting

22 Key literature on this topic includes Arrow et al. (1996), Lind (1994), Schelling (1995), Solow (1992), Manne (1994), Toth (1994), Sen

(1982), Dasgupta (1982), and Pearce and Ulph (1994).
hypothetical, but perhaps plausible, estimates of the

elasticity of marginal utility and the rate of growth of

consumption over time are introduced. The product of

these two factors is the implied social discount rate. This

computational procedure in essence derives an implied

social rate of discount under the assumption that future

generations will be richer than current generations, so that

the marginal utility of consumption is projected to fall over

time. Rates developed using this technique generally

range from one-half percent to three percent.23

Optimal growth modeling, however, is only one strand of

the substantial body of research and writing on intertemporal social welfare maximization and optimal growth.

This literature extends from the economics and ethics of

inter-personal and inter-generational wealth distribution,

to the more specific environment-growth issues raised in

the "sustainability" literature, and even to the appropriate

form of the social welfare function, e.g., utilitarianism or

Rawls' maxi-min criterion.

Clearly, economics alone cannot provide definitive guidance for selecting the "correct" social welfare function or

the social rate of time preference. Nevertheless, economics can offer a few insights concerning the implications

and consequences of alternative choices and some advice

on the appropriate and consistent use of the social welfare

function approach as a policy evaluation tool.

Approaches Based on Existing Individuals'

Preferences

The major alternative to the social welfare planner

approach for inter-generational discounting is to rely on

the preferences of current individuals for an appropriate

discount rate. At its core, this perspective rejects the view

that the problem is one of balancing the interests of all

humans who will live now and in the future. Instead,

according to this perspective, it is fundamentally about

individuals alive today allocating their scarce resources to

competing ends, one of which happens to be the welfare of

future generations. Several specific approaches fall into

this category. 

Consumption rate of interest/infinitely-lived

individuals: Although not popular in theoretical

terms, in practice it is common to adopt the approach

of simply making no great distinction between intergenerational and intra-generational social discounting. Models of infinitely-lived individuals, for example, suggest the consumption rate of interest as the

social discount rate. But the assumption that people

live forever is contrary to the fact that individuals

actually do not live long enough to experience distant

future consequences of a policy and to report today

the present values they place on those effects. As

such, models of infinitely-lived individuals essentially

ignore the fundamental problem posed in evaluations

of policies that affect distant future generations.

Inter-generational discounting vs. time discounting: Another suggestion for social discounting

in inter-generational contexts is to examine possible

differences between how current individuals evaluate

the welfare of their descendants versus how they discount their own future consumption.24 It is possible

that the year-by-year exponential time discounting 25

that underlies an individual's allocation of his or her

own consumption in the present and the future does

not apply to this individual's valuation of his or her

descendant's welfare. That is, a person might indeed

value future generations' consumption less than his

or her own current and future consumption, but not

as low as would be implied by standard discounting

techniques. An individual's present valuation of the

consumption of successive future generations might

decline gradually and approach some constant positive value, so that the value of a unit of consumption

by a person 10 generations from the present might be

considered to be the same as a unit of consumption

by a person 11 generations from now.

A related line of reasoning suggests that large-scale

catastrophic consequences in the future are viewed

differently than marginal changes in welfare, so that it

matters little whether these possibilities are 100 years

50

Chapter 6: Social Discounting

23 See IPCC (1996), pp. 131-132.

24 Sources discussing this approach include Rothenberg (1993), Cropper et al. (1992), Shefrin and Thaler (1988), Thaler (1985), and

Cowen and Parfit (1992).

25 Exponential time discounting applies discounting factors to future values that increase as the time between the present and the future

when those values will be experienced increases. As a result, the present value of a benefit to be enjoyed 50 years from now is much higher than the

present value of the same benefit if it accrues 100 years from now.
or 1,000 years in the future. If so, applying exponential, or year-by-year, time discounting to such

future consequences is inappropriate.

Revealed/stated preferences for altruism:

According to this view, environmental policies that

affect distant future generations are considered to be

altruistic acts.26 As such, they should be valued by

current generations exactly the same as other acts of

altruism. Hence, the discount rate in question is not

that applied to an individual's consumption, but

instead that applicable for an individual's valuation of

the consumption or welfare of someone else.

At least some altruism is apparent from international

aid programs, private charitable giving, and bequests

within overlapping generations of families. But the

evidence suggests that the importance of other people's welfare to an individual appears to grow weaker

with temporal, cultural, geographic, and other measures of "distance." The implied discount rates that

survey respondents appear to apply in trading off

present and future lives are also relevant under this

approach. One such survey (Cropper, et al., 1992)

suggests that these rates are positive on average, consistent with the rates at which people discount monetary outcomes, and decline as the time horizon

involved lengthens.

Opportunity cost of alternatives: A variety of perspectives in the inter-generational discounting literature converge on the broad notion that devoting

resources to long-time-horizon environmental projects—largely because low discount rates appear to

make these attractive in present value terms—neglects numerous other social investment opportunities

with higher values.27

Advocates of this point of view point to numerous

alternative social investments that would generate far

larger benefits now and in the future, such as basic

infrastructure, education, medical assistance, and

other projects in developing nations.

Depending on the context, this point of view is often

expressed in two different ways: (1) many other

investments would be more beneficial to society and

so long-time-horizon environmental programs face

very high opportunity costs, and (2) the rates of

return offered by these alternative investments are

high and these rates ought to be used as the social

rate of discount.

As noted earlier in the context of intra-generational

social discounting, the first statement of this opportunity cost argument is the correct one, the second is

somewhat problematic. The opportunity costs of

alternative government or private investment programs are appropriately measured by calculating their

present values using the social rate of discount. If

these projects have higher rates of return than the

social discount rate, their social present values will

also be high. But this does not imply that the social

rate of discount itself ought to be set equal to some

alternative project's rate of return. For example, an

alternative project might offer a very large rate of

return for only one year, but this should not become

the social rate of discount for very-long-time-horizon

projects and policies.

Paretian compensation tests: One final approach

for social discounting in an inter-generational context

returns to the theoretical motivation and ethical

underpinnings of intra-generational social discounting. This approach views social discounting in intergenerational contexts as a question of whether the

distribution of wealth among many different generations could be adjusted in order to compensate the

losers under an environmental policy and still leave

the gainers better off. Whether gainers could compensate losers hinges on the rate of interest at which society (the U.S. presumably or perhaps the entire world)

can transfer wealth across hundreds of years. Some

argue that in the U.S. context, a good candidate for this

rate is the federal government's borrowing rate.

What lies at the foundation of this approach is the

goal of maintaining overall inter-generational equity.

The implicit assumption is that society starts from a

position at which the distribution of wealth across

present and future generations is "acceptable." Then

51

Chapter 6: Social Discounting

26 Schelling (1995) and Birdsall and Steer (1993) are good references for these arguments.

27 Many authors cite high opportunity costs of public investments. Among these are Birdsall and Steer (1993), Nordhaus (1993), Schelling

(1995), and Lyon (1994).
it is discovered that some current environmental

action or inaction will impose large burdens on future

generations. To maintain inter-generational equity,

some sort of accumulation fund is necessary to provide compensation for those harms.

While this approach offers solid advice for selecting a

social discount rate for inter-generational policy

evaluation, its resolution of the many difficult social

choice problems posed by such policies rests on two

critical assumptions. One is that the initial

distribution of inter-generational wealth is socially

acceptable. If this is not the case, it is not clear that

attempting to maintain that distribution after

discovering the long-term environmental problem is

an appropriate goal.

Second, if the compensation fund is not accumulated,

then the decision not to remedy this environmental

problem is once again recast as an inter-generational

equity problem, not a question purely of economic

efficiency. There is considerable skepticism regarding

the willingness of the current generation to provide

these compensation funds and a significant concern

that intervening generations might not continue the

accumulation process. Thus, actually undertaking

the process of locking away sufficient savings for distant future generations to compensate them for environmental harms is a very different matter than

determining the rates of interest at which such a fund

might grow.

6.3.2.3 Summary of Advice from the

Economics Literature

There is little consensus in the economic literature on social

discounting for inter-generational policies. In particular, the

fundamental choice of what moral perspective should guide

inter-generational social discounting—a social planner who

weighs the utilities of present and future generations, the

preferences of the current generations regarding future generations, or perhaps other approaches—cannot be made on

economic grounds alone.

It is important, however, to view this result in the proper

context. In fact, the practical effect of this lack of consensus concerning social discounting for inter-generational

policies is not as profound as it at first appears. The major

problems with discounting in long-time-horizon contexts

occur in probably a few cases out of a vastly larger set, particularly where costs and benefits are inherently high and

are substantially divorced in time. But the environmental

policies that fit this description are uncommon because

most environmental programs are relatively short in duration and reversible, with their time frames determined

largely by capital investments.

6.3.2.4 Guidance for InterGenerational Social Discounting

Based on the theoretical social discounting literature and

other considerations, economic analyses of policies with

inter-generational effects should generally include a "no

discounting" scenario by displaying the streams of costs

and benefits over time. This is not equivalent to calculating a present value using a discount rate of zero (i.e., the

flow of benefits and costs should be displayed rather than

a summation of values).

Economic analyses should present a sensitivity analysis of

alternative discount rates, including discounting at two to

three percent and seven percent as in the intra-generational

case, as well as scenarios using rates in the interval one-half

to three percent as prescribed by optimal growth models.

The discussion of the sensitivity analysis should include

appropriate caveats regarding the state of the literature with

respect to discounting for very long time horizons.

6.4 Discounting and

Non-Monetized Effects

Despite analysts' best efforts to assign monetary values to

all of the consequences of an environmental policy, there

are instances in which monetization is not feasible. This

section briefly explores social discounting when some elements are not expressed in monetary terms.28

52

Chapter 6: Social Discounting

28 Although this discussion focuses exclusively on non-monetized benefits, many cost categories are often not monetized as well. The time

costs consumers experience as a result of some policies, the financial costs of business delays that result from others, and the quality and performance impairments caused by yet other policies often are not monetized in economic analyses. Discounting policy regarding these non-monetized

effects should largely track discounting practices for monetized costs unless there are reasons for not doing so, similar to those described in this section, for leaving some non-monetized benefits undiscounted.
6.4.1 Perspectives on

Discounting Non-Monetized

Effects

One strategy for addressing future non-monetized effects is

to discount them as though they had been monetized.

Some argue, however, that environmental benefits that

have not been monetized cannot—or should not—be discounted and summarized together with costs in a costeffectiveness or benefit-cost summary. Two basic lines of

reasoning are normally offered. One is that because discounting is essentially a financial process designed to evaluate investment decisions, it is only relevant to dollardenominated streams, and so benefits that are in physical

rather than dollar terms cannot be discounted.

Discounting some types of benefits, such as avoided damages to human lives or natural resources, treats these tangible risk-related benefits as monetary outcomes, when

they are not in fact financial consequences.

The other line of reasoning for not discounting non-monetized benefits is that it is ethically unacceptable to discount

physical units. If, for example, cancer cases that occur in

the future are discounted to the present, this effectively

asserts that a future cancer case is not really a cancer

case, but rather is only 80 percent, 20 percent, or some

other fraction of a "full" current cancer case. Discounting

therefore somehow cheapens the future effect's value or

reduces its importance and is unfair to future individuals

or generations whose lives or natural resources are at

stake. This argument is often applied not only to human

health and environmental effects that are simply enumerated, but also to those that are monetized.

Evaluating these arguments requires a clear understanding

of the various reasons why benefits might not be monetized in any given analysis. In some cases, benefits are not

monetized because the environmental and health impacts

may be unknown, so that only changes in emissions, production, exposure, or other imperfect proxies for benefits,

damages, or harms, are available. Sometimes there may

be an estimated time stream of human health and environmental impacts, but the needed valuation tools and

information on how to monetize the benefits are not—or

are only partially—available. Finally, in still other cases,

physical effects have been estimated and could be monetized, but this last step—converting measured physical

effects into dollar values of benefits—has simply not been

taken.

6.4.2 When Discounting NonMonetized Effects Is Appropriate

In many cases, quantitative information on the time

streams of physical effects is available and these effects are

measured in terms of human health consequences and

ecosystem damages that correspond to endpoints that are

normally monetized. If so, then these non-monetized

benefits ought to be discounted if monetized costs and

benefits are discounted. Discounting non-monetary effects

in these cases is not inherently different from discounting

these units after attaching a unit value in dollar terms.

What is being conveyed is the notion that effects felt farther in the future are worth less in today's terms than

those that occured earlier in time. Thus, if two policies

have identical current costs and the same amount of benefits in the future except that one produces these benefits

earlier in time, the policy that offers earlier benefits will

have a higher social value.

Choosing not to discount non-monetized benefits can have

perverse consequences. First, to the extent that the act of

discounting and the choice of discount rate embody a

rational investment criterion, failing to discount non-monetized benefits may produce results that appear to be irrational or intrinsically unappealing. Suppose, for example,

there is a policy that is estimated to save five lives in the

year it is implemented. This policy can either be implemented today (Option A) or 20 years from now (Option

B), and the undiscounted costs in current dollars are the

same for both options. If the discounted costs are compared with undiscounted benefits, a cost-effectiveness evaluation will clearly favor Option B. Thus, failing to discount

benefits can produce a situation in which society has little

motive to pursue current environmental benefits because

by investing instead, larger net environmental benefits can

be gained in the more distant future.

Finally, surveys that examine individuals' attitudes toward

public policies with non-monetized benefits suggest that

people do appear to apply a positive discount rate to these

future effects. For example, contingent valuation studies

(Cropper et al., 1992; Carson et al., 1987; Horowitz and

Carson, 1990) that look at individuals' preferences for

53

Chapter 6: Social Discounting
saving lives find that individuals prefer projects that save

lives in the near term over equivalent cost projects that

save lives in the future.

6.4.3 When Discounting NonMonetized Effects Might Not Be

Appropriate

While there are many cases in which non-monetized benefits can and should be discounted along with all of the

other costs and benefits of environmental policies, there

are others in which benefits are not monetized for reasons

that pose more significant problems for discounting.

Specifically, sometimes the available measures of benefits

are very poor proxies for ultimate damages, making it difficult to discount them correctly.

When an analysis stops far short of the physical effects that

are good proxies for damages, the relationship between

harms and emissions—or other relevant physical measures—might be poorly understood. In the case of the

greenhouse effect, for example, the ultimate impact of a

ton of greenhouse gas emitted in a given year depends on

the subsequent change in the time paths of temperature,

sea level, and other variables, and on the physical effects

and economic impacts accompanying these changes.

Changes in temperature depend, in turn, on the magnitude of emissions of all greenhouse gases over time and

their radiative forcing. Further, the impacts of climate

change may depend not only on the absolute levels of

these effects, but on the rate at which they occur. Because

linking quantified physical harms to a unit of emissions is

a difficult task, discounting greenhouse gas emissions

would be a premature and problematic step in determining the cost-effectiveness of two alternative emission

reduction strategies.

Similarly, even when benefit estimates are based on linkages from emissions to other physical and biological endpoints, often these benefit measures are still not close

enough to the endpoints of ultimate concern to allow discounting. For example, although pollution damages can

be measured in terms of species diversity, ecosystem

health, and forest productivity, the further detailed linkages

from those damages to current and future recreation, production, non-use, or other values identified by economists

and ecologists often do not exist.

Discounting non-monetized effects is also not warranted

when doing so actually conceals information of value to

policy makers. For example, suppose a policy reduces

current and future effluent discharges to a river. Suppose

further that this river has a complex chemistry, so that

interactions between the effluent reduced by this environmental policy and other natural and human inputs to the

river are unknown and/or the relationship between effluent discharges and damages is nonlinear (e.g., the river is

subject to degradation only after passing some threshold).

Here, the same quantities of effluent reduction in different

time periods are not necessarily identical in their effects,

so not only is there a time element to contend with, but

also possible differences in ultimate environmental benefits. In this case it might be far more useful to display the

stream of effluent reduction and probabilities of exceeding

thresholds each year, rather than to discount all of the

future effluent reduction.

In all of these examples, the problem is that analysts have

an incomplete understanding of the relationship between

emissions—and production or other physical units that

are potentially subject to control—and the actual harm to

human health or the environment that result. However, a

general preference for earlier benefits over later ones still

applies. The problem is that discounting in these cases

masks important information by implicitly assuming that a

unit of benefits in one period has an identical effect on the

ultimate benefit consequences of concern as a unit of the

same benefit in another period. When non-monetized

benefits measures are far from the human health and

other benefit categories of true concern, this assumption

often is contrary to reality.

When it is not appropriate to discount certain non-monetized benefits, comparisons of costs and benefits can still

be made without directly discounting the benefits. For

example, if costs and benefits occur in each time period

over the course of a policy, and these do not change significantly over time, net social benefits can be explored without discounting by examining a representative year's costs

and benefits. Similarly, if the benefits are relatively constant through time, but the costs are not, the costs can be

annualized and compared to the annual benefits using

cost effectiveness analysis. Another approach is to cumulate costs forward with interest to compare this future

value to the benefits, a method that is particularly suitable

when the benefits occur in only one future year. If none of

54

Chapter 6: Social Discounting
these methods applies, simply presenting the streams of

costs and monetized and non-monetized benefits to policy

makers is often sufficient.

55

Chapter 6: Social Discounting
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Lyon, R. M. 1990. Federal Discount Rate Policy, the Shadow Price of Capital, and Challenges for Reforms. Journal of

Environmental Economics and Management 18(2): 29-50.

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Lyon, R. M. 1994. Intergenerational Equity and Discount Rates for Climate Change Analysis. Paper presented at IPCC

Working Group III Workshop on Equity and Social Considerations Related to Climate Change, 18-22 July, Nairobi, Kenya.

Manne, A. S. 1994. The Rate of Time Preference: Implications for the Greenhouse Debate. In Integrative Assessment of

Mitigation, Impacts, and Adaptation to Climate Change, edited by N. Nakicenovic, W.D. Nordhaus, R. Richels, and F.L.

Toth. Laxenburg, Austria: International Institute for Applied Systems Analysis (IIASA).

Nordhaus, W. D. 1993. Reflections on the Economics of Climate Change. Journal of Economic Perspectives 7(4): 11-25.

Pearce, D. W. and R. K. Turner. 1990. Discounting the Future. Chapter 14 in Economics of Natural Resources and the

Environment. Baltimore, MD: The Johns Hopkins University Press.

Pearce, D. W. and D. Ulph. 1994. A Social Discount Rate for the United Kingdom. Mimeo No. 95-01, Centre for Social and

Economic Research on the Global Environment, University College London and University of East Anglia, UK.

Rothenberg, J. 1993. Economic Perspectives on Time Comparisons: Evaluation of Time Discounting. In Global Accord:

Environmental Challenges and International Responses, edited by C. Nazli. Cambridge, MA: MIT Press.

Schelling, T. C. 1995. Intergenerational Discounting. Energy Policy 23(4/5): 395-401.

Scheraga, J. D. 1990. Perspectives on Government Discounting Policies. Journal of Environmental Economics and

Management 18(2): 65-71.

Sen, A. K. 1982. Approaches to the Choice of Discount Rates for Social Benefit-cost Analysis. Chap. 9 in Discounting for

Time and Risk in Energy Policy, edited by R. C. Lind. Washington, D.C.: Resources for the Future.

Shefrin, H. M. and R. H. Thaler. 1988. The Behavioral Life-cycle Hypothesis. Economic Inquiry XXVI(October): 609-43.

Solow, R. 1992. An Almost Practical Step Toward Sustainability. Paper presented at the Fortieth Anniversary of Resources

for the Future, 8 October, in Washington, D.C.

Thaler, R. 1985. Mental Accounting and Consumer Choice. Marketing Science 4(3): 199-214.

Toth, F. L. 1994. Discounting in Integrated Assessments of Climate Change. In Integrative Assessment of Mitigation,

Impacts, and Adaptation to Climate, edited by N. Nakicenovic, W.D. Nordhaus, R. Richels, and F.L. Toth. Laxenburg,

Austria: International Institute of Applied Systems Analysis (IIASA).

U.S. Environmental Protection Agency. 1995. Regulatory Impact Analysis of Proposed Effluent Limitations Guidelines

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U.S. Office of Management and Budget. 1992. Guidelines and Discount Rates for Benefit-Cost Analysis of Federal

Programs. OMB Circular A-94, October 29, 1992. http://www.whitehouse.gov/OMB/circulars/a094/a094.html (accessed

8/28/2000).

U.S. Office of Management and Budget. 2000. Guidelines to Standardize Measures of Costs and Benefits and the

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(accessed 8/28/2000).

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Chapter 6: Social Discounting
7.1 Introduction to

Analyzing Benefits

At its roots, benefits analysis develops monetary values to inform the policy making process. These values are important because they allow decision makers to directly compare costs and benefits using the

same measure (i.e., dollars). A complete benefits

analysis is also useful because it makes explicit the

assumptions about the value of benefits embedded in

different policy choices. This chapter focuses on

those benefits that can be expressed in terms of dollars. Chapter 10 discusses the presentation of nonmonetized benefits, those that cannot be expressed in

dollar terms.

This chapter presents information on the theory and

practice of benefits assessment for environmental

policies. The discussion focuses on the benefits possible from a "typical" EPA policy or regulation that

reduces emissions of contaminants into the environment. However, the principles discussed here apply

to other types of EPA policies, such as those that provide information or regulatory relief.

Most EPA benefits analyses face two serious challenges. First, a given policy may produce many different benefits, but it is seldom possible to obtain a

single, comprehensive value estimate for the collection of effects. This will often leave analysts with no

alternative but to address these effects individually,

aggregating values to generate an estimate of the total

benefits of a policy alternative. Although there are

exceptions to this "effect by effect" process for benefits analysis, much of the discussion in this chapter

assumes that analysts will be forced to adopt this

approach.

The second major challenge faced by analysts is the

difficulty of conducting original valuation research in

support of specific policy actions. Because it is often

too expensive or time consuming to perform original

research, analysts will need to draw upon existing valuation estimates for use in benefits analysis. The

process of applying these estimates to value the consequences of policy actions is called benefits

transfer. Although the benefit transfer method is

detailed in only one section, this chapter is generally

written with benefit transfer in mind. For example,

the descriptions of valuation methods in Section 7.5

include recommendations for assessing the quality of

published studies. This is done to help analysts

determine which studies deserve consideration for

use in benefit transfers.

While analysts should always seek precision, they

must make assumptions and exercise professional

judgment to face the challenges noted above, as well

as numerous others that arise in a benefits analysis.

Existing value estimates, for example, are often subject to large uncertainty bounds due to measurement

error, model uncertainty, and the inherent variability

of individual preferences. When drawing from these

studies—and when using quantitative estimates of

any kind—analysts should carefully assess the quality of the data and should clearly state the reasons for

their analytical choices. As with any analytical exercise, the maxim "garbage in, garbage out" always

applies.

The next section briefly summarizes the conceptual

economic framework for benefits analysis. Section

7.3 outlines the effect-by-effect process for benefits

analysis, including some general implementation

principles. The fourth section defines and describes

the types of benefits associated with environmental

policies, followed by a review of available economic

valuation methods in Section 7.5. This chapter

59

Chapter 

7

Chapter 7: Analyzing Benefits
concludes with specific recommendations for valuing types

of benefits that are common to many EPA policies.

7.2 A Conceptual

Framework for Benefits

Analysis

This section describes the theoretical economic foundation

for valuing benefits. The theoretical discussion here

serves as a conceptual starting point for benefits estimation—it is not a full and comprehensive treatment of welfare economics. The section includes a discussion of willingness to pay, consumer surplus, and analytical problems

arising from the lack of markets for environmental

improvements. References are provided for further reading on the specific topics introduced in this section, but

useful texts for general reference include Just et al.

(1982), Braden and Kolstad (1991), and Freeman (1993).

Boardman et al. (1996), Brent (1995) and Hanley and

Spash (1993) are useful, general references for benefitcost analysis.

7.2.1 Welfare Measures:

Willingness to Pay and

Willingness to Accept

Compensation

Economists define benefits by focusing on measures of

individual satisfaction or well-being, referred to as measures of welfare or utility. Economic theory assumes that

individuals can maintain the same level of utility while

trading-off different "bundles" of goods, services, and

money. For example, one may be equally satisfied by going

fishing or viewing a movie. The tradeoffs individuals make

reveal information about the value they place on these

goods and services.

The willingness to trade off compensation for goods or

services can be measured either as willingness to pay

(WTP) or as willingness to accept compensation (WTA).

Economists generally express WTP and WTA in monetary

terms. In the case of an environmental policy, willingness

to pay is the maximum amount of money an individual

would voluntarily exchange to obtain an improvement (or

avoid a decrement) in the environmental effects of concern. Conversely, willingness to accept compensation is

the least amount of money an individual would accept to

forego the improvement (or endure the decrement).1

WTP and WTA are not necessarily equal. The

amount an individual would be willing to pay to

obtain an environmental improvement is not necessarily identical to the amount he or she would be willing to accept to forego the improvement. One reason

for this difference is that the starting points of the two

measures differ. For environmental improvements,

WTP uses the level of utility without the improvement

as a reference point. WTA, on the other hand, uses as

its reference point the level of utility with the

improvement. Although these two measures are distinct and sometimes differ in practice, under conventional assumptions economists expect that the difference between them will be small in most cases. This

result generally holds as long as the amounts in question are a relatively small proportion of the individual's income. Nonetheless, in the case of environmental goods, some additional considerations modify

this general result. Hanemann (1991) shows that

while this result holds for price changes, it does not

strictly hold for changes in quantity or quality. Also, if

a good has no close substitutes, differences in WTP

and WTA may be large even if the effect on income is

small.

WTP and WTA can also be identified with what

they imply about property rights—whether entities have a right to pollute, so the public must pay

them not to, or whether the public has a right to a

clean environment and must be compensated for pollution. For example, in the case of a policy that

would reduce existing pollution levels, the use of WTP

measures to value benefits implicitly assumes that the

property right rests with the polluting firm. 

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Chapter 7: Benefits

1 In the case of environmental improvements, WTP is identified as the compensating variation measure of welfare change, while WTA in

this case is identified as the equivalent variation measure. For environmental decrements, these associations are reversed. For a more detailed

treatment of welfare measures that includes these issues see Just et al. (1982), Freeman (1993), and Hanley and Spash (1993).
In practice, WTP is generally used to value benefits

because it is often easier to measure and estimate. To

simplify the presentation, we use the term "willingness to

pay" (or WTP) throughout this chapter to refer to the

underlying economic principles behind both WTA and WTP.

Aggregating Individual Willingness to Pay

Measures

The benefits of a policy are the sum total of each affected

individual's WTP for the policy. Because benefit-cost analysis assesses only the efficiency of policy choices, each individual's WTP must be given the same weight in the summation. This means that no individual or group of individuals is given preferential treatment in assessing the efficiency of the program except to the degree that they are

willing to pay for it. As described in Chapter 9, equity

assessments and impact analyses can be used to describe

the effects of policies on populations of concern.

Altruism

While benefits are generally calculated by summing each

individual's WTP for his or her own welfare, there are conditions under which it is appropriate to include altruistic

values, or individuals' WTP for the welfare of others.

Economic theory concludes that if one cares about a

neighbor but respects the neighbor's preferences, and if

the neighbor would have to pay for the policy action being

analyzed, then altruistic benefits should not be counted in

a benefit-cost analysis. The intuition behind this result is

that, if one respects the neighbor's preferences, one cares

about both the benefits and the costs the neighbor faces.

It is therefore inappropriate to add the value one attaches

to the neighbor's benefits without considering the cost

implications of doing so. Comparing individual benefits

and costs in this case is the appropriate decision rule.

Altruistic benefits may be counted either when altruism

toward one's neighbor is paternalistic or when one will in

fact bear the costs of the project but the neighbor will not.

In the first case (paternalistic altruism), one cares about

the benefits the neighbor will enjoy, e.g., from a health or

safety project, but not about the costs the project will

impose on him. An example of the second case would be

a project whose costs are borne entirely by the current

generation; i.e., the project imposes no costs on future

generations. In this case, altruism toward future generations by the current generation could legitimately be

counted as a benefit.

7.2.2 Market Goods: Using

Consumer Surplus and Demand

Curves

Willingness to pay is closely related to the concept of consumer surplus, which is both an individual and an aggregate concept. An individual demand curve indicates the

maximum amount an individual would be willing to pay to

acquire an additional unit of good. These individual

demand curves can then be aggregated into a market

demand curve that provides the cumulative WTP for additional units. Consumer surplus is derived from market

estimates of how much of the good is demanded in the

aggregate at each price and can be easier to estimate than

individual WTP.

A market demand curve for a given good or service traces

out the amounts that consumers will purchase at different

price levels; i.e., their collective WTP for the good or service. Consumer surplus is the excess amount that purchasers are willing to spend on a good or service over and

above that required by the market price (i.e., the area

under the demand curve but above the price line). This

surplus serves as a measure of the social benefits of producing the good. Policies that affect market conditions in

ways that decrease prices will generally increase consumer

surplus. This increase can be used to measure the benefits of the policy.2

The use of demand curves and consumer surplus highlights the importance of assessing how individuals will

respond to changes in market conditions. For example, if

a policy affects the price or availability of a commodity

traded in a market (e.g., if it leads to increases in the commercial fish harvest), multiplying the increased quantity

by current prices generally will not provide an accurate

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Chapter 7: Benefits

2 Technically, consumer surplus serves as a precise measure of benefits only if the demand curve represents a compensated or Hicksian,

demand function. However, Willig (1976) shows that ordinary, or Marshallian, demand curves can often be used to derive an approximate measure

of welfare. The difference in these two types of demand curves is that the former holds utility constant, while the latter holds income constant. More

background on the theoretic basis for welfare measures can be found in several texts including Freeman (1993), Johansson (1993), Just et al. (1982),

and Varian (1992).
Chapter 7: Benefits

62

measure of benefits. Depending on the elasticity of the

demand curve, a one percent price increase may lead to

more (or less) than a one percent increase in the quantity

demanded, affecting the change in consumer surplus.3

While not detailed here, supply curves also vary in elasticity and have an analogous effect on producer surplus.

Information on the elasticity of the supply and demand

curves is needed to estimate benefits in the form of

increases in consumer (and/or producer) surplus.4

7.2.3 Non-Market Goods

One challenge facing analysts of environmental policies is

the lack of a market for most environmental improvements. Because "cleaner air" or "cleaner water" is not

normally bought or sold, market data are generally not

available for benefit valuation. Economists have therefore

developed other methods for eliciting values for these

types of effects. These methods rely either on information

from the markets for related goods (revealed preference

methods) or on direct information on people's preferences

(stated preference methods). Individual WTP values estimated in these studies can be aggregated (or an average

value multiplied by the total number of affected individuals) to produce an estimate of the total benefit for a good

or policy. Section 7.5 provides more information on the

economic foundations of specific methods, and Section 7.6

details how these methods have been—or can be—

applied in benefits analysis.

7.3 The Benefits

Analysis Process

From the perspective of economic theory, an appropriate

measure of a policy's benefits is the sum of individual WTP

estimates for that policy. While it may be possible in some

circumstances to obtain individual WTP estimates for the

entirety of a policy decision, in practice, analysts must

often use an "effect-by-effect" approach for benefit valuation. This section discusses this approach to benefits

analysis, concluding with some general principles to keep

in mind when implementing this approach.

7.3.1 A General "Effect-by-Effect"

Approach

The most widely used approach for estimating the benefits

of a policy option is to evaluate separately the major effects

of a given policy and then sum these individual measures

to arrive at total benefits. This general approach usually

involves describing the physical effects of the pollutants

(e.g., various types of damages to human health and ecological systems) and assessing each type of effect separately. In some cases, it may be desirable and feasible to

diverge from this approach. For example, contingent valuation or other methods could be used to develop estimates

of WTP for the combined effects of the policy change,

reducing the need to identify, quantify, and value each

effect separately. A comprehensive value estimate for the

entire set of effects from a policy change can also be useful

as an indication of the upper bound expected from the

sum of values developed with the effect-by-effect

approach.5 However, because it is difficult to develop estimates of the total value of the pollution reduction and

decision makers are often interested in information on

individual benefit categories, an effect-by-effect valuation

approach is most often used by EPA in economic analyses

of regulations.

The general effect-by-effect approach for assessing the

benefits of environmental policies includes three

components:

Identify potentially affected benefit categories by

developing an inventory of the physical effects that

may be averted by the policies.

3 Elasticity is a measure of relative change. For a given demand curve, price elasticity is defined as the percentage change in quantity

demanded divided by the percentage change in price. Where this value is less than one in absolute value, demand is considered to be "inelastic."

Elasticity values greater than one (in absolute value) indicate that demand is "elastic."

4 It is important to keep in mind that elasticity is a local concept. Generally, one can expect the elasticity of supply and demand curves to

vary along their respective lengths. This means that elasticities measured at a particular point on these curves may not be appropriate for estimating

large changes or changes elsewhere on the curve. In these cases, it may be necessary to characterize the demand and supply functions in the relevant range of prices and quantities.

5 Randall (1991) presents a framework for comparing total value and "independent valuation and summation" and reviews many issues

associated with estimating total values.
Quantify significant physical effects to the extent

possible working with managers, risk assessors, ecologists, physical scientists, and other experts.

Estimate the values of these effects using studies

that focus on the effects of concern or transferring

estimates from studies of similar impacts.

These steps may be implemented using an iterative

process. For example, analysts can begin by conducting

screening analyses using available data and relatively simple assumptions, then collect additional data and refine

the analysis as needed to better inform decision-making.

Each step in this approach is discussed in more detail

below, focusing on the actions that are generally undertaken when conducting benefits analyses for typical EPA policies. However, this guidance is intended to be flexible.

Analysts will need to determine on a case-by-case basis

whether this framework is appropriate for assessing a specific policy, given the effects particular to that policy and

the information needed for related decision-making.

Step1: Identify Potentially Affected Benefit

Categories

The first step in the benefits assessment is to determine

the types of benefits most likely to be associated with the

particular policy. Section 4 of this chapter contains a

detailed presentation of the categories of benefits typically

associated with environmental policies and regulations. To

identify benefit categories, analysts should, to the extent

feasible, do several things:

Develop an initial understanding of policy

options of interest by working with cost analysts

and policy makers. Information should also be collected on the likely range of emissions levels associated with the baseline and with implementation of each

of the policy options. At the outset of the analysis, the

range of options and associated emissions levels considered may be very broad because emissions levels

and preferred policy options can change significantly

in the course of the policy making process.

Research the physical effects of the pollutants

on human health, welfare, and the environment.

This can be done by reviewing the literature and, if

necessary, meeting with other experts. This step

requires considering the transport of the pollutant

through the environment along a variety of pathways,

including movement through the air, surface water

and groundwater, deposition in soils, and ingestion or

uptake by plants and animals (including humans).

Along these pathways, the pollutant may have detrimental effects on natural resources (e.g., affecting oxygen availability in surface water or reducing crop

yields) as well as direct or indirect effects on human

health (e.g., affecting cancer incidence through direct

inhalation or through ingestion of contaminated food).

Consider the potential change in these effects as

a result of possible policy options. If policy options

differ only in their level of stringency, then each

option may have an impact on all identified physical

effects. In other cases, however, some effects may be

reduced while others remain unchanged under a specific policy option. Evaluating how physical effects

change under each policy option requires evaluation

of how the pathways differ in the "post-policy" world.

Evaluate which effects are likely to be significant

in the overall benefit analysis according to at least

three criteria:

— whether there are likely to be observable changes

in the benefits category when comparing the policy options to each other and to the baseline; 

— whether the benefits category is likely to account

for a major proportion of the total benefits of the

policy; and 

— whether stakeholders or decision makers are

likely to need information on the benefits category, even if its magnitude is relatively small.6

The outcome of this initial step in the benefits analysis can

be summarized in a list or matrix that describes the physical effects of the pollutant, identifies the benefits categories

associated with these effects, and an initial ranking of

which effects may be significant enough to warrant further

investigation. 

Initially, the list of benefit categories may be lengthy and

include all effects that reasonably can be associated with

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Chapter 7: Benefits

6 This criteria relates to equity considerations detailed in Chapter 9.
the policy options under consideration. Analysts should

preserve and refine this list of benefit categories as the

analysis proceeds, and the effects that are not assessed in

detail should be discussed qualitatively when presenting

analytic results. In some cases, it may not be feasible to

assess some of the more significant impacts, either

because of insufficient scientific data (e.g., data are lacking

on the effects of changes in pollution levels on the benefit

category of concern) or because the time or resources

needed to assess the effect are high compared to the significance of the benefits category in the decision-making

process. These issues should be discussed when presenting the results of the benefits analysis. The discussion

should address (1) the criteria used to exclude selected

benefit categories from detailed quantitative analysis, (2)

the likely magnitude of the non-quantified benefits, and

(3) the extent to which these effects are or are not important considerations for the decision-making process.

Step 2: Quantify Significant Physical Effects

The second step is to quantify the physical impacts related

to each category. Data are usually needed on the extent,

timing, age distribution of the affected population, and

severity of the effects. The focus should be on the changes

attributable to each policy option in comparison to the

baseline. For example, if the risk of lung cancer is one of

the effects of concern, data may be needed on the changes

in risk associated with each option, the timing of the risk

reductions, the age distribution of those experiencing the

risk reductions, and the percentage of cases likely to be

fatal. If visibility is a concern, data may be needed on the

geographical areas affected and the change in visibility levels attributable to each policy option.

Work closely with analysts in other fields.

Estimating these impacts is largely, but not completely, the domain of other scientists, including risk assessors, ecologists, and other experts. These experts are

generally responsible for evaluating the likely transport of the pollutant through the environment and its

potential effects on humans, ecological systems, and

manufactured materials under the baseline and each

policy option. The principal role of the economist is

to communicate with these experts in order to ensure

that the information provided is adequate to support

the benefits analysis, including information on the

uncertainty associated with the estimates of physical

impacts. However, economists may also be able to

provide insights, information, and analysis on behavioral changes that can affect the results of the risk

assessment.

Try to match the risk assessment and economic

endpoints. A key consideration in this interaction is

that the endpoints quantified and described in the

risk assessment match well the effects for which economic valuation is feasible. Effects that are described

too broadly or that cannot be associated with economic welfare will limit the ability of the analysis to capture the full range of benefits associated with policy

options. It is difficult, for example, to produce an

economic measure of the benefits associated with a

reduction in the number of persons exposed to a contaminant at a particular level. If, however, the risk

assessment can produce an estimate of the reduction

in the number and type of adverse health effects from

exposure, then the economic valuation exercise is much

more feasible. This means that the analyst must be

aware of the available economic data and tools when

working with risk assessors and other scientists.

Describe qualitatively effects that cannot be

quantified. It will not be possible to quantify all of

the significant physical impacts for all policies. For

example, animal studies may suggest that a contaminant causes severe illnesses in humans, but the data

available may not be adequate to determine the number of expected cases associated with different human

exposure levels. Likewise, it is often not possible to

quantify all the ways in which an ecosystem may

change as a result of an environmental policy. In

these situations, the effect should be described qualitatively when presenting the results of the benefits

analysis. Analysts should also assess the implications

of not being able to include this effect in quantitative

benefits estimates.

EPA has developed extensive guidance on the assessment

of human health and ecological risks and analysts should

refer to those documents and the offices responsible for

their production and implementation for further

64

Chapter 7: Benefits
guidance.7 No specific guidance exists for assessing changes

in materials damages or amenity effects. Analysts should

consult relevant experts and existing literature to determine

the "best practices" appropriate for this type of analysis.

Step 3: Estimate the Values of the Effects

Once information on the physical effects of the pollutant is

available, the next step is to assess the value of related

benefits based on estimates of individual WTP. As discussed earlier, no market exists for many of the types of

benefits anticipated from environmental regulation. In

most cases, analysts will need to rely upon the results of

other methods for estimating economic values. Details on

these methods and examples of how they may be applied

can be found in Sections 7.5 and 7.6, respectively. 

Consider using more than one method to

estimate benefits. Different methods often address

different subsets of total benefits and the use of

multiple methods allows for comparison of alternative

measure of value. Double-counting is a significant

concern when applying more than one method,

however, and any overlap should be noted in

presenting the results. In addition, some

components of the total value of benefits may not be

amenable to valuation and will need to be described

in other terms when presenting the analytic results.

The discussion of benefit transfer in Section 7.5

describes many of the issues involved in applying

values from one study to another situation.

Describe the source of estimates and confidence

in those sources. Valuation estimates always contain a degree of uncertainty. Using them in a context

other than the one in which they were initially estimated can only increase that uncertainty. If many

high-quality studies of the same effect have produced

comparable values, analysts can have more confidence in using these estimates in their benefits calculations. Some specific benefit transfer methods

described in Section 7.5 provide a systematic manner

of combining multiple estimates. In other cases, analysts may have only a single study—or even no directly comparable study—to draw from. In all cases, the

presentation of the benefits analysis should clearly

describe the sources of any values used, along with

some assessment of the confidence associated with

those sources.

7.3.2 Implementation Principles

When applying this framework to assess the benefits of

specific policies, analysts should keep in mind the following general principles:

Focus on key issues. Resources should be focused

on benefit categories that are likely to influence policy

decisions. To use time and resources effectively, analysts must weigh the costs of conducting additional

analysis against the usefulness of the additional information provided for decision-making. The analysis

should devote significant time and resources to carefully assessing those benefits categories that are likely to

influence the selection among policy options. In some

cases, relatively simple screening analyses may provide

adequate information on these benefits. Additional

data collection may not be warranted because it is

unlikely to lead to significant changes in the conclusions of the analysis. For example, screening using a

broad range of values for selected effects may indicate

that a policy is clearly worth pursuing and analysts may

conclude that any possible refinements to the analysis

are likely to simply reinforce this conclusion. In this

case, the analyst should discuss the approach taken and

note that the benefits estimate may represent a lower

bound. Likewise, some categories of benefits may not

be assessed either because they are expected to be

small or because the costs or time needed to quantify

them far exceed the time or resource levels appropriate

for analysis of the particular policy. 

Applying this approach to benefits assessment

involves first conducting scoping analyses to collect

available information on the potential benefits of the

policies and using this information to develop

65

Chapter 7: Benefits

7 In September 1986, EPA published final risk assessment guidelines for a number of health effects, including Guidelines for Carcinogen

Risk Assessment, which are currently under revision. Many other risk-related guidelines have been published, revised, and updated since 1986.

Recent additions include Guidelines for Exposure Assessment (EPA, 1992) and Guidelines for Reproductive Toxicity Risk Assessment (EPA, 1996).

More information on these and other guidelines, as well as electronic copies of the documents themselves, can be found on the home page of EPA's

National Center for Environmental Assessment at http://www.epa.gov/nceawww1/raf/rafguid.htm (accessed 8/28/2000).
preliminary estimates (see, for example, Morgan and

Henrion,1990). The results from this initial

screening analysis can then be used to inform the

early stages of the policy development process and to

focus future research on those areas most in need of

further assessment. In many cases, it may be useful

to use benefits transfer techniques in the initial stages

of the analysis, as discussed later in this chapter.

Coordinate frequently with others involved in

developing the policies. Ongoing coordination with

the analysts responsible for assessing costs and economic impacts, and with the work group considering

policy options is crucial to ensure consistency as the

policy options and analyses evolve. This coordination

should begin in the planning stages of the analysis, and

should continue throughout the development process.

Successful efforts often involve informal conversations

among lead analysts several times each week, supplemented by larger and more formal periodic meetings

to report on progress and discuss next steps.

Coordination will help ensure that the cost and benefit results are comparable and based on consistent

baseline and policy assumptions. In addition, information from the cost analysis is often needed for the

analysis of benefits and vice versa. For example, if a

policy requires firms to install new pollution controls,

benefits analysis requires information on the number

of facilities likely to install each type of control and

the associated reduction in emissions. On the other

hand, where a performance standard is being considered, the cost analysis may need data from the risk

models in considering which controls are likely to

meet the standard.

Consider changes in behavior. The use of an

effect-by-effect approach does not necessarily mean

that one should simply value benefits by estimating

the physical changes attributable to changes in pollution emission levels (e.g., increases in the fish population) then assigning a unit value to these changes

(e.g., the price of the fish). Such a limited analysis

will be inappropriate in many cases because it leaves

out the effects of changes in behavior attributable to

changes in environmental quality. For example,

increased fish populations may cause commercial

prices to drop, in which case consumers may

increase their purchases. Commercial fisheries may

also respond to changes in pollution levels by altering

their production processes. While it may not be possible in practice to capture all of these types of

responses in the analysis, those that are likely to be

significant should be addressed.

Guard against double-counting benefits. If

there is significant overlap across the values used for

estimating the benefits of different effects, summing

values across these effects could substantially

overstate expected benefits. For example, property

value studies may estimate people's WTP for all

perceived effects. This would overlap with values

estimated separately for any one of these effects, such

as reduced risk, so simply adding these two values to

estimate benefits would be inappropriate. Analysts

should also take care to ensure that important effects

of the policy have not been omitted in the benefits

analysis, as this will lead to significant underestimates

of total benefits.

Explicitly address uncertainty and non-monetized effects. Benefits assessments for environmental policies often involve significant uncertainty.

Sometimes this uncertainty cannot be reduced (or

better characterized) given the need to regulate in a

timely manner and the resources available for the

analysis. These uncertainties should be clearly communicated when presenting the results of the analysis, focusing on the implications for decision-making.

For example, if benefits may be significantly overstated due to the conservatism inherent in the risk estimates, then the materials summarizing the analysis

should state this explicitly. Guiding principles for

addressing and presenting uncertainty are presented

in Chapter 5 of this guidance. The relative significance of benefits categories that are not quantified, or

quantified but not monetized, should also be

described, as discussed in Chapter 10.

7.4 Types of Benefits

Associated with

Environmental Policies

This section describes the types of benefits that are

typically associated with environmental policies. These

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Chapter 7: Benefits
descriptions are provided with an understanding that it is

desirable to quantify and monetize these benefits.

Available valuation techniques are described in Section 7.5.

Benefits from environmental policies can be broadly classified into those that directly affect humans and human

welfare and those that affect human welfare through systems

or processes. The former category includes human health

improvements such as reduced mortality rates, decreased incidence of nonfatal cancers, chronic conditions and other illnesses, and reduced adverse reproductive or developmental

effects. Improved amenities are another type of benefit experienced directly by humans. Improved taste and odor of tap

water resulting from treatment requirements are an example

of direct amenity benefits.

Benefits that affect human welfare through systems or

processes include reduced materials damages and

numerous other effects collectively termed ecological

benefits. EPA policies may result in ecological impacts that

affect the human use of natural resources (e.g., improving

commercial fishing, increasing agricultural yields,

enhancing recreational opportunities.) Ecological effects

may also provide passive use (or "non-use") benefits that

arise from a variety of motives including, for example,

one's own utility in knowing that clean resources exist or

the desire to preserve clean resources for future

generations. In some cases, environmental policies also

reduce damages to manufactured materials or improve a

resource's aesthetic qualities. Reducing air pollution may

decrease damages to building exteriors or improve

visibility. Exhibit 7-1 illustrates this categorization scheme

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Chapter 7: Benefits

Benefit Category Examples of Service Flows Commonly-Used 

Valuation Methods

Human Health

Mortality Risks Reduced risk of • Averting behaviors

• Cancer fatality • Hedonics

• Acute fatality • Stated preference

Morbidity Risks Reduced risk of • Averting behaviors

• Cancer • Cost of illness

• Asthma • Hedonics

• Nausea • Stated preference

Amenities • Taste • Averting behaviors

• Odor • Hedonics

• Visibility • Stated preference

Ecological Benefits

Market: products Provision of

• Food • Market • Market

• Fuel • Timber

• Fiber • Fur, eather

Non-market: Provision of • Production function

recreation and • Recreational opportunities, • Averting behaviors

aesthetics e.g., viewing, fishing, boating, • Hedonics

swimming, hiking • Recreation demand

• Scenic vistas • Stated preference

Indirect: ecosystem • Climate moderation • Pollination by wild species • Production function

services • Flood moderation • Biodiversity, genetic library • Averting behaviors

• Groundwater recharge • Water filtration • Stated preference

• Sediment trapping • Soil fertilization

• Soil retention • Pest control

• Nutrient cycling

Non-use: existence No associated services • Stated preference

and bequest values

Materials Damage -- • Averting behaviors

• Market

Exhibit 7-1 Examples of Benefit Categories, Service Flows, and 

Commonly-Used Valuation Methods
and suggests commonly-used techniques for estimating

their values, although the list is not exhaustive.8 A detailed

discussion of valuation techniques is presented in the next

section of this chapter. The remainder of this section

describes each of these categories briefly and notes issues

associated with quantification.

7.4.1 Human Health: Mortality

Risks

Some EPA policies are designed to decrease the risks of

contracting potentially fatal health effects, such as some

cancers. Reducing these risks of premature fatality provides welfare increases to those individuals affected by the

policy. It is important to keep in mind that policies generally provide marginal changes in relatively small risks.

That is, most policies do not provide assurance that one

will not prematurely die of environmental causes, they

only marginally reduce the probability of such an event.

Reduced mortality risks are often measured in

terms of "statistical lives." This measure is the

aggregation of many small risks over an exposed population. Suppose, for example, that a policy affects

100,000 people and reduces the risk of premature mortality by one in 10,000 for each individual. Summing

these individual risk reductions across the entire affected population results in the policy saving 10 statistical

lives. It is unknown who these ten people might be—

everyone faces some risk of being affected—but the

policy can be expected to prevent premature fatality for

10 individuals in the population.

Alternative measurements may include "statistical life years." A somewhat more refined approach

to measuring reduced mortality risks includes the

degree of life extension in the estimate. This is usually done by looking not just at the reduced probability

of a premature fatality, but also at the expected life

span of those enjoying the risk reduction. A risk

reduction of one in 10,000 experienced by a population of 100,000 people with an expected remaining

life span of 50 years each, for example, would save 10

"statistical lives" or 500 "statistical life years."

Measuring mortality risk reduction in terms of statistical life years provides more information about the

expected benefits of a policy, but requires risk estimates for specific age groups.9 Often these risk estimates are not available.

7.4.2 Human Health: Morbidity

Effects

This benefits category consists of reductions in the risk of

non-fatal health effects ranging from mild illnesses such

as headache and nausea to very serious illnesses such as

cancer. A complete list of morbidity effects is beyond the

scope of this document, but the presumption for all of

these effects is that the illness will not generally result in

premature fatality.

Morbidity effects can generally be characterized

by their duration and severity. For duration of illness, the primary distinction is between acute effects

and chronic effects. Acute effects are discrete

episodes usually lasting only a few days, while chronic

effects last much longer and are generally associated

with long-term illness. Severity defines the degree of

impairment associated with the illness and may be

measured in terms of "restricted activity days," "bed

disability days," or "lost work days."10 Severity may

also be described in terms of health state indices that

may combine multiple dimensions of health into a

single quantity, or index. The difference in the index

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Chapter 7: Benefits

8 This classification scheme is offered here to facilitate discussion in this document. It is similar in many respects to one offered in

Freeman (1993), but other researchers have offered alternatives. Freeman (1993) describes some general characteristics of these alternatives. The

list of techniques for each benefit category is not intended to be comprehensive or exclusive

9 Additional refinements to account for quality of life or health status are often employed in the public health and health economics.

Existing measures include "quality adjusted life years" (QALYs) and "disability adjusted life years." These measures have not been fully integrated

with the literature on benefits analysis for environmental policies. More information on QALYs can be found in Gold et al. (1996) and additional

information on DALYs can be found in Murray (1994).

10 As Cropper and Freeman (1991) note, these descriptions are essentially characterizations of a behavioral response to the illness. Lost

workdays, for example, in some cases requires a decision on an individual's part not to go to work due to illness. Such a response may depend upon

various socioeconomic factors as well as the physical effect of the illness.
value reflects the relative difference in disutility associated with symptoms or illnesses.11 Morbidity effects

can be further characterized by the set of symptoms

associated with an illness.

Morbidity effects are usually quantified in terms

of the number of expected cases of a particular

illness. Given the risks faced by each individual and

the number of persons exposed to this risk, an estimate of "statistical cases" can be defined analogously

to "statistical lives" described above. Alternatively,

morbidity effects may be described according to the

expected number and duration of particular symptoms associated with the illness. These estimates of

"symptom days" may be used in benefits analysis

when appropriate estimates of economic value are

available.

7.4.3 Amenities

Direct amenities include improvements in aesthetic attributes associated with environmental commodities. This

includes improvements in taste, odor, appearance, or visibility. In short, these benefits are determined by how the

senses are affected and how individual's welfare is changed

as a result. This class of benefits is unique in that the

focus is on the sensory experience and not on a physical

or material effect.

Despite this conceptual distinction, aesthetic benefits are

often intertwined with other benefit categories such as

health and recreation. A policy that improves air quality,

for example, might simultaneously improve visibility and

reduce mortality risks associated with airborne

contaminants. New treatments for drinking water might

reduce health risks as well as alter the taste and odor of

tap water. These relationships may make it extremely

difficult to separately quantify and value improvements in

aesthetic qualities. 

Many types of policies can be expected to have some

impact on these kinds of amenities and they may be the

focus of a given policy. Amenity improvements may be

major component of total expected benefits. Improved visibility from better air quality is one example that has been

the subject of several empirical studies.12

7.4.4 Ecological Benefits

Ecosystems provide services that benefit humans. For

example, a freshwater lake may provide recreational and

boating sites; a wetland provides a service by being a

breeding ground for fish and fowl. Although ecosystems

have a profound impact upon human well-being, the

quantitative assessment of ecological benefits presents a

formidable challenge for several reasons. First, natural

systems are inherently complex. The many services they

provide and how they provide them may be poorly understood by even the scientific community. Second, ecological

risks vary widely in terms of persistence (e.g., eutrophication versus species extinction), geographic extent (e.g.,

toxic contamination versus global climate change), and the

degree to which the overall threat can be predicted (e.g.,

effects of ozone on crops versus developmental and behavioral effects of chemicals on wildlife populations). Third,

many of the less tangible benefits are not readily amenable

to monetary valuation.

Section 7.3 discussed generally the three steps involved in

assessing the benefits of environmental policies. However,

some issues associated with identifying and quantifying

ecological benefits are particularly complex and warrant

more detailed treatment.

Identifying Ecological Benefits

The first step in assessing ecological benefits is to identify

those relevant to policy options under consideration,

focusing on service flows that are likely to change as a consequence of guidance or regulatory action. In general,

these ecological benefits may be thought of as flows of

services from the natural asset in question. These can be

categorized by how directly they are experienced and

where they fall along a private good/public good continuum. Exhibit 7-2 illustrates how the categories relate to

one another. Not only is it useful as a conceptual tool, this

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Chapter 7: Benefits

11 These indices may be constructed in a number of ways, but consistency with welfare economics requires affected individuals to define

these relative tradeoffs for themselves rather than having them determined by health experts. Several economic analyses have employed some form

of health state index. Recent examples include Desvousges et al. (1998) and Magat et al. (1996).

12 Examples of these studies include Rae (1983), Johnson et. al. (1983), Schulze et al. (1983), Chestnut and Rowe (1990), Crocker and

Shogren (1991), and McClelland et al. (1993).
categorization helps direct analysts to suitable valuation

methods.13

Market benefits: Direct market benefits are some of

the most readily identified service flows provided by

ecosystems. These typically relate to primary products that can be bought and sold competitively as factors of production or final consumption products.

Although they may be managed to a high degree, agricultural systems are nevertheless predicated on ecological processes. As a consequence, increased productivity of farmland and rangeland may provide significant market benefits. Other products include

commercial fish species and timber. When access is

controlled and appropriate user charges levied, recreational opportunities may also be considered direct,

market benefits.

Non-market benefits: Recreational opportunities

and aesthetic qualities provided by ecosystems are

also experienced directly by individuals, albeit in a

non-market setting. Non-market benefits include

both consumptive uses (e.g., recreational fishing and

hunting) and non-consumptive uses (e.g., scenic vistas, wildlife viewing, hiking, and boating). These services are typically provided by natural assets held in

common (e.g., public lands). They have public goods

characteristics—since access is not or cannot be controlled, consumption is not exclusive. On the other

hand, like private goods, they are rival in consumption

because excessive use by others (i.e., congestion) tends

to diminish one's own enjoyment of these services.

Indirect benefits: Ecosystem services that do not

directly provide some good or opportunity to individuals may be valued because they support off-site ecological resources or maintain the biological and biochemical processes required for life support. These

indirect benefits tend to be purely public in nature—

access to or use of the service is not exclusive and a

virtually unlimited number of individuals can share

in the benefits without reducing the average benefit

accruing to each. Each type of ecosystem provides

various indirect benefits. Wetlands recharge groundwater, mitigate flooding, and trap sediments. Forests

sequester carbon, anchor soil, and maintain microclimates. Estuaries protect adolescent fish. Terrestrial

ecosystems provide habitat for natural pollinators. All

of these systems support biodiversity.

Non-use benefits: Some benefits are not associated

with any direct use by either individuals or mankind.

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Chapter 7: Benefits

Ecological

Benefits

Use Non-Use

Direct Indirect

Market Non-Market

Private Goods Public Goods

Exhibit 7-2 Ecological Benefits Classification Scheme

13 A more detailed discussion of these concepts is also found in EPA's Conceptual Framework for Assessing Ecological Costs or Benefits

(EPA, 1999b). A draft is available at http://intranet.epa.gov/oerrinet/ecoweb/index2.htm (accessed 8/29/2000).
Rather, they result because individuals might value an

ecological resource without using or even intending to

use it. Non-use values, also referred to as passive use

values, are those associated with the knowledge the

resource exists in an improved state, bequest values

for future generations and altruistic values for others'

enjoyment of the resource. An individual's commitment to environmental stewardship may also be the

source of existence value. The commitment of some

groups to particular animals or ecosystems provides

an example of this.14

Quantifying Ecological Risk

The second step in the analysis of ecological benefits is to

estimate the physical effects of each policy option, comparing the flow of services with and without the policy. It falls

upon ecologists and environmental toxicologists to conduct

the ecological risk assessments to estimate the expected

adverse ecological effect of a particular stressor.15

Ecological risk assessments can be either narrow in scope,

with inquiry limited to a single species or population (e.g.,

the effect of chemical exposure on an endangered bird

species) or focus broadly on an entire ecosystem. Further

information on ecological risk assessment can be found in

Ecological Risk Assessment Guidelines (EPA, 1998).

The results of an ecological risk assessment generally

include the effect's magnitude (expressed in such metrics

as hazard quotients or percent change in population),

duration, spatial distribution, and time period of recovery.

The analysis of ecological risks may be highly uncertain.

Limited availability of data and models, and imperfect

understanding of key issues, hampers our ability to

describe ecological effects.

7.4.5 Reduced Materials

Damages

The materials damages benefit category includes welfare

impacts that arise from changes in the provision of service

flows from the "material" environment. The "material"

environment is distinguished from the natural environment discussed in the ecological benefits section and

includes constructed or highly-managed physical systems.

Changes in the stock and quality of these material environmental resources are assessed in a similar fashion to their

natural environment counterparts. Analytically, benefits

assessment for materials improvements parallels that for

managed ecosystems such as agriculture or forestry, with

most benefits arising from direct, market effects or use

values. For example, effects from changes in air quality on

the provision of the service flows from physical resources

such as buildings, bridges, or roads are handled in a similar fashion to the effects from changes in air quality on

crops or commercial timber stocks. The most common

empirical applications involve air pollution damages and

the soiling of structures and other property.

7.5 Methods for

Benefits Valuation

Economists have developed a number of methodologies to

measure the benefits of environmental improvements. 

Market methods can be used when direct markets

for environmental goods and services exist. The benefits of a change in quantity of a good are estimated

using data on these market transactions. By knowing

how the good was bought and sold, economists can

infer directly how people appear to value that good.

Unfortunately, direct markets for environmental goods

and services do not often exist. In the absence of these

markets, environmental and natural resource economists must rely upon alternative methodologies to

measure the benefits of environmental improvements.

Revealed preference methods (or indirect

approaches) allow economists to infer the value

placed on environmental goods using data on actual

choices made by individuals in related markets.

Revealed preference methods include recreational

demand models, hedonic wage and hedonic property

models, and averting behavior models.

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Chapter 7: Benefits

14 Even though it does not involve use, non-use value still falls under the rubric of welfare economics. It emanates from human interest,

alone, and does not encompass any rights or ethics-based justification for preservation (see Kopp, 1992 and Mazzotta and Kline, 1995).

15 Other types of frameworks for ecological assessment include injury assessments undertaken as part of natural resource damage assessments (IEC, 1995 and Huguenin et al., 1996) and environmental assessments undertaken to meet the requirements of NEPA.
Stated preference methods (or direct approaches)

allow economists to estimate the value placed on

environmental goods using data on hypothetical

choices made by individuals responding to a survey.

Stated preference methods include contingent valuation, conjoint analysis, and contingent ranking. 

Specific approaches that fall under these two broad categories are presented below. This presentation includes an

overview of each method, a description of its general application to environmental benefits assessment, and a discussion of issues involved in interpreting and understanding

studies using the method. This information is primarily

designed to help analysts evaluate existing studies being

considered for benefit transfer, but it can also assist analysts in assessing the feasibility of employing these methods. The discussion below concludes with a separate

overview of benefit transfer methodology in general. It is

important to keep in mind that research on all of these

methods is ongoing, sometimes at a rapid pace. The limitations and qualifications described here are meant to

characterize the state of the science at the time these

guidelines are published. Analysts should consult additional resources as they become available.

7.5.1 Market Methods

Economic Foundation of Market Methods

Market methods are used to value environmental goods

and services that are directly traded as market commodities. Market methods are used, for example, to examine

the effects of air quality improvements on agriculture and

commercial timber industries and the effects of water

quality improvements on commercial fisheries.

Market methods apply when environmental goods are factor inputs. Changes in the quality or stock of an environmental good can affect production costs, which can then

alter the price and quantity of output and the returns to

other factor inputs. In turn, these market responses affect

the decisions and welfare of consumers and producers.

Changes in the prices of marketed goods consumers face

and changes in the income of the owners of the factor

inputs reveal information about the welfare of consumers

and producers. For example, the benefits of an environmental improvement are often realized as increases in

consumer and producer surplus that arise from lower

costs and prices and increases in the quantity of the marketed good. For more detailed discussion of the economic

foundation of market methods, see Just et al.(1982) or

Freeman (1993).

General Application to Benefits Assessment

When applying market methods to assess the benefits of

environmental improvements, two types of market

responses are important: the impacts of the environmental

change on the relevant marketed good (e.g., factor) and

the response of producers and consumers to this change.

When examining these responses, it is important to consider the range of market responses available to producers

and consumers. Overlooking market adjustments can bias

benefits assessment. For instance, the damage function

approach, which derives benefits by applying a unit price

to a physical measure of damage or loss, ignores consumer responses to market adjustments.16 Measures of

price-elasticities, cross-price elasticities, and substitution

possibilities indicate the extent to which market adjustments are likely to occur.

In practice, characterizing the market response to a

change in environmental quality can be difficult. Two

techniques that rely on observations of direct market

behavior, cost and production function approaches, facilitate the measurement of consumer and producer surplus

changes, but one must assume optimizing behavior on the

part of producers and consumers. A different approach

for benefits assessment is to use optimization models that

simulate behavior. All three of these approaches require

considerable information and data on the relevant market

participants.

Benefits estimation using market methods varies with the

types of markets affected by the environmental improvement. The nature of firms affected on the producer side

(e.g., single-product firms or multi-product firms), the

market structure (e.g., vertically linked markets), and the

presence of market distortions (e.g., monopoly power,

price supports) influence the complexity of benefits

assessment. Freeman (1993) singles out two cases where

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Chapter 7: Benefits

16 Although the damage function approach does not account for market adjustments, it may be a useful screening tool when time and

resources are limited. 
benefits assessment is relatively straightforward. The first

case is one in which the environmental good or quality is a

perfect substitute for another input. Here, the benefits of

an environmental improvement can be calculated by estimating the reduction in input costs caused by substituting

away from the other input, as long as the change in total

costs does not affect marginal costs or output. The second

case is where observable market data (e.g., cost, demand,

and market structure) imply that benefits from an environmental improvement will accrue to owners of fixed factors. Here, benefits can take the form of increased productivity and are realized as profit or quasi-rents. One

such case would be where the producer affected by the

environmental improvement is small relative to the market, and variable prices for factors and products are not

affected by the environmental improvement.

Empirical applications of market methods are diverse.

Among other topics, the empirical literature has addressed

the effects of air quality changes on agriculture and commercial timber industries. It has also assessed the effects

of water quality changes on water supply treatment costs

and on the production costs of industry processors, irrigation operations, and commercial fisheries. Refer to Adams

et al. (1986), Kopp and Krupnick (1987), Taylor (1993),

and EPA (1997) for empirical examples.

Considerations in evaluating and understanding

market studies

Issues to consider when interpreting the results of market

studies include:

Data requirements and implications: Employing

market methods requires information on the effect of

the environmental resource on production costs, supply conditions for output, demand curve for final

good, and factor supplies.

The model for estimation: Data availability plays a

large role in the selection of a modeling approach and

the structure of the model. Production function, cost

function, and simulation optimization models are all

options for understanding the market response to

environmental improvements.

7.5.2 Revealed Preference

Methods

In the absence of market data on the value of environmental improvements, WTP may be estimated by looking at

related goods that are traded in markets. Methods that

employ this general approach are referred to as "revealed

preference" methods because people's behavior in associated markets reveals the value they place on the environmental improvements. For example, if pollution levels

affect the use of a lake for recreational fishing, individual

WTP to travel to a substitute site can be used to estimate

the value of averting the damages to the lake of concern.

Four distinct revealed preference methods have been widely used by economists: recreation demand models (including travel cost and discrete choice models), hedonic pricing models, averting behavior models, and cost-of-illness

studies.

7.5.2.1 Recreation Demand Models 

Improvements in environmental quality may enhance

recreation opportunities at one or more sites in a region.

For example, policies that control the level of toxics in surface water bodies might result in a reduction in the number of lakes and streams subject to fish consumption advisories, thereby enhancing recreational angling opportunities. Recreation improvements constitute a potentially

large class of environmental benefits, but measurement of

these values is complicated by the fact that access to recreation activities are only partially regulated by observable

market mechanisms. Recreation demand models,

including the travel cost model, the random utility model

(RUM), and other approaches, may be used to assess nonmarket benefits associated with recreation activities. 

Economic Foundation of Recreation Demand

Models

Recreation demand models focus on the choice of trips or

visits to sites for recreational purposes. The basic trade off

to be considered is between the satisfaction gained from

participating in an activity at a site and the value of money

and time given up. The fundamental assumption is that

people may weigh the money and time costs of travel to a

site in the same way as an admission fee. Thus, by examining the patterns of travel to particular sites, one may

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Chapter 7: Benefits
infer how individuals value the site or particular aspects of

the site such as environmental quality.

As with other economic studies, recreation demand models rely on individual perceptions. While it is possible to

value changes in environmental quality that have an obvious effect on popular recreation activities, recreation

demand methods may not be appropriate for valuing

changes in environmental quality that are difficult for people to observe or only indirectly affect well-known species.

Travel cost models: The simplest recreation

demand model involves trips to a single site. User

surveys provide data on visitors and trip origins and

the data is organized by distance to the site.

Generally, an inverse relation between distance traveled and the number of visits emerges. The distance

variable may be converted to cost by including factors

for the dollar per mile cost of vehicle travel as well as

the cost of travel times and, the relationship among

the variables may be interpreted as a demand function, with the number of trips from a particular area

as a function of the travel costs of reaching the site.

The single-site travel cost model may be extended to

multiple sites, usually by estimating a system of

demand equations, with the number of trips to a

given site taken to be a function of the cost of visiting

that site as well as the costs of visiting other available

sites. A number of extensions to the simple travel

cost model are described in Freeman (1993).

Travel cost models are most appropriate for estimating changes in the number of trips over a given period of time, also known as participation. They are limited, however, in their ability to model the recreationist's choice among competing sites. A separate but

related body of literature has developed around models that directly address the decision of "where to go"

and estimate welfare changes associated with this

alternative theoretical framework.

Discrete choice models: For analyses focusing on

the role of environmental quality variables, changes

in social welfare may best be estimated through discrete choice models (also referred to as RUMs).

Discrete choice models focus on the decision to recreate at a specific site as compared to alternative substitute sites. The model considers travel cost and environmental quality variables associated with all competing sites. Detailed treatments of the discrete

choice model include Bockstael et al. (1986) and

Bockstael et al. (1991). 

Although well suited for analyzing welfare effects of

changes in site quality per visit, the discrete choice

model is less useful for predicting the number of trips

over a period and measuring seasonal welfare

changes. Most recreation demand studies use either

variations on the discrete choice model or combinations of travel cost and discrete choice approaches to

estimate changes in social welfare.

Considerations in Evaluating and Understanding

Recreation Demand Studies

There are several issues that must be confronted in a

recreation demand model:

Definition of a site: Ideally, one could estimate a

recreation demand model in which sites are defined

as specific points, such as launch ramps, campsites,

etc., but the data requirements of detailed models are

large. Similarly, for a given site, the range of alternative sites may vary by individual. Ultimately, every

recreation demand study strikes a compromise in

defining sites, balancing data needs and availability,

costs, and time. 

Opportunity cost of time: Part of the cost of taking

a recreation trip is the value of recreation time, which

varies with respondent's income and work schedules.

Recreation demand models typically use some fraction of the wage rate in calculating travel costs, but

the tradeoffs between work hours and leisure time

involve complex theoretical and methodological

issues. Furthermore, it is presupposed that travel

time detracts from the overall satisfaction of a recreation trip, but this assumption may not always hold.

Other time-related issues include the treatment of onsite time, which varies from case to case but is often

ignored altogether.

Multiple site or multipurpose trips: Recreation

demand models assume that the particular recreation

activity being studied is the sole purpose for a given

trip. Visits to multiple sites or multipurpose trips confound attempts to measure social welfare changes.

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Chapter 7: Benefits
7.5.2.2 Hedonic Wage Studies (WageRisk studies)

Hedonic wage studies draw on the framework of hedonic

pricing methods. This section describes the hedonic wage

method, but first provides some general background on

hedonic pricing methods in general. Property value studies, another large area of research based upon this framework, is described in Section 7.5.2.3. 

Background on Hedonic Pricing Methods in

General

Hedonic pricing methods apply to heterogeneous goods

and services. Heterogeneous goods and services consist of

"bundles" of attributes and are differentiated from each

other by the quantity and quality of these attributes. Job

opportunities, housing units, computers, and cars are

common examples of heterogeneous goods. Hedonic pricing methods explain variations in price using information

on attributes. For example, determinants of wages are

expected to include worker characteristics (e.g., level of

education, tenure, age) and job characteristics (e.g., risk of

fatal injury). Determinants of housing prices may include

structural attributes (e.g., number of bedrooms and age of

house), neighborhood attributes (e.g., population demographics, crime, and school quality), and environmental

attributes (e.g., air quality and proximity to hazardous

waste sites).

The economic theory underlying hedonic pricing methods

extends from a model of market equilibrium, where suppliers and demanders of heterogeneous goods interact

under conditions of perfect information and zero transactions costs. Consumers derive utility from the attributes of

the heterogeneous goods and adjust purchases in response

to differences in these attributes. Producers or sellers of

goods and services incur costs that vary with the range of

attributes offered. An equilibrium price schedule develops

from the market interactions of consumers and suppliers.

The foundation of the hedonic pricing method as it relates

to job opportunities is analogous, with workers and

employers interacting in the labor market. The equilibrium price schedule is termed the hedonic price function

and forms the basis for benefits assessment using hedonic

pricing methods. Rosen (1974) is the seminal article on

the economic theory of hedonic methods. 

Empirical hedonic pricing research typically concentrates

on the hedonic price function and the decisions of consumers or workers. The hedonic price function is approximated by regressing price on measures of attributes and

the estimated coefficients represent the marginal WTP for

the associated attribute. Applications of hedonic methods

to labor wages and property values have been used to

characterize the benefits of environmental improvements.17 These are known as hedonic wage studies and

hedonic property value studies, respectively. Each is considered separately below.

Economic Foundation of Hedonic Wage Studies

(Wage-Risk Studies)

Hedonic wage studies, sometimes known as wage-risk or

compensating wage studies, are based on the premise that

individuals make tradeoffs between higher wages and

increased occupational risks of death or injury. Essentially,

higher risk jobs are expected to pay higher wages, all else

held constant. Hedonic wage studies use statistical regression and data from labor markets to isolate the increment

in wages associated with higher job risks. The outcome of

these models is an estimated value of small changes in

mortality risks. Some models also attempt to estimate the

value of small changes in morbidity, or non-fatal risks.

The key to an effective hedonic wage study lies in separating the portion of compensation associated with occupational health risks from other job characteristics, including

supervisory responsibility, job security, and similar factors.

The wage rate is also affected by the industry in which the

individual is employed, characteristics of the location and

the personal characteristics of the workers (e.g., age, education, experience). All of these data are needed to disentangle the effects of worker characteristics from those of

job attributes in determining wages paid. 

In hedonic wage studies, workers' perceptions of risk levels

across jobs are assumed to match actual risk levels. If

perceived risks do not match actual risks faced by the

workers, then the resulting estimates of compensation

required to accept additional risk will be biased. Most

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Chapter 7: Benefits

17 Palmquist (1991) and Freeman (1993) contain current discussions of the use of hedonic methods for characterizing the demand for

environmental quality and benefits assessment. See Palmquist (1982) for a discussion of a benefits assessment method related to hedonic property

value studies known as repeat sales analysis.
analysts believe that this potential bias is small, but others

argue that workers generally underestimate on-the-job

risks. If the latter is true, hedonic wage studies will

understate the additional compensation required for

bearing risks. Some studies attempt to account for

workers' perceived risks, but the results of these studies

are not markedly different from those that do not.

Another assumption employed in hedonic wage studies is

the existence of perfect labor markets in which workers

are freely mobile and there is perfect information about

jobs and job risks. Hedonic wage studies will not produce

accurate estimates of the wage-risk tradeoff in imperfect

markets where workers are unable to move freely between

jobs or in which only union members have sufficient

information and market power to receive higher wages for

higher risk jobs. Since in reality labor markets are somewhat imperfect, many studies attempt to control for union

membership and similar factors that might influence wage

rates.

Hedonic wage models are limited to estimating values for

relatively small risk changes. The observed wage and the

estimated increment, or "premium," to accept higher risks

represents the market equilibrium price for the entire set

of workers in the study. This estimate is not necessarily

the value that any particular worker would require to

accept a risk increase, but for small changes in risk, it is

very close.

A thorough treatment of the hedonic wage model that

includes all of these considerations can be found in Viscusi

(1992, 1993).

General Application of Hedonic Wage Studies to

Benefits Assessment

Because they are narrowly focused on labor market tradeoffs, hedonic wage studies are not generally well-suited to

measure the benefits of environmental regulation directly.

That is, it is not usually feasible to perform a hedonic wage

study to estimate the benefits that would accrue from a

specific environmental policy action. Nonetheless, these

studies have yielded consistent estimates of how groups of

workers appear to value small risk changes.

Environmental benefits assessments can draw upon these

studies to estimate the value of reductions in environmental mortality risks.18 Such an application is essentially an

exercise in benefits transfer, which is described in greater

detail later in this chapter.

Analysts should be aware that, although hedonic wage

studies currently provide the most reliable and consistent

estimates of the value of mortality risks, there are important differences in the types of risks captured in an hedonic wage study and the types of risks that are affected by

environmental regulation. For instance, hedonic wage

studies tend to focus on accidental deaths occurring

among prime-aged males while deaths associated with

environmental risk often occur among the elderly and may

involve an extended latency period. Furthermore, elevated

risks in hedonic wage studies are voluntarily accepted

while environmental risks are often involuntarily borne.

The nature and importance of these and other differences

are detailed in Section 6 of this chapter.

Estimates of the value of changes in fatal risks are generally more relevant for environmental benefits assessment

than are those for job-related non-fatal injuries. This is

because these injuries are usually quite different from the

non-fatal health risks associated with environmental policy

actions.

Hedonic wage models have also used wage differentials

across geographic areas to estimate values for environmental quality differences.19 Theoretically, jobs in areas

with poor environmental quality should pay less than identical jobs in areas with high environmental quality, again

holding all else equal. There are a number of difficulties

with employing hedonic wage models in this manner,

including integrating wage and housing choices, and the

need to assess intra-city variation in amenities. The majority of hedonic wage studies relevant for most EPA policies

have focused on estimating values for health risks.

Considerations in Evaluating and Understanding

Hedonic Wage Studies

Data requirements and implications: Hedonic

wage studies require large sets of data on labor

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Chapter 7: Benefits

18 Values of mortality risk have also been estimated using hedonic studies of automobile prices. While these studies produce values of life

in a similar range, most environmental risk assessments rely on hedonic wage studies. For information on the automobile price literature, see

Dreyfus and Viscusi (1996) and Viscusi (1992).

19 This should not be confused with attempts to control for wage differentials across broad regions found in most existing wage-risk studies.
market behavior. Data on worker and job

characteristics are generally collected using survey

techniques. Risk information, however, is frequently

retrieved from published sources reported at the

occupation or industry level. These risk measures are

then matched to the worker in the sample using

information provided by the respondent on his or her

job. The risk data used in most studies, however, are

not complete. For example, although accidental, onthe-job (and almost immediate) deaths are generally

reported, occupational diseases such as cancer are

not accurately captured in most data.

The estimated wage-risk tradeoff can vary considerably across data sets and across methodologies. In

particular, studies that draw upon data from high-risk

jobs will generally provide valuations of risk that are

lower than those that rely upon data from lower-risk

jobs. This is due to a sample selection problem.

Study results reflect the value to the sample population. High risk jobs tend to attract those who are less

averse to taking risks and therefore require less compensation to face them.

Controlling for other risks: If the study seeks to

estimate values for fatal risks, it is important that the

study control adequately for non-fatal risks in order to

obtain an unbiased wage-risk estimate for mortality.

Conversely, when values for non-fatal risk are being

estimated, mortality risks should be considered in the

wage-risk equation.

The scope of the risk measures: Some labor market studies use actuarial data to determine the risk

levels faced by workers. However, these data are not

limited to occupational risks. They include all types

of fatality risks faced by the individual both on and off

the job. The degree to which these risks are correlated with job risks is unclear, but they would not be

reflected in job-related compensation. These studies

generally should be excluded from use in policy

analysis since this problem will cause the tradeoffs

they estimate to be biased downwards by an unknown

amount.

The model for estimation: Some labor market

studies attempt to determine the value of a life year

and the implicit discount rate workers apply to this

value. While attractive in theory, the complexity of the

structural models used in these studies leads to less

robust estimates of the value of risk reduction than

studies using conventional wage-risk estimation procedures. Such studies should be viewed as less reliable for use in valuing lifesaving programs.

7.5.2.3 Hedonic Property Value

Studies

Hedonic property value studies are applications of the

hedonic pricing method. The introduction to Section

7.5.2.2 (Hedonic Wage Studies) provides background on

hedonic pricing methods in general. 

Economic Foundation of Property Value Studies

Hedonic property value studies assert that individuals

perceive housing units as bundles of attributes and derive

different levels of utility from different combinations of

these attributes. When transaction decisions are made,

individuals make tradeoffs between money and attributes.

These tradeoffs reveal the marginal values of these

attributes and are central to hedonic property value

studies. Hedonic property value studies use statistical

regression methods and data from real estate markets to

examine the increments in property values associated with

different attributes.20

Structural attributes (e.g., number of bedrooms and age of

house), neighborhood attributes (e.g., population

demographics, crime, and school quality), and

environmental attributes (e.g., air quality and proximity to

hazardous waste sites) may influence property values.

When assessing an environmental improvement, it is

essential to separate the effect of the relevant

environmental attribute on the price of a housing unit

from the effects of other attributes. While deriving

measures of marginal WTP using hedonic methods is

straightforward, estimating measures of WTP for

substantial or discrete (non-marginal) improvements in

environmental quality is difficult. The use of hedonic

property value studies for benefits assessment rests on

careful interpretation of the hedonic price function and its

relevance to the policy scenario being considered. Bartik

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Chapter 7: Benefits

20 To simplify the discussion, housing units are consistently used as examples. Hedonic property value studies are also completed on

vacant land parcels. 
(1988b) and Palmquist (1991, 1988) provide excellent,

detailed discussions of benefits assessment using hedonic

methods.

When using hedonic property value studies for benefits

assessment, the measurement of the environmental attribute is central to the analysis. If the measurement of the

environmental attribute does not match individuals' perceptions, then the results of the analysis may be biased. 

The hedonic price function for housing units represents

an equilibrium that results from the interaction of suppliers and demanders of housing in a market with full information. When this assumption is not met, the results of

an hedonic analysis will not provide an exact representation of the tradeoffs individuals make across housing

attributes and the marginal values associated with these

different attributes.

General Application of Hedonic Property Value

Studies to Benefits Assessment

Benefits assessment applications of hedonic property value

studies focus on the relationship between property values

and environmental attributes such as air quality, water

quality, proximity to hazardous waste sites, and landscape

characteristics. Hedonic property value studies are not

widely used in environmental benefits assessments

because of the limited transferability of hedonic results

and the difficulties of using hedonic methods to describe

the benefits associated with discrete (non-marginal) environmental improvements. 

Using data on a sample of transactions, price is regressed

on measures of the observable attributes and an hedonic

price function is estimated. The coefficient on the environmental attribute reveals the marginal WTP for that

attribute. Therefore, if the policy scenario considered

results in a marginal environmental improvement, the

estimated hedonic is well-suited to measure benefits.

However, if the policy scenario considered results in a discrete improvement that affects numerous properties, additional information on preferences and the hedonic price

function is required for assessing the true benefits of the

environmental improvement.21 When larger changes in

environmental quality are considered, the analytical

requirements increase because the hedonic price function

and the level of utility of individuals may change. 

The hedonic price function does not typically provide general information on individuals' WTP for the different

attributes. Methods for identifying demand (or WTP)

functions for the different attributes (e.g., using data from

multiple markets or imposing assumptions about the

functional form of the hedonic and/or the utility functions

of individuals) exist, but they often rely on restrictive

assumptions.22 Furthermore, identifying WTP functions

does not ensure the ability to measure the welfare gain

from a discrete environmental improvement because markets intervene and prices change. As a result of these difficulties, approximations of welfare gains based on the

hedonic price function are sometimes employed to assess

benefits. See Palmquist (1991, 1988) and Bartik (1988b)

for a detailed discussion of benefits assessment using

hedonic methods, including guidance on developing lower

and upper bound measures of benefits.

Considerations in Evaluating and Understanding

Property Value Studies

Data requirements and implications: Property

value studies require large amounts of disaggregated

data. Market transaction prices on individual parcels

or housing units are preferred to aggregated data

such as census tract information on average housing

units because aggregation problems can be avoided.

Data on attributes may include housing characteristics, sale dates, neighborhood amenities such as

schools and parks, neighborhood demographic characteristics such as income, age, and race, and environmental quality. 

Errors in variables: Problems may arise from error

in measuring prices (aggregated data) and errors in

measuring product characteristics (particularly those

related to the neighborhood and the environment).

In addition, omitted variable bias problems may

occur if relevant data are not available.

The measurement of environmental attributes:

The measurement of the environmental attribute

included in the hedonic price function is central to

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Chapter 7: Benefits

21 There are cases when the hedonic price function can alone be used to measure welfare effects from a non-marginal change in the environmental attribute. For example, this holds if few properties are affected and the hedonic price function is not expected to shift.

22 See Palmquist (1991) for a detailed discussion of identification issues.
the assessment of benefits. Researchers often use

information available from the scientific community

such as air or water quality monitoring data and then

must determine how to assign the data to the individual houses in the data set. However, there may be

differences between how these attributes are measured by scientists and how they are perceived by individuals. If this difference is large, the hedonic price

function will not accurately represent the values of

these attributes. Individual perceptions of environmental attributes are central to this type of analysis.23

Another issue to consider is the timing of the effect

from the environmental improvement. Some effects

from environmental improvements change over time.

Others may be understood differently over time

depending on available information (e.g., hazardous

waste sites). The choice of when and how to measure

the environmental attribute for a given transaction

price is complicated. Refer to Kiel and McClain

(1995) for a discussion of price responses over time.

The model for estimation: There are numerous

statistical or econometric issues associated with

applying hedonic methods to property value studies.

These include the choice of functional form, the definition of the extent of the market, identification, and

endogeneity. A brief overview of the first two estimation issues is presented below. Refer to Palmquist

(1991) for a thorough treatment of the econometric

issues associated with hedonic property value studies.

Because economic theory offers limited guidance on

the functional form of an hedonic price function,

researchers often try several forms when estimating

hedonic functions (e.g., semilogarithmic, inverse

semilogarithmic, log-linear, or quadratic Box Cox).

However, it is important to note that the choice of

functional form has implications for benefits assessment. See Graves et al. (1988) and Cropper, Deck,

and McConnell (1988) for discussions of issues related to the choice of functional form.

The choice of data also has an effect on estimation.

The extent of the market is defined by the scope of

housing market data collected. Questions have been

raised about how to define the extent of housing markets. Empirically, it is important to note that if the

market is defined to be too big, the resulting coefficients of the hedonic price function may be biased.

Conversely, if the market is defined too narrowly, the

coefficients of the hedonic price function are less efficient. Refer to Michaels and Smith (1990) for information on defining the extent of the market. 

Assessing the results an empirical study: Two

simple ways to assess the quality of a property value

study are noted here. First, a review of the empirical

work is informative. This involves assessing the quality of the data collected, the framing of the policy

problem, the measurement of environmental attributes, and the statistical regression analysis. Second,

the existing literature on hedonic methods is a valuable resource. Comparing data, modeling assumptions, and results across studies is a useful exercise.

While variation is expected across studies, especially

between those completed on different areas, some

factors such as the signs of particular coefficients may

be consistently reported. 

7.5.2.4 Averting Behavior Method

The averting behavior method infers values from observations of how people change defensive behavior in response

to changes in environmental quality. Defensive behaviors

are usually defined as actions taken to reduce the risk of

suffering environmental damages, as well as actions taken

to mitigate the impact of environmental damages. The

former category includes behaviors such as the use of air

filters or boiling water prior to drinking it, while the latter

includes the purchase of medical care or treatment. Faced

with a given level of environmental risk, the averting

behavior method assumes that individuals engage in these

defensive behaviors to achieve an optimal level of health.

By analyzing the expenditures associated with these defensive behaviors economists can attempt to estimate the

value individuals place on small changes in risk.24

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Chapter 7: Benefits

23 For example, hedonic property value studies that address water quality often use measures such as water clarity because these are

observable characteristics. In contrast, standard scientific measures such as BOD or pH may not be readily perceived by individuals.

24 As Desvousges et al. (1998) note, the term "averting behavior study" has been used to describe at least three somewhat different

approaches: attempts to estimate WTP for environmental quality; attempts to estimate WTP for health effects or other specific impacts; and simple

summation of observed expenses.
Economic Foundation of Averting Behavior Method

The economic theory underlying the averting behavior

method rests on a model of household production. In

these models, households produce health benefits by combining an exogenous level of environmental quality with

inputs such as defensive behaviors. The underlying theory

predicts that a person will continue to take protective

action as long as the perceived benefit exceeds the cost of

doing so. If there is a continuous relationship between

defensive actions and reductions in health risks, then the

individual will continue to avert until the cost just equals

his or her WTP for these reductions. Thus, the benefit for

a small reduction in health, or health risk, is estimated

from two primary pieces of information (1) the cost of the

averting behavior or good and (2) its effectiveness, as perceived by the individual, in offsetting the loss in environmental quality.

Averting behaviors methods can provide theoretically correct measures of WTP to avoid a decline in environmental

quality or an increase in environmental risks. To do so,

however, they require a great deal of data and particular

assumptions about consumer preferences. In practice, it

has proven difficult to meet these requirements. More

detail on the difficulties inherent in applying the averting

behavior model can be found in Cropper and Freeman

(1991).

One approach to estimation is to use observable expenditures on averting and mitigating activities to generate values that may be interpreted as a lower bound on WTP.

Harrington and Portney (1987) demonstrate this by showing that WTP for small changes in environmental quality

can be expressed as the sum of the values of four components: lost time, changes in averting expenditures, changes

in mitigating expenditures, and the loss of utility from pain

and suffering. The first three terms of this expression are

observable, in principle, and can be approximated by

using changes in these expenditures observed after a

change in environmental quality. The resulting estimate

can be interpreted as a lower bound on WTP that may be

used in benefits analysis. These estimates can be an

improvement over cost-of-illness estimates alone, because

the latter usually captures only mitigating expenditures

and lost time.25

Averting behavior results cannot always be interpreted as

lower bounds on WTP, however, because conclusions may

depend critically upon modeling conditions. For example,

Shogren and Crocker (1991) use a theoretical model to

show that the impact of changes in risk on defensive

expenditures is ambiguous and that these expenditures

need not be a lower bound value. Using the same model

Quiggin (1992) imposes restrictions under which defensive expenditures will increase in response to increases in

risk, providing support for self-protection expenditures as

a method for benefits valuation. Recently, Shogren and

Crocker (1999) show that averting behavior need not be a

lower bound on value when both private and collective risk

reduction strategies are considered.

Large, or non-marginal, changes in environmental quality

require a somewhat different valuation strategy. Generally,

it is not possible to obtain exact estimates of WTP for these

changes. However, Bartik (1988a) details the conditions

under which upper and lower bounds on WTP may be estimated in this circumstance. These bounds effectively

bracket WTP.

Finally, analysts should remember that consumers base

their actions on perceived benefits from defensive behaviors. If these perceptions differ from objective estimates

of, for example, risk changes, the analysis will produce

biased WTP estimates for a given change in objective risk.

Surveys may be necessary in order to determine the benefits individuals perceive they are receiving when engaging

in defensive activities. These perceived benefits can then

be used as the object of the valuation estimates.

General Application of Averting Behavior Method to

Benefits Assessment

The averting behavior method can, in theory, provide WTP

estimates for a wide range of environmental benefits,

including changes in mortality risks, morbidity risks, and

damage to materials. Most recent research, however, has

focused on health risk changes. 

Mortality risks can be estimated with the averting behavior

method by observing purchases of items that reduce the

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Chapter 7: Benefits

25 Cropper and Freeman (1991) note that the full costs of medical expenditures and lost work time may not be borne by individuals making these decisions due to insurance and paid sick leave. An analysis of social benefits would need to include the costs that have been shifted from

the consumer to others.
risks of dying in an accident. These applications are

sometimes known as consumer market studies. One of

the difficulties with the use of averting behavior methods

in this context is that many of the risk reduction actions

are discrete rather than continuous, leading to estimates

that are likely to understate the value of risk reduction to

the average purchaser. These studies can also be sensitive

to assumptions about unobserved costs such as the time

required for employing or maintaining the risk-reducing

good.

The most common focus of averting behavior models has

been the estimation of values for non-fatal health (morbidity) risk changes. There have been many analyses of

observable averting and mitigating expenditures. Some of

these studies focus on behaviors that prevent or mitigate

the impact of particular symptoms (e.g., shortness of

breath, headaches), while others have examined averting

expenditures in response to specific episodes of contamination (e.g., groundwater contamination). The difference

in these endpoints is important. Because many contaminants can produce similar symptoms, studies that estimate values for symptoms may be more amenable to benefit transfer than those that are episode-specific. The latter

may be more useful, however, if assessing the benefits of a

regulation expected to reduce the probability of similar

contamination episodes. 

Considerations in Evaluating and Understanding

Averting Behaviors Studies

Data requirements and implications: Cropper

and Freeman (1991) describe the data required for

estimating WTP using the averting behavior method.

These requirements are quite burdensome and

include information detailing the severity, frequency,

and duration of symptoms; exposure to environmental contaminants; actions taken to avert or mitigate

damages; the costs of those behaviors and activities;

and other variables that affect health outcomes (e.g.,

age, health status, chronic conditions).

Often, data availability will limit the analysis to an

examination of observed defensive expenditures.

These results can be cautiously interpreted as a lower

bound on WTP. Analysts should note that costs associated with pain and suffering will not be included in

the estimate.

Separability of other benefits: Many defensive

behaviors not only avert or mitigate against environmental damages, but also provide other benefits. For

example, air conditioners obviously provide cooling in

addition to air filtering, and bottled water may not

only reduce health risks, but may also be better tasting. The degree to which individuals engage in averting behaviors to obtain these benefits provides evidence of the value of these qualities, but disentangling

the value of different components is not an easy task.

In order to accurately produce estimates of WTP for a

risk change, for example, averting behaviors studies

must isolate the value for the effect of interest from

the value of the other benefits conferred by the defensive activity. It is also possible that the averting behavior may have negative effects on utility. For example,

wearing helmets when riding bicycles or motorcycles

may be uncomfortable. Failure to account for "other"

benefits and disutilities associated with averting

behaviors will result in biased estimates of WTP.

Analysts should exercise caution in interpreting the

results of studies that focus on goods in which there

may be significant interrelated costs and benefits.

Modeling assumptions: As noted above, restrictive

assumptions are sometimes needed to make averting

behavior models tractable. For example, assuming

that the economy and the environment are additively

separable may lead to unambiguous results, but it

may be plausible only in particular circumstances.

Shogren and Crocker (1999) note this fact and suggest that this assumption be justified whenever

invoked. Analysts drawing upon averting behavior

studies will need to review and assess the implications

of these assumptions for the valuation estimates.

7.5.2.5 Cost-of-Illness Method

The health economics literature relies heavily upon the

cost-of-illness method to value morbidity changes. The

cost-of-illness method does not estimate WTP, but rather

estimates the change in explicit market costs resulting

from a change in the incidence of a given illness. Two

types of costs measured in a typical cost-of-illness study

are direct costs (such as diagnosis, treatment, rehabilitation, and accommodation) and indirect costs (including

loss of work time). 

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Chapter 7: Benefits
Economic Foundation of Cost-of-Illness

The theoretical basis for the cost-of-illness method relies

on two major assumptions (1) direct costs of morbidity

reflect the economic value of goods and services used to

treat illness and (2) a person's earnings reflect the economic value of lost production. Because of distortions in

medical and labor markets, an argument could be made

about whether these assumptions hold, but they are

broadly consistent with neoclassical economics.

It is important to note that the cost of illness is not a

measure of WTP. The cost-of-illness approach simply

measures ex post costs and does not attempt to measure

the loss in utility due to pain and suffering or the costs of

any averting behaviors that individuals have taken to avoid

the illness altogether (see Section 7.5.2.3 on averting

behaviors). However, the cost-of-illness estimate may be

considered a lower bound estimate of WTP (Harrington

and Portney, 1987; Berger et al., 1987). The main reason

that the cost of illness understates total WTP is the failure

to account for many effects of disease. It ignores pain and

suffering, defensive expenditures, lost leisure time, and

any potential altruistic benefits. As a simple hypothetical

example, if an individual spends five dollars on pain medication to treat a headache, and does not miss any time

from work due to the headache, his or her cost of illness is

five dollars. The individual's actual WTP to avoid the

headache is likely to be greater than five dollars, assuming

he experiences disutility from the pain the headache causes prior to taking the pain medication. Available comparisons of cost-of-illness and total WTP estimates suggest

that the difference can be large (Rowe et al., 1995).

However, this difference varies greatly across health effects

and across individuals.

Most existing cost-of-illness studies estimate indirect costs

based on the typical hours lost from a work schedule or

home production, evaluated at an average hourly wage.

The direct medical costs of illness are generally derived in

one of two ways. The empirical approach uses a database

of actual costs incurred for patients with the illness to estimate the total medical costs of the disease. The theoretical approach uses a panel of physicians to develop a generic treatment profile for the illness. Illness costs are estimated by multiplying the probability of a patient receiving

a treatment by the cost of the treatment. For any particular application, the preferred approach will depend on

availability of reliable actual cost data as well as characteristics of the illness under study.

Detailed descriptions of the cost-of-illness approach can be

found in Cooper and Rice (1976), Hartunian et al. (1981),

Hu and Sandifer (1981), Rice (1966), Rice et al. (1985)

and EPA's Cost of Illness Handbook (EPA, forthcoming).

General Application of Cost-of-Illness Method to

Benefits Assessment

Because the cost-of-illness approach does not rely on elaborate econometric models, and data are often readily available, implementation of this approach is relatively straightforward. For these same reasons, the approach is easy to

explain to policy makers and the general public and tends

to be less resource intensive than other approaches to

health valuation. The method is generally suited for illnesses such as non-fatal cancers and other incidents of

morbidity.

Cost-of-illness measures will understate WTP because they

do not capture the disutility associated with anxiety, pain

and suffering, or averting costs. On the other hand, some

WTP estimates may understate social costs because they

are unlikely to account for health care costs passed on to

third parties (e.g., health insurance companies or hospitals in the case of direct medical expenses, and employers

who offer sick leave in the case of time/productivity loss).

Considerations in Evaluating and Understanding

Cost-of-Illness Studies

Ex post vs. ex ante measure: As noted above, the

cost-of-illness measures ex post costs of an illness

rather than WTP to avoid the illness. Although the

approach may account for costs shifted from the individual experiencing the illness to third parties, it fails

to account for the disutility of pain and suffering, or

any costs that may have been incurred in order to

avoid the illness. Also, ex post measures cannot capture any value associated with risk attitudes. These

attitudes may have a significant effect on WTP to

reduce risks of more severe illnesses.

It is also important to keep in mind that this measure

captures the costs of choices that individuals make.

Individuals generally choose when and how often to

go to the doctor and when and for how long to stay

home from work. These choices may be affected by

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Chapter 7: Benefits
the existence of health insurance, sick leave, and

socioeconomic status.

Technological change: Medical treatment technologies and methods are constantly changing, and this

could push the true cost estimate for a given illness

either higher or lower. When using previous cost-ofillness studies, the analyst should be sure to research

whether and how the generally accepted treatment

has changed from the time of the study.

Measuring the value of lost productivity: Several

issues arise in the indirect cost portion of a cost-of-illness study. Simply valuing the actual lost work time

due to an illness may not capture the full loss of an

individual's productivity in the case of a long-term

chronic illness. Chronic illness may force an individual to work less than a full-time schedule, take a job

at a lower pay rate than he or she would otherwise

qualify for as a healthy person, or drop out of the

labor force altogether. A second issue involved with

estimating the value of lost productivity is the choice

of wage rate. Even if the direct medical costs are estimated using individual actual cost data, it is highly

unlikely that the individual data will include wages.

Therefore, the wage rate chosen should reflect the

demographic distribution of the illness under study.

Furthermore, the value of lost time should include

the productivity of those persons not involved in paid

jobs. Homemakers' household upkeep and childcare

services, retired persons' volunteering efforts, and

students' time in school all directly or indirectly contribute to the productivity of society. Finally, the value

of lost leisure time to an individual and his family is

not included in most cost-of-illness studies.

7.5.3 Stated Preference

Methods

Stated preference approaches attempt to measure WTP values directly. Unlike the revealed preference methods that

infer values for environmental goods and services from

observed behavior, stated preference methods rely on data

from surveys that directly question respondents about

their preferences to measure the value of environmental

goods and services. This class of methods comprises several related techniques, including contingent valuation

(CV), stated choice or conjoint analysis (CA), and less frequently, contingent ranking (CR). The common feature of

these methods is direct questioning of members of a population about their likely choices in a hypothetical market.

These three techniques are discussed below.

Economic Foundation of Stated Preference

Methods

There are some situations in which data on actual behavior and choices cannot be used to derive estimates of the

value of environmental goods and services. Stated preference methods rely on survey data rather than on data on

observed behavior, therefore, they can be used to measure

the value of environmental goods and services in most situations. The responses elicited from the surveys, if truthful, are either direct expressions of WTP or can be used to

estimate WTP for the good in question.

Contingent Valuation: Contingent valuation (CV) is

the most well developed of the stated preference

methods. CV surveys either ask respondents if they

would pay a specified amount for a described hypothetical commodity or ask their highest WTP for it (for

a good overview of the method see Hanemann, 1991;

Mitchell and Carson, 1989; Carson, 2000; or Kopp et

al. 1997). Concerns about the reliability of value estimates that come from CV studies have dominated

debates about the methodology, since research has

shown that bias can be introduced easily into these

studies, especially if they are not carefully done. In

particular, the concern that CV surveys do not require

respondents to make actual payments has led critics

to argue that responses to CV surveys are biased

because of the hypothetical nature of the good.

Reliability tests on the data that conform to expectations from both economic and psychological theory

can enhance the credibility of a CV survey. Surveys

without these tests should be suspect; surveys whose

results fail the tests may be discredited. 

The result of the debates about the reliability of the

CV method has been an infusion of methods and theory, particularly from the disciplines of psychology

and survey research, to enhance questionnaire design

to mitigate these concerns (Krosnick, 1991; Fischhoff,

1997). In addition, the National Oceanic and

Atmospheric Administration (NOAA) convened a panel

of well-known economists to review and evaluate the

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methodology in 1993. The panel devised a set of

"best practices" recommendations for the method,

particularly as it relates to natural resource damage

assessments (NOAA, 1993). EPA subsequently prepared comments on the panel recommendations and

regulations NOAA proposed that drew upon the

panel's report (EPA, 1994).

Conjoint Analysis and Contingent Ranking:

Conjoint analysis (CA) and contingent ranking (CR)

studies ask respondents to make choices between two

or more (in the case of CA), or rank several (in the

case of CR), similar commodities with different attributes and prices, in order to tease out the marginal

value of particular attributes of the commodity of

interest (Johnson et al., 1994). These methods are a

variation on stated preference methods that aim to

evaluate marginal tradeoffs rather than the total value

for a described change that is evaluated in CV studies.

Arising out of the marketing discipline, these methods

rely on respondents' ability to make choices between

commodities whose attributes differ in relation to one

another. These methods often present respondents

with a series of binary choice questions (e.g., "Given

the descriptions of A and B, would you prefer A or

B?") or multiple choice questions that ask respondents to make tradeoffs between prices and other features of commodities that are presented to them. 

General Application of Stated Preference Methods

to Benefits Assessment

More than 2,000 stated preference studies have been

undertaken since the early 1970's. Among other things,

these have been used to value changes in visibility

(Chestnut and Rowe, 1990; Tolley et al. 1985), changes in

surface water quality (Mitchell and Carson, 1984, 1986b),

groundwater protection (McClelland et al., 1992), recreation services (Cameron and James, 1987; Bishop and

Heberlien, 1979) and changes in health effects attributable

to pollution (Krupnick and Cropper, 1989; Mitchell and

Carson, 1986a; Viscusi et al., 1991).

Currently, contingent valuation is the only established

method capable of estimating non-use values; however,

most CV studies are designed to elicit respondents' total

value for a given commodity. A number of researchers

have attempted to disaggregate WTP values into "use" and

"non-use" components. Examples of studies where nonuse values have been specifically evaluated include

McClelland et al. (1992) and Schulze et al. (1993). A

more practical approach is to represent non-use values by

employing the total WTP amounts given by persons who do

not use the resource. The downside to this convenience is

that there might be significant differences between those

who use the resource and those who do not. Applying

non-use values from the latter population to the former

one may result in biased estimates.

In the context of environmental valuation, the commodity

being purchased is usually a described change in environmental quality. This is a Hicksian measure, since it asks

respondents to state the amount of income that they

would be willing to forgo in order to have the described

commodity, while making them as well off as they were

without it and the payment. Similarly, they might be asked

how much they would be willing to accept to put up with a

nuisance or a loss. However, willingness to accept applications of CV are much more problematic because, unlike

the case of WTP, there is no upper limit on the size of the

opportunity set available to the respondent. This results in

a strong potential for respondents to overstate the amount

they would need to receive to compensate them for a loss.

While conjoint analysis (CA) has been used in marketing

for some time, its application to environmental valuation

began in the late 1980's. To date, it has not been subject

to the level of testing and scrutiny that CV has had, so

much less is known about the reliability (and how to

enhance it) of these studies. The main methodological

concerns that arise with CA studies are the viability of disaggregating the good in question into attributes that can be

separately traded off in respondents' minds, and the problem that many respondents display intransitive preferences

over the numerous, and often complex, set of choices. As

a result of this complexity, heteroskedasticity is a pervasive

problem with these methods.

An important limitation to using contingent valuation and

other stated preference techniques is that it is expensive

and time-consuming to survey the public about their

preferences. Samples must be drawn, questionnaires

developed, surveys administered either by mail, telephone

or in person, and results coded and analyzed. In-person

interviews are most expensive, but in some contexts are

unavoidable due to the need to present complicated

information to respondents or when they are required as

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Chapter 7: Benefits
criterion for legal evidence. Mail and phone surveys carry

much lower costs and are often sufficient for use in the

analysis of EPA policies.

Considerations in Evaluating Contingent Valuation

Studies

Accurately measuring WTP for environmental goods and

services using contingent valuation depends on the reliability and validity of the data collected. There are several

issues to consider when evaluating study quality.

Content validity: To evaluate a survey instrument

itself, the analyst should look for a number of

features that the researchers should have

incorporated into the survey scenario. First, the

commodity being valued must be clearly and

concisely defined. A detailed explanation of the

salient features of the environmental change being

valued (the "commodity") begins with a careful

exposition of the conditions in the baseline case and

how these would be expected to change over time if

no action were taken. Next, the action (policy

change) should be described, including an illustration

of how and when the policy action would affect

aspects of the environment that people might care

about. Finally, the way the payment will be made

(e.g., through taxes, user fees, etc.) may have large

implications for the outcome, so careful attention

should be paid to the rationale given for the choice of

payment mechanism. Respondent attitudes about the

provider and the implied property rights of the survey

scenario can be used to evaluate the appropriateness

of these features of the commodity description

(Fischhoff and Furby, 1988). Questions that probe for

respondent comprehension and acceptance of the

commodity scenario can offer important indications

about the potential for the study to be reliable. 

Construct validity: In CV studies, the main indicators of study quality are tests of internal validity that

can be incorporated into study design. Internal validity is supported when variables that are expected by

theory to be important determinants of preferences

actually are statistically significant with the correct

sign. For example, with normal goods, price is

expected to have a negative effect on demand for a

good, while household income is expected to have a

positive effect, all else equal. Thus, respondents with

higher income are expected to demand more of the

good than respondents with low income. Familiarity

with the good or its context can also be an important

indicator of internal validity. One would intuitively

expect that someone who fishes would know more

about, and be willing to pay more for, a commodity

that improves conditions for fishing than someone

who never engages in outdoor recreation. Tests of

sensitivity to scope, where the amount of the commodity is varied randomly over different sub-samples

of survey respondents, can increase confidence in the

results where the findings are consistent with theoretical expectations (Carson et al., 1993). 

Criterion validity: In order to assess criterion validity, the analyst needs to have an indicator of true

value against which to evaluate values from contingent valuation studies. Given the lack of actual market prices, it is often impossible to conduct criterion

validity tests. However, the quality of a CV study can

also be gauged by comparing valuation estimates

obtained using CV with those obtained using other

techniques. At least one study that has compared CV

valuation estimates with estimates derived using other

valuation techniques has shown that, where the CV

study was carefully designed, CV estimates are not

inflated relative to the other estimates for the same

commodity (Carson, 1996). 

In conclusion, because of the issues raised here, among

other factors, there is a divergence of views within the economic profession concerning whether stated preference

methods can provide useful information on economic values and on validity of individuals' responses to hypothetical questions. Nonetheless, for goods providing non-use

value, stated preference methods may provide the only

analytic method currently available for benefits estimation.

7.5.4 Benefit Transfer

Benefit transfer can be a feasible alternative to using one

of the primary stated or revealed preference research

methods described in previous sections. Rather than

collecting primary data, the benefit transfer approach

relies on information from existing studies that have

applied other methods. More precisely, Boyle and

Bergstrom (1992) define benefit transfer as "the transfer

of existing estimates of nonmarket values to a new study

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Chapter 7: Benefits
which is different from the study for which the values were

originally estimated." The case for which the existing

estimates were obtained is often referred to as the "study

case," while the case under consideration for a new policy

is termed the "policy case." 

Existing applications of benefit transfer often focus on

recreation demand. For an example of such a study, see

Walsh et al. (1992). Applications of benefit transfer to

value health effects have also been completed. See, for

example, EPA's retrospective and prospective reports on

the benefits and costs of the Clean Air Act (EPA, 1997a;

EPA 1999a). Here, ranges of values for multiple-symptom

health effects were calculated by combining results of

studies that valued individual health effects. More information on benefit transfer in general and some of the

issues discussed below can be found in EPA (1993) and a

special issue of Water Resources Research (1992, Volume

28, Number 3) dedicated to the topic. More recently,

Desvousges et al. (1998) discusses transfer studies in general, not only for valuation purposes. The authors illustrate the transfer method with a case-study estimating

externalities associated with electric utility generation.

Is Benefit Transfer the Appropriate Technique?

The advantages to benefit transfer are clear. Original studies are time consuming and expensive; benefit transfer can

reduce both the time and financial resources needed to

develop benefits estimates of a proposed policy. Given the

demands of the regulatory process, these considerations

may be extremely important. Additionally, while the quality of primary research is unknown in advance, the analyst

performing a benefit transfer is able to gauge the quality of

existing studies prior to conducting the transfer exercise. 

However, benefit transfer is not without drawbacks. Most

important, estimates derived using benefit transfer techniques are unlikely to be as accurate as primary research

tailored specifically to the new policy case. Of concern to

the analyst is whether more accurate benefits information

make a difference in the decision-making process. There

are many situations in which a benefit transfer may provide adequate information. For example, if the entire

range of benefits estimates from the transfer exercise falls

well above or below the costs of the policy being considered, more accurate estimates will probably not alter the

efficiency conclusion.

Other factors to consider when deciding whether to conduct a benefit transfer include the availability of relevant,

high-quality existing studies and the degree to which additional primary research would reduce the uncertainty of

the current benefits estimate.

Considerations in Evaluating and Understanding

Benefit Transfer Studies

Currently, a systematic process for conducting benefit

transfer does not exist. There are, however, well-accepted

steps involved in the process. When conducting a benefit

transfer, one should make certain that each of the following steps are carried out carefully:

Describe the policy case. The first step in a benefit

transfer is to describe the policy case so that its characteristics and consequences are understood. It is

equally important to describe the population impacted by the proposed policy. As part of this step, it is

important to determine whether effects of the policy

will be felt by the general population or by specific

subsets of individuals (e.g., users of a particular

recreation site or children). Information on the

affected population will generally be used to convert

per person (or household) values to an aggregate

benefits estimate.

Identify existing, relevant studies. Existing, relevant studies are identified by conducting a literature

search. This literature search should, ideally, include

searches of published literature, reviews of survey

articles, examination of databases, and consultation

with researchers to identify government publications,

unpublished research, works in progress, and other

"gray literature."

Review available studies for quality and applicability. In the third step, the analyst should review

and assess the studies identified in the literature

review for their quality and applicability to the policy

case. The quality of the study case estimates will, in

part, determine the quality of the benefit transfer.

Indicators of quality will generally depend on the

method used. See the previous discussions on each

of the primary research methods for more information on assessing the quality of studies. Assessing

studies for applicability involves determining whether

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Chapter 7: Benefits
available studies are comparable to the policy case.

Specifically:

— the basic commodities must be essentially

equivalent;

— the baseline and extent of the change should be

similar; and

— the affected populations should be similar. 

The analyst should also determine whether adjustments can be made for important differences between

the policy case and the study case. In some cases, it

may prove enlightening to discuss your interpretation

and intended use of the study case with the original

authors. See Desvousges et al. (1992) for additional

information on criteria used to determine quality and

applicability. For more information on applicability as

related to specific benefit categories, see the draft

Handbook for Non-Cancer Valuation (EPA, 1999c),

the Children's Health Valuation Handbook (EPA,

forthcoming), and Desvousges et al. (1998).

Transfer the benefit estimates. This step involves

the actual transfer. There are four types of benefit

transfer studies: point estimate, benefit function,

meta-analysis, and Bayesian techniques. The point

estimate approach involves taking the mean value (or

range of values) from the study case and applying it

directly to the policy case. As it is rare that a policy

case and study case will be identical, this approach is

not generally recommended. Rather than directly

using existing values, analysts will often adjust point

estimates based on judged differences between the

study and policy cases. Judgments of this type should

be based on economic theory, empirical evidence, and

experience (Brookshire and Neill, 1992). The benefit

function transfer approach is more refined but also

more complex. If the study case provides a WTP

function, valuation estimates can be updated by substituting applicable values of key variables, such as

baseline risk and population characteristics (e.g.,

mean or median income, racial or age distribution)

from the policy case into the benefit function. The

most rigorous benefit transfer exercise uses metaanalysis. Meta-analysis is a statistical method of combining a number of valuation estimates that allows

the analyst to systematically explore variation in existing value estimates across studies. As with the benefit

function transfer approach, key variables from the

policy case are inserted into the resulting benefit

function. An alternative to the meta-analytic

approach is the Bayesian approach. These techniques

provide a systematic way of incorporating study case

information with policy case information. Studies

that have explored these concepts include Atkinson et

al. (1992) and Boyle et al. (1994). A discussion of

Bayesian approaches appears in Desvousges et al.

(1998). Regardless of the procedure used, estimates

are generally aggregated over the affected population

to compute an overall benefits estimate.

Address uncertainty. Benefit transfer involves

judgements and assumptions. Throughout the analysis, the researcher should clearly describe all judgements and assumptions and their potential impact on

final estimates, as well as any other sources of uncertainty inherent in the analysis.

7.6 Values for Major

Benefit Categories

As noted earlier, EPA policies may reduce the risk of premature death, typically measured as the number of statistical lives "saved" as a result of the policy action. The benefits of these risk reductions are usually measured using

the concept of the "value of a statistical life" (VSL). VSL

estimates are derived from aggregated estimates of individual values for small changes in mortality risks. If 10,000

individuals are each willing to pay, for example, $500 for a

reduction in risk of 1/10,000, then the value of saving one

statistical life equals $500 times 10,000—or $5 million.

This does not mean that any identifiable life is valued at

this amount, but rather that the aggregate value of reducing a collection of small individual risks is worth $5 million in this case.

7.6.1 Human Health: Mortality

Risks

EPA policies reduce a wide array of mortality risks. Some

risks are experienced by young persons and others by

older persons. Some risks result in death shortly after

exposure, while others take years to manifest. For benefits

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Chapter 7: Benefits
analysis, mortality risks can generally be classified across

two broad dimensions: the characteristics of the affected

population and the characteristics of the risk itself, such as

timing. These dimensions can be expected to affect the

value of reducing mortality risks.

An ideal value estimate for fatal risk reduction would

account for all of these demographic and risk characteristics. It would be derived from the preferences of the population affected by the policy, based on the type of risk that

the policy is expected to reduce. For example, if a policy

were designed to remove carcinogens at a suburban hazardous waste site, the ideal measure would represent the

preferences for reduced cancer risks for the typical suburban dweller in the area. Unfortunately, it is simply too

expensive and time-consuming to obtain such unique risk

value estimates for each EPA policy.

Because original research is usually infeasible, analysts at

EPA will need to draw from existing VSL estimates that

have been obtained using well-established methods.

However, virtually all available applications of these methods focus on risks that differ from environmental risks in

a number of ways. Applying existing VSL estimates found

in the economics literature is an exercise in benefit transfer and raises a number of issues associated with this

technique.

This section characterizes and assesses these issues, recognizing that there are limitations to how effectively analysts

can make adjustments in the benefit transfer process. The

discussion is sometimes necessarily broad, given that

there are a variety of different types of mortality risks

affected by EPA policies. First, this section briefly reviews

relevant economic valuation methods and the VSL estimates they provide. Then the bulk of this section highlights key considerations when considering and transferring these values for use in EPA benefits analysis. In order

to focus the discussion, this section emphasizes those considerations that may be unique to benefit transfer in the

context of mortality risk changes. Benefit transfer considerations that are common to all applications, including

most demographic characteristics of the study and policy

populations, are described in the section of the benefit

transfer method itself.

7.6.1.1 Available Methods for

Estimating Mortality Risk Values

The value of small changes in mortality risk is well-studied, although researchers generally acknowledge that there

are formidable difficulties in measuring risk-dollar tradeoffs. Economists have developed three broad methods to

estimate a value of mortality risk reduction, each of which

is described below. When using any of these methods,

researchers encounter uncertainties not only in isolating

the amount of compensation received for assuming higher

mortality risk, but also in estimating the actual and perceived risk increment inherent in the transaction.

Wage-risk analysis: This method is well-established

and the economics literature contains at least twenty

high-quality wage-risk studies. The resulting VSL estimates range from about $0.7 million to more than

$16 million (1997$) and are included in Exhibit 7-3.

Wage-risk studies have been performed in a number

of different industries and countries and their estimates appear to be somewhat sensitive to the data

and econometric model used.26 Workplace mortality

risks, which tend to be dominated by deaths associated with accidents or other immediate causes, form

the basis for VSL estimates from these studies.

Environmental risks affected by EPA policies often differ from these types of risk in a number of ways.

Contingent valuation: There are at least five highquality published estimates of VSL based on the contingent valuation method. These estimates are broadly consistent with those generated by the wage-risk

method and are included in Exhibit 7-3. These studies have not employed a fatal risk scenario involving

an environmental cause and, therefore, suffer from

some of the same "risk context" differences as wagerisk studies when transferred for use in EPA policy

analyses. Recently, however, researchers have exhibited renewed interest in using the contingent valuation

method to explore how particular factors affect WTP

to reduce risks.27

Averting behavior studies: The published literature contains several examples of averting behavior

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Chapter 7: Benefits

26 Viscusi (1992, 1993) discusses the implications of different specifications and data sets.

27 Johannesson and Johansson (1996), for example, attempt to value extensions to life expectancy. The design of this study has, however,

received some criticism (Krupnick et al., 1999).
studies, also known as "consumer market studies."

Consumer market studies have examined risk-dollar

tradeoffs associated with highway speed (Ghosh et al.,

1975), seatbelt use (Blomquist, 1979), use of smoke

detectors (Dardis, 1980; Garbacz, 1989), and the use

of child safety seats (Carlin and Sandy, 1991). All of

these studies suffer from problems in estimating the

full costs of consumer actions to reduce risks. For

example, it is difficult to quantify the added expense

and "cost of time" involved in purchasing, installing,

and maintaining a smoke detector. Further, these

studies cannot generally control for reductions in

non-fatal risks that are associated with the averting

action. Some researchers argue that these and other

limitations lead consumer market studies to produce

downwardly biased VSL estimates.28

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Chapter 7: Benefits

Study Method Value of Statistical Life

Kneisner and Leeth (1991 - U.S.) Labor Market $0.7 million

Smith and Gilbert (1984) Labor Market $0.8 million

Dillingham (1985) Labor Market $1.1 million

Butler (1983) Labor Market $1.3 million

Miller and Guria (1991) Contingent Valuation $1.5 million

Moore and Viscusi (1988) Labor Market $3.0 million

Viscusi, Magat and Huber (1991) Contingent Valuation $3.3 million

Marin and Psacharopoulos (1982) Labor Market $3.4 million

Gegax et al. (1985) Contingent Valuation $4.0 million

Kneisner and Leeth (1991 - Australia) Labor Market $4.0 million

Gerking, de Haan and Schulze (1988) Contingent Valuation $4.1 million

Cousineau, Lecroix and Girard (1988) Labor Market $4.4 million

Jones-Lee (1989) Contingent Valuation $4.6 million

Dillingham (1985) Labor Market $4.7 million

Viscusi (1978, 1979) Labor Market $5.0 million

R.S. Smith (1976) Labor Market $5.6 million

V.K. Smith (1976) Labor Market $5.7 million

Olson (1981) Labor Market $6.3 million

Viscusi (1981) Labor Market $7.9 million

R.S. Smith (1974) Labor Market $8.7 million

Moore and Viscusi (1988) Labor Market $8.8 million

Kneisner and Leeth (1991 - Japan) Labor Market $9.2 million

Herzog and Schlottman (1987) Labor Market $11.0 million

Leigh and Folsom (1984) Labor Market $11.7 million

Leigh (1987) Labor Market $12.6 million

Garen (1988) Labor Market $16.3 million

Derived from EPA (1997) and Viscusi (1992).

28 These criticisms include Fisher et al. (1989) and Viscusi (1992).

Exhibit 7-3 Value of Statistcal Life Estimates (mean values in 1997 dollars)
No clear consensus establishes one of these three methods

or any particular study as exhibiting superior features for

use in regulatory analyses. However, the relative abundance of available VSL estimates from wage-risk studies

provides a range of broadly applicable values for reduced

mortality risk. As in other benefit transfer exercises, a

range or distribution of values serves as a starting point

when seeking to identify values appropriated for a particular policy context.

7.6.1.2 Existing Reviews of Value of

Statistical Life Estimates

Literature surveys found in Viscusi (1993) and Fisher

(1989) represent the best starting points for VSL estimates.

In both cases, the authors' goals included presenting a

broadly applicable range of values rather than a point estimate. Viscusi (1993) is more recent and includes some

studies not considered by Fisher.29

Drawing from these reviews, EPA identified 26 policy-relevant risk VSL studies as part of an extensive assessment

titled The Benefits and Costs of the Clean Air Act, 1970 to

1990 (EPA, 1997a).30 These are summarized in Exhibit 7-3

(IEc 1992, 1993a, 1993b). Five of the 26 studies are contingent valuation studies, the rest are wage-risk studies. To

allow for probabilistic modeling of mortality risk reduction

benefits, the analysts reviewed a number of common distributions to determine which best fit the distribution of

mean values from the studies. A Weibull distribution was

selected with a central tendency (or mean) of $5.8 million

(1997$).

Although these studies are generally of high-quality, the

$5.8 million measure of central tendency does not account

for variation in study-specific factors underlying these VSL

estimates. Further research on synthesizing the results of

these and other studies, including the use of meta-analysis, may provide estimates better suited for benefit transfer

to environmental policies.

7.6.1.3 Benefit Transfer Considerations

for Using Existing VSL Estimates

Exhibit 7-3 contains the best range of estimates available

at this time. For use in benefits analyses, EPA recommends a central estimate of $4.8 million (1990$), updated

to the base year of the analysis. For example, updating

this figure for inflation produces an estimate of $6.1 million in 1999 dollars.31

However, as with any benefit transfer exercise, it is important to consider differences in the nature of the base and

policy cases. As noted earlier, for fatal risks these differences fall into two major categories: 

differences in the characteristics of the population;

and

differences in the characteristics of the risks being

valued.

Particular differences in these categories are detailed

below. Following this presentation is a summary assessment of how analysts might assess the impact of these

population and risk dimensions. Generally, policy analysts

considering mortality-related benefits should include at

least a qualitative discussion of the potential impact of

these factors on the overall results. It is important to recognize that the ultimate objective of the benefit transfer

exercise is to adjust or correct for all of the factors that significantly affect the value of mortality risk reduction in the

context of the policy. Analysts should carefully consider

the implications of making adjustments for some relevant

factors, but not for others.

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Chapter 7: Benefits

29 A third literature survey, Miller (1990), reviews a broad range of value of life studies, including estimates from averting behavior studies

that others forcefully argue are not appropriate for environmental policy purposes. In addition, Miller's results are dependent on adjustments he

makes to wage-risk data. These adjustments are the subject of debate among economists and may be difficult to defend in environmental contexts.

30 This approach for valuing mortality risks was subject to extensive external peer review during the development process of this report.

Since the report's release, this approach has been adopted in other EPA benefit analyses. Peer reviewers have recently confirmed the approach for use

in a prospective analysis of the Clean Air Act (EPA, 1999a).

31 This was estimated using the Consumer Price Index (CPI) for all goods and services. Many economists prefer to use the Gross Domestic

Product (GDP) Deflator inflation index in some applications. The key issue for EPA analysts is that the chosen index be used consistently throughout

the analysis.
Factors Associated with Demographic

Characteristics

Age (longevity): Several authors have attempted to

address potential differences in the value of statistical

life due to differences in the average age of the affected population or the average age at which an effect is

experienced.32 In the case of reductions in mortality

risks, a young person is assumed to experience a

greater expected benefit in total lifetime utility than

an older person. This hypothesis may be confounded

by the finding that older persons reveal a greater

demand for reducing mortality risks and hence have

a greater implicit value of a life year (Ehrlich and

Chuma, 1990). Though few in number, empirical

studies and theoretic models suggest that the value of

a life follows a consistent "inverted-U" life-cycle, peaking in the region of mean age.33

Two alternative adjustment techniques have been

derived from this literature. The first, valuation of

statistical life-years, is based on the concept of statistical life years introduced in Section 7.4.1. The most

common application of this approach is illustrated in

Moore and Viscusi (1988) and presumes that 1) the

value of statistical life equals the sum of discounted

values for each life year and 2) each life year has the

same value. This method was applied as an alternative case in an effort to evaluate the sensitivity of the

benefits estimates prepared for EPA's retrospective

study of the costs and benefits of the Clean Air Act

(EPA 1997). A second technique is to apply a distinct

value or suite of values for mortality risk reduction

depending on the age of incidence. However, there is

relatively little available literature upon which to base

such adjustments.34

Health status: Individual health status also appears

to affect WTP for mortality risk reduction. This is a

relevant factor for valuation of environmental risks

because individuals with impaired health are often

the most vulnerable to mortality risks from environmental causes (for example, particulate air pollution

appears to disproportionately affect individuals in an

already impaired state of health). Health status is distinct from age (a "quality versus quantity" distinction)

but the two factors are clearly correlated and therefore must be addressed jointly when considering the

need for an adjustment. At least one pilot study has

found that WTP for increased longevity decreases with

a declining baseline health state (Desvousges et al.,

1996).35

Factors Associated with Characteristics of Risk

and Other Considerations

Risk characteristics appear to affect the value that

people place on risk reduction. A large body of work

identifies eight dimensions of risk that affect human

risk perception:36

— voluntary/involuntary;

— ordinary/catastrophic;

— delayed/immediate;

— natural/man-made;

— old/new;

— controllable/uncontrollable;

— necessary/unnecessary; and

— occasional/continuous.

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Chapter 7: Benefits

32 See, for example, Cropper and Sussman (1990) and Moore and Viscusi (1988).

33 Jones-Lee et al. (1985) reach this conclusion empirically, considering both remaining years of life and the value of a life year. This conclusion supports theoretical predictions by Shepard and Zeckhauser (1982).

34 This second approach was illustrated in one EPA study (EPA, 1995) for valuation of air pollution mortality risks, drawing upon adjustments measured in Jones-Lee et al. (1985).

35 The fields of health economics and public health often account for health status through the use of quality adjusted life years (QALYs) or

disability adjusted life years (DALYs). These measures have their place in evaluating the cost effectiveness of medical interventions and other policy

contexts, but have not been fully integrated into the welfare economic literature on risk valuation. More information on QALYs can be found in Gold

et al. (1996) and additional information on DALYs can be found in Murray (1994).

36 A review of issues in risk perception is found in Slovic (1987). Other informative sources include Rowe (1977), Otway (1977), and

Fischhoff et al. (1978).
Transferring VSL estimates between these categories

may introduce bias.37 There have been some recent

efforts attempting to quantitatively assess these

sources of bias. These studies generally conclude

that voluntariness, control, and responsibility affect

individual values for safety, although the direction and

magnitude of these effects are somewhat uncertain.

Environmental risks may differ from those that form

the basis of VSL estimates in many of these dimensions. Occupational risks, for example, are generally

considered to be more voluntary in nature than are

environmental risks, and may be more controllable.

Latency periods: Many environmental policies are

targeted at reducing the risk of effects such as cancer,

where there may be an extended period of latency

between the time of exposure and eventual death

from the disease.38 While the benefit of a reduction in

exposure is an immediate reduction in the risk of the

associated health endpoint, latency periods between

exposure and manifestation may affect the value of

that risk reduction. Existing VSL estimates are based

upon risks of relatively immediate fatalities, making

them an imperfect fit for a benefits analysis of many

policies. Economic theory suggests that reducing the

risk of a delayed health effect will be valued less than

reducing the risk of a more immediate one, when

controlling for other factors.

A simple ad hoc approach to adjusting existing VSL

estimates is to apply a financial discount rate over the

expected latency period. However, defining latency

periods with existing risk assessment methods may be

difficult and empirical estimates may be highly

uncertain. Further, the underlying assumptions

supporting this procedure may oversimplify how

individuals appear to consider delayed health effects.39

Cropper and Sussman (1990) develop an alternative

procedure to account for the influence of time on

fatal risk reduction values, but their demonstration is

data-intensive, requiring detailed life tables and agespecific VSL estimates.

Altruism: The existing VSL literature focuses on

individual risk tradeoffs, but there is evidence that

people are willing to pay to reduce risks incurred by

others. Although the literature on altruism is limited,

several studies suggest that these values may be significant.40 Other analysts advocate caution in attempting to inflate value of life estimates to reflect altruism,

primarily because of concerns over the potential for

double-counting.41

7.6.1.4 Summary of Advice from the

Economics Literature

It is important to recognize the limitations of a single VSL

point estimate and to consider whether any of the factors

discussed above may have a significant impact on the benefits estimated for mortality risk reductions from environmental policies. In any given policy context, there may be

several components that are both relevant and important

and that could act to increase or decrease the appropriate

risk reduction value used to estimate benefits.

Adjustments for each these factors may offset one another

to some extent.42 Analysts should exercise caution in

accounting for some important risk and population characteristics when unable to account for others.

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37 Examples include Mendeloff and Kaplan (1990), McDaniels et al. (1992), Savage (1993), Jones-Lee and Loomes (1994, 1995, 1996),

and Covey et al. (1995). 

38 Although latency is defined here as the time between exposure and fatality from illness, alternative definitions may be used in other contexts. For example, "latency" may refer to the time between exposure and the onset of symptoms. These symptoms may be experienced for an

extended period of time before ultimately resulting in fatality.

39 See, for example, the choice of discount rate discussion in Horowitz et al. (1990) and Rowlatt et al. (1998).

40 In a study that included willingness to pay to reduce others' risk of illness from insecticides, Viscusi et al. (1988) found evidence of significant altruistic values. Jones-Lee et al. (1985) suggests an adjustment to value of statistical life estimates of about one-third to account for people's

concern for the safety of others. 

41 Examples include Bergstrom (1982) and Viscusi (1992).

42 Sometimes this might mean that very different risks will be valued similarly. There are relatively few studies that assess responses to

different types of risk in an individual choice framework. A notable exception is Magat et al. (1996), which finds individuals indifferent between mortality risks from an automobile accident and those from fatal lymph cancer.
Because of the inherent uncertainty in any analysis, however, analysts should consider qualitative evaluations of

these factors and explore where sensitivity analysis can satisfactorily address some of these concerns. The importance and relevance of each of the risk and demographic

characteristics need to be considered. Depending upon

specific policy context, there may be multiple alternatives

for supplemental analysis. 

For example, when policies do not affect the entire population equally, a sensitivity analysis may show the cost per

life saved. In some contexts these values may provide useful information to decision makers on the relative merits

of alternative policy options. However, cost-per-life-saved

measures implicitly assume that all costs are associated

with mortality reduction. For policies that provide other

types of benefits, cost-per-life-saved measures may be misleading unless the value of those benefits are first deducted from cost estimates, but it is impossible to make these

deductions when some benefits are either non-quantified

or non-monetized. Because of these shortcomings, analysts will need to assess the usefulness of cost-per-lifesaved measures on a case-by-case basis.

In general, the decision to perform sensitivity analysis will

also depend upon the relative importance of mortality values in the overall benefits estimates and upon having

sound theoretical and empirical economic literature upon

which to structure the analysis. Parameter values used to

formulate the sensitivity analyses must also be supported

by the underlying risk assessment data.

What support does the economics literature currently offer

for making these potential adjustments? Existing, feasible

methods for age (or longevity) adjustments have significant limitations. Age adjustments may be desirable from a

theoretical standpoint, but the relationship between the

value of risk reductions and expected remaining life span

is complex. Application of existing valuation of statistical

life years approaches implicitly assumes a linear relationship in which each discounted life year is valued equally.

As OMB (1996) notes, although "there are theoretical

advantages to using a value of statistical life-year-extended

(VSLY) approach, current research does not provide a

definitive way of developing estimates of VSLY that are sensitive to such factors as current age, latency of effect, life

years remaining, and social valuation of different risk

reductions." The second alternative, applying a suite of

values for these risks, lacks broad empirical support in the

economics literature. However, the potential importance

of this benefit transfer factor suggests that analysts consider sensitivity analysis when risk data—essentially risk estimates for specific age groups—are available. Emerging

literature on the value of life expectancy extensions, based

primarily on stated preference techniques, is beginning to

help establish a basis for valuation in cases where the

mortality risk reduction involves relatively short extensions

of life.43

A small body of literature on the quantitative impact of risk

characteristics on risk valuation exists. Although there is

some qualitative consistency in the results of these studies,

the risk valuation literature is not sufficiently robust to

support quantitative adjustments for these factors at this

time. Considerations associated with risk characteristics

may deserve qualitative discussion in some policy contexts.

Both of the procedures available for accounting for latency

have potentially serious shortcomings. For example, neither procedure addresses the dread of death or the morbidity that occurs prior to fatality from protracted diseases,

such as that experienced with many cancers. As noted

earlier, the simple "discounted VSL" approach may also

oversimplify how individuals consider latency in their

expressed WTP for reduced mortality risks. This literature

does, however, suggest one alternative for conducting sensitivity analysis on this benefit transfer component.

7.6.1.5 Conclusion

In summary, these guidelines recognize the theoretically

ideal measure of mortality risk reduction benefits and this

section has discussed the many variables affecting such a

measure. Due to current limitations in the existing

economic literature, these guidelines conclude that an

appropriate default approach for valuing these benefits is

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Chapter 7: Benefits

43 It should be noted that many observers have expressed reservations over adjusting the value of mortality risk reduction on the basis of

population characteristics such as age. One of the ethical bases for these reservations is a concern that adjustments for population characteristics

may imply support for variation in protection from environmental risks. Another consideration is that existing economic methods may not capture

social willingness to pay to reduce health risks. Chapter 9 details how some these considerations may be informed by a separate assessment of equity.

Chapter 10 describes the potential for efficiency and equity considerations to be considered together in a social welfare function.
provided by the central VSL estimate described earlier.

However, analysts should carefully present the limitations

of this estimate. Economic analyses should also fully

characterize the nature of the risk and populations

affected by the policy action and should confirm that these

parameters are within the scope of the situations

considered in these guidelines. While a qualitative

discussion of these issues is generally warranted in EPA

economic analyses, analysts should also consider a variety

of quantitative sensitivity analyses on a case-by-case basis

as data allow. The analytical goal is to characterize the

impact of key attributes that differ between the policy and

study cases. These attributes, and the degree to which

they affect the value of risk reduction, may vary with each

benefit transfer exercise, but analysts should consider the

characteristics described above (e.g., age, health status,

voluntariness of risk, latency) and values arising from

altruism.

As the economic literature in this area evolves, WTP estimates for mortality risk reductions that more closely

resemble those from environmental hazards may support

more precise benefit transfers. Literature on the specific

methods available to account for individual benefit transfer

considerations will also continue to develop. EPA will continue to conduct annual reviews of the risk valuation literature and will reconsider and revise the recommendations

in these guidelines accordingly. EPA will seek advice from

the Science Advisory Board as guidance recommendations

are revised.44

Despite the limitations described in this section, analysts

should remember that mortality risk valuation remains

one of the most studied benefit categories for environmental policies. Wage-risk studies, while not without limitations, nonetheless provide revealed preference estimates

based on a well-tested method. Estimating mortality related benefits will often be relatively straightforward to implement, while other benefit categories will require more time

and attention.

7.6.2 Human Health: Morbidity

Risks

Morbidity valuation, or the valuation of non-fatal health

effects, often requires addressing a more diverse set of

issues than mortality valuation. First, there is a tremendous variety in the health endpoints considered for valuation. These endpoints vary with respect to their severity,

including the degree to which other activities can be pursued and the degree of discomfort or pain associated with

the ailment. The duration of the effect also varies considerably, from short term effects to those that may be permanently debilitating. Non-fatal health effects differ considerably with respect to the availability of existing value

estimates. Some of these health effects have been valued

multiple times with different methods, while others have

not been the subject of any valuation studies. 

Willingness to pay to reduce the risk of experiencing an illness is the preferred measure of value for morbidity

effects. This measure includes several components.

Illness imposes direct costs, such as expenses for medical

care and medication, and indirect costs, such as lost time

from paid work, maintaining a home, and pursuing leisure

activities. Illness also imposes less easily measured, but

equally real costs of discomfort, anxiety, pain, and suffering. Methods used to estimate WTP vary in the extent to

which they capture these components.

A commonly used alternative to WTP is the avoided costs

of illness (COI). For a given health effect, the COI

approach will generally understate true WTP. By focusing

on market measures of the value of health effects, it leaves

out important components such as the value of avoiding

pain and suffering. By focusing on ex post costs, it also

does not capture the risk attitudes associated with ex ante

WTP measures. However, for many effects, estimates of

WTP are not currently available or are highly uncertain.

Where estimates of WTP are not available, the potential

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Chapter 7: Benefits

44 A second review on this subject was recently completed by the Science Advisory Board (SAB), the results of which can be found in "An

SAB Report on EPA's White Paper Valuing the Benefits of Fatal Cancer Risk Reductions," EPA-SAB-EEAC-00-013, July 27, 2000 (website address

http://www.epa.gov/sab/eeacf013.pdf, accessed 8/28/00). The SAB review elaborates further on using the wage-risk literature for valuing mortality

risk reductions, concluding that among the demographic and risk factors that might affect VSL estimates, the current literature can only support

empirical adjustments related to the timing of the risk. First, the review supports adjusting willingness-to-pay estimates to account for higher future

income levels, though not for cross-sectional differences in income. The second time-related adjustment recommended is to discount for risk reductions that are brought about in the future by current policy initiatives (that is, after a latency period), using the same rates used to discount other

future benefits and costs. More information on the SAB review and its implications for the Guidelines will be released in a forthcoming supplement

to this document.
bias inherent in relying on cost-of-illness estimates should,

at minimum, be discussed qualitatively.

Time and resources will often not allow for original morbidity valuation research to support specific benefit analyses. As with other types of benefits, analysts will then need

to look for estimates available from existing sources, and

apply these values to the policy case using benefit transfer

techniques. The discussion here is presented with this

benefit transfer exercise in mind. The remaining parts of

this section present a summary of methods commonly

used to value reductions in morbidity, useful references for

obtaining existing values, and issues that arise in transferring existing values to the analysis of EPA policies.

7.6.2.1 Available Methods for

Estimating Morbidity Values

Researchers use a wide range of methods to value changes

in morbidity risks. Some available methods measure the

theoretically-preferred value of individual WTP to avoid a

health effect, while others provide useful data but are less

well-grounded in economic theory. Methods also differ in

the perspective from which valuation is measured (e.g.,

before or after the incidence of morbidity) and the degree

to which they account for all of the components of total

WTP. 

The three primary research methods used most often to

value environmental morbidity are cost of illness, contingent valuation, and averting behavior, as described earlier.

Several other primary valuation methods have been used

less frequently to value morbidity from environmental

causes: hedonic methods, risk-risk tradeoffs, health-state

indexes, and studies of jury awards. However, these methods often do not provide monetary estimates of WTP or

suffer from other methodological flaws, and are generally

less useful for policy analysis.

Cost-of-illness: The cost-of-illness method is

straightforward to implement and explain to policy

makers and has a number of other advantages. It has

been applied for many years, is well-developed, and

measures of direct and indirect costs are easily

explained without reference to complex economic

theory. Collection of additional data is often less

expensive than for other methods, perhaps making it

feasible to develop original cost-of-illness estimates in

support of a specific policy or set of policies.

Estimates for many illnesses are available from existing studies and span a wide range of health effects.

EPA's Cost of Illness Handbook (EPA, forthcoming)

contains an extensive collection of cost-of-illness estimates. As noted earlier, however, the cost-of-illness

method has several shortcomings and its theoretical

basis is quite limited. Generally, cost-of-illness estimates should be considered lower bounds on WTP.

Averting behavior: In the case of morbidity valuation, the averting behavior method can provide WTP

estimates based on actual behavior. These measures

can account for all of the effects of health on individual well-being, including altruism toward other

household members if averting actions are taken

jointly (e.g., if everyone in the household drinks bottled water). However, the method has several weaknesses, as described in Section 7.5. Existing studies

vary in their analytical approach. Some existing studies have attempted to estimate WTP for particular sets

of illnesses (Gerking and Stanley, 1986; Dickie and

Gerking, 1991; Bresnahan and Dickie, 1995). Others

do not attempt to estimate ex ante WTP, but focus

instead on actual household expenditures in response

to a particular contamination episode or event

(Harrington et al., 1989; Abdallah, 1990). In practice, most averting behavior estimates should be

interpreted cautiously as a lower-bound estimate on

WTP. Also, because behaviors generally avert a range

of symptoms (e.g., a water filter removes contaminants with several potential health effects), it is difficult to isolate the value of avoiding those individual

health effects that may be attributable to a particular

EPA policy. Indiscriminate use of this method may

raise significant problems with double counting or

overestimation.

Stated preference methods: Contingent valuation

and other stated preference methods can be used to

account for all the effects of illness on individual wellbeing, including pain and suffering. These methods

appear to be the only ones capable of eliciting dollar

values for altruism toward persons outside the household. Unlike the averting behavior or cost-of-illness

methods, these can be applied to value the risks of illness lacking any connection to market transactions.

Stated preference methods have been used to value a

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Chapter 7: Benefits
number of different health outcomes including accidental poisoning (Viscusi and Magat, 1987; Viscusi et

al., 1988); coughing, congestion, and other minor

symptoms (Berger et al., 1987); chronic bronchitis

(Viscusi et al., 1991; Krupnick and Cropper, 1992);

and nonfatal nerve disease (Magat et al., 1996).

Some economists, however, express concerns about

the hypothetical nature of the transaction and the difficulties inherent in ensuring that respondents understand the change in health status they are being asked

to value.45

7.6.2.2 Existing References for

Morbidity Values

Analysts have a number of resources available for obtaining information on morbidity values. While these references provide valuable information, they are not substitutes for careful evaluation of original studies when considering a benefit transfer. Useful general references for

valuing non-fatal health effects include Tolley et al. (1994 )

and Johanneson (1995). Both of these books provide references to many existing health valuation studies and discuss issues associated with using these estimates for policy

valuation. Desvousges et al. (1998) assess a number of

existing studies in the context of performing a benefit

transfer for a benefits analysis of improved air quality.

Another good starting point for reviewing available estimates is EPA's Handbook for Non-Cancer Valuation (EPA,

1999c). This report will provide available, published estimates for many illnesses and reproductive and developmental effects.

Because estimates of WTP will not always be available for

particular health effects, another useful resource is EPA's

Cost of Illness Handbook (EPA, forthcoming). This handbook includes cost-of-illness estimates for many cancers,

developmental illnesses and disabilities, and other illnesses. Work on the handbook is ongoing and new estimates

will be included as they become available.46

Existing EPA economic analyses may also provide useful

insights. For example, the Benefits and Costs of the

Clean Air Act (EPA, 1997a) draws upon a number of existing studies to obtain values for reductions of a variety of

health effects. The report describes the central estimates

used in the analysis, how these estimates were derived,

and attempts to quantify the uncertainty associated with

using the estimates.

7.6.2.3 Benefit Transfer Using Existing

Morbidity Value Estimates

Benefit transfer was detailed earlier in this chapter; however, there are issues associated with benefit transfer particular to morbidity valuation. As with any benefit transfer,

analysts should: 

carefully describe the policy case; 

assess the quality of the studies and their applicability

to the policy case; 

evaluate the plausibility of the findings;

consider possible adjustments for differences between

the subject of the study and the policy case; and

explicitly address uncertainty.

EPA's Handbook for Non-Cancer Valuation (EPA, 1999c)

contains additional information on this subject.

Matching the Study Case to the Policy Case

Assessing applicability: A key element in evaluating the applicability of a study is the correspondence

between the health effect valued in the study and the

health effect influenced by the policy. An assessment

of this correspondence must consider the set of

symptoms covered in the study. The analyst should

consider whether the study case consists of a larger or

smaller set of symptoms than the policy case. The

severity of the symptoms should also be commensurate, including the degree to which the illness limits

activities and the extent of any discomfort, pain and

suffering. Analysts should also assess whether the

duration of the base and policy cases are similar.

A second key factor is the similarity between the population examined in the study and the population

affected by the policy. Key considerations include the

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Chapter 7: Benefits

45 See, for example, Mitchell and Carson, 1989; Cummings et al., 1986; NOAA, 1993; Bjornstad and Kahn, 1996; NRDA, 1994; Diamond

and Hausman, 1994.

46 The Cost of Illness Handbook will be available online.The website will be continuously updated as additional COI estimates are completed.
baseline health status of the populations, the age of the

populations, and other demographic characteristics.

Evaluating plausibility: The analyst should conduct some initial checks to evaluate whether the study

case values are plausible or reasonable. For example,

if the estimated value of avoiding an acute, reversible

effect exceeds other reasonable estimated values for

avoiding long-term, chronic effects, then the value for

the acute effect is probably too large and will be difficult to defend. On the other hand, WTP values that

are less than cost-of-illness values for the same effect

are probably too low, particularly if the effect clearly

results in pain or otherwise impairs activity.

Using the results of multiple studies: After

reviewing the quality and applicability of available

studies, the analyst can apply the valuation estimates

to the data on cases averted by each policy option.

Because the value of morbidity avoidance is difficult

to quantify precisely, it is useful where possible to

apply estimates from more than one valuation technique. Where multiple studies are available that provide differing estimates, the range of values should be

presented with a discussion of the advantages and

limitations of the studies used. Estimates based solely on cost-of-illness values should be flagged as potentially understating total values. WTP studies of health

effects that are similar in severity and duration may

be used as a point of comparison.

Addressing Uncertainty and Related Concerns

Available estimates of non-fatal effects may suffer from

several limitations. They may be derived from cost-of-illness methods that do not fully measure WTP to avoid the

effect or may be transferred from studies of effects that are

similar, but not identical to, the effect of concern. The

extent to which adjustments or new research are needed

to address these concerns will depend largely on the value

of new information to the decision-making process. If

morbidity values are a small component of total benefits

and unlikely to influence the choice among policy options,

then a qualitative discussion of uncertainty may be appropriate. Where morbidity values are a significant concern,

quantified sensitivity analysis and additional data collection

may be desired.

Some of the major sources of uncertainty are described

below. Because of the diversity of the health effects of concern and of the studies used to value morbidity effects, this

discussion is relatively general. The limitations and potential adjustments or analyses of uncertainty that are appropriate will vary greatly depending on the approach used for

a particular policy analysis. More information on these

issues is provided in EPA's Non-Cancer Valuation

Handbook (EPA, 1999c).

Ex ante and ex post valuation estimates:

Environmental contamination will generally not cause

an adverse health effect with certainty, but rather will

increase the probability that the effect occurs,

increase its severity given that it occurs, or both.

People are likely to value these changes in risk differently than they would value certain changes in health

status. While contingent valuation and other methods

can adopt an ex ante perspective and obtain estimates for risk changes, many available studies provide ex post value estimates for morbidity effects. For

minor health effects this difference in perspective

may not be important, but for severe health effects

the difference may be significant and ex post estimates may understate the benefits of a policy action.

Analysts should address this issue at least qualitatively

in these cases.

Incomplete estimates of willingness to pay: The

widespread availability of health insurance and paid

sick leave shift the costs of illness from individuals to

others. While this cost-shifting can be addressed

explicitly in cost-of-illness studies, it may lead to

problems in estimating total WTP through contingent

valuation surveys. If the researcher does not adequately address these concerns, respondents may

understate their WTP, assuming that some related

costs will be borne by others.

Timing of health effects: Environmental contamination may cause immediate or delayed health effects

and the value of avoiding a given health effect likely

depends on whether it occurs now or in the future.

Recent empirical research confirms that workers discount future risks of fatal injuries on the job; that is,

they are willing to pay less to reduce a future risk

than a present risk of equal magnitude (Viscusi and

Moore, 1989). In addition, a separate study concluded that individuals value policies that yield health

benefits in the present more highly than policies that

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Chapter 7: Benefits
yield the same benefits in the future (Cropper et al.,

1994).

7.6.2.4 Summary

Morbidity benefits valuation can be a difficult process,

often requiring careful judgment decisions by the analyst.

Whether the analyst is conducting original research that

supports the policy action or is drawing upon existing

studies, clarity and transparency in the analysis is vital.

When employing benefits transfer, some shortcomings in

the "fit" of the study case to the policy case is to be expected. Addressing these shortcomings explicitly, conducting

appropriate sensitivity analysis, and clearly stating assumptions can greatly enhance the credibility of the benefits

analysis.

7.6.3 Ecological Benefit

Valuation

In estimating ecological benefits, one is generally forced to

value individual ecological service flows separately and

then sum these estimates rather than constructing prices

for changes in the structure and function of entire ecosystems. Alternative approaches that estimate the total value

of ecosystems based on the replacement cost of the entire

ecosystem or its embodied energy (e.g., Costanza et al.,

1997; Ehrlich and Ehrlich, 1997; Pearce, 1998; Pimentel

et al., 1997) have received considerable attention as of

late. However, the results of these studies should not be

incorporated into benefit assessments. The methods

adopted in these studies are not well grounded in economic theory nor are they typically applicable to policy analysis.

Pearce (1998) contains a critical review of the total value

approach, as does Bockstael et al. (2000).

Although the economics literature is replete with benefit

studies, the coverage is patchy considering the broad range

of services and stressors addressed by EPA programs.

Especially rare in the literature are examples of wide-scale

changes, very small changes, or the consequences of long

term ecological and economic change. Ongoing research

has begun to address these data limitations. Examples

include recent contingent valuation studies undertaken for

purposes of natural resource damage assessments that

attempt to elicit WTP for marginal changes in long-term

environmental quality (Kopp et al., 1994). In addition,

Layton and Brown (1997) attempt to elicit from respondents the value of one attribute of the long-term ecological

changes expected to be associated with climate change. 

Available Methods for Estimating Ecological

Benefits

Economists have employed a variety of methods to estimate the benefits of improved ecological conditions.

Issues particular to their implementation for this benefit

category are discussed below.

Market models: The benefit of changes in commercial crop, timber, or fish harvests can be estimated

using a variety of available market models. Several

studies have assessed the social welfare implications

of changes in yields for a number of crop species.

For example, Taylor et al. (1993) apply the

Agricultural Sector Model and Kopp et al. (1985)

apply the Regional Model Farm Agricultural Benefits

Assessment Model to estimate welfare impacts of agricultural yield changes. Adams et al. (1997) use the

Agricultural Simulation Model to estimate the economic effects associated with yield changes resulting

from climate change. 

When dealing with timber or fisheries, bioeconomic

models are designed to deal explicitly with time to

account for the fact that environmental and market

changes are not coincident. EPA has used the Timber

Assessment Market Model (TAMM) to estimate ozone

effects on commercial timber harvesting. The welfare

impacts of changes in commercial fish harvests have

also been examined, e.g., Alaskan king crab in

Greenberg et al. (1994); herring in Mendelsohn

(1993); and lobster in Wang and Kellogg (1988).

If changes in service flows are small, current market

prices can be used as a proxy for expected benefit.

For example, a change in the commercial fish catch

might be valued using the market price for the affected species. This approach can only be used in cases

where fishing effort and price are unlikely to be affected by the policies. If these conditions do not hold, a

market model should be applied to assess the effects

of increased catch rates on supply conditions and

market price, as discussed earlier in the section on

consumer and producer surplus.

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Chapter 7: Benefits
Production function approach: Values for indirect,

non-market benefits can be estimated when their

contribution to production processes are expressed

explicitly in a production function. As service flows

increase, the welfare gain is essentially the marginal

product of the service for small changes or is reflected by the shift in the marginal cost curve. Several

studies have examined the relationship between environmental quality and crop production, such as

measurement of ozone impacts by Heck et al. (1983).

Moreover, researchers have applied this approach

using household production functions to examine

ecosystem services that benefit individuals directly or

to establish the link between some services and their

off-site benefits. Bell (1997) values wetland contributions to recreational fishing and Barbier (1994) values a range of indirect wetland benefits. Smith et al.

(1993) estimate the impact of nitrogen and pesticide

loadings on coastal water recreational fishing.

Averting behaviors approaches: One such

approach, the replacement cost method, uses purchases of market goods to infer the value of indirect,

non-market services. Willingness to pay is revealed

by efforts made to substitute for services provided by

ecosystems. For example, since water treatment

infrastructure replaces wetland functions, investment

and operations and maintenance costs provide an

estimate of the value of the water filtration service

provided by wetlands. This method is justified only

when individuals are proven willing to incur such

replacement costs, through either their voluntary purchases or their support for public works projects. If

so, the value of the service is at least as much as the

replacement cost.

Another variation on this theme applies to actions

that reduce the cost of complying with existing policies. For example, a reduction in atmospheric nitrogen deposition in the watershed of an estuary may

ultimately reduce the costs incurred in reducing other

sources of nitrogen to the system, such as added controls on POTWs. This approach is generally useful in

situations satisfying two criteria: alternative pollution

control methods are prescribed through existing policies and the new policies under consideration would

provide a lower cost method for achieving the desired

level of environmental protection.

Hedonic methods: Hedonic property models can

isolate the relationship between environmental quality

and housing prices from the effects of variation in

other attributes such as size, location, and security.

This method is often used to use to value regional difference in air quality. Smith and Huang (1995) conduct a meta-analysis to examine how well the models

perform in this context and discern a statistically significant relationship between housing prices and air

quality measures in general. Hedonic models have

also been used to estimate the impact of landfill closure (Kohlhase, 1991), nuisances from odors

(Palmquist et al., 1997), and the existence and remediation of toxic contaminated sites (Kiel, 1995) on

nearby property values. Other applications have

addressed the costs of land-use restrictions (Parsons,

1992) and the benefits of water quality improvements

(Rich and Moffitt, 1982). A promising development

involves the application of hedonic methods in a

model of land-use change to explore the ecological

and economic consequences of landscape alteration

(Bockstael, 1996). In addition, Geoghegan et al.

(1997) estimate the impact of land uses adjacent to

and near one's home.

Recreation demand models: Recreation demand

models are discussed in detail in Section 5.2.1 of this

chapter. Recreation demand models are based on the

tradeoff between travel expense and environmental

quality. While early travel cost models dealt with single sites, did not consider environmental quality, and

suffered from a range of limitations and biases, more

recent efforts overcome these problems. For example, a travel cost model was used to estimate the WTP

by Chesapeake Bay beach users for a 20 percent

improvement in water quality as measured by nitrogen

and phosphorous loadings (Bockstael et al., 1989). 

Random utility models have been used in a wide

variety of studies to estimate the recreational fishing

benefit of fresh water quality improvements.

Montgomery and Needelman (1997) apply a random

utility model to fishing behavior and estimate the

benefits of eliminating toxic contamination from New

York lakes and ponds. Recreation demand models

also have been used in the context of forest

management (Englin and Mendelsohn, 1991; Dwyer

et al., 1983), the ecological effects of natural resource

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Chapter 7: Benefits
damages (Hausman et al., 1995; Morey and Rowe,

1995), health risks associated with fish advisories

(Jakus et. al., 1997), and non-point source pollution

controls in estuaries (Kaoru et al., 1995).

Stated preference approaches: As discussed earlier, stated preference methods represent the only

means of obtaining a value for non-use benefits. For

instance, research has tried to measure how much

better people feel that various wildlife species are alive

and well (Stevens et al., 1991). Individuals have also

expressed a willingness to pay to protect visibility in

national parks, whether or not they plan to visit these

parks (Crocker and Shogren, 1991). Contingent valuation has been applied to the other ecological benefit

categories as well. EPA has regularly used the results

of one such study to value water quality improvements in fresh water (Mitchell and Carson, 1986b).

7.6.4 Materials Damage

Market methods are the primary technique used to quantify benefits falling in this category. Materials damages can

include changes in both the quantity of the materials and

in the quality. Linking changes in environmental quality

with the provision of service flows from materials can be

difficult because of the limited understanding of the physical effects (e.g., scientific information), the timing of some

effects (e.g., long-term), and risk responses of producers

and consumers of these service flows. When feasible,

assessment typically involves combining the output of an

environmental model with stressor-response function

and/or price information to estimate the impact of the

change in environmental quality on production (inputs) or

consumption (output) of the material service flows. The

market response to this impact serves as the basis for the

welfare change and benefits assessment. In practice, these

market methods may be implemented as reduced from

economic models that relate averting or mitigating expenditures to ambient pollutant levels. The degree to which

behavioral adjustments are considered when measuring

the market response are important and models that incorporate behavioral responses are preferred to those that do

not. Refer to Adams and Crocker (1991) for a detailed discussion of this and other features of materials-damagesbenefits assessment. See the analysis of household soiling

in EPA (1997b) for an example that employs a reduced

form economic model relating defensive expenditures to

ambient pollutant levels.

100

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112

Chapter 7: Benefits
8.1 Introduction 

The goal of a benefit-cost analysis is to determine the

net change in social welfare brought about by a new

environmental policy, as measured by changes in the

producer and consumer surpluses. In general, the

economic effects of a new environmental policy

result in many different people and firms being

affected, both positively and negatively. The previous

chapter looked at the positive effects (or social benefits). This chapter considers the negative effects (or

social costs). It is the sum of these changes, when

combined with the social benefits, that yield a measure of the net changes in social welfare.

As with social benefits, when computing the social

cost of a policy (i.e., the negative impact on social

welfare), monetary sums that measure changes in

individuals' welfare are all weighted equally in benefit-cost analysis. Other methods for evaluating the

welfare consequences of policies on particular individuals, groups, or sectors should be examined using

either economic impact analysis, equity assessment

techniques, or social welfare functions (all described

in Chapter 9). 

This chapter is organized into four major sections

followed by a concluding section. Section 8.2 reviews

the theoretical foundations of social cost estimation

for environmental policies. Section 8.3 discusses

how to estimate and model total social cost.1 Next,

four types of models for estimating social cost are

examined in Section 8.4. Then the estimation of the

costs of specific regulatory approaches is reviewed in

Section 8.5. Finally, Section 8.6 provides a discussion

of the choice of tools for each type of policy

.

8.2 The Theory of

Social Cost Analysis

The total social cost is the sum of the opportunity

costs incurred by society because of a new regulatory

policy; the opportunity costs are the value of the

goods and services lost by society resulting from the

use of resources to comply with and implement the

regulation, and from reductions in output. These

costs, however, do not take into account any of the

health, environmental, safety, or other benefits which

offset the social welfare costs. 

The five basic components of total social costs are

listed here in the general order of relative ease of

estimation, and hence inclusion, in most social cost

analyses of environmental policies. They include:

Real-resource compliance costs: These

direct costs are the principal component of total

social costs and are associated with: (1) purchasing, installing, and operating new pollution

control equipment, (2) changing the production

process by using different inputs or different

mixtures of inputs, or (3) capturing the waste

products and selling or reusing them. (The last

two options can actually result in negative compliance costs.)

These real-resource costs should also include

unpriced resources that have opportunity costs

associated with them, such as unpaid labor

diverted from other productive uses, and extra

administrative costs associated with compliance.

However, the pre-tax compliance costs do not

include any transfers, such as emissions taxes,

licensing fees, or subsidies (which are included

in the firm's private costs).

113

Chapter 

8

Chapter 8: Analyzing Social Costs

1 Several texts on applied microeconomics and policy evaluation provide substantially more theoretical depth and examples

than the overview presented in this chapter, such as Arnold (1995), Gramlich (1981), and Just et al. (1982).
Government regulatory costs: These include the

monitoring, administrative, and enforcement costs

associated with new regulations. This also includes

the cost of setting up a new market when incentivebased regulations are established, such as tradable

permits.

Social welfare losses: These are the losses in consumer and producer surpluses associated with the

rise in the price (or decreases in the output) of goods

and services that occurs as a result of an environmental policy.

Transitional costs: These include the value of

resources that are displaced because of regulationinduced reductions in production, and the private

real-resource costs of reallocating those resources.

Offsetting these costs, in theory, are regulationinduced increases in resource use in both primary

and related markets (e.g., more workers and equipment are needed for pollution control).

Indirect costs: These other costs include the

adverse effects policies may have on product quality,

productivity, innovation, and changes in markets indirectly affected by the environmental policy, all of

which may have impacts on net levels of measured

consumer and producer surplus.

8.2.1 An Illustration of Social

Costs and Externalities

Exhibit 8-1 illustrates an externality (pollution) associated

with the production of a good or service (Q). In this

figure:

MR is marginal revenue from selling the good;

MPC is the marginal private real-resource cost of

production;

MSD is the marginal social damage from pollution

associated with production; and

MSC is the total marginal social cost of supplying the

good.

The producer operates where marginal revenue (MR)

equals marginal private real-resource costs (MPC), so it

produces Q1 items at a price of P1 per item. In this example, the producer also is assumed to impose a social cost

on society due to pollution associated with its production

of Q. Here the actual pre-policy total social cost of supplying the good is measured by the marginal private realresource cost (MPC) plus the marginal social damage

(MSD, also known as an externality) caused by pollution.

Together the MPC plus the MSD gives the true marginal

social cost (MSC) of supplying the good. 

114

Chapter 8: Social Costs

Price

P4

P*

P1

P2

P3

0 Q* Q1 Quantity

DWL MSD

MPC

MSC

F

E

G

H

MR

Exhibit 8-1 Producer and Consumer Surplus with an External Cost
The producer surplus is indicated by the area of triangle

P1GP3 and the consumer surplus is measured as the area

of triangle P1GP4, but the total social damage is indicated

by the area of P3GF P2. Therefore, the deadweight loss to

society (DWL) is equal to the area of triangle EFG. If producers have to pay for the damage caused by the pollution,

their producer surplus is reduced to area of triangle P2HP1

minus the area of triangle HGF. In this case the firm

would be making negative profits since the area of triangle

HGF is larger than their producer surplus. Net social welfare in this case would be the area of triangle P2EP4 less

the area of triangle EFG (the deadweight loss).

If, however, the optimal amount of the product is produced (i.e., where MR equals MSC), then the firm's output

is Q* at a price of P*. In this case, consumer surplus is

equal to the area of triangle P4EP* and producer surplus

is the area of triangle P2EP*. Since there is no deadweight

loss to society, net social welfare has increased and is

equal to the area of triangle P2EP4.

Suppose that producers can do nothing to reduce the pollution damages other than decrease the amount of output

supplied. If the government places a tax equal to the MSD

on each unit of pollution, this would increase private production costs (but not private real-resource costs) by the

amount of the MSD, which would cause a rise in consumer (taxpayer) welfare. This occurs because of the

reduction in adverse health effects. Depending on the revenue policy of the government, it could lead to a possible

reduction in consumer taxes, since producers are now

paying an additional tax (the double-dividend hypothesis,

which is described in greater detail later in this chapter).

Although there is a decrease in the producer surplus (and

the obvious consumer surplus), the overall social welfare

has increased because of the reduction in the externality

costs.2 Adding all of these surplus changes together, and

subtracting the transfers to the government (i.e., taxes),

yields the net social cost of the policy.

If instead of an emissions tax, a firm is required to install

pollution control devices, the private compliance costs will

raise the firm's supply curve (or MPC) up by the amount

spent on the new equipment. Under a permit system,

where a set number of permits are issued for each unit of

pollution, and firms are allowed to buy and sell these permits, then each firm will consider buying permits if the

private cost of a permit is less than the unit cost of reducing pollution. Conversely, a firm that can reduce its pollution by less than the cost of a permit will consider selling

its "extra" permits. In both cases, the firms' MPC curves

will shift up by the price of the permits, just as it did in the

case of an emissions tax.

8.3 A General Approach

to Social Cost Analysis

The challenge in developing an estimate of the social cost

of an environmental policy is to consider the market(s)

being affected by the policy, assess the available data and

analytic methods, and adopt an analytic approach that will

yield an estimate suitable for use in the benefit-cost analysis. An important requirement in measuring social costs

is to characterize the supply and demand equations of the

regulated market or behavior. This section briefly reviews

the estimation of supply and demand equations and their

relevance to social cost, but concentrates on the variety of

social costs that may be encountered from different types

of environmental policies: (1) direct social costs, (2) transitional costs, and (3) indirect costs. Finally, some other

issues that arise in characterizing and presenting social

costs are examined, including discounting, difficulties in

monetizing costs, consideration of sensitivity analyses, and

simplifying market effects. 

8.3.1 Estimating the Supply and

Demand Equations of All the

Affected Markets

Empirical estimates of the supply and demand curves for

each market are usually needed to calculate the social

costs of proposed regulations and policies. In addition to

private sources, government reports and academic studies

can provide useful information needed to estimate the

115

Chapter 8: Social Costs

2 If the regulation causes social costs to be greater than the MSD, then net social welfare may actually fall because of the new regulation;

one cause being the diversion of investment capital to excess pollution control and away from its highest valued use.
Chapter 8: Social Costs

116

supply and demand equations.3 Solving these equations

will yield equilibrium quantities and prices in each market

that approximate the baseline figures.

In most situations, the supply and demand functions can

be derived based on engineering cost estimates. For example, a step-function demand curve for a particular good

can be computed based on the prices at which various segments of the market will turn to substitute goods. This

technique is relatively more successful for products that

are used as inputs to other processes and consumer goods

that have well-defined alternatives. Similarly, an estimate

of producer surplus can be derived based on the value of

plant and equipment dedicated to supplying a particular

good, and the ease or difficulty with which this capital can

be deployed in other markets to supply different goods. In

the long run, the supply curve is often assumed to be horizontal.

Information on the elasticity of demand is available for the

aggregate output of most industries. When such information is unavailable, as is often the case for intermediate

goods, the elasticity of demand may be quantitatively or

qualitatively assessed. Econometric techniques, such as

multiple regression, can be used to estimate a demand

curve when sufficient data are available. For example,

when dealing with intermediate products, econometric

models can be constructed using engineering cost data to

estimate both the supply and demand curves. In general,

econometric tools are frequently used to estimate supply

and demand equations and the factors that influence

them.

Information on the availability of product or service substitutes, the impact of price increases on final goods (where

the product or service is an intermediate good), the

amount of a person's income devoted to the good or service, and the necessity of the final product or service can be

used to qualitatively assess demand elasticities. The estimate selected for the point elasticity should be consistent

with the equilibrium point (the time allowed for adjustments to occur) used in the analysis.

Estimating the equations that govern market supply and

demand may be time and resource intensive, in addition

to the formidable tasks of developing the means to structure and compute the considered models. While many

types of markets have been researched in detail by the academic community, others may be too new to have much

information available. It may be difficult to obtain data

from the affected firms or industries because of confidentiality provisions or the proprietary nature of some data

and models. Achieving sufficiently reliable results will

often depend on the quality of the data, and overcoming

problems with data will be a primary hurdle in many

social cost analyses.

8.3.1.1 Definition of Elasticities

In general, economists use the term "elasticity" to refer to

the sensitivity of one variable to changes in another variable.4 The price elasticity of demand (or supply) refers to

changes in the quantity demanded (or supplied) that

would result from a change in the price of a good or service. Changes are measured assuming all other things,

such as incomes and tastes, remain constant. Demand

and supply elasticities are rarely constant and often change

depending on the quantity of the good. Therefore, when

calculating elasticities, it is important to state the price and

quantity of the good.

"Elastic" demand (or supply) indicates that a small percentage increase in price results in a larger percentage

decrease in quantity demanded (or supplied). How much

of the price increase that will be passed on to consumers

is determined by the elasticity of demand relative to supply

(as well as the degree of competition within the industry

and existing price controls). All other things equal, an

industry facing a relatively elastic demand is less likely to

pass on costs to the consumer because increasing prices

will result in reduced revenues. 

3 Sources can include trade publications, financial studies, and data collected through surveys administered in support of the regulation

(e.g., Section 308 surveys administered under the Clean Water Act for promulgation of effluent discharge limitations). Government agencies and the

private sector also publish data and studies on the economic activity of the public and private sector and households. A more complete listing of

examples is provided in Exhibit 9-3 on sources used to prepare economic profiles of industries. Additional illustrations can be found in existing EPA

economic reports, several of which are referenced later in this chapter.

4 Own price elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price.

Own price elasticity of supply is defined as the ratio of the percentage change in quantity supplied divided by the percentage change in price.
8.3.1.2 Determinants of Demand

Elasticity

Among the many variables that affect the elasticity of

demand are: (1) the availability of close substitutes, (2)

the percentage of income a consumer spends on the good,

(3) how necessary the good is for the consumer, (4) the

amount of time available to the consumer to locate substitutes, (5) the level of aggregation used in the study, and

(6) the expected future price of the good. In this section,

only the first four will be discussed.

The availability of close substitutes is one of the

most important factors that determine demand

elasticities. A product with close substitutes tends to

have an elastic demand, because consumers can

readily switch to substitutes rather than paying a

higher price. Therefore, a company is less likely to be

able to pass through costs if there are many close

substitutes for its product.

Whether the affected product represents a

substantial or necessary portion of customers'

costs or budgets is another factor that affects

demand elasticities. When price increases occur for

products that represent a substantial portion of

downstream producers' costs or consumers' budgets,

these producers or consumers may be more likely to

seek alternatives. Where the product subject to the

price increase is less important in customers'

budgets, customers may be less motivated to use

substitutes (even if they are available) or to forego

consumption entirely. A similar issue concerns the

type of final good involved. Reductions in demand

may be more likely to occur when prices increase for

"luxuries" or optional purchases than for basic

requirements.

The time frame considered is a third important

factor in determining elasticity. Elasticities tend to

increase over time, as firms and customers have

more time to respond to changes in prices. A

company facing an inelastic demand curve in the

short run may experience greater losses in demand in

the long run, as customers have time to make

adjustments that allow use of substitutes or as new

substitutes are developed.

It is important to keep in mind that elasticities differ

at the firm versus the industry level. For example, if

twenty companies are producing pesticide formulations that are equally effective, each firm may face an

elastic demand curve because of competition within

the industry, although the industry as a whole may

face an inelastic demand curve for its products as a

group. In this example, it would not be appropriate

to use an industry-level elasticity to estimate the ability of only one firm to pass on compliance costs when

its competitors are not subject to the same costs.

8.3.1.3 Determinants of Supply

Elasticities

The elasticity of supply depends, in part, on how quickly

costs per unit rise as firms increase their output. Among

the many variables that influence this rise in cost are: 

the availability of close input substitutes; 

the amount of time available to adjust production to

changing conditions; 

the degree of market concentration among producers; 

the expected future price of the product; 

the price of related inputs and related outputs; and

the speed of technological advances in production

that can lower costs. 

Supply elasticities will tend to increase over time as firms

have more opportunities to renegotiate contracts and

change production technologies.

Characteristics of supply in the industries affected by a regulation can be as important as demand characteristics in

determining the economic impacts of a rule. For highly

elastic supply curves, it is likely that costs will be passed

through to consumers. The main determinants of industry supply curves are the structure of costs and the time

period of the analysis. Industry supply curves are defined

as the aggregation of the supply curves of individual firms

within an industry. 

If detailed financial profiles of individual establishments or

categories of establishments and production data are available, they can be used to define an industry supply curve.

Explicit information on the cost structure of an industry is

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Chapter 8: Social Costs
very useful in predicting impacts more precisely than is

possible using industry average data. A given firm may

experience significant impacts if it is already a relatively

high cost producer. Such firms would be more vulnerable

to closure if subjected to high compliance costs. 

8.3.1.4 Obtaining Supply and Demand

Elasticities

Elasticity estimates may be obtained from existing literature or from original research. The use of published estimates avoids the time and expense of gathering the necessary data. Sources for published estimates include previous agency rule makings or relevant studies found in the

economics literature. The analyst will have to employ

careful judgement in deciding whether and how to use

elasticity estimates from previous studies. Estimates

should be drawn from studies based on:

similar market structure and level of aggregation;

sensitivity to potential differences in regional elasticity

estimates;

current economic conditions; and

appropriate time horizon (i.e., short or long run).

This is not an exhaustive list of issues which must be considered in applying existing estimates to new analyses.

There are a number of statistical and technical issues that

may influence the quality of elasticity estimates. Relevant

texts cited below should be consulted and technical assistance sought when necessary.

New or original estimates of elasticities are derived from

demand and supply functions for goods or services that

have been estimated using econometric methods.

Econometrics is the use of statistical analysis in applied

economic research. For example, the demand for a good

or service is often estimated as a function of its price, the

price of related goods (substitutes and complements),

consumer demographic characteristics, as well as variables

that may represent institutional or technological characteristics of a market. Supply and demand elasticities may be

derived from a variety of functional forms that embody

various assumptions about the relationships between the

data. Methods of calculating elasticity estimates differ

according to the specification of the function. The analyst

should consult relevant texts and seek technical assistance.

The availability of sufficient data, both in terms of quantity

and quality, is the first threshold that determines whether

econometric tools can be used. Only with sufficient data

can elasticity estimates be considered reliable. The analyst

should carefully document data sources. Once the decision to employ econometrics is made, there are a number

of issues which the analyst must address, including the

choice of an appropriate modeling technique, proper functional form, and ensuring that the mathematical properties required for the chosen technique to yield proper

results are achieved. For example, ordinary least squares

(OLS) requires that:

values of independent variables are non-stochastic or

fixed;

expected mean value of the error term is zero;

expected value of the variance of the error term is

constant;

no correlation exists between error terms; and 

no correlation exists between error terms and

independent variables.

If any of these conditions are violated, the analyst will have

to make a corrective adjustment to the OLS or consider an

alternative econometric technique. For example, if one of

the independent variables is endogenous, the first and last

condition will be violated, resulting in a biased and inefficient coefficient estimate. In the context of estimating a

demand function, the price variable is likely to be endogenous, which would render the coefficient estimate and

derived elasticity incorrect. A method known as two-stage

least squares (TSLS) represents one means of accounting

for endogeneity. The number of potential econometric

approaches, mathematical requirements, and corrective

measures is beyond the scope of this guidance document.

Analysts should consult relevant texts for a more thorough

discussion of all of these issues.5

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Chapter 8: Social Costs

5 For detailed review of econometric modeling and technical issues see Greene (1996), Maddala (1992), or Pindyck and Rubinfeld (1991).

Kennedy (1998) provides a more intuitive discussion in the main text with detailed technical notes provided in appendices.
8.3.1.5 Uses and Substitutes Analysis

A "Uses and Substitutes Analysis" may provide useful information on the characteristics of demand as a supplement

to or substitute for elasticity estimates.6 This is "...an indepth examination of each significant use of the substance

in question, and an assessment of the costs, performance,

and useful life of substitutes, on a product-by-product

basis."7 A "Uses and Substitutes Analysis" includes four

steps:

1) define markets and segments of markets that are relatively homogeneous;

2) assess the cost and performance characteristics of the

products in question;

3) identify the most appropriate substitutes; and

4) estimate the incremental costs and performance

characteristics of the substitutes in each specific

application.

The results of the analysis can then be used to generate

demand functions, based on the price at which substitute

products become economical for different uses. This

analysis can be time and information intensive and may

produce relatively crude results. It is nonetheless a useful

alternative to estimating demand functions when elasticities are not available. 

8.3.2 Determining the Different

Types of Social Costs 

Having established measures of supply and demand, the

analysis then considers how equilibrium price and quantities will change from measured baseline conditions.

Social cost changes in each of the affected markets are

assessed by examining the direct, indirect, and transitional

effects that occur as a result of the new policy. The types

of social costs that need to be examined to determine how

the supply and demand equations change are summarized, with examples in Exhibit 8-2. A short description of

direct costs, which include private and public compliance

costs, government regulatory costs, and other types of

social costs, is presented. Other social costs less routinely

included in empirical analyses of social costs, including

indirect costs and the transitional costs, are then reviewed.

8.3.2.1 Direct Social Costs 

The direct social costs of a new environmental policy arise

from: (1) changes in the private real-resource compliance

costs, (2) additional government regulatory costs, (3)

social welfare losses, and (4) transitional social costs. The

largest fraction of direct social costs arises from the realresource compliance costs due to the new regulation.

These new compliance costs arise from the installation,

operation, and maintenance of new capital equipment, or

are a result of changes in the production process that raise

the price of producing the good.

The additional compliance costs can be used to estimate

the new equilibrium price and quantity in the affected

markets which will change social welfare. However, these

changes will affect other markets, resulting in further price

and quantity changes in other goods, giving rise to additional changes in social welfare. The significance of the

changes in other markets will influence the type of model

necessary for the economic analysis (see Section 8.4,

"Modeling Tools"). Changes in social welfare also result

from increased government regulatory costs and transitional costs from plant closures and unemployment. 

Private real-resource compliance costs can arise

from: (1) the capital costs associated with the

purchase, installation, operation, and maintenance of

new pollution control equipment, (2) changes in the

inputs or mixtures used in the production process, or

(3) the capture of waste products that can either be

disposed of, sold, or reused.

Real-resource costs are theoretically straightforward

to calculate if they arise from the purchase of new

pollution control equipment. For example, having

information on the number of factories and the price

of purchasing and operating new equipment required

to meet a policy would provide a means of estimating

the compliance costs for the industry. However, since

all factories are not identical, costs may be estimated

based on cost studies of representative factories

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Chapter 8: Social Costs

6 Uses and substitutes analysis is described in Arnold (1995).

7 Ibid., p. 21.
chosen by random sampling procedures, which can

be extrapolated to the universe of affected factories. 

Additional costs involve the operating expenses, maintenance, and training associated with the new equipment. Further costs may occur from maintenance

changes in other equipment. Also, additional administrative costs may be associated with obtaining permits and preparing required monitoring reports.8

In the two other methods of compliance, the private

costs may actually be negative and thus need to be

included for an accurate estimate of social costs.

When waste products are captured and then disposed

of, sold, or reused, the cost calculation is also

straightforward. Disposal charges are easily determined and the selling price of the waste product (if it

is used as an input for other goods) can also be

obtained. However, if the production process is

changed so that different inputs are used or the mixture of the inputs is altered, the costs involved will be

difficult to determine before the change takes place.

In addition, the changes may be considered proprietary information.

Government regulatory costs are incurred by

federal, state, or local governments to administer and

enforce new policies. Government regulatory costs

include: administration, training, monitoring/reporting

(if they are not included in compliance costs),

enforcement, litigation, and the cost of developing and

distributing permits. These incremental costs must be

financed through additional taxation or other

governmental financing mechanisms.

Because they are hard to translate into producer and

consumer surplus terms, governmental administration and enforcement costs are typically examined in

terms of their dollar costs and staffing requirements

(expressed as full-time equivalent employment

(FTEs)). Ultimately, these costs are borne by taxpayers unless other administrative costs are reduced to

accommodate a new policy. Since government costs

are usually small compared to the explicit compliance

costs, they are not usually included in partial

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Chapter 8: Social Costs

8 A good recent illustration of the measurement of compliance costs can be found in EPA (1997), Economic Analysis for the NESHAPS for

Source Categories: Pulp & Paper Production; Effluent Limitations Guidelines, Pretreatment Standards: Pulp, Paper, and Paperboard Category,

Phase I. For useful empirical presentations on engineering approaches, see Vatavuk (1990) for air pollution controls and EPA (1984) for a wider variety of pollution control technologies.

Social Cost Category Examples

Real-resource Compliance Costs • Capital costs of new equipment

• Operation and maintenance of new equipment

• Waste capture and disposal, selling, or reuse

• Change in production processes or inputs 

• Maintenance changes in other equipment

Government Sector Regulatory Costs • Training/administration

• Monitoring/reporting

• Enforcement/litigation

• Permitting

Social Welfare Losses • Higher consumer and producer prices

• Legal/administrative costs

Transitional Social Costs • Unemployment

• Firm closings

• Resource shifts to other markets

• Transaction costs

• Disrupted production

Source: Adapted from Harrington et al. (1999).

Exhibit 8-2 Examples of Social Cost Categories
equilibrium models. However, if they are significant,

they should be estimated separately and added to the

surplus-based social cost estimates.

Monitoring and enforcement costs, incurred by the

government, can be either (1) the opportunity costs

of other activities that are discontinued because of

fixed government budgets, or (2) the private costs

imposed on taxpayers to support the increased government expenditure necessary for the program. The

costs of government monitoring and enforcement

efforts are normally based on the cost of necessary

administrative activities.9

Social welfare losses occur when real-resource

compliance costs result in higher prices for the good

or service and when additional government regulatory

costs result in higher taxes passed on to the

consumer. New regulations may lead to increased

legal and administrative costs for the government, as

well as for the regulated entities. The change in social

welfare resulting from an increase in taxes or fees

assessed in order to pay for government regulatory

costs will typically be small relative to social welfare

losses attributable to the real-resource compliance

costs. 

If the imposition of real-resource compliance costs

leads to an increase in the price of the good, this will

lead consumers to either buy less or switch to substitutes, thereby leading to a fall in the consumer surplus. The amount of the private costs passed through

to the consumer is determined by the market structure, and the elasticities of demand, supply, and

income. Once the prices, quantities, and elasticities

are known, the process of calculating changes in producer and consumer surpluses is also theoretically

straightforward.10

Transitional effects vary depending on the length of

the time period examined; therefore, social cost

analyses should be explicit about the time frame

being studied. In the short run, the private

annualized costs of compliance, both for consumers

and producers, will be higher relative to the

annualized long-run costs. This is because the shortrun analysis will not provide for possible adjustments

in the production process, or allow consumers to find

substitutes. Some workers may become unemployed

in the short run, but will almost certainly find other

jobs in the long run. 

However, over time the impact of a policy can easily

spread out to a variety of markets and result in a

number of unanticipated adverse effects. Therefore,

it is not always appropriate to assume that social costs

arising in the short run as a consequence of transitional effects will be resolved in the long run. For EPA

economic analyses, the four transitional effects most

frequently considered include: (1) plant closings and

resultant unemployment, (2) resources shifting to

other markets, (3) transactions costs associated with

setting up incentive-based programs, and (4) disruptions in production.

Firm closings and unemployment: In the simplest

static models, the time frame is assumed to be a period of time in the near future (e.g., the first year after

a new policy is promulgated). Surplus-based measures of social cost are therefore short-run estimates.

But as time passes, adjustments are likely to occur.

Workers who suffer transitional unemployment will

usually find new jobs, and new plant and equipment

installed in the future might require relatively less

costly pollution control. These long-run changes

should be considered as the yearly social costs of a

policy are calculated into the future.

In most cases, involuntary unemployment and plant

closings are consequences that are difficult to model

using a conventional partial equilibrium framework

(which will be discussed in the following section on

modeling tools). Predicting these specific consequences would require far more detailed analysis and

data than are usually available for practical assessments. Unemployment rates for each group of workers, the duration of unemployment, and the cost of

job training programs are just some of the factors that

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Chapter 8: Social Costs

9 A useful illustration of the measure of government regulatory costs for a rule can by found in EPA (1995a), Economic Analysis of the

Title IV Requirements of the Clean Air Act Amendments.

10 An example of the steps taken to estimate the measurement of social welfare losses from a rule is EPA (1998), Economic Analysis of

Effluent Limitation Guidelines and Standards for the Centralized Waste Treatment Industry.
need to be taken into account when estimating how

the transitional costs decline over time. 

These temporary effects are typically assessed and

reported as part of an "economic impact" of the policy, and are incorporated into the development of the

social cost section of an economic analysis. Chapter

9 of this document reviews such methods to assist in

detecting situations in which a policy's private costs

are sufficiently large to induce social costs from

occurring as a consequence of business closures,

reduced employment, or other such impacts.

Shifts of resources to other markets: These shifts

occur when the payments to factors of production

(labor, land, and capital) are reduced. These shifts

are partly responsible for the decreased output level

of the product or service. Those that remain earn

less than before, at least in the short run, which is

reflected in the lower net price received by producers

for the good or service. Some of the resources no

longer employed in producing this good or service

might even become unemployed for a while, such as

labor, or be permanently and prematurely scrapped,

such as plant and equipment. These and other realworld phenomena can change the position and slope

of the supply functions in other markets. Likewise,

consumers of the product either pay more for the

same good or purchase substitutes that are less suitable or more costly, which can change the position

and slope of several demand functions. The analysis

of these types of effects is also treated more fully in

Chapter 9.

Transaction costs: These costs are encountered with

incentive-based policies, such as with a tradable permits program. A market must be established so that

the efficiency gains from trading permits are maximized, and rules for trading are developed that

enable the market to function under the rules of perfect competition. Therefore, initial short-run costs

associated with setting up the market will be high, but

are expected to diminish over time as the created

market begins to function with less government oversight. The private cost of buying and selling permits

will then become similar to the purchase of any other

resource needed to produce a good or service.

Disruptions in production: This may take place when

new equipment is installed or new production

processes or inputs are applied. These costs can be

estimated as the amount of time the production line

is stopped or slowed down to allow for the necessary

changes to comply with the new policy regulations.

However, if the changes are made during previously

scheduled down-time or required maintenance, then

downward adjustments should be made to the estimated costs to reflect this.

To conclude, in many cases transitional costs are considered to be small enough that their inclusion in the overall

social cost estimate would not appreciably alter the quantitative conclusions. However, when these are expected to

be significant, the costs should be estimated. For example,

lost wages and job search costs during the time workers

are unemployed can be used as a proxy for this transitional social cost. Similarly, the value of prematurely retired

plant and equipment can be calculated and added to the

surplus-based social cost estimates to capture this transitional effect, as long as this is not reflected already in the

supply and demand framework.

8.3.2.2 General Equilibrium (Indirect)

Effects 

Other possible components of social costs, such as effects

on product quality, productivity, innovation, and market

structure, can require fairly complex dynamic models to

quantify. Although most individual regulatory policies will

not have such dramatic effects, these costs can be quite

significant in certain instances, such as when a policy's

requirements delay industrial projects or affect new product development. Such policy effects have implications for

future social costs but are difficult to measure and express

in social cost terms. However, an effort should be made to

qualitatively describe these factors and look at approaches

that can quantify these effects when data and resources

can support this level of detailed analysis of social costs. 

Changes in market structure may occur if the

expense of pollution control is sufficiently high that it

drives out enough firms to cause changes in the

market concentration and competitiveness of firms

remaining in the industry. Such a change often

results in shifts of both firm and industry supply

curves, which can lead to changes in output and

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Chapter 8: Social Costs
prices in several markets affecting both producer and

consumer surpluses.

Labor and capital productivity may decrease

under new regulations. For example, the

administrative costs of monitoring emissions and

filing reports with regulatory agencies may require

firms to hire more workers whose labor does not

increase productivity (as measured by labor employed

relative to produced output). Pollution control

devices or restrictions on the use of products may

cause lower levels of output relative to unconstrained

production processes. For example, placing

restrictions on pesticide use may reduce the yield of

crops susceptible to pest damage, holding other

factors of production (e.g., labor, fertilizer) constant.

In each case, however, private costs are captured by

changes in the supply and demand curves of the

product, and therefore care should be taken to insure

that social costs associated with productivity losses are

not double counted with other social cost estimates.

Discouraged investment may occur if research and

development funds are reallocated to meet additional

compliance costs. This may result in decreases in

technological innovation and product quality. The

latter can be modeled as the reduced amount

consumers are willing to pay for the low quality good,

relative to what they were willing to pay for the

original, higher quality good. In practice, changes in

technological innovations are not commonly analyzed

in most economic models used in benefit-cost

analyses of individual regulations and policies.

8.3.3 Other Issues Arising in

Presentation of Social Costs

Four additional issues to note arise in the organization and

presentation of social costs, several of which have also

been raised earlier in this document in connection with

the measurement of social benefits. These issues discussed here on social costs include: (1) discounting, (2)

difficulties valuing some social cost categories, (3) conducting sensitivity analyses, and (4) simplifying market

effects. 

Discounting: Social discounting procedures for

economic analyses are reviewed in considerable detail

in Chapter 6. For purposes of computing the social

costs of environmental policies, costs should be

discounted using the methods and social discount

rates discussed in that chapter. This is the case

regardless of the methods used to estimate social

costs. Social costs can be estimated in detail year-byyear, or estimated using growth rates, or merely

assumed to be constant. These streams of social

costs can then be adjusted to yield: (1) discounted

present value, (2) future value, or (3) the annualized

cost of the policy. All three approaches are different

ways to express the same concept and choosing which

method to present the results will depend on the

method that most effectively allows comparisons

among the options and the measurement of net

benefits.11

Difficulties of valuing social costs: Some

consequences of environmental policies are difficult

to represent in the definitive, quantitative terms of

conventional social cost analysis. Irreversible

environmental impacts, substantial changes in

economic opportunities for certain segments of the

population, social costs that span very long time

horizons, socioeconomic effects on communities, and

poorly understood effects on large-scale ecosystems

are difficult to summarize in a quantitative benefitcost analysis. Some alternative techniques for

measuring and presenting these effects to policy

makers are reviewed in section 7.6.3 of the benefits

chapter that discusses measuring ecological benefits.

The relative significance of social cost categories that

are not quantified—or are quantified but not

valued—should be described in the analysis.

Sensitivity analysis: The estimates in the social cost

analysis will not be known with certainty. In fact,

some data and models will likely introduce

substantial uncertainties into the estimations of social

costs. Numerous assumptions are made in regard to

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Chapter 8: Social Costs

11 Many EPA analyses typically prepare an annualized cost estimate, since this measure is one of several used to determine whether rules

require additional review and oversight, and is used to help establish the scope of the economic analysis to be conducted (e.g., the social cost threshold of $100 million in annual costs is used to identify rules that require a benefit-cost analysis under the provisions of EO 12866).
the baseline, predicting responses to policy, and the

number of affected markets. Therefore, the

conclusions drawn in the benefit-cost analysis will be

sensitive to the degree of uncertainty present and the

assumptions that were made. Reporting the

uncertainty of the data, the assumptions used, and

how the uncertainty and assumptions affect the

results are important components of the presentation

of social cost. Section 5.5 outlines the process of

analyzing and presenting uncertainty.

Simplifying market effects: Given the complexity

of modern economies, measuring and predicting all

of the consequences of a particular action would

involve a significant effort. The central question

explored in this section is whether some or all

markets indirectly affected by a policy must be

analyzed to obtain a measure of social costs suitable

for a benefit-cost analysis, or whether the calculation

of social costs can be limited to an assessment of the

directly affected markets without introducing

unacceptable biases and errors into the analysis.

In general, the social cost of a policy can be measured

exclusively by changes that occur in the markets directly

targeted by a policy, as long as significant net changes in

social welfare are not generated in indirectly affected markets. If price changes in other markets generate both

gainers and losers among the producers and consumers,

then they may offset each other in a social cost analysis as

transfers.12 However, if there are strong reasons to believe

that conditions in other related markets might generate

important net social welfare consequences, these should

be examined. If a policy indirectly increases or decreases

the quantity of a good that is consumed, whose production

or consumption involves an externality, then this results in

net social welfare effects that may be worth considering

when calculating total social costs (and benefits).

8.4 Modeling Tools 

The following section first focuses on the basic framework

common to all models used to estimate social costs, while

the remaining sections examine the models commonly

used: (1) direct compliance cost methods, (2) partial

equilibrium models, (3) multi-market models, and (4)

computable general equilibrium models.

8.4.1 The Basic Framework

Benefit-cost models must predict what actions firms are

likely to choose when attempting to comply with a new

policy and what the compliance costs of those actions will

be. Normally, these are based on engineering or process

cost models that examine firms' alternative compliance

methods. Engineering cost estimates typically specify the

capital, operating, and maintenance costs that are likely to

occur in adopting different pollution control strategies.

When possible, these initial engineering cost estimates

should include the expected level of compliance costs, as

well as reasonable lower and upper bounds for purposes

of sensitivity analysis.

In addition to the preliminary engineering or other estimates of the social costs of various compliance strategies,

other costs may be significant. As noted earlier, for some

market-based approaches, transaction costs can often be

substantial. For example, when setting up the market for

a permit trading system, determining how many permits

to purchase or sell can involve detailed cost modeling and

forecasting, in addition to the social costs associated with

operating the trading system. When these costs are likely

to be significant, they should be estimated in addition to

the basic private real-resource costs of capital and the

operating costs of alternative compliance methods.

8.4.2 The Direct Compliance

Cost Method 

In some cases, social costs are estimated using the direct

compliance cost method. This is the simplest approach

used in estimating social costs. Under this approach, the

social cost for a policy is simply set equal to the initial

engineering or other compliance cost estimates for the

compliance options the firms are likely to adopt; no additional modeling is undertaken. If only compliance costs

are calculated, the private (compliance) costs are likely to

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Chapter 8: Social Costs

12 This conclusion regarding the net social welfare implications of price changes in related markets requires some qualification. Even

when non-zero welfare effects are produced by price changes in related markets, they are likely to be small relative to the estimated producer and

consumer welfare effects in the directly affected markets. See Arnold (1995) for more discussion of related markets and welfare measurement.
be overestimated. This is because private costs are computed for the pre-policy level of output under the implicit

assumption that there is no substitution away from the

affected products or activities into other relatively less

expensive ones. That is, firms do not make any capital or

labor adjustments in their production processes. In addition, when the resulting changes in consumer surplus are

calculated at the new higher prices, consumer welfare

losses are also likely to be overestimated since changes in

consumer behavior will not be taken into account. 

Nevertheless, using direct compliance costs as an approximation of actual social costs may be reasonable for a policy when price and quantity changes are small, and there

are few indirect effects. However, if consumers can easily

switch to substitute goods, this adjustment will make the

actual social cost of the policy significantly less than indicated by the direct compliance cost estimates. Likewise, if

firms can find less costly substitutes for their inputs or

production processes, which have been made more expensive by the new regulations, then compliance costs will be

an overestimate of the actual social costs.

8.4.3 Partial Equilibrium Analysis 

Because of the limitations of using direct compliance costs

as a measure of social costs, an alternative approach is to

model the economic effects of these compliance costs on

producers and consumers using a partial equilibrium

supply and demand model of the affected markets. This

allows for a more complete analysis of social costs and

their incidence. "Partial" equilibrium refers to the fact

that the supply and demand functions are modeled for

just one or a few isolated markets and that conditions in

other markets are assumed either to be unaffected by a

policy or unimportant for social cost estimation.

For example, if using a partial equilibrium supply and

demand framework, a new environmental policy that

increases production costs will cause a change in the supply function. The demand function, the old and new supply functions, prices, and quantities can then be used to

compute changes in producer and consumer surpluses. If

the relevant markets are evolving over time, this technique

can be applied in each future time period using new supply and demand functions. This makes it possible to estimate the changing distribution of social costs over time.

The practical difference between the results of the partial

equilibrium supply and demand-based modeling and the

direct compliance costs approach depends on the nature

of the policy and the magnitude of its effects. For small

compliance costs, price and quantity movements are likely

to be minimal, so the social cost estimates derived from

the partial equilibrium model framework will not be significantly different from the results obtained from the direct

compliance cost method.

For policies with larger compliance costs, price and quantity movements could be more substantial. The estimated

social costs using the supply and demand framework in

these cases may be considerably less than those suggested

by the simpler direct compliance cost approach.

Moreover, policies that effectively ban products or activities

cause the loss of all producer and consumer surpluses in

these markets. Therefore, it is difficult to calculate social

costs of these policies without an explicit supply and

demand framework.

Analyzing the effects of a policy using a partial equilibrium

model of the directly affected markets is appropriate when

the ramifications in indirectly affected markets do not generate net social costs. It is also a reasonable framework as

long as the social costs imposed by a policy are small and

do not significantly alter other markets or produce measurable macroeconomic effects (e.g., changes in national

unemployment levels). 

In most cases, a conventional partial equilibrium framework comparing the pre-policy baseline with the expected

results of a new environmental policy will suffice for an

economic analysis. For analyzing environmental policies

that pose very large consequences for the economy, computable general equilibrium modeling is an alternative

technique that is particularly useful and is discussed later

in this chapter.13

The partial equilibrium framework is a commonly used

theoretical tool for modeling and measuring the social

costs of environmental policies. In theory, a variety of

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Chapter 8: Social Costs

13 Useful recent illustrations of partial equilibrium analyses prepared in support of environmental policies include EPA (1998) Economic

Analysis of Effluent Guidelines and Standards for the Centralized Waste Treatment Industry, and EPA (1996) Economic Impact Analysis of

Proposed NESHAP for Flexible Polyurethane Foam.
social costs can be observed and calculated using this

technique. Even transitional effects that result in shortrun social costs, such as premature capital equipment

retirement and relatively brief spells of involuntary unemployment, can be modeled and estimated using this

framework. Thus, the approach offers a theoretically

sound, if limited, method for conceptualizing the consequences of an environmental policy and measuring their

social costs.

Deriving the supply and demand functions is the foundation of benefit-cost analysis and is necessary in all economic models used to analyze social costs and benefits.

However, because of its importance and the uncertainties

associated with estimating supply and demand functions,

it may be useful to evaluate key assumptions with sensitivity analyses and develop a range of estimated social costs.

The typical analysis is performed assuming a competitive

market, although unusual circumstances may require

relaxing this assumption. Even should competitive market

conditions fail to hold, partial equilibrium analysis can be

adapted to analyze varying market conditions that may

more closely reflect real-world conditions. It is useful to

indicate when social benefits or social costs have been

overestimated or underestimated because of biases caused

by market distortions. However, the principles underlying

partial equilibrium analysis can serve as a useful model to

evaluate the real-resource costs of many of EPA's regulations and policies.

As previously discussed in Section 5.6, "Emerging CrossCutting Issues," environmental policies usually can be analyzed assuming a first-best regulatory setting, although

actual conditions reflect a second-best world in light of

taxes placed on a variety of goods and services. Therefore,

it is conceivable that a regulatory policy in one sector may

have effects in labor markets and other sectors of the

economy. Thus, examining costs in only the final

goods market may cause costs (or even benefits) to be

underestimated. 

The scope of the regulatory program is likely to be proportional to the effects experienced in other sectors of the

economy. Therefore, the larger the program, the more

important it is to examine several markets to accurately

estimate costs and determine (1) tax interaction effects,

(2) changes in technology, and (3) the effects on firms'

research and development decisions. Thus, multi-market

models are needed for regulatory policies that may have

large economic effects on several sectors of the economy.

8.4.4 Multi-Market Models 

Multi-market models go beyond partial equilibrium analysis by extending the inquiry to more than just a single

market. Multi-market analysis attempts to capture at least

some of the interactions between markets. However,

unlike the general equilibrium models discussed in the

next section, multi-market models do not attempt to

incorporate a representation of the entire economy.

An example of the use of a multi-market model for environmental policy analysis is contained in a report prepared

for EPA on the regulatory impact of controls on asbestos

and asbestos products (EPA 1989). The model developed

for the study describes the interactions between the

asbestos fiber market and markets for the goods that use

the fiber as an intermediate input. The collective demands

for final goods that use asbestos create a derived demand

for asbestos fiber. The price of the fiber is determined

through the interaction between the demand and supply

schedules for asbestos. Changes in this price in turn influence the prices and demands for the downstream goods.

The specification of the links between the input and output

markets is especially important for simulating alternative

regulatory policies, including interventions in both the

input market (caps on the usage of asbestos fiber) and in

the output market (bans on some of the goods that use

asbestos as an input), as well as combinations of the two.

The model was then used to compare the efficiency losses

under various regulatory scenarios.

8.4.5 General Equilibrium

Analysis

Although the use of a partial equilibrium or multi-market

model may be appropriate when policies are likely to affect

a limited number of markets, they are not able to capture

interactions between a large number of sectors. Many

environmental policies, such as energy taxes, can be

expected to impact a large number of sectors both directly

where the policy is applied, and indirectly through

spillover and feedback effects on those and other sectors.

A strength of general equilibrium models is their ability to

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account consistently for the linkages between all sectors of

the economy. Three types of general equilibrium models

that have been used for the analysis of social costs are

input-output models, linear programming models, and

computable general equilibrium (CGE) models.

8.4.5.1 Input-Output (I/O) Models

The central idea underlying I/O analysis is that in modern

economies, production activities are closely interrelated.

An input-output table represents the flow of goods and

services through the economy, usually measured as transactions occurring over the course of a year. In addition to

the primary factors of capital, labor, and land, most productive sectors use many different intermediate inputs. In

an I/O table, the column associated with a particular sector lists the value of the individual intermediate and primary inputs consumed by that sector. The row associated

with an individual sector lists the value of that sector's output purchased as both intermediate inputs and final

demand. For each sector in a table, the column sum represents the total costs of production and the row sum represents total expenditure on that sector's output. A key

feature of I/O tables is that, by definition, for every sector,

total costs must equal total expenditures during the year.14

An I/O table can be turned into a simple linear model

through a series of matrix operations. The intermediate

inputs matrix defines a matrix of technical coefficients,

based on the assumption that inputs to production are

consumed in fixed proportions to output and that there

are constant returns to scale. The model is manipulated

by making exogenous changes to the vector of final

demands. The model will then calculate how much of

each of the intermediate goods is required to produce the

new final demand vector. The sum of the intermediate

inputs required plus final demand is equal to total output

for the year. 

I/O models have a long history in environmental policy

analysis. Leontief (1970) showed how it was possible to

augment the basic I/O model with an additional set of

coefficients for pollution generation and/or abatement.

When a set of pollution coefficients has been defined, an

I/O model can then produce an estimate of the quantity of

pollution that would be generated along with a given

amount of final demand or total output. The quantity of

pollution generated may be specified in either monetary

terms (as damages) or in physical units. 

Some economic research firms use I/O models to provide

upper bound estimates on price effects. Others use I/O

models to look at the related markets and their potential

significance prior to adopting a partial or general equilibrium model. The I/O approach has also been extended further to include non-market, ecological commodities such

as ecosystem services.15 

Although I/O models can be a useful as a consistency

check or a first-order approximation, they have a number

of shortcomings that limit their applicability as a predictive

tool:

Given that prices are normally assumed to be fixed

and do not adjust to indicate scarcity, there is nothing

to ensure that the total demands generated by

manipulation of the model are consistent with the

actual productive capacity of the economy. 

The fixed coefficients assumption leaves no scope for

substitution of inputs in production. 

Since there is no producer or consumer behavior

built into I/O models, simulation of policy

interventions that would affect those agents is of

limited value. 

Because the construction of an input-output table is a

costly and time-consuming process, usually requiring

a specialized survey, the application of input-output

analysis to environmental policy making will normally

only be possible when an appropriate table already

exists. More importantly, since input-output tables

are used in linear programming and computable

general equilibrium models, this last shortcoming is

shared by these models as well. 

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14 A general reference on input-output models is Miller and Blair (1985).

15 A discussion of the application of input-output models to environmental policy analysis, with a number of examples, is provided in

Chapter 7 of Miller and Blair (1985). Another example applied to the environmental protection industry is EPA (1995b), The U.S. Environmental

Protection Industry: A Proposed Framework for Assessment.
8.4.5.2 Linear Programming (LP)

Models

I/O models are driven by exogenous changes in final

demand. Since they do not contain an objective function,

I/O models are difficult to use for decision making among

multiple alternatives. However, it is possible to extend the

basic I/O model into a LP model by incorporating an

explicit objective function and a set of inequality constraints.16

In addition to the usual economic variables, the objective

function may be specified to include a number of environmental variables, such as the discharge of air or water pollutants. The specification of multiple inequality constraints allows for a great deal of flexibility in the application of LP model (because of this flexibility, EPA's Office of

Air and Radiation has used linear programming models

for many years). Shadow prices generated in the dual

form of LP models have a limited relationship to market

prices and may sometimes be useful as indicators of the

importance of the individual constraints. Sensitivity analysis can be conducted by varying key parameters in the

model.17

The flexibility in the specification of LP models is also

something of a liability of the approach. The problem is

that the selection of the constraints used is often ad hoc

and may influence the model solution. As with many linear models, there is often a tendency towards unrealistic

solutions, such as excessive specialization in production or

trade. Finally, the lack of realistic consumer and producer

behavior is carried over from I/O models.

8.4.5.3 Computable General

Equilibrium (CGE) Models

As discussed in the previous sections on I/O and LP models, these approaches have shortcomings that make them

less than ideal tools for policy analysis in modern market

economies. In particular, in both I/O and LP models, the

behavior of producers and consumers does not reflect the

independent optimizing behavior that is usually assumed

to be a characteristic of agents in a market economy.

Without the specification of realistic producer and consumer behavior, model-based policy simulations will be

unable to correctly account for the reactions agents may

have to policies that impact them. Computable general

equilibrium (CGE) models incorporate more realistic

behavioral specifications of the agents into the model and

are thus able to provide a better laboratory for many types

of policy analysis. CGE models have been used to analyze

a wide variety of policy interventions, including issues in

public finance, international trade, development, and

increasingly, the environment.18

Most policies meant to protect the environment, ranging

from those relying on market-based instruments, such as

effluent taxes, to command and control regulations,

induce changes in the behavior of consumers and producers. These changes may occur directly where the intervention takes place or indirectly as the effects of the intervention are passed through the economy. Because they focus

on both trying to model more accurately the expected

reactions of consumers and producers to policy interventions and on the interactions between various actors in the

economy, for some problems CGE models may be the

most appropriate tool for the analysis of social costs. CGE

models are particularly good at examining questions of

static resource allocation, such as the effects the imposition of a tax may have on sectoral output, income, and

employment. Under certain specifications, CGE models

may also be useful for assessing impacts on overall measures of economic performance, such as aggregate output,

employment, and various measures of welfare. 

In almost all cases, CGE models start from the framework

and data of an input-output table, which provides a basic

set of accounting identities for the production sectors.

Producers are assumed to maximize their profits through

their choice of productive inputs, typically labor, capital,

and intermediate goods, and sometimes land. Consumers,

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16 The term linear programming actually refers to any applied mathematical programming exercise where an objective function is either

maximized or minimized subject to a set of inequality constraints and where all of the equations are linear. In this section, only general equilibrium

applications (i.e., those based on an input-output table) are discussed.

17 Linear programming models are discussed in Dervis et al. (1982). A number of examples of the application of linear programming

models to environmental problems are given in Hufschmidt et al. (1983).

18 General references on CGE models include Dervis et al. (1982) and Ginsburgh and Keyser (1997). Applications to environmental policy

are discussed in Wajsman (1995).
or in many cases a representative consumer, are assumed

to maximize their utility by choosing their consumption

bundles, subject to a budget constraint. Although not usually specified as an optimizing agent, most CGE models also

include a government sector that collects a variety of taxes to

pay for its purchases of goods and services. The domestic

demand for imports and the supply of exports are determined

based on the relative prices of domestic and foreign goods.

CGE models may be categorized across a number of

dimensions. These can include (1) the method by which

the parameters of the model are specified (through calibration or econometric estimation), (2) the time horizon

of the model (static or dynamic), and (3) the scope of the

model (single- or multi-country). Most CGE models are

calibrated to a single base year, which is assumed to be in

equilibrium. After the specification of a subset of elasticities and other data obtained through a literature search

(or using informed judgments) the rest of the parameters

can be determined by working backward from a social

accounting matrix (SAM) for the base year.19 An alternative

to the calibration approach is econometric estimation.20

General equilibrium econometric estimation allows models to incorporate the representation of more sophisticated

producer and consumer behavior than would normally be

possible through calibration. However, econometric estimation requires a consistent set of multi-sector timeseries data and this data is usually not available for developing countries. 

CGE models can also be differentiated by the time horizon

of the analysis. The majority of CGE models are "static,"

meaning that no explicit dynamics are incorporated and

the time frame for the attainment of a new equilibrium

following a policy or external shock is indeterminate. In

conducting simulations, an exogenous shock is introduced

or a variable, such as a tax rate, is altered. The model is

then allowed to search for a solution until a new set of

prices is found which again equilibrates the system. The

new prices in turn determine a new set of factor demands,

outputs, and incomes. The values from this new solution

are then compared with the values from the original equilibrium. Dynamic models, on the other hand, incorporate

an explicit updating of time dependent variables, such as

the labor supply, capital stock, technology, and demand

patterns. In conducting a simulation, a baseline case is

first run with a given set of assumptions about the timedependent variables. Next, an alternative or counterfactual

simulation is run with the same set of assumptions, but

with a policy or external shock. The values resulting from

the alternative solution are then compared with the original baseline. These values may be compared at different

points in time or discounted to estimate present values, or

to evaluate changes in welfare.

Another dimension along which CGE models may be classified is by scope: (1) single country or single region models, (2) multi-country or multi-region models, and (3)

global models encompassing all countries and regions.

Although models representing a single country or region

are the most common, multi-country or multi-region

models are being developed in increasing numbers.

Because trade is inherently a multi-country phenomenon,

multi-country models are generally the best suited for

examining issues that involve the flow of goods, services,

and capital across national boundaries.

CGE models have been applied to an expanding array of

environmental policy issues. Most recently, they have been

used for the analysis of policies designed to avert or slow

global climate change, such as those proposed in the Kyoto

Protocol. Both single country and multi-country CGE

models have been used for these simulations, with multicountry models able to assess policies like global emissions trading. Because they are able to incorporate taxes

and other existing distortions, CGE models have been used

to explore the potential for a "double dividend"—a reduction in pollution plus a reduction in the inefficiencies of

the tax system—from substituting taxes on pollutants for

pre-existing taxes on output, income, or wages. In addition, CGE models have been used to perform retrospective

analyses of the economic costs of a number of environmental regulations.21

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19 References on social accounting matrices include Pyatt and Round (1985) and Chapter 10 of Sadoulet and de Janvry (1995).

20 This approach has been pioneered by Dale Jorgenson and a number of his collaborators. See in particular the papers collected in

Jorgenson (1998a, 1998b). Another example of the use of the econometric approach is Hazilla and Kopp (1990).

21 For example, the Jorgenson-Wilcoxen dynamic CGE model of the U.S. was used to estimate compliance costs between 1970 and 1990 for

EPA's retrospective study of the benefits and costs of the Clean Air Act (EPA, 1997b). A previous CGE-based study by Hazilla and Kopp (1990) looked

at the costs of both the Clean Air and Clean Water Acts.
While CGE models have a number of advantages as tools

for policy analysis, they also have serious drawbacks:

Although the costs have been reduced in recent years,

the construction of a CGE model can be still be time

consuming and expensive. 

In addition to an appropriate input-output table, a

considerable amount of data on national accounts,

trade, elasticities, and environmental externalities

must be collected and made consistent with the

sectors chosen to be part of the analysis. 

Dynamic models also require that forecasts be made

for many exogenous variables. 

Many environmental policies only affect a small part

of what may be a highly aggregated sector in an inputoutput table. Sometimes it will be possible to

separate these smaller sectors out, but sufficient data

is often not available at that level of detail.

8.5 Estimating the

Social Costs of

Alternative Policy

Approaches 

This section discusses the methods of estimating the social

costs for several alternative regulatory and nonregulatory

policy approaches, which are divided into three categories:

(1) direct controls, (2) incentive-based controls, and (3)

voluntary actions taken to reduce environmental risks.

The discussion focuses on the significant features of each

regulatory approach that must be examined in either partial equilibrium, multi-market, or CGE models. In addition to the private compliance costs, transactions costs

may be significant. Therefore, the associated changes in

the prices of goods and services will alter producer and

consumer surplus and must be calculated to estimate the

total social costs. 

Independent of the method used, the social cost analysis

should explain how the uncertainties and assumptions in

the data and models affect the results. Since much of the

data used is not known with certainty and many assumptions must be made to develop the necessary analytical

models, social cost estimates can never be known with

total certainty. Another difficulty is that private (compliance) cost bounds in one project may be based on the

intuition of a single engineer, but the private cost bounds

in another sector may be developed based on adequate

data permitting the estimation of confidence intervals.

Aggregating these into a single study may conceal important uncertainties rather than enlightening the decision

making process.22

8.5.1 Direct (or StandardsBased) Controls

In general, direct or standards-based controls rely on different types of standards that mandate a level of performance intended to acheive an environmental objective.

8.5.1.1 Technology Standards

Estimating the private compliance costs of standards-based

regulations is relatively straightforward compared to incentive-based approaches. Technology standards often require

Best Available Technology (BAT) or Best Practicable

Technology (BPT). Since these technologies already exist,

their costs and the number of firms required to use them

are often well documented. Additional compliance costs

include expenditures on maintenance and training costs

associated with installing and operating the equipment.

However, estimating the private compliance costs is not

always simple, especially for proposed regulations. For

example, unanticipated scaling effects, as well as unforeseen bottlenecks in construction and implementation may

occur, resulting in differences between the anticipated bids

for a project, the bids received, and the actual construction

cost.

The private real-resource costs, when discounted over

time, correspond to the sum of investment costs and discounted annual costs (operating and maintenance and

other annual regulatory costs) that will be incurred by

firms to comply with the regulation. Thus, the realresource costs of regulation can be approximated, in most

instances, by methodologies routinely used by other EPA

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22 Another reason for variability of the compliance cost estimates for pollution control may be due to the way emission rates are characterized, their method of transport, and chemical transformation rather than variations in the price of pollution control equipment and labor costs.
program offices to evaluate compliance costs.

Furthermore, the supply and demand curves that implicitly lie behind such calculations need not be formally estimated unless the effects of the regulation on price and

output are expected to be significant.

8.5.1.2 Emission Standards

Regulations that limit emissions are usually targeted at

particular point sources or geographic regions, but there

also exist national standards such as ambient air and

water quality standards. For point sources, private compliance cost estimates are usually based on the cost to purchase and operate regulatory equipment needed to comply

with the regulations. This equipment will be similar to

that needed to meet technology standards. Since it may be

prohibitive to examine in detail each area and all its pollution sources, private social and compliance cost estimates

can be based upon random samples of representative

areas and industries. The survey should accurately reflect

the expected compliance costs for different categories and

sizes of industries in each area. In each of the three cases,

additional social costs are involved with monitoring and

enforcement of the regulations.

8.5.1.3 Production Bans

The prohibition of a product or service results in shutdowns, causing short- and, sometimes, long-term unemployment, as well as the loss or premature retirement of

capital equipment. Therefore, adjustment costs should

include: (1) the value of wages temporarily or permanently foregone because of reductions in production levels in

the directly affected markets23 and (2) the social cost of reemploying displaced workers (including the administrative

cost for transfer payment programs, but excluding the payment itself). Moreover, policies that effectively ban products or activities cause the loss of all producer and consumer surpluses in these markets. Regulations also may

substantially affect secondary or linked markets. CGE and

multi-market models will account for these effects, but

partial equilibrium models will not do so unless a separate

model is used.

Some policies, although not explicitly banning production,

may be so stringent that the effect on production is the

same. In this case, the concept of compliance cost is less

applicable. For example, if the mandated environmental

protection controls would be so costly that the new equilibrium level of output is zero (because the consumers of the

good shift completely to substitutes and producers of the

good exit this market to produce other outputs), then it is

not possible to use compliance costs as an estimate of

social costs. A ban on producing this good would produce

a similar result.

In the case of an effective ban on production, the social

cost of the new policy is measured by the complete loss of

all producer and consumer surpluses in this market. The

real-resource cost in this case might be conceptualized as

the welfare change associated with the additional expense

and lower quality of the other goods that consumers purchase as substitutes for their previous use of the product. 

8.5.2 Incentive-Based Controls 

The appeal of incentive-based approaches is their potential

ability to achieve environmental improvement goals more

cost effectively than traditional standards-based methods.

The approaches examined here include: marketable permits, emission taxes, bubbles and offsets, user charges,

product charges, subsidies for pollution reduction, government cost sharing, refundable deposits, pollution indemnity, and information and labeling rules. In many cases, significant transfers will occur between private parties and

the government, but in most cases, these policies achieve

their greater economic efficiency through mechanisms

that encourage private parties to use information known to

them but not to the environmental authorities. Such

information may include differences in emission control

costs among different firms. Analyses of the social costs of

incentive-based approaches may require different information and tools than those used to analyze more traditional

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Chapter 8: Social Costs

23 Lost wages, rather than lost production, is suggested as a proxy for the value of displaced resources. In most cases, lost wages will capture most of the value of displaced resources because it is likely that inputs other than labor will be reallocated to other sectors of the economy fairly

quickly and at little cost.
policies. The task of calculating the exact compliance costs

of these policies is therefore more difficult.24

8.5.2.1 Marketable Permits

Permits are usually denominated in the amount of emissions allowed and the number and denomination of permits issued determines the aggregate amount of emissions.25 Marketable permits establish the aggregate quantity of pollution allowed and allow the price of those entitlements to vary. Since different polluters incur different private costs to control emissions, they will be willing to pay

different amounts for permits. The price of permits, in

theory, will be established by the unit cost of control of the

marginal polluter. Marketable permits are traded between

emission sources, giving rise to a transfer among private

parties but not social costs.

In contrast to technology standards, incentive-based

approaches (taxes or permits) do not require any particular firm to install particular pollution control devices.

Therefore, it is usually necessary to predict what technology will be used by the firms to meet the new regulations to

estimate costs. Under a marketable permit system, the

private costs of pollution control are estimated following a

three-step process: 

Calculate the demand and supply functions for the

permits (these demand and supply functions are

based on the costs of different sources' pollution

control options). Polluters will be willing to pay

prices for the permits up to the unit cost of reducing

emissions.

Estimate the equilibrium price for permits. This

price will determine which firms will install pollution

control measures and those which will purchase

additional permits. 

Calculate the real-resource cost of the regulation by

summing the investment costs and the present value

of operating and maintenance costs incurred to

reduce emissions. (The cost of the permits purchased

by firms is classified as an income transfer between

firms, not a social cost.)

Marketable permits may be sold at auction initially, in

which case the prices bid for the newly issued permits

again represent income transfers to the government.

Alternatively, permits may be allocated to sources by some

rule, in which case no private costs are imposed at the

outset. In neither case is the private cost of a permit

counted as part of the social cost, since it is not a realresource cost, but rather a transfer from one firm to

another or a transfer from a firm to the government. The

act of establishing the permit system and assigning property rights to the distributed permits may result in some type

of "wealth transfer" taking place, which should be accounted for in the equity assessment of the benefit-cost analysis.

As described earlier, the marketable permit systems

requires the creation of a functioning market. This results

in administrative costs and also additional enforcement

costs since it is necessary to ensure that emissions do not

exceed the levels for which permits are held. Both need to

be added to the social cost estimate.

8.5.2.2 Emission Taxes

Estimates of the social costs of pollution control under

emissions taxes are virtually the same as those under marketable permits. Here however, the unit price of pollution

will be known (since it is set by the regulation) and does

not have to be calculated. Because the private cost of pollution control varies among firms, firms with the highest

private costs of pollution control are expected to cut back

production and pay the tax on the remaining emissions,

rather than install required pollution control equipment.

Most often, firms will choose some combination of cutbacks in production, installation of pollution control

equipment, and payment of the tax. However, as in the

case of most regulations, real-world limitations may

reduce the possible selection of cost-minimizing alternatives chosen or firms may simply decide to engage in litigation to delay the regulation, which adds an additional cost.

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Chapter 8: Social Costs

24 However, after the policy is passed, compliance costs are much easier to calculate. In the case of emission taxes, cost-minimizing polluters, in theory, will reduce emissions up to the point where the marginal cost of control equals the tax. Of course, these conclusions rest upon the

assumptions of perfectly competitive markets, low transactions costs, and complete information.

25 Permits may also be weighted based on the impact the pollutant has on air or water quality.
After the supply (or abatement cost) function for each firm

is estimated, then the equilibrium amount of pollution

generated can be determined. The new production levels

can then be calculated for each firm along with how much

pollution control equipment will be installed. Finally, the

real-resource costs and private costs are calculated as is

done above for marketable permits. However, here the

pollution taxes or charges may involve transfers of tax revenues from the private sector to the government, but

because such fees accrue to the government, they are

again income transfers and should not be included in total

social costs.

8.5.2.3 Bubbles and Offsets

Bubbles and offsets allow emissions to be averaged among

specific regions or among different sources within a particular facility. The resulting level of emission control must

be equivalent to or better than that required by existing

regulations. If "banking" is allowed, pollution credits can

be traded across time—with potential offsets created in

one period to be used in later periods. Bubbles and offsets

create incentives to reduce emissions in firms where the

private costs of control are relatively low. Compared with

direct controls, bubbles and offsets usually result in lower

compliance costs (relative to costs incurred under technology and emission standards).

Additional social costs associated with bubbles and offsets

are similar to those encountered with marketable permits.

Initial administrative costs may be significant and some

additional enforcement costs for monitoring emission levels also may be incurred. The private cost of the offsets

traded in a formal market are transfers between the creator and the user of the offset and are not social costs.

However, the transactions costs incurred to arrange the

trade, both private and public, are part of total social costs.

8.5.2.4 User Charges

Charges may be imposed directly on users of publicly

operated facilities. Such charges have been imposed on

firms that discharge waste to municipal wastewater treatment facilities and on non-hazardous solid wastes disposed of in publicly operated landfills. User charges are

usually set at a level sufficient to recover the private costs

of operating the public system, rather than to create incentives for reducing pollution. Measuring the total social cost

imposed by user charges is similar in concept to measuring the social costs of emission charges, but is not always

based on a per unit charge of the pollutant.

8.5.2.5 Product Charges

Charges may be imposed on intermediate or final products

whose use or disposal pollutes the environment. The private and social costs imposed by product charges depend

on the extent to which users switch to substitutes, reduce

the rate at which the product is used by recycling or other

process changes, or continue to use the regulated products. Predicting responses and estimating compliance

costs is difficult and requires analysis of the social costs

and effectiveness of substitute products as well as the

social costs of recycling and reuse. Any charges paid as a

result of continuing use represent private costs, but are

not social costs because these are borne by the consumer

who buys less of the more expensive product. 

8.5.2.6 Subsidies for Pollution

Reduction

Subsidies paid to polluters based on their reductions in

pollution have the same general effect on behavior as

charges on pollution. Sources may reduce pollution up to

the point where the private costs of control equal the subsidy. Using subsidies instead of charges shifts private costs

to the government. This may result in more sources continuing to operate than if a charge system were used.

Thus, subsidies and charges may not have the same aggregate social costs or the same degree of pollution control.

Measuring the social costs resulting from a system of pollution subsidies is similar in concept to measuring the

social costs resulting from pollution charges, except that

private costs are reduced by the amount of the subsidy,

rather than being increased by the amount of the fee.

Again, the subsidies themselves are income transfers and do

not constitute a social cost. Therefore, private real-resource

costs should be computed excluding the subsidies.

8.5.2.7 Government Cost-Sharing

In addition to issuing the regulations described above, the

government may take actions to lower the private costs of

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Chapter 8: Social Costs
specific actions—most notably, by subsidizing investments

in pollution control equipment. These subsidies may take

the form of reduced interest rates, accelerated depreciation, direct capital grants, and loan assistance or guarantees for pollution control investments. Such policies may

not by themselves induce changes in private behavior.

However, in conjunction with direct controls, pollution

fees, or other regulatory mechanisms, they may influence

the nature of private responses and the distribution of the

cost burden. In particular, such subsidies may encourage

investment in pollution control equipment, rather than

other responses that do not require capital investments

(e.g., changes in operating practices or recycling and

reuse).

Government cost-sharing subsidies reduce the private

costs associated with the resulting private investments.

However, social costs may arise if cost-sharing programs

lead to resource misallocations. Additional social costs will

result from administration of the subsidy program, but are

likely to be minor if the incentives are provided through

the existing tax system. However, they may be significant if

new administrative structures are required.

8.5.2.8 Refundable Deposits

Refundable deposits create economic incentives to return

a product for reuse or for proper disposal, providing that

the deposit exceeds the private cost of returning the product. Therefore, to predict the rates of return, the private

cost of returning products must be estimated.

Under a refundable deposit system, compliance costs consist of the resources (labor, equipment, and transportation) required to return the regulated product, and the private cost of preparing products for reuse (if required), less

the cost of new products replaced by recycled products.

The private administrative costs of a deposit system vary,

depending on where in the production-consumption cycle

they occur and from whom the deposits are collected.

Record-keeping requirements may also be a cost component. For those that participate in a recycling/refund program, the opportunity cost of the time spent sorting trash

is an important component, and the analysis must address

whether other behavior changes may be expected to take

place (e.g., whether consumers may adjust their consumption of products marketed in recyclable containers).

The deposits themselves represent transfers from one

point in the production-consumption cycle to another and,

hence, are not social costs. These transfers are temporary

if the deposit is reclaimed, but permanent if it is not.

Enforcement costs are minimal since no standards have

been set and no laws are broken if the product is not

returned. 

A government "buy-back" constitutes another type of

refundable deposit. Under this system, the government

either directly pays a fee for the return of a product or

subsidizes firms that purchase recycled materials. They

are equivalent to product deposits, except that the government, rather than the purchaser, provides the deposit.

The government subsidy represents a transfer from the

government to the private sector, which offsets the private

costs of recycling products.

8.5.2.9 Pollution Indemnity

Regulations that impose stricter liability on polluters for

the health and environmental damage caused by their pollution may reduce the transaction costs of legal actions

brought by affected parties. Such regulations do not

impose additional social costs, but only shift the costs

from one party to another. However, this may induce polluters to alter their behavior and expend real resources to

reduce their probability of being required to reimburse

other parties for pollution damages. For example, they

may reduce pollution, dispose of waste products more

safely, install pollution control devices, reduce output, or

invest in added legal counsel.

Other regulations may require firms to demonstrate financial ability to compensate damaged parties by posting performance bonds that are forfeited in the event of damages,

by obtaining liability insurance, or by contributing to a

pool of funds to compensate victims. The administrative

and enforcement costs imposed by such requirements

represent the use of economic resources but are not

counted as part of the social costs because the funds used

to pay damages do not represent a use of resources, but

are transfers among private parties (between polluters,

insurers, and victims of pollution). Again, however, these

requirements are likely to alter private behavior and lead

to increased outlays of real resources to reduce the probability of accidents, or reduce the probability of having to

pay using any of the methods cited above.

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Chapter 8: Social Costs
8.5.2.10 Information and Labeling

Rules

Information or labeling rules may be applied to specific

substances or to certain contaminated locations. For

example, warning labels may be required for hazardous

substances that describe safe-handling procedures or

describe the risks posed by the product. Purchasers may

then switch to less damaging substitutes for some or all

uses or handlers of hazardous substances may be better

able to prevent damages. Posting information on contaminated locations gives potentially exposed parties the opportunity to avoid hazards—for example, contaminated dump

sites or drinking water aquifers.

Calculating the private costs of complying with information

and labeling requirements for particular cases is straightforward. Compliance costs include the cost of developing

the required information (analyzing the composition of

substances, monitoring and testing of sites, testing for

health damages, etc.) and the cost of disseminating information (printing and applying labels, maintaining and

publishing information on sites).

Similarly, the direct costs of enforcing and administering

the requirements (including government review and

approval of labels) can be calculated directly. Calculating

aggregate private costs may be more difficult, however, if

the number of containers requiring labels or the number

of facilities affected is unknown. In addition, it is difficult

to predict responses by the recipients of the information

and, hence, the social cost of avoidance.

8.5.3 Voluntary Actions 

While there can be social costs associated with voluntary

actions taken to mitigate environmental polluting behavior,

it may be difficult to establish the relation between decisions made by firms or individuals and the role EPA and

other regulatory agencies may play in inducing or contributing to the adoption of these practices. EPA and other

regulatory agencies are looking to alternative nonregulatory approaches in an effort to change behavior that contributes to health and environmental risks. Examples of

EPA programs of this type include the 33/50 program for

reduction of toxic pollutant discharges and energy conservation and greenhouse gas mitigation measures, such as

ENERGY STAR and Climate Wise programs.26

A basic premise underlying social cost analyses is the

assumption that profit-maximizing firms undertake investment decisions, voluntary or otherwise, when it is in their

private interests to do so (i.e., where private benefits are

greater than private costs). If actions would not have

occurred absent EPA's involvement in these programs,

then there may be social costs (beyond those costs

incurred by EPA) that are associated with actions taken by

participants in the programs. Social costs may arise, for

example, from firms exhibiting strategic behavior in their

investment decision that incorporates expectations that

voluntarily participating in nonregulatory programs may

serve to reduce or delay promulgation of future, potentially

more stringent enforceable compliance standards.

Without some assessment of costs, it is difficult to establish whether a particular voluntary program is cost-effective in comparison with other policy actions. As a consequence, it is useful to investigate the social costs associated with nonregulatory programs—quantifying how they

affect economic markets, and evaluating the relative economic efficiency of these approaches as compared with

regulatory policies.

8.6 Summary and

Conclusions 

This chapter has reviewed the theoretical foundations of

social cost assessments as well as practical methods for

measuring the social costs of environmental policies.

Several key conclusions reached in this discussion are

worth reiterating.

First, in most cases, the social costs of an environmental

policy or other action can be measured with sufficient

accuracy by limiting the analysis to the directly affected

markets. This allows the analysis to focus on the sectors

that must comply with a policy. In these cases, the disturbances that ripple outward from the directly affected markets to numerous other markets should have a minimal

effect on the estimation of social costs.

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Chapter 8: Social Costs

26 More information on the operations and objectives of these types of programs can be found in publications prepared by EPA's Office of

Reinvention and at the following website http://www.epa.gov/reinvent/ (accessed 8/28/2000).
Second, a conventional partial equilibrium depiction and

modeling of the directly affected markets will often be sufficient to measure social costs. The detail and precision of

applying this approach in practice will depend on the availability of information, the resources devoted to the evaluation, and the value to policy makers of improved accuracy

of the results.

Finally, other modeling techniques, such as CGE, are often

used to measure a variety of indirect costs, the many transitional effects of environmental policies, and, when they

are significant, transactions costs borne by private sector

entities. Nevertheless, the majority of the economic analysis of environmental policies can employ the conventional

partial equilibrium modeling approach to evaluate social

costs of EPA policies and programs.

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Chapter 8: Social Costs
8.7 References 

Arnold, F.S. 1995. Economic Analysis of Environmental Policy and Regulation. New York, NY: John Wiley and Sons, Inc.

Dervis, K., J. de Melo, and S. Robinson. 1982. General Equilibrium Models for Development Policy. New York, NY:

Cambridge University Press.

Friedman, L. E. 1984. Microeconomic Policy Analysis.: New York, NY: McGraw-Hill.

Ginsburgh, V. and M. Keyser. 1997. The Structure of Applied General Equilibrium Models. Cambridge, MA: MIT Press.

Goulder, L. H. 1995. Effects of Carbon Taxes in an Economy with Prior Tax Distortions: An Intertemporal General

Equilibrium Analysis. Journal of Environmental Economics and Management 29: 271-297.

Gramlich, E. M. 1981. Cost-Benefit Analysis of Government Programs. Englewood Cliffs, NJ: Prentice-Hall, Inc.

Greene, W. H. Econometric Analysis. 1996. 3rd edition. New York, NY: Macmillian.

Harrington, W., R. Morgenstern and P. Nelson. 1999. On the Accuracy of Regulatory Cost Estimates, Discussion Paper

99-18. Resources for the Future, Washington, D.C.

Hazilla, M. and R. J. Kopp. 1990. Social cost of environmental quality regulations: a general equilibrium analysis. Journal

of Political Economy, 98 (4): 853-873.

Hufschmidt, M. M., D. E. James, A. D. Meister, B. T. Bower, and J. A. Dixon. 1983. Environment, Natural Systems, and

Development. Baltimore, MD: The Johns Hopkins University Press.

Jorgenson, D. W. 1998a. Growth, Volume 1: Econometric General Equilibrium Modeling. Cambridge, MA.: MIT Press.

Jorgenson, D. W. 1998b. Growth, Volume 2: Energy, the Environment, and Economic Growth. Cambridge, MA: MIT

Press.

Just, R. E., D. L. Hueth, and A. Schmitz. 1982. Applied Welfare Economics and Public Policy, Englewood Cliffs, NJ:

Prentice-Hall, Inc.

Kennedy, P. 1998. A Guide to Econometrics. 4th edition. Cambridge, MA: MIT Press.

Leontief, W. 1970. Environmental Repercussions and the Economic Structure: An Input-Output Approach. Review of

Economics and Statistics, (52)3.

Maddala, G. J. 1992. Introduction to Econometrics. 2nd ed. Englewood Cliffs, NJ: Prentice Hall.

McKibbin, W. J. and P .J. Wilcoxen. 1995. The Theoretical and Empirical Structure of the G-Cubed Model. Brookings

Discussion Papers in International Economics, no. 118 (December).

Miller, R. E. and P. D. Blair. 1985. Input-Output Analysis: Foundations and Extensions. Englewood Cliffs, NJ: PrenticeHall.

Morgenstern, R. D. 1997. Economic Analysis at EPA: Assessing Regulatory Impact. Resources for the Future,

Washington, D.C.

Nestor, D. V., and C. A. Pasurka, Jr. 1995. CGE Model of Pollution Abatement Processes for Assessing the Economics

Effects of Environmental Policy, Economic Modeling 12(1): 53-59.

Pyatt, G. and J. I. Round (eds.) 1985. Social Accounting Matrices: A Basis for Planning. World Bank, Washington, D.C.

137

Chapter 8: Social Costs
Pindyck, R. S. and D. L. Rubinfeld. 1991. Econometric Methods and Economic Forecasts. 3rd edition. New York, NY:

McGraw Hill.

Sadoulet, E., and A. de Janvry. 1995. Quantitative Development Policy Analysis. Baltimore, MD: The Johns Hopkins

University Press.

U.S. Environmental Protection Agency. 1984. The Cost Digest: Cost Summaries of Selected Environmental Control

Technologies. EPA/600/8-84-010, Office of Research and Development.

U.S. Environmental Protection Agency. 1989. Regulatory Impact Analysis of Controls on Asbestos and Asbestos

Products: Final Report. Prepared by the Office of Pesticides and Toxic Substances.

U.S. Environmental Protection Agency. 1995a. Economic Analysis of the Title IV Requirements of the Clean Air Act

Amendments. Prepared by the Office of Air and Radiation.

U.S. Environmental Protection Agency. 1995b. The U.S. Environmental Protection Industry: A Proposed Framework for

Assessment. EPA/230/R-95-011, Office of Policy, Planning and Evaluation.

U.S. Environmental Protection Agency. 1996. Economic Impact Analysis of Proposed NESHAP for Flexible Polyurethane

Foam. Prepared by the Office of Air and Radiation.

U.S. Environmental Protection Agency. 1997a. Economic Analysis for the NESHAPS for Source Categories: Pulp & Paper

Production; Effluent Limitations Guidelines, Pretreatment Standards: Pulp, Paper, and Paperboard Category, Phase I.

EPA/821/R-97-012, Office of Water.

U.S. Environmental Protection Agency. 1997b. The Benefits and Costs of the Clean Air Act. Prepared for U.S. Congress by

the Office of Air and Radiation and Office of Policy, Planning and Evaluation.

U.S. Environmental Protection Agency. 1998. Economic Analysis of Effluent Guidelines and Standards for the

Centralized Waste Treatment Industry. EPA/821/R-98-019, Office of Water.

Vatavuk, W. M. 1990. Estimating Costs of Air Pollution Control. Chelsea, MI: Lewis Publishers, Inc.

Wajsman, N. 1995. The Use of Computable General Equilibrium Models in Evaluating Environmental Policy, Journal of

Environmental Management 44: 127-143.

Zerbe, R. O. and D.D. Dively. 1994. Benefit-Cost Analysis: In Theory and Practice. New York, NY: Harper Collins.

138

Chapter 8: Social Costs
139

9.1 Introduction

In an effort to fully understand a regulation's impact

and make an informed judgement regarding its

desirability, policy makers study many different regulatory consequences. Economic information is

important to the evaluation of at least two consequences—a regulation's efficiency and its distributional consequences. In principle, both types of consequences could be estimated simultaneously by a

general equilibrium model. In practice, for reasons

discussed in Chapter 5, they are usually estimated

separately.

A benefit-cost analysis (BCA) calculates the social

benefits and costs of an environmental policy and

answers the question of whether the benefits are sufficient for the gainers to potentially compensate the

losers, leaving everyone at least as well off as before

the policy. Its calculation of net benefits helps ascertain the economic efficiency of a regulation. Two

other ways to express economic information—an

economic impact analysis (EIA) and an equity assessment—assess changes in social welfare by examining

the distributive effects of a regulation. An EIA focuses

on traditional classifications of affected populations1

(e.g., industrial sector classifications). Under the

heading of equity assessment analysts can address

broad concerns such as changes in the national distribution of income or wealth. In addition, an equity

assessment can provide information to decision makers on how policies affect specific sub-populations.

Disadvantaged or vulnerable sub-populations (e.g.,

low income households) may be of particular concern.

Economic Impact Analysis (EIA)

An EIA helps answer the questions, "Who are the losers and gainers from a policy?" and "By how much

do they lose or gain?" Traditionally, EIAs have

focused on the losers and the negative impacts of an

environmental regulation. This focus is in response

to existing legislative and administrative statutes and

policies which direct analysts to examine the distribution of negative regulatory impacts or costs.

Currently, several of these same statutes and policies

call for a similar examination of the positive impacts

of a regulation.

Unlike a BCA which rests its conclusions exclusively

on comparisons of social benefits and costs, an EIA

examines the distribution of many different economic impacts. Conventional impacts include monetized

effects such as changes in profitability or in government revenues, as well as non-monetized effects

such as increases in unemployment rates or numbers of plant closures. An EIA will often examine and

report on regulatory outcomes that a BCA would not.

For example, when measuring impacts on private

Chapter 

9

Chapter 9: Distributional Analyses:

Economic Impact Analyses and Equity

Assessments

1 The term "affected" is applied throughout the chapter in its most general use as an economic term. Analysts should be

aware of how the authorizing statute for the rule, as well as other applicable statutes and administrative orders noted in this chapter,

make more specific use of this term. For example, the Regulatory Flexibility Act includes the clause "subject to the requirements of the

rule" when quantifying economic impacts. This results in analyzing entities that are directly affected, so that conclusions can be drawn

as to the significance of impacts of the rule. Alternatively, provisions in UMRA and EO 12866 address both direct and indirect impacts, so

that the affected population of entities may be more inclusive than only those "subject to the requirements of the rule." For more information, Chapter 8, Section 3 on "Social Cost Analysis" covers the economic concepts and terminology relevant to direct and indirect

impacts.
businesses, an EIA will include changes in transfer payments from firms to the public sector whereas a BCA

would not. Transfer payments become important when

analyzing the distributional consequences of a regulation.

To achieve the objective of an EIA and educate policy makers about who will lose or gain as a result of a particular

regulation, analysts have traditionally relied upon the

assortment of impacts described in Section 9.2 below.

Equity Assessment

Generally, assessments of equity examine a regulation's

impact on the distribution of national income or wealth.

Decision makers may use this information in conjunction

with economic efficiency measures as captured in a benefit-cost analysis to evaluate tradeoffs between equity and

efficiency. For the most unified treatment, both equity and

efficiency issues can be addressed in a computable general

equilibrium model.2 In practice, data constraints will limit

analysts to undertake distributional analyses independently

from benefit-cost analyses.

As is true for an EIA, an equity assessment is generally

more concerned with sub-populations who experience net

costs or other negative impacts than with those who experience net benefits or positive impacts. An equity assessment may consider effects on any sub-population, but it

should always consider the economic effects of a regulation on disadvantaged or vulnerable sub-populations;

specifically, sub-populations who are physically susceptible

to environmental contamination, are less than fully capable of representing their own interests, or are economically

disadvantaged or vulnerable. Examples include children,

low-income or minority communities, and small businesses, governments, and not-for-profit organizations. For

many of these sub-populations, EPA has been directed by

statute or policy to examine the effects of its rules when

they are expected to have a "disproportionate," "significant

and substantial," or other such impact.

An equity assessment draws on information and analytic

tools used in BCA and may report on impacts using measures found in an EIA. Therefore, an early step in an equity

assessment is to identify sub-populations likely to be

affected by a regulation. Once identified, if data permits,

the social costs and benefits estimated for the BCA can be

disaggregated and net benefits for the sub-population(s) or

the distribution of net benefits among sub-populations,

can be examined. An equity assessment may also examine

economic impacts, such as increases in rates of unemployment or other traditional impact measures, for the

identified sub-population(s). 

Consistency Between BCA and Distributional

Analyses

Ensuring consistency in analytic design and interpretation

of results for the BCA, EIA and equity assessment supporting a particular regulation is essential. All three examine

impacts that, in principle, could be estimated by a single

general equilibrium model (see Section 5.2). Both an EIA

and an equity assessment must be conducted following the

principles that frame a BCA, even if the formal preparation

of BCA is not undertaken. When a BCA is undertaken, to

the extent possible, both distributive analyses should adopt

the same set of assumptions used in the BCA. For example, all three should rely upon the same set of baseline

assumptions and all three should assume the same values

for relevant elasticities. However, because all the information needed to estimate distributive outcomes is often not

integral to the calculations performed in a BCA, in many

cases further assumptions must be developed specifically

for the EIA or the equity assessment. For example, new

assumptions regarding definitions of sub-populations must

be developed and there might be good reason to assume

different elasticities for different sub-populations. Even in

these cases, analysts should ensure that the implications,

if any, of the added assumptions for the outcome of the

BCA are understood and made manifest to policy makers. 

Using a Social Welfare Function to Evaluate

Efficiency-Equity Tradeoffs

Potentially, a regulation's effects on distribution, analyzed

by its EIA and/or equity assessment, and its effects on

efficiency, analyzed by its BCA, can be incorporated into a

single social welfare function. A social welfare function

establishes criteria under which efficiency and equity

outcomes are transformed into a single metric, making

them directly comparable. A potential output of such a

function is a ranking of policy outcomes that have different

aggregate levels and distributions of net benefits. A social

welfare function can provide empirical evidence that a

policy alternative yielding higher net benefits, but a less

140

Chapter 9: Distributional Analyses

2 Computable general equilibrium models are discussed in section 8.4.5.
equitable distribution of wealth, is better or worse than a

less efficient alternative with more egalitarian

distributional consequences.3

In practice, developing a universally acceptable social welfare function is difficult because it requires explicit decisions to be made about society's preferences for the distribution of resources. Nonetheless, future research may

result in some feasible practical alternatives.4 These guidelines do not suggest a particular social welfare function or

that analysts attempt to use this approach at this time, but

the approach may merit further consideration as additional research and applications develop.

Chapter Summary

This chapter begins with a brief discussion of an iterative

process between analysts and management to facilitate

thorough consideration of the output from distributional

analyses. The bulk of the chapter occurs in Section 9.2 on

Economic Impact Analysis which, after reviewing statutes

and policies that require examination of economic

impacts, describes methods for estimating economic

impacts that are relevant for both EIAs and equity assessments. The final section of this chapter discusses the relatively new distributional analysis, equity assessment.

Statutes and policies that require equity assessment, definitions of sub-populations, and a general framework for

conducting an equity assessment, including possible data

sources, are reviewed. 

9.1.1 A Process for Economic

Impact Analyses and Equity

Assessments

This section describes an iterative process between EPA

analysts and senior management5 as an integral part of an

EIA and an equity assessment. At several points of the regulatory development process, senior analysts should report

the results of distributional analyses to senior management and receive feedback. Only through such ongoing

communication can senior management remain sufficiently informed so that potential economic effects of proposed environmental regulations receive proper attention

within the regulatory development process. 

As discussed above, ensuring consistency between the EIA,

equity assessment, and BCA is critical. The methods and

results of an EIA and an equity assessment are inherently

linked to their corresponding BCA. Consequently, concerns regarding distributional outcomes that arise through

the iterative process that necessitate a change in the regulatory approach will also require adjustments to the

assessment of social benefits and costs.

This iterative process is not expected to add significant

additional administrative procedures to the current EPA

regulatory development process. Rather, its objective is to

bring greater attention to opportunities for the workgroup

and senior management to have ongoing communication

related to potential economic impacts and equity dimensions of proposed environmental regulations. Frequent

and timely exchanges of information between senior management and the workgroup will focus greater attention on

affected sectors of the economy as well as affected subpopulations and may influence the final regulatory alternative selected.

Information contained in Exhibit 9-1 illustrates such a

process. Its contents are consistent with the procedures

outlined in the document, Regulation Development in

EPA (EPA, 1997) and with the process for promulgating a

regulation illustrated by the flow chart in Guidance for

Analytic Blueprints (EPA, 1994). There are two key components of Exhibit 9-1 that are designed to institutionalize

the iterative process between the workgroup and senior

management for EIAs and equity assessments. The first

component is an explicit incorporation of the identification

and analysis of economic impacts and equity dimensions

such as those listed in Exhibits 9-2 and 9-5 into the regulatory development process. The second component,

depicted by the arrows, is a process for initiating multiple

141

Chapter 9: Distributional Analyses

3 For more on the use of social welfare functions in policy analysis see Sen (1970), Arrow (1977), and Jorgenson (1997). An empirical

application of this approach can be found in Norland and Ninassi (1998).

4 For a recent description of potential alternatives see Farrow (1998).

5 Senior management is used as shorthand for persons responsible for authorizing and using these forms of analysis. Most often, these

persons will include the Assistant or Regional Administrator of the lead office or region that is considering the regulation or other upper management

within that office or region.
Chapter 9: Distributional Analyses

142

re-evaluations of a regulation during the development

process. This process includes three key tasks.

Identify potentially important economic impacts

and equity dimensions for senior management

to help determine which may be of concern. This

should be done as part of the analytical blueprint

process. The analytic blueprint provides an opportunity for early identification of important issues in

order to enhance the quality of information provided

to senior management to assist in decisions for a particular regulation or policy. While required for Tier 1

and 2 regulations, analytic blueprints are encouraged

for Tier 3 regulations as well.

Conduct a preliminary analysis of these economic impacts and equity dimensions once senior management has approved the analytic blueprint.

This is the second point where the iterative process

affects a regulation's development. Analysts should

share the results with senior management who

should then determine whether to proceed to a more

detailed analysis or to revisit the preliminary analysis.

Senior management may even decide to alter the

overall regulatory approach being considered which

could require revising the BCA as well as the analytic

blueprint. The potential need to revise the analytic

blueprint is consistent with the idea that it is a living

document.6

Develop options and prepare detailed economic

analysis after the preliminary analysis is complete.

Data and information developed as part of this effort

will provide input for conducting distributional analyses for the impacts and dimensions identified earlier.

Here is the third point where the iterative process

comes into play. It is recommended that input from

senior management be sought once more before proceeding to closure. Additional economic impact and

6 For a detailed discussion of the concept of the analytic blueprint as a living document and more information on the "Tiering" of rules,

see pp. 12-13 Guidance for Analytic Blueprints (EPA, 1994) and see section 5, p. 31 Regulation Development in EPA (EPA, 1997).

Tier Assigned & 

Workgroup Members 

Identified

Early Guidance

from

Senior Management

Workgroup Prepares 

Analytic Blueprint and 

Identifies Potential 

Economic Impacts and 

Equity Dimensions

Senior Management 

Reviews Analytic 

Blueprint

Approval

Workgroup Conducts 

Preliminary Analysis and 

Analyzes Economic 

Impacts and Equity 

Dimensions

Senior Management 

Reviews Preliminary 

Analysis

Non-approval

Approval

Workgroup Develops 

Regulatory Options and 

Analyzes Economic 

Impacts and Equity 

Dimensions

Senior Management 

Reviews Detailed 

Analyses

Non-approval

Approval

Workgroup Prepares 

Rule, Draft Policy, etc.

Alternatives Selection

OMB Review

Workgroup Closure

Administrator's Signature

Federal Register 

Publication

Non-approval

Exhibit 9-1 Flow Chart: A Process for Economic Impact Analyses and Equity Assessments 
equity analysis may be warranted for a variety of reasons including new insights gathered from the regulatory review process.

9.2 Economic Impact

Analysis

9.2.1 Introduction to Economic

Impact Analysis

As discussed in Chapter 5 above, a BCA calculates the total

social benefits and total social costs associated with an

environmental policy and measures the change in overall

economic efficiency. As part of the effort to inform policy

makers, it is important to not only understand the change

in economic efficiency, but to understand the distribution

of negative and positive impacts associated with this

change. An EIA contributes to this understanding. It identifies losers and gainers from a policy and estimates the

magnitude of their gains and losses. An EIA does this by

studying the economic changes occurring across broadly

defined economic sectors of society such as industry, government, not-for-profit organizations, and consumers. In

addition to these broad categories, an EIA will examine

more narrowly defined sectors within these broad categories such as the solid waste industry or an individual

solid waste company. Traditionally, EIAs have focused on

the losers and the negative impacts of an environmental

regulation, although at least two general directives (see

Exhibit 9-2) suggest that the positive impacts be examined

as well. 

EIAs measure impacts in different ways, from direct

impacts on private business—including individual plants,

whole firms, and industrial sectors—to indirect impacts

on customers and suppliers. EIAs also measure direct and

indirect impacts on governments and not-for-profit entities

such as schools or hospitals. Impacts include changes in

profitability, employment, prices paid by consumers, government revenues or expenditures, trade balances, and

other changes of interest to policy makers. 

Ensuring consistency of the EIA with the BCA for a particular regulation is essential. For consistency, an EIA must be

conducted within the analytical bounds of its corresponding BCA. To the extent possible, the EIA should adopt the

same set of assumptions used by the BCA. Adjustments or

additions to these assumptions or to the overall modeling

framework used for the BCA should be made only when

they help bridge the difference between social and private

perspectives, such as the difference between the social cost

of a regulation and private compliance costs.

EPA's programs and regulations vary greatly in the types of

parties affected and the nature of economic impacts that

may be important. The data available for analysis vary

widely as well. Thus, while specific methods for estimating

impacts are reviewed, it is expected that every EIA will

focus on the particular issues associated with the set of

regulations under review. The general methods outlined

here should be adapted to fit the needs of a particular

analysis.

The remainder of this section is divided into twelve subsections. The first outlines the statutes and policies that

direct EPA, and other government agencies, to study the

distribution of positive and negative impacts. The second

gives a broad overview of models for estimating social

costs and how such models might relate to distributional

analyses. In the third section, we begin explaining how to

assess economic impacts. We begin with the first step,

which is to calculate compliance costs. The next steps—

how to screen for significant impacts and how to profile

affected entities—are outlined in the fourth and fifth sections. Finally, beginning in Section 9.2.7, we review methods for estimating specific impacts, in the following order:

impacts on prices; impacts on production and employment; impacts on profitability and plant closures; impacts

on related industries and consumers; aggregate impacts

on innovation, productivity, and economic growth; impacts

on industry competitiveness; and impacts on governments

and not-for-profit organizations.

9.2.2 Statutes and Policies

Requiring Examination of

Economic Impacts

There are at least two general administrative laws or orders

that direct analysts to examine economic impacts; each is

reviewed below. Some parts of environmental statutes also

require consideration of economic impacts. Relevant quotations from a selection of these are presented. 

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Chapter 9: Distributional Analyses
9.2.2.1 General Administrative Laws or

Orders

At least one statute—The Unfunded Mandates Reform Act

of 1995 (UMRA)—and one executive order—EO 12866,

"Regulatory Planning and Review"—require agencies to

analyze various economic impacts of regulatory actions.7

These directives require analysts to report on economic

information that does not directly concern the net benefits

tests for efficiency in a BCA. The first calls for analysts to

examine the distribution of benefits and costs across different sectors of the economy. The second directs that certain outcomes be examined, such as changes in unemployment rates. For each policy, Exhibit 9-2 gives the

dimensions for which impacts are to be analyzed and the

corresponding analytical requirements. A discussion of

these requirements follow the table.

As outlined by Exhibit 9-2, UMRA requires analysts to

examine the costs, benefits, and budgetary effects of regulatory actions as experienced by state, local, and tribal governments; regions; urban or rural or other types of communities; or particular segments of the private sector. For

the national economy, UMRA suggests many impacts that

must be examined, including effects on productivity, economic growth, full employment, creation of jobs, and

international competitiveness. These requirements apply

only to rules that include federal mandates "which may

result in the expenditure by state, local, and tribal governments, in the aggregate, or by the private sector, of $100

million or more in any one year."8

Exhibit 9-2 also briefly summarizes relevant parts of guidance from the Office of Management and Budget for EO

128669 (OMB, 1996 or Best Practices) and Guidelines to

Standardize Measures of Costs and Benefits and the

Format of Accounting Statements10 (OMB, 2000 or OMB

Guidelines). The Best Practices suggests that analysts

examine the distribution of impacts across various sectors

of the economy: "Information on distributional impacts

related to the (regulatory) alternatives should accompany

the analysis of aggregate benefits and costs."11 In the OMB

Guidelines, the focus for a distributional analysis is placed

on those sectors that are likely to feel substantial impacts:

"If these distributive effects are important, you should

describe the effects of various regulatory alternatives quantitatively to the extent possible, including their magnitude,

likelihood, and incidence of effects on particular groups."12

The Best Practices also states, "The term 'distributional

effects' refers to the description of the net effects of a regulatory alternative across the population and economy,

divided up in various ways . . ."13 This clearly suggests that

both positive and negative impacts are relevant.

OMB cautions analysts conducting distributional analyses

to recognize that transfer payments will become relevant,

to avoid double-counting even when mixing monetized and

physical effects, and to describe distributional effects without judging their fairness. 

"Since generally accepted principles do not exist

for determining when one distribution of net

benefits is more equitable than another, you

should describe distributional effects without

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Chapter 9: Distributional Analyses

7 EO 13132, Federalism which took effect on November 2, 1999, and EO 13084, Consultation and Coordination With Indian Tribal

Governments which took effect on August 12, 1998, both support the objectives of UMRA. 

8 UMRA § 202.

9 U.S. Office of Management and Budget's Economic Analysis of Federal Regulations Under Executive Order 12866, January 11, 1996.

This "Best Practices" document can be found at the U.S. White House, Office of Management and Budget website:

http://www.whitehouse.gov/OMB/inforeg/riaguide.html under the section titled "Regulatory Policy" (accessed 8/28/2000).

10 U.S. Office of Management and Budget's M-00-08 Guidelines to Standardize Measures of Costs and Benefits and the Format of

Accounting Statements, March 22, 2000. The OMB Guidelines serves to implement Section 638(c) of the 1999 Omnibus Consolidated and

Emergency Supplemental Appropriations Act and Section 628(c) of the Fiscal Year 2000 Treasury and General Government Appropriations Act. They

require OMB to issue guidelines to help agencies estimate the benefits and costs of Federal regulations and paperwork and summarize the results of

the associated analysis. The OMB Guidelines can be found at the U.S. White House, Office of Management and Budget website: http://www.whitehouse.gov/OMB/memoranda/index.html under the section titled "Selected Memorandum to Heads of Federal Departments and Agencies" (accessed

8/28/2000).

11 Best Practices, p. 10.

12 OMB Guidelines, p. 16.

13 Best Practices, p.23.
judging their fairness. You should describe these

effects broadly, focusing on large groups with

small effects per capita, as well as on small

groups experiencing large effects per capita. You

should also note any equity issues not related to

the distribution of policy effects if they are important, and describe them quantitatively to the

extent you can."17

9.2.3 Models for Assessing

Economic Impacts

As noted above, the analytic methods used for a distributional analysis of a particular regulation should be consistent with those used for the corresponding BCA. This section returns to the four methods for estimating social costs

covered in Chapter 8, adding more insights on their application to distributional impacts.18 The most sophisticated

method—computable general equilibrium (CGE)—is

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Chapter 9: Distributional Analyses

General Administrative Dimension Analytical Requirements

Law or Order

UMRA State, local, and tribal Qualitative and quantitative assessment of anticipated 

governments; the costs and benefits of the federal mandate, including costs

private sector and benefits to state, local, and tribal governments or the 

private sector.

Geographic location Estimates of any disproportionate budgetary effects of the 

Federal mandate upon any particular regions of the nation

or particular state, local, or tribal governments; urban or 

rural or other types of communities; or particular 

segments of the private sector.

National economy Estimates of the effect of the federal mandate on the 

national economy, such as the effect on productivity, 

economic growth, full employment, creation of productive

jobs, and international competitiveness of U.S. goods and 

services.

OMB Guidance for Population and An economic analysis (EA) should describe the net effects 

EO 12866 and economy, divided of a regulatory alternative across the population and 

Accounting Statements up in various ways economy.

(e.g., income groups, "Irrespective of the presentation of monetized

race, sex, industrial benefits and costs, the EA should present available

sector) physical or other quantitative measure of the effects of 

the alternative actions to help decision makers 

understand the full effects of alternative actions."16

14 Exhibit 9-2 does not include a discussion of The Regulatory Flexibility Act of 1980 (RFA), as amended by the Small Business Regulatory

Enforcement Fairness Act of 1996 (SBREFA), as they are discussed below in Section 9.3, "Equity Assessment."

15 The Office of Regulatory Management and Information's Rule and Policy Information Development System (RAPIDS)

http://intranet.epa.gov/rapids (accessed 8/18/2000, internal EPA document) is a resource for EPA personnel who wish to read relevant statutes, executive orders or Agency policy documents in their entirety or to acquire copies.

16 Best Practices, p. 23.

17 OMB Guidelines, p. 16.

18 For additional information regarding the four methods for estimating social costs see Section 3 of Chapter 8.

Exhibit 9-2 Economic Impacts Required by General Administrative Law or Order14,15 
treated first and moves to less complex approaches, concluding with direct compliance costs. 

9.2.3.1 Computable General

Equilibrium Models

A CGE framework can be used to describe the effect of a

particular policy on overall measures of economic performance, such as aggregate output, welfare, and the level

of employment. CGE models are particularly effective in

assessing static resource allocation and welfare distribution effects. These include the allocation of resources

across sectors (e.g., employment by sector), the distribution of sectoral output, the distribution of income among

factors, and the distribution of welfare across different

consumer groups, whole regions, and countries. By construction, the basic capacity to describe and evaluate these

sorts of distributional impacts exists to some extent within

every CGE model. More detailed impacts, or impacts of a

particular kind, will require a more complex and/or tailored model formulation (and the data to support it).

The simplest CGE models generally include a single, representative consumer, a few production sectors, and a government sector, all within a single-country, static framework. Complexities may be specified for the model in a

variety of ways. Consumers may be divided into different

groups along the lines of income, occupation, or other

socioeconomic criteria. Producers may be disaggregated

into dozens, or even hundreds, of sectors, each producing

a unique commodity. The government, in addition to

implementing a variety of taxes and other policy instruments, may produce public sector outputs, provide a public good, or run a deficit. CGE models may be international in scope, consisting of many countries or regions linked

by international flows of goods and capital. The behavioral

equations that characterize economic decisions may take

on simple or complex functional forms. The model may

be solved dynamically over a long time horizon, incorporating inter-temporal decision-making on the part of consumers or firms. This will have implications for the treatment of savings, investment, and the long-term profile of

consumption and capital accumulation. 

9.2.3.2 Multi-Market Models

CGE modeling captures multiple effects of a given policy

change throughout an entire economy and can provide

comprehensive distributional information across economic

sectors (e.g., employment by sector). A CGE model may

not be feasible or practical to use as a consequence of limited data and resources or when the scope of expected significant market interactions is limited to a subset of economic sectors. In such instances a multi-market analysis

can be adopted as an alternative to a CGE model.19 Multimarket analysis considers the interactions between a regulated market and other important related markets (outputs and inputs), requiring estimates of elasticities of

demand and supply for these markets as well as crossprice-elasticities also found in CGE models. Multi-market

models are best used when potential economic impacts

and equity effects on related markets might be considerable, but more complete modeling using a CGE framework

would offer a negligible improvement on the quality of

information produced.

9.2.3.3 Partial Equilibrium Models

Unlike multi-market and CGE models, a partial equilibrium framework limits a distributional analysis to considering impacts on entities associated with the directly affected

output markets only. Distributional consequences for

other output markets and input markets are not estimated

using these models. As discussed in Chapter 8, a partial

equilibrium framework requires knowledge of demand

and supply functions for directly affected markets only. 

If information is required for distributional outcomes that

this method is not designed to address, it may be possible

to adopt further assumptions and acquire additional data

to approximate distributional consequences of concern.

These new assumptions should be consistent with those

used for the corresponding BCA. 

9.2.3.4 Direct Costs of Compliance

A relatively unsophisticated distributional analysis examines the direct costs of compliance paid by regulated entities. Often these analyses simply assume that the quantity

of output and state of technology in the regulated industry

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Chapter 9: Distributional Analyses

19 For a detailed discussion of multi-market analysis see Chapter 9 in Just et al. (1982).
remain unchanged after the regulation becomes effective.

An analyst could disaggregate compliance costs for regulated industries or sectors or geographic regions.

9.2.4 Calculating Compliance

Costs

The first step in assessing impacts is to estimate and verify

the costs of compliance. This step is necessary regardless

of whether the entities affected are for-profit, governmental, communities, or not-for-profit entities. Compliance

costs include annual costs (such as operation and maintenance of pollution control equipment or increased production cost) and any capital costs. In certain situations it

may be appropriate to estimate the costs year by year,

especially in cases where the costs are expected to vary

over time. Depending on the nature of the analysis, these

costs may be annualized, so that they can be compared to

average annual income and other measures of financial

strength.20

Verifying the compliance cost estimates entails two steps.

First, the full range of responses to the rule needs to be

identified, including pollution prevention alternatives.

Second, the costs for each response need to be checked to

determine if all elements are included and the costs are

consistent with a given base year. Either a general inflation factor, such as the Gross Domestic Product (GDP)

implicit price deflator, or various cost indices specific to

the type of project can be used.21 The base year and indexing procedure should be stated clearly. Implicit costs that

do not represent direct outlays may be important. The

cost estimates should include such elements as production lost during installation, training of operators, and education of users and citizens (for example, for programs

involving recycling of household wastes). The cost of

acquiring a permit is not so much the permit fee as it is

the lost opportunities during the approval process.

Likewise, the cost of having a car's emissions inspected is

not so much the fee as it is the value of registrant's time. 

EIAs and BCAs use different concepts of cost. BCA relies

on estimates of the social costs of a regulation. EIA costs

are the private costs needed to predict compliance

responses and assess economic impacts in several ways.

Social costs represent costs to society as a whole, whereas

private costs reflect costs as they are experienced by the

affected parties. Often, the same basic engineering compliance cost estimates are used as the basis for developing

both social and private cost estimates and are adjusted to

provide the required costs. 

There are several issues analysts must consider when estimating the private costs of environmental polices. These

include: 

Before- versus after-tax costs: The costs of complying with regulations are generally deductible as

expenses for income tax purposes. The effective burden of compliance costs is reduced for taxable entities

because they can reduce their taxable income by the

amount of the compliance costs. The effect of a regulation on profits is therefore measured by after-tax

compliance costs. Different components of engineering cost estimates should be adjusted based on their

specific impact on taxes, to provide the inputs needed

for an EIA.22 Operating costs are generally fully

deductible as expenses in the year incurred. Capital

investments associated with compliance must generally be depreciated over some number of years.23

In most cases, communities, not-for-profits, and governments do not benefit from reduced income taxes

that can offset compliance costs. Therefore, adjustments to cost estimates, annualization formulas, and

cost of capital calculations required to calculate aftertax costs should not be used in analyses of impacts

on governments and not-for-profits.

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Chapter 9: Distributional Analyses

20 As previously discussed, the discount rate used should be specific to the task. The rate used to annualize costs is dependent on the entity's cost of capital and, thus, the sources of financing used as well as the credit rating of the borrower. When calculating the present value of a stream

of future social costs (or benefits), the social rate of time preference is the appropriate discount rate. See Chapter 6 for a complete discussion of discount rates.

21 The GDP implicit price deflator is reported by the U.S. Department of Commerce, Bureau of Economic Analysis in its Survey of Current

Business. The annual Economic Report of the President, Office of the President, is another convenient source for the GDP deflator time series. 

22 Engineering costs can often be used in their before-tax form to calculate social costs. Adjustments may be required, however, if the

available compliance cost estimates do not reflect the social cost of the resources used.
Transfers: Social costs reflect the real value of economic resources—labor, equipment, supplies—used

to achieve compliance. However, some types of compliance costs incurred by the regulated parties may

represent transfers among parties. Transfers, such as

payments for insurance or payments for marketable

permits do not reflect use of economic resources.

Private cost estimates used in the EIA should include

such transfers, but these transfers should be excluded

when calculating social costs for the benefit-cost

analysis.

Discounting: Compliance costs often vary over time,

perhaps requiring initial capital investments and then

annual operating costs. To estimate impacts, the

stream of costs is generally discounted to provide a

Present Value of Costs (PVC) that reflects the time

value of money.24 In contrast to social costs and benefits, which are discounted using a social discount rate,

private costs are discounted using a rate that reflects

the regulated entity's cost of capital.25 The private discount rate used will generally exceed the social discount rate by an amount that reflects the risk associated with the regulated entity in question.26 For firms,

their cost of capital may also be determined by their

ability to deduct debt from their tax liability. 

Annualized costs: Annualizing costs involves calculating the annualized equivalent of the stream of cash

flows associated with compliance. It provides a single

annual cost number that reflects the various components of compliance costs incurred over some selected time period (e.g., 15 or 30 years).27 The annual

value is the amount that, if incurred each year over

the selected time period, would have the same present value as the actual stream of compliance expenditures. Annualized costs are therefore a convenient

compliance cost metric that can be compared with

annual revenues and profits. It is important to

remember that using annualized costs masks the timing of actual compliance outlays. For some purposes,

using the underlying compliance costs may be more

appropriate. For example, when assessing the availability of financing for capital investments, it is important to consider the actual timing of capital outlays.

Fixed versus variable costs: Some types of compliance costs vary with the size of the regulated enterprise (e.g., in proportion to production). Other components of cost may be fixed with respect to production, such as the costs involved in reading and understanding regulatory requirements.28 Requirements

that impose high fixed costs will impose a higher cost

per unit of production on smaller firms than on larger firms. It is important that the effects of any

"economies of scale" be reflected in the compliance

costs used to analyze economic impacts.29 Using the

same average annualized cost per unit of production

may mask the importance of such fixed costs and

understate impacts on small entities.

9.2.5 Screening for Potentially

Significant Impacts

A comprehensive analysis of all aspects of economic

impacts associated with a rule can be highly resource

intensive. Detailed and explicit analysis of impacts may

not be justified in all cases, if a preliminary analysis

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Chapter 9: Distributional Analyses

23 Current federal and state income tax rates can be obtained from the Federation of Tax Administrators in Washington, D.C. FTA, State Tax

Rates & Structure, available from http://www.taxadmin.org/fta/rate/tax_stru.html (accessed 8/28/2000).

24 This Present Value of Costs may then be annualized to provide an annual equivalent of the uneven compliance cost stream, as described

below.

25 While the discount rate differs, the formula used to discount private costs is the same as used for social costs. See Chapter 6.

26 Risk adjusted rates for different industries can be obtained from the Ibbotsen Associates Handbook or for specific firms from the Value

Line Investment Survey.

27 Annualized costs are also discussed in Chapter 6 on social discounting. The formula for calculating annualized costs is presented in

Section 6.2.

28 Note that fixed versus variable costs is not the same thing as capital versus operating costs. Capital costs may be fixed or variable with

respect to the size of the operation, as may operating costs. This distinction between capital and operating costs is important for calculating after-tax

costs. 

29 Economies of scale characterize costs that decline on a per unit basis as the scale of an operation increases. 
suggests that economic impacts will be minor. Screening

analyses provide a way to focus attention and analytic

resources on the areas where economic impacts are most

likely to be significant. These screening analyses generally

use simplifying assumptions about market outcomes (e.g.,

the alternative no-cost-pass-through and full-cost-passthrough assumptions) or simple tests of financial impacts

(e.g., a ratio of compliance costs to sales or to profits) to

screen for potentially significant impacts.

It is important to keep in mind the limitations in screening analyses when interpreting and presenting their

results. They typically identify cases of potentially significant impacts. More detailed investigation beyond the

screening analysis is usually needed to reach a reliable

conclusion about the likelihood of significant impacts.

In addition, screening analysis criteria should be chosen to

balance the risk of identifying "false positives" versus "false

negatives." That is to say, using too low a threshold will do

little to distinguish true differences in potential impacts

(false positives), while using too high a threshold runs the

risk of missing some sectors that may be significantly

affected (false negatives). 

Finally, when screening analyses are based on alternative

assumptions about market responses, it is important to

note in presenting the results that they represent extreme

assumptions that in practice cannot occur simultaneously.

For example, worst case impacts on profits cannot occur

simultaneously with worst case impacts on prices.30

9.2.6 Profile of Affected Entities

9.2.6.1 Compiling an Industry Profile

and Projected Baseline

The impact of a regulation on business profitability and

other economic outcomes depends on the magnitude of

the compliance costs associated with the rule, on the distribution of compliance costs across firms, and on the economic and financial characteristics of the affected firms

and industries.31 A substantial portion of an EIA involves

characterizing the affected firms and industries as a basis

for evaluating economic impacts. The following are

important inputs to an EIA:

Standard Industrial Classification (SIC) and

North American Industrial Classification System

(NAICS) industry codes: These definitions can be

developed by working with engineering analysts, the

EPA project team and workgroups, industry roundtables and industry specialists at the Department of

Commerce. The SIC codes and their definitions

appear in the Standard Industrial Classification

Manual: 1987, available from the Government

Printing Office (OMB, 1987). This industry classification system is being replaced by the North American

Industry Classification System (NAICS), which will be

reflected in the forthcoming data series (OMB, 1998).

A regulated entity that is a small part of a larger

industry may require fractional multipliers in order to

estimate the regulated category's share of the larger

industry.

Compilation of summary statistics: Data regarding total employment, revenue, number of establishments, and number of firms are available from the

economic censuses and interim updates (e.g.,

Department of Commerce Annual Survey of

Manufactures, for non-manufacturers, the

Department of Commerce County Business Patterns,

and Agricultural Statistics from the Department of

Agriculture). The profile should also define the

industry and its products, describe major production

technologies, and discuss important business and

regulatory trends.

The level and distribution of compliance costs:

Estimates of compliance costs reflect predicted

responses to the rule and are often developed based

on engineering estimates. It is important to know

how costs are distributed among plants and firms in

the same industry, since firms that are not affected by

the rule or that incur lower compliance costs than

their competitors may gain competitive advantage as a

result of the rule. If only a few producers in an

industry incur added costs, they are less likely to be

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Chapter 9: Distributional Analyses

30 A more detailed treatment of the considerations in the conduct of sensitivity analysis is presented in Chapter 5.

31 Generally, analysts should presume a perfectly competitive market structure. The purpose of developing an industry profile is to confirm

this presumption or discover evidence to the contrary.
able to raise their prices to recover costs. In contrast,

a rule that affects all industry participants equally is

more likely to result in price increases and less likely

to change the competitive structure of the industry.

In addition, some rules impose different requirements and costs on new versus existing sources.

Such rules may affect industry competition, growth,

and innovation by raising barriers to new entry.

Baseline industry growth and financial

condition: Industries and firms that are relatively

profitable in the baseline will be better able to absorb

new compliance costs without experiencing financial

distress. Industries that are enjoying strong growth

may be better able to recover increased costs through

price increases than they would have been had there

been no demand growth. Section 9.2.9 provides

suggestions for using specific ratios to assess the

significance of economic impacts on a firm's financial

condition. 

Baseline industry structure: Industry-level

impacts depend on the competitive structure and

organization of the industry and the industry's relationship to other economic entities. In addition, the

number and size distribution of firms and facilities

and the degree of vertical integration are important

aspects of industry structure that affect the economic

impacts of regulations.

Characteristics of supply and demand: Assessing

the likelihood of changes in production and prices

requires information on the characteristics of supply

and demand in the affected industries. The relevant

characteristics are reflected in price elasticities of supply and demand, which, if available, allow direct

quantitative analysis of changes in prices and production. Often, reliable estimates of elasticities are not

available, and the analysis of industry-level adjustments must rely on simplifying assumptions and

qualitative assessments. 

The industry profile provides a general understanding of

an industry or industries affected by a regulatory action

and characterizes their ability to absorb compliance costs.

This information provides the basis for assumptions central to the impact analysis, as well as information needed

for some of the special analyses such as Regulatory

Flexibility Analyses. 

9.2.6.2 Profile of Other Affected

Entities

Careful consideration needs to be given to the question of

whether or not a particular rule will affect government

entities,32 not-for-profit organizations,33 or households. For

example, air pollution regulations that apply to power

plants may affect municipally owned electric companies;

air regulations that apply to vehicles may affect municipal

bus companies, as well as other municipal vehicles such

as police cars and public works vehicles; effluent guidelines for machinery repairing activities may affect municipal garages. Thus, the first step is to identify all the government entities that may be affected.

Relevant characteristics of government entities may

include: 

the community's size (number of people living in the

community); 

household income levels (both median and some

measure of the income range); 

number of children (since education is frequently the

major service provided by local governments);

number of elderly residents (who frequently have

fixed incomes); 

unemployment rate; 

revenue amounts by source; and 

the credit or bond rating of the community. 

If the property tax is the major revenue source, then the

assessed value of property in the community and the percentage of this assessed value represented by residential

versus commercial and industrial property should be

determined. If the government entity serves multiple

communities, such as a regional water or sewer authority,

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Chapter 9: Distributional Analyses

32 Government entities that may be affected by a program include states, cities, counties, towns, townships, water authorities, villages,

Indian Tribes, special districts, military bases, etc.

33 Examples of not-for-profits include non-profit hospitals, colleges, universities, and research institutions.
then this information needs to be collected for all the

communities covered by the entity.

Data on community size, income, number of children and

elderly, and unemployment levels are available from the

U.S. Bureau of Census. Data on property values, amount

of revenue collected from each revenue source, and credit

rating will need to be collected directly from the community or state finance agencies. If the regulated activity is provided by an "Enterprise Fund" then revenue and cost

information will need to be obtained directly from the

fund.34 Depending on the number of communities affected and the level of detail warranted, the analysis may rely

on generally available data only. In other cases, a survey of

affected communities may be necessary. However, in

cases where a survey is needed, there will be a need to

comply with the requirements of the Paperwork Reduction

Act (PRA).

Relevant characteristics of not-for-profit entities include

their size, the goods or services they provide, their operating costs, and the amount and sources of their revenue. If

the entity is raising its revenues through user fees or in

other ways charging a price for its goods/services (such as

university tuition), then the income levels of its clientele

are relevant. If the entity relies on contributions, then it

would be helpful to know the financial and demographic

characteristics of its contributors. If it relies on government funding (such as Medicaid) then possible future

changes in these programs should be identified.

Relevant features of households are standard socioeconomic and demographic characteristics. These characteristics include, for example, their income level, size, age

distribution, education level, and ethnic group.

9.2.6.3 Profile Data Sources

Profiles generally draw from at least two types of information: 1) literature from economic journals, dissertations,

and industry trade publications, and 2) quantitative data

describing the characteristics of the industry. The relevant

literature can be useful in characterizing the industry

activities and markets as well as regulations affecting the

industry. Identification of relevant literature is most efficiently performed through a computerized search using

on-line services such as Dialog, BRS/Search Services, or

Dow Jones News/Retrieval. These on-line services contain

more than 800 databases covering business, economic,

and scientific topic areas. Exhibit 9-3 lists some commonly used sources.

The industry profile may also identify those situations

where sufficient data for an EIA cannot be obtained

through published and commercial sources. These situations arise particularly when the affected industry is one of

many product lines or other activities of identified facilities; in addition, for some industries, identification of the

appropriate SIC or NAICS code for all the firms or facilities

included in the industry may be difficult if the industry

can be categorized in a variety of ways. In these cases, and

particularly if facility-level data are required to estimate

economic impacts, a survey of either a statistical sample

or a census of affected facilities may be required to provide

sufficient data for analysis.

9.2.7 Impacts on Prices

Predicting impacts on prices is the basis for determining

how the burden of compliance costs will be shared

between the directly-affected firms and their customers

and suppliers in a typical market. At one extreme, regulated firms may not be able to raise their prices at all and

they will bear the entire burden of the added costs in the

form of reduced profits. Reduced profits may result from

reduced earnings on continuing production, lost profits on

products or services that are no longer produced, or some

combination of the two. At another extreme, firms may be

able to raise prices enough to recover costs fully. In this

case, there will be no impacts on the profitability of the

directly-affected firms but their customers will bear the

burden of increased prices. Another possible outcome is

that suppliers to the directly-affected firms will bear some

of the burden in lost earnings if the regulation results in a

decline in demand for particular products.35

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Chapter 9: Distributional Analyses

34 Public services that are funded entirely by fees charged to users are referred to as "enterprises" and their revenues are referred to as

"Enterprise Funds." 

35 Regulations limiting sulfur emissions may result in reduced demand for high-sulfur coal, for example, which will result in a fall in the

price of such coal and lost profits for its producers. 
In general, the likelihood that price increases will occur

can be evaluated by considering whether competitive conditions will allow the affected facilities to pass on their

costs. The methods used to conduct the analysis of the

directly-affected markets will depend on the availability of

appropriate estimates of supply and demand elasticities.

In many cases, reliable estimates of elasticities will not be

available.37 In these cases, the analyst will need to rely on a

more basic investigation of the characteristics of supply

and demand in the affected market to reach a judgment

about the likelihood of full or partial pass-through of costs

via price increases.

9.2.8 Impacts on Production and

Employment

Regulations may raise the cost of doing business sufficiently to make some or all production unprofitable or may

reduce the quantity demanded as producers raise their

prices to maintain profitability. The associated reductions

in output may result from lower operating rates at existing

plants, closure of some plants, or reduced future growth in

production relative to what would have occurred in the

baseline. Losses in employment are typically associated

with reductions in output.

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Chapter 9: Distributional Analyses

36 Economic Censuses include: Census of Manufacturers, Census of Construction Industries, Census of Mineral Industries, Census of

Retail Trade, Census of Service Industries, Census of Transportation, and Census of Wholesale Trade.

37 See Chapter 8 for a more complete discussion of costs and elasticity.

Source Data

Trade Publications Market and technological trends, sales, location, regulatory events, ownership 

changes.

U.S. Department of Commerce, Total revenue by 4-SIC (generally); payroll; quantity and value of products shipped

Economic Censuses36 and materials consumed; value added; capital expenditures, assets, inventories, 

employment, and geographic area, distribution by size, kind of business.

U.S. Department of Commerce, Description of industry, trends, international competitiveness, regulatory events.

U.S. Industry & Trade Outlook

United Nations, Foreign trade volumes for selected commodities, major trading partners

International Trade Statistics 

Yearbook

Robert Morris Associates, Income statement and balance sheet summaries, profitability, debt burden and

Annual Statement Studies other financial ratios, all expressed in quartiles and available for recent years. 

Based on loan applicants only.

Dun & Bradstreet, Type of establishment, SIC code, address, facility and parent firm revenues and

Information Services employment.

Standard & Poor's Publicly held firms, at 4-digit SIC level. Prices, dividends, and earnings, 

line-of-business and geographic segment information, S&P's ratings. Quarterly 

History (10 years): income statement, ratio, cash flow, and balance sheet analyses

and trends.

Standard & Poor's, Industry profiles, competitors for selected firms. Firm Level Data:

Research Reports (publicly traded companies) company background, stock prices, major 

competitors, description of business organization, summary financial data.

Securities and Exchange Income statement and balance sheet, working capital, cost of capital,

Commission 10k Filings, employment, outlook, regulatory history, foreign competition, lines of business,

EDGAR System Database ownership and subsidiaries, mergers and acquisitions.

Value Line Industry Reports Industry overviews, company descriptions and outlook, performance measures.

FINDS database Facility SIC, latitude and longitude, zip code, size, ownership structure.

Exhibit 9-3 Frequently Used Profile Sources
EPA has used a variety of methods to assess reductions in

production and employment. In some cases, demand and

supply elasticities are used directly to calculate changes in

output and prices that would result from a shift upward in

the supply curve associated with compliance costs. Often

estimates of the shape of the supply curve are not available

and assumptions are made about its shape in the region of

interest to allow use of demand elasticity estimates to predict output and price adjustments.

In other cases, analysts may assess the impacts of rules on

the profitability of specific firms or industry segments, and

identify potential line or plant closures based on a financial analysis.38 If partial or full plant closures are projected, it is important to consider whether the production lost

at the affected facilities will be shifted to other existing

plants or to new sources or will simply no longer be produced. If there is excess capacity in the industry in the

baseline and some plants with excess capacity can operate

profitably in compliance with the rule, they may expand

production to meet the demand for products no longer

produced at plants that can no longer operate profitably.39

Even if total production does not decline but is simply

shifted from higher-cost plants to more efficient competitors and even if total employment does not change, localized changes in employment may interest policy makers.

This is especially the case for rules that may have a strong

regional impact. For example, UMRA § 202 requires such

an analysis as an element of the UMRA cost analysis. Data

on the ratio of production or sales to employment can

help predict the number of jobs lost as a result of reductions in production. The regional distribution of job losses

can be calculated based on plant locations.

9.2.9 Impacts on Profitability and

Plant Closures

The availability of financial information used to assess

profitability varies greatly, depending on the industry in

question and the extent to which EPA is able to collect new

information by surveying the affected entities. With limited exceptions, detailed financial information is not generally available for individual plants or for privately-held

companies from published sources. Financial data for

publicly-held companies may be too aggregated to allow

analysis of the specific business practices affected by the

rule. In the absence of new data collection by EPA, analysts may need to rely on financial profiles constructed for

model plants, or on industry-average data provided by the

Census Bureau and other sources.40 In some cases, financial profiles used in the analysis of a previous rule-making

might be adapted and updated to analyze the impacts of

the rule in question.

Analysis is conducted by determining how the added costs

of compliance will affect the financial strength of the firm.

As with predicting price increases, it may be worthwhile to

start with a screening analysis based on an extreme

assumption about the incidence of costs—in this case,

that no costs can be recovered through price increases.

This assumption provides a worst case estimate of impacts

on profits, potential closures, and employment reductions

in the directly-affected market. Where firms in an industry do not appear to experience financial distress under

the no-cost-pass-through scenario, more detailed analyses

to predict actual market adjustments and price increases

are not needed. 

The severity of financial impacts to firms from a rule can

range from no impact (if all costs are recovered through

price increases, for example) to a modest reduction in

profits, closure of a production line or plant, to bankruptcy

of the firm. Criteria for assessing the degree of financial

distress and for predicting when a production line or plant

would be shut-down are not clear-cut.41 If detailed financial profiles can be developed, including revenues, costs,

income statements, and balance sheets, a variety of financial tests can be used to assess the likelihood of financial

distress or closure. These tests address the following

issues:

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Chapter 9: Distributional Analyses

38 Analysis of impacts on profitability and plant closures are discussed later in this section.

39 Some surviving plants could experience increases in production, capacity utilization, and profits even though subjected to regulatory

requirements, if their competitors face even greater cost increases. 

40 Sources of financial data are listed in Exhibit 9-3. 

41 This section assumes a perfectly competitive market, which in practice does not always correctly characterize the market structure being

analyzed. In these cases, this section should be adapted to the relevant market structure.
Do the costs of the regulation result in a negative discounted after-tax cash flow?42

Does the facility or firm's profitability fall below

acceptable levels?

Is the facility or firm's ability to finance its operations

and pay its obligations jeopardized?

Establishments that fail the first test are potentially at risk

for closure.43

Closure Decisions

A variety of considerations affect a firm's decision to close

a production line or a plant.

The profitability of the plant itself provides

insight into whether the operation will be contined if

the plant represents a stand-alone business. This

also assumes that it is possible to construct a financial profile of that business.

The role the plant plays in a larger operation

may influence closure decisions. For example, some

plants may be part of a vertically or horizontally integrated operation. Such plants might not be viable as

a stand-alone operation but may continue to operate

based on its contribution to the business line as a

whole. In general, however, the analysis should

assume that an operation will be closed if compliance

with the rule would increase costs to the point where

continued operation is no longer profitable. 

A negative discounted cash flow indicates that

returns are below the rate of return required to provide the required return on equity and payment of

interest. Closures in the short run are likely to occur

if earnings do not cover variable costs plus the cost of

compliance. Disinvestment and closures will occur

over the longer term if earnings are not sufficient to

justify investment in plant and equipment as well. 

Where closures and reduced production are likely for

some but not all plants, firms may face complex decisions

about which plants to close. These decisions reflect relative

operating costs, age of equipment, tax and other incentives

offered by local communities and states to retain business,

and logistical considerations. Analyses of plant closures

should include caveats stating that the analysis identifies

candidates for closure, rather than providing reliable predictions of which specific plants will close. The available

information on plant-level operating costs and contributions to earnings is generally too uncertain to allow more

precise prediction of plant closures.

Financial Distress Short of Closure

Short of closure, financial distress may occur. Financial

distress measures a continuum from mild to severe financial weakness and may result in difficulties obtaining

financing and attracting capital.44 Although in practice,

analysts may use a variety of measures of financial distress, use of specific financial ratios has the advantage that

it mirrors analyses that investment and lending institutions perform to evaluate industries and businesses.

Particular measures include:

Measures of impacts on profitability, e.g., pre-tax

return on assets (net operating income divided by

total assets) or return on equity. These measures

reflect the profit performance of a firm's capital

assets. If returns are reduced to unacceptable levels

when compliance costs are included, the firm may

have difficulty financing new investment or attracting

capital even if it is not earning negative returns. 

Measures of impacts on liquidity, e.g., interest

coverage ratio (cash operating income divided by

interest expense), times-interest-earned (earnings

before interest and taxes divided by interest expense),

and the current ratio (current assets divided by current liabilities.) These measures reflect the firm's

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42 If after-tax cash flow is negative under baseline conditions (before considering compliance costs), the facility is a likely candidate for closure even in the absence of additional compliance costs. These closures should not be attributed to the rule, but rather should be classified as baseline closures.

43 If it is possible to estimate plant liquidation values, another test can be added to assess the likelihood of closure. Plants may be predicted to close if the value of continuing to operate is less than the liquidation value. 

44 Researchers have developed various composite measures that are designed to assess the potential for bankruptcy. The most commonly

cited is the ZETA model or "Z-score" developed by Altman et al. (1993). This model uses a weighted average of five variables to predict potential for

bankruptcy. The ratios include working capital/total assets, retained earnings/total assets, earnings before interest and taxes (EBIT)/total assets, market value of equity/par value of debt, and sales/total assets. The model includes levels for this composite score that represent clear potential for bankruptcy, low or no potential for bankruptcy, and an uncertain grey area.
ability to meet its financial obligations out of current,

on-going operations. If operating cash flow does not

comfortably exceed its payment obligations, the firm

may have to use resources required for on-going

operations to pay contractual obligations and its creditworthiness will suffer.

9.2.10 Impacts on Related

Industries and Consumers

The economic and financial impacts of regulatory actions

propagate to industries and communities that are linked to

the regulated industries, resulting in indirect business

impacts. These indirect impacts may include employment

and income losses, as well as changes in the competitiveness and efficiency of related markets. Compliance-related

industries, on the other hand, may yield offsetting gains in

employment and income when a regulated industry purchases equipment, facilities or labor in order to comply

with a regulation.

Although, in principle, every economic entity can be

thought of as having a connection with every other entity,

practical considerations usually require an analysis of indirect impacts to be performed or presented for a manageable subset of economic entities that are most strongly

linked to the regulated entity. In addition to considering

major customers and specialized suppliers of the affected

industry, it is also important to consider less obvious but

potentially significant links, for example, basic suppliers

such as electricity generators.

For this reason, the analysis of linkages should use a

framework that thoroughly measures indirect as well as

direct linkages. Whatever the approach, the goal of the

analysis is to measure—given a certain amount of

employment and income change in a regulated market—how

employment and income will likely change in related entities. 

9.2.11 Impacts on Innovation,

Productivity, and Economic

Growth

While regulatory interventions can theoretically lead to

macroeconomic impacts, such as growth and technical

efficiency, such impacts may be impossible to measure or

observe.45 In some cases, however, it may be feasible to

use macroeconomic models to evaluate the regulatory

impact on gross national product (i.e., including trade

effects and plant location decisions), factor payments,

inflation, and aggregate employment.

For programs or rules that are expected to have significant

impacts in a particular region, use of regional models—

either general equilibrium or more limited models—may

be valuable. 

Some macroeconomic regulatory effects are beyond the

capacity of the typical regulatory impact analysis to quantify. For example, price changes induced by a regulation can

lead to technical inefficiency because firms are not choosing the production techniques that minimize the use of

labor and other resources in the long run. Instead, firms

will tend to overuse resources whose prices are artificially

depressed by the regulation compared to the resources'

true cost to society.

Additional anecdotal, theoretical and limited empirical literature are available that point to possible macroeconomic

impacts.46

9.2.12 Impacts on Industry

Competitiveness

Regulatory actions that substantially change the structure

or conduct of firms can produce indirect impacts by

changing the competitiveness of the regulated industry, as

well as that of linked industries. An analysis of impacts on

competitiveness begins by examining barriers to entry and

market concentration and by answering two key questions.

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Chapter 9: Distributional Analyses

45 OMB states that macroeconomic effects are likely to be measurable only if the impact of the regulation exceeds 0.25 to 0.5 percent of

GDP. See OMB (1995).

46 See Jaffe et al. (1995) and Gray and Shadbegian (1997).
Will the regulation erect entry barriers that

might reduce innovation by impeding new

entrants into the market? High sunk costs associated with capital costs of compliance or compliance

determination and familiarization would be an entry

barrier attributable to the regulation. Sunk costs are

fixed costs that cannot be recovered in liquidation;

they can be calculated by subtracting the liquidation

value of assets from the acquisition cost of assets facing a new entrant, on an after-tax basis.47 Lack of

access to debt or equity markets to finance fixed costs

of entering the market can also present entry barriers, even if none of the fixed costs are sunk costs.

However, if financing is available and fixed costs are

recoverable in liquidation, the magnitude of fixed

costs alone should not present any barrier to entry.

Will the regulation tend to create or enhance

market power and reduce the economic efficiency of the market? The tools presented in the section describing how to create an economic profile also

address this question. The most important of these

tools include measures of horizontal and vertical integration (i.e., concentration), among both buyers and

sellers, in the baseline compared to post-compliance

cases. Closely related to concentration, product differentiation may occasionally be either increased or

decreased by a regulatory action. For a hypothetical

example, certain labeling restrictions might reduce

the ability of firms to segment their market by differentiating an essentially uniform product with packaging. In such a hypothetical baseline, firms might

enjoy effectively higher concentration ratios and less

competition after imposition of a uniform labeling

policy.

9.2.13 Impacts on Government

Entities and Not-for-Profit

Organizations

Section 9.2.9 of this chapter discussed ways of measuring

the impact of regulations and requirements on private

entities, such as firms and manufacturing facilities. When

dealing with private entities, the primary focus is on measures that assess changes in profits. This section describes

impact measures for situations where profits and profitability are not relevant—where the regulations affect government entities and/or not-for-profit organizations. Many

of the same questions, however, apply:

Which entities are affected and what are their characteristics?

How much will the regulation increase operating

costs?

What impact will the regulation have on operating

procedures?

Will this change the amount and/or quality of the

goods and services provided?

Can the entity raise the necessary capital and will this

change its ability to raise capital for other projects?

The major difference is that instead of ultimately

measuring the regulation's impact on profit levels, when

government entities are involved, the ultimate measure is

the ability of its citizens to pay for the requirements.

Likewise, in the case of a not-for-profit, the measure is the

reduction in the organization's ability to provide its goods

and services.

9.2.13.1 Measures of Government

Impacts

EPA regulations can affect governments in at least three

ways. They can directly impose requirements on the governmental entity, such as water pollution requirements for

publicly-owned wastewater treatment works (POTWs) or

air pollution restrictions that affect municipal bus systems

or power plants. Second, they can involve costs for governments to implement and enforce regulations imposed on

other parties. Finally, they can impose indirect costs on

government entities, such as increased unemployment in

a community because an EPA regulation has resulted in

reduced production (or even closure) at a factory in the

community. Keep in mind that some of the impacts may

reduce the community's financial resources and thus its

ability to pay for the requirements. For example, the

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Chapter 9: Distributional Analyses

47 Sunk costs are sometimes referred to as exit barriers. Without exit barriers, there can be no entry barriers, as long as there are no liquidity constraints.
closure of a facility may increase the drain on social services at the same time that tax revenues are declining.

Impacts of Programs That Directly Affect

Government and Not-for-Profit Entities

The direct impact measures can be divided into two categories, (1) those that measure the impact itself in terms of

the relative size of the costs and the burden they place on

citizens and (2) those that measure the economic and

financial conditions of the entity that affect its ability to pay

for the requirements. For each category, there are several

types of measures that can be used either as alternatives,

or jointly, to illuminate various aspects of the question.

Measuring the relative cost and burden of the regulations. There are three commonly used approaches to

measuring the burden of the rule; all involve calculating

the annualized costs of complying with the regulation. For

government entities, the three approaches are:

Annualized compliance costs as a percentage of

annual costs for the service included: This measure tries to define the impact as narrowly as possible

and is particularly appropriate when the service or

activity to be regulated is provided by a single-purpose

entity. For example, if the regulated activity is sewage

treatment, the POTW may not be able to draw on general government revenues to cover its increased cost.

Thus the appropriate comparison would be to estimate the resulting increase in its costs. Even if the

affected entities are not able to draw on general government revenues, it is useful to know how the rule

affects the cost of the activity in question. In practice,

EPA has often used the condition that if compliance

costs are less than one percent of the current annual

costs of the activity, it is usually assumed that the

compliance costs are placing a small burden on the

entity.

Annualized compliance costs as a percentage of

annual revenues of the governmental unit: The

second measure corresponds to the commonly used

private-sector measure of annualized compliance

costs as a percentage of sales. Referred to as the

"Revenue Test," it is one of the measures suggested in

EPA Revised Interim Guidance for EPA Rulewriters:

Regulatory Flexibility Act as amended by the Small

Business Regulatory Enforcement Fairness Act (EPA,

1999).48 This differs from the prior measure in that it

compares annualized compliance costs to the total

revenues of the entity (which usually is multi-purpose

in nature). If compliance costs are less than one percent of revenues, then the requirements are usually

considered to be affordable. Compliance costs in the

range of one to three percent of government revenues

are less easily interpreted. If all affected communities

fall in this range, then further thought should be

given to lowering annual compliance costs, if only a

small percentage of communities fall into this range

and the rest fall below one percent, then the requirements can probably be considered affordable.

Compliance-cost-to-revenue ratios of greater than

three percent indicate that the requirements are placing a heavy burden on the community.

Per household (or per capita) annualized compliance costs as a percentage of median household (or per capita) income: The third measure

compares the annualized costs to the ability of residents to pay for the cost increase. Commonly

referred to as the "Income Test," it is described in the

Revised Interim Guidance (EPA, 1999) and EPA's

Office of Water Interim Economic Guidance for

Water Quality Standards. Workbook (EPA, 1995a).49

Costs can be compared to either median household

or median per capita income. In calculating the per

household or per person costs, the actual allocation

of costs needs to be considered. If the costs are

entirely paid through property taxes, and the community is predominately residential, then an average per

household cost is probably appropriate. If, however,

some or all of the costs are allocated to users (e.g.,

fares paid by bus riders or fees paid by users for

sewer, water, or electricity supplied by municipal utilities), then this needs to be taken into account. In

addition, if some of the costs are borne by local firms,

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Chapter 9: Distributional Analyses

48 See Section 9.3 for a discussion of the analytic and procedural requirements under SBREFA.

49 For example, materials presented in the water guidance and other EPA Office of Water analyses are: less than one percent indicates little

impact, over two percent indicates a large impact, with the range from one to two percent being a gray area of indeterminate impact.
then that portion of the costs needs to be handled

separately. 

Two commonly used impact measures for not-for-profit

entities are: (1) annualized compliance costs as a percentage of annual operating costs and (2) annualized compliance costs as a percentage of total assets. The first is

equivalent to the first of the impact measures described

for government entities, measuring the percentage

increase in costs that would result from the regulation

being analyzed. The second is a more severe test, measuring the impacts if the annualized costs were paid for out of

the assets of the institution. As presented in EPA's Revised

Interim Guidelines, the guidelines for annualized compliance costs as a percentage of annual operating costs are:

annualized compliance costs less than 1 percent of operating costs indicate that the rule does not represent a burden, annualized compliance costs between one and three

percent of operating costs indicates that the rule may

impose a burden, and annualized compliance costs that

are more than three percent of operating costs indicates

that the rule may impose a heavy burden.

Measuring the economic and financial health of the

community: This second category of impact measures

looks at the economic and financial health of the community involved, since these will affect its ability to finance

expenditures required by a program or rule. A given cost

may place a much heavier burden on a poor community

than on a wealthy one of the same size. As with the

impact measures described above, there are three categories of economic and financial condition measures:

Indicators of the community's debt situation:

Debt indicators are important because they measure

both the ability of the community to absorb additional

debt (to pay for any capital requirements of the rule)

and the general financial condition of the community.

While several indicators have been developed and

used, this section describes two. One measure is the

governmental entity's bond rating. Awarded by companies such as Moody's and Standard & Poor's, bond

ratings summarize their assessment of a community's

credit capacity and thus reflect the current financial

conditions of the governmental body. A second frequently used measure is the ratio of overall net debt

(the debt to be repaid by property taxes) to the full

market value of taxable property in the community.

Overall net debt should include the debt of overlapping districts. For example, a household may be part

of a town, a regional school district, and a county

sewer and water district, all of which have debt that

the household is helping to pay off.50 See Exhibit 9-4

for interpretations of the values for these measures.

Neither of these two debt measures will always be

appropriate. Some communities, especially small

ones, may not have a bond rating. This does not necessarily mean that they are not creditworthy, it may

only mean that they have not had an occasion recently to borrow money in the bond market. Second, if

the government entity does not rely on property taxes,

as may be the case for a state government or an

enterprise district, then the ratio of debt to full market value may not be relevant. Information on debt

and assessed property values are available from the

financial statement of each community. The state's

auditor's office is likely to have this information for all

communities within the state.

Indicators of the economic/financial condition of

the households in the community: There are a

wide variety of household economic and financial

indicators. Two commonly used ones are: the unemployment rate and median household income. Both

measure the financial well-being of households.

Unemployment rates are available from the U.S.

Bureau of Labor Statistics. Median household

income is available from the U.S. Census and some

states maintain more up-to-date databases on income

levels. Benchmark values for these two measures are

presented in Exhibit 9-4.

Financial management indicators: This category

consists of indicators measuring the general financial

health of the community as an entity, as opposed to

the general financial health of the residents. Since

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Chapter 9: Distributional Analyses

50 An alternative to the net debt as percent of full market value of taxable property is the net debt per capita. Commonly used benchmarks

for this measure are:

Net debt per capita: less than $1,000 = strong financial condition

Net debt per capita: $1,000 and $3,000 = mid-range or gray area

Net debt per capita: greater than $3,000 = weak financial condition
most local communities rely on the property tax as

their major source of revenues, two indicators of

property tax health are presented here. One measures the burden property taxes are placing on the

community in terms of property tax revenues as a

percent of full market value of taxable property. The

second indicator measures the efficiency with which

the community's finances are managed, and indirectly, whether the tax burden may already be excessive,

in terms of the property tax collection rate. As the

property tax burden on tax payers increases, they are

more likely to not pay their taxes or pay them late. 

Measuring the financial strength of not-for-profit entities

includes assessing (1) how much reserve the entity has,

(2) how much debt the entity already has and how its

annual debt service compares to its annual revenues, and

(3) how the entity's fees or user charges compare with the

fees and user charges of similar institutions. Again, this

part of the analysis is meant to judge whether the entity is

in a strong or weak financial position to absorb additional

costs.

Impacts of Programs That Place Administrative and

Enforcement Burdens on Governments

Many EPA programs require effort on the part of different

levels of government for administration and/or enforcement. These costs must be considered to comply with

UMRA and to calculate the full social costs of a program or

rule. EPA is currently investigating methods for estimating

and evaluating the impacts of such costs. Revisions to this

guidance document will be made in the future to incorporate the results of that work. 

Impacts of Programs That Indirectly Affect

Government Entities

The previous section describes how to measure the impact

of regulations that directly affect the provision of goods or

services by government or not-for-profit entities. This section addresses the indirect or induced impacts on government entities. For example, a manufacturing facility may

reduce or suspend production in response to an EPA regulation, thus reducing the income levels of its employees.

In turn, these reductions will propagate through the economy by means of changes in household expenditures.

These induced impacts include the familiar multiplier

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Chapter 9: Distributional Analyses

Indicator Weak Mid-Range Strong

Below BBB (S&P) BBB (S&P) Above BBB (S&P)

Below Baa (Moody's) Baa (Moody's) Above Baa (Moody's)

Overall Net Debt as 

Percent of Full Market Above 5% 2% to 5% Below 2%

Value of Taxable Property

More than 1 percentage Within 1 percentage More than 1 percentage

Unemployment Rate point above national point of national point below national 

average average average

Median Household More than 10% Within 10% of the More than 10%

Income below the state median state median above the state median

Property Tax as Percent

of Full Market Value of Above 4% 2% to 4% Below 2%

Taxable Property

Property Tax 

Collection Rate Less than 94% 94% to 98% More than 98%

Bond Rating

Exhibit 9-4 Indicators of Economic and Financial Well-Being of Government Entities
effect, in which loss of income in one household results in

less spending by that household and, therefore, less

income in households and firms associated with goods

previously purchased by the first household. Unlike production-based linkages, income-based linkages tend to be

more geographically localized, with the strength of the

linkage typically decreasing as geographic distance increases (although the number of linked economic entities

increases with distance).

Decreased household and business income can affect the

government sector by reducing tax revenues and increasing expenditures on income security programs (the automatic stabilizer effect), employment training, food and

housing subsidies, and other fiscal line items. Due to wide

variation in these programs and in tax structures, estimating public sector impacts for a large number of government jurisdictions can be prohibitively difficult.

On the other hand, compliance expenditures increase

income for businesses and employees that provide compliance-related goods and services. These income gains also

have a multiplier effect, offsetting some of the induced

losses in tax revenue and increases in government expenditures identified above.

9.3 Equity Assessment

9.3.1 Introduction

In the context of an EPA economic analysis, an equity

assessment is an important type of distribution analysis.

An equity assessment examines the accrual of a regulation's net costs, net benefits, or other economic impacts to

a specific sub-population(s) and/or examines the distribution of these costs, benefits, and impacts among sub-population(s). This examination includes the possibility of analyzing a regulation's impact on the distribution of national

income or wealth. 

Generally, cost bearers and beneficiaries belong to one of

four populations: individuals, businesses, not-for-profit

organizations, or governments. Within each of these populations are sub-populations whose particular circumstances EPA wishes to better understand, either because

the sub-population is more physically susceptible to environmental contamination, is less than fully capable of representing its own interests, or is economically disadvantaged or vulnerable. For many of these sub-populations,

the EPA has been directed by statute, executive order, or

agency policy to examine the effects of its rules when they

are expected to have a "disproportionate," "significant and

substantial," or other such impact on a particular subpopulation. An equity assessment gives rule makers a better understanding of the economic effects of the EPA's

rules on these sub-populations and, for comparison or

other purposes, on other specific sub-populations as well.

An equity assessment examines the magnitude as well as

the distribution of effects on sub-populations.

There are several considerations to keep in mind when

performing an equity assessment. Each of these points

will be detailed in this chapter.

There are specific equity dimensions that must

always be considered, but there are none that

must always be analyzed when assessing the

impact of environmental regulations. Generally

speaking, the regulation under review, and the specific

issues associated with it, will determine which equity

dimensions are relevant and in need of an equity

assessment.

The methods used by a regulation's BCA and EIA

should guide the methodology used by an equity

assessment. Neither this chapter nor OMB's Best

Practices and OMB Guidelines outline a specific

methodology for conducting an equity assessment.

However, the models and assumptions developed for

these other two analyses should not conflict with

those used by an equity assessment. 

An equity assessment may draw on the information

compiled for its corresponding BCA as well as include

measures of impact similar to those in its corresponding EIA. An early step in an equity assessment is to

identify sub-populations likely to be affected by a regulation. Once identified, if data permits, the social

costs and benefits estimated for the BCA can be disaggregated and net benefits examined for the sub-population(s). An equity assessment also examines other

economic impacts, such as increases in rates of

unemployment or other traditional impact measures,

for the identified sub-populations(s).

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Chapter 9: Distributional Analyses
An equity assessment is not an independent

form of economic analysis, but is a reflection of

decisions made on many of the other analytic issues

arising in the benefit, cost, and economic impact sections of this guidance. For example, the analysis of

distributions over long time horizons can be greatly

affected by the analyst's treatment of uncertainty or

choice of a discount rate. Baseline issues are important in the determination of net benefits expected to

accrue to specific sub-populations. When making

decisions on these and other relevant issues, the analyst should keep in mind the ramifications borne by

the equity assessment. 

Many of the instructions offered in the preceding sections

on estimating economic impacts will be directly applicable

to an equity assessment. The difference will be extending

the analysis or presentation of results to describe sub-population(s) for which impacts are estimated. Whereas an

EIA focuses on traditional classifications of affected populations (like industrial classifications), an equity assessment often focuses on "disadvantaged or vulnerable" subpopulations (like low income households) but, for comparison or other purposes, can also focus on other relevant sub-populations (like upper income households). In

this section, we outline a general framework for conducting an equity assessment but refer the reader to Sections

5, 6, and 9.2 for approaches used to estimate specific

impacts. As is true for an EIA, generally speaking, an equity assessment is more concerned with sub-populations

experiencing net costs or other negative impacts than

those experiencing net benefits or positive impacts.

The following parts of this section accomplish three objectives. First, the existing environmental and administrative

statutes, executive orders, and agency policies which direct

analysts to consider specific sub-populations when assessing the economic effects of EPA's regulations are reviewed.

The statutes and policies are enumerated, the relevant

sub-populations are identified, and definitions are established for these sub-populations. Second, a broad framework for conducting an equity assessment is outlined.

This section concludes with a review of general sources of

data for assessing equity impacts.

9.3.2 Statutes and Policies

Requiring Equity Assessment and

Definitions of Sub-Populations

Equity issues are at the heart of two existing statutes—The

Regulatory Flexibility Act of 1980 (RFA), as amended by

the Small Business Regulatory Enforcement Fairness Act of

1996 (SBREFA), and The Unfunded Mandates Reform Act

of 1995 (UMRA)51—and two executive orders—EO 12898,

"Federal Actions to Address Environmental Justice in

Minority Populations and Low-Income Populations" and

EO 13045, "Protection of Children From Environmental

Health Risks and Safety Risks,"—all of which require

agencies to consider a regulation's distributional impact on

various entities or sub-populations.52 These administrative

laws or orders suggest several equity dimensions; in particular, entity size, minority status, income level, and childhood status. Exhibit 9-5 lists these equity dimensions and

links each to the relevant statute or order, to a population,

and to at least one established definition of sub-populations. 

A second executive order—EO 12866, "Regulatory

Planning and Review" has multiple objectives regarding

regulatory planning and review, many that have nothing to

do with improvements in equity. It does, however, include

a specific directive for agencies to consider distributive

impacts and equity when designing regulations. Thus,

Exhibit 9-5 lists the equity dimensions suggested by the

OMB's Best Practices for EO 12866 and noted in its OMB

Guidelines for economic analyses. The equity dimensions

are discussed in more detail below.

9.3.3 Entity Size

The RFA as amended by SBREFA and UMRA require agencies to consider economic effects on small entities—

specifically, small businesses, small governmental

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Chapter 9: Distributional Analyses

51 EO 13132, Federalism and EO 13084, Consultation and Coordination With Indian Tribal Governments, both support some objectives

in UMRA. 

52 The Office of Regulatory Management and Information's Rule and Policy Information Development System (RAPIDS)

http://intranet.epa.gov/rapids (accessed 4/05/2000, internal EPA document) is a resource for those who wish to read relevant statutes, executive

orders or Agency policy documents in their entirety or to acquire copies.
Chapter 9: Distributional Analyses

162

Equity Dimension Administrative Law Population Definitions of Sub-Populations

or Order

Entity Size RFA; UMRA; OMB Guidance Businesses,

to EO 12866 Governmental

Jurisdictions,

Not-for-Profit

Organizations

Minority Status E.O. 12898; OMB Individuals or

Guidance to EO Households

12866; EO 13084 

for Indian tribal 

communities only

Income Level EO 12898; OMB Individuals or

Guidance to EO 12866 Households 

The RFA references the Small Business Act

definition of small business which defines

small business using SIC codes. Definitions

sometimes depend on number of employees

and other times depend on annual receipts.

The RFA defines small governmental

jurisdiction as the government of a city,

county, town, school district, or special

district with a population of less than 50,000.

The RFA defines a small not-for-profit

organization as an enterprise which is

independently owned and operated and is not

dominant in its field.54

UMRA defines small government jurisdiction,

similar to the RFA, as the government of a

city, county, town, school district, or special

district with a population of less than 50,000,

and any tribal government.

Minority population of the affected area

exceeds 50 percent or minority population

percentage of the affected area is meaningfully greater than the minority population

percentage in the general population or other

appropriate unit of geographic analysis.

(Minorities are those individuals classified by

OMB Directive No. 15 as Black/African

American, Hispanic, Asian and Pacific

Islander, American Indian, Eskimo, Aleut,

and other non-white persons.)

"Indian tribe" means an Indian or Alaska

Native tribe, band, nation, pueblo, village, or

community that the Secretary of the Interior

acknowledges to exist as an Indian tribe

pursuant to the Federally Recognized Indian

Tribe List Act of 1994, 25 U.S.C. 479a. (See

EO 13084.)

53 Some environmental statutes may also identify sub-populations that merit additional consideration, but this document is limited to

those with broad coverage. 54 The RFA also allows agencies to establish an alternative definition of small entity after notice-and-comment, and for small businesses

only, after consultation with the Small Business Administration (SBA).

Annual statistical poverty thresholds from

the U.S. Bureau of the Census' Current

Population Reports, Series P-60 on Income

and Poverty. Consumers grouped according

to consumption expenditures (e.g., into

deciles).

Exhibit 9-5 Equity Dimensions Potentially Relevant to Environmental Policy Analyses53
jurisdictions, and/or small not-for-profit organizations.

Definitions of "small" for each of these entities are considered below. For guidance as to when it will be necessary to

examine the economic effects of a regulation under the

RFA, analysts should consult EPA guidelines on these

administrative laws.55 These guidelines include the types

of economic effects that must be considered and establishment of the baseline for purposes of determining if a rule

may have a significant economic impact on a substantial

number of small entities. Further, these guidelines

explain the requirements in the event the rule is found to

have a significant economic impact on a substantial number of small entities. Note that the RFA only applies to

rules for which notice-and-comment rulemaking is

required.

9.3.3.1 Small Business

The RFA requires agencies to begin with the definition of

small business that is contained in the SBA's small business size standard regulations.56 The SBA defines small

business by category of business using SIC codes, and in

the case of manufacturing, generally defines small business as a business having 500 or fewer employees. For

some types of manufacturing, however, the SBA's size standards define small business as a business having up to

750, 1000, or 1500 employees, depending on the particular type of business. In the case of agriculture, mining,

and electric, gas, and sanitary services, the SBA size standards generally define small business with respect to

annual receipts (from $0.5 million for crops to $25 million for certain types of pipelines).

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Chapter 9: Distributional Analyses

Equity Dimension Administrative Law Population Definitions of Sub-Populations

or Order

Childhood Status, EO 13045, OMB Individuals or

Age Guidance to EO 12866 Households

Gender OMB Guidance to Individuals Male/Female

EO 12866

Time OMB Guidance to Individuals or Current/Future Generations

EO 12866 Households

Physical Sensitivity OMB Guidance to Individuals or

EO 12866 Households

EPA's Office of Children's Health Protection

does not adhere to a single definition of

"child." It suggests that the definition will

vary depending upon the issue(s) of

concern.

U.S. Bureau of the Census reports statistics

by age in five-year age groups and for the

following special age categories: 16 years

and over; 18 years and over; 15 to 44 years;

65 years and over; 85 years and over.

Varies according to the rule under review.

For example, a rule that controls an air

pollutant might define a physically sensitive

sub-population as individuals with asthma.

55 U.S. Environmental Protection Agency, Revised Interim Guidance for EPA Rulewriters: Regulatory Flexibility Act as Amended by the

Small Business Regulatory Enforcement Fairness Act, dated March 29, 1999.

56 5 U.S.C. § 601; see also the SBA's "Small Business Size Regulations" are contained in the Code of Federal Regulations at 13 CFR 121 and

in the Federal Acquisition Regulation 46 CFR 19. The SBA reviews and reissues the size standards every year. The current version can be viewed at:

http://www.sbaonline.sba.gov/gopher/Financial-Assistance/Size-Standards/ (accessed on 8/28/2000).

Exhibit 9-5 Equity Dimensions Potentially Relevant to Environmental Policy Analyses

(Continued)
The RFA also authorizes any agency to adopt and apply an

alternative definition of small business "where appropriate

to the activities of the agency" after consulting with the

Chief Counsel for Advocacy of the SBA and after opportunity for public comment. The agency must publish any

alternative definition in the Federal Register.

57

9.3.3.2 Small Governmental

Jurisdiction

The RFA defines a small governmental jurisdiction as the

government of a city, county, town, school district, or special district with a population of less than 50,000. Similar

to the definition of small business, the RFA authorizes

agencies to establish alternative definitions of small government after opportunity for public comment (consultation with the SBA is not required). Any alternative definition must be "appropriate to the activity of the agency" and

"based on such factors as location in rural or sparsely populated areas or limited revenues due to the population of

such jurisdiction." Any alternative definition must be published in the Federal Register.

58

Section 202 of UMRA directs agencies to obtain meaningful

input from state, local, and tribal governments for each

proposed and final rule "containing significant federal

intergovernmental mandates." More specifically, this

requirement is for rules that include federal mandates

"which may result in the expenditure by state, local, and

tribal governments, in the aggregate, or by the private sector, of $100 million or more in any one year."59 Section

203 of UMRA requires that agencies assess whether its

rules "might significantly or uniquely affect small governments" so as to consider the need for a compliance plan.

Small governments are defined in the paragraph immediately above. The phrase "small towns" refers to very small

governments with populations of under 2,500 citizens. As

part of the "Small Government Agency Plan" required

under UMRA, EPA evaluates such factors as whether small

governments will experience higher per-capita costs due to

economies of scale, whether they would need to hire professional staff or consultants for implementation, or if they

would be required to purchase and operate expensive or

sophisticated equipment.60

9.3.3.3 Small Not-for-Profit

Organization

The RFA defines a small not-for-profit organization as an

"enterprise which is independently owned and operated

and is not dominant in its field." Examples might include

private hospitals or educational institutions. Here again,

agencies are authorized to establish alternative definitions

"appropriate to the activities of the agency" after providing

an opportunity for public comment (consultation with the

SBA is not required). Any alternative definition must be

published in the Federal Register.

61

9.3.4 Minority Status and Income

Level

Executive Order 12898, "Federal Actions to Address

Environmental Justice in Minority Populations and LowIncome Populations" and its accompanying memorandum

have the primary purpose of ensuring that "each federal

agency shall make achieving environmental justice part of

its mission by identifying and addressing, as appropriate,

disproportionately high and adverse human health or environmental effects of its programs, policies, and activities

on minority populations and low income populations... ."

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Chapter 9: Distributional Analyses

57 U.S. Environmental Protection Agency, Revised Interim Guidance for EPA Rulewriters: Regulatory Flexibility Act as Amended by the

Small Business Regulatory Enforcement Fairness Act, dated March 29, 1999.

58 Ibid.

59 U.S. Environmental Protection Agency, Interim Guidance an the Unfunded Mandates Reform Act of 1995, memorandum from Office

of General Counsel, March 23, 1995b. 

60 Ibid. p. 4.

61 U.S. Environmental Protection Agency, Revised Interim Guidance for EPA Rulewriters: Regulatory Flexibility Act as Amended by the

Small Business Regulatory Enforcement Fairness Act, dated March 29, 1999.
The Executive Order also explicitly calls for the application

of equal consideration for Native American programs.62

EPA's Interim Final Guidance for Incorporating

Environmental Justice Concerns in EPA's NEPA

Compliance Analyses (EPA, 1998), discusses the meaning

of key terms and phrases contained in EO 12898. Their

conclusions regarding four key phrases: "minority population," "low-income population," "disproportionately high

and adverse human health effects," and "disproportionately high and adverse environmental effects" are summarized below. 

9.3.4.1 Minority Population

Minority individuals are those classified by Office of

Management and Budget Directive No. 15 as Black/African

American, Hispanic, Asian and Pacific Islander, American

Indian, Eskimo, Aleut, and other non-white persons. A

minority population should be identified where either (1)

the minority population of the affected area exceeds 50

percent or (2) the minority population percentage of the

affected area is meaningfully greater than its corresponding percentage in the general population (or other appropriate unit of geographic analysis). A minority population

also exists if there is more than one minority group present and the percentage calculated by aggregating all minority persons meets one of these thresholds. In identifying

minority communities, the Agency may consider as a community either: (1) a group of individuals living in geographic proximity to one another or (2) a geographically

dispersed/transient set of individuals (such as migrant

workers or American Indians), where either type of group

experiences common conditions of environmental exposure or effect. The selection of the appropriate unit of geographic analysis may be a governing body's jurisdiction, a

neighborhood, census tract, or other similar unit that is to

be chosen so as to not artificially dilute or inflate the

affected minority population. The selection of the appropriate unit of geographic analysis may also be influenced

by the accuracy and precision of environmental quality

models.

9.3.4.2 Low-Income Population

Low income populations in an affected area can be identified with the annual statistical poverty thresholds from the

U.S. Bureau of the Census' Current Population Reports,

Series P-60 on Income and Poverty. In conjunction with

census data, the analysis should also consider state and

regional low-income and poverty definitions as appropriate. In identifying low-income populations, the Agency

may consider as a community either a group of individuals

living in geographic proximity to one another or a geographically dispersed/transient set of individuals (such as

migrant workers or American Indians), where either type

of group experiences common conditions of environmental exposure or effects.63

One alternative to measuring annual incomes is to examine expected lifetime incomes. Generally, consumption is

better than annual income at tracking households' expected lifetime incomes. For example, an analyst might divide

the population by consumption deciles and see how the

lowest deciles fare. These data will be harder to access as

the Census does not contain consumption data. 

9.3.4.3 Disproportionately High and

Adverse Human Health Effects

When determining whether human health effects are disproportionately high and adverse, the Agency is to consider

the following three factors to the extent practicable:

Whether the health effects, which may be measured

in risks and rates, are significant, unacceptable, or

above generally accepted norms. Adverse health

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Chapter 9: Distributional Analyses

62 In addition, EO 13084, Consultation and Coordination with Indian Tribal Governments, requires regulations that "significantly or

uniquely" affect the communities of Indian tribal governments and that impose substantial direct compliance costs on such communities to either

refund the direct costs incurred or to consult with elected officials and other representatives of the Indian tribal governments and to provide a

description of the consultation and/or communication to the Office of Management and Budget. 

63 Two additional tests available for identifying low-income populations in an affected area are: (1) the U.S. Department of Health and

Human Services poverty guidelines or (2) the U.S. Department of Housing and Urban Development statutory definition for very low-income for the

purposes of housing benefits programs. Information on these and other tests can be found in the CEQ report Environmental Justice: Guidelines for

National Environmental Policy Act (CEQ, 1997) and the Interim Final Guidance for Incorporating Environmental Justice Concerns in EPA's

NEPA Compliance (EPA, 1998).
effects may include bodily impairment, infirmity, illness, or death;64 and

Whether the risk or rate of hazard exposure by a

minority population or low-income population to an

environmental hazard is significant and appreciably

exceeds or is likely to appreciably exceed the risk or

rate to the general population or other appropriate

comparison group;65 and

Whether health effects occur in a minority or lowincome population affected by cumulative or multiple

adverse exposures from environmental hazards.

9.3.4.4 Disproportionately High and

Adverse Environmental Effects

When determining whether environmental effects are

adverse and disproportionately high, the Agency is to consider the following three factors to the extent practicable:

Whether there is or will be an impact on the natural

or physical environment that significantly and

adversely affects a minority or low-income population.

Such effects may include ecological, cultural, human

health, economic, or social impacts on minority communities or low-income communities, when those

impacts are interrelated with impacts on the natural

or physical environment; and 

Whether environmental effects are significant and are

or may be having an adverse impact on minority populations or low-income populations that appreciably

exceeds, or is likely to appreciably exceed, those on

the general population or other appropriate comparison group; and 

Whether the environmental effects occur or would

occur in a minority population or low-income population affected by cumulative or multiple adverse exposures from environmental hazards.

9.3.5 Childhood Status

EO 13045, Protection of Children From Environmental

Health Risks and Safety Risks states that:

"A growing body of scientific knowledge demonstrates that children may suffer disproportionately from environmental health risks and safety

risks. . . . Therefore, to the extent permitted by

law and appropriate, and consistent with the

agency's mission, each Federal agency: (a) shall

make it a high priority to identify and assess environmental health risks and safety risks that may

disproportionately affect children; and (b) shall

ensure that its policies, programs, activities, and

standards address disproportionate risks to children that result from environmental health risks

or safety risks."66

The order also states that each "covered regulatory

action"67 submitted to OMB, unless prohibited by law,

should be accompanied by "...an evaluation of the environmental health or safety effects of the planned regulation

on children."68 The term "children" is not defined. EPA's

Office of Children's Health Protection, established in

response to this order, does not use a single definition of

"child." They suggest that the definition will vary depending upon the issue(s) of concern. See Exhibit 9-5 for age

classifications reported by the U.S. Bureau of the Census.

EPA is currently developing a practical guide for valuing

children's health effects. 

166

Chapter 9: Distributional Analyses

64 The definition of adverse health effects contained in specific environmental statues, under whose authority a regulation is being developed, may also guide the consideration of adverse health effects in conducting equity assessments.

65 The definition of risk or rate of hazard exposure contained in specific environmental statues under whose authority a regulation is being

developed may also guide the consideration of risk or rate of hazard exposure in conducting equity assessments.

66 EO 13045, Protection of Children From Environmental Health Risks and Safety Risks effective April 21, 1997.

67 A "covered regulatory action" is any substantive action in a rule making that is likely to result in a rule that may (a) be economically significant (have an annual effect on the economy of $100 million or more or would adversely affect in a material way the economy, a sector of the economy, the environment, and so on) and (b) concern an environmental health risk that an agency has reason to believe may disproportionately affect

children.

68 EO 13045.
9.3.6 Case Specific Equity

Dimensions

EO 12866, Regulatory Planning and Review has several

requirements that contribute to the preparation of economic information, including a specific directive for agencies to consider distributive impacts and equity when

designing regulations. The OMB Guidelines (OMB, 2000)

also makes note of several specific equity dimensions.

But, unlike the laws and orders mentioned above, it does

not suggest that analysts must always consider these

dimensions. Rather, the suggestion is that the regulation

under review should determine which equity dimensions

are relevant.

"Those who bear the costs of a regulation and

those who enjoy its benefits often are not the

same people. Regulations have 'distributional

effects' that affect different segments of the population and economy in various ways: by income

groups, race, sex, industrial sector, and others.

Regulations often distribute benefits and costs

unevenly over time, perhaps spanning several

generations... . If these distributive effects are

important, you should describe the effects of various regulatory alternatives quantitatively to the

extent possible, including their magnitude, likelihood, and incidence of effects on particular

groups. You should carefully analyze regulations

that significantly affect outcomes for different

groups."69

OMB seems to be offering a general directive to study distributive effects on any grouping of sub-populations when

those effects are expected to be significant, without requiring agencies to always consider a predetermined set of

equity dimensions. 

9.3.6.1 Additional Equity Dimensions

In its general directive, OMB specifically mentions gender

as a way to divide effects. Certain regulations may be found

to have differential impacts on males and females. Thus,

we add gender to the equity dimensions in Exhibit 9-5.

Later in the OMB Guidelines it states, "The economic

analysis should also present information on the streams of

benefits and costs over time in order to provide a basis for

judging intertemporal distributional consequences, particularly where intergenerational effects are concerned."70

This leans more towards being a directive and suggests

that time is an important equity dimension. The OMB

Guidelines give some suggestions for conducting an intergenerational analysis including:

"Special approaches may also be appropriate

when comparing benefits and costs across generations. One approach is to follow the discounting

method discussed above, and address the intergenerational equity and fairness issues explicitly,

instead of modifying the discount rate."

"One alternative approach is based on the perspective that this generation is concerned about

the welfare of future generations and, in fact, is

willing to defer consumption and invest or preserve resources for future use at a discount rate

that is less than the discount rate used in making

decisions within a generation. For this purpose,

you could use as a discount rate a special rate of

time preference based on the growth of per capita

consumption. Again, check with us if you plan to

use such an approach."71

Both OMB and EPA recognize that inter-generational equity

issues are potentially addressed by applying a discounting

procedure. In the quotation above, OMB offers some analytical approaches to inter-generational discounting.

Chapter 6 of this document provides information on alternative methods of discounting in this context and discusses when such discounting is, and is not, appropriate.

When discussing risk assessment, the Best Practices mentions that, 

"Exposures and sensitivities to risks may vary

considerably across the affected population.

These difficulties can lead; for example, to a

range of quantitative estimates of risk in health

and ecological risk assessments that can span

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Chapter 9: Distributional Analyses

69 OMB Guidelines, p. 16.

70 Ibid., p. 8.

71 Ibid., p. 8.
several orders of magnitude... . All of these concerns should be reflected in the uncertainties

about outcomes that should be incorporated in

the analysis."72

Hence, we include physical sensitivity as an important

equity dimension. The definition of who precisely is physically sensitive will vary according to the rule being developed. For example, a rule that controls an air pollutant

might have a large impact on individuals with asthma. Or,

a rule that diminishes the quantity of a hazardous substance that winds up in soils near residential areas, might

have a large impact on children with pica (a disorder that

results in an urge to eat non-food substances such as

dirt).

The Best Practices is not the only source directing attention to physical sensitivity. There are sections of environmental statutes which require EPA to address sensitive

populations, analyze effects, and take actions to avert or

mitigate adverse impacts. For example, the Clean Air Act

section 108(f)(1)(C) requires the Administrator to publish

and make available "information on other measures which

may be employed to reduce the impact on public health or

protect the health of sensitive or susceptible individuals or

groups... ."

Finally, the Best Practices mentions that economic analyses might need to consider different age categories. 

"The literature identifies certain attributes of risk

that affect value. These attributes include the

baseline risk, the extent to which the risk is voluntarily or involuntarily assumed, and features

(such as age) of the population exposed to risk.

For regulations affecting some segments of the

population (e.g., infants) more than those groups

which have served as the basis for most of the

information used to estimates (sic.) values of a

statistical life (e.g., working-age adults), the use

of values of a statistical life from the literature

may not be appropriate."73

Age is clearly the issue in EO 13045, though its specific

focus is on childhood status. Thus, Exhibit 9-5 lists childhood status and age as two aspects of a single equity

dimension and cites the Best Practices and OMB

Guidelines, as well as EO 13045. The next three entries of

Exhibit 9-5 list the other equity dimensions suggested by

the Best Practices and OMB Guidelines and links each to

a population and at least one established definition of subpopulations.

While directing agencies to consider the differential impact

of a regulation on relevant sub-populations, the OMB

Guidelines state that an economic analysis should focus

on the distribution of the costs and benefits of complying

with a regulation rather than on the financial well-being of

regulated entities. 

"Since generally accepted principles do not exist

for determining when one distribution of net

benefits is more equitable than another, you

should describe distributional effects without

judging their fairness. You should describe these

effects broadly, focusing on large groups with

small effects per capita, as well as on small

groups experiencing large effects per capita. You

should also note any equity issues not related to

the distribution of policy effects if they are important, and describe them quantitatively to the

extent you can."74

OMB cautions analysts conducting distributional analyses

to recognize that transfer payments will become relevant;

to avoid double-counting even when mixing monetized and

physical effects and to describe distributional effects without judging their fairness.

9.3.7 A Framework for Equity

Assessment

What follows is a very general three-step framework to

guide analysts conducting equity assessments.

Instructions for estimating particular impacts on sub-populations are given above in the section on EIA. Whether

disaggregating benefits and costs or estimating economic

impacts, the primary purpose of an equity assessment is

168

Chapter 9: Distributional Analyses

72 Best Practices, p. 15.

73 Ibid., p. 29.

74 OMB Guidelines, p. 16.
to examine regulatory consequences for specific sub-populations of concern. Thus, the framework developed here

offers an approach on how to identify a sub-population to

be analyzed. 

For each step, choosing to measure the equity-related consequences of a regulation involves balancing costs of data

acquisition and analysis against the value of improved

accuracy. The framework attempts to conserve resources

by screening out situations for which any of the variety of

equity impacts probably will not occur. This permits more

extensive analytical and empirical efforts to focus on circumstances with a higher probability of creating significant

equity-related effects. The three steps should not be

viewed as necessarily sequential. Instead, at the outset of

a particular regulatory analysis, all aspects of the suggested

approach should be considered. This will help to ensure

that the data gathered and the analyses performed will be

well suited to measuring the equity impacts of concern.

9.3.7.1 Step 1: Equity Scoping

Analysis

This first step consists of several tasks described here in

sequential order.

Determine which populations listed in Exhibit

9-5 are within the scope of the analysis or exist

relevant markets. In certain cases, some of the

populations might not be connected closely enough to

the regulation to be meaningfully affected. For example, governmental entities might not be involved in

the activities that would be affected by a regulation. If

so, then no further analysis is necessary for these

populations. It will be useful to make this determination early so that resources may be used in the most

effective manner possible.

Determine whether the rule or regulatory alternative imposes costs, offers benefits, or results

in other economic effects too small to warrant

further analysis. When considering the cost side of

the analysis, it might be possible to argue that incremental unemployment and plant or firm closures

resulting from even small regulatory costs cannot be

distinguished from changes that would probably be

triggered by the underlying economic viability of these

activities. This step also applies when a regulation

imposes one burden on an entity, but reduces another on the same entity, so that the net effect is small.

Although some equity impacts might be dismissed on

this basis, others will probably require further analysis beyond this initial de minimis screen.

Identify which equity dimensions from Exhibit

9-5 are relevant if further analysis is required.

Negative impacts on small entities, low income populations, minority populations, and children are

important to consider in all cases because of statutory

and other mandates (see Section 9.3.2). For example, rules requiring additional safeguards against contamination of groundwater by landfills clearly benefit

communities where landfills are sited. There is a

long-standing concern among the environmental justice movement that locally unwanted facilities, including landfills, are sited disproportionately in poor

and/or minority neighborhoods. Thus, for regulations

affecting siting and management of landfills, wealth

and race are equity dimensions of concern. Rules

requiring additional safeguards are likely to have a

positive impact on neighborhoods hosting landfills.

This positive impact should be noted and possibly

estimated. For other rules, it is likely that concern for

other equity dimensions will naturally arise.

In addition to those equity dimensions that must

always be considered for distributional analysis, the

other dimensions listed by Exhibit 9-5 should be considered as part of the effort to identify which are relevant. In attempting to decide for a particular case

whether some of the less obvious dimensions matter,

analysts should collect readily accessible information

on the characteristics of affected entities and populations. Attention should be paid to who is expected to

receive the benefits of the regulation as well as who

will pay the costs. Negative net benefits or net costs

are ultimately what should trigger concern. Financial,

health, and other non-monetary benefits and costs

should be included.

Prioritize relevant equity dimensions. Assuming

there is more than one relevant equity dimension,

they should be prioritized according to which dimension seems to warrant greatest concern. The level of

concern should be determined by how strongly

analysts expect a regulation to affect a particular

sub-population.

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Chapter 9: Distributional Analyses
9.3.7.2 Step 2: Define Distributional

Variables for the Equity Dimensions of

Concern

The next step is to define distributional variables associated with the equity dimensions from Step 1. For example,

if one were concerned about a regulation's potential

impact on poor neighborhoods, then a classification system for "poor" versus "not-poor" neighborhoods should be

developed. The established definitions reviewed in Section

9.3.2 above could be used or alternatives developed.

Referring again to the landfill example where one of the

relevant equity dimensions is race, analysts would need to

establish a rule for defining what qualifies as an AfricanAmerican neighborhood or a minority neighborhood. In

this case, one could rely on the established definitions presented in Section 9.3.2.

9.3.7.3 Step 3: Measure Equity

Consequences

The next step is to begin to measure specific economic

effects across the distributional variables. In some cases,

estimating the equity-related effects of a regulation will

involve disaggregating existing costs and benefits and tabulating or otherwise accounting for their distribution across

the distributional variables defined in Step 2. This process

would subject the equity assessment to the same set of

assumptions applied to the benefit-cost analysis. 

In other cases, an equity assessment will examine other

impacts, such as increases in unemployment, for identified sub-populations. The section above on EIA reviews

these other impacts and outlines how to estimate them.

Any assumptions, for example those concerning elasticities

of demand, used in the EIA, should also be applied to the

Equity Assessment unless there are specific reasons for

why the assumptions are inappropriate for the identified

sub-population(s).

A thorough equity assessment, when resources permit,

might include a disaggregation of benefits and costs from

the BCA as well as an examination of economic impacts

for the identified sub-population(s).

9.3.8 Data for Conducting Equity

Assessments

The discussion in the preceding sections suggests several

types of data that would be useful for estimating the distribution of impacts of environmental policy options. This

section presents some of the data sources for each category of data needed. This is not an exhaustive list of data

sources, but is presented to provide initial guidance for

this information. 

9.3.8.1 Data on Businesses,

Governments, and Not-For-Profit

Organizations 

Two specific Internet sites provide access to some of the

most commonly needed data. The first is the SBA's Office

of Advocacy website.75 Data provided on this website

include the number of firms, number of establishments,

employment, annual payroll, and estimated receipts. The

data are available by employment size categories. Data

may be viewed and downloaded for the U.S., by state or by

metropolitan statistical area. A second website that analysts may find useful is the home page of the U.S. Bureau

of the Census, Office of Statistics.76 Here a variety of relevant data may be accessed including information published in the County Business Patterns and other published data series on population characteristics, including

income and age distributions. 

9.3.8.2 Demographic Data

The U.S. Bureau of the Census collects household data and

aggregates them in forms that may be useful for environmental justice matters. Data are available on population

distributions by race and household income at the state,

county, metropolitan statistical area, or census tract level.

An additional, Census website allows one to view a map of

any part of the U.S., at the desired scale, that shows data

on population distributions by family income or a specified

race (e.g., percent white or percent black).77 In addition,

income data collected by the Internal Revenue Service and

170

Chapter 9: Distributional Analyses

75 The address for this site is http://www.sba.gov/ADVO/stats/ (accessed 8/28/2000, internal EPA document).

76 The address for this site is http://www.census.gov (accessed 8/28/2000). 

77 The address for this site is http://www.census.gov/geo/www/tiger/index.html (accessed 8/28/2000).
made available in aggregated form on the Internet may be

useful for some analyses.78

9.3.8.3 Other Potentially Useful Data

Sources

There is a range of other sources that may provide useful

data on other factors potentially relevant to equity analyses. For example, import and export data are available

from the Bureau of the Census publication, The U.S.

Merchandise Trade: Exports, General Imports, and

Imports for Consumption. The U.S. Department of

Commerce may also have data that would be useful for

estimating changes in demand as a result of regulatory

costs, or the turnover rate for capital equipment in various

industrial sectors.

171

Chapter 9: Distributional Analyses

78 The address of the website providing these data is http://trac.syr.edu/tracirs/. Note that a user ID and password are necessary to access

the data. Registration is available at http://trac.syr.edu/register/registration.html (accessed 8/28/2000).
9.4 References

Altman, E. I. et al. 1993. Corporate Financial Distress and Bankruptcy, 2nd Ed., New York: John Wiley and Sons. 

Arrow, K. J. 1977. Extended Sympathy and the Possibility of Social Choice. American Economic Review, Vol 67, No. 1,

February. 219-225.

Dun & Bradstreet Information Services, Industry Norms & Key Business Ratios, New York, NY: (annual).

Economic Report of the President, transmitted to the Congress, February (annual). Washington, D.C.: US Government

Printing Office.

Farrow, S. 1998. Environmental Equity and Sustainability: Rejecting the Kaldor-Hicks Criteria. Ecological Economics,

27(2): 183-188.

Federation of Tax Administrators, State Tax Rates & Structure, from http://www.taxadmin.org/fta/rate/tax_stru.html

(accessed 8/28/2000). 

Gray, W. and R. Shadbegian. 1997. Environmental Regulation, Investment Timing, and Technology Choice. National

Bureau of Economic Research, Working Paper 6036, May.

Ibbotsen Associates, Handbook, Chicago, IL (annual).

Jaffee, A. et. al. 1995. Environmental Regulation and the Competitiveness of U.S. Manufacturing: What Does the Evidence

Tell Us? Journal of Economic Literature, 32(1): 132-163.

Jorgenson, D. W. 1997. Welfare: Volume 2 - Measuring Social Welfare. Cambridge, MA: MIT Press.

Just R. E., D. L. Hueth, and A. Schmitz. 1982. Applied Welfare Economics and Public Policy, Englewood, NJ: PrenticeHall.

Norland, D. L. and K. Y. Ninassi. 1998. Price It Right: Energy Pricing and Fundamental Tax Reform. Report to the

Alliance to Save Energy, Washington, DC.

Robert Morris Associates, Annual Statement Studies, Philadelphia, PA (annual).

Sen, A. K. 1970. Collective Choice and Social Welfare. San Francisco, CA: Holden-Day.

Standard & Poor's Corp., Industry Surveys, (loose-leaf, updated weekly).

United Nations, Statistical Office, International Trade Statistics Yearbook, New York, NY (2 volumes).

U.S. Council on Environmental Quality. 1997. Environmental Justice. Guidance under the National Environmental

Policy Act.

U.S. Department of Agriculture, Agricultural Statistics. Annual reports, Washington, D.C.: U.S. Government Printing

Office.

U.S. Department of Commerce, Bureau of the Census, Annual Survey of Manufacturers. Annual reports. Washington,

D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Construction Industries. Published every five years, with

most recent data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Governments. Published every five years, with most

recent data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

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Chapter 9: Distributional Analyses
U.S. Department of Commerce, Bureau of the Census, Census of Manufacturers. Published every five years. Washington,

D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Mineral Industries. Published every five years, with

most recent data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Population. Published every five years with most recent

data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Retail Trade. Published every five years, with most

recent data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Service Industries. Published every five years, with most

recent data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Transportation. Published every five years, with most

recent data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Census of Wholesale Trade. Published every five years, with most

recent data for 1997 published in 1999. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Concentration Ratios in Manufacturing, Census of Manufacturers

Subject Series (available on computer tape or CD-ROM). Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, County Business Patterns. Annual reports. Washington, D.C.: U.S.

Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Enterprise Statistics. Annual reports. Washington, D.C.: U.S.

Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Quarterly Financial Report for Manufacturing, Mining, and

Trade Corporations. Quarterly reports. Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of the Census, Statistics of U.S. Businesses. Annual reports. Washington, D.C.:

U.S. Government Printing Office.

U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business. Monthly reports. Washington,

D.C.: U.S. Government Printing Office.

U.S. Department of Commerce, International Trade Administration. U.S. Industry and Trade Outlook. Annual report.

Washington, D.C.: U.S. Government Printing Office.

U.S. Department of Labor, Bureau of Labor Statistics, Handbook of Labor Statistics. Annual report. Washington, D.C.:

U.S. Government Printing Office.

U.S. Department of Labor, Bureau of Labor Statistics, Monthly Labor Review. Monthly reports. Washington, D.C.: U.S.

Government Printing Office.

U.S. Environmental Protection Agency. 1994. Guidance for Analytic Blueprints. Office of Policy, Office of Regulatory

Management and Information. June 15, 1994. 

U.S. Environmental Protection Agency. 1995a. Interim Economic Guidance for Water Quality Standards. Workbook,

Office of Water. EPA-823-B-95-002, March 1995.

U.S. Environmental Protection Agency. 1995b. Interim Guidance an the Unfunded Mandates Reform Act of 1995,

memorandum from the Office of General Counsel, March 23, 1995.

173

Chapter 9: Distributional Analyses
U.S. Environmental Protection Agency. 1997. Regulation Development in EPA. Training materials prepared by the Office

of Policy, Office of Regulatory Management and Information.

U.S. Environmental Protection Agency. 1998. Interim Final Guidance for Incorporating Environmental Justice

Concerns in EPA's NEPA Compliance Analyses, Office of Federal Activities, April.

U.S. Environmental Protection Agency. 1999. Revised Interim Guidance for EPA Rulewriters: Regulatory Flexibility Act

as Amended by the Small Business Regulatory Enforcement Fairness Act, Office of Regulatory Management and

Information, March 29.

U.S. Office of Management and Budget. 1987. Standard Industrial Classification Manual. Washington, D.C.: U.S.

Government Printing Office.

U.S. Office of Management and Budget. 1995. "Guidance for Implementing Title II of S. 1," Memorandum #M-95-09,

from Alice Rivlin to Heads of Executive Departments and Agencies, March 31.

U.S. Office of Management and Budget. 1996. Economic Analysis of Federal Regulations Under Executive Order No.

12866. (or Best Practices document), January 11.

U.S. Office of Management and Budget. 1998. North American Industry Classification System (NAICS) Manual. 1998.

Washington, D.C.: U.S. Government Printing Office.

U.S. Office of Management and Budget. 2000. Guidelines to Standardize Measures of Costs and Benefits and the

Format of Accounting Statements. Report #M-00-08, (or OMB Guidelines document), March 22.

Value Line. Investment Survey, (loose-leaf in several volumes, with weekly updates). New York, NY.

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10.1 Introduction

This chapter provides some general rules for presenting analytical results to policy makers and others

interested in environmental policy development. As

emphasized several times in these EA Guidelines,

especially by the flowchart and discussion of equity

assessments in Chapter 9, economic analyses play an

important role throughout the policy development

process. From the initial, preliminary evaluation of

potential options and their consequences through the

preparation of the final economic analysis document,

economic analysts participate in an interactive

process with policy makers. The fundamental goal of

this process is to refine the information available for

making policy choices.

Hence, this guidance for presenting inputs, analyses,

and results applies at all stages of this process, not

only for the final document embodying the completed economic analysis. In particular, reporting ranges

of uncertainty, critical assumptions, and key unquantified effects to decision makers as they weigh various

options and alternatives is as critical as including

these in a final economic analysis document at the

conclusion of the policy development process.

This chapter first reviews some important features of

economic analyses of environmental policies to

include or describe in all presentations of analyses

and results. Following this is some general guidance

on what types of results are most useful to report and

useful formats for presenting them. Some brief comments on the relationship between economic analyses and environmental policy making conclude the

chapter. All of the recommendations in this chapter

are, of course, subject to resource availability and

statutory prohibitions.

10.2 Communicating

Assumptions and

Methods

All economic analyses of environmental policies must

balance the goals of accuracy and completeness

against the costs of data acquisition, detailed

modeling, and valuation of consequences. Hence,

the results of applied economic analyses inevitably

contain uncertainties in particular areas,

assumptions in the place of data that are not

available, and effects that cannot be quantified or

monetized. Analysts should highlight these

limitations when presenting the inputs, modeling,

and results of economic analyses.

Some general guidelines for communicating these

considerations include the following:

Clarity and transparency: Presentations of

economic analyses should strive for maximum

clarity and transparency of all aspects of the

assessments. An analysis whose conclusions

can withstand close scrutiny of all of its facets is

more likely to provide policy makers with the

information they need to develop the best environmental policies. In addition, if a rule is later

challenged, the more clear, transparent and

thorough analysis is, the easier it is to defend

the agency's regulatory approach.

Delineation of data and assumptions:

Economic analyses should clearly describe all

important data sources and references used, as

well as key assumptions and their justifications.

All of these inputs should be available to policy

makers, and other researchers and policy analysts, to the extent that these data are not

175

Chapter 

10

Chapter 10: Using Economic

Analyses in Decision Making
confidential business information or some other form

of private data.

Exposition of modeling techniques: Although

modeling frameworks for many economic analyses

can be complex, it is important to convey at least the

basic framework used for modeling a policy's consequences. The presentation should highlight the key

elements or drivers that dominate the framework and

its results. 

Ranges for inputs and results: At a minimum,

uncertainties should be explored through the use of

expected values supplemented by upper and lower

bounds for important inputs, assumptions, and

results. Sensitivity analyses using these ranges generally enhance the credibility of environmental policy

assessments. If key elements for an economic analysis are extremely uncertain, these should be clearly

indicated. Analysts should explore how resolving

these uncertainties affects the conclusions of the

analysis.

Monetizing a policy's effects: To the extent feasible

and warranted by their contribution to the results, as

many of the effects of a policy as possible should be

monetized. This enhances the value of the conclusions to policy makers weighing the many, often disparate consequences of different policy options and

alternatives.

Highlighting non-monetized and unquantified

effects: Economic analyses should present and highlight non?monetized effects when these are important

for policy decisions. Reasons why these consequences cannot be valued in monetary terms are

important to communicate as well. Unquantified, but

potentially significant, consequences of a policy also

should be highlighted, especially when these could be

important enough in magnitude to affect the broad

conclusions of an economic analysis of different policy options and alternatives.

Presenting aggregate and disaggregated results:

Finally, the analytic framework should be organized to

provide information on the separate economic consequences of important individual programs or component parts identified with the regulation. This can be

particularly challenging when the underlying physical

science and engineering information needed by the

economist to prepare the economic analysis may not

be amenable to a simple separation of the individual

contributions of pollution control choices (e.g.,

installed emission control devices) to changes in risks

from pollutants. Further, some economic values used

in analyses represent a quantified aggregate value for

a set of environmental goods (e.g., a consumer benefit measure for total improvements to surface water),

and it is unknown how to divide the value among the

individual attributes that comprise this reported

value. Nevertheless, it is valuable to describe disaggregate information on the costs and benefits attributable to individual policies whenever possible, given

the frequent necessity to package or link regulatory

actions or evaluations together into a single analysis.

10.3 Presenting the

Results

The results of economic analyses of environmental policies

should generally be presented in three clusters:

Results from benefit-cost analysis: Estimates of

the net social benefits should be presented based on

the benefits and costs for which dollar values can be

assigned, and a discussion of non-monetizable or

unquantifiable benefits and costs should be provided;

Results from economic impact analysis and

equity assessment: Results of the economic

impacts analysis and equity assessments should be

reported, including predicted effects on prices, profits,

plant closures, employment, and other effects, and

findings concerning the distribution of effects for

particular groups of concern, such as small entities,

governments, and disadvantaged and vulnerable

populations.

Results from cost-effectiveness analysis: This

policy evaluation technique is used when many benefits are not easily monetized and when the statutes or

other authorities dictate specific regulatory objectives.

Results of these analyses should also be presented

when these analyses are conducted.

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Chapter 10: Decision Making
The relative importance of these three clusters will depend

upon the policy and statutory context of the decision.

Generally, analyses leading to these findings normally

should be conducted simultaneously and the results

should be presented together as different ways to examine

a policy's social consequences.1

10.3.1 Results from Benefit-Cost

Analysis

The net social benefits of each major alternative is estimated by subtracting the present value of monetary social

costs from the present value of monetary social benefits

(as defined in Chapter 6). For this calculation the same

baseline must be used in both the benefit and cost analyses. Plausible upper- and lower-bound estimates of net

benefits should be provided, the "best" or most-likely estimate should be identified and the sensitivity of the net

benefits estimate to variations in uncertain parameters

should be examined.

Other considerations for presenting and summarizing the

results from benefit-cost analyses include the following:

Discounting benefits and costs is the preferred

method for summarizing benefits and costs that

accrue over several years. The conditions for discounting in benefit-cost analysis are outlined in

Chapter 6. Alternatives to discounting include annualizing costs and benefits, comparing those figures,

and accumulating costs and benefits through time to

a future year. When both traditional discounting and

these alternatives are not feasible or advisable, it is

appropriate to display the streams of costs and benefits over time for policy makers to consider.

Present and evaluate non-monetized and nonquantified effects. The net social benefit estimate

should be carefully evaluated in light of all the effects

that have been excluded because they cannot be valued in monetary terms. Thus, immediately following

a net benefit calculation, there should be a presentation and evaluation of all benefits and costs that can

only be quantified but not valued, as well as all benefits and costs that can be only qualitatively described.

Present the incremental benefits, costs, and net

benefits of moving from one regulatory alternative to more stringent ones. This presentation

should be done both globally and by sub-population.

This should include a discussion of incremental

changes in quantified and qualitatively described benefits and costs. It is sometimes necessary to evaluate

all combinations of options and alternatives when key

sources of benefits and costs of a policy are affected

by more than one option. In these cases, identifying

the combination of alternatives with the highest net

social benefits cannot rely only on the incremental

benefits and costs of each individual option when

added to other pre?existing options.

Discuss other potential costs and benefits that

may be by-products of the proposed action.

These include transfers of the pollutant problem from

one exposure medium or program office jurisdiction

to another or possible exacerbation of exposures for

specific groups (e.g., sensitive sub-populations, maximum exposure groups, or specific types of workers)

not captured already in the economic impacts analysis and equity assessment.

10.3.2 Results from Economic

Impacts Analysis and Equity

Assessment

Economic impact analyses and equity assessments focus

on distributional outcomes. Therefore, the presentation of

these results should focus on disaggregating effects to

show impacts separately for the groups and sectors of

interest. If costs and/or benefits vary significantly among

the sectors affected by the policy, then both costs and benefits should be shown separately for the different sectors.

Presenting results in disaggregated form will provide

important information to policy makers that may help

them tailor the rule to improve its efficiency and equity

outcomes.

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Chapter 10: Decision Making

1 There are other, more limited types of economic analysis that can inform policy decisions. One example is health-health analysis (sometimes known as risk-risk analysis) that assesses the health risks introduced by diverting to regulation resources otherwise available for individual

health care. Although limited, health-health analysis may be useful in contexts where benefit-cost analysis is infeasible. The method has been

employed by several researchers (Viscusi, 1994; Keeney, 1997), but is not without criticism (Portney and Stavins, 1994).
Chapter 10: Decision Making

178

The results of the economic impact analyses should also

be reported for important sectors within the affected community—identifying specific segments of industries,

regions of the country, or types of firms that may experience significant impacts or plant closures and losses in

employment. 

Reporting the results of equity assessments may include

the distribution of benefits, costs, or both for specific subpopulations including those highlighted in the various

mandates. These include minorities, low-income populations, small businesses, governments, and non-profits, and

sensitive and vulnerable populations (including children).

Where these mandates specify requirements that depend

on the outcomes of the distributional analyses (such as

the Regulatory Flexibility Act), the presentation of the

results should conform to the criteria specified by the

mandate.

10.3.3 Results from CostEffectiveness Analysis

When many benefits cannot easily be monetized, or when

statutes or other authorities set forth a specific policy

objective, economic analyses should present the results of

a cost-effectiveness analysis. This will provide useful information to policy makers and it conforms to the general

principle of minimizing the cost of achieving particular

policy goals.

The cost-effectiveness of a policy option is calculated by

dividing the annualized cost of the option by non-monetary benefit measures. Such natural units measures range

from the amount of the reduction in pollution measured

in physical terms, to the ultimate improvements in human

health or the environment measured in terms of specific

effects and damages avoided.

Cost-effectiveness analysis does not necessarily reveal what

level of control is reasonable, nor can it be used to directly

compare situations with different benefit streams.

Moreover, other criteria, such as statutory requirements,

enforcement problems, technological feasibility, or quantity

and location of total emissions abated, may preclude

selecting the least-cost solution in a regulatory decision.

However, where not prohibited by statute, cost-effectiveness analysis can indicate which control measures or policies are inferior options.

10.4 Use of Economic

Analyses in Policy

Choices

The primary purpose of conducting economic analysis is

to provide policy makers and others with detailed information on wide variety of consequences of environmental

policies. One important element these analyses have traditionally provided to the policy-making process is estimates of social benefits and costs—the economic efficiency of a policy. Hence, the EA Guidelines reflect updated

information regarding procedures for calculating benefits

and costs, monetizing benefits estimates, and selecting

particular inputs and assumptions.

Determining which regulatory options are best even on the

restrictive terms of economic efficiency, however, often is

made difficult by uncertainties in data and by the presence

of benefits and costs that can be quantified but not monetized or that can only be qualitatively assessed. Thus, even

if the criterion of economic efficiency were the sole guide

to policy decisions, social benefit and cost estimates alone

would not be sufficient to define the best policies.

A large number of social goals and statutory and judicial

mandates motivate and shape environmental policy. For

this and other reasons, the EA Guidelines contain information concerning procedures for conducting analyses of

other consequences of environmental policies, such as

economic impacts and equity effects. This is consistent

with the fact that economic efficiency is not the sole criterion for developing good public policies.

Even the most comprehensive economic analyses are but

part of a larger policy development process, one in which

no individual analytical feature or empirical finding dominates. The role of economic analysis is to organize information and comprehensively assess the economic consequences of alternative actions—benefits, costs, economic

impacts, and equity effects—and the tradeoffs among

them. These results serve as important inputs for this

broader policy-making process along with other analyses

and considerations.
10.5 References

Jorgenson, D. W. 1997. Welfare, Volume 2: Measuring Social Welfare. Cambridge, MA: MIT Press.

Keeney, R. L. 1997. Estimating Fatalities Induced by the Economic Costs of Regulations. Journal of Risk and

Uncertainty, 14(1): 5-23.

Portney, P. R. and R.N. Stavins. 1994. Regulatory Review of Environmental Policy: The Potential Role of Health-Health

Analysis. Journal of Risk and Uncertainty, 8(1): 11-122. 

Viscusi, W. K. 1994. Risk-Risk Analysis. Journal of Risk and Uncertainty, 8(1): 5-17.

179

Chapter 10: Decision Making
180

Chapter 10: Decision Making
Appendix A

181

Appendix A: An SAB Report on

the EPA Guidelines for Preparing

Economic Analysis
182

Appendix A
United States Science Advisory EPA-SAB-EEAC-99-020

Environmental Board (1400) September 1999

Protection Agency Washington DC www.epa.gov/sab

AN SAB REPORT ON THE

EPA GUIDELINES FOR 

PREPARING ECONOMIC

ANALYSES

A Review by the Environmental

Economics Advisory Committee
 

 UNITED STATES ENVIRONMENTAL PROTECTION AGENCY

 WASHINGTON, D.C. 20460

September 30, 1999

OFFICE OF THE ADMINISTRATOR 

SCIENCE ADVISORY BOARD

EPA-SAB-EEAC-99-020

The Honorable Carol Browner

Administrator

United States Environmental Protection Agency

401 M Street, SW

Washington, DC 20460

Subject: An SAB Report on the EPA Guidelines for Preparing Economic

Analyses

Dear Ms. Browner:

This Report on the Environmental Protection Agency’s (EPA’s) revised Guidelines for

Preparing Economic Analyses was developed by the Environmental Economics Advisory

Committee (EEAC) of the Science Advisory Board (SAB) in response to a charge received from

the Deputy Administrator on August 4, 1998 (attached). The review was carried out in a series of

meetings with the Agency’s Office of Policy, beginning in August 1998, and ending with a

telephone conference on July 27, 1999. 

As is described in detail in the full report, the Committee’s general conclusion is that the

Guidelines succeed in reflecting methods and practices that enjoy widespread acceptance in the

environmental economics profession. Although some concerns remain about particular parts of

the Guidelines, our overall assessment is that the Guidelines are excellent. It is our hope that the

Guidelines demonstrate EPA’s commitment to credible and consistent economic analyses in

support of the policy process.

The best analytical tools of environmental economics are constantly changing, as

experience with applications of existing tools and as new theoretical and empirical techniques

appear in the scholarly literature. As a result, it is important that EPA carry out new reviews of

the Guidelines every two to three years to reflect these developments in environmental economics. 

The Committee looks forward to working with EPA to strengthen this document in the years

ahead.
2

The iterative process that the EEAC employed with EPA for this review represents a

departure from the end-of-pipe assessments that are more typical of SAB practice. It was

consistent, however, with the Mission Statement of the EEAC prepared by the Deputy

Administrator, and was consistent with the SAB Executive Committee’s previously expressed

aims. Although this approach will not necessarily be appropriate for all SAB reviews, it may be a

useful model in selected cases. Therefore, we briefly describe the procedure in the full report.

Finally, Dr. Albert McGartland and his staff in the Office of Economy and Environment

should be commended for the professionalism they brought to this process. The excellence of the

revised Guidelines is testimony to the dedication of the talented team of Agency economists and

analysts who worked on this project. It was, as always, a pleasure for the EEAC to interact with

Dr. McGartland and his staff. We anticipate that you and everyone involved will be proud of the

quality of the new Guidelines for Preparing Economic Analyses, and we look forward to your

questions and your response to our Report.

Sincerely,

/s/ /s/

Dr. Joan M. Daisey, Chair Dr. Robert N. Stavins

Science Advisory Board Environmental Economics Advisory

 Committee

Science Advisory Board
i

NOTICE

This report has been written as part of the activities of the Science Advisory Board, a

public advisory group providing extramural scientific information and advice to the Administrator

and other officials of the Environmental Protection Agency. The Board is structured to provide

balanced, expert assessment of scientific matters related to problems facing the Agency. This

report has not been reviewed for approval by the Agency and, hence, the contents of this report

do not necessarily represent the views and policies of the Environmental Protection Agency, nor

of other agencies in the Executive Branch of the Federal government, nor does mention of trade

names or commercial products constitute a recommendation for use.

Distribution and Availability: This Science Advisory Board report is provided to the EPA

Administrator, senior Agency management, appropriate program staff, interested members of the

public, and is posted on the SAB website (www.epa.gov/sab). Information on its availability is

also provided in the SAB’s monthly newsletter (Happenings at the Science Advisory Board). 

Additional copies and further information are available from the SAB staff.
ii

U.S. Environmental Protection Agency

Science Advisory Board

Environmental Economics Advisory Committee

Panel for Review of the Economic Analysis Guidelines

CHAIRMAN

Dr. Robert N. Stavins, Albert Pratt Professor of Business and Government, John F. Kennedy

School of Government, Harvard University, Cambridge, MA 

MEMBERS

Dr. Nancy E. Bockstael, Professor, Department of Agricultural & Resource Economics,

University of Maryland, College Park, MD

Dr. Dallas Burtraw, Fellow, Resources for the Future, Washington, DC 

Dr. Trudy Ann Cameron, Professor, Department of Economics, University of California, Los

Angeles, CA 

Dr. Maureen L. Cropper, Senior Economist, The World Bank, Washington, DC 

Dr. Herman E. Daly, Senior Research Scholar, School of Public Affairs, University of Maryland,

College Park, MD

Dr. A. Myrick Freeman, Professor, Department of Economics, Bowdoin College, Brunswick,

ME 

Dr. Dale W. Jorgenson, Frederic Eaton Abbe Professor of Economics, Department of

Economics, and JFK School of Government, Harvard University, Cambridge, MA

Dr. Paul L. Joskow, Elizabeth and James Killian Professor of Economics, Massachusetts

Institute of Technology, Cambridge, MA 

Dr. Catherine Kling, Professor, Department of Economics, Iowa State University, Ames, IA 

Dr. Richard L. Revesz, Professor of Law, New York University School of Law,

New York, NY

Dr. Jason F. Shogren, Stroock Distinguished Professor of Law and Economics, Department of

Economics and Finance; University of Wyoming, Laramie, WY.

Dr. Hilary A. Sigman, Assistant Professor, Department of Economics, Rutgers University, New

Brunswick, NJ. 
iii

SCIENCE ADVISORY BOARD STAFF

Mr. Thomas O. Miller, Designated Federal Officer, Science Advisory Board (1400), U.S.

Environmental Protection Agency, Washington, DC 

Mrs. Dorothy M. Clark, Management Assistant, Science Advisory Board (1400), U.S.

Environmental Protection Agency, Washington, DC
iv

TABLE OF CONTENTS

1. Executive Summary and Conclusions .......................................... 1

2. Introduction ............................................................. 2

3. Specific Responses to Charge Questions. ....................................... 3

3.1. Discounting ...................................................... 3

3.2. Quantifying and Valuing Human Fatalities ............................... 4

3.3. Certainty Equivalents ............................................... 5

3.4. Valuation Approaches for Human Morbidity and Improved Ecological 

Conditions ..................................................... 5

3.5. Economic Impact and Net Social Benefits ............................... 6

3.6. Computable General Equilibrium ...................................... 6

3.7. Economic Impacts to the Private Sector, Public Sector, and Households ........ 7

3.8. Equity .......................................................... 8

3.9. Altruism ......................................................... 8

 References .............................................................. R-1

Appendix A .............................................................. A-1
1

1. EXECUTIVE SUMMARY AND CONCLUSIONS

The Environmental Economics Advisory Committee (EEAC) of the EPA Science

Advisory Board (SAB) reviewed the Agency’s draft Guidelines for Preparing Economic

Analyses (EPA, 1999) during a series of meetings extending from August 1998 to July 1999, in

response to a request received from EPA to perform a full and complete review. This is EPA’s

first major overhaul of these guidelines in more than a decade. Because the Guidelines are to be

used by all parts of the Agency for carrying out regulatory analyses, it is important that they

reflect “methods and practices that enjoy widespread acceptance in the environmental economics

profession,” as specified in the charge to the EEAC received from the EPA Deputy Administrator. 

The draft Guidelines have been revised and improved as a result of the interactions between the

Committee and EPA staff in several public meetings over the past year. The EEAC’s general

conclusion is that the Guidelines reflect best methods and practices that enjoy widespread

acceptance in the environmental economics profession, notwithstanding the several EEAC

concerns that remain about particular parts of the Guidelines. The Committee hopes that the

Guidelines demonstrate EPA’s commitment to credible and consistent economic analysis in

support of the policy process. 

The fundamental ingredients of an economic analysis of a proposed or existing

environmental policy or program are well covered in the Guidelines, and key conceptual, analytic,

and empirical issues are highlighted. The Guidelines acknowledge the practical limitations facing

EPA analysts in terms of time, resources, and expertise, and hence provide flexibility to analysts. 

The Guidelines are just that — guidelines for analysis, not a rigid (or simplistic) cook book.

Economics, like any scholarly discipline, is constantly changing. Environmental

economics, a relatively young branch of the discipline, has experienced particularly rapid growth. 

New areas of the literature continue to emerge, and existing areas change and expand. Hence,

despite the Committee’s generally positive assessment of the revised Guidelines, we urge EPA to

carry out new reviews every two to three years. The time investments that will be required for

such periodic reviews — both on the part of EPA staff and on the part of the EEAC — will be

much less than was required for this first revision in ten years. 

The interactive process that the EEAC employed with EPA for this review was something

of a departure from the end-of-pipe assessments that are more typical of SAB practice. It was

consistent, however, with the Mission Statement of the EEAC prepared by the Deputy

Administrator, and, moreover, was consistent with the SAB Executive Committee’s previously

expressed interest in early involvement with the Agency on important issues. Although this

approach will not necessarily be appropriate for all SAB reviews, it may be a useful model in

selected cases. Therefore, we briefly describe the procedure here.

During the past twelve months, the EEAC held three one-day meetings in Washington,

D.C., devoted primarily to our review of EPA’s revised Guidelines for Preparing Economic
2

Analyses, plus a fourth meeting via teleconference. Each of the meetings was attended by Dr.

Albert McGartland, Director of the Office of Economy and Environment, and many members of

his staff. Intensive and extensive substantive discussions at these meetings provided an effective

forum in which EEAC members and the Committee as a whole could pose questions, describe

concerns, and express views, and for Agency representatives to explain the thinking behind their

drafts. Each of the first three meetings led to a subsequently revised draft, which in every case

addressed the general and specific concerns expressed by the EEAC at the previous meeting, and

thereby represented a significantly improved draft document. Dr. McGartland and his staff should

be commended for the openness, professionalism, and lack of defensiveness which they brought to

this process.

2. INTRODUCTION

The Environmental Economics Advisory Committee was requested to perform a full and

complete review of the Guidelines for Preparing Economic Analyses (EAGs or the Guidelines). 

EPA asked for comments on all aspects of the guidance document and written documentation,

when applicable, on recommendations from the Committee for alternative methodologies,

assumptions and data sources to improve the presentation of issues addressed in the guidance

document.

The stated intent of the Guidelines is to:

a) Represent EPA policy on preparing economic analyses under a variety of

authorizing statutes and administrative requirements, each of which can influence

the conduct and use of analyses by different EPA offices;

b) Demonstrate EPA’s commitment to credible/consistent economic analyses in

support of the policy making process;

c) Emphasize the need for analytic efforts commensurate with the value of that

information in the EPA policy making process; 

d) Reflect mainstream economic science/methods that are well demonstrated and

relatively straightforward to apply to particular environmental issues; 

e) Cover a number of principles and practices that virtually all economic analyses

should follow and clarify, for a number of identified analytic issues, the process

that analysts are to follow as they organize and conduct the analysis;

f) Account for some of the practical limitations on time and resources that EPA

analysts must contend with when preparing economic analyses; and 

 
3

g) Provide some flexibility to analysts to permit them to “customize” analyses to

conform to administrative and legal procedures.

The document embodying the Guidelines is not intended to be a text on the theory and

methods of applying economic analysis to EPA regulations and policies nor do they preclude new

or path breaking forms of analysis. EPA intends to regularly and frequently review and revise

parts of the Guidelines to reflect and report on significant changes in the literature used to support

EPA analyses, as well as changes in administrative and legal requirements that affect the conduct

of economics at the EPA.

3. SPECIFIC RESPONSES TO CHARGE QUESTIONS 

The Committee’s specific comments on the Guidelines are organized into nine sections,

the first eight of which address, respectively, questions posed in EPA’s charge to the Committee. 

The last section includes the Committee’s advice on the topic of altruistic benefits.

3.1 Discounting 

Charge Question 1. Does the published economic theory and empirical literature

support the statements in the guidance document on the treatment of discounting benefits

and costs in the following circumstances: a) private and public costs for use in an

economic impact analysis, b) social benefits and costs in an intragenerational context; c)

social benefits and costs in an intergenerational context; and d) social benefit and cost

information that is reported in nonmonetary terms?

The guidance document is consistent with published theoretical and empirical analysis on

the use of discounting for (a) private and public costs in an economic impact analysis, and for (d)

social benefit and cost information expressed in non-monetary terms. The current literature also

supports the discussion of issue (b), discounting social benefits and costs in an intragenerational

context. In this context, the document should encourage the use of a discount rate in the middle

of its recommended range, in addition to the values currently mentioned, to reflect common

practice.

The proper application of discounting in an intergenerational context (issue (c)) remains

controversial in the published literature. The guidance document lays out the positions in this

debate clearly. Reflecting the disagreement within the economics profession, there is diversity of

opinion within the EEAC on this issue. Some members believe that the guidance document is

more critical than the published literature of the view that intergenerational discounting should not

differ from other discounting, while other members support the document's current emphasis. 

The final quantitative recommendations for discount rate values in the intergenerational context

are broad enough to be uncontroversial.
4

3.2 Quantifying and Valuing Human Fatalities 

Charge Question 2. Does the published economic theory and empirical literature

support the statements in the guidance document on quantifying and valuing the social

benefits of reducing fatal human health risks?

The guidance document recommends that the mean value of a statistical life (VSL) based

on 26 published studies be used as the default value in Agency analyses. It urges that a

qualitative discussion of the appropriateness of this estimate to the population and risks analyzed

accompany the use of the central tendency estimate.

The EEAC encourages the use of value of a statistical life (VSL) estimates in benefit

valuation and in providing guidance for policy. Moreover, it believes that the general magnitude

of the benefit value suggested in the Guidelines is in a reasonable range for broad population

groups. However, these estimates could be refined, particularly when certain segments of the

population are affected, such as children or persons over the age of 65.

One refinement that EPA could undertake now is to narrow the set of VSL studies to the

most reliable estimates for the U.S. population, rather than taking the mean value from a set of

studies of varying quality and with different statistical controls and with populations from various

countries. 

Hedonic studies based on market tradeoffs give values reflected in actual market

decisions. Such studies have focused primarily on the labor market, but some have considered

implicit values of life reflected in car safety and in housing price responses to hazardous wastes

and pollution. Contingent valuation studies can also prove useful with respect to variations due to

age, health status, and other factors not readily estimated using market data.

Care should be taken to avoid conveying the impression that $5.8 million (in 1997 dollars)

is always and everywhere the correct figure to use for the value of a statistical life. Footnote 29 in

Section 7.6.1.2 attaches some important caveats to the $5.8 million figure cited in the document. 

These caveats should be placed more prominently, so that casual readers do not come away with

the notion that $5.8 million is “the” value of a statistical life. It is, of course, simply the central

tendency of a number of estimates of the VSL for some rather narrowly defined subpopulations. 

The individual study values from which this number is derived range from $0.7 million to $16.3

million, indicating considerable heterogeneity across different contexts. 

In some cases, it may be desirable to use a VSL estimate specific to particular populations. 

The most prominent possible variation is with respect to age, but characteristics such as gender

and income could also be influential. How and whether these differences should affect policy

benefit assessment is more controversial. However, as a first step, EPA should show the age

distribution of the lives saved, or the quantity of life at risk. In addition, when policies do not

affect the entire population equally, a sensitivity analysis can show both the cost per life saved and
5

the cost per discounted life year. Policymakers can then be better able to assess the efficacy of the

policy.

Clearly, any re-evaluation of the literature will take time. In the interim, if the mean VSL

cited in the Guidelines is to be used, the limitations of the estimate should be described. In cases

where the estimate is to be applied to populations whose age differs significantly from the average

age of the populations in the 26 studies, a quantitative sensitivity analysis should be performed,

such as that used in The Benefits and Costs of the Clean Air Act, 1970-1990 (EPA, 1997).

3.3 Certainty Equivalents

Charge Question 3. Does the published economic theory and empirical literature

support the statements in the guidance document on the treatment of certainty

equivalents in the assessment of social benefits and costs of environmental policies?

The discussion of principles for uncertainty analysis in the Guidelines highlights the

important distinction between the analyst’s uncertainty and individuals’ uncertainty about future

outcomes. The latter relates to assessing the effects of environmental changes on individuals’

welfare under uncertainty. In this regard, the Guidelines are consistent with mainstream economic

theory and the empirical literature in that they recognize the importance of taking account of

individual attitudes towards risk and suggest certainty equivalents as one way of incorporating

risk aversion into the assessment of social benefits and costs of environmental policies. However,

the Guidelines recognize that information on risk attitudes may be difficult to obtain. The

Guidelines also recognize that experts’ and lay individuals’ risk perceptions may differ. Because

the latter affect individuals’ behavior, it is important for the analyst to consider both types of risk

assessments. The Guidelines are also consistent with current literature in recognizing the

important role information plays in welfare evaluation in an uncertain world.

3.4 Valuation Approaches for Human Morbidity and Improved Ecological Conditions

Charge Question 4. Does the published economic theory and empirical literature

support the statements in the guidance document on the merits and limitations of

different valuation approaches to the measurement of social benefits from reductions in

human morbidity risks and improvements in ecological conditions attributable to

environmental policies?

Overall, Chapter 7 does a very good job of explaining the state-of-the-art in the

measurement of environmental benefits. This literature continues to evolve, and so frequent

updates are likely to be necessary for this chapter. All currently relevant methods appear to be

represented and sufficient caveats have generally been offered. Four concerns, however, should

be highlighted.
6

First, care should be taken to avoid creating the impression that the benefits or costs

associated with a proposed regulation are being misrepresented. Socially efficient policy-making

is not well served by exaggeration or understatement of the benefits or costs of alternative policy

choices. When benefits are uncertain, expected values should be emphasized. However, an

assessment should be made concerning the sensitivity of the policy conclusions to the full range of

possible benefits estimates.

Second, the claim that averting expenditures can reliably be used as a lower bound on

environmental benefits is too strong. The draft overstates the idea that averting behavior is a

generic lower bound on ex ante economic value for morbidity and mortality. The theoretical

literature reveals that averting behavior need not be a lower bound on value when both private

and collective risk reduction strategies are considered. Private actions to reduce risk mixed with

collective actions yield ambiguous results. Further discussion is available in Shogren and Crocker

(1999).

Third, the treatment of altruistic benefits should be clearer. Circumstances wherein

altruistic benefits should, and should not, be included as a separate component of total social

benefits should be highlighted. It is important to avoid double-counting of benefits and costs in

assessing proposed policies. This issue is taken up, below, in Section 3.9.

3.5 Economic Impact and Net Social Benefits

Charge Question 5. Does the published economic theory and empirical literature

support the statements in the guidance document on the relationships and distinctions

between the measurement of economic impacts and net social benefits?

The guidance document makes it clear that in order to make informed policy judgements it

is important to study a variety of consequences of environmental policies, including impacts on

particular industries, regions, and demographic groups (as well as other impacts whose analyses

are mandated by statute) to complement conventional benefit-cost analysis. The relationship

between conventional benefit-cost analysis and the analysis of the broad and diverse distributional

impacts of environmental policies are discussed clearly and the relationships between these

complementary policy analyses is consistent with the published economics literature.

3.6 Computable General Equilibrium Models 

Charge Question 6. Does the guidance document contain an objective and reasonable

presentation on the published economic theory, empirical literature, and analytic tools

associated with computable general equilibrium (CGE) models, and description of their

relevance for economic analyses performed by the EPA?

The use of general equilibrium analysis, both as a conceptual and a numerical tool, is

gaining expanded use in economics. The Guidelines provide a useful discussion of the current
7

uses and limitations of computable general equilibrium (CGE) models in Chapter 8. This is a

rapidly developing area in economics, and so for the Guidelines to remain relevant, the Agency

will need to commit to ongoing review of new tools and applications that broaden the applicability

of CGE models, and that provide new intellectual insights that can guide benefit-cost analysis.

One area where new insights are proliferating is the interaction of environmental

regulations with pre-existing economic distortions (that is, the deadweight loss due to existing

taxes). Of particular relevance in this regard is the role of pre-existing taxes. Recent literature in

economics indicates that the costs and benefits of regulations can be substantially different than

indicated by partial equilibrium analysis. In addition, the relative cost-effectiveness of different

policy instruments (technology standards, tradable permits, etc.) can be affected by these

interactions.

The Guidelines address the issue of interactions of regulations with pre-existing economic

distortions in a paragraph near the end of Chapter 5, under the label “Emerging Cross-Cutting

Issues.” This is appropriate because the issue is both rapidly emerging and broadly cross-cutting. 

But the issue is not mentioned in Chapter 8 (“Analyzing Social Costs”), where general equilibrium

analysis is discussed in detail. The exclusion of the issue from Chapter 8 is unfortunate: (a)

because of the potential magnitude associated with “interactions” and (b) because general

equilibrium tools provide the method for considering these “interactions.” Hence, one of the most

compelling reasons to use CGE models is to develop an understanding of, and to estimate the

magnitude of, this potential influence. While in most regards, the discussion of CGE models is

objective and reasonable, the failure to integrate a discussion of tax interactions undermines the

presentation.

3.7 Economic Impacts to the Private Sector, Public Sector, and Households

Charge Question 7. Does the guidance document contain an objective and reasonable

presentation on the measurement of economic impacts, including approaches suitable to

estimate impacts of environmental regulations on the private sector, public sector and

households? This includes, for example, the measurement of changes in market prices,

profits, facility closure and bankruptcy rates, employment, market structure, innovation

and economic growth, regional economies, and foreign trade.

The guidance document provides an objective and reasonable presentation of these topics. 

3.8 Equity

Charge Question 8. Does the guidance document contain a reasonable presentation and

set of recommendations on the selection of economic variables and data sources used to

measure the equity dimensions identified as potentially relevant to environmental policy

analysis? 
8

Conventional, primary dictionary definitions of equity refer to concepts such as fairness,

impartiality, and justice. Thus, equity is typically treated as a normative concept in everyday

parlance. The Guidelines, in keeping with mainstream practice in economics, however, seek

merely to supply statistical measures of the distribution of costs and benefits, leaving it to citizens

to judge whether the described distributions are fair or equitable. In this way, the document

provides positive information that is relevant to making normative judgments, but offers no

explicit discussion of norms. At the same time, however, since market prices and willingness-topay criteria are employed in the Guidelines, and because they are based on the existing

distributions of income and wealth, those existing distributions are implicitly accorded normative

status. Some may object to taking the existing distribution as the norm for equity assessments,

especially as that distribution has become more concentrated in recent decades. This issue is

noted, but in accord with mainstream practice, is not considered further in the document.

The Guidelines contain a reasonable presentation and set of recommendations on the

selection of economic variables and data sources that can be used to measure the distributional

consequences of environmental policies, both on the benefit side and the cost side.

3.9 Altruism

The Guidelines would benefit from a discussion of when it is appropriate to include

altruistic benefits in a benefit-cost analysis. Economic theory is quite clear on this point (JonesLee, 1991). If I care about my neighbor and respect his preferences, and if my neighbor would

have to pay for the program or project being analyzed, then altruistic benefits should not be

counted in a benefit-cost analysis. The intuition behind this result is that, if I respect my

neighbor’s preferences, although I value the benefits he will receive from the project, I also care

about the costs it will impose on him. It is, therefore, inappropriate to add the value I attach to

his benefits without considering the cost implications of doing this. Comparing individual benefits

and costs in this case is the appropriate decision rule.

Altruistic benefits may be counted either when my altruism toward my neighbor is

paternalistic, or when I will in fact bear the costs of the project but he will not. In the first case

(paternalistic altruism), I care about the benefits my neighbor will enjoy, e.g., from a health or

safety project, but not about the costs the project will impose on him. An example of the second

case would be a project whose costs are borne entirely by the current generation; i.e., the project

imposes no costs on future generations. In this case, altruism toward future generations by the

current generation could legitimately be counted as a benefit.
R-1

REFERENCES

Jones-Lee, M. W. (1991). “Altruism and the Value of Other People’s Safety.” Journal of Risk

and Uncertainty, 4, pp. 213-219.

Shogren, Jason F., and Thomas D. Crocker (1999). “Risk and Its Consequences,” Journal of

Environmental Economics and Management, 37, 44-51.

U.S. Environmental Protection Agency (1997). The Benefits and Costs of the Clean Air Act,

1970 to 1990. Submitted to Congress pursuant to Section 812, Clean Air Act

Amendments of 1990. Washington: U.S. EPA Office of Administration and Resources

Management/Office of Policy, Planning, and Evaluation. October, 1997.

U.S. Environmental Protection Agency (1999). Guidelines for Preparing Economic Analyses.

US EPA/OP, Office of Economy and Environment. June 11, 1999. Draft.
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APPENDIX A

CHARGE TO THE COMMITTEE

August 4, 1998

Dr. Robert Stavins

Professor of Public Policy and Faculty Chair

John F. Kennedy School of Government

Harvard University

79 John F. Kennedy Street, Room L-313

Cambridge, Massachusetts 02138

Dear Dr. Stavins:

The Science Advisory Board, Environmental Economics Advisory Committee (EEAC or

the Committee) is requested to perform an advisory review of a revised guidance document

prepared for the Environmental Protection Agency (EPA) on the conduct of economic analysis. 

The document, titled “Guidelines for Preparing Economic Analyses,” is the product of a

deliberative Agency-wide process initiated at my direction and managed by the EPA’s Regulatory

Policy Council. The document is designed to represent Agency policy on the preparation of

economic analysis called for under applicable legislative and administrative requirements,

including, but not limited to Executive Order 12866 on regulatory planning and review. The

revisions to the guidance document should embody sound economic thinking so that its

application will continue to demonstrate the EPA’s commitment to make credible and consistent

economic analytic decisions in support of the regulatory and policy making process. The Agency

is seeking external peer review of the guidance documents because of the pervasive influence of

the documents on the conduct of agency-wide economic analysis. 

Background

The decision to prepare a revised document is based on a number of events and factors. 

The current EPA operating guidance on performing economic analysis was written over the

period 1983-1986. Since that time, there have been numerous advances in the economic

literature. Because the guidance document is primarily intended to serve as a source for technical

information on the conduct of economic analysis, it is important that the document reflect the

most recent economics literature.

The original EPA guidance document was also written to support the administrative

process for using economic information when developing regulations set forth in Executive Order

(E.O.) 12291 on Regulatory Planning and Review (released in 1981). The Office of Management
A-2

and Budget (OMB) issued its own federal guidelines for performing economic analysis following

the release of E.O. 12291. The EPA elected to issue its own guidance document in an effort to

elaborate on the materials described in the OMB guidance, and provide additional source material

to assist in the application of the OMB analytic principles to analyses prepared by the EPA. The

issuance of an updated Order on the federal regulatory development process (E.O. 12866 released

in 1993) led OMB to revise its federal guidelines for performing economic analysis in early 1996. 

The new OMB guidance drew heavily on the previous document, but developed additional details

on several aspects of conducting economic analysis that reflected advances in the economic

literature, and added information on several administrative measures and policy objectives

receiving additional emphasis included in E.O. 12866. The new EPA economic guidance

document seeks to accomplish the same objective, but in a manner that meets the distinctive needs

of EPA staff working on economic analyses.

 Other administrative and legislative requirements were issued since the mid-1980s that

now affect the development and conduct of economic analysis at the EPA. Most are not directed

exclusively at EPA regulatory activities, but their addition has led to some modifications to the

preparation of economic analyses by the EPA. Some examples include legislation to consider

unfunded mandates on non-federal governments, and the assessment of economic impacts on

small entities. The revised EPA economic guidance document seeks to update and make

reference to existing and anticipated guidance on these Congressional mandates and executive

orders.

One major goal of the new guidance document is to provide more assistance to EPA

analysts in the adoption of a consistent set of procedures used to formulate its economic analyses. 

The responsibility for preparing economic analyses at the EPA rests in many different offices in

the Agency. As a consequence of differences in the authorizing statutes they operate under, the

conduct and use of economic analysis can vary across documents prepared by these offices. 

Despite these differences, there are a number of guiding principles and practices that the EPA

proposes to follow to aid in the consistent development of economic information. The new

economic guidance document has been written to make clear, for a number of identified analytic

issues, the process that EPA analysts are to follow as they organize and perform their economic

analyses. One of the objectives in revising the guidance document was to adopt a process

whereby the Agency’s economic analytic staff participated as a group in the review and revision

of the document. Because these offices have greater authority and responsibility for the content

and quality of their economic analysis, the process provided a productive forum for raising

common and critical issues that arise in the conduct of economic analysis.

The current guidance document’s publication date of 1983 belies the fact that work has

been undertaken by EPA since that time to support advances in the development and use of

economic tools and information in its economic analyses. The Agency draws upon the results of

new research and participates in professional workshops (e.g., events supported by the

Association of Environmental and Resource Economists) to be current with the state of economic

knowledge. EPA also uses materials produced by other government agencies (e.g., General
A-3

Accounting Office reviews, reports by the Presidential/Congressional Commission on Risk

Assessment/Risk Management), incorporating new information and thinking into its economic

analyses. Recognizing that the previous process resulted in development of a “static” EPA

economic guidance document, this effort is viewed as the first of a series of more regular and

frequent actions to continually review and revise component parts of the documents. The

development and release of materials will follow a schedule that reflects and reports on significant

changes in the literature used to support EPA analyses, as well as changes in administrative and

legal requirements that affect the conduct of economics at the EPA. 

The materials to be submitted to the SAB-EEAC for an advisory review at this time

include a complete draft of the revised guidance document. The document consists of a main

document and five separate appendices. Each appendix provides greater detail on subjects treated

in the main document. The appendices are organized into major component parts of economic

analyses produced by the EPA, or treat an analytic topic that merits significant attention. As of

this revision, the guidance document contains appendices on the analysis of economic benefits,

social costs, economic impacts, equity effects, and discounting future benefits and costs.

Charge to the Committee: 

The charge to the Committee is to undertake an advisory review of the draft materials and

provide advice to the Agency pursuant to a series of questions concerning the preparation of

economic analyses by the EPA. The EPA guidance directly refers to methods and practices that

enjoy widespread acceptance in the environmental economics profession. The guidance document

does not intend to preclude new or path breaking forms of analysis, but to provide EPA analysts

with a reasonably concise and thorough treatment of mainstream thinking on important technical

issues that arise in the conduct of economic analysis. The guidance accounts for some of the

practical limitations on time and resources that EPA analysts must contend with when preparing

economic analyses. It also is shaped by administrative and statutory requirements that contain

direct references to the development of economic information in the formulation of regulations

(e.g., evaluations of economic achievability). As a result, the guidance is not written to resemble

a text on the theory and methods of applying economic analysis to EPA regulations and policies. 

Some of the language in the guidance was chosen for the express purpose of providing some

flexibility to analysts that should enable them to “customize” the analysis to be as complex and

complete as is necessary to conform to administrative and legal procedures. The document also

emphasizes the need for the EPA analyst to ensure that their analytic efforts are commensurate

with the value the information will provide to the regulatory and policy making process at the

EPA. The document covers a number of principles and practices that virtually all economic

analyses should follow, and it is these items to which the Committee is asked to devote the

greatest attention in its review.

In general, we believe the Guidance should reflect mainstream economic science and

methods that are well demonstrated and relatively straightforward to apply to particular

environmental issues. Ideally, these methods should be general enough that EPA program
A-4

analysts can use them consistently across all of EPA's programs. Thus, while EPA recognizes that

this document needs to provide pragmatic guidance, we have also attempted to reflect the state

of the economic science. In some cases, our goal of making this useable has meant that we had to

shorten or simplify the document. Your views about whether there are any important omissions

or oversimplifications are critical.

The review questions to the Committee are as follows:

1. Do the published economic theory and empirical literature support the statements in the

guidance document on the treatment of discounting benefits and costs in the following

circumstances:

1a. Discounting private and public costs for use in an economic impact analysis?

1b. Discounting social benefits and costs in an intragenerational context?

1c. Discounting social benefits and costs in an intergenerational context?

1d. Discounting social benefit and cost information that is reported in nonmonetary terms?

2. Do the published economic theory and empirical literature support the statements in the

guidance document on quantifying and valuing the social benefits of reducing fatal human health

risks?

3. Do the published economic theory and empirical literature support the statements in the

guidance document on the treatment of certainty equivalents in the assessment of social benefits

and costs of environmental policies?

4. Do the published economic theory and empirical literature support the statements in the

guidance document on the merits and limitations of different valuation approaches to the

measurement of social benefits from reductions in human morbidity risks and improvements in

ecological conditions attributable to environmental policies?

5. Do the published economic theory and empirical literature support the statements in the

guidance document on the relationships and distinctions between the measurement of economic

impacts and net social benefits?

6. Does the guidance document contain an objective and reasonable presentation on the published

economic theory, empirical literature, and analytic tools associated with computable general

equilibrium (CGE) models, and description of their relevance for economic analyses performed by

the EPA?
A-5

7. Does the guidance document contain an objective and reasonable presentation on the

measurement of economic impacts, including approaches suitable to estimate impacts of

environmental regulations on the private sector, public sector and households? This includes, for

example, the measurement of changes in market prices, profits, facility closure and bankruptcy

rates, employment, market structure, innovation and economic growth, regional economies, and

foreign trade.

8. Does the guidance document contain a reasonable presentation and set of recommendations on

the selection of economic variables and data sources used to measure the equity dimensions

identified as potentially relevant to environmental policy analysis? 

The EPA requests that the Committee provide written review and documentation, when

applicable, to support recommended changes to the guidance document. Our intention is that the

Committee conduct a full and complete review. Although the specific questions identified above

are those EPA believes are the most appropriate for the Committee to consider, EPA seeks

comments on all aspects of the guidance document. The EPA also seeks recommendations from

the Committee on alternative methodologies, assumptions and data sources that will improve the

presentation of economic issues addressed in the guidance document. We would like the

Committee to conclude its review by the end of October.

Review materials

The first attachment to this memorandum is to both the Designated Federal Official and

Chairman to the Environmental Economics Advisory Committee. The memorandum lists the

publicly available documents supporting the “Guidelines for Preparing Economic Analyses.” This

memorandum contains a list of the documents which are to be submitted to the Committee to

assist in their review of the guidance document. The other attachments are the documents.

Please direct any inquiries regarding the review materials to me at 202-260-3354, or by email at mcgartland.al@epa.gov. Thank you for your assistance.

Sincerely,

 / S /

Fred Hansen, 

Deputy Administrator
ABSTRACT

The Environmental Economics Advisory Committee (EEAC) of the EPA Science

Advisory Board (SAB) reviewed the Agency’s draft Guidelines for Preparing Economic

Analyses during a series of meetings extending from August 1998 to July 1999, in response to a

request received from EPA to perform a full and complete review. The draft Guidelines have

been revised and greatly improved as a result of the interactions between the EEAC and EPA staff

during the public meetings over the past year. The EEAC’s general conclusion is that the

Guidelines now succeed in reflecting methods and practices that enjoy widespread acceptance in

the environmental economics profession, notwithstanding the concerns that remain with several

particular parts of the Guidelines.

Keywords: benefit-cost analysis; economic efficiency; cost effectiveness; regulatory impact

analysis
Appendix B

205

Appendix B: EPA’s Response to

SAB Review
206

Appendix B
December 21, 2000

Dr. Robert N. Stavins

Chairman, Environmental Economics Advisory Committee

Science Advisory Board (A-101)

Environmental Protection Agency

Ariel Rios Building

1200 Pennsylvania Avenue, N.W.

Washington, D.C. 20460

Dear Dr. Stavins:

Thank you for your letter to Administrator Browner and the report An SAB Report on the

EPA Guidelines for Preparing Economic Analyses: A Review by the Environmental Economics

Advisory Committee (EPA-SAB-EEAC-99-20, September 30, 1999). Before I respond to the

specifics of your review, allow me to thank the Board for the sustained and intensive level of effort

devoted by the SAB’s Environmental Economic Advisory Committee (EEAC) to the development

and review of the Agency’s economic analysis guidelines. By incorporating the “best

mainstream” economics into our guidelines and analyses, the overall credibility of our work will

be sustained, the Agency’s decisions will be better informed, and public discourse on

environmental policy will be enhanced. The SAB report contains a thorough review of our

Guidelines for Preparing Economic Analyses (or EA Guidelines), and provides many useful

recommendations that the Agency has taken under consideration in revising the document. Other

suggestions in the review help illuminate larger issues that the Agency continues to explore and

consider.

Given the importance of economic assessments to the Agency, it is imperative that they are

conducted as consistently and accurately as possible. The best way to ensure that analyses meet

these goals is to provide Agency analysts with a clear set of guidelines and recommendations that

have a solid foundation in the current state of economic science. As your letter notes, evolution of

analytical tools and practices requires that such guidelines be reviewed every few years. The

Agency is committed to undertaking regular reviews of the materials contained in the EA

Guidelines, and looks forward to receiving further recommendations from the Science Advisory

Board’s Environmental Economics Advisory Committee (EEAC) that will strengthen and improve

the EA Guidelines in the years ahead.
As you also note in your letter and report, the process employed by the EEAC and the Agency in

the review of the EA Guidelines is unique. The Agency agrees that this departure from the

standard practice was of great benefit in preparing the document. Not only did early involvement

by the EEAC ultimately result in a much stronger document, but the open exchange between

EEAC members, the Committee as a whole, and Agency personnel served to clarify a number of

issues that may have been difficult to address otherwise. The Agency is hopeful that a similar

process may prove useful in other contexts.

The EA Guidelines serve as a set of principles, consistent with current economic thinking,

for analysts to draw upon in performing economic analyses. Section Three of the SAB report

provides specific recommendations for the application of these principles. The Agency’s

responses to the main recommendations included in the SAB report, including references to

sections in the EA Guidelines where resulting changes or additions to the document can be found,

are enclosed.

Finally, I would like to again thank the Board for its thoughtful comments provided in the

report, and the extensive feedback offered by the membership of the committee during the public

meetings on the EA Guidelines. The Agency sincerely appreciates the time and effort of the SAB

as a whole and of the individual members of the EEAC.

Sincerely,

/s/

W. Michael McCabe

Deputy Administrator

Enclosure

cc: Assistant Administrators

Associate Administrators

Regional Administrators

Regulatory Policy Council

Science Advisory Board

bcc: Economic Consistency Workgroup members
December 21, 2000

Dr. Morton Lippmann

Interim Chairman, Executive Committee

Science Advisory Board (A-101)

Environmental Protection Agency

Ariel Rios Building

1200 Pennsylvania Avenue, N.W.

Washington, D.C. 20460

Dear Dr. Lippmann:

Thank you for your letter to Administrator Browner and the report An SAB Report on the

EPA Guidelines for Preparing Economic Analyses: A Review by the Environmental Economics

Advisory Committee (EPA-SAB-EEAC-99-20, September 30, 1999). Before I respond to the

specifics of your review, allow me to thank the Board for the sustained and intensive level of effort

devoted by the SAB’s Environmental Economic Advisory Committee (EEAC) to the development

and review of the Agency’s economic analysis guidelines. By incorporating the “best

mainstream” economics into our guidelines and analyses, the overall credibility of our work will

be sustained, the Agency’s decisions will be better informed, and public discourse on

environmental policy will be enhanced. The SAB report contains a thorough review of our

Guidelines for Preparing Economic Analyses (or EA Guidelines), and provides many useful

recommendations that the Agency has taken under consideration in revising the document. Other

suggestions in the review help illuminate larger issues that the Agency continues to explore and

consider.

Given the importance of economic assessments to the Agency, it is imperative that they are

conducted as consistently and accurately as possible. The best way to ensure that analyses meet

these goals is to provide Agency analysts with a clear set of guidelines and recommendations that

have a solid foundation in the current state of economic science. As your letter notes, evolution of

analytical tools and practices requires that such guidelines be reviewed every few years. The

Agency is committed to undertaking regular reviews of the materials contained in the EA

Guidelines, and looks forward to receiving further recommendations from the Science Advisory

Board’s Environmental Economics Advisory Committee (EEAC) that will strengthen and improve

the EA Guidelines in the years ahead.
As you also note in your letter and report, the process employed by the EEAC and the Agency in

the review of the EA Guidelines is unique. The Agency agrees that this departure from the

standard practice was of great benefit in preparing the document. Not only did early involvement

by the EEAC ultimately result in a much stronger document, but the open exchange between

EEAC members, the Committee as a whole, and Agency personnel served to clarify a number of

issues that may have been difficult to address otherwise. The Agency is hopeful that a similar

process may prove useful in other contexts.

The EA Guidelines serve as a set of principles, consistent with current economic thinking,

for analysts to draw upon in performing economic analyses. Section Three of the SAB report

provides specific recommendations for the application of these principles. The Agency’s

responses to the main recommendations included in the SAB report, including references to

sections in the EA Guidelines where resulting changes or additions to the document can be found,

is enclosed.

Finally, I would like to again thank the Board for its thoughtful comments provided in the

report, and the extensive feedback offered by the membership of the committee during the public

meetings on the EA Guidelines. The Agency sincerely appreciates the time and effort of the SAB

as a whole and of the individual members of the EEAC.

Sincerely,

/s/

W. Michael McCabe

Deputy Administrator

Enclosure

cc: Assistant Administrators

Associate Administrators

Regional Administrators

Regulatory Policy Council

Science Advisory Board

bcc: Economic Consistency Workgroup members
Enclosure to the Deputy Administrator’s Response to

SAB Report on the EPA Guidelines for Preparing Economic Analyses: A Review by the

Environmental Economics Committee

On the subject of discounting, the Agency appreciates the recommendation that, to reflect

common practice, the EA Guidelines should encourage the use of a discount rate between

the range specified in the review draft of the document. Chapter Six, Section 6.3.1 in the

final EA Guidelines includes a recommendation for analysts to employ such a rate in

addition to the other rates specified, if it is believed the additional information would be

useful to decision makers. One reason analysts may include such a rate is because its use

is routinely practiced for the specific type of analysis being performed. An example would

be the recent analyses prepared by the Agency on the benefits and costs of the Clean Air

Act and its 1990 Amendments. Other economic analyses have found it sufficient for

decision making purposes to rely on presentations

of economic information using the range alone. The Agency views both presentations to

be supported by the EA Guidelines and in accord with the position taken on discounting by

the SAB in the report.

Estimating the value of reductions in fatality risks remains one of the more difficult aspects

of benefit-cost analysis, and the Agency appreciates the attention given this issue in the

SAB report. Since receiving the SAB report on the draft EA Guidelines, the Agency has

received additional SAB recommendations on the subject of valuing reductions in fatal

cancer risks (SAB report EPA-SAB-EEAC-00-013, dated July 27, 2000). As noted in

Chapter Seven, Section 7.6.1 of the final document, the Agency will release a supplement

to the EA Guidelines on this topic once it has more thoroughly considered the July 27 SAB

report on valuing fatal cancer risks.

The Agency agrees with the SAB that the limitations associated with the concepts and

empirical studies available to use in quantifying a value of a statistical life (VSL) should be

described in detail whenever VSL estimates are introduced in a benefit-cost analysis. The

final EA Guidelines specifically require analysts to carefully present these limitations in

their analyses. The document also advises analysts to fully characterize the nature of the

risk and the populations affected as they relate to the choice of available literature used in a

benefits analysis, as well as the presentation of uncertainties associated with such

estimates. Some important considerations noted by the SAB report have resulted in an

expanded discussion in the document, including recognition of how demographic

characteristics (e.g., age) of the population at risk compare with those same characteristics

of the population studied in the underlying economic literature used to derive benefit

values. The final EA Guidelines continues to make reference to the numeric VSL range

found to be reasonable by the SAB, and the Agency agrees with the SAB on the merits of

improving and refining measures of this benefit category through reasoned use of the

existing relevant literature. Analysts are further encouraged to consider quantitative

sensitivity analyses as data allow, recognizing that the need for such analyses and the

ability to perform them may vary with each benefit transfer exercise. The SAB report also
notes that measures of cost-effectiveness may be employed as a sensitivity analysis, which

is now included in the final document.

The SAB report raises several issues related to valuation for morbidity and

ecological effects. The Agency agrees with the SAB that the benefits of a policy should be

neither understated nor exaggerated, and has revised the EA Guidelines to inform analysts

of these hazards and to encourage explicit consideration of uncertainty. Benefits will

always be uncertain to some extent and the Agency agrees that expected values should be

emphasized, as noted in Chapter Five, Section 5.5 in the expanded discussion of

uncertainty.

The final EA Guidelines also contains a revised discussion of averting expenditures

as a measure of benefits. This discussion recognizes that averting behavior is not always a

lower bound on an ex ante economic value for health improvements because of the

presence of private and collective risk reduction strategies. The reference on this subject

suggested by the Committee is now included in Chapter Seven, Section 7.5.1 in the final

EA Guidelines.

The Agency agrees with the SAB that computable general equilibrium (CGE)

analysis is growing in use as an analytical tool. The Agency is committed to an ongoing

review of tools that broaden the applicability of CGE models and is enthusiastic about their

implications for benefit-cost analysis. The discussion of CGE models in the Chapter

Eight, Section 8.4.5 of the final EA Guidelines has been expanded to include “tax

interaction” effects as recommended in the SAB report.

The SAB notes that the document would benefit from a more detailed discussion of

the role of altruism in benefit-cost analysis. The Agency agrees with the SAB and has

expanded the discussion of altruism in Chapter Seven in order to clarify when altruistic

benefits may and may not be included in a benefit-cost analysis. The expanded discussion

is found in Chapter Seven, Section 7.2.1 of the final EA Guidelines and draws, in part,

from the language in the SAB report.
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