Cost calculation methods

This paragraph contains information on cost calculation methods. The application of (economic) Evaluation methods is an essential part of any Decision Support System. Weighing the costs and benefits makes the decision making process about the advantages and disadvantages of possible measures more explicit and transparent.

1. What are exactly these costs and benefits and how can they be measured?
An extensive body of literature and guidelines has been developed in the last decades order to carry out an evaluation and to conduct (Societal) Cost-Benefit Analysis, also in the field of environmental issues, water- and sediment policy (references). As this paragraph is meant to help water management we will not go into much of the details of this literature and rather adopt a more simple and straightforward approach. It will however be useful to bear in mind that:

• no simple answers may be given to complicated questions; in this case it may be worthwhile to be assisted by experienced economists with considerable knowledge in this field and/or
• to look for experiences and literature elsewhere and to check to which extent these can be applicable (NB: cases).

One also has to bear in mind that economic analysis has to be performed anyhow as consequence of the legislation concerning the water framework directive. For example: when evaluating the different options for source control of priority substances one has to take into account all the information that will /has been gathered when compiling the river basin management plan, including the (socio-) economic analysis that may have been (or has to be) conducted.
In most instances this will imply that the evaluation of different options to control-, and ultimately phase out priority substances must not be carried out in “splendid isolation" but are part of the “larger system": the river basin management plans and the water framework directive.

2. Costs
The measures that may be taken in order to control the release of priority substances into the water may consist of technical measures, such as using filters and other end of pipe solutions and/or more integrated management options, such as rearranging the production process (e.g. by substitution of the priority substance). More complex options may include dredging and to stop the production and/or use of the substances. Regardless of the complexity of the measure two basic cost categories always have to be taken into account for deriving the total costs of the option:

• Fixed costs: usually capital investment costs (how much, how long will these last)
• Variable costs: costs that depend on the throughput (e.g. costs of substitution of one agent by another in the production process, extra man power, electricity, other resources).

In order to make the fixed- and variable costs comparable and to put these under one denominator either (a) the fixed costs have to be put in annual terms or (b) the net present value of variable costs has to be calculated. For option (a) the depreciation time of the capital investment is needed. For option (b) — which is used more often — a discount rate has to be applied to calculate the present value of future expenditures. In North- Western Europe (e.g. the Netherlands) a discount rate of 4 % is in vigor.
Example: using a discount rate of 4 % on a sum of 100 Euros means that the value after one year (in year 2) has fallen to 96 Euros. The same 100 Euros will be worth 70 Euros in year 10. Summing up annual expenditures of 100 Euros during 10 years, by using a discount rate of 4%, a total present value of 840 Euros results.
Suppose that there are 3 options for a factory with a throughput of 100 Units and a discount rate of 4 %

• Capital costs : 1000 Euros, (linear) depreciation time: 10 years, rest value: none Variable costs: 10 cent per Unit
• Capital costs: 200 Euros, depreciation time 10 years , rest value: none Variable costs: 80 cent per unit
• Capital costs: 500 Euros , depreciation time 10 years, rest value none Variable costs : 40 cent per unit

Present Value option:
1000 + 84 = 1084 Euros
200 + 674 = 875 Euros
500 + 337 = 837 Euros

According to both calculation methods option 3 has the lowest costs.
Of course it should be borne in mind that possibly more than one source of priority substances is at stake, so total costs will equal the sum of all sources in the river basin.
A second remark regards the possibility that the measures taken will have a larger effect within the firm or the measure taking actor group than reducing the release of priority substances. This may be the case if, for example, the measures not only have an effect on priority substances but also on other substances, product quality, energy efficiency etc. In such cases an analysis will have to be made of such effects that have to be taken into account. Depending on the amplitude and the nature of these effects they have to be put in monetary terms and added / subtracted to the costs of measures. If for example option 2 also induces the use of energy by 20 Euros / year, the total annual costs of option 2 would be 80 Euros and the present value 704 Euros. Option 2 would gain over options 1 and 3. So when talking about costs we´d look at all NET costs for and within the firms /actors that implements the measures.

3. Benefits
Of course the first benefit is the reduction of the release of priority substances.
If the decision making process is limited to this benefit it suffices to choose the waste reduction options on the basis of the lowest costs to obtain the desired reduction (in the case of priority substances: a complete phase out by the year 2020).
It gets more complicated if the benefits are to be measured in terms of reduction of concentrations. In this case an analysis has to be carried out in the preceding steps of the DSS to investigate the relation between the reduction of the release of priority substances and the concentrations. Nevertheless a Cost Effectiveness Analysis (CEA) is the evaluation method to be used in order to select the (packages of) measures with the highest reduction at the lowest costs.

If other effects besides the costs of compliance and/or the reduction of priority substances are relevant, they should be taken into account as well in the decision making process.
The first step then to be taken is making an inventory of these effects in a so called effect matrix in which for each of the alternatives (packages of measures) these effects are depicted.
In Table 6five different options to reduce the priority substances are mentioned. Selecting on basis of the lowest costs criterion option nr 1 would be the most favorite one. Obviously, this option is most attractive for the actors that have to pay for the costs. Selecting on basis of the lowest risk (highest reduction of PS) option nr 5 would be chosen. This option is often the most popular for policy makers that do not have to pay for the costs but who see the highest reduction as their policy yield.

However if one were to select on the basis of direct cost effectiveness option 2 would be chosen. According to the direct Cost Benefit ratio, option nr 2 has the lowest ratio (1.14) and therefore ranks nr one. Option 5 has the highest ratio (1.50) and ranks fifth and last.
However: most of the options, all except option nr 1, have other effects than the costs of compliance and the reduction % of PS. If these other effects are to be taken into consideration the ranking of the options may change.

We see in Table 1 that option nr 2 has a negative side effect: use of the substitute causes pollution, not by PS but, for example, by CO2. An analysis has to be made in order to quantify the amount of extra CO2 that will be emitted. Next a “price tag" may be put on this amount to put this negative effect in monetary terms thus make it comparable with the initial costs of substitution.
In the example this can be done in two different ways:

• In order to avoid the extra emissions of CO2 measures have to be taken (e.g. by capturing CO2 in the factories or by using another technology): the (shadow) costs there of are (for instance) 75 which should be added to the 800, bringing the total to 875.
• It may prove to be cheaper to buy trade able CO2 emission rights for, say 50. In this case a market exists and total costs are 850. Assuming that the factories at hand are rational actors and that the market for CO2 permits reflects the scarcity of CO2 free air, the factory will chose to buy the emission rights. However the Cost Benefit ratio of option nr 2 has risen to 1.21, which makes it less attractive than option nr one which has a ratio of 1.19.

• Extra tourists will spend money in the market: the direct effects of the (extra) expenditures e.g. in hotels, restaurants will lead to a rise in the added value which will be generated in these sectors. The added value (and not the turn over!) is to be considered as a direct economic welfare effect.
• Indirect economic welfare effects will be generated in the economic sectors that deliver goods and services to the tourism industry (e.g. bakeries, beer producers etc.) In their turn these sectors are also supplied by again other sectors (e.g. agriculture). Economists call these indirect economic effects “multiplier effects"
• Besides the (a) direct- and (b) indirect economic effects that are generated through the market system another type of welfare effects exists that has no real market price. Tourist enjoyment of the (“new" or regained) recreation possibilities in the river basin has a higher value than their expenditures. This extra value over the price they pay for is called consumer surplus. If one decides to take these effects into account and to put a monetary value on the consumer surplus a difficulty arises as no “real" market exists and nobody cashes this value. Hence economists have developed a number of methods to calculate the consumer surplus in monetary terms. Two of the most well known methods are: 1. The “travel cost method": an analysis is made of the travel costs that the tourists make in order to travel and stay in the recreation area. On the basis of this analysis a so called “demand curve" is constructed that depicts the relation between the demand (the number of tourists) and the travel costs. Obviously, demand decreases with rising travel costs vice versa. Tourists paying the highest travel costs have no consumer surplus. But the tourists who pay less than these highest costs do enjoy consumer surplus, which can be quantified in monetary terms on basis of the demand curve. The curve can only be constructed on basis of an ex post analysis of touristic statistical data that depict the revealed preferences. This makes the method less suitable for an ex ante valuation for “new" touristic areas (unless empirical data for other “comparable" areas can be used). For this reason so called “stated preferences" methods are developed, such as: 2. The “contingent valuation method". Basically this methods entails asking people what they would be willing to pay for a good or service that has no real market price (such as a walk on a beach or angling). This method, which is also called the “willingness to pay method", is widely used in environmental economics and the water frame work directive. It should however be noted that the values obtained through this method may be somewhat questionable as there may be a large difference between statements and actual behavior of people. Furthermore it must be stressed that the “willingness to pay" only reflects a modest part in the total value of improvements of the water quality. A good ecological status of the Rhine may for example be reflected in the return of the Salmon. But it would be a very large under estimation of the total benefits of the good ecological status by asking anglers how much they would be willing to pay for catching one and to put this as a proxy of the good ecological status.

Let´s suppose that the direct effects of recreation, mentioned under (a) have a value of 50 and that the multiplier for indirect effects is 2, so that the multiplier effects also are 50.
The consumer surplus is, for example, 30. Total beneficial effects of tourism / recreation equal 130. In a societal evaluation these effects have to be taken into account, although the benefits are enjoyed by other actors than the parties that have to bear the costs. In a Societal Cost Benefit Analysis the total initial costs of option 3 are 900. Benefits equal a 75 % reduction of PS plus 130 recreational value. For the sake of simplicity we will subtract the 130 of the initial costs of dredging so we can make an easier comparison of the different options. The 770 (net) costs will then generate a 75% of PS and the Cost Benefit ratio, which was originally 1.20 is lowered to 1.03.

Option 4 also features improved recreational possibilities for tourists, as in option nr 3.
Moreover: the strong reduction of PS by 90% leads to better harvests, for instance of wood and to a rise in value of the houses built on the riverbanks.
The economic effects on agriculture, in this case wood production, can be easily measured, provided that it is known how much extra wood can be harvested. The added value of the extra production can be calculated through the market system, using the market prices for wood, subtracted by the marginal costs of the extra wood production.
The rise in house prices creates an extra value for the house owners. This value can be calculated by using estimates (house brokers / owners can be a valuable source of information), and/or by the “hedonic price method". With the latter method (which was applied in the analysis of the third London airport and other regional economic studies), the actual changes in house value is analyzed by using statistics on the subject. The estimation method bears resemblance with the “stated preferences methods" mentioned earlier when discussing the economic effects of recreation/tourism. The Hedonic price method falls into the category of “Revealed preferences".
In option 4 the production of PS related goods is abandoned. If there are no viable alternatives for these goods, the indirect (multiplier) effects can be very substantial and this option will possibly not even be taken into consideration in the short to medium term. The amplitude of these negative effects depends very much on the function of the good (e.g. intermediary or final good), the availability of alternatives (also the possibilities for importing) and the time horizon needed for the possible transition and technological innovation.

Suppose that the effects of option 4 are:

• recreation/ tourism: + 130 (as in option 3)
• wood production: + 100
• house value: + 150
• multiplier effects: - 600

Option nr 5 assumes that all use of PS will be abandoned: a complete shut down of all factories using - or producing PS with no possibility of substitution or importation.
This option is more drastic than option 4, but bears similarities in the fields of recreation /tourism, wood production, rise in house values and multiplier effects. Possibly these effects will be larger in option 5 than in option 4, but in this example we will assume that the effects in these fields will be the same.
For illustrating purposes we assume that option 5 will generate 2 other different effects that were not present in the other options:
Better Health: assume that (x) less people get sick and (y) less people a year die. Health effects are particular difficult to put monetary values on. Usually in a Societal Cost Benefit Analysis the effects are only partially put in financial terms, if at all. Provided it is possible to estimate the reduction of the number of people getting sick or the number of deaths, it may be possible to estimate the reduction in the costs of medical treatment, burial costs, loss of labor hours etc. Let´s assume that these effects are valued at 200. However, this value does not include human suffering, pain etc. Again, there are methods that also quantify these effects, mostly using the “willingness to pay" concept, but there is a substantial debate on the outcomes, also from an ethical point of view. In this example we will not try to quantify these effects, but not forget that these should be noted.
Avoided costs of collective water purification: as the reduction of PS in this example is supposed to be 100 % it may be possible that it is no longer necessary to purify the water for these substances in collective treatment plants. This will possibly lead to a cost reduction of, say 50.
Additional effects of option 5 are:

• recreation/ tourism: + 130 (as in option 3 and 4)
• wood production: + 100 (as in option 4)
• house value: + 150 (as in option 4)
• multiplier effects: - 600 (as in option 4)
• health effects: + 200 avoided costs (+ x reduction in sickness and y reduction in deaths)
• Avoided costs of collective water sanitation: + 50
• Original costs: 1500, which are lowered to 1470, bringing the Cost Benefit ratio to 1.47 (excluding x reduction in sickness and y reduction in deaths)