Irreversibility + Non-Substitutability = CBA adé?

The cost-benefit analysis (CBA) is one of the most important and, for that matter, most useful tools for economic analysis. It is especially widely used to calculate the net value of investment projects. But it can be applied in other areas as well: in the analysis of tax schemes, when infrastructure projects are planned – or in the area of environmental economics. Since the latter is the main subject of this blog, I would like to shed light on an issue related (and, indeed, crucial) to the application of the cost-benefit analysis when functions and services of the environment are to be dealt with: the combination of irreversibility and non-substitutability.

Environmental economists have found it useful to apply the cost-benefit analysis when analysing the interactions between human activity and the natural environment. The “starting point” of this is the assumption that there is a particular level of our use of the nature that is optimal (optimality is, along with maximization, the most important word in the modern economist’s vocabulary). What follows is that the use of nature’s “services” (from pollination, through the delivery of geo-resources, to the climate) has, on the one hand, benefits (otherwise we wouldn’t use them) but, on the other hand, costs. Both are assumed to be comparable with each other. By virtue of such cost-benefit comparisons it can be decided which level of man’s interference with ecosystems delivers the highest net benefit.

A typical example of CBA in environmental economics is given by the so-called integrated assessment models in the economics of climate change. They are used to define how much we shall invest in climate protection to reap the highest possible benefits (now and in the future).

Many problematic issues arise from this approach. I already once gave an overview and wrote more extensively on the issue of discounting the future. Today I would like to draw your attention to the consequence of the combination of two issues: irreversibility and non-substitutability.

It has been emphasized repeatedly that many environmental processes (indeed, most of them) are irreversible. They cannot be made “undone” – at least not when time scales are considered men can deal with. When we run out of oil, then we have it no more, definitely. When we “run out” of a stable climatic system, we cannot get it back. When a species gets extinct, it is lost forever. When we burn down a forest, it never will be the same, even if it regenerates. In some cases, as in the latter, this may not be a catastrophe – whether it is heavily depends on scale. Considering our current dependence on oil and our general dependence on a stable climate, losing them would clearly be a catastrophe. This is what is meant by “irreversibility” – an issue that is not really controversial, but, nevertheless, often ignored.

Non-substitutability (of ecosystem services), on the other hand, is a controversy. Mainstream economics “assumes it away” by design of its production functions. It does so by implicitly claiming that natural resources and other ecosystem services can be substituted by “capital”. Abstracting here from the fact that physical capital must be produced in the first place (using natural resources) and that we clearly cannot live out of “immaterial capital” (such as knowledge), it is important to reasonate whether much can be produced without (or with ever less) inputs from nature. I already mentioned oil. Then there is wood, metals, minerals… To some extent they can be substituted among each other (e.g., coal for oil) – but this extent is very limited, indeed, and unsure. Furthermore, there are ecosystem services that are not direct inputs in production processes – the (stable) climate, for instance, or drinkable water. These are clearly non-substitutable. Indeed, I would argue, most relevant ecosystem services either are non-substitutable, or it is deeply uncertain whether they are replacable – what, reasonably taken, is the same.

Thus seen, irreversibility and non-substitutability are inherent characteristics of ecosystems. Given this – does cost-benefit analysis (CBA) in environmental economics make much sense? The answer is: It does not. The cost of losing something that is essential for our existence, irreversibly and without much possibility for replacement, is tending towards infinity. Thus, the benefit of protecting it is per definitionem overrunning any costs (unless they themselves are infinite).

What does follow for environmental economics? The application of CBA is only very limitedly reasonable (when we are dealing with the few exceptions from the irreversible-and-non-substitutable rule, or with only very minor changes in the ecosystem under consideration). It certainly is not reasonable when the object of enquiry is as complex and important as, e.g., the climate.

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