Wednesday, April 27, 2005

Economist.com | Environmental economics

Economist.com | Environmental economics
As Matt S. points out: "IRR and NPV pop up in the strangest of places." Actually not strange at all! Just in areas where the average non-finance person would not expect them.

Short version: NPV and IRR can (and should) be used to evaluate environmental decisions as well. the problem however is that these costs and especially benefits are often difficult to quantify.

Slightly longer version:
The World Bank (at least since 1991) has used NPV and IRR to study the environmental impact of its decisions. While finding the true cost and benefit of environmental questions is notoriously difficult, it is something that must be done.

From "A Review of the Valuation of Environmental Costs and Benefits in World Bank Projects" by Silva and Pagiola. (Take a look at the boxes for nice summaries!)
"If a project activity causes environmental damage, that damage needs to be included in the economic analysis of the project together with the activity’s benefits and any other damages. To do otherwise would be to make the activity appear artificially more attractive than it is. Likewise, if additional costs are incurred to avoid such damage, those costs need to be included in the project costs considered in the economic analysis."
From the Economist article:
"The turning point for this way of looking at things was in 1997. In that year, the city government of New York realised that changing agricultural practices meant it would need to act to preserve the quality of the city's drinking water. One way to have done this would have been to install new water-filtration plants, but that would have cost $4 billion-6 billion up front, together with annual running costs of $250m. Instead, the government is paying to preserve the rural nature of the Catskill Mountains from which New York gets most of its water. It is spending $250m on buying land to prevent development, and paying farmers $100m a year to minimise water pollution."
Actually I am including this in the blog not because it is new per se, but because
  1. it is so interesting and thought provoking
  2. it could be used to motivate those who are less inclined towards finance to see the importance of NPV and IRR calculations--indeed I plan on using it in my Finance 301 class in the fall!
  3. if all of the environmental costs and benefits were included, the world would be a better place.

Thanks for the heads up on this one Matt! (BTW Matt is a former JMU student who is about to take off on a several month around the world adventure!)

2 comments:

j david said...

Thanks for sharing this Jim. I'm interested to hear what your class makes of this issue.

What will it take to get the next generation of tools introduced? The World Bank analyses seem to be begging for real and financial options approaches. Do you plan to cover these with your students?

j david said...
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