Cost-Benefit Analysis of Environmental Policy in ... · on cost-benefit analysis, discussing its adoption and uses in the developed world as well as special advantages that cost-benefit

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Estudios Públicos, 117 (summer 2010).IssN 0716-1115 (print) IssN 0718-3089 (electronic).

Cost-Benefit AnAlysis of environmentAl PoliCy in DeveloPing

Countries*

michael A. livermore

Abstract: the use of cost-benefit analysis as an aid to environmental decision-making has expanded in recent years as many countries at earlier stages of development—which are now beginning to take up environmental regulation—have become interested in how it can inform their decisions. this paper proceeds as follows. Part I provides brief background on cost-benefit analysis, discussing its adoption and uses in the developed world as well as special advantages that cost-benefit analysis may have for developing countries. Part II discusses practical challenges that many developing countries will face as they attempt to make cost-benefit analysis more pervasive in government decision-making. Part III discusses the special importance of distributional analysis for developing countries. Part IV discusses potential reforms that may help cost-benefit analysis better accommodate the needs and priorities of developing countries.Keywords: cost-benefit analysis; environmental regulation, developing countries.

Michael a. liverMore. Executive Director, Institute for Policy Integrity, New York University School of Law.

* this paper expands on a presentation given at Centro de Estudios Públicos (CEP) in Santiago, Chile on June 17, 2009. Many thanks for the participants in the CEP workshop for their comments and feedback. thanks also to David Mehretu, Gonzalo Moyano, and Richard L. Revesz for helpful comments.

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2 Estudios Públicos, 117 (summer 2010).

introduction

While in time, high levels of domestic environmental regulation will become pervasive, as things stand, some countries are further along than others. the key environmental statutes in the united States have been on the books for nearly forty years, while in some least developed countries, even the most serious environmental risks are unregulated. However, in all of the myriad conceptions of the good, there is a nearly universal desire to reduce risks to health and safety, to breathe clean air and drink clean water. As nations continue economic progress, there is ample evidence of a trend towards greater control of the negative impacts of industrial development, to ensure that economic growth does not come at the cost of an unlivable environment.

The decision to control environmental pollution is only the first step in a very long process of facing uncertainty and making trade-offs between environmental, public health, and economic risks. One of the primary tools that countries with advanced regulatory systems use to inform their decision-making is “cost-benefit analysis,” a technique that gathers as much relevant information about a regulatory decision as possible to identify the regulatory alternative that delivers the greatest net benefits, all things considered. While cost-benefit analysis is far from a complete science, it has grown exponentially in recent decades, as the need for a systematic tool to incorporate the many factors that affect regulatory decisions into a single understandable model has become clear.

The use of cost-benefit analysis as an aid to environmental decision-making has expanded in recent years as many countries at earlier stages of development —which are now beginning to take up environmental regulation— have become interested in how it can inform their decisions. However, while cost-benefit analysis began in developed countries and has grown to be an extremely useful tool for them, it will need to see important reforms to be of equal use for developing countries. there are both practical challenges that must be overcome, as well as more fundamental changes that should be made to address the needs of developing countries. On the practical side, countries must overcome political hurtles—such as the need to simultaneously build support for cost-benefit analysis while creating regulatory systems from the ground up—as well as the capacity

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A. LIvERMORE / Cost-Benefit Analysis of Environmental Policy in Developing Countries 3

problem of developing the analytic resources needed to conduct assessments of complex environmental policy. More fundamentally, the distributional affects of regulation must be a central aspect of regulatory impact analysis in the development context —both with respect to equity today and to ensure that future generations are not wrongfully shortchanged. Further changes to cost-benefit analysis, including attempts to incorporate insights from development economics, may also be warranted.

this paper proceeds as follows. Part I provides brief background on cost-benefit analysis, discussing its adoption and uses in the developed world as well as special advantages that cost-benefit analysis may have for developing countries. Part II discusses practical challenges that many developing countries will face as they attempt to make cost-benefit analysis more pervasive in government decision-making. Part III discusses the special importance of distributional analysis for developing countries. Part IV discusses potential reforms that may help cost-benefit analysis better accommodate the needs and priorities of developing countries.

i. Background: existing systems and special Potential

Cost-benefit analysis has become a widely practiced tool for improving government decision-making throughout the developed world, but it also holds special potential in the developing context to add quality, transparency, and efficiency to environmental, public health, and safety regulation. While there are clear and important differences between regulating in developed and developing economies, many of the dissimilarities provide additional justification for cost-benefit analysis for developing countries.

A. Cost-benefit analysis in developed economies

Cost-benefit analysis of environmental policy has become standard practice in most developed countries. the purpose of cost-benefit analysis, in the words of Cass Sunstein (the head of the office charged with overseeing cost-benefit analysis within federal agencies in the United States) is to institutionalize the practice of “look before you

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leap” for environmental, public health, and safety policy.1 Cost-benefit analysis estimates the negative and positive consequences of policies and then compares them along a common metric to identify the net effects of regulation. According to the standard formulation of the cost-benefit criteria, the purpose of regulation is to maximize net benefits at the margin—i.e. to adopt regulation up to the point where marginal benefit equal marginal costs.2

The United States has placed cost-benefit analysis at the core of its regulatory system. In 1981, then-President Ronald Reagan signed Executive Order 12,291 which directed all executive agencies to conduct cost-benefit analysis prior to adopting new regulations. The order also gave authority to the Office of Information and Regulatory Affairs (OIRA) within the Office of Management and Budget (OMB) in the White House to review all proposed regulations to ensure that they complied with the requirements of the Executive Order. Only those rules that pass a cost-benefit test would be allowed through OIRA review, with the exception of cases where analysis of costs and benefits of agency action was prohibited by law. However, this exemption is quite limited; while there are some important cases where statutes explicitly prohibit the use of cost-benefit analysis, for the most part, courts have protected agencies ability to use cost-benefit analysis to structure regulatory decisionmaking.3

President Reagan’s move drew significant criticism, especially from interests that tend to promote regulation, like environmental organizations, consumer groups, and labor unions. However, while there was debate over the new centralization of authority over federal agencies, and especially the use of cost-benefit analysis to evaluate environmental and public health policy, the practice of OIRA review and cost-benefit analysis continued throughout the Reagan era. This practice continued through the four-year presidency of George H.W.

1 Public hearing to consider the nomination of Cass R. Sunstein to be Administrator, Office of Information and Regulatory Affairs, Office of Management and Budget (videocast in 42:11). see http://hsgac.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&Hearing_Id=bd4574c9-9ca1-4f5c-9f0e-3618ee203a20.

2 this formulation follows from the assumption of marginal increasing costs and marginal decreasing benefits—the point where marginal costs equal marginal benefits is the optimal regulatory level that maximizes net benefits.

3 See e.g., Entergy Corporation v. Riverkeeper, Inc., 129 S.Ct. 1498 (2008) (finding that EPA may undertake cost-benefit analysis when applying technology based standards under the Clean Water Act).

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Bush. Importantly, when Congress attempted to defund OIRA and refused to confirm President George H.W. Bush’s appointment to head OIRA, regulatory oversight simply moved to a less formal office, the Council on Competitiveness, chaired by vice-President Dan Quayle.4

President William Jefferson Clinton continued the practice of regulatory review and cost-benefit analysis of environmental and public health policy during his term. After taking office, he issued Executive Order 12,866 that updated the Reagan Executive Order in several important ways, but retained the fundamental architecture of central review using cost-benefit analysis. The federal government has operated under Executive Order 12,866 since that time, with only a few modifications by President George W. Bush near the end of his term that were rescinded by President Barack Obama when he took office.

the European union (Eu) has also found an important place for a version of cost-benefit analysis within its regulatory process.5 the expanded authority of European level regulatory institutions has given greater power to regulatory bodies within the European Union, creating a need to cabin the discretion of these bodies and ground their decisions in some transparent and generally accepted criteria. the most clear manifestation of the growth of cost-benefit analysis in the EU is the Better Regulation initiative which the European Commission has been in the process of implementing since 2002. the Commission has stated the purpose of the initiative as

to ensure that the regulatory framework helps to stimulate entrepreneurship and innovation, allows businesses to compete more effectively and to exploit fully the potential of the internal market. In doing so, the Better Regulation agenda contributes to growth and job creation while maintaining high standards of social, environmental, health and consumer protection.6

4 see the article from Bob Woodward and David Broder: “Quayle’s Quest: Curb Rules, Leave ‘No Fingerprints’”, Wash. Post (Jan. 9, 1992) at A1. See also the article from Susan Reed, “Enemies of the Earth”, People Magazine (Apr. 1992) (reporting that environmental groups saw the Council “a backdoor through which industry has entered to water down regulations it finds too costly”); De Witt (1993).

5 Wiener (2006).6 see Communication From the Commission to the European Economic

and Social Committee and the Committee of the Regions, Third Strategic Review of Better Regulation in the European Union, at 2, COM (2009) 15 Final (Jan. 28, 2009) [hereinafter Communication for the Commission].

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A key component of the Better Regulation program is a requirement of regulatory impact analysis for all Commission “initiatives which are likely to have a significant impact.”7 the purpose of the “impact assessments” is to “analyze both benefits and costs, and address in a balanced way all the significant economic, social and environmental impacts of a possible initiatives.”8 these impact assessments for Commission actions—including both legislative and regulatory proposals—is a clear move to place a version of cost-benefit analysis at the very heart of regulatory decision-making at the European level.

the Commission has also taken several important steps to formalize and standardize impact assessments. In 2005, the Commission issue “Impact Assessment Guidelines”—a lengthy technical document to be used to structure the process of impact assessment, both at the EU level and also as a guide to domestic policymakers. The guidelines have been updated several times, and after a lengthy public review process, new guidelines were issued in January 2009.9 The guidelines direct analysts to “[i]dentify (direct and indirect) economic, social and environmental impacts [of proposed initiatives] and how they occur (causality).”10 Furthermore, the guidelines state that, after impacts are identified, they should be assessed “against the baseline in qualitative, quantitative and monetary terms.”11 The guidelines go on to recommend that, “[i]f quantification is not possible, explain why.”12

Equally importantly for the development of cost-benefit analysis in the European system, the Commission has “put in place a demanding, central quality control function in the form of the Impact Assessment Board (IAB) which is independent of the policy making departments.”13 The IAB is charged with reviewing all of the impact assessments of the Commission. In a January 2009 communication from the Commission to the other EU political branches, the

7 Id. at 6.8 Id.9 European Commission, Impact Assessment Guidelines No. 92/2009 of

15 January 2009.10 see id.11 id. at 6.12 Id.13 Communication From the Commission, supra note 6, at 6.

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Commission reported that the IAB “has improved policy quality by requesting resubmissions of impact assessments in 32% of cases in 2008.”14 The IAB has also placed “increasing emphasis on the need to quantify impacts more systematically.”15

There are several justification for the use of cost-benefit analysis, chief among these is that it helps to structure the exercise of agency discretion. In the United States, environmental, public health, and safety laws grant administrative agencies—which are under the control of the President—wide discretion for carrying out their statutory duties. some of these statutes give agencies extraordinary ambit for their authority, and relatively little guidance. For example, the Occupational Health and Safety Act of 1970 provides for workplace standards “reasonably necessary or appropriate to provide safe or healthful employment or places of employment.”16 For clear reasons, this language gives the secretary vast discretion to set a regulatory agenda and adopt—or refuse to adopt—a large field of potential rules. Other statutes give agencies more direction. For example, many of the core environmental statutes that are administered by the Environmental Protection Agency stipulate in great detail how the agency should go about regulating—creating both mandatory duties for the agency as well as clear requirements. Where the agency fails to act on a mandatory duty, or runs afoul of a statutory limit, the United states federal courts have shown little hesitancy to step in and correct the agency.17 However, even where Congress has given the agency more complete statutory instructions, there remains a large measure of agency discretion, especially on technical matters where courts are loath to overturn expert agency decisions.18

Because of this vast discretion, both agency and commentators have looked for ways to structure and cabin agency decisionmaking. Without clear guidelines for how agencies should exercise their discretion, agencies are given unchecked power that can be exercised in a nontransparent, inefficient, or even arbitrary fashion. A mechanism

14 id.15 Id.16 see 29 u.s.C. § 652(8).17 see Massachusetts v. EPA, 549 U.S. 497 (2007); Lead Industries

Association v. EPA, 647 F.2d 1130 (1980).18 see Whitman v. American Trucking Associations, 531 U.S. 457

(2001).

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is needed to create a balance between standards of reasonable decisionmaking and the legitimate exercise of the political authority vested in agencies.

A similar concern about discretion and the existence of a “democracy deficit” can be used to justify the use of cost-benefit analysis in European union institutions. Eu institutions exist at the supra-national level, and are therefore somewhat removed from the nation-states that constitute its members—some view this lack of “demos” as undercutting the democratic legitimacy of these institutions.19 In addition, the diffused decisionmaking authority between EU institutions and member states, and the increasingly technocratic focus of Eu-level institutions have also called into question the democratic grounding for the authority of the EU.20 Popular discontent with and lack of interest in the Eu also fuel concerns about the legitimacy of EU-level decisions. Because, at some level then, traditional democratic institutions as the justifying basis for the decisions of EU-bodies are lacking, cost-benefit analysis can potentially serve as an alternative—both procedurally and substantively—to provide legitimacy for the decisions made by Eu institutions.

Cost-benefit analysis, thus, provides a partial solution to problems associated with the separation of decisionmaking authority from institutions with broadly recognized democratic pedigree. However, while the theoretical purpose of cost-benefit analysis is to structure decisionmaking around a criteria of maximize net benefits—whether by strengthening or weakening regulatory proposals—the political context that has given rise to broader use of cost-benefit analysis is often more antiregulatory in nature. As Jonathan Weiner has written:

the us adopted regulatory reform efforts in the 1970s and 1980s in part to combat inflation and recession. Europe

19 see Jolly (2005) (discussing nature and importance of concept of “demos” in context of European integration); Weiler (1995) (arguing that lack of “demos” for European Union does not preclude Union-wide democratic institutions).

20 See generally Grimm (1995) (analyzing calls for European Union constitution); Rabkin (2000) (arguing that the EU has a democratic deficit because their policies are biased in a social democratic direction).

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turned to Better Regulation in the last five years to remedy its sluggish economy, which has been growing at about 2 percent per year of late . . . .21

…It almost goes without saying that one key purpose of regulatory reform is to reduce costs. In the 1980s the US had a Task Force on Regulatory Relief, later called the Competitiveness Council; the EU now has a Competitiveness Council of Commissioners. the UK Better Regulation Executive was earlier called the Regulatory Impact Unit, and before that the Deregulation unit in the 1990s.22

Regulations impose costs on society, typically by requiring private actors to incur compliance expenses. the costs of regulation are less obvious than direct public spending—rather than direct taxes, the average citizen only experiences compliance costs indirectly through higher consumer prices, fewer employment opportunities, and lower return to capital. Because these costs are less obvious, they are not given the same weight as direct government spending.

When public attention focuses on environmental, public health, and safety risks, there is broad support for strong regulatory programs. In an economy where under-regulation is prevalent, environmental and public health risks are obvious and salient—they relate directly to individuals’ daily lives, and can be understood in relatively tangible terms. Government efforts to address these risks can be easily explained, and experience with the downsides of regulation are relatively scarce.

However, when public attention turns to economic concerns—inflation, economic growth, and job creation—then officials typically look for mechanisms to reel-in costs imposed by regulation. some macroeconomic trends are beyond the direct control of government while others are subject to manipulation through measure that impose short-term economic pain, such as decreasing monetary supply. Attempting to effect macroeconomic change—like increasing

21 Weiner, supra note 5, at 455. 22 Id. at 456.

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employment opportunity or reducing inflation—through the relatively pain free method of regulatory reform can look appealing.

Recognizing the political difficulty of simply eliminating popular programs, governments have looked for objective criteria that could be used to justify deregulatory steps, and cost-benefit has proven to be a useful tool. During both the Reagan “regulatory relief” efforts in the United States, and the “better regulation” campaign in Europe, cost-benefit analysis has become an important tool for calibrating regulatory costs. Rather that seeking to undo all progress in the area of environmental, public health, and safety areas in pursuit of lower compliance costs, governments have instead sought a mechanism to balance the need for these programs against the need for economic growth.

B. Advantages to Cost-Benefit Analysis for Developing Countries

While cost-benefit analysis has become quite popular in the United States and Europe, the practice is just beginning to take hold in the developing world. there are a variety of institutional and even conceptual issues that have hampered more widespread adoption, but interest in the subject is beginning to grow as many countries begin to develop more sophisticated environmental, public health, and safety regulation. Many of the same questions that have arisen in the United states and Europe are bound to be raised in many other countries in the near future: How clean is clean enough? What costs are we willing to impose to achieve environmental protection? How can we regulate to achieve maximum results at the lowest costs?

In addition, there are reasons why cost-benefit analysis can provide special advantages in the development context. First, and most obviously, developing countries have less money to waste, and therefore mechanisms to ensure that regulations are delivering benefits that justify their costs are especially important. the economic problems within the united states and Europe that provided the political impetus for adoption of cost-benefit analysis are small compared to the vastly larger economic difficulties faced by many developing countries. For these reasons, there is less social wealth to be spent generally, and on environmental, public health, and safety protections specifically. Given the more limited resources of developing countries, it is doubly

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important that regulations be able to achieve much with as little waste as possible.

By the same token, however, cost-benefit analysis can help justify regulatory expenditures even in cases where governments face tight budget constraints by showing where regulations have net social benefits—where benefits exceed costs. While some developed countries may be willing to adopt regulations that have net costs, in order to achieve other social goals like fairness or to discharge widely felt moral responsibilities (for example, in the context of protections for endangered species), developing countries are less able to afford to adopt net cost measures. But, where there are net benefits to regulation, then, absent some countervailing problem like distributional concerns, the economics justify regulations, and even poor countries should move forward. In cases where benefits exceed costs, rich countries and poor countries are on equal footing—failing to regulate in those circumstances is the costly choice.

second cost-benefit analysis can help improve regulatory systems that lack transparency, or in which special interest politics has become too dominant. Just as there is persistent concern within developed countries that regulatory agencies have been delegated too much power, creating a “democracy deficit” between regulators and the public they are supposed to serve, there are similar questions about the exercise of state authority in many developing countries. Rules on transparency of government action, public participation, access to media, judicial review, and reason-giving are sometimes new, non-existent, or poorly understood and enforced. Independent institutions that have power-checking functions in developed countries—like independent media, scholarly institutions, professional associations, and other civil society actors—are often weak, more subject to state control, or simply lack the necessary information to bring government actors to account. More to the point, democratic institutions can themselves be weak, voters can be ill-informed about the day-to-day goings on government, and there may be ineffective oppositional forces to challenge ruling parties. While these same kinds of problems can also affect developed countries, they are worse in many parts of the developing world.

Cost-benefit analysis improves transparency by making the decision-making process explicit, requiring decision-makers to report

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their data, assumptions, and expectations, and subjecting analysis to outside scrutiny and criticism by experts. While the public is often ill-situated to evaluate cost-benefit analysis performed by government officials, scholars, political commentators, and civil society actors can review and criticize cost-benefit analysis in a way that is simply impossible when decisions are made behind closed doors. In this way, cost-benefit analysis can improve the ability of outside institutions to subject government actions to scrutiny. While cost-benefit analysis clearly cannot solve all of a society’s transparency problems, by forcing government actors to make their choices and the information that they are using to arrive at decisions more explicit, it can serve an extremely important transparency function.

A third important advantage is the ability to identify and shame inefficient programs. Wasteful regulation—rules that stifle innovation or economic growth, but deliver little in terms of environmental protection or public health—are a clear threat to development. However, without a systematic methodology to identify such regulation, they can remain on the books for years, even decades, causing unnecessary economic harm. Cost-benefit analysis can help identify bad rules—hopefully in most cases before they are adopted. Perhaps more importantly, it supplies a neutral language with which to condemn unwise programs. The methodological limits of cost-benefit analysis create constraints on how far it can legitimately be “stretched” to justify wasteful programs that may be supported by political officials. By creating a universal standard applicable to a broad range of programs, cost-benefit analysis can draw attention to those programs that are particularly inefficient or ill-conceived.

For these reasons, inter alia, cost-benefit analysis can provide a useful supplement to decisionmaking procedures throughout the developing world. Just as it has helped developed countries cabin the discretion of executive decision-makers by providing substantive criteria and formal procedures for good decision-making, cost-benefit analysis can substantially improve how decisions are made in developing countries as well. For countries that face special challenges—including the need to boost economic growth and grow stable and well-functioning political institutions—cost-benefit analysis can be an especially useful tool.

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However, while there may be special potential for cost-benefit analysis in developing countries, there are also special challenges as well. The next two sections deal directly with that issue, first addressing technical and political barriers to greater adoption of cost-benefit analysis, and then turning to deeper conceptual issues that arise for cost-benefit analysis in the developing context, and how those issues can potentially be resolved.

ii. Practical Challenges

While cost-benefit analysis is widespread in the developed world, it has not seen wide adoption in developing countries. There are many potential reasons including specific political, economic, and capacity challenges faced by developing countries.

A. Politics

In developed countries, cost-benefit analysis is a well established technique that tends to add positive legitimacy to the decisions of policymakers. Regulatory review, with cost-benefit analysis at its core, has been practiced for nearly three decades in the United States. Economics is accepted within academic and political circles as well as the general population as a legitimate tool of policy analysis. When economics is used to justify policy, it has the effect of increasing support for the policy.

there are some voices in developed economies that do not support the use of economics or cost-benefit analysis to assess policy, but these groups represent a small fraction of the political discourse. In fact, those groups that tend to eschew cost-benefit analysis undercut their ability to effectually promote their policy prescriptions. the most clear example of this is within the regulatory context, where some groups have not participated in forums that make important policy choices.23 the result is an unbalanced process where some interests have greater representation.

23 See the interview with Sally Katzen, former Dep. Dir. for Mgmt., OMB in Wash. D.C. (Feb. 20, 2007) in Revesz and Livermore (2008).

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Even in political processes where cost-benefit analysis does not have a formal institutional role—for example in the legislature and media—economic analysis has broad political cache. Where groups reject cost-benefit analysis, it tends to hurt the causes they support more than it hurts cost-benefit analysis. Where it was possible for opponents of a policy to insinuate that economic analysts does not support the policy, they can use that to great effect.24

Cost-benefit analysis may not enjoy the same level of positive legitimacy in certain developing countries. Part of the legitimacy of cost-benefit analysis and economics generally in developed countries is simply output legitimacy—it is seen as having successfully contributed to a long-term trend of growth and increased consumption. so long as the consequences of economic analysis seem to be generally positive, the public and political class are willing to accept its use, despite whatever misgivings or misunderstandings they may have.

Economic analysis does not have the same track record in developing countries, essentially by definition. In many countries, the field of cost-benefit analysis may be seen as a foreign import that has little applicability to the types of issues presented by development. While there is nothing inherent in cost-benefit analysis that endorses a free-market style approach to regulation, it may be closely linked, at least at a psychological level, with “Washington Consensus”-type policies that have not met with universal approval in the developing world.25 To the extent that cost-benefit analysis is weighed down by association with unpopular policies or approaches, it will enjoy less legitimacy.

In addition, developed countries began widespread adoption of cost-benefit analysis after they had put in place significant regulatory

24 One good example is how opponents to EPA regulation of greenhouse gases argued that OMB opposed the proposed regulations, on the office internal memorandum that stated that there would be serious economic consequences from those proposed rules. However, as unearthed by reporter David Roberts, the statement was never issued by the OMB but was one of the comments that were generated by inter-agency review. see http://www.grist.org/article/2009-05-13-omb-epa-sba-endangerment

25 In particular, there has been widespread public anger over neoliberal policies promoted by international institutions, especially contractory policies promoted through International Monetary Fund structural adjustments. Of course, the term “[‘Washington Consensus’] has been used to mean different things by different people,” not all of them bad. see Williamson (2004).

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systems to address environmental, public health, and safety risk. The initial regulatory agenda was set on the basis of risk perceptions by the public, which provided the political environment needed to create new regulatory agencies with broad power, and justified greater intervention in the marketplace by regulators. Cost-benefit analysis came later, as a tool to add rationality to pre-existing regimes as they continued to exercise their authority.

the political dynamic that led to adoption of cost-benefit analysis in the united states and European union does not exist in developing countries. Both the United States and European Union adopted cost-benefit analysis and regulatory review when their economies faced periods of flagging growth within a long-term trend of increasing prosperity. they had already achieved high levels of development, had undertaken risk regulation on an ambitious scale, and addressed many of the underlying difficulties that continue to plague many developing countries. Cost-benefit analysis in developed countries came about in part because of sentiment that governments needed to trim back on spending on a “luxury” good, i.e. high levels of protection against environmental and public health risks.

the economic problems that provided the political basis for adoption of cost-benefit analysis—including inflation and persistent unemployment—are often present in exacerbated form in developing countries, and they are accompanied by a host of other economic challenges as well. However, developing countries, facing vastly greater economic constraints, have never been in the position to undertake “luxury” spending on environmental protection in the first place. For countries that are at the beginning of a pro-regulatory cycle, the political argument in favor of cost-benefit analysis will have to change. More specifically, if cost-benefit analysis is structured and perceived as a check on regulation, it is may be both politically unpopular, and potentially harmful if it unduly slows down or hampers regulatory systems that are in their beginning stages. Rather, cost-benefit analysis needs to be explicitly conceptualized as a mechanism for agenda-setting—a neutral tool that can help new regulators identify which problems to address first—comparing alternatives, and achieving maximum net benefits by properly calibrating regulations so they are neither unduly strict, nor overly weak. Only if cost-benefit analysis has this proactive role will it avoid retarding the growth of necessary

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regulation and be seen as a productive element of the policymaking process.

Finally, the broad political support enjoyed by cost-benefit analysis is in part simply the result of having been practiced longer in developed countries. Countries that have less experience with the tool will naturally face greater uncertainty about cost-benefit analysis, and in the early years of adoption may face greater opposition based on fears of potential problems. In this respect, the best way that cost-benefit analysis can gain legitimacy is to prove its utility.

B. The Problem of International Comparison

A particular issue that could erode popular support for cost-benefit analysis in developing countries is the problem external inequality. Because risk-preferences tend to track fairly closely with wealth, it can be expected that rich countries will be willing to pay more to reduce environmental, public health, and safety risk than countries in earlier stages of development.26 Cost-benefit analysis would take these preferences into account, and ultimately would justify less strict regulatory levels in developing countries.

From a purely economic standpoint, regional differences in risk-preferences is neither surprising nor troubling. the correlations between wealth and willingness to pay to avoid risks is quite well established.27 In fact, differences in preferences generally provides justification for the diffused systems of government that we see both international and within nations that implement some version of a federalist division of power or “subsidiarity.”28 If the residents of California and Mississippi have different preferences for local environmental protection, the division of authority between states allows those preferences to be

26 Empirical research on willingness-to-pay and risk in developing countries tends to support this intuition. see Soma, et al. (2007) (variations of willingness to pay according to income); Hammitt, and Zhou (2005).

27 see Armantier and treich (2003). 28 see Buchanan (1995). Also, for a rebuttal of the argument that

placing federal environmental regulation is a way to avoid a socially undesirable “race to the bottom”, see Revesz (1992). For a reference in the European context, see Wils (1994). Wouter argues for a broadening of the principle of subsidiarity.

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vindicated in different laws. Within the European Union, countries have maintained significant levels of autonomy over regulatory choices, and the principles of “subsidiarity”—where decisions are allocated to the most local jurisdictional body that can make efficient decisions, has been adopted in the founding documents of the union.29 At the international level, differences in preferences and culture account for huge differences in policy choices, not only with regards to regulation, but also in such far flung areas as civil liability for wrong-doing and health care.

However, the fact of different preferences for risk, especially when those preferences are closely associated with levels of development, creates the problem of “international comparison.” Put most strikingly—and put in the language or morality that is sometimes used to evaluate cost-benefit analysis: “Is an American life worth more than the life of a Chilean life?”

This debate is far from academic. One consequence of differing preferences for risk is that lower levels of environmental protection will be justified in developing countries because they are wiling to spend less to “save a life” than developed countries. The trade-off between economic growth and environmental protection is simply different in countries that have different levels of economic development. to some, this result seems unfair because it disadvantages populations in developing countries through higher degrees of environmental risk. If, as some have argued30 some degree of environmental protection is a human right, then no country can fall below that baseline standard, regardless of risk-preferences or level of economic development.

The flip side of this argument is seen in developed countries, where labor unions and workers complain that lower environmental standards in the developing world amount to an unfair advantage for workers in those countries. Environmental and public health regulations impose cost on capital, creating incentives for industry to move to countries with less stringent regulation. When industry

29 The Treaty of Rome, which was amended by both the Single European Act (1986) and the Maastricht Treaty (1992), establishes that Community policies on the environment shall not prevent any member states from introducing more stringent protective measure. The Maastricht treaty also explicitly adopted the subsidiarity principle.

30 see McCallion and Sharma (2000); Boyle (2007).

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moves, there are consequences for local communities and jobs. Throughout the American “rust-belt” states, including Ohio, Pennsylvania, and Michigan, large industry has shuttered factories and laid-off thousands of workers. Often, highly paid unionized manufacturing employment is replaced by lower paid, non-union service employment, if it is replaced at all. Strict regulations compounds other factors, like high labor costs, to create incentives for firms to locate in less developed countries. Unions and localities harmed by capital flight sometimes blame developing countries for having rules that are “too weak” or bemoan a “race to the bottom” that undercuts environmental progress.31

Another political fraught consequences of international differences in risk-preferences is that, from a purely economic standpoint, risk transfer from developed countries to developing countries can be justified. This reality was discussed by Lawrence Summers, currently a top economic advisor to President Obama, when he was at the World Bank. A 1991 memorandum signed by Summers said, inter alia, that “the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that.”32

the reaction to the summers memo was swift and global. As just one example, shortly after the memo was released publicly, Brazil’s then-Secretary of the Environment Jose Lutzenburger wrote to summers: “your reasoning is perfectly logical but totally insane... your thoughts [provide] a concrete example of the unbelievable alienation, reductionist thinking, social ruthlessness and the arrogant ignorance of many conventional ‘economists’ concerning the nature of the world we live in.”33

The reaction to Summers’s suggestion, however, indicates exactly the kinds of political perils faced by those that wish to expand the use of cost-benefit analysis. Economic analysis can sometimes

31 Whether such a “race to the bottom” exists, or could be considered inefficient from an economic perspective, is another question. Revesz, supra note 23.

32 See Jim vallette, Larry Summers’ War Against the Earth, Counter Punch, http://www.globalpolicy.org/component/content/article/212/45462.html (last visited Sep. 28, 2009).

33 The above quote from Jose Lutzenburger is widely cited on websites opposed to the work of the World Bank and can also be found in Jensen (2004).

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cast public policy choices in a stark and unforgiving light, clarifying tradeoffs between highly value-laden goods like environmental protection and public health. Cost-benefit analysis is likely to highlight the realities of global inequalities of distribution as protections that are justified in some countries will not be justified in others.

the issue of international comparison can invoke strong feelings. But solving this problem will not be easy. There are three potential solutions, all of which have serious drawbacks. The first is to “launder” the preferences of people in developing countries to exclude risk valuations that are “too low.” There are potential justifications for such laundering—risks may be misunderstood; populations could be subject to information processing disadvantages or flawed heuristic mechanisms vis-à-vis comparable populations in rich countries. It is possible that normatively troubling influences on preferences could increase risk-tolerance, such as habituation to involuntary risks associated with poverty, crime, or internal strife. Most controversially would be the claim that preferences developed under conditions of poverty are always coerced, and can therefore be ignored.

The argument against laundering preferences is two-fold. First, if the preferences that serve as the foundation for cost-benefit analysis are manipulated, it is not clear what the results of cost-benefit analysis would show. Typically, a net positive cost-benefit analysis would mean that people would be willing-to-pay more for regulatory benefits than they would be willing-to-pay to avoid the cost imposed by a regulation. If preferences are laundered, then analysts would have to make claims about “true welfare” distinct from welfare as described by preference satisfaction. While there are philosophers that have attempted to create a foundation for cost-benefit analysis on the basis of objective welfare criteria,34 in pluralistic countries where there are many acceptable conceptions of the good, arriving at agreement on the content of such objective criteria is extremely difficult.

Second, laundering preferences creates the real possibility that regulations that “pass” a cost-benefit analysis will nevertheless make people worse off according to their own estimation. For example, if a workplace safety regulation is adopted that imposes marginal costs on each unit of labor, the result is decreased worker productivity, and

34 Adler and Posner (2006).

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therefore reduced wages. If the workers value the safety benefit less than the lost wages, the state has not done them any favors.

Finally, advocates of preference laundering rarely discuss increasing risk tolerance in rich countries. From a purely economic perspective, adjusting preferences upward in developing countries would result in a regressive global transfer of wealth, as some of the comparative advantage of developing countries—willingness to take on greater environmental and public health risk—would be foregone. Given current levels of inequality, wealth transfers from developing countries to rich countries are clearly normatively problematic.

the second option to deal with the problem of international comparison would be to treat international differences in risk preferences the same way that they are generally treated for internal domestic purposes. developed countries do not create differing risk valuations for differing populations—they use an average value for the entire population. the use of an average value avoids troubling fairness problems, and, so long as regulatory costs are not focused toward the lower side of the income distribution, results in mild redistribution downward as poor people receive slightly more protection than they would be willing to pay for, but regulatory costs are mostly carried by wealthier portions of the population.

there are several reasons why an average global value for risk preferences is unlikely to be a successful strategy. On a conceptual level, it would face the problems discussed below in the case of a single developing country. Huge global disparities in wealth, coupled with significant demographic clustering around wealth and income, would be mean that the assumption underlying the use of an average value in the domestic context—that regulatory costs track wealth—would be less likely to hold. This means that in some cases, poor countries would be locked into adopting regulations that result in net costs, because even though an average value was used, that value was based in part on risk-preferences in rich countries, who may not actually be paying for the regulation. Similarly, rich countries would be precluded from adopting some regulations that have net benefits, because the average value is based on risk valuations in poor countries that are subject to neither the costs or the benefits. An average value constraint for internal regulation, then, would result in real welfare losses for the purpose of maintaining a single global risk valuation.

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Even if a compelling case could be made on a conceptual level for a unitary global risk valuation standard, it would be essentially impossible to maintain from a political perspective. It would require the ceding of sovereign power over environmental and public health regulation, something that few countries are likely to voluntarily do. When developing countries were forced to adopt overly strict regulation, or developed countries could not adopt sufficiently strict regulation, local population would grow discontented with such a rule. And, given the very large disparities of wealth at the global scale and the significant amount of clustering of wealthy and poor populations, the average risk value is going to be very far away from the optimal risk valuations for many countries. If only for purely practical reasons, then, it is extremely unlikely that a universal value is likely to be adopted any time in the near future.

the final option to deal with the problem of international comparison is simply to face the potential political backlash that may result from differing risk valuations, and perhaps make some limited concessions in order to avoid the most obviously troubling consequences. There are several potential such compromises. Direct and obvious risk-transfers to developing countries, for example through transportation of hazardous waste, could be avoided. Where rich countries are causing cross-border risk, for example in the climate change context, then policy can be set using the wealthier country’s risk preferences, because that is where costs will be imposed. Wealthier countries that want developed countries to adopt stricter regulation in order to lower differences in comparative advantage for attracting industry can create compensation regimes, at the very least through technology transfer. While none of these compromises is strictly economically efficient, they could avoid a potential backlash that ends up costing even more.

In the end, differences in risk valuation call attention to the tremendous problem of wealth inequality at the global level. If it seems striking to a person in the united states or Europe that a person in a developing country is not willing to pay what may seem to be paltry sums of money to avoid very significant risks, that should shock the conscience and show in striking terms the need for real measures to reduce global poverty. The best solution is not to hide away the problem of inequality by laundering preferences or creating an artificial global average value, but is instead to address the issue of inequality head-on.

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C. Analytic Capacity

Even where there is broad support for cost-benefit analysis, finding the resources to implement it on a widespread basis will pose a challenge. Developed countries have devoted significant resources to conducting cost-benefit analysis. Because it has been practicing cost-benefit analysis on a large scale at the federal level for three decades, the united states has developed the most sophisticated capacity in this area. U.S. administrative agencies have hired significant personnel with expertise in economics, risk-analysis, and related disciplines for the purpose of analyzing policy alternatives. Many agencies have policy offices that are directly charged with developing regulatory agendas. the u.s. Environmental Protection Agencies (EPA) in particular has devoted time, money, and staff to conducting cost-benefit analysis. Among other steps, EPA has created the National Center for Environmental Economics (NCEE) which employs dozens of economists and other professionals in order “conduct[] and supervise[] research and development on economic analytic methods”; “lead[] production of EPA economic reports”; “provide guidance for performing economic analysis”; and prepare its own economic analyses of environmental policy.35 In addition to the NCEE, the EPA has created a standing committee of its Science Advisory Board—the Environmental Economics Advisory Committee (EEAC)—composed of economists and other experts from academia, that provides EPA with guidance on the economic analysis of environmental policy.

the EPA has even developed its own extensive guidelines for conducting economic analysis of proposed environmental regulation.36 the guidelines cover topics ranging from appropriate assumptions concerning willingness-to-pay to avoid risk, discount rates to be used when regulatory benefits accrue in the future, how to best estimate the compliance cost of proposed regulation, identifying appropriate alternative policies, and the scope of secondary consequences that

35 National Center for Environmental Economics, About NCEE, http://yosemite.epa.gov/ee/epa/eed.nsf/webpages/AboutNCEE.html (last visited May 20, 2009)

36 u.s. EnvironMental Protection Agency, Guidelines for Preparing EconoMic Analyses (2000). Available at http://yosemite.epa.gov/ee/epa/eed.nsf/webpages/Guidelines.html/$file/Guidelines.pdf

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must be considered. the guidelines are an extremely well-articulated technical document based on decades of scholarship and research that had been conducted in the field of environmental economics and cost-benefit analysis.

In addition to the capacity within administrative agencies at the federal level, there is also a centralized body, the Office of Information and Regulatory Affairs (OIRA) within the Office of Management and Budget (OMB) that is charged with overseeing the cost-benefit analyzes performed by all agencies. This office has its own complement of several dozen professional staff that has developed significant expertise in the practice of cost-benefit analysis and regulatory review. In nearly three decades of operation, OIRA has developed a deep capacity for regulatory analysis and for improving the methodology and technical sophistication of agency analysis. While that capacity comes at a cost—OIRA may be relatively slow to change or adopt more cutting edge approaches—it represents an extremely important asset that facilitates the widespread use of cost-benefit analysis in the United States.

Beyond direct government spending, there is also a complement of academics that provide a great deal of data and analysis that augments governments efforts.37 The fields of risk analysis, cost-benefit analysis, and environmental and public health economics are well developed across the developed world, with faculty at top institutions of higher education devoted to teaching new professionals and enhancing and expanding the field through scholarship. Within the United States alone, there are several interdisciplinary centers devoted to the cost-benefit analysis and regulatory issues, including the Center for Risk Analysis at Harvard University, Benefit-Cost Analysis Center at the University of Washington, and the Institute for Policy Integrity (IPI) at New York University School of Law.

Another factor that facilitates cost-benefit analysis in developed countries is the significant extant literature that has been developed over the past several decades that forms the basis of much contemporary analysis. Any cost-benefit analysis is going to include a significant number of parameters that link, for example, risk-exposure scenarios with outcomes, and outcomes with preferences, to estimate regulatory

37 See e.g. viscusi (1978); Farrow et al. (2004). Other researches discuss the institutional context of cost-benefit analysis and how it can improve decisionmaking. See e.g., Morgenstern (1997).

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benefits, or that estimate compliance needs and technological development to estimate costs. A great deal of scientific research has been done to estimate the various parameters concerning risk and health-endpoints, for example, that could easily be translated to other countries—the dose response curve for a carcinogen can be expected to hold across national borders (putting aside the problem of exposure to multiple pollutants, which is not something that even the most sophisticated cost-benefit analysis can often take into account). However, a great deal of research has also been done on economic questions, and in particular people’s preferences regarding risk exposure. These studies have taken a variety of forms, from “contingent valuation” studies that solicit preferences by asking survey-respondents about their willingness-to-pay to avoid risk; to labor-market analysis that looks back at data on wages and differential injury risks to statistically infer a “risk premium” that workers demand to take more hazardous jobs.

The cross-social applicability of this research is questionable. As an initial matter, it is well known that risk preferences change with wealth, so that the wealthier a person is, the more he or she is willing to pay to avoid risk. Some estimates exist for parameters to define this relationship,38 although they are controversial.39 However, it is not clear that sound estimates can be made about risk preferences in developed countries merely by discounting willingness-to-pay estimates from rich countries to account for differing levels of wealth—there are likely cultural, social, political, and other factors that may influence risk-preferences as well. use of discounted values from developed countries does not seem well-suited for generating parameters that will always be meaningful in other contexts. to have accurate inputs into their analyzes, it is likely that developing countries will have to conduct a significant amount of original research on at least some of the key economic parameters.

In the developed world, it has made sense to devote resources to regulatory analysis. Even where regulations have relatively small impacts as a percentage of the economy, the overall size of their

38 Robinson and Hammitt (2009) (report prepared for the World Bank). Available at http://regulatory-analysis.com/robinson-hammitt-air-pollution-africa.pdf

39 id. at 19.

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economies means that they have large impacts in absolute terms. The threshold for subjecting national regulations to full cost-benefit analysis in the United States is $100 million (USD) annual impact—regulations that have less of an impact are subjected to less analysis.40 Similarly, the European Union guidelines limits full impact analysis to “significant” policies, and recommends proportionally less analysis to those policies with less impact.41 However, with the relatively high threshold set in the United States, there are still many regulations that are subjected to cost-benefit analysis. Given the amount of economic value at stake, devoting the, relatively, small amount of resources needed for cost-benefit analysis is money well spent.

Even within developed countries, however, smaller governmental units—like states in the US—sometimes have difficulty mustering the analytic resources to carryout cost-benefit analysis. IPI is in the midst of a large-scale project to determine how states use regulatory review and cost-benefit analysis to shape environmental and public health regulation. Perhaps unsurprisingly, our preliminary findings, which accord with the past research on the subject,42 are that states generally do not have significant resources devoted to cost-benefit analysis, and that where regulatory review is carried out, it is often much more cursory that review at the federal level, and at times far less sophisticated. But, for states facing resources constraints, it is reasonable to avoid spending too much on analytic efforts to make marginal improvements in regulatory efficiency. Because state regulations affect smaller economies, the absolute economic effects of their regulations are smaller, so the returns to investment in analysis are less.

developing countries can be expected to face a similar dilemma when deciding the level of resources to devote to cost-benefit analysis. For small countries with relatively small economies, subjecting regulation to expensive cost-benefit analysis will not generally be efficient. Because there will be relatively few policy moves that have sufficient economic impact to justify lengthy and

40 the threshold has remained unchanged since the original Executive Order. Compare Executive Order No. 12,866 of September 30, 1993 (58 Fed. Reg. 51,735) with Executive Order No.12,291 of February 17, 1981 (46 Fed. Reg. 13,193).

41 European Commission, supra note at 13. 42 Hahn (1998).

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resource intensive cost-benefit analysis, the start-up costs necessary to develop sufficient capacity to conduct this type of analysis would be too expensive. Countries at lower levels of development may also not have a sufficiently large professional class such that highly educated community members can be optimally used in conducting regulatory analysis instead of serving in other high-value roles that need to be filled.

While the issues of analytic capacity are serious, the will not pose insurmountable barriers in all cases. In addition, some steps—like pooling analytic resources between countries or conducting analysis of similar policies across a number of countries—can be taken to reduce redundancies and allow developing countries to take advantage of returns to scale that have empowered developed countries to justify the devotion of significant resources for cost-benefit analysis. Furthermore, as countries expand economically, the real impact of potential regulations will grow, creating greater justification for committing scare resources to undertaking cost-benefit analysis of environmental, public health, and safety policy.

iii: the Problem of Distribution

Examining the distribution of regulatory costs and benefits is a fundamental aspect of regulatory impact analysis. there can be distributional differences intra-generationally—so that some members of the same generation are burdened while others benefit. Distributional effects can also exist inter-generationally, where benefits or costs are spread unequally over time. Both are explored below.

A. Intragenerational Equity

The most fundamental criticism of cost-benefit analysis based on unfairness of intra-generational distribution is that the inputs to cost-benefit analysis are sensitive to wealth. The most important measure of regulatory benefits is “willingness-to-pay.” If a regulation reduces the risk of exposure to a contaminant, that risk reduction is monetized by asking how much the beneficiaries of the rule would be willing to pay to avoid this risk. Whatever the affected population is willing to pay to avoid the risk is the benefit of the proposed rule.

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The first distributional concern presented by cost-benefit analysis is that willingness-to-pay is closely correlated with wealth. A person with higher income can be expected to be willing to pay more for a reduction of the same risk than a person with a lower income. If cost-benefit analysis were to individualize willingness to pay, or separate classes of regulatory beneficiaries by income, it would have the affect of giving higher levels of protection to wealthy people than poor people, because they are willing to pay more for protection. For many, this outcome could conflict with fundamental concepts of fairness and equality before the law.

There are two basic responses to this criticism; one conceptual and one practical. On a conceptual level, proponents of cost-benefit analysis can argue that willingness-to-pay is really a proxy for the welfare effects of regulation. The questions that cost-benefit analysis asks is whether regulations are welfare enhancing, not only whether willingness-to-pay exceeds costs. By taking into account the diminishing marginal value of consumption, cost-benefit analysis could theoretically be structured to identify the welfare consequences of regulation, approving regulations that maximize net well-being.43 this response serves as the basis for cost-benefit analysis techniques that give greater weight to policies that have net benefits for lower-income individuals discussed below.

The more practical response is that, as conducted, cost-benefit analysis uses average valuations, not individual valuations, of policy costs and benefits. Thus, the value of statistical life is set for the entire u.s. population—there are no separate values for higher or lower income people. this situation comes about for both simple technical reasons—it would be more complex to try and divide the population into sub-groups, assign differing values for risks to those groups, and then classifying all regulatory impacts according to those sub-groups—as well as the obvious political difficulty that would arise if groups were treated differently. this practical solution undermines the distributional critique, and in fact, so long as burdens are distributed evenly

43 An interesting consequence of cost-benefit analysis along these lines is that it would justify straight wealth transfers, where money is taken from the wealthy and given to the poor. By looking at only willingness to pay, a certain amount of error is introduced if welfare is important Armantier and Treich, supra note 27.

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throughout the population (or clump upwards), results in a downward (progressive) redistributional trend.

some steps have been taken to integrate distributional analysis into regulatory assessment. the executive order governing regulatory review in the United States explicitly calls for distributional analysis,44 and the EPA guidelines45 and other guidance documents46 provide for mechanisms to assess the distributional impacts of regulatory proposals. However, the issue is far from resolved, and President Obama has specifically called attention to the need to develop better tools for assessing and weighing distributional issues.47

A second order criticism is that, even where average values are used, cost-benefit analysis is insensitive to the distribution of regulatory costs and benefits. In most basic form, cost-benefit analysis is only interested in maximizing net benefits in the aggregate, it is not concerned with how those regulatory benefits are distributed. Thus, a program that increases the wealth of the rich, while creating burdens on the poor, could be justified by cost-benefit analysis so long as the value of the regulatory benefits was greater than the value of regulatory costs.

For this reason, cost-benefit analysis is potentially insensitive to an important aspect of regulation: distributional effects. Without some mechanism to account for distributional effects, cost-benefit analysis will create an incomplete assessment of policy. If decisions are based on cost-benefit analysis alone, there is a real risk of bad policy being adopted. Cost-benefit analysis, then, needs to be augmented by some form of distributional analysis to give a more complete picture of the consequences of environmental, public health, and safety regulation.

These distributional issues, while they are important in developed economies, are much more important for developing countries. Income inequality is a larger problem in developing countries, a situation that some commentators argue has been

44 Executive Order No. 12,866, supra note 40 at section 1(b)(5). 45 U.S. Environmental Protection Agency, supra note 36.46 Office of Management. & Budget (OMB), Circular A-4, Regulatory

Analysis 14 (2003) 47 Regulatory Review: Memorandum for the Heads of Executive

Departments and Agencies, 74 Fed. Reg. 5977 (Jan. 30, 2009) (calling for recommendations on the subject from the Director of OMB).

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exacerbated by the expansion of globalization48—international trade, rapidly expanding telecommunications technology, trade, foreign investment all create economic opportunity, but may also tend to concentrates wealth in fewer and fewer hands.49

Income inequality is especially troubling, from a normative perspective, when portions of the population live a subsidence or near-subsidence levels, and have access to inadequate housing, food, health care, and education. While theories of distributional justice abound, there is a persuasive argument that people should have access to at least those resources necessary to achieve some sufficient level of autonomy and self-direction.50

The consequence of these two distributional facts: greater total inequality and populations living at or near subsistence, complicates the picture for developing countries wishing to engage in cost-benefit analysis. First, there may be certain classes of regulatory measures which are simply impermissible on a moral basis no matter what the cost-benefit ratios. For example, if a regulation burdened a group of individuals at or near subsistence, so that their wealth levels fell below subsistence, that regulation would potentially be immoral, even if it did result in aggregate increases in wealth. In order for the regulation to be legitimately adopted, their would have to be mechanisms of compensation put in place to ensure that those who were negatively affected by the regulation were made whole and did not experience the potentially catastrophic consequences to their well-being of even small negative changes to their wealth.

48 see Narula (2008) (“some have begun to tell the tale of two Indias, wherein inequalities are further polarized by globalization’s steady march, and where Indians are anointed into the Billionaire’s Club”); Ben S. Bernanke, Chairman of the Bd. of Governors of the Fed. Reserve Sys., The Level and Distribution of Economic Well-Being, Address at the Greater Omaha Chamber of Commerce (Feb. 6, 2007), available at http://www.federalreserve.gov/newsevents/speech/Bernanke20070206a.htm (“Beyond the effects of technological change, the variety of economic forces grouped under the heading of “globalization” may also have been a factor in the rise in inequality, even as these forces have provided a major stimulus to economic growth and to living standards overall.”).

49 see Faux et al (2006) (citing rising income inequality as a disturbing trend resulting from NAFTA); see also Polaski (2003), available at http://www.carnegieendowment.org/files/nafta1.pdf.

50 see dworkin (1981).

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Second, where inequality is already high, there needs to be special attention to ensure that a bad situation is not made worse. Typically, many economists think that there is a trade-off between economic productivity and economic equality,51 such that measures taken to alleviate poverty often distort incentives, reducing overall economic productivity. Regulations that exacerbate inequality then can be thought of as imposing actual costs on societies that must take affirmative steps to reduce that inequality—say by expanding redistributional tax policy. Because developing countries already face large distributional problems, it is likely the case the where those problems are exacerbated by a regulation, government would have to step in to counter those effects. Cost-benefit analysis must take into account these costs or risk failing to account for a key regulatory consequence.

Third, the technical fix that has been used in developed countries of using a single population-wide metric for valuing regulatory benefits results in reasonable outcomes if regulatory burdens are roughly distributed according to wealth—i.e. the wealthier population tends to be more burdened by regulation. If regulatory burdens are not so distributed, then negative wealth transfers, or even simply inefficient regulations, arises. For example, if only the bottom quintile is both burdened and benefited by a regulation, but risk valuations are based on the middle-quintile, then regulations will be inefficiently strict. Likewise, if only the top quintile is burdened and benefited, they will be inefficiently weak. If the top quintile is benefited, and the bottom quintile is burdened, it would result in a normatively problematic transfer of wealth.

Because income inequality is exacerbated in developing countries, it is possible that more regulatory proposals will fall into these problematic categories where use of an average value for risk valuations will have bad consequences. If that is the case, then an alternative mechanism to conduct risk valuation that both avoids these consequences, while respecting commitments to fairness and equal protection, would need to be developed. As it currently stands, there is no obvious candidate for such a valuation methodology.

51 Recent advances in development economics challenges this view, as will be discussed below.

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these distributional issues present clear challenges to the expanded use of cost-benefit analysis in developing countries. Specifically, they create a need for the development of more nuanced and sophisticated ways of conducting distributional analysis and incorporating that alongside cost-benefit analysis when assessing the impacts of proposed environmental, public health, and safety policy. While some attempts have been made in the developed world to deal with the distributional consequences of regulation, they are rudimentary, and not up to the task faced by developing countries in setting policy. It will be for leaders and thinkers in developing countries to create the next generation of analytic tools to address these issues.

B. Challenges of Distributional Analysis

there are several methods in which distributional analysis could be incorporated into regulatory impact analysis. the choice among these methods will reflect both analytic needs and limitations, as well as social value choices about how the distribution of costs and benefits should factor in environmental or public health policymaking.

1. Counting distribution

At its most fundamental, distributional analysis is based on an exercise in accounting: not only must aggregate costs and benefits be calculated, but the identifies of the parties bearing those costs or receiving those benefits (up to some pre-determined level of granularity) must be determined. Normative questions will arise even at this early stage—an analyst must identify which characteristics are relevant for the analysis. distribution can be measured according to region, income, race, gender, age, socio-economic status, business size, industry, or any other of a potentially limitless set of characteristics that could be determined to be relevant for purposes of policymaking. the initial decision about the groups to be targeted for distributional analysis will form the bedrock of future decisions about how to weigh inequalities in the allocation of costs and benefits.

Second, the degree of distributional analysis should be identified. Policy can have a wide range of direct and indirect effects, creating

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a potentially limitless analytic task if all effects must be estimated. In standard cost-benefit analysis, a traditional decisionmaking rule would require an analysis to stop at the point where the value of the information generated from additional investigation is outweighed by the cost (including delay) of further research. distributional analysis does not admit of such a straightforward rule—there needs to a normative decision about the value of distributional information to determine the analytic resources that should be devoted.

Distributional analysis will also likely require greater attention to certain types of policy effects. There are a variety of “pathways” through which environmental policy can have regressive distributional consequences—i.e. where lower-wealth individuals bear proportionally greater costs or fewer benefits of the policy as a percentage of overall wealth.52 These pathways include increased product prices, reductions in real wages, allocation of new property rights, differential valuation, increasing returns to real property ownership, and transition/job effects.53

some of these pathways can be relatively easily incorporated into regulatory impact analysis. For example, the creation of new property rights, and the allocation of those rights, for example through a cap-and-trade program where allowances are distributed to existing emitters, will have clear distributional consequences. Because the creation of the new right is a direct goal of the policy, and the means of allocation of the new right is likely to be explicit, it is relatively straightforward to anticipate the distributional consequences of that discrete aspect of a policy.

On the other hand, the secondary effects of the same policy—for example, a cap-and-trade scheme on some environmental pollutant—are harder to anticipate, and it is especially difficult to anticipate who will bear the consequences of those secondary effects. The cap-and-trade program is likely to increase factor costs for certain industrial processes, potentially leading to losses in shareholder value (progressive), but potentially causing job losses (regressive). Other industries in substitute goods, or which use the regulated factor more efficiency will likely benefit from the policy, increasing

52 see Fullerton and Karney (2009) 53 id.

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shareholder value (regressive), but also potentially causing job creation (progressive). Consumer prices for basic necessities, like energy or food, may increase—a regressive effect. But, consumer prices for luxury goods may also increase—a progressive effect.54

There are two additional complicating factors. First, where possible, it is likely that the benefits of environmental regulation will be incorporated into market prices, leading to complications as benefits are distributed into the market. For example, a land use regulation that restricts new buildings in a city center is likely to generate an increase in the value of existing buildings. some owners of those buildings will sell into the market, producing consumer surplus for a new buyer and capturing a windfall profit. Tenants, on the other hand, will experience disruption and potential transition costs if rental values increase as a consequence, although new tenants, willing to pay the greater prices, will enjoy consumer surplus. While a standard cost-benefit analysis could simply accept higher prices as a benefit of regulation—reflecting wealth creation as a consequence of the policy—distributional analysis requires much deeper investigation of who benefits and who losses out as the effects of the price increase ripple through the economy.

Second, distributional analysis may require that differences in valuation for regulatory benefits be taken into account, in a way that standard cost-benefit analysis does not. As discussed above, individual valuation of the benefits of environmental policy can be expected to track wealth—the higher the income a person has, the higher the average valuation for a given environmental benefits. As a consequence, there is a second mechanism in which benefits can be regressively delivered—even if every citizen receives an equal environmental benefit, the valuation of those benefits will mean that wealthier individuals will receive greater value.

2. Policy-by-Policy vs. Holistic Responses to Distributional Concerns

After gathering basic facts about how costs and benefits are distributed, policymakers must face the question of how distributional concerns should be factored into decisionmaking. Where there are a

54 Despite the difficulties of modeling the distributional effects of a greenhouse gas controls, there are several sophisticated attempts. See e.g., Burtraw et al.( 2009).

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large number of policies, the distributional effects of some policies will be canceled out by the distributional effects of others. some groups that benefit from one regulation will be burdened by other regulations. In this way, over a large number of policy choices, distributional imbalances will tend to be self-correcting. If distributional corrections are made at a policy-by-policy level, then, some distributional effects that would be canceled out through the normal course of decisionmaking may instead be eliminated by changing the policy, presumably at the expense of overall efficiency.

An example is illustrative. Image two policies Alpha and Beta that impose costs of $100 and generate benefits of $200. Alpha imposes costs on Person B and generates benefits for Person A, and Beta does the opposite. There are alternative policies, Alpha´ and Beta´ that impose each imposes costs of $55 on each person, and generates $100 in benefits for each person.

A B

Costs Benefits Costs Benefits

Alpha $0 $200 $100 $0 Alpha´ $55 $100 $55 $100 Beta $100 $0 $0 $200 Beta´ $55 $100 $55 $100

If distributional analysis is carried on a policy-by-policy level, then it is possible that Alpha´ and Beta´ will be selected. Under Alpha, there is a very unequal distribution of costs a benefits, with Person A made $300 better off than Person B. Under Alpha´, the two groups receive an equal net benefit, and neither is better off than the other.

Likewise, under Beta, there is a similar unequal distribution of the costs and benefits of the rule. If each rule is evaluated separately, then the alternative policies, with better distributional evenness, look reasonable.

However, if analysis is carried out of both policies, then Alpha and Beta will be selected, because there is no distributional imbalance when both policies are considered. The net benefits under the alternative policies lead to $180 in net benefits, while the net benefits of Alpha and Beta are $200—evaluating the policies together, then, has a net benefit of $20 with no negative distributional consequences.

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In this example, if the policies are evaluated separately, then alternative policies that have fewer distributional consequences, but also deliver fewer net benefits, may be selected. The result over both regulations of selecting the alternative policies is to lower overall net benefits without affecting any positive redistribution of the costs and benefits of the policies taken together. In this case, making modifications to account for distribution to individual policy choices will lead to less efficient outcomes than accounting for the distributional impacts of environmental policy as a whole.

While this example is clearly stylized, it has applicability in the real world. In the case of actual policy making, we would instead expect there to be probability distributions of how costs and benefits would be distributed for a regulation. the expected distributions for all groups for all regulations should be equitable—i.e. costs and benefits should track the population of each group, so that all individuals have the same expected payoff. For individual regulations some groups would come out ahead and others behind. However, over large numbers of policy choices, we would see the actual payoffs approach the expected payoffs, leading to a roughly even distribution of costs and benefits.

this situation is compounded by economic theory which suggests that redistribution through regulation is likely to be more costly than using a tax and transfer system to effect redistribution.55 In the above example, if there was only a one-time policy choice between Alpha and Alpha´, it might still make sense to choose Alpha if an equitable redistribution of wealth can be accomplished through the tax code for less than $10.

In general, there will be no need for systematic redistribution of the costs and benefits of regulation—because unequal distribution will tend to cancel out—unless there is some systematic bias such that some groups are consistently forced to pay for benefits that go to others. In those cases, it also may be the case that looking at inequality more generally, including inequality caused by policy choices but also inequality that arise from the marketplace, will lead to more efficient redistributional policy because it can be done holistically rather than through piecemeal correctives at the level of individual polices. Holistic

55 See generally Kaplow and shavell (2002).

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redistribution can be done either through the tax-and-transfer system, or where appropriate through targeted regulations that have positive distributional benefits even if they may not be optimal from a purely economic standpoint.

Understanding that a holistic, all things considered, approach to redistribution—with environmental and public health policy designed to maximize wealth, and a second tax-and-transfer or even targeted inefficient but redistributional environmental or public health policies to correct for unequal distributional of well-being—may be optimal, there may nevertheless be a place for distribution to be taken into account at the level of individual policies. Most obviously, in cases where progressive redistribution of costs or benefits can be achieved through minor changes in policy, at lower efficiency costs than redistributing through the tax and transfer system, then adopting those changes would be justified.

It also may be that, though redistribution through the tax-and-transfer system is efficient, it is politically difficult for a variety of reasons. If that is the case, the regulatory system would be a second best means of correcting distributional inequality. In this scenario, a holistic approach that looks at all regulations systematically to determine distributions, with corrections made to some policies where distributional goals can be achieve most cheaply, would be efficient.

Only in cases where tax-and-transfer is largely off the table, and a holistic approach to modifying regulations is also difficult, would distributional rules built into cost-benefit analysis be the most efficient mechanism to achieve egalitarian goals. This may actually be the case for many countries. In the United States, for example, tax-and-transfer policy is politically unpopular, and modifying regulation is extremely difficult and time consuming. In these circumstances, making distributional corrections at the policy-by-policy level may be justified.

there are a variety of possible tools that could be used to explicitly incorporate distribution into regulatory decisionmaking. the most popular approach is equity weighting, where benefits and costs are treated differently depending on the populations affects. systems of equity weighting have been put into practice in the UK and World

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Bank.56 Equity weighting has also been the subject of significant discussion in the economics literature.57

With equity weighting, costs and benefits for disadvantaged populations count more that costs and benefits for wealthy populations. For example, with a simple weighting scheme such that that costs and benefits for B are four-times as important as costs and benefits for A, we see different policy outcomes being preferred.

A (.2) B (.8) Costs Benefits Costs Benefits

Alpha $0 $40 $80 $0Alpha´ $11 $20 $44 $80Beta $20 $0 $0 $160Beta´ $11 $20 $44 $80

Under these equity weights, policies Alpha´ and Beta would be preferred, whether the policies were considered individually or collectively. Alpha generates a net loss of $40, while Alpha´ generates a net benefit of $45. Beta has a net benefit of $140, whereas Beta´ has a net benefit of only $45. Out of the four possible combinations,(Alpha/Beta), (Alpha/Beta´), (Alpha´/Beta), (Alpha´/Beta´), the third —(Alpha´/Beta)— has the highest net return.

There is no general consensus on appropriate equity weights. Typically, distributional weights are based on social welfare function comprised of aggregate individual utility, where individual utility functions are concave in income—each additional unit of income produces less utility than the last.58 While the fundamental structure of marginally decreasing utility of income is widely accepted, the actual shape of the curves—at what rate income produces marginally less utility—is subject to no such consensus. Even were a regime of equity weighting to be generally accepted, arriving at the weights to be used would be no simple manner.

56 See H.M Treasury, The Green Gook: Appraisal and Evaluation in Central Government 25, 91-96 (2003); Dr`eze (1998).

57 See e.g. Johansson-Stenman (2005).58 See e.g. id.

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C. Intergenerational Equity and Discounting

A persistent issue that arises for cost-benefit analysis is the mechanism to discount benefits that occur in the future. In general, future cash flows are less valuable—all things considered—than current cash flows, so cost-benefit analysis in the fiscal context would discount future cash flows to present values in order to make valid comparisons between costs incurred today and the future benefits of a project. The discount rate in a purely fiscal context is set according to the risk-free rate of return (usually thought to be around 2% or 3%) and then adjusted upward to account for a risk premium if the payouts from the project are unsure.59 the discount rate in the regulatory context is somewhat different and represents the rate at which a society is willing to substitute present day consumption for future consumption. It is typically thought to be comprised of the sum of two components: a term for a “pure rate of time preference”; and a term that accounts for the effects of economic growth on the marginal utility of consumption.60 this formula is typically expressed as:

Social discount rate = r + μg

Where:r is the rate of pure time preferenceg is expected growth rate in per capita consumption; andμ is the negative elasticity of marginal utility to consumption.

However, it is not clear that a straightforward application of discounting is appropriate in the regulatory context. As an initial matter,

59 The most influential model of combining a risk-free rate an risk premium to estimate a rate of return on investment (and therefore discount rate) is the “capital asset pricing model” (CAPM) developed by a handful of economists in the 1960s, including William Sharpe, Harry Markowitz, and Merton Miller, who jointly received the Nobel Memorial Prize in Economics for their contribution to developing the model. In finance, CAPM is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset’s non-diversifiable risk. see Grossman (1995).

60 see Ramsey (1928) (describing what has been named the Ramsey Equation).

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it is worthwhile to distinguish between two different contexts where regulatory benefits occur in the future: long-latency context and future generations context.61 the long-latency context describes situations where there is a long lag between exposure to a risk and realization of the risk. the paradigmatic example is exposure to carcinogens: it can be years or even decades between the time when a person is exposed to a harmful chemical and the diagnosis of a disease.

Distinct from the question of long-latency is the question of future generations. In the future generations context, steps are taken today that will reduce risks far out into the future. this means that the peopled burdened by the regulation are different from the people that will benefit from the regulation—there is a temporal distinction that means that the two classes will be large distinct. the paradigmatic case of benefits being delivered to future generations is greenhouse gas reductions undertaken now. Because of how long greenhouse gases tend to remain in the atmosphere, reduction in emissions today will not result in substantial reductions in atmospheric concentrations for many years.

The use of a pure rate of time preference is justified in the long-latency context. For long-latency threats, discounting is just a matter of respecting individual preferences. If a person has a preference to enjoy goods sooner rather than later, and put off harms even if the are inevitable, then those preferences should be respected. Just as cost-benefit analysis typically does not question individuals risk preference, there is no reason to question preferences about the distribution of risks over time.

However, the intergenerational context is different, because there, the distribution of risk is not between two different times for the same individual, but instead the distribution is between two different individuals. In this case, the question is not merely a matter of respecting preferences for when individuals prefer to experience costs and benefits, but represents a social decision to allocate greater burdens or benefits to different classes of people. The two questions are distinct, and must be analyzed differently. This is especially true with respect to the pure rate of time preference. the term in the social discounting formula that takes into account diminishing returns to consumption is

61 see Revesz (1999); see also Burton (1993).

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well understood and fairly well justified. It is not clear to what extent any pure rate of time preference is justified.

the debate over the social discount rate as taken on special importance in the context of climate change. The Stern Review, the most large scale economic assessment that has been conducted of climate change by a government body, for example, used a rate of pure time preference near zero, to reflect the moral notion that people in the future should be treated with equal regard.62 Because a small discount rate was used, relatively strict greenhouse gas controls were found to be justified. However, the report was subjected to large amounts of criticism from academic economists—many of whom support mandatory limits on greenhouse gas emissions—for using a very low social discount rate, which they felt skewed the results to favor larger expenditures on climate change controls. 63

While there is much disagreement about the use of a pure rate of time preference, the second term in the social discount rate formula—which accounts for the effect of economic growth on the marginal utility of consumption—could also pose challenges in the developing context. this term itself can be disaggregated into two parts: the relationship between total consumption and the marginal utility of consumption, and predictions about economic growth. While the exact term for the elasticity of marginal utility of consumption is debated, the fundamental intuition is widely shared, and a declining marginal utility of consumption is a basic principle of economic theory. In general, then, accounting for projected growth in consumption is uncontroversial.

However, the rates that are used in developed and developing countries for projected growth are likely to be very different. developed countries have experienced economic growth for many years, and the most advanced economies generally have relatively mild,

62 Stern Review: The Economics of Climate Change available at http://www.hm-treasury.gov.uk/stern_review_report.htm part 1 at 31 (“We take a simple approach in this Review: if a future generation will be present, we suppose that it has the same claim on our ethical attention as the current one.”)

63 See e.g., Nordhaus (2007) (“[T]he Stern Review’s alarming findings about damages, as well as its economic rationale, rest on its model parameterization— a low time discount rate and low inequality aversion—that leads to savings rates and real returns that differ greatly from actual market data.”).

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though persistent, levels of economic growth. Because they are starting from a lower level, many important developing countries have high rates of economic growth.64

the higher growth rates in developing countries will justify a higher discount rate. The consequence will be less regulation that benefits future generation. In essence, the higher discount rate reflects a judgment that populations in the future will be wealthier than current populations, and therefore it would be unjust to redistribute wealth from the current generation to the future. Only in cases where the value of future benefits exceeds the value of costs incurred today would regulations be justified.

there are some problems that could arise from differential discount rates for developing countries. First, the problem of international comparison arises again. Actions that would be justified in developed countries to protect future generations would not be justified, potentially raising the ethical and political problems discussed above.

Perhaps more importantly, using differential growth rates for global problems—climate change being the most important case—could lead to perverse results. Higher growth rates stem, at least in part, from the lower level of economic development. While some cost-benefit models of climate change use “equity weighting” to account for the lower consumption rates of poor countries, many do not. The use of differential discount rates, then, would bias the results because the diminishing return to consumption would be accounted for in one context—discounting of future benefits—but would not be accounted for in another context—current distribution of wealth. this would create a bias against policies that would benefit developing countries in the future: equity is not taken into account when it would increase the value of benefits for developing countries, but is taken into account when it would decrease the value of benefits for the same countries.

Even in the domestic context, care would have to be taken. If regulatory burdens in the present are imposed on wealthier segments of the population, but regulatory benefits in the future accrue to less

64 see Central Intelligence Agency World Factbook available at https://www.cia.gov/library/publications/the-world-factbook/.

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wealthy segments of the population, then the assumption of diminishing return to consumption would not necessarily hold, and certainly not at the general growth rate for the economy. discounting would have to take into account the incidence of regulatory costs and benefits not only according to the dimension of time, but also along the wealth distribution within the country. In essence, discounting would be subsumed into the larger project of distributional analysis.

there is another potential trap from the use of a high discount rate based on high projected long-term growth. A very high discount rate may discourage long-term policies, and ultimately result in reductions in economic growth in the future as the current generation consumes rather than making regulatory investments. Where a very high discount rate is used, there should be additional scrutiny that policies that are justified by the high rate do no threaten the economic growth that is the basis of a high rate in the first place. While this does not mean that a higher discount rate based on projected growth in consumption is never justified, it does mean that discount rates cannot be unproblematically incorporated into cost-benefit analysis.

IV: Adapting Cost-Benefit Analysis for the Developing Context

the field of development economics focuses on positive economic questions involving development and developing countries, rather that the normative questions that concern welfare economics. Development economics tries to answer questions about the empirical consequences of policies, or to identify policies associated with long-range economic growth. Whether those policies are “good” or not is left to the individual policymakers, and development economics does not itself propound any ultimate set of decisionmaking criteria upon which choices “should” be made.

However, that does not mean that development economics has nothing to offer cost-benefit analysis. The positive claims of development economics may be of clear value to a normative assessment of the wisdom of particular policy choices—a policy’s impact on growth could have major consequences for determining its net benefits.

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A. Effects of Environmental Policy on Physical Capital Accumulation

Capital accumulation is a well-established variable that influences development.65 Countries without access to capital have less productive workers,66 have fewer opportunities to participate in the global economy through trade, and rely to a greater extent on agricultural production and raw materials for wealth—subjecting them to weather risks and highly variable global prices.67 Accumulating the wide range of assets classified as capital—from factories to technological know-how—lies at the heart of industrialization and development.

The most obvious category of capital is physical: the machines, factories, transportation and communications infrastructure, energy generation capacity, and built real estate that make a modern economy run. Physical capital provides the foundation to maximize worker productivity and increase overall ability to produce goods and services.

there are a variety of positive and negative impacts that environmental regulation can have on physical capital. Within the field of environmental economics, there has been a great deal of recent interest in the concept of “ecosystem services.” The basic idea behind ecosystem services is that nature itself can be thought of as a form of physical capital, providing important services to a community. Classic examples of ecosystem services include water-filtration: preserved forests or wetlands in a watershed area improve water quality by filtering rainwater recharge. Managing preservation programs to avoid building expensive water filtration plans is a key aspect of New York City’s water management plan, for example. In this case, managing an existing natural resource can avoid the need to devote social resources to building new physical capital—resources that can be put to a higher use elsewhere in the economy.

developing countries are at a special advantage for protecting ecosystem services. Many advanced economies have already

65 urata (2002); Cao (1997); seita and tamura (1994)66 see Urata, supra note 68.67 Eubanks II (2009) (“In response to depressed global cotton prices,

for example, an estimated 40,000 cotton farmers in India committed suicide between 1996 and 2005, while thousands more sold one of their kidneys on the black market for approximately $800.”).

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converted natural capital to built uses—clearing forests for real estate development; filling in wetlands; damning rivers. Many of these decisions are either irreversible or very costly to reverse. However, many developing countries have not locked themselves into particular choices concerning natural resources—there remain significant unexploited natural capital reserves. Making wise decisions about these resources, including keeping the option to rely on ecosystem services in the future, is a key asset that cannot be underestimated as the world’s natural resources become ever more scarce.

there are many other ways that environmental regulation can impact physical capital outside of directly protecting ecosystem services. Influence on foreign direct investment is no doubt an important consideration. A common complaint among labor leaders in developed countries is that other governments, by keeping low levels of environmental regulation, “unfairly” attract capital to their shores. Of course, where the effects of less strict regulation is local, this simply represents a trade-off—a willingness to bear additional environmental costs in order to generate economic benefit. The situation is more complicated, of course, in the presence of externalities, where the choices of local governments have effects that spill-over into other regions. In those cases, environmental agreements and cooperation and necessary to avoid inefficiently high levels of pollution.

While the standard narrative of companies moving around the world to chase the lowest possible level of regulation has wide cache, the effects environmental regulation on foreign direct investment is complex and contested.68 there are many confounding factors that make the study of the relationship between FdI and environmental regulation difficult, including regional variation and many potentially omitted variables—such as stability, location, abundance of natural resources, local corruption, and cultural connection. “Third-country” variables, where factors outside of either the investor country or recipient country, affect investment, present a particularly tricky problem.69 Some have posited that causation runs in the other direction, from foreign direct investment to lower environmental standards.70 While the state of economic knowledge is unclear, countries should

68 See generally, fullerton (2006). 69 see Kukenova and Monteiro (2008).70 Cole et al. (2004).

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explicitly recognized whatever risks to foreign direct investment are posed by strong environmental standards.71

Environmental regulation could also have positive effects on certain areas of foreign direct investment as well. the most obvious example is in the tourist industry. Investment in preservation can return dividends in tourist dollars to national parks; investment in clean water controls protect lakes, rivers, and oceanfront areas that generate economic activity and attract foreign investment for hotels, resorts, and associated local industries. Given the vast size of the global tourist industry,72 and the degree to which some developing countries rely on tourism to generate investment,73 the potential for environmental protection to generate investment in tourist infrastructure is clear.

Whether environmental protections encourage or discourage foreign direct investment, then, is likely to be context specific. It will not always be the case the environmental regulations will scare away foreign investors, but nor is it likely that compliance costs are completely ignored by firms making location decisions. To make rational and well-though out decisions about environmental policy, examining the impact on foreign direct investment—with associated effects on development—will be important.

Environmental regulation can also impact the rate of technological innovation and adoption—spurring investment in these areas. the role of technology in growth is well established. As

71 Clarifying the extent of the risk to foreign direct investment of strong environmental regulation can also help alleviate fears associated with new environmental policies—if the effects on investment are unrecognized or understudied, then it is easier to exploit those fears to stop critical progress, even if the fears are ill-founded or out of proportion to actual risks.

72 According to World Travel and Tourism Council, the value of travel and tourism is expected to rise from $5,474 billion in 2009 to $10,478 billion by 2019. see Tourism Impact Data and Forecasts, World Travel and tourism Council available at http://www.wttc.org/eng/Tourism_Research/Tourism_Economic_Research/. According to the united Nations World Tourism Organization, international tourism receipts represented in 2003 approximately 6 percent of worldwide exports of goods and services. see United Nations World Tourism Organization,Tourism and the World Economy, http://unwto.org/facts/eng/economy.htm.

73 See, e.g., CIA World Factbook, Barbados (three quarters of GDP and 80% of exports attributable to services related to tourism and other industries) available at https://www.cia.gov/library/publications/the-world-factbook/geos/bb.html.

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technology becomes more widespread, worker productivity increases. Gains in worker productivity sit at the base of economic growth—while institutions are important, and robust markets and exchange create economic benefits, it is the ability to use technology to leverage worker productivity that accounts for the huge consumptions gains that have been experienced in many parts of the world in the past several centuries.74

some economists have argued that environmental regulation can increase productivity directly. The “Porter hypothesis” holds that “stringent environmental regulation (under the condition that it is efficient) can lead to win-win situations, in which social welfare as well as the private net benefits of rims operating under such regulation can be increased.”75 The proposed mechanism is that firms have a variety of productivity enhancing innovations available to them, of which they are unaware. Environmental regulation, by forcing an investment of intellectual resources in thinking through production processes and new technologies, can spur firms to take advantage of innovation opportunities that had been ignored in the status quo ante. Because it proposes large-scale irrationality amongst business firms—under conditions in which competition should weed out less efficient firms—the Porter hypothesis is controversial.76

Even if the Porter hypothesis does not hold, widespread adoption of environmental technologies can have “spill-over” effects to other areas, where technology can increase worker productivity. Investment in technology to improve productivity can “piggy-back” on investments to improve environmental performance—a regulation requiring that heating boilers in a municipality be upgraded from residual fuel oil to natural gas can be an opportunity not only to improve environmental quality, but also upgrade efficiency to generate net savings for businesses, for example. As societies respond to controls on greenhouse gas emissions, serious rethinking of design and production will spur investments in a wide number of areas, some of which will ultimately be largely unrelated to the original government intervention.

Environmental regulation has a well-established relationship with technological change. technological change in response to

74 See generally, Maddison (2001). 75 Wagner (2003). 76 Id.

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environmental regulation has been documented in many contexts, from steps taken to comply with the Montreal Protocol on Ozone Depleting Substances,77 to power producers production process changes to reduce costs of the Acid Rain Program in the United States,78 to recent technological develops to save the incandescent light bulb in the face of impending energy efficiency rules.79 this innovation not only springs from investment that had been made in research and development, but ultimately adds to the stock of physical capital available to a society to fuel economic growth.

In the case of technological adoption, while many developing countries lag advanced economies in their access to technology, they also have certain advantages because they are not locked-into particular technological choices from past decisions. For example, the transportation infrastructure of Europe and the united states is largely locked in, and in the United States at least, heavily dependant on private cars using gasoline as the primary power source. While most developing countries have invested some capital building similar transportation infrastructures, they have not made the same level of commitment, leaving them room to adapt their systems as new technologies come online.

A similar situation arises in the case of private industry—production changes are much easier to put in place at the front end when designing a plant, rather than attempting to retrofit existing capital to comply with environmental regulations. this higher level of flexibility makes it especially important for developing countries to take account of the ability of technological innovation and change to reduce the cost of environmental protection.

B. Environmental Regulation and Human Capital

Human capital —the stock of skills and knowledge of a countries workforce—is also clearly related to development. New

77 Victor (1999) (“the Montreal Protocol, for example, has strengthened over time in part because technological innovation has made benign substitutions for ozone-depleting substances available to the market”).

78 see Ellerman et al., (2000).79 see the article of Leora Broydo vestel, called “Incandescent Bulbs

Return to the Cutting Edge”, N.Y. Times, July 5, 2009.

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fields of development theory in particular have focused on the role of knowledge, education, and technological know-how to contribute to development.80

Investment in education has well known payoffs in productivity and economic growth.81 this is especially true as countries continue to adopt technology and increase worker productivity. Economists have shown for generations that “to the extent that the productivity changes are caused by technological change, skilled labor becomes relatively more important, and the need for human capital development becomes a crucial factor of continued growth. An educated work force is more adaptable to innovations on the job.”82

However, it is also known that “the market underproduces human capital.”83 Many of the investments necessary to increase human capital are accomplished through public subsidies—money spent on school construction and public education. A well functioning capital market that would supply optimal capital for human capital investments is almost impossible to imagine: children would have to take out loans to pay for education. Clearly, cognitive limitations would interfere with the proper functioning of this market. While private capital can have an important role to play in human capital accumulation —like in the United States where students take on significant debt to pay for college and graduate-level studies— it is almost certain that public subsidies will be necessary to achieve optimal investment.

Human capital accumulation does not only take the form of formal education. Learning-by-doing, on-the-job training, diffusion of technology and know how through worker movement: all work with formal educational systems to increase worker capacity. A workplace environment where technology is pervasive is self-reinforcing: workers become gain technical knowledge that can be easily carried to new jobs; managers can adopt production processes to new areas; and innovators have ample opportunity for cross-fertilization. All work together to reduce the start-up costs of introducing new technologies, which feeds back into a virtuous cycle of increased worker productivity.

80 Romer (1990).81 Gardner (1989); Baldacci et al. (2005) (“a country with literacy

scores above the sample´s average . . . experienced an above- average increase in annual per capita GDP growth”).

82 Compare Blakemore and Herrendorf (2009) with Nelson and Phelps (1966) (making this argument).

83 see Basu (1997).

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there are a wide variety of pathways that environmental regulation can affect human capital. As discussed above, environmental regulation can help spread the adoption of technology—increasing the human capital of workers that are exposed to that technology. Managers and engineers are forced to think through production processes, which exposes them to new technological developments. Experience implementing environmental control technology can be easily transferred to other situations where technological upgrades can improve worker productivity. Environmental regulation, then, can act as a periodic spur to firms and workers to upgrade their technologies—and therefore their skill sets—which in tandem with the opportunity to use those skills in a the broader workplace environment, helps contribute to a virtuous cycle of human capital development.

Environmental regulation can also contribute more directly to human capital accumulation. Environmental pollution has a wide range of harmful effects on health, increasing risks of long-term and acute conditions that can interfere with education and worker productivity. Of particular importance are neurotoxins and endocrine disrupting toxins that can have long range effects on intellectual capacity. there are many well known examples of environmental pollutants that can have harmful consequences for neurological development, including lead and mercury. the exposure of pregnant women to neurotoxins can be especially important. there can be no more clear investment in human capital than ensuring that future generations are not exposed to pollutants that permanently reduce their ability to learn.

Environmental regulation can also help generate human capital by helping firms attract and retain high quality workers. Environmental quality and amenities are key attributes of any place of business or work, and if a firm is located in a place with poor environmental quality, it will have to pay relatively more to retain the same quality workforce as a firm located in areas with good environmental quality and amenities. By providing a clean environmental, governments help subsidize efforts to hire workers with high-demand skills. The presence of high quality workers also spills over to increase the productivity of other workers—for location dependant tasks, the ability to attract competent staff is vital to maximizing the potential of all workers. A strong form of this phenomenon is described as “O-Ring Theory”84

84 Basu, supra note 83, at 33–36.

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where, if any worker does not perform their jobs adequately, there are large scale reductions in productivity for an entire firm. Certain key positions—including management, engineering, or sales and advertising—can be thought of as “o-ring” components of firm productivity. Environmental quality and amenities can make it cheaper for firms to hire these types of workers, with productivity benefits that spill over to all workers in the firm.

the distributional effects of environmental policy must again be taken into account in the context of human capital accumulation as well. Even in systems where public education is widespread, private actors are called on to make important contributions to human capital accumulation: giving children proper nutrition and attention; paying for school supplied; allowing children to remain free for overbearing work commitments during adolescence; paying for undergraduate and graduate expenses (including room and board); guaranteeing student loans—all of these vital private investments accumulate to amount to a vast social expenditure for human capital accumulation. However, these types of expenditures are also impossible for families at or near subsistence or poverty incomes. For investments in education to be possible, other necessities but be provided at adequate levels.

to the extent that environmental regulation has negative distributional consequences, especially for the lowest income sectors of society, it will have the effect of reducing expenditures for human capital accumulation, undercutting social efforts at development. Any harmful distributional effects must be identified and, to the extent possible, counteracted through alternative policies or compensation programs. Otherwise, policymakers run the risk of impeding one of the most well-recognized pathways to generating long term economic growth.

C. Poverty Traps

In addition to identifying some of the key requirements of growth, development economics is concerned with conditions detrimental to growth, especially vicious cycles where sets of conditions interact to create negative feedback loops that hinder economic growth. Avoiding these “poverty traps,” is an important goal of development economics.

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there are several poverty traps that are relevant to environmental regulation, and which should be considered in a cost-benefit analysis as a developing country anticipates the effects of a new rule. While none of these considerations should be dispositive, they nonetheless will require careful consideration as countries develop environmental policy.

One of the persistent challenges of many developing countries is to spread the benefits of growth to the entire population. As countries have engaged in industrialization, entered the global economy through trade, and invest in education and public infrastructure, many of the positive effects of economic progress are felt by a relatively small percentage of the population that tend to be concentrated in affluent mini-economies located in urban centers.85 Often, large productivity in many sectors is hampered by a lack of legal institutions, including strong property rights.86 While per capita GDP, or other measures of economic growth, continue to rise, the lives of many of the population, especially the poorest segments or households located out of urban centers, tend to be left out of new prosperity. The benefits of growth accrue to a small number of elites in an “inner economy” while a large number of unskilled workers in the “outer economy” see little change.

Where a dual economy is a problem, it should be taken into account when developing environmental policy. If certain regulations create a barrier to entering the legal economy —for example, by creating burdensome record-keeping requirements87 or subjecting small business owners to arbitrary and/or unreviewable action by

85 Blanchard (2005) (“China’s modernization policy has ... exacerbated existing economic disparities between its small fraction of urban elite and the hundreds of millions of peasants far removed from the country’s new-found wealth.”); International Bank for Reconstruction and Development, World Development Report 2008, Agriculture for Development (2007) (“The rural-urban income divide is large and rising in most transforming [developing ] countries”).

86 For a controversial assessment of the importance of property rights in development, see de soto (2000).

87 International Bank for Reconstruction and Development, (2000) “Can Africa Claim the 21st Century?” (“In many countries restrictive regulations and practices, often aimed at generating rents for officials and favored groups, constrain business activity, affecting both agriculture and industry.”); Burki and Perry (1997) (unnecessary regulations resulting in excess paperwork and administrative costs produce inefficient economic outcomes).

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bureaucrats88 —it may exacerbate a dual economy problem: regulatory alternatives that do not create this problem would be preferred.

Environmental policy can also help to reduce dual-economy problems as well. Preservation programs can sometimes have negative consequences for rural communities, where environmental protection is seen by local groups as the removal of productive resources, but can also be designed to incorporate the participation of local groups and help spur local economic development.89 For example, rather than burning down forest land that is used (usually only briefly90) for grazing, local individuals can be employed for preservation purposes, or local industries that use forest lands in a sustainable manner can be subsidized.91 By focusing on how environmental policies affect the dual economy problem, cost-benefit analysis can help identify regulations that minimize negative effects on the poorest members of society, and ease barriers between the inner and outer sectors of the economy.

Another well known poverty trap is political stability and its relationship to economic variability. If an economy is subjected to sever boom bust cycles, even where there is average positive economic growth, it creates the possibility for political instability that can threaten foreign investment, drain human capital, and lead to politically motivated policies that have negative impacts on long-term growth. If a policy can help smooth economic, or generally makes a country less susceptible to political instability, that is a clear benefit that should be considered. By the same token, if policies tend to have strongly cyclic effects, or undermine stability, that is a cost that equally must be taken into account.

Environmental policy could have effects that reinforce or reduce the strength of the business cycle. For example, spending

88 see Nabli (2007) (“studies have found that ... an honest and efficient bureaucracy emerge as the components [of government] with the best documented and strongest links to economic development and growth.”).

89 sobrevila (2008).90 see Pearce et al. (2002). 91 See, e.g., United Nations Foundation, UNDP Helping Coffee

Growers Adjust To Economic Crisis (2002) available at http://www.unwire.org/unwire/20021115/30382_story.asp (A UNDP program in Guatemala provides credit, training, alternative crop development support and technical assistance to farmers for the purpose of reducing erosion and diversifying the local economy).

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on for long-term environmental investments could be timed to stimulate the economy during downturns—this was the logic of many provisions of the American Recovery and Reinvestment Act passed by the United States Congress in early 2009. China, in a recent round of stimulus spending, also invested heavily in projects expected to benefit the environment.92 During boom times, taxes could be levied that could build up spending reserves that could be used for environmental protection during down years.

Environmental regulation may also have either cyclic or counter-cyclic effects. Land use controls, environmental taxes, pollution control requirements will all likely dampen growth and can be expected to have incrementally high effects as the growth rate increases, which will provide an automatic slowing mechanism as the economy heats up.93 By channeling economic development in productive ways, environmental regulation can also ensure that times of growth are used productively, rather than in unwise overbuilding and hasty exploitation of natural resources that adds little to the stock of physical or human capital. When growth rates are low or zero, it is unlikely that well-designed environmental regulations will significant hamper economic development; rather than bursting at the seams and looking for every possible investment opportunity, an economies with low growth rates are beset by uncertainty and excess inventory, or ill-invested capital that is no longer productive. In these cases, regulations can be structured to provide additional market security, and give signals to investors of potentially profitable ventures.

Naturally, environmental regulation can also reinforce business cycles if, during periods of downturn, overly burdensome, paperwork intensive, or wasteful rules are implemented, and during periods of growth regulatory regimes are weakened. An example may be the case of financial regulation where powerful financial

92 Stimulus Is Greenest in South Korea and China, N. Y. Times, Sept. 24, 2009 available at http://www.nytimes.com/2009/09/25/business/global/25green.html (citing the united Nations Environment Program explaining that “China lead the world’s 20 largest economies in the percentage of economic stimulus money they invest in environmental projects”).

93 Goodhart et al. (1998) (“It is the role of the Central Bank to take away the punch bowl, just when the party is getting going”).

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lobbies can succeed in reducing regulation when markets are working well, but when markets fail regulators step in to rein in a problem after the market has already corrected. Environmental regulation could follow a similar path if industry is given greater leeway when it is producing growth, but loses political power during low-points in the business cycle and face greater scrutiny from regulators during those times. the goal should be to have consistent levels of regulation throughout the business cycle, and if possible use regulation to channel growth in the most productive ways during up-cycles and resolve uncertainty and spur investment during down-cycles.

Conclusion

One of the most vexing problems in cost-benefit analysis, and development in general, is deciding how to trade short-term consumption against long-term investment. If countries invest too little, then they risk short circuiting the virtuous cycle of capital accumulation that allows for ever increasing worker productivity. But, if too much is invested, it threats the political coalitions necessary to maintain stability—countries walk a delicate balancing act of protecting the interest of future generations while keeping current generations happy. these issues are especially severe in developing countries, where the immediate demands of food, shelter, and basic education and health care are substantial.

Cost-benefit analysis, property reformed to take account of the circumstances of developing countries—which is to say the vast majority of the world’s population—can help in making these choices. While the technique will never be value-free or purely technical, it can help clarify value choices, and ensure policy makers are aware of the most efficient way to achieve their goals.

While cost-benefit analysis was developed in advanced countries as a political response to short-term economic downturns, it is a technique that has wide applicability throughout the world. At its heart, cost-benefit analysis is equivalent to rational decisionmaking—aggregating available information, identifying goals, quantifying uncertainty, and making a choice that best achieves them with the fewest negative consequences. For

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countries that don’t have money to waste, but that have prioritized environmental protection as an important component of sustainable development, it can be the right tool at the right time.

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Cost-Benefit Analysis of Environmental Policy in ... · on cost-benefit analysis, discussing its adoption and uses in the developed world as well as special advantages that cost-benefit