Environmental Externalities

Environmental externalities are a particular form of externalities that economic

analysis should take into account. They should be identified and

quantified where possible and included in the economic analysis as project

costs (as might be the case for a decreased fish catch or increased illness) or

benefits (as might be the case with the reduction in pollution of coastal

areas). After assigning a monetary value to the costs and benefits, the analyst

should treat them as any other cost and benefit and enter them into the

cash flow tables.

Project Boundaries and Time Horizon

Analysts must make two major decisions when assessing environmental

impacts. First, they must decide how far to look for environmental impacts,

that is, they must determine the boundary of the economic analysis.

By assessing the internal benefits and costs of a project, the boundaries

of the analysis become clear. If the benefits accrue to the project

entity or if the costs are borne by the project entity, they enter into the

analysis. When we attempt to assess the externalities of a project to determine

its impact on society, the boundaries become blurred. Identifying

externalities implies expanding the conceptual and physical boundaries

of the analysis. A mill that generates wastewater will adversely affect

downstream uses of water for drinking, irrigation, and fishing. The analyst

can easily identify, and maybe even measure, these impacts. Other

impacts on the environment, such as the effects of emissions from a power

plant on creation of acid rain, may be more distant or more difficult to identify. How far to expand the analysis is a matter of judgment and depends

on each individual project.

The second decision concerns the time horizon. Like the project’s physical

boundaries, its time horizon also becomes blurred when we go from

financial to economic analysis. A project’s environmental impact may not

last as long as the project, or it may outlive it. If the environmental impact

lasts less time than the expected economic life of the project, the effects can

be included in the standard economic analysis. If the analyst expects the

effects to last beyond the lifetime of the project, the time horizon must be

extended. This can be done in two ways, either by extending the cash flow

analysis a number of years, or by adding the capitalized value of that part

of the environmental impact that extends beyond the project’s life to the

last year of the project. The latter technique treats the environmental impact

much as one would treat a project’s capital good whose life extends

beyond the project’s lifetime by giving it a salvage value.