Lecture Notes ECON 437837 ECONOMIC COSTBENEFIT ANALYSIS Lecture

Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Twelve 1

RISK ANALYSIS AND MANAGEMENT 2

Decision-Making Under Uncertainty What is risk? Risk generally describes the possible deviation from a project outcome. To project any uncertain outcome into the future, you need to have a “predictive model”, which could be a simple formula or a very complex worksheet. Risk analysis How to identify, analyze, and interpret the expected variability in project outcomes Risk diversification and management How to diversify unsystematic risk How to redesign and reorganize projects in order to reallocate risk 3

Risk Analysis WHY? Project returns are spread over time Each variable affecting NPV is subject to a high level of uncertainty Information and data needed for more accurate forecasts are costly to acquire Need to reduce the likelihood of undertaking a "bad" project while not failing to accept a "good" project 4

Deterministic or Base Case Inputs are projected as certainties. By that we assign 100% probability that the single value of the input we use in the projection will actually arise. However, any deviation in any of the critical input variables from the deterministic case values will generate a new scenario with a different outcome. There are potentially an infinite number of combinations of input values possible, each causing a different set of results. 5

Alternative Methods of Dealing with Risk Sensitivity Analysis Scenario Analysis Monte Carlo Risk Analysis 6

Sensitivity Analysis Test the sensitivity of a project's outcome (NPV or other key variables) to changes in value of one parameter at a time: "What if" analysis Allows you to test which variables are important as a source of risk A variable is important depending on: Its share of total benefits or costs - Likely range of values Sensitivity analysis allows you: - to determine the direction of change in the NPV. - to de-bug the spreadsheet. - to determine how much a variable must change before the NPV or other key variables moves into its critical range turns negative: also called break-even analysis. 7

Sensitivity Analysis for the Mindanao Poverty Reduction Case -- Tomato Paste in the Philippines -World T. P. Price (S. F. FOB) US$/Ton 587 637 687 737 787 837 887 937 987 1037 1087 Divergence from Original Cost Estimate -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Real NPV (Million Pesos) -228 -103 22 147 272 397 522 647 772 897 1022 Real NPV (Million Pesos) Inflation Rate 5% 8% 11% 14% 17% 20% 23% 26% 29% 32% 35% Real NPV (Million Pesos) 161 147 136 126 118 111 105 99 94 89 84 Real NPV (Million Pesos) Capacity 190 169 147 125 103 82 60 38 17 -5 -27 Utilization Factor 60% 65% 70% 75% 80% 85% 90% 95% -189 -147 -105 -63 -21 21 63 105 147 189 8 231

Tomato Paste (cont’d) For tomato paste plant capacity utilization is critical. What can cause capacity utilization to be low? a) b) c) Technical problems with the plant. The demand for product does not exist at the price that covers the costs. The plant can not get adequate supplies of raw materials. Fact sheet: this plant eventually run into financial troubles could not attain adequate supplies of raw materials 9

Notes for Sensitivity Analysis 1. Range and probability distribution of variables Sensitivity analysis doesn't represent the possible range of values Sensitivity analysis doesn't represent the probabilities for each range. Generally there is a small probability of being at the extremes. 2. Direction of effects For most variables, the direction is obvious a) Revenue increases NPV increases b) Cost increases NPV decreases c) Inflation Not so obvious 10

Notes for Sensitivity Analysis (cont’d) 3. One-at-a-Time Testing is Not Realistic One-at-a-time testing is not realistic because of correlation among variables: a) If Q sold increases, costs will increase. Profits = Q (P - UC) b) If inflation rate changes, all prices change. c) If exchange rate changes, all tradable goods' prices and foreign liabilities change. One method of dealing with these combined or correlated effects is scenario analysis. 11

Scenario Analysis Scenario analysis recognizes that certain variables are interrelated. Thus, a small number of variables can be altered in a consistent manner at the same time. What is the set of circumstances that are likely to combine to produce different "cases" or "scenarios"? a) Worst case / Pessimistic case b) Expected case / Best estimate case c) Best case / Optimistic case Interpretation is easy when results are robust: a) Accept project if NPV > 0 even in the worst case; b) Reject project if NPV < 0 even in the best case; c) If NPV is positive in some cases and negative in other cases, then results are not conclusive. 12 • Note: The analysis does not take into account the probability of

Monte Carlo Risk Analysis A natural extension of sensitivity and scenario analysis is a Monte Carlo analysis Simultaneously takes into account different probability distributions and different ranges of possible values for key project variables Allows for correlation between variables Generates a probability distribution of project outcomes (NPV) instead of just a single value estimate The probability distribution of project outcomes may assist decision-makers in making choices, but there can be problems of interpretation and use. 13

Steps in Building a Monte Carlo Simulation 1. Project evaluation spreadsheet for deterministic case 2. Identify variables which are sensitive and uncertain 3. Define uncertainty Establish a range of options (minimum and maximum) Allocate probability distribution Normal distribution Triangular distribution Uniform distribution Step distribution 4. Identify and define correlated variables Positive or negative correlation Strength of correlation 5. Simulate model 6. Analysis of results Statistics Distributions 14

Sensitivity Analysis $ Risk Variables Price V 1 Quantity V 2 Revenue (V 1 x V 2) Materials F 1 V 3 Salaries V 4 Expenses Operating Cost (V 3 + V 4 +V 5) Fixed Cost V 5 V 6 Total Costs (F 2 + V 6) F 3 Profit/Loss (F 1 - F 3) F 4 F 2 15

Deterministic vs Simulation Analysis $ Price V 1 Quantity V 2 Revenue (V 1 x V 2) F 1 Materials V 3 Salaries V 4 Expenses V 5 Operating Cost (V 3+V 4+V 5) F 2 Fixed Cost V 6 Total Costs (F 2 + V 6) F 3 Profit/Loss (F 1 - F 3) F 4 Simulation Analysis V 1 V 2 V 3 V 4 V 5 16 Deterministic Analysis

Foundations of Risk Analysis -- 3 Symmetrical Distributions -Relative Prob. or Density Function Cumulative Probability Area = 100% Prob X X 0 100% Normal Prob. of X 50% X X 0 Triangular 100% Prob. of X 50% A B X Uniform 100% Prob. of X 50% A B X A 17 B X

Simulation Runs $ V 1 Price Quantity V 2 V 3 V 4 V 5 y x -0. 8 Revenue (V 1 x V 2) Materials V 1 V 2 x F 1 +0. 9 V 3 Salaries V 4 Expenses Operating Cost (V 3+V 4+V 5) V 5 y F 2 Fixed Cost V 6 Total Costs (F 2 + V 6) F 3 Profit/Loss (F 1 - F 3) F 4 Results R 1 R 2 R 3 R 4 18

Results of Simulation Analysis Statistics Expected Value of Outcome Standard Deviation and Variance Range: Minimum and Maximum Values Coefficient of Variability Distribution of Outcome Generate the potential outcomes with their likelihood of occurrence 19

Case 1: Probability of negative NPV=0 20

Case 2: Probability of positive NPV=0 21

Case 3: Probability of zero NPV greater than 0 and less than 1 22

Case 4: Mutually exclusive projects (given the same probability, one project always shows a higher return) Case 4: Non‑intersecting cumulative probability distributions of project return for mutually exclusive projects 23

Case 5: Mutually exclusive projects (high return vs. low loss) Case 5: Intersecting cumulative probability distributions of project return for mutually exclusive projects 24

Cost of Uncertainty 25

Expected Loss Ratios 26

Risk under Conditions of Limited Liability 27

Advantages of Risk Analysis Highlights project areas that need further investigation and guides the collection of information Aids the reformation of projects to suit the requirements of the investors Bridges the communication gap between the analyst and the decision maker Provides the information to facilitate a more efficient allocation and management of risk among various parties involved in a project 28

Steps to Undertake Risk Analysis 1. Complete the financial and economic analysis of project -- Deterministic Case 2. Identify “risk parameters”, which are sensitive and uncertain 3. Choose a probability distribution and correlations for risk variables. 4. Identify “risk forecasts” such as NPVs, Debt Services Ratios 5. Run a risk simulation, using Crystal Ball Software. 6. Prepare a risk report – a summary of the risk assumptions and the final results of the simulation. 7. Interpret and analyze results. 29

Risk Management Problems: Many projects have large investment outlays long periods of project payout incomplete sharing of information and technology, especially with foreign investors differences in the ability of the parties to bear risks unstable contracts Projects may be attractive in aggregate but are unattractive to one or more parties due to uncertainties about sharing risks and returns The result is that attractive projects are not being undertaken 30

Principles of Contracting, Risk Sharing and Risk Reduction Case A: A Cement Additives Plant in Indonesia 31

Existing Information The existing financial evaluation of the project over a 12 -year time horizon: * Basic Parameters * Revenues * Formulas for estimating revenues, unit costs and taxes * Costs * Investment Costs and Depreciation * Loan Schedule for Long-Term Debt * Income Tax Schedule * Cash Flows - Total Investment perspective * Cash Flows - Equity Holders Perspective Table 1: Basic Parameters Inflation Rate 5. 50% Expected Inflation Rate 5. 50% Price of Quick Fix in Year 0 Po= Growth Rate of Real Price rp= Quantity of Quickfix in Year 0 Growth Rate in Q g= Unit Cost in Year 0 co= Growth Rate of Real Unit Cost 18 $/10 kg container 2. 00% per year Qo= 5 million units 4. 00% per year 9 $/units rc= 3. 00% per year Capital Assets Purchased Ao= 300 $million Economic Depreciation Rate de=1/20 or 5. 00% per year Tax Depreciation Rate (Straight Line Depreciation) dtax=1/12 or 8. 33% per year Loan Initial Investment Loan Real Interest Rate Risk Premium on Debt Real Supply Price of Equity Corporate Tax Rate ir= re= Tc= Do= 160 $million 6. 00% per year R= 2. 00% per year 10. 00% per year 25. 00% per year 32

Cash Flows: Total Investment Perspectives (millions of dollars) Year 0 1 2 3 1. 113 1. 174 4 5 6 7 8 9 10 11 1. 239 1. 307 1. 379 1. 455 1. 535 1. 619 1. 708 1. 802 Inflation Index 1. 000 1. 055 Revenues 100. 72 112. 72 126. 15 141. 18 158. 01 176. 83 197. 90 221. 48 0. 00 247. 87 277. 40 Liquidation Values 270. 31 Expenses Investment 300 Operating Expenses 50. 86 57. 47 Before Tax Net Cash Flow -300. 00 49. 87 55. 25 64. 95 73. 40 82. 95 93. 75 105. 94 119. 73 135. 31 152. 91 61. 20 67. 78 75. 05 83. 09 91. 96 101. 75 112. 56 124. 48 1. 21 3. 66 6. 40 9. 47 12. 90 16. 74 19. 19 21. 89 24. 87 0. 00 -300. 00 43. 65 54. 04 57. 54 61. 38 65. 59 70. 19 75. 22 82. 56 90. 67 99. 61 270. 31 After Tax Net Cash Flow Real -300. 00 41. 38 48. 55 49. 00 49. 55 50. 18 50. 90 51. 71 53. 80 56. 00 58. 32 150. 00 Tax Payments After Tax net Cash Flow Nominal 0. 00 6. 22 33 270. 31

Cash Flows: Equity Holders’ Perspective (millions of dollars) 34

Risk Analysis -- Risk Variables and Probability Distribution -- 35

Expected Value of NPV = -28. 19 Standard Deviation = 61. 26 Expected loss from accepting = 40. 96 Expected loss from rejecting = 12. 77 Cumulative NPV Distribution Equity Capital: Owner’s View 1. 0 0. 9 0. 8 0. 7 Cumulative Probability 0. 6 0. 5 0. 4 0. 3 0. 2 0. 1 -200 0. 0 -150 -100 -50 0 50 100 150 P(NPV<0) = 71. 00%, and Expected loss ratio = 76. 23%

Risk Reallocation Sources of Contracting Benefits Risk Shifting Differing risk preferences. e. g. , less risk averse investor willing to accept a lower return on a risky asset Differing capacity to diversify. e. g. , foreign investors may be able to diversify risk in more efficient capital markets Differing outlooks or predictions of future. e. g. , some investors are more tolerant and some are more optimistic Risk Management Differing ability to influence project outcomes 37

Risk Shifting The following options are available: Contracts that limit the range of values of a particular cash flow item, or of net cash flow. For example, a purchaser may agree to purchase a minimum quantity or to pay a minimum price in order to be sure of delivery; these measures would put a lower bound on the sales revenue. Other measures include: limited liability a limited product price range a fixed price growth path an undertaking to pay a long-run average price specific price escalator clauses that would maintain the competitiveness of the product, e. g. indexing price to the 38 price of a close substitute

Censored Distribution Case of a floor price, Pf Prob. of Price The result is that project revenues and hence the expected NPV will have (a) a higher expected value, and (b) a lower variance Pf P Price P contract Contract offers price equal to market price unless market falls below Pf when it pays guaranteed floor price of Pf. P = mean or expected market price without floor price guarantee. P contract = expected price project will receive with floor price guarantee. 39

Re: Quickfix Project - contract that specifies that unit costs (co) will not rise above $12 Expected value of NPV = - $0. 74 Srd. Deviation = $44. 41 Expected loss from accepting = 18. 28 Expected loss from rejecting = 17. 54 Cumulative NPV Distribution 1. 0 Owner’s View with a Ceiling on Initial Costs (Co) 0. 9 0. 8 0. 7 Cumulative Probability 0. 6 0. 5 0. 4 0. 3 0. 2 0. 1 0. 0 -100 -50 0 50 100 150 40 P(NPV<0) = 63%, and Expected loss ratio = 51. 03%

Restructuring Intra-project Correlations Risk-sharing contracts that reduce the risk borne by investors by increasing the correlation between sales revenue and some cost items, e. g. , profit sharing contract with labor bonds with interest rates indexed to the product’s sales price Risk-sharing contracts that decrease the correlation between benefit items or alternatively between cost items. 41

Restructuring Intra-Project Correlations (cont’d) The benefits from restructuring correlations are based on the formula for the variance of the sum of two random variables (x and y): v (ax + by) = a 2 v (x) + b 2 v (y) + 2 ab cov(x, y) where a and b are parameters or constants. For example, let: x = revenues (R); y = costs (C); and a = 1, b = -1 v(net profit) = v(R-C) = v(R) + v(C) - 2 cov(R, C) Any measure that will increase the positive correlation between R and C will increase cov(R, C) and reduce the variance of the net profit (provided, of course, that the measure does not increase the variance of a cost item by more than twice the cov) 42

Example: A Profit-Sharing Agreement Assume that wages are the only cost Without the agreement: total cost = C With the agreement: Let g = proportion of the costs that is still paid to workers as a wage, h = labor’s share of profit after wages have been paid. Thus, total cost = g. C + h(R - g. C) Net profit = R - g. C - h(R - g. C) = (1 -h)R - g(1 - h)C v(net profit) = (1 -h)2 v(R) + g 2(1 -h)2 v(C) - 2 g(1 -h)2 cov(R, C) If 0< g < 1 and 0< h < 1, then the variance of net profit will be lower than it was without the agreement. 43

Re: Quickfix Project - contract with supplier that establishes a cost ceiling of $12 - correlated initial selling price (po) and unit cost (Co) such that 18<Po<20 and correlation between Co & Po = +0. 6 Expected Value of NPV = 23. 72 Standard Deviation = 34. 53 Expected loss from accepting = 2. 82 Expected loss from rejecting = 26. 53 Cumulative NPV Distribution Owner’s View: Cost Ceiling & Correlated Selling Price 1. 0 0. 9 0. 8 0. 7 Cumulative Probability 0. 6 0. 5 0. 4 0. 3 0. 2 0. 1 0. 0 -40 -20 0 20 40 60 140 P(NPV<0) = 26%, and Expected loss 120 ratio = 9. 61% 80 44 100

Re: Quickfix Project - cost ceiling of $12 - contract for selling price linked to initial costs (Co) If Co < 9, Po = 16; otherwise Po = 20 Expected Value of NPV = $48. 73 Standard Deviation = $28. 24 Expected loss from accepting = 0. 09 Expected loss from rejecting = 48. 82 Cumulative NPV Distribution Owner’s View: Cost Ceiling & Contract for Selling Price 1. 0 0. 9 0. 8 0. 7 Cumulative Probability 0. 6 0. 5 0. 4 0. 3 0. 2 0. 1 0. 0 -40 -20 0 20 120 40 140 P(NPV<0) = 3%, and Expected loss ratio = 0. 18% 60 80 45 100

Principles of Contracting, Risk Sharing and Risk Reduction Case B: Mexican Cheese Operation 46

Mexican Cheese Operation Queso OAXACA Inc. 1. Project to build cheese processing plant in Mexico. 1. Product sold 70 percent in the U. S. and 30 percent in Mexico 1. Investment of $2. 0 million pesos, financed by 23% equity and 77% debt 1. Initially loans and equity all from Mexican sources 1. Investment during first year, operations for a ten-year period. 1. No imported inputs 47

QUESO OXACA Inc. TABLE 1: TABLE OF PARAMETERS PRICES (as of year 0) Output: Cheese Export price ($/Kg) % Change in real export price Price Risk V. >> 1. 50 Risk V. >> Wages (Ps/day/person) Other direct costs (Ps/Kg) Indirect costs (Ps) INPUT LEVELS Raw materials (liters per kg of cheese) Milk Fuel Labor (number of workers) INVESTMENT COST (in yr. 0 Pesos) Land Buildings Machinery Utilities Mechanical installation Electrical installation Furniture and equipment (in year 1 Pesos) Vehicles Pre-operating expenses FISCAL DEPRECIATION Buildings Vehicles Machinery, Utilities, Installation costs Furniture and equipment 5. 13 WORKING CAPITAL Accounts receivable Accounts payable Cash balance 18. 0% 12. 0% 13. 0% TAXES Corporate income tax Domestic sales tax 32. 0% 10. 0% LOANS (domestic) Suppliers' credit: Risk premium Real interest rate Instalments 1. 0% 3. 0% 10 Commercial bank loan: Risk premium Real interest rate Instalments 0. 5% 3. 0% 10 -0. 5% Increase in real domestic price Inputs: Milk (Ps/l) Fuel (Ps/l) % real change Ps/Kg above real export pr. 7. 00 2. 50 2. 0% 1. 0% 60 4. 7 2, 900, 000 3. 0% 0. 0% 3. 0% Year 2 2. 660 0. 0110 32 Year 3 2. 530 0. 0106 40 Years 4 -10 2. 470 0. 0102 45 Year 0 Year 1 Year 6 160, 000 800, 000 750, 000 COST OF CAPITAL Return to equity, real 50, 600 103, 000 60, 700 28, 000 9, 450 46, 095 INFLATION AND EXCHANGE RATES <<Risk V. Domestic inflation 30. 0% Foreign inflation 3. 0% Exchange rate in Yr 0 7. 8 Ps/$ <<Risk V. Yearly apprec. of Mex. Peso 0. 20% 10. 0% PRODUCTION AND INVENTORY Starting production in Year 2 (Kg) 9, 450 Useful life for tax purp. (years) 25 5 15 7 % increase in production Ending inventory as % of gross sales Operating days EXPORTS 48 Exports as a % of sales 500, 000 Year 3 40. 0% 35. 0% 330 70. 0% Year 4 2. 0% Years 5 -10 1. 0%

49

50

QUESO OAXACA Inc. Risk Variables Report Risk Variable Real exchange rate (US$/Pesos) factor Probability distribution: Range: Standard deviation: Degree of skewness: MIN -16. 5% MEAN 0. 0% NORMAL MAX 16. 5% 5. 5% 0%

52

53

CONTRACT: PRICE OF MILK / liter = 20. 3% OF PRICE OF CHEESE / kilo Cumulative Distribution of NPV (Equity Viewpoint) Expected Value = 1, 471 Standard Deviation = 2, 803 Probability of Negative Outcome = 31. 5% Expected Loss = 547 Expected Loss Ratio = 0. 213 100% probability 80% 60% 40% 20% 0% (8, 000) (6, 000) (4, 000) (2, 000) 0 2, 000 4, 000 6, 000 8, 000 54 10, 000 12, 000

Management and Alleviation of other Project Risks A. Pre-Completion Risks Types of Risks Examples of Ways to Reduce or Shift Risk Away from Financial Institution Participant Risks - Sponsor commitment to project - Require Lower Debt/Equity ratio - Reduce magnitude of investment - Finance investment through equity and then by debt - Financially weak sponsor - Attain third party credit support for weak sponsor (e. g. , letter of credit) - Cross default to other 55 sponsors

Management and Alleviation of Risks A. Pre-Completion Risks (cont’d) Types of Risks Process failure Completion Risks Cost overruns Examples of Ways to Reduce or Shift Risk Away from Financial Institution - Process / Equipment warranties - Pre-agreed overrun funding - Fixed (real) price contract Project not completed - Completion guarantee - Tests: mechanical/financial for completion Project does not attain mechanical efficiency - Assumption of debt by sponsors if not completed satisfactorily 56

B. Post-Completion Risks Examples of Ways to Reduce or shift Types of Risks Risk Away from Financial Institution Natural Resource/Raw Material Availability of raw materials - Independent reserve certification - Example: Mining Projects: reserves twice planned mining volume - Firm supply contracts - Ready spot market Production/Operating Risks Operating difficulty leads to insufficient cash flow - Proven technology - Experienced operator/management team - Performance warranties on equipments - Insurance to guarantee 57 minimum cash

B. Post-Completion Risks (cont’d) Examples of Ways to Reduce or Shift Types of Risks Risk Away from Financial Institution Market Risk Volume: cannot sell entire output Price: cannot sell output at profit Force Majeure Risks Strikes, floods, earthquakes, etc. - Long term contract with creditworthy buyers: take-or-pay; take-and-pay - Minimum volume/floor price provisions - Price escalation provisions - Insurance - Debt service reserve fund 58

Examples of Ways to Reduce or shift Types of Risks Risk Away from Financial Institution Political Risk Covers range of issues from nationalization/expropriation, changes in tax and other laws, currency inconvertibility, etc. - Host govt. political risk assurances - Assumption of debt - Official insurance: e. g. , EXIM - Private insurance: e. g. , LLOYDS - Offshore Escrow Accounts Abandonment Risk Sponsors walk away from project - Abandonment test in agreement for banks to run project Other Risks: Not really project risks but may include Syndication risk - Secure strong lead financial institution Currency risk - Currency swaps / hedges Interest rate exposure - Interest rate swaps Rigid debt service - Built-in flexibility in debt 59 service obligations

Evaluation of Regulations Example: Cost-Benefit Analysis of Reductions of the Sulphur Level in Gasoline in Canada 60

Regulatory Policy In November 1999, the Government of Canada instituted the policy that a cost-benefit analysis must be carried out for all significant regulatory proposals to assess their potential impacts on the environment, workers, business, consumers, and other sectors of society. In 2006, all regulatory departments and agencies are expected to show that the recommended option maximizes the benefits in relation to costs and yields greater net benefits over time than any other type of regulatory or non-regulatory action. Other countries and international communities such as the U. S. , Australia, European Commission, etc. have also come to recommend that a cost-benefit analysis is the centre of regulatory analysis. 61

Identification of Policy Issues In 1997, the sulphur content of Canadian gasoline and diesel fuels varied widely across the country. Fuels with high sulphur levels affect tailpipe emissions of motor vehicles and contribute to air pollution. Emissions of pollutants from vehicles cause harm to the health of Canadians and to the environment. High sulphur fuels hinder the development of more fuel efficient motor vehicles needed for the future control of greenhouse gas emissions. 62

Setting Objectives Development of alternative regulatory and nonregulatory policy options to reduce concentration of sulphur in motor fuels: - Non-regulatory options include use of economic instruments, i. e. , taxes. (Economic instruments not suitable because of difficulty of having a national tax policy on motor fuels); - Regulatory options in terms of the level of sulphur concentration. Cost-benefit analysis is a tool to assess the benefits and costs of alternative options. 63

Development of Alternative Scenarios The alternative scenarios and the base case are developed on the basis of the sulphur reductions in gasoline and diesel fuels that would come into effect on January 1, 2001. The base case is established with the maximum level of sulphur maintained at 410 ppm over the period from 2001 to 2020. Six alternative scenarios are related to the reduction of sulphur in gasoline and three options are associated with the reduction of sulphur in diesel fuels. General rules: All scenarios are required to have a maximum annual level of sulphur in gasoline or diesel fuels and the level of sulphur at any point in time must never exceed a specified level of sulphur. 64

Approaches to Measure the Benefits and Costs of Alternative Scenarios Two alternative approaches: - first, estimate both the gross annual benefits and costs of alternative scenarios and the base case; - second, estimate the incremental annual benefits and costs of alternative options in excess of the baseline scenario. Principle for measuring the economic benefits is WTP while for measuring the economic costs it is the opportunity cost of the resources used. 65

Measurement of Economic Costs Compliance costs by the private sector: - 17 refineries produce fuels in Canada; Each refinery employs different strategies to meet the specification of each scenario; Capital costs reflect changes in facilities required by refineries to meet the regulation set by each scenario; Annual operating costs are increased to operate the facilities with lower levels of sulphur. Administrative costs by governments to enforce the regulations. Additional social costs are accounted for as a result of refinery closure. 66

Measurement of Economic Benefits Using an atmospheric model, the change in sulphate concentration is estimated brought about by changes in the level of sulphur in gasoline and diesel fuels for each of seven cities. Using the benefit transfer approach, - take the estimates from related research of the impact on human health and then adjust to reflect the circumstances of the situation in Canada; - assign probability weights for low, central and high estimates to account for uncertainty. Measure the impact on health and environment in monetary value. 67

Sulphate Concentration Reductions for Selected Scenarios in Years 2001 and 2020 (µg/m 3) Scenario 4 (150 ppm) 2001 2020 - Halifax 0. 08 0. 09 - Toronto 0. 25 0. 30 - Vancouver 0. 04 0. 05 Scenario 7 (400 ppm) 2001 2020 - Halifax 0. 15 0. 20 - Toronto 0. 15 0. 18 - Vancouver 0. 12 0. 16 Scenario 6 (30 ppm) 2001 2020 - Halifax 0. 11 0. 13 - Toronto 0. 31 0. 38 - Vancouver 0. 08 0. 11 68

M o Estimated Health Responses for a 1 µg/m 3 r b Change in Sulphate Concentration i d i. Mortality t Range Weights y - Low 1. 14 x 10 -5 22% C - Central 2. 54 x 10 -5 h - High 5. 70 x 10 -5 r o n i c R e s p i r 67% 11% 69

Total Reductions of Yearly Health Effects for Scenario 6 2001 Premature Mortality 2010 84 Morbidity Effects - Chronic Respiratory Disease 302 - Respiratory Hospital Admissions 52 - Cardiac Hospital Admissions 43 - Emergency Room Visits 270 - Asthma Symptom Days 131, 402 - Restricted Activity Days 63, 721 - Acute Respiratory Symptoms 438, 197 - Child Lower Respiratory Illness 3, 683 2020 103 129 372 469 65 82 53 66 333 420 161, 680 203, 570 78, 392 98, 686 538, 961 678, 317 4, 553 5, 764 70

Health Effects in Monetary Values Principles for measuring the benefits is WTP. If WTP estimates are not available, cost-of-illness estimates are used and adjusted upward to reflect the economic benefits. Central Value per Case ($1994 prices) Mortality (Age-weighted average) Morbidity Effects - Chronic Respiratory Disease - Respiratory Hospital Admissions - Cardiac Hospital Admissions - Emergency Room Visits 4 m 291 k 65, 000 8, 300 600 - Asthma Symptom Days 49 - Restricted Activity Days 74 - Acute Respiratory Symptoms - Child Lower Respiratory Illness 14 360 71

Measurement of Gross Health Benefits The size of benefits is directly related to the reductions of the sulphur content of fuels: - for the most stringent scenarios, the health benefits accrue to individuals across the country; for the less stringent cases, only the areas with high sulphur at the present time are affected. The benefits generated from avoiding premature mortality risks account for more than three-quarters of the total benefits. 72

Measurement of Net Economic Benefits (a) The net benefits are derived from the gross economic benefits minus the incremental economic costs. E. g. , for scenario 6, the amounts of benefits and costs are expressed in millions of 2000 prices: NPV @7% Gross Economic Benefits $6, 127. 37 Economic Costs - Compliance Costs 3, 307. 66 - Administrative Costs: Federal : Provincial - Closure of Refineries Net Economic Benefits 0. 64 (14. 12) 19. 29 2, 813. 90 73

Net Health Benefits for Canada (b) Using the 7% discount rate, the NPV of net economic benefits are positive for scenarios 1 to 7 while scenarios 8 and 9 would result in a negative net benefit. Some omissions and uncertainties should be noted, e. g. , pollutants other than sulphate may have independent health effects; - the impact of the long-range transport of air pollution is not accounted for; - the impacts on agriculture, forest, and fishing are not quantified. - 74

NPV of Economic Benefits for Alternative Scenarios (millions of dollars in 2000 prices) Annual Average Gasoline: Max. to Exceed - Scenario 1 360 Never NPV @7% (ppm) 420 (ppm) 1, 985. 8 - Scenario 2 250 300 - Scenario 3 200 250 - Scenario 4 150 200 Scenario 5 100 150 2, 994. 6 - Scenario 6 30 80 Diesel: - Scenario 7 400 - Scenario 8 300 350 - Scenario 9 50 100 2, 330. 3 2, 694. 3 2, 879. 4 2, 813. 9 300 2, 498. 0 (136. 4) (709. 1) 75 -

Dealing with Uncertainty and Risk variables and probability distribution: - capital costs, +/- 40%, normal distribution; - operating costs, +/- 25%, normal distribution; - responses of premature mortality to sulphate with 22%, 67% and 11% for low, central and high estimates (1. 14 x 10 -5, 2. 54 x-5, and 5. 70 x-5), step distribution; - values of statistical life with 33%, 50% and 17% for low, central and high estimates ($2. 4 m, $4. 0 m, and $7. 9 m), step distribution. Perform Monte Carlo simulations for scenarios 4, 6 and 7: - the expected value of the NPV of economic benefits for each scenario is very close to the value of the respective deterministic cases; - there is zero probability of getting the negative net benefit. 76

Distribution of Net Benefits by Stakeholders The oil refiners are required to comply with the regulation by incurring capital expenditures and additional operating costs. However, a significant portion of the costs would be passed forward to consumers in the higher prices of gasoline fuels. Individuals are the main beneficiaries of the regulations because having cleaner air lowers the risks of premature mortality and morbidity. Some refinery workers will suffer temporary income losses as a result of refinery closures. Provincial government will save costs of medical care because of lower hospital admissions due to avoided health effects. Finally, the federal government will incur marginal administrative costs to monitor and enforce the regulations. 77

PV of Net Benefits by Stakeholders (millions of dollars in 2000 prices) Refinery Consumers Government Refiners Workers /Individual Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Scenario 6 Scenario 7 Scenario 8 Scenario 9 (117. 0) (272. 9) (339. 7) (444. 8) (578. 4) (826. 9) (238. 0) (189. 2) (542. 6) 0 0 (4. 8) (14. 5) (19. 3) (4. 8) 0 (4. 8) Prov. Fed. 2, 097. 6 2, 595. 9 3, 029. 9 3, 328. 4 3, 580. 5 3, 646. 6 2, 733. 6 51. 9 (164. 5) Total 5. 8 (0. 6) 7. 9 (0. 6) 9. 6 (0. 6) 10. 8 (0. 6) 12. 4 (0. 6) 14. 1 (0. 6) 7. 9 (0. 6) 1. 5 (0. 6) 3. 4 (0. 6) 78 1, 985. 8 2, 330. 0 2, 694. 3 2, 879. 4 2, 994. 6 2, 813. 9 2, 498. 0 (136. 4) (709. 1)

Conclusions Lowering the sulphur levels in gasoline will generate a substantial amount of health benefits to Canadians for all alternative scenarios. The most stringent scenario 6 may not be the scenario with the largest amount of benefits. However, it is the scenario that will create a suitable regulatory environment because it would generate not only a considerable amount of benefits but also a number of benefits that are not easily taken into account in the quantitative analysis. They are: - help vehicle control systems function more efficiently; - help Canada control greenhouse gas emissions in the future. In the case of sulphur level in diesel, the NPV of the net benefits are negative for both scenarios 8 and 9. However, scenario 7 with a modest change in the sulphur level to 400 ppm would produce a significant health benefit for Canadians. 79

Ex Post Assessment Regulations: The sulphur in gasoline regulations was set at a maximum level of 30 ppm with a never-to-beexceeded maximum of 80 ppm beginning in January 2005. An interim step was to have the sulphur level in gasoline limited to 150 ppm with a level never exceed 200 ppm starting July 2002 to the end of 2004. The levels of sulphur in gasoline have followed closely those set by the Regulations. These results show a significant improvement in the air quality in Canada. There has been no closure of any refineries since the introduction of the regulations. Some refineries have even skipped the phase-in approach and moved directly to the sulphur level of 30 ppm. 80