Distributional Weights in Environmental Valuation and Cost-benefit Analysis: Theory and Practice

Abstract

Cost-benefit analysis (CBA) is built on the Kaldor-Hicks efficiency criterion whereby projects that have aggregate positive net benefits are recommended even if those who lose are not compensated for their losses. Two kinds of problems can be identified with the use of the criterion. First, as income tends to affect monetary welfare changes positively, the preferences of those with higher wealth have a larger weight in societal decision-making. Second, monetary welfare changes can be thought of as changes in real income, which matter more for those with a lower initial wealth level. Both problems can be mitigated with distributional weighting. Despite their strong theoretical pedigree, distributional weights have been largely neglected in practical CBAs, one exception being analyses in climate change economics. We present the theory of distributional weighting and illustrate how weights can be applied empirically in an international environmental CBA that deals with marine water quality improvements. We show that different weighting schemes can result in different policy recommendations. We also show that taking the income distribution within countries into account can change a country's willingness to participate in the water quality improvement program and that the income elasticity of willingness to pay (WTP) is an important indication of the direction of change.