Cost-benefit analysis is the wrong tool for tackling climate change

by Rachel Samson. Originally published on Policy Options
November 1, 2021

Everyone loves a simple way to make hard choices. Cost-benefit analysis has long been the magic 8 ball for government policy decisions. If costs exceed benefits, then the policy proposal should be shelved. If benefits exceed costs, then it should get the green light.

When it comes to climate policy, however, cost-benefit analysis is leading decision-makers astray. It generally overestimates costs, underestimates benefits and is better suited to incremental changes than the system-wide transformation needed to address climate change.

It is time for governments to update the tools they use to make decisions on climate policy. The stakes couldn’t be higher. Making the wrong choices today will lead to far worse economic and societal outcomes down the line, especially in the face of the major global market shifts on the horizon. There are better alternatives, such as “risk-opportunity analysis.” See, for example, this 2021 study by Mercure et al., which evaluates a range of positive and negative impacts under plausible scenarios.

Cost-benefit analysis isn’t equipped for transformative change

In evaluating specific policy choices to respond to climate change, cost-benefit analysis fails the test for four reasons. Under it,

1. Company expenditures are considered costs, not investments. Traditional cost-benefit analysis does not account for the competitive benefits of actions that companies take in response to policy. It puts all costs in the “bad” column and pits them against benefits in the “good” column, but many expenditures that companies make today are likely to pay off in future as the global low-carbon transition accelerates. Expenditures that yield a future return should be seen as investments, not costs. Increased private sector investment in emission reductions and new, transition-consistent product lines are critical to improving the resilience of Canada’s economy to global change.

2. Businesses that could benefit from the policy are ignored. The focus of cost-benefit analysis is usually large incumbent businesses that will face costs, rather than newer companies that could see increased demand for their products or services. Recent analysis found more than 500 Canadian companies that could benefit from increased climate action through increased demand for their technologies or products. Supporting the growth of new companies and sectors that are positioned to capture market opportunities through global low-carbon transition is key to strengthening Canada’s long-term competitiveness.

3. Society is not benefitting from technology adoption. Policies that increase technology adoption also help to drive down costs, as they accelerate learning rates and economies of scale. This creates a positive feedback loop (or green vortex) that further increases technology adoption and improves the feasibility of more ambitious climate action. If a policy today leads to lower policy costs in the future (and therefore greater global progress in reducing emissions), it has a societal benefit beyond the direct emission reductions achieved.

4. Policy-certainty benefits are not captured. Regulation is often viewed solely as a drag on economic growth and a burden to business. When it comes to climate policy, greater clarity for businesses on market transition scale and timing can also unlock private investment. Certainty on policy directions can generate economic benefits.

Consider, for example, the federal commitment to achieve 100 per cent zero-emission passenger vehicle sales by 2035. If governments use traditional cost-benefit analysis to assess policies aimed at reaching that goal, they might conclude that slower, incremental changes would be better for the economy because they would imply lower costs for auto manufacturers. However, that decision could actually lead to less economic growth and fewer jobs in the future.

When we at the Canadian Institute for Climate Choices stress-tested auto companies under global low-carbon transition scenarios for our report Sink or swim: Transforming Canada’s economy for a global low-carbon future, the future competitive benefits of early investments in electric vehicle readiness became clear. Figure 1 shows that auto companies that invest in electric vehicles would see increased profitability from now until 2050, while those that do not would see substantial profit loss. Well-designed policies that increase expenditures on electric vehicle manufacturing can improve competitiveness.

A broader set of companies will face risks and opportunities from the policy and could be missed in a narrow cost-benefit analysis. Supply chains and repair shops will have to adjust, and new businesses managing charging networks and recycling batteries will need to emerge. Canada has a number of businesses that could benefit, such as vehicle-charging software provider AddÉnergie, electric vehicle battery recycler Li-Cycle, and mining companies active in battery minerals such as lithium and copper. Greater demand for electric vehicles could also help attract more battery manufacturers.

Decisions based on cost-benefit analysis alone could lead to reduced competitiveness and missed opportunities, resulting in worse overall economic outcomes.

Even small adjustments would make a big difference

A relatively simple near-term step to address the problems with traditional cost-benefit analysis is to include some of the missing benefits in the analysis. As with early efforts to incorporate values for the social cost of carbon, there will need to be some methodological experimentation. Benefit estimates could be developed using analysis similar to that in the Sink or Swim report, which models company profitability under different global transition scenarios and analyzes areas of potential transition opportunity. Governments could also use economic modelling, similar to the 2021 Clean Energy Canada and Navius  Research projections of clean energy GDP increases, associated with the federal climate plan.

In the longer term, shifting to the risk-opportunity analysis proposed in the Mercure study would support better decision-making; for example, it

• Assesses a portfolio of policies designed for transformative systems change rather than one policy aimed at incremental change
• Evaluates a range of qualitative and quantitative risks and opportunities under various plausible scenarios rather than producing one metric
• Considers positive feedback loops between components, such as declining technology costs; and
• Presents decision-makers with findings that include uncertainty ranges and confidence levels.

Risk-opportunity analysis will not produce a magic yes-no answer, but it would support more thoughtful debate about the policy mix that would deliver the best overall climate, economic and societal outcomes.

Cost-benefit analysis is a small part of a bigger challenge

There is a reason that cost-benefit analysis was designed for incremental change. Incremental change is what governments, and often societies, prefer. People have a status quo bias and are less comfortable with large, sweeping transformation.

The problem is that incremental change is no longer in the cards. Canada will not succeed in climate change or in maintaining a strong economy without transformative change. The world is rapidly transforming around us, and unless we anticipate and adapt to new market realities we will be left behind.

There are massive opportunities, including the potential for a future that is much more inclusive and prosperous than the past. But success won’t happen on its own. It requires action, investment, planning, co-ordination, innovation, and a boldness that will be hard for some to embrace.

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Changing how decisions are made to reflect the scope and scale of the problems we face and the solutions we need would be a good place to start.

This article first appeared on Policy Options and is republished here under a Creative Commons license.