Risk and Uncertainty in Cost-Benefit Analysis

Toolbox paper written by Karsten Stæhr and published by the Environmental Assessment Institute in April 2006 on how to handle risk and uncertainty inside cost-benefit analysis. Reviews the standard textbook treatments, sets out why many analyses of environmental projects and policies must build on scientific results that carry little explicit uncertainty information, and explains the two errors a decision maker can make: rejecting a project that would have benefited society, and undertaking one that is not socially favourable, with the trade-off that measures which reduce the first error usually increase the second. Covers the estimation of probability distributions, the difference between independent variation across variables and serial correlation across periods for a single variable, illustrated by the persistence of consumption patterns, the assumption of an exponential utility function implying constant risk aversion, and the balancing act of quantifying risk without giving weight to events that are highly unlikely.