CERE Working Papers,
CERE - the Center for Environmental and Resource Economics

Abstract: Resource-based compensation aims to offset the public's welfare loss associated with environmental injuries. Compensatory payments are frequently scaled using Equivalency Analysis (EA). EA's focus on ensuring equity in utility terms for the victim may lead to an inefficient outcome for society as it fails to incorporate the social opportunity cost of the compensatory payment. An alternative scaling approach based on Cost-Benefit Analysis (CBA) may better address the trade-offs facing society by considering the social marginal benefits of additional compensation, which may be a function of the cost of provision and the quality of existing resources. A simple numerical model illustrates the differences in scaling approaches. In contrast to EA, CBA suggests that the optimal compensatory payment may be positive, zero or negative (i.e., additional damage should be allowed). EA need not lead to a decline in welfare if the environmental damage or the costs of compensation are marginal, or if policy makers have a particular welfare function in mind vis a vis the polluter. The lack of credible methods for pricing non-market resources may lead to a preference by policy makers for the equity-focused EA approach rather than one aiming for socially efficient outcomes. Both methods require inevitable value judgments to determine whether society is, in fact, "no worse off" following compensation. EA seems in conflict with governments' otherwise increasing, but still limited, use of environmental CBA to direct scarce conservation resources to a variety of environmental challenges.

Keywords: Equivalency Analysis (EA); Cost-Benefits Analysis (CBA); interim loss; equity; efficiency; social profitability

JEL-codes: D61

25 pages, May 25, 2012

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