Accounting for Economy-Wide Effects, Risk Aversion, and Inequality Aversion in the Cost-Benefit Analyses of Extreme Events

Abstract

Traditional economic analysis techniques, such as Cost-Benefit Analysis (CBA), often form a critical input to decision-making when attempting to manage and invest in risk-reduction options. However, these techniques tend to be applied narrowly and uniformly across affected parties and contexts. Although one of the main tenets of CBA is to improve social welfare, the disregard of heterogenous valuation of income is still evident in most CBA protocols. It can be argued that this is highly inappropriate when intra- and inter-generational income inequality is among the most pressing issues facing current governments.

Contrary to the traditional application of CBAs, the literature has demonstrated that individuals with different levels of income value impacts differently. This study uses a fuel disruption case study in New Zealand to illustrate one of the most essential concepts in economics, the one of a utility function representing well-being, and its more realistic treatment through the concept of marginal utility, to improve the current implementation of CBAs. Specifically, it analyses a case study using a dynamic economy-wide model under alternative evaluation approaches, considering differing risk aversion levels across individuals, as well as intra- and inter-generational inequality aversion by society.

The results show that new tools and processes are needed to better support decision-making around extreme events (i.e. low-probability, high-impact events), and, in turn, to effectively enable Priority Three of the Sendai framework: "Investing in disaster risk reduction for resilience", and Goal 10 of the Sustainable Development Goals: "Reduce inequality within and among countries".