Bringing Social Standards into Project Evaluation Under Dynamic Uncertainity

Abstract

Society often sets social standards that define thresholds of damage to society or the environment above which compensation must be paid to the state or other parties. In this paper, we analyze the interdependence between the use of social standards and investment evaluation under dynamic uncertainty where a negative externality above a threshold established by society requires an assessment and payment of damages. Under uncertainty, the party considering implementing a project or new technology must not only assess when the project is economically efficient to implement but when to abandon a project that could potentially exceed the social standard. Using real option theory and simple models, we demonstrate how such a social standard can be integrated into cost-benefit analysis through the use of a development option and a liability option coupled with a damage function. Uncertainty, in fact, implies that both parties interpret the social standard as a target for safety rather than an inflexible barrier that cannot be overcome. The larger is the uncertainty, in fact, the greater will be the tolerance for damages in excess of the social standard from both parties.