How do you account for externalities and social benefits in NPV analysis?

1 Adjust the cash flows

One way to account for externalities and social benefits in NPV analysis is to adjust the cash flows of the project to include the monetary value of these effects. For example, if a project reduces carbon emissions, you can add the social cost of carbon (SCC) to the cash inflows. The SCC is an estimate of the economic damage caused by one ton of carbon dioxide emitted into the atmosphere. Similarly, if a project increases public education, you can add the social value of education (SVE) to the cash inflows. The SVE is an estimate of the economic benefits of one additional year of schooling for an individual and society. By adjusting the cash flows, you can compare the project's NPV with and without externalities and social benefits.

2 Adjust the discount rate

Another way to account for externalities and social benefits in NPV analysis is to adjust the discount rate of the project to reflect the social opportunity cost of capital (SOCC). The SOCC is the rate of return that society could earn by investing in alternative projects with similar risk and social impact. For example, if a project has positive externalities and social benefits, you can use a lower discount rate than the market rate to increase the NPV of the project. Conversely, if a project has negative externalities and social costs, you can use a higher discount rate than the market rate to decrease the NPV of the project. By adjusting the discount rate, you can incorporate the social preferences and trade-offs of society into the NPV analysis.

3 Use a multi-criteria approach

A third way to account for externalities and social benefits in NPV analysis is to use a multi-criteria approach that combines quantitative and qualitative measures of the project's performance. For example, you can use a balanced scorecard (BSC) to evaluate the project's impact on four dimensions: financial, customer, internal, and learning and growth. The BSC allows you to assign weights and scores to different indicators and objectives that reflect the project's externalities and social benefits. For example, you can measure the project's environmental impact by using indicators such as greenhouse gas emissions, energy consumption, or waste management. You can also measure the project's social impact by using indicators such as customer satisfaction, employee engagement, or community involvement. By using a multi-criteria approach, you can capture the complexity and diversity of the project's outcomes and stakeholders.

4 Consider the uncertainty and sensitivity

A fourth way to account for externalities and social benefits in NPV analysis is to consider the uncertainty and sensitivity of the estimates and assumptions used in the previous methods. Externalities and social benefits are often difficult to measure and value, and may depend on various factors such as time, location, population, or behavior. Therefore, it is important to test the robustness and reliability of the NPV results by using techniques such as scenario analysis, sensitivity analysis, or Monte Carlo simulation. Scenario analysis involves creating different scenarios that reflect different assumptions and parameters for the project's externalities and social benefits. Sensitivity analysis involves changing one variable at a time and observing how it affects the NPV of the project. Monte Carlo simulation involves generating random values for the variables and calculating the probability distribution of the NPV. By considering the uncertainty and sensitivity, you can assess the risk and variability of the project's externalities and social benefits.

5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?