Environmental Economics: Determining values and analyzing options John A. Dixon [email protected]...

Environmental Economics: Determining values and analyzing options

John A. Dixon

[email protected]

Kailua, Hawai’i

May 2007 2Environmental Economics - John A. Dixon

Why do environmental economic analysis? To determine if the benefits exceed the costs of a

government policy or investment project – often in a benefit-cost analysis framework

To estimate the “values” of environmental goods and services that are not priced and/or imperfectly priced by the market

To estimate the costs of present environmental damages (e.g. pollution effects on health) or future, potential environmental damage (e.g. global warming)

To identify market and policy failures and propose solutions to these problems


Benefit-Cost Analysis: a basic project or policy analysis tool often used in environmental analysis Benefit-cost analysis (BCA) is a project and/or policy analysis

tool developed in the US in the 1940s (first focused on water resource development)

Asked the simple question “Do the expected benefits of an investment justify the costs?” (Flood Control Act of 1936)

Present day BCA includes: Monetary estimates of both the benefits and costs of the activity

(both projects and policies) over time A defined time horizon (cf. short-run (5 years or less), medium-

run (10 – 15+ years), and the (Keynesian) long-run (when we are all dead!))

A defined discount rate (possibilities include social rate of time preference, productivity of capital, cost of capital, others…)

Explicit inclusion of externalities (both temporal and spatial) is what usually defines an environmental economic analysis


An aside -- BCA or CEA, which is

best?? B/CA, or benefit–cost analysis, is preferred since it

includes monetary estimates of both benefits and costs over time. The answer is usually a measure of net economic benefits generated by the activity/ policy

CEA – or cost-effectiveness analysis – is useful when it is impossible to estimate benefits of a project (and project costs are almost always known) and so we seek the least cost way to reach a stated goal or objective


Why BCA is Preferred (and NPV is best) BCA gives a quantitative measure of the

generation of net social benefits/ social welfare (usually measured in $$$)

BCA can take several forms – NPV (net present value), BC Ratio (benefit cost ratio) or EIRR (economic internal rate of return)

All three forms use the same data as inputs but vary in how they handle the discount rate (r).


BCA – Alternative Decision Rules based on the same basic inputs – benefit and cost information

Net Present Value (NPV)

Economic Internal Rate of Return (EIRR)

Benefit-Cost Ratio (B/CR)

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Each evaluation criteria yields a different answer to the decision question The answer to a NPV analysis is a monetary amount ($$$)

The EIRR determines the discount rate where the PV of benefits is just equal to the PV of costs (and the EIRR is then compared to the discount rate)

The answer to a B/CR calculation is a ratio (a pure number, often just less than or just more than 1.0)

All three criteria use the same input data on benefits and costs over a defined time period (the “time horizon”), and with a pre-determined discount rate for NPV and B/CR. The EIRR solves for the discount rate where PV benefits is equal to PV of costs.


The effect of discounting

Project analysis assumes constant relative prices; Discounting therefore is free of inflation and different discount rates can reflect various factors: Social rate of time preference (society’s willingness to trade

off present for future consumption), Productivity of alternative/ competing investments Cost of borrowing money (the usual World Bank approach) Political or Social factors


The impact of discounting

The Present Value today of a periodical payment of $100 in the future varies with the time horizon (t) and the discount rate, (r): If t = 20 years and r = 5%, the PV = $1,246 If t = 20 years and r = 10%, the PV = $ 851 If t = 20 years, and r = 15% the PV = $ 626 A useful “rule of thumb”: For an infinite time

horizon (t = ∞), then the PV = annual payment/ r. e.g. with an annual payment of $100 with r = 10%, the PV =$1000.


Externalities and Valuation – central issues in environmental economics and in carrying out a BCA There are two major causes of poor economic analysis

of the environment – environmental externalities and economic valuation

Externalities – a disconnect between cause and effect, either over space or over time (the person affected by something is not part of the decision making process); results in ignoring important impacts

Valuation – lack of market prices to signal scarcity or value: results in low or “zero” prices for important benefits or costs


Why is economic valuation so important in environmental economics?? Many goods and services are not “priced” correctly

in normal markets Economic valuation therefore allows a fuller

accounting of benefits and costs (more things are included in the analysis, including environmental goods and services that are often ignored)

Valuation improves the chance of projects passing an EIRR test (WHY?)

Valuation helps us overcome “failures” in existing markets by identifying distorted prices (e.g. gasoline consumption , gas prices, and health and GHG impacts of increasing energy use)


Economic valuation can “price” different types of goods -- private, public, and in-between

Excludable?

YesRival?

Yes

No

No

Private Goods

• Clothing

• Congested toll roads

Collective Consumption Goods

• Software

• Uncongested toll roads

Common Property Resources

• Ocean fisheries

• Congested non-toll roads

Public Goods

• National defense

• Uncongested non-toll roads


The Total Economic Value (TEV) Approach TEV includes both Use Values and Non-Use

Values of any good or service Use values are easier to measure and

include direct use (both consumptive and non-consumptive), indirect use, and option values (a future use value)

Non-use values include bequest values and existence values; these are harder to measure

The TEV is the sum of all of these values


The TEV Table – The case of a forest

TotalEconomic

Value

UseValue

Non-useValue

Direct UseValue

Indirect UseValue

OptionValue

BequestValue

ExistenceValue

Timber productsRecreation

Hydrologicalservices

Potential forgenetic research

or future use

Timber and hydro services

for futuregenerations


TEV – the resource being valued does make a difference! For some environmental products, most of the value is

in direct use values : e.g. drinking water, plantation forests, aquaculture, ground water, oil deposits..

Indirect uses values include watersheds, coral reefs and shoreline protection or fisheries, special habitats

For other environmental goods and services, most of the value is in non-use values: e.g. endangered species (e.g. whales, the panda,…) or remote but special places (e.g. the Galapagos, Mt Everest, the Great Barrier Reef, Antarctica,..)


So, How much is nature worth? Many techniques exist to value the “unpriced/ underpriced”! Many rely on observing the behavior of

people (revealed preferences) in markets or other situations

Some techniques rely on people stating their preferences in hypothetical situations (stated preferences), such as contingent valuation methods, survey-based techniques,..


Valuation techniques: Change in production (a revealed preference technique) A basic “price x quantity” approach that is very

useful in many NRM projects, e.g changes in production of crops or fisheries

Changes in production may have been ignored because they occurred “off-site” (externalities) or because of pricing problems (valuation)

Fairly easy to estimate and also easy for decision makers to understand


Cost-of-Illness approaches (both revealed and stated preferences) Morbidity costs:

Cost of medical treatment, lost work time, medicines, care giving

Costs of avoiding getting sick Mortality costs:

Lost productivity (human capital-HC- approach) Value of statistical life (VSL) includes both revealed and

stated preferences –is a willingness-to-pay measure, often 10 times larger than HC approach – WHY?


Cost-of-Illness approaches (revealed preferences)-continued Very widely used in the Bank in both “cost of

environmental degradation” studies, as well as in justifying investment projects in pollution control, road safety, health care, disease prevention,…

Mortality (death) costs are almost always big numbers and swamp morbidity figures (WHY might this be so??). US average VSL now is over $5 million. How can this be used in developing countries? Why might CEA be preferred to BCA in this case?


Valuation techniques: Contingent valuation method (CVM) (stated preferences) CVM as a second-best approach that relies on

surveys and questions on willingness-to-pay (WTP) or willingness-accept-compensation (WTAC) for such things as an environmental good or service, or damage to health

When should you use WTP and when WTAC??? – in theory and in practice??

Especially useful when the market does not exist (e.g. a yet to be established protected area) or for non-use values like bequest and existence values (e.g. for endangered species)


Valuation techniques: Contingent valuation method (CVM) –contd. Extensively used for ecosystem damage assessments when there is

human use or knowledge of the ecosystem Sometimes applied by the use of Benefit Transfer techniques –

applies the valuation results (or benefit functions) from study site A to a similar resource in study site B (may be in different countries) A quick way to get an answer overnight Use of “meta analysis” from the literature helps strengthen

credibility of benefit transfer Important caveats

Both study sites (the resource being valued) must be similar Population using each site must be similar wrt important

characteristics Not a substitute for actual work in location B if time and money

permit Good point about CVM – you always get an answer! Bad point about CVM – you always get an answer!!


An example --WTP for a National Park in Georgia Estimating the WTP for new and existing

national parks in Georgia Uses CVM approach to estimate WTP by

different user groups for the proposed park Surveys Georgians in country, and foreigners

living in Georgia, Armenia, and Azerbaijan (the main users to existing recreation areas)

Derives estimates for both daily and annual passes for Georgians ($$ per day, $$ per year)


Another example: measuring WTP for restoration of Lake Sevan, Armenia Designed to augment a change in productivity

analysis (for agricultural crops) for a proposed investment operation by including use and non-use values by Armenians

Includes responses from Armenians in Armenia and also Armenians resident abroad (a much larger number)

Tests two different payment vehicles – a one time payment and monthly payments for 3 years

Applies Benefit Transfer to estimate total expatriate WTP (based on relative income levels and other factors and survey results in one or two locations)


Valuation techniques:Travel cost method (revealed preferences) A “revealed preference” approach based on

observation or survey data on actual travel patterns including the monetary costs and time involved in travel

Solid theoretical and practical foundations and applications

A good technique for many recreational/ cultural amenities where visitation is an important use

Remember: the travel cost itself is not the value of the resource – but this information is used to derive a demand curve to then estimate values for the resource


Valuation techniques : Hedonic price methods (revealed preferences) Value environmental amenities (and

disamenities) by changes in property values or location-specific prices (such as sites with differing views)

Applied to housing, hotels, land and other site-specific valuation issues

A very strong revealed preference approach However, willingness to pay is naturally

limited by the ability to pay


More jargon -- resource rents, market failures, policy failures Resource rents: Rent is an excess return to a factor:

R = p – (economic cost of production)Related conceptually to producer’s surplusExamples: oil production in Saudi Arabia [<$5 to produce a barrel], share-cropping, Pavarotti, Picasso, Pele, …

Market failures occur when prices do not send the right signals (e.g. public beaches or coastlines, the Mall in Washington…)

Policy failures occur when government policies send the wrong signals, usually via distorted prices (e.g. government subsidies for kerosene; “free” admission to Smithsonian Museums; subsidized parking spaces downtown…)


Conclusions

Environmental economics is economic analysis when one is concerned with valuation, externalities, rent capture, market failures, and policy failures

Economic valuation is a key issue and a wide variety of valuation techniques exist and can be used – in WB projects the most common applications are those relating to changes in health (usually from pollution; could also be from STDs or other causes) or changes in production of crops, fisheries, forests, …

The applied literature on environmental economics is expanding rapidly in both developed and developing countries


Conclusions (contd.)

There is increased acceptance of both the analytical techniques and the results by government decision makers and the general public. The next session on global warming illustrates this.

Cannot value all environmental components –e.g. what is biodiversity worth????

Valuation can be built into project design and does not have to be terribly expensive

Some short cuts are possible (quick and dirty approaches, e.g. benefit transfer, rules of thumb or simple CEA results) but have to be used with caution

For more advice, see your friendly local World Bank environmental economist for assistance!!!

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