Environmental Economics: Determining values and analyzing options John A. Dixon johnkailua@aol.com Kailua, Hawai’i

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 May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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 May 2007 Environmental Economics - John A. Dixon

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 May 2007 Environmental Economics - John A. Dixon

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). May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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) May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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. May 2007 Environmental Economics - John A. Dixon

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 May 2007 Environmental Economics - John A. Dixon

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. May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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 May 2007 Environmental Economics - John A. Dixon

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) May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon Economic valuation can “price” different types of goods -- private, public, and in-between Rival? No Yes 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 Yes Excludable? No May 2007 Environmental Economics - John A. Dixon

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 May 2007 Environmental Economics - John A. Dixon

The TEV Table – The case of a forest May 2007 Environmental Economics - John A. Dixon

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,..) May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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,.. May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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 May 2007 Environmental Economics - John A. Dixon

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? May 2007 Environmental Economics - John A. Dixon

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? May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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) May 2007 Environmental Economics - John A. Dixon

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!! May 2007 Environmental Economics - John A. Dixon

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) May 2007 Environmental Economics - John A. Dixon

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) May 2007 Environmental Economics - John A. Dixon

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 May 2007 Environmental Economics - John A. Dixon

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 May 2007 Environmental Economics - John A. Dixon

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 surplus Examples: 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…) May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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 May 2007 Environmental Economics - John A. Dixon

Environmental Economics - John A. Dixon 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!!! May 2007 Environmental Economics - John A. Dixon