Part II. Environmental Valuation

1. Part II. Environmental Valuation Value Environmental Decision Making

2. B. Environmental Decision Making Chapter 5

3. Intro • Once you value the environmental good/service, can be used to test the “economic efficiency” of a potential decision or outcome. • One aspect of this process is the measurement of both the value of environmental resources and the value of changes in the level of environmental quality. • This is essential information when comparing the benefits of environmental policy against the costs of obtaining those benefits.

4. Decision-Making Criteria • Economic efficiency • Equity • Sustainability • Environmental Justice • Ecological impact/environmental stewardship • Ethics

5. Economic Efficiency • Economic efficiency has to do with maximizing the difference between the social benefit and social cost of an economic activity, policy, or project. • Economic efficiency is usually measured in one of two different ways: • Net economic benefit – preferred by economists and explored in Chp. 4; • Gross domestic product – preferred by international development and lending agencies.

6. Economic Efficiency – Net Economic Benefit • As the information presented in Chapter 4 indicated, the demand curve represents marginal WTP and the supply curve represents marginal opportunity cost of production. • Net economic efficiency subtracts total opportunity cost from total WTP and is represented by the area under the demand curve and above the supply curve for a particular good or service.

7. Economic Efficiency – Gross Domestic Product? • Gross Domestic Product is a measure of the total value of all goods and services produced in an economy. • Because expenditures become income, GDP is also a measure of national income. • GDP is not a measure of social welfare because it does not measure other dimensions of the quality of life, such as health, environmental quality, social justice, freedom from crime, etc.

8. Economic Efficiency – GDP? • GDP also fails as a measure of economic efficiency. • It does not consider the opportunity costs of producing the good or service. • This failure means that GDP would rise because of a rise in HIV/AIDS due to the increased expenditure on health care costs. • Net economic efficiency would not rise – damages from disease, opportunity cost of using those monies in next best option.

9. Economic Efficiency – Pareto Criterion • What constitutes an improvement in economic efficiency? • One option is the Hicks-Kaldor criterion, or the criterion of potential Pareto improvement. • Pareto improvement – resources are reallocated in such a fashion that some people are better off and no one is worse off. • Potential Pareto improvement – is reallocation whereby the gain of people who are helped is larger than the losses of those made worse off. If the gainers could compensate losers, the gainers would still be better off.

10. Equity • Potential Pareto improvement does not consider equity issues. • The equity criterion for evaluating policy considers how costs and benefits are distributed among members of society. • These distributional impacts could be within a country, across international borders, or across generations.

11. Equity Across Generations & Sustainability • Intergenerational equity is important because many of the decisions regarding resource use today may generate important environmental costs for future generations. • The process of discounting future costs and benefits can exacerbate this problem. • An alternate criterion of sustainability is based on improving the condition of the current generation without compromising the ability of future generations to meet their needs and improve their quality of life.

12. Equity Indicators • Income is one component of equity. • Two different measures are the primary tools for considering the inequality of the distribution of income, the Lorenz curve and the Gini coefficient. • The curve illustrates the % of income received by a given % of the population. • Equity is illustrated by the diagonal line bisecting the origin. Along this line the two % are equal. • Inequity in income distribution is illustrated by a curved line.

13. Equity Measures - Lorenz Curve

14. Equity Measures – Gini Coefficient • The farther the Lorenz curve is skewed away from the diagonal line, the more inequitable the income distribution. • This curve can be transformed into a single variable, the Gini coefficient. • Calculated by taking the area between the diagonal line and the Lorenz curve and dividing by the entire area under the diagonal line =100*A/(A+B) This value is then multiplied by 100. • Can range from 0 to 100, where greater numbers are associated with greater inequity.

15. Gini Coefficient

16. Environmental Justice • Studies have suggested that certain segments of the population face disproportionate exposure to environmental risk. • In the US, minorities, especially those of low income living in rural areas, face greater exposure to carcinogenic and mutagenic hazardous chemicals. • In developing countries, with giant cities, levels of air pollution as well as exposure to toxic waste surpass that of developed countries. • Environmental justice is an issue in rural areas where high levels of pesticide use by large plantation owners impacts villages downwind.

17. Ecological Criteria • There is no consensus on how to develop measures for quality and functionability of an ecological system. • The first question is how to define a desirable state of an ecosystem. • Ecosystem health – measures a system’s ability to provide a flow of ecological services. • Ecosystem integrity – measures the closeness of the system to a hypothetical reference system that is completely undisturbed by human activity.

18. Operational Indicators of Environmental Quality • At least 4 methods have been suggested to develop operational indicators: • The use of “representative” environmental variables. • The use of a “green” GDP. • The development of satellite accounts for National Income and Product Accounts. • The development of indices of sets of environmental variables.

19. “Representative” environmental variables • Sulfur dioxide’s Environmental Kuznets Curve (EKC): U-shaped relationship between environmental quality and income – indicator of air quality • Spotted owl – indicator species for Pacific old-growth forests • Abundance/biodiversity of mussels – biodiversity indicator for rivers in Tenn. River Valley

20. Green GDP • Many economists have argued that disastrous consequences for the environment result when macroeconomic policy is based on growth of GDP. • While net domestic product (NDP) subtracts the depreciation of human-made capital from GDP, it does not consider the depreciation of natural capital (forest clear cut, soil degraded, stocks of minerals depleted, etc.) • If increasing NDP is the primary policy goal, then the loss of future income from depleted natural capital is important.

21. Satellite accounts • Physical measures of environmental variables maintained side by side with GDP accounting (not integrated like GGDP) • Presented in flow and balance sheets just as GDP accounting • Idea is that rough monetary estimates can be made from these accounts

22. Indices • US Environmental Protection Agency’s EMAP (Environmental Monitoring and Assessment Program) – develops overall indicators for individual ecosystems (forests, wetlands, estuaries) • E.g., Estuaries – 20 indicators: water clarity, presence of trash, etc. Then aggregate index created by summing individual indicators

23. Ethics • Particularly important and particularly difficult to quantify. • Does the firm or agency have an ethical obligation for environmental stewardship independent of the impact on social welfare? • Should decision-making have an anthropocentric or biocentric approach? • “Deep ecology”, developed by Arne Ness, rejects management of the environment. All components of an ecosystem, as well as the ecosystems themselves, have an intrinsic value and an inherent right to exist. • Ethics can be treated as constraints to the decision-making process.

24. What do you think? • Should decisions be based solely on anthropocentric ideals? • Do ecosystems have inherent rights? • Is it okay to put a price on environmental goods/services? • If not, how to reconcile for policy making?

25. The Use of Multiple Criteria in Decision Making • How do policy makers take multiple decision-making criteria and jointly employ the criteria so as to inform the actual decision? • If too much aggregation is done across criteria, then a lot of the information that is contained in the different criteria will be lost. • Cost-benefit analysis is one approach which has been frequently employed and is even legally required of governmental agencies in many countries.

26. Cost-Benefit Analysis • The most important concept is that cost-benefit analysis is NOT a decision-making tool; it is only an information organizing tool • There is no single correct answer to a cost-benefit analysis exercise • Different assumptions about future states of the world or key analytical parameters will have a big impact on the final outcome • The analysis should produce a suite of numbers reflecting the sensitivity of the analysis to alternative analytical assumptions

27. Cost-Benefit Analysis • Cost-benefit analysis should be a dynamic analysis, investigating costs and benefits far into the future, where future costs and benefits are discounted. • The simplest version of a discounting formula is PV = FV(1/(1+r))t, • where PV is present value, FV is future value, r represents the discount rate and t is the time period.

28. Cost-Benefit Analysis • The objective of cost-benefit analysis is to identify the alternative project, plan, or policy that has the greatest net present benefit, which will therefore maximize economic efficiency.

29. Choice of the discount rate • A critical aspect of the analysis is the choice of the appropriate discount rate • The market rate of interest is not appropriate because it includes inflation rates and risk components • Inflation should be removed from interest rate because CB calculations should be conducted in real (inflation-adjusted) terms (using CPI)

30. Choice of the discount rate • The risk component reflects a compensation for the variations in risk of default across different types of borrowers • Because risks of public investment are shared by all citizens, and because society has a diverse portfolio of projects, many analysts argue that the rate used should be the real, risk-free rate of interest (btw. 3-4% historically)

31. Choice of the discount rate • The choice of discount rate is critically important because it represents the relative importance of the future. • Even small differences in discount rate can become very important. • This is illustrated in Table 5.3, where the present value of a future stream of income decreases by 90 percent with a 1 percent change in the discount rate. • This difference in value is much less at greater distances in the future where the value in the distant future is unimportant.

32. Choice of the discount rate

33. Cost-Benefit Analysis • The first step in implementing any cost-benefit analysis is to determine what should be evaluated. • The analyst must identify the credible alternatives to the proposed project and include them in the cost-benefit analysis. • In defining alternatives, the analyst must consider political feasibility, technical feasibility, and economic feasibility.

34. Cost-Benefit Analysis • The next step is to list the costs and benefits to make sure that all relevant issues are considered. • Care must be taken to factor in environmental costs, both on-site and off-site. • In some cases religious, cultural, and historical significance must be taken into account. • Indirect costs must also be considered.

35. Cost-Benefit Analysis • In general, benefits are easier to measure than costs. • It is important to recognize alternative solutions in the measurement of the benefit of one project. • It is also important to recognize both private and social benefits associated with a project. • It is important to recognize the difference between the creation of new benefits and the transfer of benefits from one area to another.

36. Cost-Benefit Analysis – Multiple Scenarios • It is important to build different scenarios when conducting a cost-benefit analysis. • These different scenarios need to consider differing assumptions or predictions about the future states of the world. • Among these are: • Rates of population growth • Rates of growth in GDP • Level of global climate change • Rate of technological innovation • Change in environmental policy.

37. Cost-Benefit Analysis – Decision Rules • Each scenario should also be evaluated using different discount values. • Various decision rules can be made to allow qualitative comparison and determination of which projects are best. • Examples of decision rules include: • Choose the project that is in the top ranking in the most states of the world. • Choose the project that is in the top two categories in the most states of the world.

38. Cost-Benefit Analysis – Missing Values • One of the major problems with cost-benefit analysis is how to deal with missing values. • It is not appropriate to use a value of zero. • If the missing value is associated with environmental costs, then it is possible to conduct an analysis without the costs and then consider how the answer might change with those costs factored in. • Alternative approaches to comparing projects with missing information include: • The dominance method choose the option that is best across multiple scenarios; • Estimate how big the missing value would have to be to change the outcome. • Provide general impressions of the unmeasured environmental benefits.

39. Marginal Analysis • Cost-benefit analysis is a good tool for choosing between a set of discrete alternatives. • Marginal analysis is useful when a choice must be made about which level to choose from a potentially infinite spectrum. • How many hectares of wetlands to preserve, how much deforestation to allow, how large a fish harvest should be, etc.

40. Marginal Damage Functions • As discussed in Chapter 3, marginal damage functions and marginal abatement functions can be used to identify the optimal level of pollution. • A marginal damage function specifies a relationship between an incremental unit of emissions and the damages the emissions generate. • As Figure 5.5. illustrates, this relationship is actually a complex series of cause-and-effect relationships.

42. Marginal Damage Functions • The first set examines how pollution emissions generate concentrations of pollution in the environment. • The next set considers how exposure occurs. • The next considers the impact of exposure. • The next considers the damages which result and finally, the resulting change in social welfare.

43. MDF & Policy Analysis • It quite unlikely that it will be possible to completely identify the set of marginal abatement cost functions and marginal damage functions for a particular problem. • Even so, knowledge of the properties of a particular damage function can help identify policy goals.

44. MDF & Policy Analysis Damages Emissions e1 e2 e3

45. Marginal Damage Function and Policy Analysis • Identify key points along function • Between 0 and e1 – damages not great • As increase between e1 and e2, assimilative capacity of environment becomes overtaxed, damages begin to increase • e3 on, damages may cause systemwide collapse

46. Marginal Damage Function and Policy Analysis • Use information from figure 5.5 to make estimates about these turning points • For example, makes little sense to have target level of pollution less than e1 unless abatement very low • Similarly, want to avoid very steep portion (after e3) • Broad range from e1 to e3 – can then use other criteria to narrow this range

47. Summary • Various research and analytical tools can help narrow the decision set and further guide the decision process. • Cost-benefit analysis has proven to be a useful tool in organizing information about economic efficiency. • The most important need in terms of making better decisions is the need to develop better indicators related to the nonefficiency related decision-making criteria.

48. Expected Value Analysis(Appendix 5b) • A way to compare alternatives where each alternative has several possible outcomes, each of which occurs with a different probability • Example: deciding which of 3 games going to play. Fee for playing each $1.00. First game flip coin – heads $2, tails $0. • EV = – $1.00 + 0.5($2.00) + 0.5(0) = 0

49. Expected Value Analysis • 2nd game: 3 cards. Pick Jack, get $1. Pick Queen, get $2. King, get $3. EV = – $1.00 + 0.33($1) + 0.33($2) + 0.33($3) = $0.98 • 3rd game: 4 marbles. Pick red: $2, blue: $1, green: $0.50, yellow: $0. EV = – $1.00 + 0.25($2.00) + 0.25($1.00) + 0.25($0.50) + 0.25($0) = – $0.13

50. Expected Value Analysis • In general, if is probability of outcome i, and is net benefits of outcome i, then the EV of an alternative with m potential outcomes is: