Valuation of Nature: An Economic Perspective

1. Valuation of Nature: An Economic Perspective Stephen J. Conroy, Ph.D. Professor of Economics

2. I. How to Value an Asset? • Simply put, an asset is something that you own that has value. • This value may derive from some useful function or other aesthetic attribute that the asset possesses (e.g., gold has aesthetic as well as useful attributes—as jewelry that never oxidizes in air or water.) • There are two basic types of assets, those that generate cash flows over time (like stocks that pay dividends, most bonds, some real estate) and those that do not (e.g., gold, silver, some real estate). All assets may appreciate, remain constant, or depreciate in value over time.

3. II. Value of the Firm • Let’s focus on one of these . . . stocks. However, since a share of stock grants the owner to a partial ownership of a firm, the value of a share of stock derives from the value of the firm itself. • So, let’s focus on deriving the value of a firm. • How to estimate this value??? • Forecasting net income into future • Determine appropriate discount rate

4. II. Value of the Firm Let’s start by taking an example of valuing a firm: Where Pis profit, or net income, and k is the appropriate discount rate. We can rewrite this more compactly as:

5. II. Value of the Firm • What measurable value (“statistic”) should this estimate compare to??? • If financial markets are “robust” . . . Then the Market capitalization (“market cap”) {(No. of outstanding shares of stock) * (Price per share)}

6. II. Value of the Firm • What about a stock like ExxonMobil? • ExxonMobil generates about $40 billion per year in net income (profits). How much is ExxonMobil worth? • Yahoo Finance Quote from 2/15/12:

8. II. Value of the Firm • Go to Excel Spreadsheet Example for Exxon Mobil • Asset valuation in economics and finance takes on this basic construct, though with lots of different variations.

9. III. Valuing Nature • Now, let’s apply the same approach to valuing nature. The “natural capital” in an ecosystem produces benefits to society. . . • What are these benefits or “profits” in nature? • Costanza et al. (1997) paper suggests a number of benefits or “services” from ecosystems (see p. 254, Table 1) • Gas, water, soil, fruit, habitat, recreation, cultural/aesthetic

10. Costanza et al. 1997

11. III. Valuing Nature • How to value these services? (Is there a market for all of these services?) • Costanza et al. (1997) provide a discussion of willingness to pay (WTP). • If an ecosystem provides $50 in benefit to lumber companies and $70 in aesthetic value, then the total benefit is $120, but only $50 contributes to the monetary part of the economy—or has an explicit value.

12. Costanza et al. 1997

13. III. Valuing Nature • When Americans look at Haitians’ massive deforestation, we wonder about the Haitians’ rationality. Why would anyone do this? • This is important in terms of policy: • If cutting down a tree is irrational then policy implication is simple: “education” • If it is rational, however, then policy is not so simple: “education plus”

14. III. Valuing Nature • In the following simulation, I wish to create a model which demonstrates the conditions under which a rational “economic human” may choose to cut down a tree sooner, rather than later, leading ultimately to deforestation. • Here, I will assume property rights are well defined and the individual owns the tree. • The model may lead to important policy implications.

15. IV. Simulation—A Model • Go to Excel Spreadsheet. • Assume we have a mango tree that generates $20/year in fruit. • Assume the mango tree also generates an additional $5/year in water benefits (retention, purification/filtration • Assume the mango tree could also be harvested as either lumber or charcoal. Say the lumber benefit is $1,000 but that means the tree will die.

16. IV. Simulation—A Model • Assume the mango tree grows at a rate of 3% per year, thus increasing the fruit, water and “board” benefits in a similar manner. (This is the “inflator” in the model.) • I present four different outcomes: • Harvest for wood/charcoal after year 1 • Harvest after year 10 • Harvest after year 20 • Harvest after year 30

17. IV. Simulation—Scenario 1 • Scenario 1: The “normal” scenario is presented first. • Reasonable (for U.S.) discount rate of 0.04 • Reasonable inflator of 0.03 • Somewhat-reasonable values for other amenities. • Result: highest value is from waiting for 30 years to cut down tree

18. IV. Simulation—Scenario 2 • Scenario 2: Now, what if agents are impatient (e.g., because they are hungry) • Discount rate increases, say, to 0.50 (from 0.04) • Everything else the same. • Result: highest value, by far, is to cut down the tree after just the first year! ($683.33 vs. $74.58 after 10 years; $53.69 after 20 years; $53.20 after 30 years)

19. IV. Simulation—Scenario 3 • Scenario 3: Now, assume that the price of boards (or charcoal) increases dramatically (e.g., due to scarcity of trees). • Price of boards/charcoal triples to $3,000. • Everything else the same as in Scenario 1. • Result: highest value is to cut down the tree after just the first year. ($2,909 vs. $2,875 after 10 years; $2,840 after 20 years; $2,809 after 30 years)

20. IV. Simulation—Scenario 4 • Scenario 4: Now, assume that the annual flow of benefits from the tree (mangos and water) has no (explicit or implicit) value. • Price of mangos and water goes to zero. • Everything else the same as in Scenario 1. • Result: highest value is to cut down the tree after just the first year. ($962 vs. $881 after 10 years; $800 after 20 years; $727 after 30 years)

21. V. Discussion • The results of these simple simulations demonstrates that—under certain conditions—rational economic agents would have an incentive to cut down trees after the first period, thus promoting deforestation. • Thus, as despicable as it is, deforestation is not a completely “ignorant” or irrational act. Education alone will not necessarily solve the problem.

22. V. Discussion • Policy would need to be “Education Plus.” • Programs designed to: • Decrease the discount rate of individuals: • Provide universal access to quality K-12 education (increases opportunities and view of the world, especially for women) • Reduce mortality and morbidity rates through improvements to healthcare—particularly low-cost, public health programs and clinics • Improve economic opportunities (e.g., microfinance). • Improve access to credit • Improve access to private and public pension programs

23. V. Discussion • Increase the perceived value of nonmonetary services (e.g. “water” in this model). • Promote ecological education and information (e.g., watershed, biodiversity, gas emissions) • Decrease the price of boards and charcoal. • Subsidize natural gas distribution to reduce demand for charcoal • Promote alternatives for cooking and building materials (solar ovens, natural gas pipelines, more efficient cooking appliances)

24. V. Discussion • Increase the price of services or benefits from forests • Promote markets for “mangos” (also coffee, cacao, nuts, etc.) • Promote free/fair trade to open up export markets

25. Costanza et al. 1997

26. Costanza et al. 1997