Environmental economics and valuation - Afternoon

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Purpose of this talk. To illustrate the use of economic tools in natural resources damage assessmentTo introduce briefly economic valuation methods, in particular the contingent valuation method. Part I: Natural resources damages. . Externality. Pigou defined (1918) the concept of an externality as

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Environmental economics and valuation - Afternoon

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1. Environmental economics and valuation - Afternoon IA Summer School 25-31 July, 2004 Philippe Polomé

2. Purpose of this talk To illustrate the use of economic tools in natural resources damage assessment To introduce briefly economic valuation methods, in particular the contingent valuation method

3. Part I: Natural resources damages

4. Externality Pigou defined (1918) the concept of an externality as the effect of someone’s action on someone else In the absence of corrective action, a negative externality will lead to a socially unsatisfactory outcome. Markets will fail to produce an efficient outcome. The remedy that Pigou identified was what we now call the polluter pays principle: the polluter should pay for the damage he causes to others.

5. Non-market valuation Placing a monetary value on the damages caused by pollution is an exercise in “non-market valuation” It seeks to measure in monetary terms the value that people place on items that they care about. It has been used in the context of Cost-benefit analysis Setting effluent taxes Calculating natural resource damages

6. Natural resource damages Monetary measure of the damage from specific acts of pollution. Some key questions: What acts trigger payment? Who is required to pay? Who is entitled to receive payment?/ What is done with the money that is paid? How does one calculate the amount to be paid?

7. Purpose of the payment Three possibilities: Compensation for the damage that has been caused. Punishment for negligence. Incentive to others: influence potential future polluters to make them more careful. Our interest is in the compensation Payment could be different if we had other purposes

8. What damages are covered? Given the goal of compensation, what damages are covered? Legal systems have traditional concepts of damages, such as: damage to goods and property loss of income personal injury, loss of life loss of use and enjoyment (of property...) pain and suffering (loss of wellbeing) But these concepts do not adequately account for damage to the environment caused by pollution because: There is no owner ? no-one has standing to sue for damages. The damages fall outside the (above) conventional categories. They are typically non-pecuniary, and involve non-human victims.

9. Natural resources damages The law creates the concept of a public claim for damages, separate from the private claims. CERCLA (1980) and OPA (1990) in the US The current Council regulation in the EU (postponed!) may play the same role (proposal 2003/0209 AVC) Both legislations create a maximum liability of about €1 billion (instead of 200 M at the time of the Prestige accident) through the creation of a fund for compensation. Each fund is financed by oil receivers worldwide which are established in the EU or in the US Incentives Clarifies the responsibilities

10. Natural resources damages II The US law makes the government a trustee for the natural resources that are harmed, and gives it standing to sue for damages. The proposed EU legislation may also act in this way The consequence is that the government can (and should) claim any damages not covered by private claims, with or without the consent of the affected landowners (if any) What damages can be claimed? Damages for injury, destruction or loss of natural resources resulting from the release (including lost non-use and lost recreational) Costs of cleanup, removal, remediation Any other necessary response costs, including the costs of the damage assessment

11. Calculation of the damages Replacement cost Based on conventional (private) damage: if you break my car, you have to replace it Flawed approach: it is not possible to replace lost wildlife on a scale such as caused by an oil spill Value of injuries Based on economic valuation methods such as contingent valuation, travel cost, hedonic pricing, ... The focus is on compensating Restoration cost Based on an explicit plan (case-by-case basis) Includes at least clean-up + possibly specific actions for recovery of ecological services to an “equivalent” level or create an equivalent to the lost ecosystem Currently the preferred approach both in the EU and the US

12. The “lesser of” rule Principle of law: The correct compensation for a private loss is the lesser of what the lost item was worth to its owner what it would cost the owner to replace the item Economic efficiency prescribes the same: Inasmuch as the restoration cost is less than the value of injuries, it is the proper economic value However, both the EU and US experiences indicate a preference for restoration

13. The role of non-market valuation Compensation for interim loss Restoration takes time In the meantime (which can be decades), the patrimony is not available Justifying the cost of the restoration plan Calculate compensation for recreational losses and other human uses The restored area may not be quite the same regarding human uses (restoration is not replacement) Yet human uses have substitutes so this is a tricky subject

32. Part II: economic valuation

33. Economic notions of value: WTP – WTA Basic assumptions: Individual preferences can be represented by a utility function U(z, y), z = environmental quality, y = income The proper basis for social preferences is aggregation of individual preferences Let ?z+ > 0 and ?z- < 0 an environmental improvement/deterioration U(z, y) = U(z+?z+, y-WTP) max amount to secure an improvement U(z +?z-, y) = U(z, y-WTP) max amount to avoid a deterioration U(z+?z+, y) = U(z, y+WTA) min amount to forfeit an improvement U(z, y) = U(z+?z-, y+WTA) min amount to compensate a deterioration

34. Differences between WTP and WTA Different property rights More difficult to elicit WTA than WTP In damage assessment, we often seek compensation (=WTA): a “loop” is needed, for example Value of restoration = value of interim loss WTP to prevent any further release until restoration complete (Exxon-Valdez)

35. Traditional structuration of value Economic value (WTP, WTA) is the total value Decomposition is arduous Natural resources damages refers only to non-private damages

36. Valuation methods “Revealed preferences” methods Market pricing Under certain condition the price can be considered the marginal WTP for an item Travel cost method Travel is complementary to the environmental quality of the destimation site Hedonic pricing Amenities influence the price of certain market goods, e.g. houses Other less common techniques “Stated preferences” techniques Contigent valuation Stated choice methods Group valuation

37. Revealed vs. stated preferences methods Both types are based on surveys! Revealed preferences Are often considered more reliable Demand cut-off point is hypothetical What about those who do not participate Can become complex as substitution relations are taken into account Sometimes may allow to “pin-point” specific damages, e.g. lost recreational fishing trips Stated preferences Are sensitive to survey design Very flexible/versatile Only techniques capable of eliciting the total value

38. Contingent valuation Probably the most commonly used valuation method (>2000 papers in 2000) In the US, can be used to present estimation of damages in court. In the EU, the proposed legislation may follow that way. Principle: ask a sample of people how much they value an item ? tricky question for natural damages Why should people answer such an unusual question in a meaningful way? Valuation scenario Phrasing/format Payment vehicle Sample Biases

39. Contingent valuation: Valuation scenario In a CV survey, the respondents are asked to choose their preferred scenario regarding some future government course of action. Example: Exxon Valdez spill (1989), choose between a tanker escort ship program + some extra tax, or no escort ships but a new spill like the Exxon Valdez Choose between the baseline (“do-nothing”) scenario and the alternative (“do-something”) Each alternative must be carefully described The scenario must be credible Need not exist in reality but as a possibility Must be understandable and described in details (visual aids...) Must have some cost

40. Contingent valuation: Phrasing/format Posted price principle Simpler cognitively (as in for market goods) Dichotomous (or binary) choice Answer can be Yes/No/Don’t know/Abstain Referendum situation Place respondents in a situation in which it seems natural to interact with government policy The respondent should feel his “vote” matters! Should the referendum be explicit?

41. Dichotomous choice CV: Bid design Consequence of the referendum format Need several bids over the sample Bids must be informative How do we know what bids to use beforehand? Focus groups Sequential design

42. Contingent valuation: Payment vehicle The justification of the respondent’s payment is the cost of the programme, but there is no need that it bears a resemblance to the actual cost How is the respondent going to pay? Tax (preferably local to be credible) Combination of increased prices of some market goods e.g. if oil receivers are obliged to use double hull tankers to deliver oil in the EU, the price of oil in the EU may increase Should payment be one-time or continuing for a period of time?

43. Contingent valuation: Sample What is the population of interest? The value of the damages will depend very much who is considered to be affected Exxon Valdez Trial between Exxon and the governor of Alaska The sample used for CV on non-use value refered to the whole US population This is a consequence of the notion of natural patrimony and non-use value: Alaskan environment belongs to all the US citizens and the state’s government is a trustee to the general public Prestige: should the lost value of Finnish citizens be accounted for? Sample must be simple (all the members of the affected community must have the same probability to be interviewed, no on-site sample)

44. Contingent valuation: Potential biases The survey must be consequential Inconsequential surveys produce random answers The respondents must answer with their own preferences (symbolic response bias) The focus of a valuation survey is on individual preferences Avoid placing the respondent in hte skin of someone else e.g. what I would do if I was in the government

45. Contingent valuation: Tests Compliance with the NOAA Panel Guidelines In-person interviews (although mail surveys couls be acceptable) Dichotomous choice format with no-vote option Careful description of the good and its substitutes (“face validity”) Price sensitivity (the higher the bid the lower the proportion of Yes answers) Scope: does the WTP increase when the amount of the good increases? Usually difficult to test Debriefing: why did the respondent answer the way he did? Interviewers effect and protests should be examined Sample size must be several hundreds at least Probability of Yes equation should have several significant explanatory variables

46. Dichotomous choice CV: Estimation issues Dichotomous choice CV ? Dichotomous choice models Usually parametric: Prob{Yes} = F(xb + bidg) F probability distribution function Should accomodate for a spike at zero Care with distributions with “fat tails” (e.g. logistic) Distribution of WTP is F, often asymmetric Mean Median Reference: Haab and McConnell. Valuing Environmental and Natural Resources Edward Elgar, 2002

47. Working session: The trial of the Prestige spill We simulate a trial of spill: You have to convince the jury (Dolf and I) of your claims! The goal is for the claimants to obtain the highest possible compensations. Group 1: the defendant (Insurance company), your job is to discredit the other groups’ evidence Group 2: private claimants/stakeholders (mostly fisheries) Public claimant divided in two groups, the quality of their evidence is the quality of their CV (see below) Group 3: Deep sea natural resources (lot of uncertainty, possible irreversibility, very high cost) Group 4: Coastal and surface natural resources (likely complete recovery in 2 to 12 years) Design a CV for natural resource damages Based on the morning sessions, what are the damages? Differentiate from private claims Frame the valuation question Choose a payment vehicle What is the sample you would like? Write out the important questions explicitly ... any good idea you may come up with

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