Valuing environmental costs and benefits
Little and Mirrlees noted that from the mid 1970s to 1990s, there had been a rise and decline of project appraisal in development community. Our view is that natural resource and environmental issues may be critical for making development more sustainable. Therefore, environmental economic analysis should be pursued, preferably early in the project cycle. Even where the valuation is difficult, techniques like multi-criteria analysis are useful to make decisions.
The first step in the analysis is to determine the environmental (and social) impacts of the project or policy, by comparing the “with project” and the “without project” scenarios (see "Measuring economic costs and benefits"). Transdisciplinary work is essential (see "Basic concepts and principles of sustainomics"). The quantification of impacts in non-monetary units is a prerequisite not only for accurate economic valuation, but also for the use of other analytical methods like multi-criteria analysis. Such biophysical impacts are themselves complex and often poorly understood.
The second step in considering environmental effects involves valuing project impacts. Several practical valuation techniques are described below, based on extensions of the framework discussed in the previous section ("Measuring economic costs and benefits").
Categories of economic value
Conceptually, the total economic value (TEV) of a resource consists of its (i) use value (UV) and (ii) non use value (NUV). Use values may be broken down further into the direct use value (DUV), the indirect use value (IUV) and the option value (OV) (potential use value). One needs to be careful not to double count both the value of indirect supporting functions and the value of the resulting direct use. We may write:
TEV = [DUV + IUV + OV] + [NUV]
Figure 1 shows this disaggregation of TEV in schematic form. A short description of each valuation concept, and a few typical examples of the underlying environmental resources, are provided:
- direct use value is the contribution to current production/consumption;
- indirect use value includes benefits from functional services that the environment provides to support current production/consumption (e.g., ecological functions like nutrient recycling);
- option value is the willingness to pay for an unutilized asset, simply to avoid the risk of not having it available in the future (see "Discount rate, risk, and uncertainty in environmental decision-making"); and
- non-use value is the willingness to pay for perceived benefits not related to use value, e.g., existence value, which is based on the satisfaction of merely knowing that an asset exists, even without intending to use it.
Economic theory clearly defines TUV, but there is considerable overlap and ambiguity in the breakdown categories, especially with regard to non use values. Thus, option values and non use values are shaded in the figure. These categories are useful as an indicative guide, but the goal of practical estimation to measure TUV rather than its components.
The distinction between use and non use values is not always clear. The latter tend to be linked to more altruistic motives. Differing forms of altruism include intergenerational altruism, or the bequest motive; interpersonal altruism or the gift motive; stewardship (which has more ethical than utilitarian origins); and q Altruism, which states that the resource has an intrinsic right to exist. This final definition is outside conventional economic theory, and incorporates the notion that the welfare function should be derived from something more than purely human utility.
Practical valuation techniques
The economic concept underlying all valuation methods is the willingness to pay (WTP) of individuals for an environmental service or resource, which is itself based on the area under the demand curve.
In Figure 2, IHFD0 is the demand curve for an environmental good (e.g., liters per day of water used). AJFS is the supply curve or marginal cost (MC) for each unit supplied. The demand curve is generally downward sloping because each succeeding unit consumed has less value. However, we might expect MC to increase (e.g., as water sources become scarcer and less accessible). At any price p1, the quantity demanded is Q1 and the total economic benefit of consumption is the WTP represented by the area OIHL (i.e., mathematically ? p.dQ ). The corresponding total cost of supply is area OAJL (i.e., ? MC.dQ). The net benefit of water use is given by NB = benefit – cost = area AIHJ, which is the economic surplus (or net value) from this activity. NB has two components: areas IHG (consumer surplus), and AGHJ (producer surplus). Net benefits (AIF) are maximized at point F, when the optimal price p0 is set equal to marginal cost MC, and the optimal quantity Q0 is used.
Next, we examine how a change in quality of the same environmental good might affect its value. Suppose the curve D0 indicates the demand for an environmental resource in its original condition (e.g., polluted river water). The point I represents the choke price, at which demand falls to zero. Suppose the water quality is improved by environmental clean-up activity. Then the demand curve shifts upward to the new position D1. With the new price and quantity combination (p2, Q2), the new net benefit increases to AMN. Therefore, there is an incremental increase in net value given by the area IFNM, due to the water quality improvement – provided water and water quality are weak complements.
|Figure 3: Techniques for economically valuing environmental impacts|
|TYPE OF MARKET|
|Behavior Type||Conventional Market||Implicit Market||Constructed Market|
|Actual behavior|| Effect on production|
Effect on health
Defensive or preventive costs
| Travel cost|
Wage differences - Property values
Proxy marketed goods
|Intended behavior||Replacement cost - Shadow project||Benefit transfer||Contingent valuation|
|Source: Munasinghe (1992a)|
Theoretically, the compensated or Hicksian demand function should be used to estimate value, since it indicates how demand varies with price while keeping the user's utility level constant. The change in value of an environmental asset could also be defined by the difference between the values of two expenditure (or cost) functions. The latter are the minimum amounts required to achieve a given level of household utility or firm output, before and after varying the quality of, price of, or access to the environmental resource, while keeping all other aspects constant.
Measurement problems arise because the commonly estimated demand function is the Marshallian one – which indicates how demand varies with the price of an environmental good, while keeping the user's income level constant. In practice, it has been shown that the Marshallian and Hicksian estimates of WTP are in good agreement for a variety of conditions, and in a few cases the Hicksian function may be derived from the estimated Marshallian demand functions.
What people are willing to accept (WTA) in the way of compensation for environmental damage, is another measure of economic value that is related to WTP. WTA and WTP could diverge as discussed below. In practice both measures are used in the valuation techniques described below.
Empirical evidence indicates that WTP questions yield higher answers than WTA questions about willingness to pay to retain the same amenity. Some argue that WTA questions need more time to be properly understood and assimilated, and that the gap between WTA and WTP narrows with successive iterations. Others suggest that people are less willing to pay actual income than to receive “hypothetical” compensation. It may also be the case that individuals are more cautious when weighing the net benefits of changing assets than when no change is made. Generally, WTP is considered to be more consistent and credible a measure than WTA. However, when significant discrepancies exist between the two measures, then the higher values may be more appropriate when valuing environmental losses.
In developing countries, the ability to pay is a concern. In low income areas, money values placed on environmental goods and services are traditionally low, and income weights may be used (see "Shadow pricing"). Alternatively, other social and ethical measures might be used to protect the poor.
Practical valuation methods are categorized in Figure 3.
Direct effects valued on conventional markets
The methods considered in this section are directly based on changes in market prices or productivity, due to environmental impacts.
Change in Productivity. Projects can affect production. Changes in marketed output can be valued by using standard economic prices.
Loss of Earnings. Environmental quality affects human health. Ideally, the monetary value of health impacts should be determined by the WTP for improved health. In practice, proxy measures like foregone net earnings may be used in case of premature death, sickness, or absenteeism (and higher medical expenditures, which can be considered a type of replacement cost). One may avoid ethical controversies associated with valuing a single specific life, by costing the statistical probability of ill health or death (like the actuarial values used by life insurance firms).
Actual Defensive or Preventive Expenditures. Individuals, firms, and governments undertake “defensive expenditures” to avoid or reduce unwanted environmental effects. Defensive expenditures may be easier to obtain than direct valuations of environmental harm. Such actual expenditures indicate that individuals, firms, or governments judge the resultant benefits to exceed the costs. Defensive expenditures can then be interpreted as a minimum valuation of benefits.
Potential expenditure valued on conventional markets
Replacement Cost. Here, the costs to be incurred in order to replace a damaged asset are estimated. The actual damage costs may be higher or lower than the replacement cost. However, it is an appropriate method if there are compelling reasons for restoring the damage. This approach is especially relevant if there is a sustainability constraint that requires certain assets stocks to be maintained intact (Chapter 2).
Shadow Project. This approach is based on costing one or more “shadow projects” that provide for substitute environmental services to compensate for environmental assets lost under the ongoing project. It is often an institutional judgment of replacement cost, when “critical” environmental assets at risk, need to be maintained.
Valuation using Implicit (or surrogate) markets
Techniques described in this section use market information indirectly. Each method has advantages and disadvantages, including specific data and resource needs.
Travel Cost. The travel cost method has been used to measure benefits produced by recreation sites. It determines the demand for a site (e.g., number of visits per year), as a function of variables like consumer income, price, and various socio-economic characteristics. The price is usually the sum of observed cost elements like a) entry price to the site; b) costs of traveling to the site; and c) foregone earnings or opportunity cost of time spent. The consumer surplus associated with the estimated demand curve provides a measure of the value of the recreational site in question. More sophisticated versions include comparisons across sites, where environmental quality is also included as a variable that affects demand.
Property Value. This is a hedonic price technique based on the more general land value approach which decomposes real estate prices into components attributable to different characteristics like proximity to schools, shops, parks, etc. The method seeks to determine the increased WTP for improved local environmental quality, as reflected in housing prices in cleaner surroundings. It assumes a competitive housing market, and its demands on information and tools of statistical analysis are high
Wage Differential. This method is also a hedonic technique, which assumes a competitive market where the demand for labor equals the value of the marginal product and labor supply varies with working and living conditions. Thus, a higher wage is necessary to attract workers to locate in polluted areas or undertake more risky occupations. This method relies on private valuation of health risks, not necessarily social ones. Data on occupational hazards must be good for private individuals to make meaningful tradeoffs between health risks and remuneration. Finally, the effects of other factors like skill level, job responsibility, etc. that might influence wages must be eliminated, to isolate the impacts of environment.
Marketed Goods as Proxies for Non Marketed Goods. In situations where environmental goods have close substitutes that are marketed, the value of an environmental good may be approximated by the observed market price of its substitutes.
Benefit Transfer. Values determined at one place and time are used to infer values of similar goods at another place and time (where direct valuation is difficult), with adjustments for differences in incomes, prices, quality, behavior, etc..
Valuation using constructed markets
Contingent Valuation. When market prices do not exist, this method basically asks people what they are willing to pay for a benefit, and/or what they are willing to accept by way of compensation to tolerate a cost. This process of asking may be either through a direct questionnaire/survey, or by experimental techniques in which subjects respond to stimuli in “laboratory” conditions. The contingent valuation method has certain shortcomings, including problems of designing, implementing, and interpreting questions. However, in some cases, it may be the only available technique for estimating benefits. It has been applied to common property resources, amenity resources with scenic, ecological or other characteristics, and to other situations where market information is not available. Caution should be exercised in seeking to pursue some of the more abstract benefits of environmental assets such as existence value.
Artificial Market. Such markets could be constructed for experimental purposes, to determine consumer willingness to pay for a good or service. For example, a home water purification kit might be marketed at various price levels or access to a game reserve might be offered on the basis of different admission fees, thereby providing an estimate of the value placed on water purity or on the use of a recreational facility, respectively.
Note: The author welcomes comments, which may be sent to MIND.
- ^Little, I.M.D. and J.A. Mirrlees, 1990. Project Appraisal and Planning for Developing Countries, Basic Books, New York.
- ^Schechter and Freeman, 1992.
- ^Quiggin, 1991.
- ^Freeman, A.M. 1993. The Measurement of Environmental and Resource Values: Theory and Methods. Resources For the Future. Washington, D.C.
- ^Maler, K.G., 1974. Environmental Economics: A Theoretical Inquiry, John Hopkins University Press, Baltimore.
- ^Willig R.D., 1976. Consumers’ Surplus Without Apology. American Economic Review 66(4).
Braden J.B. and Kolstad C.D. (eds.), 1991. Measuring The Demand For Environmental Quality. Elsevier Science Publishing Co. Inc. New York.
- ^Cropper, M.L. and W.E. Oates, 1992. Environmental Economics: A Survey. Journal of Economic Literature 30.
- ^Knetsch, J.L. and J.A. Sinden, 1984. "Willingness to pay and compensation demanded: Experimental evidence of an unexpected disparity in measures of value." The Quarterly Journal of Economics 99(3).
- ^ADB, 1996. Economic Evaluation of Environmental Impacts, Asian Development Bank, Manila, Philippines.
Ecological Economics, 2006. Special Issue on Environmental Benefits Transfer, Vol.60, No. 2, December.
- Munasinghe, M., 1992a. Environmental Economics and Sustainable Development, Paper presented at the UN Earth Summit, Rio de Janeiro, Environment Paper No.3, World Bank, Wash. DC, USA.
This is a chapter from Making Development More Sustainable: Sustainomics Framework and Applications (e-book).
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