Encyclopedia of Earth

Monetary valuation

 

Introduction

As generally understood, monetary valuation involves associating a positive number of currency units with some service provided by, or some damage done to, the natural environment. It is sometimes known as ‘non-market’ valuation, the point being that environmental services/damages are not, generally, traded in markets, and so do not get market prices attached to them as values. The history of monetary valuation spans little more than three decades. It is, however, now a very active field of research and application, especially in environmental economics. It is also a highly technical field – a proper appreciation of the contents of a typical paper in, say, the Journal of Environmental Economics and Management, requires a high level of proficiency in neoclassical production/utility theory and advanced econometrics. This entry will not attempt that kind of exposition - useful points of entry to the technical dimensions of the literature are the relevant chapters in textbooks and in reference handbooks. Rather, it will look at a few fundamental questions about the purpose, nature and usefulness of monetary valuation.

Why do monetary valuation?

First: why do it? Essentially, the motivation is to inform decision making that has implications for environmental services/damages. While there is no reason in principle why it should not be, it is not usually the case that a valuation is intended to be the basis for setting a price that anybody will actually pay. Usually, the objective is to provide pure informational input to social decision making. In terms of the tightness of the intended link from valuation to social decision, three situations can be distinguished.

In cost benefit analysis the link is, at the level of principle, very direct and tight. The decision depends on which is the larger of the monetary costs and monetary benefits associated with going ahead with the policy/project that is under consideration. Monetary valuation is undertaken so that the environmental impacts can be put into the counting of total costs and benefits along with, and in an exactly equivalent way to, all of the other consequences. Cost benefit analysis of this sort is seen as capable not only of giving yes/no decisions on discrete projects/policies, but also of giving answers to questions about, for example, the proper level of some kind of environmental damage. According to the efficiency criterion, the proper level is where the associated costs and benefits are equal at the margin. The implementation of this criterion, then, requires not just knowledge of the monetary value of the existing level of damage, but knowledge of how the value varies as the level of damage varies. This is a very demanding requirement, and it does not appear to be the case that an environmental standard has ever actually been set in this way.

A second motivation is the desire to produce a measure of national income that accounts for all kinds of environmental damage, and, hence, is a measure of sustainable income. Even at the level of principle, the link from valuation to decision is somewhat weaker here. Given that cost benefit analysis has taken care of micro decisions, presumably the point here is for the government to have its macro decision making guided by a ‘proper’ measure of national income. Exactly how the feedback from movements in properly measured national income to monetary and fiscal policy is supposed to work is not spelled out in the literature. Although the theoretical literature on this produces results for adjustments to the standard measures to account for pollution and amenity losses, most applications restrict corrections to those for resource depletion, in regard to which actual prices are available. Rather than reporting measures of sustainable income as such, these applications typically report ‘genuine saving’ or some variant thereof – investment corrected for resource depletion.

The third motivation is the ‘cultural soup’ argument. In modern societies, on this argument, politicians and those who vote for them will only give proper attention to environmental considerations if they are stated in monetary terms. Thus, according to the authors of a high profile exercise in monetary valuation:

Because ecosystem services are not fully ‘captured’ in commercial markets or adequately quantified in terms comparable with economic services and manufactured capital, they are often given too little weight in policy decisions. This neglect may ultimately compromise the sustainability of humans in the biosphere.

How to do monetary valuation?

The next question is: how to do it? Most of the literature on monetary valuation is about the technical dimensions of this question, in relation to several extant methodologies. It is generally taken as given that what the methods are required to do is to ascertain what the affected economic agents would collectively pay to receive the service or avoid the damage. In some cases some economists argue that it is willingness to accept compensation rather than willingness to pay that is relevant. While the difference between willingness to pay and to accept can be numerically large, the fundamental point is that in both cases valuation is intended to reflect individual preferences as they would be expressed in markets, if such existed.

Valuations to inform social decision making could, in principle, be derived in a different way. The decision problem could be formulated as a constrained optimisation problem, and the shadow prices thus attached to environmental services/damages be used as monetary valuations. They would then, of course, reflect the objective function adopted in the problem specification. This is, in fact, what is actually done in much of the theoretical literature on the principles of valuation for national income accounting. However, the objective function used is the utility function of a representative consumer who lives forever, and it is clear that it is envisaged that in application it is actual preferences that should determine relative values.

Is this the right way to take account of the environment in social decision making? Subject to a major caveat, and assuming well-informed economic agents, for those who accept the ethical basis for neoclassical economics – preference based utilitarianism, otherwise consumer sovereignty – the answer to this question is ‘yes’. Given such acceptance, valuing the environment in terms of willingness to pay (or accept) is a necessary extension of standard welfare economics. There are other ethical positions from which to approach social decision making that have environmental implications. The major caveat concerns future economic agents, who can participate neither in current market transactions nor in surrogate vehicles for preference expression. The informational assumption – that all agents have all relevant information - is, in the environmental context especially, very strong.

Does it produce useful information?

Are the various techniques that economists have developed reliable? Can economists accurately measure willingness to pay in respect of environmental services/damage? This is a difficult question to answer. By definition, no actual payment occurs, so that there is nothing against which to directly evaluate the techniques. The assessment of accuracy is largely a matter of judgement. There appears to be, among economists, a near-consensus that where the technique involves inference from observed behavior in related contexts it can be taken to be reliable. The travel cost method, for example, infers willingness to pay for recreational services from actual expenditure on access to the area providing such. Despite the fact that the inferred willingness to pay is dependent on largely arbitrary conventions for the accounting of actual expenditures, the majority of economists take it that the travel cost method provides useful information. The contingent valuation method asks people what they would to be willing to pay in a hypothetical situation. Economists are divided here. Some take the position that hypothetical questions will always generate hypothetical answers that are not useful. Others argue that there are problems in obtaining useful information from surveys, but that they can be overcome.

Monetary values that accurately reflect willingness to pay/accept are only required by the first of the motivations distinguished above. The measurement of sustainable income requires the use of the relative unit values that go with sustainability. Those have no necessary connection with willingness to pay/accept. The required values could, in principle at least, be derived from an appropriately specified constrained optimisation problem. The fact that the appropriate specification of the problem is not, and cannot be, definitively known implies the absence of a unique set of ‘correct’ valuations. It could, however, be argued that the public discourse that sustainability requires would be better informed by scientific debate conducted in terms of competing specifications, and their implications for relative values, rather than in terms of the provision of monetary valuations supposedly reflecting willingness to pay (or accept).

As regards the cultural soup motivation, it is not clear that it requires accuracy of any kind. What seems to be required is a number that is sufficiently big to do the job required of it, to capture attention, to make people realise that ‘the environment’ is important. The high profile (it was published in Nature) exercise referred to above generated a number of responses, several of which appeared in a special issue of Ecological Economics together with a response by the authors of the original paper. According to that response, the original paper ‘succeeded’ in that it stimulated debate, while:

The results illustrated that even using admittedly narrow and imperfect conventional economic methods, the aggregate value of these services (i.e., the services of all of the globe’s ecosystems) was of the same order of magnitude as global GNP.

Glossary

Citation

Common, M., & Economics, I. (2013). Monetary valuation. Retrieved from http://www.eoearth.org/view/article/51cbee767896bb431f698014