Economic Rationale in Caring for the Environment

1. Objectives After reading this module, you should: • Be aware of the issue of resource scarcity; • Understand the main factors leading to misestimating of environmental values; • Familiarize with the methodological approaches to valuation of environmental goods and services.

2. The scarcity of environmental resources • There are powerful economic arguments in caring for the environment at all levels of the economic system. • In fact, the balance between: • use of raw materials, production and consumption processes, and • the capacity of the ecosystem to absorb the wastes produced by the economic system • could impact both positively and negatively on welfare and the natural resource base. EXAMPLE Use of a depletable resource for a given purpose may preclude its use elsewhere or for future generations. Environmental costs may also be involved where a potentially renewable resource is used or treated in a manner that reduces its quantity or quality.

3. The scarcity of environmental resources The various schools of thought all acknowledge that : problems of scarcity and declining quality of environmental resources have increased dramatically in the last few decades, particularly in the developing countries. Therefore, environmental considerations in decision-making today are of far greater economic significance than had been the case in the past. Growing Economic System compared to the Environmental Ecosystem

4. Two Views on Finite Availability of Natural Resources There are two main views on finite availability of Natural Resources. Let’s look at them. 1. The economic growth conflicts with environmentally sustainable development. An expanding economic subsystem relative to environmental goods and services provided by the ecosystem, is putting environmental resources under stress. Supply then becomes limiting in relation to the demand. Although some of these limits can be overcome (for example, substitution of solar energy for oil based energy), many of them are not (for example, landfills) and will pose a real threat to welfare improvement. Bibl.information in the notes

5. Two Views on Finite Availability of Natural Resources • 2. Economic growth remains possiblewithout necessarily exhaustingnatural resources. • This is because: • Technological progress allows the replacement of renewable resources for exhaustible ones (as well as the reduction of the quantity of natural resources required per unit of economic output); • There is possibility of substitution of man-made capital for natural capital, though within some limits; and • New sources of exploration are possible. Moreinformation in the notes

6. The concept of welfare • The term welfare is often used interchangeably with well-being and is related to the concept of utility. • An important basis from which to assess policy decisions is concerned with the concept of total welfare of society, as developed by Pigou and Hicks. • Important assumptions implicit in the approach are: • Society welfare is the sum of individual welfare; • Individualwelfarecan be measured, as reflected in prices paid for goods • and services; • Individualsmaximize their welfare by choosing the combination of goods, • services and savings that yields the largest possible sum of total utility, • subject to income constraints. Bibl.information in the notes

7. The concept of utility and welfare Utility and welfare can be obtained from goods and services even if they are provided free or at minimum cost. “TOTAL UTILITY” is the combination of the amount paid for the good or service plus any consumer’s surplus. “CONSUMER SURPLUS”, therefore, will be the difference between the amount paid (for a good or service) and the total utility enjoyed. - = TOTAL UTILITY AMOUNT PAID CONSUMER SURPLUS

8. A method to measure welfare Welfare can be related to Hicks’ definition of income: “a man’s income can be defined as the maximum value, which he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning” . AMOUNT OF GOODS AND SERVICES CONSUMED BY HOUSEHOLDS IN ONE YEAR CONSUMTPION PER CAPITA = POPULATION Therefore: if consumption per capita increases, then the average member of the population is better off (i.e., welfare improves). Bibl. information in the notes

9. Objections to this method • Various objections have been raised to this measure of welfare. • The two most important are that: • the standard national account system, from which consumption indicators are derived, fails to account for the depreciation of natural capital, and; • it does not account for equity or income distribution, thus leading policymakers to undertake unsustainable development strategies.

10. Efforts to correct limitations in the system of national accounts Many countries in recent years have attempted to correct for such limitations in the system of national accounts. However, for most countries environmental accounting of physical and monetary flows related to the overall economy is hampered by inadequate data systems, and by the lack of agreement on methodologies for estimating the depletion of natural capital. Despite these difficulties at the macro level of the national economy, at the micro and local levels the scope and prospects of undertaking environmental analysis based on economic principles are considerably better. More information in the notes

11. Reasons for misestimating Environmental Values Environment is seldom considered in policy appraisal. The reason is that environmental goods and services are not marketed. Therefore, they do not have prices that can be comparable with development costs and benefits. There are two main reasons for this absence of markets: 1. marketfailure; and 2. policy failure.

12. Definition of Market failures. According to the dominant economic theory, free and perfectly competitive markets will lead to optimal allocation of resources, including environmental goods and services, or to economic efficiency. Based on this assumption, Market failures are defined as: those circumstances that prevent the perfect competition, and therefore economic efficiency, from being achieved. More information in the notes

13. Definition of Market failures. The major sources of market failures related to natural resources are: • Presence of externalities • Nature of public goods • Lack of property rights • Ignorance, uncertainty and short-sightedness • Irreversibility of use We will look at each one in detail.

14. Market failures: 1. Presence of externalities Externalities occur when an economic activity affects technology, consumption, or preferences of someone who is neither the producer nor the consumer (i.e. a third party). These effects can be either positive or negative. In neither case externalities will be included in the financial price paid for the good produced. In other words, the market does not signal the costs/benefits of externalities to the perpetrator, who will therefore not change his/her behaviour accordingly. EXAMPLE An example of negative environmental externality is when the aerial dispersion of chemical sprays applied by farmers contaminate nearby livestock operations, increasing their production costs in the form of additional veterinarian’s bills and medication. The perpetrator of environmental costs will not be informed by the market about the costs generated to livestock producers, so he/she will not receive incentives to reduce pollution. More information in the notes

15. Market failures: 2. Nature of public goods Before considering the nature of public goods, it is important to keep in mind the classification of goods: EXCLUDABILITY RIVALRY More information in the notes

16. Market failures: 2. Nature of public goods • Environmental goods and services are often thought of as: • public goods (non-excludable and non-rival); or • common pool goods (non-excludable but rival) • Belonging to one or another category of goods may however vary according to the circumstances. EXAMPLE • To the category of public goods belong, for example: • sunlight, weather, biodiversity, flood control services of forests and coral reefs. • Other environmental services are also generally classified as public goods: • scenery, clean air, clean water. • However, the latter services can be subject to increasing rivalry or excludability as they approach a congestion point. Then, they may assume the characteristics of either common pool, toll, or private goods and services.

17. Market failures: 2. Nature of public goods • Common pool goods include all the renewable natural resources:forests, water, wildlife, fisheries. • Conceptually, common pool goods are associated to the common propertysystem, that isa system based on a property right regime regulating the access and use of the natural resources. • An extreme situation of the common property system is theopen access system. This happens when either there are no common rules at all regarding the access to and use of common pool resources or the rules have been disrupted. • Therefore, the degree of exploitation and degradation of common pool goods very much depends on whether a property rights regime exists or not, and on the effectiveness of the rules and rights established. More examples in the notes

18. Market failures: 3. Lack of property rights Property rights are any kind of legal acts defining the rights of individuals to use natural resources. These rights can be: ownership rights, lease, or use rights conferred by law (e.g. the right to use water passing over one’s property). Well defined and clear property rights allow to create markets for public goods and externalities, and consequently to place an economic value (price) on them. If these conditions are not met, like in the open access situation, the incentives to conserve, protect, and manage natural resources in a sustainable manner will be undermined. More examples in the notes

19. Market failures: 4. Ignorance, uncertainty and short-sightedness • Ignorance and uncertainty may also hinder the functioning of markets. • The limited knowledge and of some environmental processes does not help providing the users of natural resources with the required information on the possible impacts in terms of quantity, quality and time of occurrence. This can be exacerbated by an unequal distribution of information. • Short-sightedness can also cause market failures. • Often individuals or countries (particularly lower income ones) have short time horizons, thus preferring investments yielding benefits in the short to medium term rather than in the long term. This is one of the reasons why environmental investments are seldom put first on the development agenda. A simple mathematical demonstration is provided on the next slide.

20. Market failures: 4. Ignorance, uncertainty and short-sightedness This technique calculates the velocity of loss of value of money in the future. The larger the discount rate, the higher the velocity of loss of value. So, for example, a discount rate of 10 percent to a benefit of US$10 received in 10 years time will be worth US$3.85 now. If the discount rate is 3 percent, the same amount of money received in 10 years time will be worth US$ 7.44 now. The formula to calculate the present value (the value now) of the benefits received in the future is: A*1/(1+i)n where: A = amount of money received; i = discount rate used and; n = the year the amount will be received from now. In the examples above, the formulas will be: US$10*1/(1+0.1)10 = US$3.85 and US$10*1/(1+0.03)10 = US$7.44 More examples in the notes

21. Market failures: 5. Irreversibility of use Irreversibility is a typical element of environmental market failure. Some development investments may determine the irreversible loss of natural assets both for the present and future generations. This will reduce the options available to future generations to use the asset in question. However, since preferences of future generations cannot be known, it is difficult to state whether it is worth destroying a resource or to conserve it indefinitely.

22. Policy failures Government intervention should aim to correct the various forms of market failure. Failure to intervene in situations of market failure means environmental problems are perpetuated. This is one obvious form of policy failure. EXAMPLE • Governments can intervene: • to achieve efficiency objectives (internalizing externalities in the production processes or defining property rights, for instance); • in relation to objectives not related to efficiency, such as poverty alleviation, income redistribution between social groups and regions (equity objectives); • in controlling proliferation of ‘unethical’ goods, such as construction of materials hazardous to human health or genetically modified seed varieties (ethical objectives); or • stockpiling strategic food stocks (strategic objectives).

23. Policy failures Where no market failure is apparent, the policy interventions can distort an otherwise well functioning market. Also, government interventions can sometimes contribute to and even exacerbate the mismanagement of natural resource by giving the wrong signals to individuals and firms. EXAMPLE • Some examples of possible policy failures affecting the environment in developing countries include: • Low tariffs of environmental resources’ use, such as irrigation water; • Subsidized energy-intensive inputs, such as fertilizers and pesticides; • Poorly defined property rights; • Poorly designed investments; • Subsidies for environmentally depleting activities (e.g. ranching); • Low royalties charged on natural resource mining. More examples in the notes

24. Concept of Total economic value We just said that environmental resources are generally not priced. In addition, their value is generally underestimated due to lack of scientific information on the various possible services they can supply. We also considered that absence of price signals as to the true value of natural resources can lead to policy decisions that are detrimental to the environment. What can be done to deal with this problem?

25. Concept of Total economic value We must refer to the field of environmental economics, and consider the concept of total economic value of environmental resources. Environmental economists in the 1960s proposed a classification of economic values, which encompass some of the major externalities of natural resources exploitation. They identified two broad categories of values (Use Values and Non use Values) and one related category (Option Value): NON USE VALUES OPTION VALUE USE VALUES • Those benefits which do not imply a contact between the consumers and the good.Non-use values are by many authors also defined "existence value". The arguments behind existence value are: • Intrinsic value • Bequest motive It is the value placed on environmental assets by those people who want to secure the use of the good or service in the future. Option values can be either positive or negative. • Those benefits that derive from the actual use of the natural resources. • They are often divided into: • Primary Values • Secondary values More Information and examples in the notes

26. Concept of Total economic value The total value of an environmental asset is therefore obtained by summing up all the value components. Here is an example: The analyst should be sure that the values to be counted are not mutually exclusive or that they are not already captured by other value components. More examples in the notes

27. Methodological approaches to monetary valuation Ideally all these values should be expressed in monetary terms so that they can be compared with all the other costs and benefits of policy decisions. However, in practice, many environmental goods and services cannot be priced as already mentioned. In the past decades, several tools and techniques have been developed to measure the total economic value of natural resources. We will now look at different methodological approaches based on monetary valuation of environmental goods and services.

28. Methodological approaches. Basic concept. Willingness to pay or accept The monetary valuation of an environmental good is usually based on the monetary value individuals place on it. The maximum amount of money an individual is willing to pay for obtaining a benefit or avoiding a loss in most situations reflects the intensity of its preferences for such a benefit or loss. The maximum willingness to pay (WTP) can be considered therefore an expression of the individual’s values. Analogously, the minimum Willingness To Accept (WTA) an amount of money as compensation for foregoing a benefit or for incurring a loss, reflects the value of such a benefit or loss. More information in the notes

29. Methodological approaches. Basic concept. Willingness to pay or accept EXAMPLE When an individual buys an asset paying for it the market price, the price paid directly reveals a lower bound of his maximum willingness to pay. It indeed reveals that the willingness to pay for such an asset is "at least" equal to the price paid. If we observe an individual paying 10 monetary units for a kilogram of sugar, this means that he is willing to pay at least 10 monetary units for each kilogram of sugar of that quality, otherwise he would not buy it at that price. His/her maximum WTP must be equal to or greater than 10 MU.

30. Methodological approaches. Revealed and stated preferences When there is no market for an asset, obviously there is no market price that reveals the lower bound of individual’s maximum WTP and the upper bound of the minimum WTA. Here are some methodologies to evaluate people's WTP or WTA. One of the major issues in welfare economics is how to derive the measures of change in welfare. Two main approaches are practicable: REVEALED PREFERENCES STATED PREFERENCES The analyst uses information that is based on what the consumer states when directly asked to express his value judgement. The analyst recovers from the actual behaviour the consumer’s preferences, and uses this information to work out money measures of the consumer’s welfare changes. In either case, reactions of the consumer to changes in prices or quantities of environmental goods or services provide the basis for approximating the economic values attached.

31. Methodological approaches. Environmental valuation using market prices Where market prices exist the valuation of the environmental impact can be assessed using fairly conventional economic tools. These are related primarily to cost-benefit or cost effectiveness analysis approaches, as commonly used in project appraisal. The most well known techniques include incorporating loss of earnings or changes in productivity into assessment of the costs and benefits of a given action, project or programme. The implicit assumption in using market prices to determine value is that these prices reflect economic scarcity and are hence efficiency prices. If there are distortions in the market prices (for example from taxes, subsidies or exchange rate policies), these will need to be adjusted and ‘shadow’ or accounting prices used instead.

32. Methodological approaches. Environmental valuation in absence of markets • Many environmental goods are public or common pool goods in nature. As such, market prices are often not available. • The value of an increase or decrease in supply is then equal to the sum of the marginal willingness to pay or accept. • Information on these may not be easy to obtain. In the absence of complete markets, a number of different techniques for placing a value on non-marketed goods and services may be used, depending on circumstances. These techniques have been classified in several ways, according to the objective pursued. • A possible classification distinguishes three approaches: • conventional market; • implicit market; and • constructed market. More information in the notes

33. Methodological approaches. Environmental valuation in absence of markets A number of tools of varying degrees of sophistication, based on the above classification are listed in this table. Source: Adapted from Munasinghe (1993). More information on this table in the notes

34. Methodological approaches. Further readings • Detailed treatment of a number of analytical tools, including illustration with numerical exercises, is provided in other modules of the training path, as follows: • Revealed preference, direct proxy: Productivity Change Method (PCM) and Substitute Cost Method (SCM): Module 3.1.1 • Revealed preference, indirect proxy: Travel Cost Method (TCM): Module 3.1.2 • Stated preference: Contingency Valuation Method (CVM): Module 3.1.3 Also, please refer to Appendix 2 for further readings.