Session 2 Principles of Environmental Economics

1. Session 2Principles of Environmental Economics Giovanni Ruta World Bank Institute (Email: gruta@worldbank.org) (with thanks to John Dixon and Maureen Cropper)

2. Making choices OR

3. Making choices OR

4. Making choices OR

5. Making choices Economics is the science of choice… …and many choices involve the environment

6. Contents • The sustainability debate • Market failures and environmental degradation • The role of the government • Economic valuation of environmental benefits • Managing water pollution in coastal areas: a case study

7. Economic growth and the cost of environmental degradation The sustainability debate

8. Sustainable development – what are the issues? • Robert Solow (1974) • Optimal growth and sustainability concerns due to • Limited natural resources • Intertemporal rate of time preference • Population growth • Technological change may be need to guarantee non-decreasing consumption • Hartwick (1977) – sustainability possible if we invest the rents from natural resource use in man-made capital

9. Sustainability debate continued – what is necessary? • Objective – a non-decreasing level of well being (or economic welfare) over time (per capita) • Conditions • Consumption tomorrow depends on resource use today and how investments are handled • Sustainability requires a certain level of conservation (the so-called ‘safe minimum standard’) • There is some level of acceptable substitutability between natural and man-made capital

10. Sustainability debate continued:Weak sustainability • A definition of weak sustainability might be: where K is manmade capital, H is human capital, SC is social capital and N is natural capital • Under a policy of weak sustainable development, depletion of the stock of natural capital may be compensated for by investment of the same or greater value in, for instance, manmade capital

11. Sustainability debate continued:Strong sustainability • Requires that each type of capital stock be maintained above some minimum level • The minimum level of different types of natural capital stock could be determined by Safe Minimum Standards and the Precautionary Principle.

12. Understanding the problem Market failures and environmental degradation

13. Why is There Air Pollution in Beirut and Damascus? • Technical Answer: • Mobile and Stationary Sources Burn Fossil Fuels • Air Pollution Emitted as a By-Product • Economic Answer: • People, firms are not charged for their use of the environment (market failure) • As a result, each person driving in Santiago imposes an externality on the residents of the city

14. What Is An Externality? • Externality • Unintentional Damage Inflicted on Others For which No Compensation Is Paid • Why Does This Externality Occur? • Without government intervention, there are no markets for clean air: • Property rights to the atmosphere are not assigned, so no one can charge for its use • Although in theory victims of air pollution could pay sources not to pollute, in practice this is difficult

15. What Are the Solutions to This Problem? • Technical Solutions: • Install pollution control devices on cars • Replace diesel buses with CNG buses • Use cleaner fuels (e.g., lower sulfur fuels) • Will People Voluntarily Adopt the Technical Solutions? • Pollution controls are costly • If expensive but cleaners cars are available, (as well as dirty cars) will people buy them?

16. Types of Goods Rival? No Yes Yes Excludable? No

17. Air Pollution Is a Public GoodPeople Have an Incentive to “Free-Ride” • Air Pollution Is a Public Good: • When one person abates pollution, he provides clean air for everyone • No one can be prevented from consuming the clean air • This leads to the “Free-Rider” Problem: • Each person’s abatement has a small impact on air quality, and abatement is costly to him • When one person abates pollution, he provides clean air for everyone • It is therefore to his advantage to let others abate pollution, which he cannot be prevented from consuming

18. Implications of the Free Rider Problem • People will not voluntarily control pollution (any more than they will voluntarily pay taxes) • However: Everyone is better off if all people are required to abate pollution • Role of Government is to provide incentives for people to abate pollution: • Require pollution control devices on cars • Mandate that lead be removed from gasoline • Require that buses run on CNG • Tax emissions from power plants

19. The Solution The role of the government

20. How Far Should the Government Go? What Is the Right Amount of Pollution? • Should a country aim for zero emissions into air or water? • Probably not, if reducing emissions is costly • Want to balance the benefits of an additional improvement in air quality against the costs

21. Balancing Marginal Costs and Marginal Benefits • In Beirut, particulate matter (PM) is the chief air pollutant of concern • The five air pollution control strategies on the next slide are capable of reducing PM concentrations in Beirut • We will use them to look at the marginal cost of abating PM

22. CONTROL SCENARIO: COSTS AND PM10 REDUCTIONS

23. Figure 1 : Annual costs and PM10 reductions US$ 38 17 15 8 Tons abated 1,438 3,461 1,709 3,830

24. Marginal Cost Marginal Abatement Cost Curve C0 Total costs of 20% abatement Cumulative abatement 20% 100% Figure 2 : Marginal Cost of Abatement

25. Marginal Damage Total benefits of 20% abatement Marginal Damage Cost curve = Marginal Benefits curve B0 Cumulative abatement 20% 100% More pollution Figure 3 : Marginal Benefits

26. Marginal Cost and Marginal Benefit Marginal Abatement Cost curve Net benefits of 20% abatement Marginal Damage Cost curve = Marginal Benefit curve Cumulative abatement Q0 100% 20% Optimal level of abatement Figure 4 : Comparing Costs and Benefits

27. The measurement Economic valuation of environmental benefits

28. The valuation process • Step 1 – Identification of the physical links between cause and effect • Environmental degradation matters because of its impacts on (i) production; (ii) human health; (iii) amenity • Knowledge required: engineering, biology, chemistry, social sciences, … • Step 2 – Valuation (putting a monetary value on the impact) • Expressing impacts into a commonly understood unit allows (but does not imply!) decision making • Knowledge required: economics, statistics, science

29. Valuation: Direct techniques • Once the impact has been measured (step 1 in previous slide) we can multiply by the “price” per unit of impact and obtain a minimum estimate of the ‘true’ value

30. Valuation: Indirect techniques • Study the behaviour and choices of individuals to understand how environmental goods are ‘traded off’ with other goods (i.e. money) • These techniques allow obtaining a “true” measure of willingness to pay for the environment • Revealed preferences techniques are based in the analysis of actually observed behaviour • Travel cost method • Hedonic price method • Stated preferences techniques are based on hypothetical behaviour • Contingent Valuation • Contingent Ranking

31. Valuation: Transferring benefits (1) • Benefits transfer consists in using the values from Study Site A to value environmental changes in Study Site B • When transferring benefits, it is important to adjust for • Cause effect relationship  functions transfer • Income level • Population affected

32. Valuation: Transferring benefits (2) • This approach is especially useful: • To overcome data constraints • To value underdeveloped resources • Where strict comparability conditions are met (dose-response matched studies) • Where a market exists or could be created • Areas of concern: • Use of point estimates to “value the world” (the value of an environmental good is not always equal to the sum of the values of its parts) • Cases in which good or service being valued is intangible or culturally-dependent

33. Types of benefits • Total Economic Value (TEV) • Use values • Direct • Indirect • Option • Non-use values • Bequest / Vicarious • Existence

34. Environmental Improvement Dose-Response effect Estimation of impacts (envir. scientist) Habitat Changes Change in production Change in Health Willingness to Pay Revealed Hypothetical Opportunity cost approach Hedonic price method Contingent valuation method Value of changes in productivity Human capital approach Economic valuation (economist) Replacement cost approach Travel cost method Contingent ranking Opportunity cost approach Medical costs approach Replacement cost approach Averting and preventive behaviour The process of measuring benefits

35. Valuing Ecosystems: Examples of Valuation • Indirect Values: Replacement costs for reef protection in the Philippines = US $ 22 billion, productivity change method NPV for coastal protection of the Montego Bay Coral Reefs = US $ 65 million. • Non-use values: Gray Whales - US $ 16 and US $ 18 per household per year; New Jersey beaches for users = US $ 15.1 / year and for non-users = US $ 9.26 / year; Portuguese Coastal Natural Area = US $ 40 to US $ 51 / respondent; Non-use NPV of Curação reefs = US $ 4.5 million.

36. Economic Value of a Mangrove Functions Surat Thani, Thailand

37. Warming up for the course! Managing water pollution in coastal areas: a case study

38. A Case Study – water pollution in coastal areas • The problem – water quality in coastal areas heavily depends on the uses of water upstream. Impacts often occur far away from the source! • Decisions on water uses – i.e. as a receptor for sewage – are therefore made based on narrow views of the benefits and costs involved

39. The cost of water pollution • Assume that the various annual costs associated with water pollution from the industrial sector (in US$/ha/yr): • Agricultural losses: $1M • Health damages: $2M • Tourism losses: $0.5M • Loss of biodiversity in coastal areas: not estimated but thought to be substantial

40. Determining the price for clean water ($) • Assume that the appropriate discount rate is 5% • Note: the present value of an infinite future stream of a fixed amount is that amount (x) divided by the interest rate (i), that is -- x/i • Assume that an alternative exist to treat waste-water and completely eliminate the negative effects of pollution.

41. Determining the price for clean water ($) • If the treatment plant costs $10M, which of the following actors would be able to pay for the solution? • Tourism industry • Farmers • Heavy metal industry • Government • Could a “negotiated” solution be found? Why or why not? • Would you recommend estimating non-use values? Why?

42. Determining the price for clean water ($) • Assume the water treatment plant would allow the plant to save on its water bill (through recycling) an amount of $0.2M per year. • Assume that the government is planning to reduce the plant income tax to promote the investment in water treatment. • What should be the size of the tax reduction?

43. THE PROBLEM • Externalities • Discount Rate • Opportunity Cost • Open Access • Public Goods • Property Rights Information Economic Valuation Policy Instruments • Direct methods • Revealed Preferences • Stated Preferences • Benefit Transfer • Command & Control Emission Regulations Regulation of equipment process, inputs, and outputs • Market-based incentives Effluent charges tradable permits Information input/output taxes and subsidies abatement inputs Public Participation Conclusion:Why a course on valuation?

44. Summary • A high cost of environmental degradation may be a signal of ‘unsustainable’ growth: future income levels may be negatively affected • Tackling the problem requires identifying missing markets for environmental goods and services • Information on costs and benefits is crucial for effective policy making • Economic valuation is an important tool for measuring people’s preferences and guiding decisions