1
Session 2
Principles of Environmental Economics
Giovanni Ruta
World Bank Institute(Email: [email protected])
(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
1. The sustainability debate
2. Market failures and environmental degradation
3. The role of the government
4. Economic valuation of environmental benefits
5. 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
0
NSCHK
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.
0,0
,0,0
NSC
HK
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
Excludable?
YesRival?
Yes
No
No
Private Goods
• Clothing
• Congested toll roads
Natural Monopolies
• Software
• Uncongested toll roads
Common Property Resources
• Ocean fisheries
• Congested non-toll
roads
Public Goods
• Knowledge
• Uncongested non-toll
roads
17
Air Pollution Is a Public Good
People 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
Vehicles Point Sources:Convert Wood
Burning to
1.Gasoline Vehicle
Standards
2. Diesel Truck
Control
3. CNG Buses
4.Distillate Fuel Oil
5. Natural Gas
Removes (t/yr)
369 271 1,752 1,438 1,170
Costs Mn US$/yr
14 4 30 11 19
Thousand US$/ton
38 15 17 8 16
23
Figure 1 : Annual costs and PM10
reductions
US$
38
17
8
1,438 1,709 3,461 3,830
Tons
abated
15
24
Figure 2 : Marginal Cost of Abatement
Total costs of
20% abatement
Marginal
Abatement Cost
Curve
Marginal
Cost
C0
20%
Cumulative
abatement100%
25
Figure 3 : Marginal Benefits
20% 100%
Cumulative
abatement
B0
Marginal
Damage
Marginal Damage
Cost curve = Marginal
Benefits curve
More pollution
Total benefits
of 20%
abatement
26
Figure 4 : Comparing Costs and
Benefits
100%
Cumulative
abatement
Marginal Damage Cost
curve = Marginal Benefit
curve
Q0Optimal level of abatement
Marginal Abatement
Cost curve
20%
Net benefits
of 20%
abatement
Marginal Cost
and Marginal
Benefit
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
Impact Possible price
Change in rice production Price of rice (if market exists)
Price of commodity being exchanged for rice (i.e. salt)
Change in human health Cost of doctor’s visits
Cost of wage lost
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
The process of measuring benefits
Willingness to Pay
Environmental
Improvement
Dose-Response
effect
Change in
Health
Change in
production
Estimation
of impacts
(envir.
scientist)Habitat
Changes
Economic
valuation
(economist)
Value of
changes in
productivity
Opportunity
cost approach
Replacement
cost approach
Replacement
cost approach
Opportunity
cost approach
Medical costs
approach
Human capital
approach
Revealed
Averting and
preventive
behaviour
Travel cost
method
Hedonic price
method
Hypothetical
Contingent
valuation
method
Contingent
ranking
36
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.
37
Economic Value of a Mangrove FunctionsSurat Thani, Thailand
Type of economic value Net return per rai, US$ As % of total returns
Local use value 169 23
Indirect use value:
off-shore fishery
coastal protection
carbon sequestration*
13
498
68
2
67
9
Total 748 100
Source: Sathirathai, 1998.
Note: 6.25 rai = 1 hectare.
38
Warming up for the course!
Managing water pollution in
coastal areas: a case study
39
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
40
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: $0.5M
Loss of biodiversity in coastal areas: not estimated but thought to be substantial
41
Determining the price for clean water ($)
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.
42
Determining the price for clean water ($)
If the treatment plant costs $10M, which of the following actors would be able to pay for the solution? Tourism industry
Farmers
Heavy metal industry
Government
Could a “negotiated” solution be found? Why or why not?
Would you recommend estimating non-use values? Why?
43
Determining the price for clean water ($)
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?
44
Conclusion:Why a course on valuation?
• Market-based incentivesEffluent chargestradable permitsinput/output taxes and
subsidiesabatement inputs
THE PROBLEM
• Externalities
• Discount Rate
• Opportunity Cost
Policy Instruments
• Open Access
• Public Goods
• Property Rights
• Command & ControlEmission RegulationsRegulation of equipment
process, inputs, and outputs
Economic Valuation
•Direct methods
•Revealed Preferences
•Stated Preferences
•Benefit Transfer
Information
Public Participation
Information
45
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