Environmental Valuation Methods in Economic Analysis

Environmental Valuation Methods in Economic Analysis This unpublished prĂŠcis showcases 10 environmental valuation methods and stipulates the applicability of each.

Olivier Serrat 31/07/1993

1 Introduction 1.

Economic development relies on natural resources and the productivity of natural systems.

It implies sustained improvements in human welfare derived from conventional goods and services, the production of which often requires natural resources and productive natural systems.

At the same time, economic growth is often accompanied by increasing stress on natural systems and adverse effects on environmental quality that may result in real losses in long-term development potential.

2.

Traditional project appraisal, based on cost–benefit analysis, largely failed to take adverse environmental effects into account.1 The objective of maximizing net output or income encouraged investment in projects regardless of environmental costs to the detriment of projects with environmental benefits. Much present economic growth has environmental costs that are omitted from national income accounts. These costs are real and increasingly tangible.

3.

The purpose of environmental valuation is to ascribe an economic value in monetary terms to natural resources and the environment to lay the rules for their optimal use. Valuation helps to correct the balance between quantifiable and non-quantifiable effects in cost–benefit analysis. It gives a more accurate gauge of economic performance and is essential for settling disputes regarding environmental use and awarding compensation for environmental damage.

Environmental Valuation Methods 4.

Several environmental valuation methods are introduced below.2 The selection of a method will hinge on the environmental impact to be assessed and data availability. The methods are presented in decreasing order of reliance upon market information and comprise: (i) methods based on market information; (ii) methods based on surrogate market values; and (iii) methods based on potential expenditure or willingness-to-pay. One should seek to place economic values on all environmental functions that may be affected by a project.3 A.

Market-Based Methods

5.

The methods considered in this section are based directly on market prices or productivity.

They are applicable where a change in environmental quality affects actual production or production capability.

1.

Change-in-Productivity

6.

This method estimates the impact of a change in the environment on output, e.g., the damage from air pollution to crop yield, or the impact of soil erosion on farm output.

1

2

3

The Bank's Guidelines for Economic Analysis of Projects deal with environmental effects only briefly under the category of externalities and in connection with the depletion of non-renewable natural resources.

In 1986, the Bank published an Economic Staff Paper, Economic Analysis of the Environmental Impacts of Development Projects, which contributed to establishing the framework for quantification of environmental costs and benefits. The forthcoming ADB Workbook of Economic Assessment of Environmental Impacts will combine case studies with methodological summaries and provide operational guidance in the use of valuation methods.

Economic values consist of: (i) direct use values, derived from output that can be consumed directly; (ii) indirect use values, derived from functional benefits; and (iii) non-use or preservation values.

2 2.

Loss of Earnings

7.

This method measures the effects on health from environmental hazards such as air and pollution or the use of pesticides based on the loss of earnings and the cost of medical care.

3.

Defensive or Preventive Expenditures

8.

This method infers the true value of protecting the environment from what people spend to prevent the damage or to restore the environment afterwards, e.g., the cost of building terraces and protecting bunds to prevent soil erosion.

B.

Methods Based on Surrogate Market Value

9.

The methods considered in this section use market information indirectly. Each has its particular advantages and disadvantages, as well as specific requirements for data and resources.

1.

Property Value

10.

This method determines the implicit price of specific characteristics of properties to place a value on improvements or deterioration in environmental quality, e.g., the effects of air pollution in certain areas.

2.

Wage Differential

11.

This method is based on the theory that, in a competitive market, the demand for labor equals the value of the marginal product and that the supply of labor varies with working and living conditions in an area. A higher wage is therefore necessary to attract workers to a polluted area or to entice them to perform risky work.

3.

Travel Cost

12.

This method infers people's valuation of an unpriced amenity, e.g., a beauty spot or a public beach, from the time and cost they are observed to incur while travelling to the site.

4.

Marketed Goods as Surrogates

13.

This method approximates the value of environmental goods that have close market substitutes, e.g., the value of a non-marketed fish species can be valued at the price of the most similar fish being sold in local markets.

C.

Methods Based on Potential Expenditure or Willingness-to-Pay

14.

The benefits from environmental quality protection or improvements do not always lend themselves to valuation. In some of these cases, it may be possible to estimate benefits by calculating the costs of replacing the environmental services that have been or might be destroyed by a project, or by estimating what people might be willing to pay to protect an environmental asset. Care should be exercised to avoid improper evaluation.

3 1.

Replacement Cost

15.

Under this method, the costs of replacing a damaged asset are estimated, e.g., the cost of the fertilizer that would be needed to replace the nutrients lost through soil erosion.

2.

Shadow Project

16.

This method involves the design and costing of one or more shadow projects that would provide substitute environmental services to compensate for the loss of the original assets.

3.

Contingent Valuation

17.

This method is a form of market research on what people would be willing to pay or willing to accept for a change in environmental quality.

Discounting 18.

The rate at which the cost and benefit streams are to be discounted is a general issue in cost–benefit analysis but is particularly important with regard to environmental costs and benefits since some of them will accrue in the long term. The opportunity cost, i.e., the benefit foregone by using a scarce resource for one purpose instead of for its next best alternative use, increases the longer the gestation period of a project.

19.

For discounting to fulfill its purpose efficiently, it is recommended that: (i) the standard opportunity cost of capital be used for environmental cost–benefit analyses; (ii) short-term and long-term costs and benefits be estimated carefully; and (iii) a rigorous analysis be made on nonmonetary consequences to supplement standard cost–benefit analysis.

Limits to Environmental Valuation 20.

Environmental valuation can satisfactorily cover only part of the field and has several important limitations. The scientific and physical data supplied by the environmental sciences relate to processes that are complex and not fully understood. In addition, notions of environmental costs and benefits rest on concepts of sustainable development that need to be tested in operational conditions. Accordingly, considerations relevant to the selection of valuation methods include data requirements and availability, intelligibility and plausibility. Plausibility is frequently overlooked. Environmental valuation methods should be credible as well as accurate.

Examples of valuation method application, outlining in each case the main data requirements and limitations of the method concerned, are presented in the Appendix.

An Agenda for the Bank 21.

The Asian Development Bank recognizes the need for sound management of the environment and natural resources and incorporates, where relevant, considerations of environmental impact into lending, technical assistance and policy activities. To ensure that economic development is essentially sustainable, environmental valuation needs to be institutionalized and integrated into project appraisal methodologies.

22.

It is proposed that a Working Group on Environmental Valuation Methods be established to codify the general approach to be followed in the economic analysis of environmental impacts.

The Working Group, building on the forthcoming ADB Workbook of Economic Assessment of

4 Environmental Impacts, would formulate guidelines for environmental valuation for incorporation into the Bank's Guidelines for Economic Analysis of Projects to ensure uniformity of analysis, approach and coverage in all Bank projects.

23.

The Working Group, involving staff from the Programs Departments, the Projects Departments, the Economics and Development Resource Center, the Post-Evaluation Office, and the Office of the Environment, would focus on those methods that can be most readily and plausibly applied given the data and time limitations common to project analysis and the probable environmental effects of standard types of development projects.

The views expressed in this prĂŠcis are those of the author and do not necessarily reflect the views and policies of the Asian Development Bank, or its Board of Governors or the governments they represent.

Appendix VALUATION METHOD APPLICATION, DATA REQUIREMENTS, AND LIMITATIONS Valuation Method Change-in-Productivity

Examples of Application Soil erosion, deforestation, desertification, loss of ecosystems, loss of production from air and water pollution

Loss of Earnings

Air and water pollution, water related diseases, unsanitary living conditions, unsafe or unhealthy working conditions, industrial safety Soil erosion, siltation, noise, air and water pollution, flood control, coastal protection

Defensive or Preventive Expenditure

Property Value

Noise, air, water and odor pollution, slum upgrading, sewage projects, traffic congestion

Wage Differential

Risk of death from industrial accidents, health risks from pollution

Travel Cost

Recreational sites, benefits from tourism, fuelwood and water supply

Market Goods as Surrogates

Sewage treatment as proxy for water purification by ecosystems See defensive or preventive expenditures Restoration of commercial

Replacement Cost Shadow Project

Data Requirements Physical impacts quantified and attributed, information on market prices, production and consumption responses to changes prices, prices of closest substitutes, appreciation of the behavioral adjustments of producers and consumers in response to environmental damage Economic value of lost productive time quantified, information on costs of health care and the size of the population at risk Actual spending on safeguards against environmental risks, willingness to pay against environmental threat, costing Information on the principal factors influencing the value of properties, specification and calibration of environmental variables such as air and water quality Wages and benefits in different occupations and across locations, categorization of occupations according to key attributes, quantification of environmental risks to which workers are exposed Survey of the number of visitors to the site, their place of origin for the journey, basic socioeconomic features, computation of travel time, expenses Data requirements depend on the surrogate selected See defensive or preventive expenditures Data requirements depend

Limitations Physical relationships between activities affecting the environment are rarely well-established, need to assess the market structure, elasticities and supply and demand responses when the effect on markets is substantial

Multiple causative factors, psychic cost considerations, definition of human productivity, inapplicable for life threatening impacts Minimum valuation of benefits, depends on perception of the costs of an environmental damage by parties responsible or their victims Assumes a well-functioning property market and awareness by households of all aspects of environmental quality

Assumes a competitive labor market, difficulty of measuring occupational or locational risks, degree of risk-aversion varies among individuals, difficulty of measuring the damage to health from pollution Difficulty of valuing time taken outside working hours, travel may be part of the pleasure, ignores nonvisitors or potential visitors, some travels are multipurpose Environmental surrogates may not exist or may not be widely marketed See defensive or preventive expenditures Difficulty of compensating

6 Valuation Method

Examples of Application freshwater fisheries damaged by discharges

Data Requirements on the type of project financed

Contingent Valuation

Recreational sites, water supply, sanitation, garbage collection, cleaning up of heavily polluted rivers or waste dumps, relocation of polluting industries, conservation of forests and biological diversity

Use of questionnaire surveys to elicit people's preferences for certain environmental states and the money values they would put on them

Source: Author.

Limitations for the loss of complex ecological systems, difficulty of offsetting complicated hydrological or atmospheric effects, shadow projects are likely to have their own environmental effects Based on hypothetical, not actual behavior, asymmetry between willingness to pay and willingness to accept, adding-up problems, grossing up from sample survey to the total population is tricky