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Session 2

Principles of Environmental Economics

Giovanni Ruta

World Bank Institute(Email: gruta@worldbank.org)

(with thanks to John Dixon

and Maureen Cropper)

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Making choices

OR

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Making choices

OR

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Making choices

OR

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Making choices

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

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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

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Economic growth and the cost of environmental degradation

The sustainability debate

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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

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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

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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

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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

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Understanding the problem

Market failures and

environmental degradation

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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

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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

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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?

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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

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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

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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

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The Solution

The role of the government

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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

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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

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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

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Figure 1 : Annual costs and PM10

reductions

US$

38

17

8

1,438 1,709 3,461 3,830

Tons

abated

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Figure 2 : Marginal Cost of Abatement

Total costs of

20% abatement

Marginal

Abatement Cost

Curve

Marginal

Cost

C0

20%

Cumulative

abatement100%

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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

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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

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The measurement

Economic valuation of environmental benefits

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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

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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

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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

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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

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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

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Types of benefits

Total Economic Value (TEV)

Use values

Direct

Indirect

Option

Non-use values

Bequest / Vicarious

Existence

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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

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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.

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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*

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498

68

2

67

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Total 748 100

Source: Sathirathai, 1998.

Note: 6.25 rai = 1 hectare.

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Warming up for the course!

Managing water pollution in

coastal areas: a case study

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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

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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

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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.

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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?

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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?

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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

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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