Session 2
Principles of Environmental
Economics
Giovanni Ruta
World Bank Institute
(Email: [email protected])
(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:




K  H  SC  N  0
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
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Sustainability debate continued:
Strong sustainability
Requires that each type of capital stock be
maintained above some minimum level


K  0, H  0,


SC  0, N  0
The minimum level of different types of natural
capital stock could be determined by Safe
Minimum Standards and the Precautionary
Principle.
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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
Rival?
Yes
Yes
Private Goods
• Clothing
• Congested toll roads
Common Property
Excludable? Resources
• Ocean fisheries
No • Congested non-toll
roads
No
Natural Monopolies
• Software
• Uncongested 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
1.Gasoline
Vehicle
Standards
Point Sources:
Convert Wood
Burning to
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$/yr
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4
30
11
19
Thousand
US$/ton
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15
17
8
16
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Figure 1 : Annual costs and PM10
reductions
US$
38
17
15
8
1,438
1,709
3,461
3,830
Tons
abated
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Figure 2 : Marginal Cost of Abatement
Marginal
Cost
Marginal
Abatement Cost
Curve
C0
Total costs of
20% abatement
20%
100%
Cumulative
abatement
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Figure 3 : Marginal Benefits
Marginal
Damage
Total benefits
of 20%
abatement
Marginal Damage
Cost curve = Marginal
Benefits curve
B0
20%
100%
Cumulative
abatement
More pollution
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Figure 4 : Comparing Costs and
Benefits
Marginal Cost
and Marginal
Benefit
Marginal Abatement
Cost curve
Net benefits
of 20%
abatement
Marginal Damage Cost
curve = Marginal Benefit
curve
20% Q0
100%
Cumulative
abatement
Optimal level of abatement
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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
Environmental
Improvement
Estimation
of impacts
(envir.
scientist)
Economic
valuation
(economist)
Dose-Response
effect
Change in
production
Change in
Health
Habitat
Changes
Willingness to Pay
Revealed
Hypothetical
Value of
changes in
productivity
Human capital
approach
Opportunity
cost approach
Hedonic price
method
Contingent
valuation
method
Opportunity
cost approach
Medical costs
approach
Replacement
cost approach
Travel cost
method
Contingent
ranking
Replacement
cost approach
Averting and
preventive
behaviour
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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; Nonuse NPV of Curação reefs = US $ 4.5 million.
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Economic Value of a Mangrove Functions
Surat Thani, Thailand
Type of economic value
Local use value
Indirect use value:
off-shore fishery
coastal protection
carbon sequestration*
Total
Net return per rai, US$
169
As % of total returns
23
13
498
68
748
2
67
9
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?
THE PROBLEM
• Externalities
• Open Access
• Discount Rate
• Public Goods
• Opportunity Cost
• Property Rights
Information
Economic Valuation
•Direct methods
•Revealed Preferences
•Stated Preferences
•Benefit Transfer
Information
Public Participation
Policy Instruments
• Command & Control
Emission Regulations
Regulation of equipment
process, inputs, and outputs
• Market-based incentives
Effluent charges
tradable permits
input/output taxes and
subsidies
abatement inputs
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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
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