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 19 Economic Principles and Overview of Valuation Methods for Environmental Impacts 1  Anil Markandya 1. Introduction Valuing the services derived from the environment is important because it ‘works’ – i.e. it helps make the case for protecting the environment in an effective way. Indeed it can be, in many cases, a more effective instrument than other methods of protecting the environment – such as lobbying, undertaking direct action and so on. But to be successful it has to be carried out in a credible and professional manner. This chapter provides an overview of the different methods of valuing environmental impacts. Before it can do that, however, it has to provide the conceptual basis for such valuations. Environmentalists and economists both believe that market forces by themselves will undervalue environmental services. Indeed, many examples are available of cases where the depletion of natural resources and damage to the natural environment can be attributed to the undervaluation of the goods and services the environment provides to society. The underlying reasons for the underestimation of environmental assets are to be found in what economic theory calls ‘market failure’ and ‘policy failure’ (Bator 1958; OECD 1995). In a market characterised by market failure, the prices actually paid for goods and services diverge from social marginal costs (although they may be equal to private marginal costs), i.e. the value the society attributes to the goods and services. Several types of market failure can be defined (OECD, 1994). The most common type of market failure related to the environment is the failure to internalise, or take account of, externalities. A well managed forest will have positive effects (externalities) in keeping the atmosphere clean, protecting soils from erosion, regulating water flows, protecting the gene pool and biological diversity, and other ecological functions. Conversely, indiscriminate deforestation can have negative effects on soil fertility and erosion, resulting in cost increases for the agricultural activities downstream. Both these positive and negative externalities are usually not internalised by the private producers, thus leading to a mis-estimation (usually underestimation ) of the true value of forests to society. Another important source of market failure in the environmental sector stems from the fact that many of the services provided by natural resources are public goods with no market price. A public good/service, such as free access to the recreational areas, when supplied to one person, is also available to others. Nobody can be excluded from using the environmental good or service. Individuals’ willingness to pay for the good will understate, ‘free ride’, the true benefit received since they are sure to obtain it as long as it is provided to at least one person. Another reason for market failures is the limited existing knowledge on the potential economic goods and services which the environment could provide to future generations. 1 This draws extensively on Chapter 9 of Markandya et al . 2002.

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