P522 Environmental Valuation: Theory, Techniques and ... · economics of environmental valuation. ... Part I Introduction to Environmental Valuation and Theory Unit 1 The economy,

Centre for Development, Environment and Policy

P522

Environmental Valuation:

Theory, Techniques and Application

Prepared by Iain Fraser, Laurence Smith and Alberto Zanni

This module is partially based on the earlier module:

Environmental Valuation: Theory, Techniques and Applications, prepared by Helen

Bright, Uwe Lohmann and Jamie Morrison in 2001 and revised in 2002

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P522 Environmental Valuation: Theory, Techniques and Application Introduction

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MODULE INTRODUCTION

ABOUT THIS MODULE

The main issues of this module relate to the ways in which values can be placed on

the environment, enabling environmental issues to be included in economic decision-

making. Neoclassical economics can be used as a tool to assign monetary values to

environmental goods and services and these values can then be incorporated into

decision-making at the project, sectoral and national levels. Although the methods

and techniques which this module introduces represent the mainstream approach to

environmental economic decision-making, there are many criticisms of such an

approach, and the module also addresses these concerns and outlines alternative

approaches to analysing economy–environment links.

The module first contrasts the ways in which the environment is viewed by

environmentalists, by ecologists and by economists within different economic

paradigms. The justifications for attempting to put a value on the environment are

put forward, and the place of environmental valuation within the core concept of

sustainable development is discussed. Neoclassical economics is then used to provide

a theoretical basis for environmental valuation and introduce the different ways of

measuring welfare change, using the concepts of consumer surplus, willingness to

pay and willingness to accept. The components of environmental value are analysed,

with distinctions made between use values and non-use values, including option

values and existence values.

Later units introduce the techniques of environmental valuation and their policy

applications. There are many techniques available for valuing the environment, some

of which are demand curve approaches and some non-demand curve approaches.

The main demand curve approaches examined include the travel cost method,

hedonic pricing methods, contingent valuation methods and choice experiments. The

non-demand curve techniques reviewed are the effect on productivity method,

opportunity cost measures, human capital measures, the replacement cost method,

and averting behaviour approaches. The benefit transfer approach is also reviewed

and assessed.

The penultimate unit examines applications of environmental valuation as part of

cost–benefit analysis (CBA). Finally, criticisms of environmental valuation are

considered and a range of alternative methods, including environmental impact

assessment, are briefly reviewed.


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STRUCTURE OF THE MODULE

The module consists of ten units which are divided into three parts.

Part I

Part I introduces the reader to the main concepts, ideas and theory of environmental

valuation. This part of the module provides an understanding of how environmental

valuation emerges from a particular view (ie neoclassical) of how the economy and

environment relate to each other. Based on this view many economists accept the

justification of pricing the environment, and the role of money as a common

measuring tool to weigh up the costs and benefits of environmental change is

therefore discussed. We then develop the key theoretical concepts that underpin the

economics of environmental valuation. Specifically, the theory develops various

measures of economic welfare that are the focus of applied environmental valuation

research.

Part II

Part II covers the main approaches to environmental valuation. The material in this

part of the module covers a wide array of methods that draw on the theory

developed in Part I. We consider environmental valuation methods that can be used

very rapidly and those which require far more work on the part of the researcher to

collect and analyse data. An important aspect of the material covered in this part of

the module is that many of the statistical techniques employed in the research

literature will take the reader beyond the methods they will typically cover in basic

econometrics courses. Advice on appropriate methods will be provided.

Part III

Part III of the module provides an insight into how the results of environmental

valuation can be used in practice. We also consider various criticisms of

environmental valuation as well as suggested alternatives that are implemented in

practice.


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WHAT YOU WILL LEARN

Module Aims

• To compare critically and contrast different perspectives on valuing the

environment.

• To present the development of the theory of environmental valuation.

• To explain a range of environmental valuation methods and techniques.

• To critically evaluate these valuation techniques.

• To provide illustrations of the application of the valuation techniques in

practice.

• To show how environmental values can be incorporated in economic decision-

making at the national and project level.

Module Learning Outcomes

By the end of this module, students should be able to:

• understand and assess critically the neoclassical theory of environmental

valuation

• explain and evaluate critically a range of environmental valuation methods and

techniques

• select examples to illustrate the theoretical and practical challenges of the

application of valuation techniques in practice

• understand and critically interpret the results of published environmental

valuation studies

• demonstrate and interpret how environmental values can be incorporated in

economic decision-making at the national and project level.

The examination for this module will focus on these learning outcomes. In the

module some detailed mathematical derivations relating to theory and to valuation

estimates are provided, and some guidance on selection of econometric estimation

methods appropriate for specific valuation techniques. This more advanced

quantitative material is provided for students with the appropriate prior study of

quantitative methods as guidance for application of certain valuation methods in

practice. Detailed mathematical derivations and econometric estimation techniques

will not normally be the subject of examination questions for this module.


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ASSESSMENT

This module is assessed by:

• an examined assignment (EA) worth 20%

• a written examination in October worth 80%

Since the EA is an element of the formal examination process, please note the

following:

(a) The EA questions and submission date will be available on the Virtual Learning

Environment.

(b) The EA is submitted by uploading it to the Virtual Learning Environment.

(c) The EA is marked by the module tutor and students will receive a percentage

mark and feedback.

(d) Answers submitted must be entirely the student’s own work and not a product

of collaboration. For this reason, the Virtual Learning Environment is not an

appropriate forum for queries about the EA.

(e) Plagiarism is a breach of regulations. To ensure compliance with the specific

University of London regulations, all students are advised to read the

guidelines on referencing the work of other people. For more detailed

information, see the User Resource Section of the Virtual Learning

Environment.

STUDY MATERIALS

There are two textbooks accompanying this module.

(a) Champs, P.A., Boyle, K.J. & Brown, T.C. (Eds.) (2003) A Primer on Nonmarket Valuation. Netherlands, Kluwer Academic Publishers.

This book provides a comprehensive overview of the economics of environmental

valuation. Each chapter is written by experienced researchers in the area of

environmental valuation who are able to draw on a sound body of knowledge. It

covers all of the main topics in this module at a high level. In particular, the book is

very comprehensive in linking the theory of environmental valuation with the various

methods examined. All the chapters that consider the various valuation methods

provide applications that give the reader a real feel for the results that can be

generated using the many methods covered in this module. Finally, this book has a

companion website (www.fs.fed.us/nonmarketprimerdata). This website provides

access to various data sets used in the book to illustrate the various non-market

valuation methods. It is recommended that students visit this website and look at the

various data sets provided.

(b) Pearce, D., Atkinson, G. & Mourato, S. (Eds.) (2006) Cost–Benefit Analysis and the Environment Recent Developments. Paris, Organisation for Economic Co-

operation and Development (OECD) Publishing.

This book takes a slightly less technical approach to the issue of environmental

valuation. The strength of this text is the link it makes with the many uses of the

results which are generated by environmental valuation. It also covers various


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important topics that surround environmental valuation which we only consider in

passing. Specifically, this book provides a greater understanding of how the results

of environmental valuation are employed in cost–benefit analysis.

For each of the ten units some Key Readings are also provided. These Key Readings

are drawn mainly from relevant academic journals and agency reports, and provide

applied research examples and applications of the key concepts covered. The Key

Readings are intended to extend the material covered in the units to provide a

broader and more thorough treatment of the material being covered, and their

content is examinable.

A large number of Further Readings and References are also listed. These texts are

not provided but many are available on the Internet. All references cited in the unit

text are listed here. Students are not expected to follow up each and every further

reading, but can follow up specific points of interest.

Further Readings

For each of the ten units, Further Readings and References are also listed. These

texts are not provided but many are available on the internet. Students are not

expected to follow up each and every Further Reading, but can follow up specific

points of interest. They aim to provide a range of perspectives and more depth on

the unit subject matter.

Key Terms and Concepts and Acronyms

At the end of each unit you are provided with a list of Key Terms and Concepts which

have been introduced in the unit. The first time these appear in the text guide they

are Bold Italicised.

As you progress through the module you may need to check unfamiliar acronyms

that are used. A full list of these is provided for you at the end of the introduction.


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INDICATIVE STUDY CALENDAR

Part/unit Unit title Study time in hours

Part I Introduction to Environmental Valuation and Theory

Unit 1 The economy, environment and valuation 10

Unit 2 Economic theory and environmental valuation 15

Part II Environmental Method Approaches

Unit 3 Non-demand curve methods 10

Unit 4 Travel cost method 15

Unit 5 Hedonic pricing methods 15

Unit 6 Contingent valuation 15

Unit 7 Choice experiments 15

Unit 8 Benefit transfer 15

Part III Applications and Criticism of Environmental Valuation

Unit 9 Cost–benefit analysis 15

Unit 10 Criticisms of stated preference methods and alternatives 10

Examined Assignment

Check the Virtual Learning Environment for submission deadline

15

Examination entry July

Revision and examination preparation September

End-of-module examination October


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ACRONYMS AND ABBREVIATIONS

BL budget line

BT benefit transfer

CBA cost–benefit analysis

CE choice experiment

CEA cost–effectiveness analysis

CM choice modelling

CR contingent ranking

CS consumer surplus

CV compensatory variation

CVM contingent valuation method

DMV deliberative monetary valuation

DO dissolved oxygen

EIA environmental impact assessment

EIS environmental impact statement

EOP effect on productivity

EPA Environmental Protection Agency

ESA environmentally sensitive area

EV equivalent variation

FV future value

GIS geographic information systems

HPM hedonic pricing method

IIA independence from irrelevant alternatives

ITCM individual travel cost method

LCM latent class model

LDC less developed country

MCA multi-criteria analysis

MD marginal damage

MNL multinomial logit

MPC marginal private cost

MSC marginal social cost

MXL mixed logit

NGO non-governmental organisation

NOAA National Oceanic and Atmospheric Administration


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NPV/PV net present value/present value

OLS ordinary least squares

PV property value

RUM random utility model

SCF standard conversion factor

SEA strategic environmental assessment

SIA social impact assessment

SMS safe minimum standards

SP stated preference

SRTP social rate of time preference

SSSI site of special scientific interest

SWR shadow wage rate

TCM travel cost method

TE transfer error

TEV total economic value

VSL value of a statistical life

WD wage differentials

WTA willingness to accept

WTP willingness to pay

ZTCM zonal travel cost method

Unit One: The Economy, Environment and Valuation

Unit Information 2

Unit Overview 2

Unit Aims 2

Unit Learning Outcomes 2

Unit Interdependencies 3

Key Readings 4

Further Readings 5

References 5

1.0 Some opening remarks 6

Section Overview 6

Section Learning Outcomes 6

1.1 The demand for environmental values 6

1.2 Environmental valuation remains controversial 8

Section 1 Self Assessment Questions 11

2.0 The economy–environment relationship 12

Section Overview 12


2.1 Defining economics and the environment 12

2.2 Links between the economy and the environment 13

2.3 The first two laws of thermodynamics 15


3.0 Placing an economic value on environmental goods and services 19

Section Overview 19


3.1 Why value the environment? 19

3.2 Developing a pluralistic approach to environmental valuation and

decision-making 23

3.3 Environmental valuation and neoclassical economics 25


Unit Summary 30

Unit Self Assessment Questions 32

Key Terms and Concepts 33

P522 Environmental Valuation: Theory, Techniques and Application Unit 1

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UNIT INFORMATION

Unit Overview

This unit begins by introducing the main motivation for undertaking environmental

valuation. To understand the approach to environmental valuation in practice we

then explain the links between the economy and the environment, and the different

points of view of economists, environmentalists and ecologists. The need to do this

stems from the fact that environmental valuation emerges from a particular view (ie

neoclassical) of how the economy and environment relate to each other. Based on

this view, many economists accept the justification of pricing the environment.

Finally, the role of money as a common measuring tool to weigh up the costs and

benefits of environmental change is therefore discussed.

Unit Aims

• To review the main differences between neoclassical, ecological and

institutional economics and their perspectives on valuing the environment.

• To assess the role of environmental valuation within the core ideas of

sustainable development.

• To review the differences between weak and strong sustainability.

• To evaluate critically the use of money as a common measuring tool in

assessing environmental costs and benefits.

Unit Learning Outcomes

By the end of this unit, students should be able to:

• evaluate support for environmental valuation from different schools of thought

on economic–environmental linkages

• understand how environmental valuation techniques can aid in the goal of

sustainable development

• present arguments for and against the use of monetary values in

environmental policy-making.


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Unit Interdependencies

Unit 2

In Unit 2 we introduce and explain the key aspects of economic theory that underpin

non-market valuation. These build upon the relationship between the economy and

the environment, examined in this unit.

Unit 3

In Unit 3 we describe and explain the main non-demand curve approaches to non-

market valuation. These methods are based on specific aspects of the physical

relationship between the economy and the environment.

Unit 4

In Unit 4 we introduce and explain the travel cost method. This approach to non-

market valuation takes behaviour observed in an existing market and infers values

about the environment. This approach is based on a specific view of the relationship

between environmental goods and services and the wider economy.

Unit 5

In Unit 5 we introduce and explain the hedonic pricing method. This approach to

non-market valuation takes behaviour observed in an existing market and infers

values about the environment. This approach is based on a specific view of the

relationship between environmental goods and services and the wider economy.

Unit 6

In Unit 6 we introduce and explain the contingent valuation method. This approach to

non-market valuation produces non-market valuation estimates based upon a

hypothetical market context. This method allows us to place economic values on

another aspect of the economy-environment relationship: non-use values.

Unit 7

In Unit 7 we introduce and explain the choice experiment method. This approach to

non-market valuation produces non-market valuation estimates based upon a

hypothetical market context. This method allows us to place economic values on

another aspect of the economy-environment relationship: non-use values.

Unit 8

In Unit 8 we introduce and explain the various approaches to benefit transfer. Benefit

transfer takes non-market valuation estimates from existing studies and employs

these in similar decision-making contexts. As with all the valuation methods

examined, benefit transfer allows us to place economic values on the environment.

Unit 9

In Unit 9 we examine how estimates of economic value of the environment are

employed in cost–benefit analysis. This is an important activity as it frequently

motivates the generation of economic values using the various methods considered

in this module.

Unit 10

In Unit 10 we examine various limitations of the economic valuation and alternative

approaches. The issues examined in this unit raise important questions about how

the environment is assumed to relate to the economy and how we might examine

this using alternative approaches.


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KEY READINGS

Farber, S., Costanza, R., Childers, D.L. Erickson, J., Gross, K., Grove, M.,

Hopkinson, C.S., Kahn, J., Pincetl, S., Troy, A., Warren, P. & Wilson, M. (2006)

Linking ecology and economics for ecosystem management. BioScience, 56 (2),

121–133.

This paper provides a very neat overview of how economics and the environment are linked and how, in turn, this relates to environmental valuation. Specifically, the paper uses a very comprehensive example (agricultural landscape management options) to show how environmental valuation can be linked to environmental resource management that is informed by understanding the links between the components of the system. The need to understand these links arises because the ecosystem service approach explicitly links ecology and economics so that policies that impact an ecosystem are understood in terms of their impact on society and the environment.

Freeman, A.M. (2003) Economic valuation: what and why. In: Champs, P.A.,

Boyle, K.J. & Brown, T.C. (Eds.) A Primer on Nonmarket Valuation. London,

Kluwer Academic Publishers. pp. 1–25.

This chapter provides a very nice introduction to the relationship between the economy and the environment. It also places the overall topic covered in this module — economic valuation — within its broader context.


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FURTHER READINGS

Bennett, J. (Ed.) (2013) The International Handbook on Non-Market Environmental Valuation. Cheltenham, Edward Elgar.

Freeman III, A.M. (2003) The Measurement of Environmental and Resource Values: Theory and Methods. 2nd edition. Resources for the Future, Washington DC.

Hanley, N., Shogren, J.F. & White, B. (2001) Introduction to Environmental Economics. UK, Oxford University Press.

Stavins, R.N. (Ed.) (2012) Economics of the Environment: Selected Readings. 6th

edition. Norton.

Turner, R.K., Pearce, D. & Bateman, I. (1994) Environmental Economics: An Elementary Introduction. Hemel Hempstead, Prentice Hall/Harvester Wheatsheaf.

REFERENCES

Arrow, K., Solow, R., Portney, P.R., Leamer, E.E., Radner, R. & Schuman, H. (1993)

Report of the NOAA Panel on contingent valuation. Federal Register, 58, 4601–4614.

Common, M. & Stagl, S. (2005) Ecological Economics. An Introduction. UK, Cambridge

University Press.

Hanley, N., Shogren, J.F. & White, B. (2007) Environmental Economics in Theory and Practice. 2nd edition. UK, Palgrave Macmillan.

Pearce, D. (1998) Cost–benefit analysis and environmental policy. Oxford Review of Economic Policy, 14 (4), 84–100.

Turner, R.K., Pearce, D. & Bateman, I. (1994) Environmental Economics: an Elementary Introduction. Harlow, UK, Pearson Education Limited.


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1.0 SOME OPENING REMARKS

Section Overview

In this section we examine the motivation and reasons why economists advocate the

placing of economic values on environmental goods and services. Specifically, we

consider how the demand for environmental valuation has driven the need to devise,

improve and refine the approaches employed to undertake such valuation. This

demand also helps to explain some of the inherent tensions that exist in terms of

employing environmental values in policy analysis and decision-making in general.

Section Learning Outcomes

By the end of this section, students should be able to:

• understand and assess critically the motivation driving the demand for the

generation of environmental values

• understand that the demand for environmental values is not universally

accepted and that environmental valuation remains a controversial area of

research and practice

• outline for themselves the main points in the debate about the merits of

environmental valuation.

1.1 The demand for environmental values

Environmental economists face an ever-increasing demand for environmental values

to be estimated. This demand stems from the fact that environmental issues are

taking an ever-greater prominence in decision-making at both the micro and macro

level of economic policy formulation. This is partly due to the growing awareness by

society of the environment and how human activity affects it, locally, regionally and

globally. The growth in societal awareness of the environment has led, both directly

and indirectly, to the need for new and more complex environmental policy. Of

course, many of the policy options that are considered are not complementary to

existing forms of economic activity. They can be competitive, involving trade-offs

between the benefits of production, other human activity and the minimisation of

environmental degradation. These are not just abstract trade-offs, but in the real

world they involve competition between the interests of different groups in society.

These interests can include income, jobs and livelihood opportunities. They can also

consist of values and preferences relating to quality of life issues and to natural

resources and how they are used. The competitive nature of the relationship between

many forms of economic activity and the environment inevitably means that policies

to deal with these issues have real and significant opportunity costs. As policy-

makers have become faced with choices that have real and often very large

opportunity costs, they have demanded additional information so that all costs and

benefits can be more fully considered.

In this evolving policy environment it has become important to produce evidence to

support the design and implementation of environmental policy. Sound scientific

evidence can also be an important means of raising awareness, improving


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understanding and helping to build consensus between competing groups. At the

heart of much of this policy change have been many examples of policy analysis that

weigh up the costs and benefits of the policy choices being confronted. As part of this

process we have experienced a growing demand on the part of policy-makers for

evidence about the costs and benefits associated with environment change.

The key issue here is that the vast majority of environmental goods and services are

not traded in markets. Indeed, many of the concerns expressed about the state and

use of the environment are a result of the lack of prices, with which society can

express their preferences about and for the environment. It is inevitable that goods

which are not priced may be overused and degraded. An example of this is the use of

the atmosphere to dispose of waste gases. In response to this demand for prices that

accurately reflect society’s preferences, economists have devised an array of

techniques and methods for putting economic values on environmental goods and

services that are not marketed. These non-market values can then be incorporated

into decision-making frameworks such as cost–benefit analysis (CBA), which remains

a key economic decision-making tool. There is also a view that considers that

environmental concerns have not been adequately addressed in the past because

they have been ignored in CBA and, consequently, not taken into account when

decisions were made and development planning formulated. The approach is

reflected in the following statement:

‘Our central message ... is: economic (monetary) valuation of non-marketed environmental assets may be more or less imperfect given the particular asset together with its environmental and valuation contexts; but, invariably, some valuation explicitly laid out for scrutiny by policy-makers and the public, is better than none ...’

Source: Turner et al (1994) p. 109.

This approach to environmental decision-making has become accepted and adopted

by many institutions and organisations around the world. National governments have

instituted environmental procedures and guidelines for public sector projects that

emphasise the need for environmental valuation and CBA. Thus, for example, various

government departments in the UK charged with designing and implementing

environmental policy and the Environmental Protection Agency in the USA, all employ

environmental CBA as an important part in designing rules and regulations for

industry and society.

The result of these changes in societal awareness, in policy priorities and in valuation

methods is a large and growing demand for all forms of environmental valuation. It

is also the case that this demand will grow and that this in turn will drive the

development of new and improved methods. This is explicitly reflected, at least in

part, in the leading environmental economics journals which publish an ever

increasing number of papers that develop, implement and evaluate alternative

environmental valuation techniques. Furthermore, the wider acceptance of the utility

and validity of environmental valuation methods by researchers other than

economists has led to frequent publication of environmental valuation study results

in environmental science and management journals, and also in interdisciplinary

sector and problem-focused journals.


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1.2 Environmental valuation remains controversial

Whilst the economics approach to environmental valuation and environmental

decision-making represents the mainstream view, and is central to this module, it is

not without controversy, as the quotes in 1.2.1 illustrate. Although these extracts are

from an article that is somewhat dated in its reference to UK agencies, many of the

themes and issues identified are still confronting those who advocate and practice

environmental valuation today.

1.2.1 Valuation, cost—benefit analysis and environmental policy

‘Obstacles to the further use of CBA’ (within UK government and regulatory agencies).’

‘… there continue to be doubts about the reliability of CBA studies, and especially about benefit estimation.’

‘… CBA has developed from a mix of studies prepared unilaterally by academics for research interest, and by academics and consultancies for individual agencies and government departments. While the number of studies is surprisingly large, it is not large enough to provide a statistical base for benefits transfer. Combined with the fact that the science of economic valuation has evolved and still is evolving, uncertainty is endemic in the estimates. This uncertainty presents government with several problems. First, if policy were directly related to benefit estimates, then it is conceivable that the policy could be subject to legal challenge. This prospect is discounted by some experts because policy is, ultimately, whatever politicians decide it is. Only judicial review relating to unreasonable behaviour could challenge it. None the less, there is some explanation here for the distancing of policy from CBA results.’

‘… there is outright hostility within some parts of government to some aspects of CBA, whatever the official guidance. Some of the traditional arguments against monetization are often emotive and irrational, but some coherence is afforded to these views from the belief that environmental assets are somehow “different” and should not be subject to trade-offs.’

‘… it is often argued that CBA is not “transparent”. Highly varied and different costs and benefits are “reduced” to single numbers, giving the impression of a “black box” approach to policy.’

‘… CBA “crowds out” flexibility’ by presenting a clear cut result subject to the uncertainty of the estimates. ‘At its worst this view says that politicians will do whatever they want, and that they do not want to be troubled by cost—benefit studies that might produce the opposite answer.’

‘… CBA works best when the goal of policy is economic efficiency.’ Other goals such as distributional issues, employment creation, protection of competitive position, and the desirability of the process of decision-making, tend to be omitted from CBA studies.’

‘… the science of benefit estimation changes very rapidly. … Understandable ignorance of the literature does account for some continuing hostility to monetization.’

‘… CBA is practised with varying degrees of sophistication. If it is poorly executed, critics will use poor practice as a basis for criticising the technique per se. The risk of poor practice are highest in benefits transfer since the temptation of use existing studies to provide estimates for “new” sites is a strong one: it saves the cost of an original study and is highly suited to approaches based on guidelines and manuals of practice.’

Source: Pearce (1998) pp. 92, 94, 95.


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The issues raised by Pearce (1998) in 1.2.1 are still important. There are still many

environmentalists and politicians who are uncomfortable, if not openly hostile, to the

methods employed by economists to undertake environmental valuation. Some of

the criticisms are based on sound observations about limitations that exist with the

methods currently employed. Even for those who accept environmental valuation and

stated preference techniques, there are technical issues. These relate to eliciting

individuals' true values using survey-based methods as there are many biases that

can influence responses.

However, some of the criticisms stem from a rejection of the use of economic value

as a means with which to inform and undertake resource management. Critics

question the ethics of placing monetary values on the environment for what they see

as a purely selfish, human-centered motivation (the neoclassical economics rationale

which assumes that individuals are self-interested in their motives and that social

decisions should reflect what individuals want). The controversy could be lessened by

understanding that it is not the environment itself that is being valued, but individual

preferences for environmental goods and services, these being a measure of the

well-being (or utility) that those affected attach to these goods or services. These

preferences can be motivated by any number of factors, including altruism and

concern for the rights of non-human species. Individuals may include in their non-

market valuation an element of intrinsic value, as they perceive an obligation on

society to protect the environment for its own sake and to conserve it for the future.

Valuation is also said by some to ‘debase’ the environment by setting it on a par with

goods such as a cup of coffee or a piece of furniture. However, environmental

conservation is not without cost and any cost is a forgone benefit, as the resources

making up that cost could have been put to alternate use. Opportunity costs include

opportunities (and even rights) to generate a livelihood, or to obtain clean water and

health care. Thus it can be argued that far from ‘debasing’ the environment the

correct ethical framing is one of trade-offs, whether expressed in terms of monetary

values or competing ethical priorities.

‘Only if the environment has some higher order moral status than, say, helping the poor or the elderly, can there be a moral justification for ignoring cost’.

Source: Pearce (1998) p. 97.

Arguably, use of non-market valuation and CBA gives weight to the interests of

groups in society who may otherwise be excluded from decision-making processes;

since not everyone has a well-organised lobby or access to legal and technical

advisors.

These issues will continue to remain controversial. We shall explore them further in

this introductory unit and will return to them later. What is important to understand

is that the economics profession, and environmental economists in particular, view

environmental valuation as an ever-evolving activity. Indeed, much of the literature

is concerned with improving the methods employed such that the criticisms made

about environmental valuation can be overcome. There is, therefore, a growing

understanding of how to design, conduct and evaluate data collected so that the

criticisms of the inaccuracy of environmental valuation are not endlessly repeated,


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and many of the changes in implementing environmental valuation have stemmed

from mistakes that have been made in the past.

Furthermore, economists have been prepared to listen and learn from other

academic disciplines, especially psychology, marketing and sociology, about how to

conduct, engage and frame issues that are the subject of environmental valuation.

This means that the current state of environmental valuation has strong

methodological and philosophical links with these other disciplines, and it is highly

likely that these links will only get stronger in future.

Finally, despite the many advances made by economists in relation to environmental

valuation, its approaches are unlikely ever to be perfected. We believe this means

that environmental valuation remains an active and very exciting part of the study of

applied environmental economics. The challenges that confront environmental

economists who undertake environmental valuation, only act to provide an incentive

to improve the way in which environmental valuation is conducted, evaluated and

implemented.


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Section 1 Self Assessment Questions

uestion 1

True or false?

The demand for environmental valuation research is still increasing.

uestion 2

Briefly explain why environmental valuation studies are often controversial.

uestion 3

True or false?

Economists have worked in isolation in developing environmental valuation methods

and techniques.

uestion 4

How can the criticism that CBA and environmental valuation are ‘non-transparent,

black-box’ approaches be addressed?

Q

Q

Q

Q


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2.0 THE ECONOMY–ENVIRONMENT RELATIONSHIP

Section Overview

In this section we begin by outlining the field of economics, environmental economics

and the role of this module within environmental economics. Specifically we develop

a conceptual model of the relationship between the economy and the environment

that places in context many of the activities undertaken by environmental

economists, in particular, environmental policy design and implementation. The

model we develop draws attention to some of the key relationships between the

economy and the environment and the varying importance attached to these

relationships by the environmental economics profession.



• understand the complexity of the interaction of economy and environment

• understand the extent to which economic activity can use the environment

before resource sustainability becomes an issue.

2.1 Defining economics and the environment

Our starting point is to place this module within the field of environmental

economics. To do this, we need first to have an idea of what we mean by economics

and the environment.

A dictionary definition of economics would be something like ‘the science of the

management of the material resources of an individual, community or country’.

Thus, economics is about the allocation of scarce resources amongst competing uses.

What about ‘environment’? A broad definition of the environment might be the

surroundings: the conditions influencing development or growth. Thus, you might

include any number of things that are around you as being part of our environment.

For example, the environment can be defined to include all flora and fauna, aquatic

ecosystems, energy and material resources, and the atmosphere (Hanley et al, 2007).

There are many examples of the way in which the economy and the environment

interact and are interdependent, for example, agriculture and the environment.

Society has become very aware of the environmental impact of agriculture over the

last few decades because of increased understanding of the negative consequences

of certain agricultural practices. At the same time it has become apparent that many

of these practices have resulted from the policies introduced to encourage farmers to

produce agricultural output. Examples of the negative consequences of agriculture

include: water pollution (both surface and groundwater), soil erosion and soil

compaction, the loss of wetlands because of drainage, air pollution, acidification of

soil as a result of livestock activity, and the loss of biodiversity because of land

clearance for more agriculture as well as the adoption of new technologies. These

outcomes have resulted because many commodity-specific price and income support


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programs, such as those in the EU, North America and Australia, did not require

farmers to take account of the environmental consequences of their actions.

2.2 Links between the economy and the environment

Let us begin by considering in general the ways in which the economy and the

environment are interlinked. Then we will look at how environmental economics has

developed and the scope of the subject. We employ the typical characterisation

found in many textbooks and assume the economy can be divided into two sectors:

production and consumption. These sectors use the environment in three main ways:

• as a supplier of natural resource inputs

• as a supplier of environmental and amenity goods

• in its capacity as a waste sink.

Using the environment in one of these ways may affect the other uses, as will

become clear in the following discussion.

Supplier of natural resource inputs

Land, water and stocks of raw materials are important inputs to production. These

resources frequently vary between countries and so will affect the country’s

economy. Some countries will have large stocks of minerals, while others have good

arable land.

Natural resources are either renewable (eg trees) or non-renewable (eg crude oil).

This distinction is important as it influences the way the resources have to be

managed in production.

These resources are used by the production sector to create goods and services for

use by consumers, or as inputs for another part of the production sector, but in the

process waste products will also be produced.

Can you think of an example from your country where a natural

resource is used in a production process, resulting in both a product for use by consumers and a waste product?

Answer

An example could be coal, which is used to generate electricity. As the coal is burned, it produces electricity, but at the same time, carbon dioxide and sulphur dioxide are also produced and these may have detrimental effects on the environment.

Supplier of environmental and amenity goods

Economic benefits (ie increased utility) may be directly derived from the consumption

of the flow of services that are forthcoming from a stock of environmental goods.

There are many examples of where the environment provides amenity benefits for

society. For example, some countries enjoy beautiful landscapes and the public

benefit from these via their associated recreational services and tourism.

Environmental stocks of trees can offer global services such as climatic regulation


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because the trees absorb carbon dioxide, which might otherwise contribute to climate

change.

Many people get enjoyment from the biodiversity that exists in the world, and this

can also be considered as a form of public consumption of environmental good.

Waste sink capacity

This is the capacity of the environment to assimilate the waste products of

production and consumption and convert them into harmless or ecologically useful

products. This use of the environment is the one we are most concerned with in this

module, as we look at the introduction of policies which affect how and at what level

the environment is used as a waste sink.

The environment is not only affected by waste products, but also by intentional

release of chemicals, such as pesticides, wood preservatives, paints and lubricants.

Let us put some figures on to these wastes and intentional releases.

The impact of human activity on the composition of chemicals in the atmosphere is

clear. Since 1750, the pre-industrial period, carbon dioxide concentrations have

changed from 280 parts per million to 380 parts per million in 2000. There have also

been significant increases in other gases such as methane and nitrous oxide. There

are serious concerns being expressed about these increasing concentrations in the

atmosphere and climate change.

We are thinking here about the physical assimilative capacity of the environment.

This is the physical capacity of the land, water and the atmosphere to absorb wastes

and is determined by physical factors such as the climate, rainfall, wind patterns and

geographical location.

When thinking about waste we need to distinguish between degradable and

cumulative pollutants. With cumulative pollutants we need to understand if there are

any important thresholds that need to be avoided. The figure in 2.2.1 illustrates the

importance of assimilative capacity for threshold and non-threshold cumulative

pollutants.

2.2.1 Pollution damage functions

Source: adapted from Hanley et al (2007) p. 4.

Threshold Pollution

Damages

(physical units) A

B C


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In the figure in 2.2.1 we have drawn three damage functions. Function A shows a

simple linear damage function, function B an exponential damage function, and

function C a damage function with a threshold. The important issue captured by

function C is that there is point beyond which a pollutant has a significantly increased

impact on the environment. An example is the level of oxygen in water which if it

falls below a particular level becomes extremely dangerous for fish.

It is common practice to describe the assimilative waste capacity of the environment

mathematically.

Stock of degradable pollutant )( atS at time is given by

Stock of cumulative pollutant ( ctS ) at time is given by

∑=

=*

i

*

tt

tt

ct FS

where is the positive flow in a year

is the amount assimilated in a year

is the starting date for emissions

Environmental management can require that we take actions to prevent further

pollution because we think that any important threshold might be breached. The

term used to describe this type of environmental management is the precautionary

principle.

The precautionary principle states that action on preventing or restricting

environmental damage should not be delayed just because there are uncertainties

about how the damage is caused or the level of damage (Hanley et al, 2007).

2.3 The first two laws of thermodynamics

The natural laws which govern the environment and which are, therefore, of interest

to us, are the first two laws of thermodynamics. These relate to closed systems.

Strictly speaking, the earth is not a closed system as it receives energy from the sun,

but it is almost a closed system.

First law of thermodynamics

The first law states that whenever energy is converted in form, its total quantity

remains unchanged. In other words, energy (or matter) can be neither created nor

destroyed.

Common and Stagl (2005) use the example of a coal-fired electricity generating

plant. The coal is heated, which produces electricity. A by-product of this process is

waste heat that is transported away as cooling water or gases. In addition, various

waste gases are emitted into the atmosphere, which cause pollution, such as acid

rain.

ttat AFS −=


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Second law of thermodynamics

This law states that in a closed system, entropy does not decrease.

Entropy could be described as a measure of the degree of disorder of energy. For

instance, ordered energy is useful and an example of this is the energy stored in a

battery. However, disordered energy is not useful, and an example is the energy

dispersed into the environment by a fire.

Entropy is a thermodynamic property of matter and is related to the amount of

energy that can be transferred from one system to another in the form of work. For a

given system with a fixed amount of energy, the value of the entropy ranges from

zero to a maximum. If the entropy is at its maximum, then the amount of work that

can be transferred is equal to zero, and if the entropy is at zero, then the amount of

work that can be transferred is equal to the energy of the system.

During an irreversible process the entropy of a system always increases.

The key points to remember from the above are that, because of these natural laws:

• increased extraction of minerals by the production process leads to an increase

in wastes

• there is a limit on the substitutability of inputs

• since production and consumption lead to the dissipation of matter, scarce

energy is needed for recycling.

The importance of these two laws relates to the use, re-use and recycling of the

environment after interactions with the economy.

Let us look more closely at the subject of recycling, as this would seem to offer a

chance for the economy to retain the use of scarce resources.

Recycling

There is a hierarchy of resource use that includes recycling. This is referred to as the

three Rs – reduce, re-use, and recycle. The final and least appealing option after

resource use is to dispose of any remaining waste.

There are now many materials which are routinely recycled and re-used. For

example, glass bottles have been collected and re-used by a number of drinks

companies for many years. In various countries this practice is encouraged by the

use of deposit-refund schemes. Other examples include paper, metal, glass, plastic,

textiles, and garden waste.

For instance, in the Netherlands, household waste that can be composted is collected

separately from other household waste and is composted by the local authorities. To

encourage citizens to participate in this scheme, householders received some free

compost soon after the scheme was set up. However, there are clearly costs involved

in such a scheme:

• separate waste bins were provided for the compostable waste

• information was provided to householders

• householders spend time separating their waste

• costs of separate collection and of dealing with the compost.


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In the Netherlands, chemical household waste is also collected separately, with

similar costs involved. There are numerous examples of different economic

instruments used to deal with waste at both household and industry levels.

There are clearly limits to what resources can be re-used and recycled. These limits

are not only dictated by the laws of thermodynamics, but also the costs associated

with re-using and recycling many items.


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uestion 5

According to Hanley et al (2007), what are the main components of the

environment?

uestion 6

What are the three ways in which society uses the environment?

uestion 7

True or false?

(a) According to the first law of thermodynamics energy can be destroyed.

(b) The three Rs of resource use are reduce, re-use, and recycle.

Q

Q

Q


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3.0 PLACING AN ECONOMIC VALUE ON ENVIRONMENTAL

GOODS AND SERVICES

Section Overview

In this section we explain that the need to value the environment can be motivated

by efforts to achieve sustainable development. We also examine why environmental

valuation can be a multifaceted activity.



• understand the relationship between environmental valuation and sustainable

development

• appreciate that economists (as well as other environmental scientists) have a

range of approaches and attitudes towards environmental valuation.

3.1 Why value the environment?

As a result of increased demands for the sustainable development and improved

management of environmental resources, and because environmental issues now

take ever greater prominence in decision-making, economics provides an array of

techniques and methods for putting economic values on the environment. To help

understand these methods we can consider the in relation to sustainable

development broadly defined. So how does valuing the environment relate to

sustainable development?

To answer this question we first introduce five basic concepts of sustainable

development:

• Efficiency: ensuring the efficient use of resources (including environmental

and natural resources) and the integration of environmental values into

decision-making, policy design and implementation.

• Social equity: a commitment to meeting at least the basic needs of the poor

of the present generation (as well as equity between generations).

• Environmental integrity: a commitment to protecting environmental

resources and amenities and to living within the limits created by the carrying

capacities of the biosphere.

• Quality of life: a recognition that human well-being is constituted by more

than just material wealth and economic growth.

• Participation: the recognition that sustainable development requires the

political involvement of all groups or stakeholders in society.


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How the five concepts are interpreted yields different interpretations of sustainability.

The most common distinction is between ‘weak’ and ‘strong’ sustainability.

Weak sustainability is typically understood as the requirement to keep the sum of

capital (that is, natural plus man-made capital) intact over time.

Strong sustainability is interpreted as the requirement to keep each individual type of

capital stock intact over time. Thus, there is no ability to simply substitute human

capital for natural capital which is allowed under weak sustainability.

What this difference in interpretation implies for each of the concepts is outlined in

the table in 3.1.1, below.


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3.1.1 Weak and strong sustainability

Weak sustainability Strong sustainability Efficiency. This is the most highly stressed concept in neoclassical economics. In very weak definitions it involves selecting projects that maximise net benefits with no requirement that those who are detrimentally affected by the project receive compensation.

Efficiency. Economic efficiency and growth are not regarded as the primary determinants of human welfare. Pursuit of economic efficiency may be constrained by other key objectives such as maintaining ecological integrity and improving social equity. Greater emphasis on providing compensation to those detrimentally affected by a project or policy.

Equity. Inter-generational equity is assured by passing on to future generations a stock of capital of equal value in monetary terms. This capital stock includes both man-made and natural capital. Intra-generational equity may be less emphasised, particularly if it represents a challenge to current global consumption patterns and international relations.

Equity. Inter-generational equity requires that we maintain the level of natural capital across generations. Intra-generational equity may require explicit incorporation of distributional issues into environmental policies and projects.

Ecological integrity. Puts less emphasis on environmental limits or constraints by adopting an optimistic view of the role of technology in alleviating resource scarcity and the scope for substitution between different types of capital, including human-made and natural capital.

Ecological integrity. Greater emphasis on maintaining critical natural capital stocks. Adherence to real physical ecological limits that may constrain or modify economic growth. Belief that there are limits to the extent to which natural capital can be replaced or substituted by human-made capital. Less optimistic about the role of technology in alleviating resource scarcity.

Quality of life. Economic growth is seen as the main route to achieve improved quality of life. Less weak versions of sustainability would support gross national product (GNP) adjustments to take account of undervalued environmental resources.

Quality of life. Rejects the notion that economic growth can be taken as a proxy for quality of life. Includes a wide range of socioeconomic, environmental and political factors.

Participation. The market provides the main voice for public wants, but for public and environmental resources that are not marketed, there may be a top-down process of consultation with identified stakeholders.

Participation. Adopts a bottom-up interpretation of participation, in which objective setting as well as project implementation is open to participative processes.

Source: previous module


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The tools and methods that are of use when putting sustainability into practice are

summarised in the table in 3.1.2, below. Sustainable development involves not only

economic efficiency (as is often assumed) but also a number of other aspects; for

example, social equity, ecological integrity, and the participation and quality of life.

The various academic disciplines concerned with sustainable development have

developed their own sets of tools for putting sustainable development into practice.

Some of these tools are illustrated in 3.1.2, and this module will focus on the tools

developed by economists – economic efficiency-based concepts of environmental

valuation and cost–benefit analysis. Although we will not examine many of these

methods and tools in this module, the table gives you an idea of how the economic

tools of environmental valuation and cost–benefit analysis (and cost-effectiveness

analysis) form part of the whole range of techniques applicable to sustainable

development.

3.1.2 Methodological tool kit: towards sustainable development

I Economic efficiency

II Social equity

III Ecological integrity

IV Participation and quality of life

– environmental valuation methods

– cost–benefit analysis

– distributional weights

– discounting adjustments

– social impact assessment

– environmental impact assessment

– cost-effectiveness analysis

– sustainability constraints

– environmental shadow projects

– risk/uncertainty adjustments

– stakeholder analysis – participatory

appraisal methods – citizenship juries – multi-criteria analysis


Economic efficiency is the cornerstone of neoclassical economics and is concerned

with the allocation of scarce resources in society between competing uses. The

principle of economic efficiency underlies the methods of cost–benefit analysis (CBA)

and environmental valuation methods.

Once we have estimated our environmental values these are then typically

incorporated into CBA – a key economic decision-making tool employed by

economists. The underlying rationale for this approach is the premise that

environmental concerns have not been adequately addressed in the past because

they have been ignored in CBA and, consequently, not taken into account when

decisions were made and development planning formulated that would result in

sustainable outcomes. Essentially, placing economic (monetary) values on

environmental goods and services which are not traded in markets, as we will

explain, is far from a perfect science. However, valuation exercises which are

transparent and provide information for policy-makers and the public are frequently

a valuable approach to resource and environmental management.


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This approach and its underlying philosophy to environmental decision-making has

become accepted and adopted by a whole host of institutions and organisations.

National governments have instituted environmental procedures and guidelines for

public sector projects that emphasise the need for environmental valuation and cost–

benefit analysis. For both the Environment Agency in the UK, and the Environmental

Protection Agency in the USA, environmental cost–benefit analysis plays a central

role in designing rules and regulations for industry.

For developing countries, environmental valuation is becoming an increasingly

important aspect of decision-making. Multilateral agencies such as the World Bank

have initiated environmental valuation procedures and guidelines as an integral part

of the planning process.

3.2 Developing a pluralistic approach to environmental

valuation and decision-making

Whilst the economics approach to sustainable development and environmental

decision-making represents the mainstream view, and is the one central to this

module, it is not without controversy.

Why?

There is a very obvious but important dilemma that confronts any form of

environmental valuation. Economists typically rely on individuals revealing their

preferences for goods and services as a result of market transactions. However, the

vast majority of environmental goods and services are not traded in markets: they

are not bought or sold. Thus, non-market valuation is an attempt to correct for a

form of market failure. Environmental valuation as practised by economists is an

attempt to place monetary value on these goods and services so that efficient

resource allocation decisions can be made.

Defining market failure

Neoclassical economics is concerned with markets for goods allocating scarce

resources to alternative uses, and prices being established which reflect the scarcity

of, and levels of demand for, goods.

Think for a moment about our daily lives and what affects them. We live in a

particular environment, breathing the air. However, we do not pay a price for the air,

as there is no market in air. As a result, we cannot reflect our preference for

breathing clean rather than dirty air through the market. This is an example of

market failure.

Market failure occurs when the conditions for perfect competition are not met. If the

market fails, then government intervention designed to correct the market failure

may bring benefits to society. However, government intervention may fail to secure

these benefits, even making matters worse and resulting in market failure. This is

known as government failure.

We know that the market mechanism will lead to the socially optimal outcome only

under very specific conditions. However, it is highly unlikely that these conditions will

be fully satisfied. The existence of perfect competition in reality as it is defined in

textbooks is itself highly unlikely. For example, we require that prices will result from


© SOAS CeDEP 24

the realisation of all possible markets working and existing. This is only likely to

occur when a complete and effective system of property rights exist, including

property rights to environmental goods such as clean air.

When either condition is not satisfied, markets fail, and this can, deliberately or

unintentionally, bring about undesirable consequences.

Let us work through the argument for a negative externality. In this case, the

marginal private cost (MPC) is less than the marginal social cost (MSC). The marginal

private cost represents the short-run market supply curve. Hence, with a negative

externality, the short-run market supply curve is lower than would be society’s short-

run supply curve. The difference between the MSC and MPC are the marginal

damages (MD). MDs are the amount of the negative externality which, as the

quantity of output increases, increase as well. These are damages being inflicted on

society as a result of the private producer not taking account of the costs that result

from production, such as air or water pollution. This situation is illustrated in 3.2.1.

3.2.1 Effect of a negative externality


A shows the equilibrium position with a negative externality. Price is and quantity

supplied is . shows the point of allocative efficiency or Pareto optimum, where

price is and quantity supplied is . Hence, with a negative externality, too much

of the externality-producing good is supplied at too low a price (relative to the Pareto

optimum). This is an example of market failure. It results from the absence of

property rights and a market for the MDs produced by this activity.

Issues with non-market valuation

As we will see, there are many criticisms associated with the use of the various non-

market valuation methods. How can we value the ozone layer? Many would also

observe that many environmental goods and services have value in their own right.

As a result, environmental valuation as practised by economists is not without its

critics and it still remains a controversial activity.

However, the economics profession has developed a wide array of techniques to

measure environmental value. Methods have been developed to measure the use

MSC = MPC + MD

Quantity

P*

Q*

P

Q

A

B

demand

MPC = supply

PriceMSC = MPC + MD

Quantity

P*

Q*

P

Q

A

B

demand

MPC = supply

Price


© SOAS CeDEP 25

value associated with the direct use of a resource such as walking or bird watching

in forests. There are also a set of methods that allow non-use values to be

estimated. Non-use values would be if somebody values the continued existence of

the birds in the forest without actually ever visiting the forest. To estimate these

values economists frequently employ a wide range of survey methods that ask the

public what they might be willing to pay for a benefit (seeing the birds), or what they

would accept in compensation for its loss (cutting down of the forest). The use of

these methods has entered mainstream environmental and resource management.

This can partly be traced to the NOAA Panel (Arrow et al, 1993), which published a

highly influential report on the use of contingent valuation for non-market valuation.

The NOAA Panel report came about as a result of the 1989 Exxon Valdez oil spill in

Alaska’s Prince William Sound. In the resulting legal case that followed the oil spill

extensive use was made of Contingent Valuation in an effort to determine the

magnitude of the various fines to be paid for the spill. As a result of the huge time

and effort expended on the various Contingent Valuation exercises the NOAA Panel

provided important guidance on how to implement Contingent Valuation in practice

so as to minimise many of the problems and issues associated with these methods.

3.3 Environmental valuation and neoclassical economics

The main philosophical approach to environmental valuation and decision-making

used in this module is that of neoclassical economics, as this provides the principal

methods used at the present time. However, while working through the module, you

should keep in mind that economic methods (such as environmental valuation and

cost–benefit analysis) need to be placed within a broader framework that

encompasses a wider range of decision-making tools, including environmental and

social impact assessment, sustainability constraints, and participatory environmental

appraisal. Within the economics discipline, some of these broader aspects of

decision-making have been adopted by economists who describe themselves as

being ecological economists.

What are the main differences between neoclassical and ecological economics?

(1) Environmental and economic linkages

The neoclassical approach treats the environment as a commodity which can be

broken down into different components and analysed, just like any other commodity.

For example, the economic value of a wetland ecosystem can be broken down to

show the value of different wetland products, such as wild plants, fish, and building

materials derived from wood, palm leaves, grasses, and soils. There are also

important ecological functions of the wetland, such as water filtration and climatic

regulation, which may have impacts on the agricultural or other economic sectors.

These indirect economic impacts will also be factored into the economic valuation

estimate.

This is essentially a mechanistic conception of the environment, in which the overall

value of nature is broken down into its constituent parts and reconstructed, rather

like a machine. It assumes that the environmental system can be reduced to its parts

and that the essentially deterministic relationships between the different elements

are governed by predictable laws.

Ecological economists argue that environment−economic linkages are not


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characterised by short-term deterministic relationships, but are governed by

synergy, irreversibility and ecological thresholds. They view economic, social and

ecological systems as having a dynamic and interconnected relationship that evolves

over time. This approach rejects universal policy prescriptions that flow directly from

the neoclassical model, arguing for a more pluralistic approach in which

environmental policy decisions are tailored to the specific circumstances in each

case, and in which ecological thresholds or sustainability constraints are applied to

economic decision-making.

(2) Human behaviour and the environment

The neoclassical approach emphasises the instrumental use of environmental

resources for human preference satisfaction. The central assumption of free will and

consumer sovereignty elevates the role of humankind to environmental managers. In

ecological economics the human species is seen more as an environmental steward

rather than merely a consumer of environmental goods and services. Some would

take a stronger stance, rejecting the underlying utilitarian ethic of neoclassical

economics by arguing for the extension of ‘rights of existence’ to other species,

independently of the interests of humankind. Institutional economists also argue that

environmental behaviour and preferences are largely determined by the economic

system and societal norms, hence suggesting a greater role for environmental

education.

(3) Future generations

The utilitarian ethic of neoclassical economics is concerned with maximising net

human welfare across generations. If the interests of future generations are not

explicitly protected, this approach allows the welfare of one generation to be traded

off against that of another generation. The aim of protecting the interests of future

generations has now become a central component of the widespread commitment to

sustainable development. However, the meaning of protecting the interests of future

generations is subject to multiple interpretations, and differs in neoclassical and

ecological approaches to the environment. For example, followers of the ‘weak

sustainability’ school might allow economic development that degrades the

environment so long as the overall stock of wealth (which includes both man-made

and natural capital) does not decline in value terms over time. Ecological economists

remain sceptical of this interpretation of inter-generational justice, arguing that there

is a need to conserve a ‘critical stock of natural capital’ to pass on to future

generations. This approach to sustainability may be described as a ‘strong

sustainability’ approach.

(4) Social choice and decision-making tools

Neoclassical economics is a market-orientated approach, which means that resource

allocations in society are largely governed by the forces of demand and supply.

Society expresses its choices and preferences through the types of products and

services that are demanded, and producers respond by utilising the resources of

society (such as land, labour, machinery and equipment, and environmental

resources) to supply products and services that satisfy consumer demands.

Neoclassical economists label institutional factors that pervert ideal market outcomes

as ‘market and government policy failures’, requiring corrective government

intervention. This requires a range of tools and policies that enables the market to

work more efficiently. For example, when the economic values of environmental


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resources are not revealed in actual market prices, surrogate market prices can be

imputed using environmental valuation techniques. These values can then be used to

guide rates of environmental taxation (such as carbon taxes on fossil fuels), or can

be used to guide project decisions through their integration into cost–benefit

analysis. This approach has been effectively used in order to advance environmental

ends, and has been supported by many environmental NGOs. However, there are

many loud objections to this approach on the grounds that normative issues of wide

public significance should be open to broader public debate and negotiation. This

involves developing the institutions of social choice beyond the marketplace to allow

greater public participation in environmental and economic decision-making.

Ecological economics also embraces a more pluralistic approach to decision-making,

drawing on an array of tools and methodological approaches from a range of

disciplines. As the issues are multidimensional, so must be the policy framework,

allowing case-specific, tailor-made approaches to decision-making.

The differences in opinion/philosophy between neoclassical economists and ecological

economists are also related to differences between economics and environmental

science more generally. This can be explained by how economists and ecologists

interpret the following concepts, and how this affects their perspective on valuing the

environment.

Scale, scarcity, technology and resource substitution

Although natural resource limits have not caused the crises predicted by the ‘Limits

to Growth’ adherents in the 1970s, the issue of physical constraints plays a central

role in ecology, whereas economists are more preoccupied with the concept of

relative scarcity. The scale argument has now been refined to stress the real scale

constraints on economic activity posed by energy sources and ‘critical natural stocks’

essential for life support.

Neoclassical economics is more concerned with marginal changes than large

structural shifts. For this reason they are often criticised by ecologists who are more

aware of the potentially catastrophic changes associated with small marginal changes

around ecological thresholds. In the market system, relative scarcity is expressed

through the price mechanism. In an efficient market, increasing resource scarcity will

give rise to increasing prices, technological innovations are induced by relative price

changes and substitute materials are found or developed. Technological dynamism

explains why the pessimistic predictions of the classical economists (and ecologists)

have not come true, but technological optimism may not be sufficient to enable us to

overcome the threats posed by depleting critical natural resource stocks.

Environmental valuation is seen as the best way to reflect natural resource scarcity

by the neoclassical economist. Putting a price on natural resources and

environmental resources, and thus integrating them into the market economy, is

more sustainable than letting natural resources remain free, and thus over-exploited,

resources. Ecologists are less supportive of this approach, preferring more traditional

conservation measures and environmental standards as environmental management

tools.


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Irreversibility and resource divisibility

The key difference between economists and ecologists is not about whether

irreversible change occurs, but whether it matters or not. For the economist, it is

okay to ‘kill the goose that lays the golden eggs’ so long as the benefits exceed the

costs. This is why economists may ask whether it is optimal to make a species

extinct; whereas to an ecologist such a question would not make sense within the

context of an integrated ecosystem. For an economist, natural resources are

divisible, whereas ecologists are more interested in the relationships and connections

between different elements of the ecosystem. The assumption of divisibility is crucial

for environmental valuation methods which break down the different aspects of an

ecosystem into its component parts. Various environmental valuation methods can

then be used to assign monetary values to different aspects of the ecosystem.

Discounting the future

Neoclassical economists apply discount rates to future costs and benefits. Discounted

costs and benefits can then be presented in present value terms. The practice of

discounting future costs and benefits has important implications for inter-

generational equity. Many people have called for adjustments to the discount rate –

either for it to be lowered, adjusted to zero, or in some cases to be made negative.

Others call for the explicit incorporation of sustainability constraints (or safe

minimum standards) into economic appraisal as a means to protect the interests of

future generations.

Intrinsic values

Environmental valuation methods are based on the neoclassical assumption that

people will be willing to pay for environmental benefits (or accept compensation for

environmental losses). The extent of their willingness to pay will be based on their

preferences. This ignores environmental values which are not based on preferences,

such as intrinsic values independent of human preference. Ecological economists

tend to stress the importance and pervasive nature of intrinsic values and other

environmental concerns that are not motivated by utilitarian values.

Safe minimum standards

Safe minimum standards (SMS) add a more precautionary dimension to project

appraisal and are recommended by many ecological economists, particularly when

there are issues of risk, uncertainty and irreversibility. SMS can be thought of as a

particular type of sustainability constraint, based on a more risk averse approach to

environmental management.


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uestion 8

What is meant by ‘market failure’?

uestion 9

What happens to the level of output produced when there is a discrepancy between

private and social costs?

Q

Q


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UNIT SUMMARY

In this unit, we began by introducing and placing environmental valuation within its

current policy context. That is, we explained that there is an increasing demand for

environmental valuation as an important component of policy analysis and

implementation. We then briefly examined some of the main issues surrounding

environmental valuation and why environmental valuation remains a controversial

topic.

We then looked at the links between the environment and the economy. We defined

the environment as including the atmosphere, all flora and fauna, and energy and

material resources, and stated its main uses for the economy as:

• a supplier of resource inputs

• a supplier of public consumption of environmental or amenity goods

• a waste sink.

We looked at the difference between degradable and cumulative pollution and noted

that, in mathematical terms, stock of degradable pollutant at time is given by

ttat AFS −=

stock of cumulative pollutant at time is given by

where is the positive flow in a year

is the amount assimilated in a year

is the starting date for emissions

The natural laws (that is, the first two laws of thermodynamics) which the

environment obeys mean that increased extraction of minerals leads to an increase

in wastes; there is a limit on the substitutability of inputs; and, since production and

consumption lead to the dissipation of matter, scarce energy is needed for recycling.

Recycling was examined in more depth, leading to the following conclusions:

• not everything can be recycled

• recycling uses scarce resources, so may not be either economically or

environmentally desirable.

The unit then considered the scope of environmental economics. It examines the

links between economics, ecology and the environment and places environmental

valuation within a pluralistic and multidisciplinary approach to incorporating

sustainability issues into decisions that affect the environment.

∑=

=*tt

tt

ct

i

* FS


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Next, the unit considered why neoclassical and ecological economics have different

perspectives on: the relationship between the economy and the environment; the

relationship between humankind and nature; the rights of future generations; and

the role of the market in environmental resource allocations. These different

perspectives have important implications for the role of environmental valuation in

environmental management at the project level.

Neoclassical and institutional economics give different perspectives, with neoclassical

economics emphasising the market failure approach to the environment while

institutional economics concentrates on the property rights approach. Individuals’

preferences are assumed exogenous (ie external to the model) by neoclassicists,

but endogenous (ie internal to the model) by institutionalists, and moral and social

norms are given more prominence by institutional economists.

Sustainable development can be defined in terms of five core principles: economic

efficiency; social equity; ecological integrity; quality of life; and public participation in

decision-making. These five principles have different interpretations and emphasis

according to ‘weak’ and ‘strong’ sustainability.

Environmental valuation and cost–benefit analysis focus on the efficiency aspects of

sustainable development and form part of the range of methodological approaches to

incorporating sustainable development into decision-making.

Environmental valuation uses money as a common measuring tool to weigh up

environmental costs and benefits.


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UNIT SELF ASSESSMENT QUESTIONS

uestion 1

From your reading of this section and using your imagination sketch a diagram that

captures the three functions that the environment provides when interacting with the

economy.

uestion 2

To what extent are the concepts of weak and strong sustainability associated with

the different schools of thought (neoclassical and ecological)?

uestion 3

Can you think of examples of environmental goods and services for which there are

no markets, or, if there is a market, the price does not reflect the full social value?

uestion 4

Draw a diagram to show the effect on prices and quantities, relative to the Pareto

optimum, of a positive externality.

Q

Q

Q

Q


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KEY TERMS AND CONCEPTS

endogenous variable A variable whose value is determined by one of the relationships

specified by the model under consideration.

entropy A measure of the degree of disorder.

existence value The willingness to pay to keep a good or service in existence

even when no direct use is ever intended.

exogenous variable A variable whose value is not determined by one of the

relationships specified by the model under consideration.

externality An unintended consequence, good or bad, from the actions of

another economic agent.

non-excludable An individual cannot be deprived of useful consumption of the

good even though he or she may refuse to pay for it.

non-rival Use or consumption is non-rival if that use means that the

quantity of that particular good available to others is not

diminished.

non-use value The willingness to pay to keep a good or service in existence

even when no actual, planned or possible use is intended.

option value The value associated with preserving the option to use a good or

service in the future.

Pareto optimality/criterion

A policy change that makes society better off and nobody worse

off is referred to as a Pareto improvement. The Pareto optimum

is achieved when we reach an allocation of resources such that

any change must make somebody worse off.

public goods A good which is non-rival and non-excludable.

use value A measure of value that stems from the actual use, planned use

or possible use of a good or service.

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P522 Environmental Valuation: Theory, Techniques and ... · economics of environmental valuation. ... Part I Introduction to Environmental Valuation and Theory Unit 1 The economy,