Part II. Environmental Valuation

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Part II. Environmental Valuation

1. Value
2. Environmental Decision Making

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B. Environmental Decision Making

• Chapter 5

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Intro

• Once you value the environmental good/service,
  can be used to test the economic efficiency of
  a potential decision or outcome.
• One aspect of this process is the measurement of
  both the value of environmental resources and the
  value of changes in the level of environmental
  quality.
• This is essential information when comparing the
  benefits of environmental policy against the
  costs of obtaining those benefits.

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Decision-Making Criteria

• Economic efficiency
• Equity
• Sustainability
• Environmental Justice
• Ecological impact/environmental stewardship
• Ethics

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Economic Efficiency

• Economic efficiency has to do with maximizing the
  difference between the social benefit and social
  cost of an economic activity, policy, or project.
• Economic efficiency is usually measured in one of
  two different ways
• Net economic benefit preferred by economists
  and explored in Chp. 4
• Gross domestic product preferred by
  international development and lending agencies.

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Economic Efficiency Net Economic Benefit

• As the information presented in Chapter 4
  indicated, the demand curve represents marginal
  WTP and the supply curve represents marginal
  opportunity cost of production.
• Net economic efficiency subtracts total
  opportunity cost from total WTP and is
  represented by the area under the demand curve
  and above the supply curve for a particular good
  or service.

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Economic Efficiency Gross Domestic Product?

• Gross Domestic Product is a measure of the total
  value of all goods and services produced in an
  economy.
• Because expenditures become income, GDP is also a
  measure of national income.
• GDP is not a measure of social welfare because it
  does not measure other dimensions of the quality
  of life, such as health, environmental quality,
  social justice, freedom from crime, etc.

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Economic Efficiency GDP?

• GDP also fails as a measure of economic
  efficiency.
• It does not consider the opportunity costs of
  producing the good or service.
• This failure means that GDP would rise because of
  a rise in HIV/AIDS due to the increased
  expenditure on health care costs.
• Net economic efficiency would not rise damages
  from disease, opportunity cost of using those
  monies in next best option.

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Economic Efficiency Pareto Criterion

• What constitutes an improvement in economic
  efficiency?
• One option is the Hicks-Kaldor criterion, or the
  criterion of potential Pareto improvement.
• Pareto improvement resources are reallocated in
  such a fashion that some people are better off
  and no one is worse off.
• Potential Pareto improvement is reallocation
  whereby the gain of people who are helped is
  larger than the losses of those made worse off.
  If the gainers could compensate losers, the
  gainers would still be better off.

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Equity

• Potential Pareto improvement does not consider
  equity issues.
• The equity criterion for evaluating policy
  considers how costs and benefits are distributed
  among members of society.
• These distributional impacts could be within a
  country, across international borders, or across
  generations.

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Equity Across Generations Sustainability

• Intergenerational equity is important because
  many of the decisions regarding resource use
  today may generate important environmental costs
  for future generations.
• The process of discounting future costs and
  benefits can exacerbate this problem.
• An alternate criterion of sustainability is based
  on improving the condition of the current
  generation without compromising the ability of
  future generations to meet their needs and
  improve their quality of life.

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Equity Indicators

• Income is one component of equity.
• Two different measures are the primary tools for
  considering the inequality of the distribution of
  income, the Lorenz curve and the Gini
  coefficient.
• The curve illustrates the of income received by
  a given of the population.
• Equity is illustrated by the diagonal line
  bisecting the origin. Along this line the two
  are equal.
• Inequity in income distribution is illustrated by
  a curved line.

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Equity Measures - Lorenz Curve
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Equity Measures Gini Coefficient

• The farther the Lorenz curve is skewed away from
  the diagonal line, the more inequitable the
  income distribution.
• This curve can be transformed into a single
  variable, the Gini coefficient.
• Calculated by taking the area between the
  diagonal line and the Lorenz curve and dividing
  by the entire area under the diagonal line
  100A/(AB) This value is then multiplied by 100.
• Can range from 0 to 100, where greater numbers
  are associated with greater inequity.

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Gini Coefficient
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Environmental Justice

• Studies have suggested that certain segments of
  the population face disproportionate exposure to
  environmental risk.
• In the US, minorities, especially those of low
  income living in rural areas, face greater
  exposure to carcinogenic and mutagenic hazardous
  chemicals.
• In developing countries, with giant cities,
  levels of air pollution as well as exposure to
  toxic waste surpass that of developed countries.
• Environmental justice is an issue in rural areas
  where high levels of pesticide use by large
  plantation owners impacts villages downwind.

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Ecological Criteria

• There is no consensus on how to develop measures
  for quality and functionability of an ecological
  system.
• The first question is how to define a desirable
  state of an ecosystem.
• Ecosystem health measures a systems ability to
  provide a flow of ecological services.
• Ecosystem integrity measures the closeness of
  the system to a hypothetical reference system
  that is completely undisturbed by human activity.

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Operational Indicators of Environmental Quality

• At least 4 methods have been suggested to develop
  operational indicators
• The use of representative environmental
  variables.
• The use of a green GDP.
• The development of satellite accounts for
  National Income and Product Accounts.
• The development of indices of sets of
  environmental variables.

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Representative environmental variables

• Sulfur dioxides Environmental Kuznets Curve
  (EKC) U-shaped relationship between
  environmental quality and income indicator of
  air quality
• Spotted owl indicator species for Pacific
  old-growth forests
• Abundance/biodiversity of mussels biodiversity
  indicator for rivers in Tenn. River Valley

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Green GDP

• Many economists have argued that disastrous
  consequences for the environment result when
  macroeconomic policy is based on growth of GDP.
• While net domestic product (NDP) subtracts the
  depreciation of human-made capital from GDP, it
  does not consider the depreciation of natural
  capital (forest clear cut, soil degraded, stocks
  of minerals depleted, etc.)
• If increasing NDP is the primary policy goal,
  then the loss of future income from depleted
  natural capital is important.

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Satellite accounts

• Physical measures of environmental variables
  maintained side by side with GDP accounting (not
  integrated like GGDP)
• Presented in flow and balance sheets just as GDP
  accounting
• Idea is that rough monetary estimates can be made
  from these accounts

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Indices

• US Environmental Protection Agencys EMAP
  (Environmental Monitoring and Assessment Program)
  develops overall indicators for individual
  ecosystems (forests, wetlands, estuaries)
• E.g., Estuaries 20 indicators water clarity,
  presence of trash, etc. Then aggregate index
  created by summing individual indicators

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Ethics

• Particularly important and particularly difficult
  to quantify.
• Does the firm or agency have an ethical
  obligation for environmental stewardship
  independent of the impact on social welfare?
• Should decision-making have an anthropocentric or
  biocentric approach?
• Deep ecology, developed by Arne Ness, rejects
  management of the environment. All components of
  an ecosystem, as well as the ecosystems
  themselves, have an intrinsic value and an
  inherent right to exist.
• Ethics can be treated as constraints to the
  decision-making process.

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What do you think?

• Should decisions be based solely on
  anthropocentric ideals?
• Do ecosystems have inherent rights?
• Is it okay to put a price on environmental
  goods/services?
• If not, how to reconcile for policy making?

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The Use of Multiple Criteria in Decision Making

• How do policy makers take multiple
  decision-making criteria and jointly employ the
  criteria so as to inform the actual decision?
• If too much aggregation is done across criteria,
  then a lot of the information that is contained
  in the different criteria will be lost.
• Cost-benefit analysis is one approach which has
  been frequently employed and is even legally
  required of governmental agencies in many
  countries.

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Cost-Benefit Analysis

• The most important concept is that cost-benefit
  analysis is NOT a decision-making tool it is
  only an information organizing tool
• There is no single correct answer to a
  cost-benefit analysis exercise
• Different assumptions about future states of the
  world or key analytical parameters will have a
  big impact on the final outcome
• The analysis should produce a suite of numbers
  reflecting the sensitivity of the analysis to
  alternative analytical assumptions

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Cost-Benefit Analysis

• Cost-benefit analysis should be a dynamic
  analysis, investigating costs and benefits far
  into the future, where future costs and benefits
  are discounted.
• The simplest version of a discounting formula is
  PV FV(1/(1r))t,
• where PV is present value, FV is future value, r
  represents the discount rate and t is the time
  period.

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Cost-Benefit Analysis

• The objective of cost-benefit analysis is to
  identify the alternative project, plan, or policy
  that has the greatest net present benefit, which
  will therefore maximize economic efficiency.

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Choice of the discount rate

• A critical aspect of the analysis is the choice
  of the appropriate discount rate
• The market rate of interest is not appropriate
  because it includes inflation rates and risk
  components
• Inflation should be removed from interest rate
  because CB calculations should be conducted in
  real (inflation-adjusted) terms (using CPI)

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Choice of the discount rate

• The risk component reflects a compensation for
  the variations in risk of default across
  different types of borrowers
• Because risks of public investment are shared by
  all citizens, and because society has a diverse
  portfolio of projects, many analysts argue that
  the rate used should be the real, risk-free rate
  of interest (btw. 3-4 historically)

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Choice of the discount rate

• The choice of discount rate is critically
  important because it represents the relative
  importance of the future.
• Even small differences in discount rate can
  become very important.
• This is illustrated in Table 5.3, where the
  present value of a future stream of income
  decreases by 90 percent with a 1 percent change
  in the discount rate.
• This difference in value is much less at greater
  distances in the future where the value in the
  distant future is unimportant.

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Choice of the discount rate
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Cost-Benefit Analysis

• The first step in implementing any cost-benefit
  analysis is to determine what should be
  evaluated.
• The analyst must identify the credible
  alternatives to the proposed project and include
  them in the cost-benefit analysis.
• In defining alternatives, the analyst must
  consider political feasibility, technical
  feasibility, and economic feasibility.

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Cost-Benefit Analysis

• The next step is to list the costs and benefits
  to make sure that all relevant issues are
  considered.
• Care must be taken to factor in environmental
  costs, both on-site and off-site.
• In some cases religious, cultural, and historical
  significance must be taken into account.
• Indirect costs must also be considered.

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Cost-Benefit Analysis

• In general, benefits are easier to measure than
  costs.
• It is important to recognize alternative
  solutions in the measurement of the benefit of
  one project.
• It is also important to recognize both private
  and social benefits associated with a project.
• It is important to recognize the difference
  between the creation of new benefits and the
  transfer of benefits from one area to another.

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Cost-Benefit Analysis Multiple Scenarios

• It is important to build different scenarios when
  conducting a cost-benefit analysis.
• These different scenarios need to consider
  differing assumptions or predictions about the
  future states of the world.
• Among these are
• Rates of population growth
• Rates of growth in GDP
• Level of global climate change
• Rate of technological innovation
• Change in environmental policy.

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Cost-Benefit Analysis Decision Rules

• Each scenario should also be evaluated using
  different discount values.
• Various decision rules can be made to allow
  qualitative comparison and determination of which
  projects are best.
• Examples of decision rules include
• Choose the project that is in the top ranking in
  the most states of the world.
• Choose the project that is in the top two
  categories in the most states of the world.

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Cost-Benefit Analysis Missing Values

• One of the major problems with cost-benefit
  analysis is how to deal with missing values.
• It is not appropriate to use a value of zero.
• If the missing value is associated with
  environmental costs, then it is possible to
  conduct an analysis without the costs and then
  consider how the answer might change with those
  costs factored in.
• Alternative approaches to comparing projects with
  missing information include
• The dominance method choose the option that is
  best across multiple scenarios
• Estimate how big the missing value would have to
  be to change the outcome.
• Provide general impressions of the unmeasured
  environmental benefits.

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Marginal Analysis

• Cost-benefit analysis is a good tool for choosing
  between a set of discrete alternatives.
• Marginal analysis is useful when a choice must be
  made about which level to choose from a
  potentially infinite spectrum.
• How many hectares of wetlands to preserve, how
  much deforestation to allow, how large a fish
  harvest should be, etc.

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Marginal Damage Functions

• As discussed in Chapter 3, marginal damage
  functions and marginal abatement functions can be
  used to identify the optimal level of pollution.
• A marginal damage function specifies a
  relationship between an incremental unit of
  emissions and the damages the emissions generate.
• As Figure 5.5. illustrates, this relationship is
  actually a complex series of cause-and-effect
  relationships.

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Marginal Damage Functions

• The first set examines how pollution emissions
  generate concentrations of pollution in the
  environment.
• The next set considers how exposure occurs.
• The next considers the impact of exposure.
• The next considers the damages which result and
  finally, the resulting change in social welfare.

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MDF Policy Analysis

• It quite unlikely that it will be possible to
  completely identify the set of marginal abatement
  cost functions and marginal damage functions for
  a particular problem.
• Even so, knowledge of the properties of a
  particular damage function can help identify
  policy goals.

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MDF Policy Analysis
Damages
Emissions
e1
e2
e3
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Marginal Damage Function and Policy Analysis

• Identify key points along function
• Between 0 and e1 damages not great
• As increase between e1 and e2, assimilative
  capacity of environment becomes overtaxed,
  damages begin to increase
• e3 on, damages may cause systemwide collapse

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Marginal Damage Function and Policy Analysis

• Use information from figure 5.5 to make estimates
  about these turning points
• For example, makes little sense to have target
  level of pollution less than e1 unless abatement
  very low
• Similarly, want to avoid very steep portion
  (after e3)
• Broad range from e1 to e3 can then use other
  criteria to narrow this range

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Summary

• Various research and analytical tools can help
  narrow the decision set and further guide the
  decision process.
• Cost-benefit analysis has proven to be a useful
  tool in organizing information about economic
  efficiency.
• The most important need in terms of making better
  decisions is the need to develop better
  indicators related to the nonefficiency related
  decision-making criteria.

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Expected Value Analysis(Appendix 5b)

• A way to compare alternatives where each
  alternative has several possible outcomes, each
  of which occurs with a different probability
• Example deciding which of 3 games going to play.
  Fee for playing each 1.00. First game flip coin
  heads 2, tails 0.
• EV 1.00 0.5(2.00) 0.5(0) 0

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Expected Value Analysis

• 2nd game 3 cards. Pick Jack, get 1. Pick Queen,
  get 2. King, get 3.
• EV 1.00 0.33(1) 0.33(2) 0.33(3)
  0.98
• 3rd game 4 marbles. Pick red 2, blue 1,
  green 0.50, yellow 0.
• EV 1.00 0.25(2.00) 0.25(1.00)
  0.25(0.50) 0.25(0) 0.13

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Expected Value Analysis

• In general, if is probability of outcome i,
  and is net benefits of outcome i, then
  the EV of an alternative with m potential
  outcomes is

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Expected Value Analysis

• Can be very useful in CBA, because many outcomes
  uncertain
• But, does not consider risk (risk neutral)
• If replace 1 in first game with 10,000 same
  EV equivalent?
• Most say no (risk averse)

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Expected Value Analysis

• Many cases decision maker should be risk neutral
  
• Risks spread over many people, so total loss high
  but individual loss not
• Risks spread over many projects, so even if some
  fail, enough successful to compensate for those
  that fail
• However if consequences irreversible (protection
  of rain forests, storage of nuclear waste, etc.)
  risk averse attitude may be better