Environmental Economics - The Chartered Institution of Water and Environmental Management

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Environmental Economics

Introduction

The Chartered Institution of Water and Environmental Management (CIWEM) is an independent professional body representing over 12,000 environmental professionals. CIWEM's agreed purpose is to develop and promote better and integrated management of the environment; to foster a deeper understanding of water and environmental issues and to enhance the quality of people's lives. This is achieved through CIWEM's Royal Charter, education, training and professional development; dissemination of information; conferences and events; research and publications; contact with Government agencies and other bodies, partnerships with other organisations and the publication of Policy Position Statements (PPS).

Purpose

The purpose of this PPS is to provide a general introduction and promote this lnstitution's views on the environmental economics.

Economics And The Environment

Economics may be defined as the 'study of choice under conditions of scarcity'¹. Historically, however, the environment has not generally been seen as a scarce resource; essentially the economic goods and services provided by the environment have been treated as having no cost. Robert Hahn summed it up thus: 'In earlier times, when environmental problems were few and far between, such ignorance was bliss and made good sense in some cases.'² In recent decades society has begun to realise that 'the economy' and 'the environment' are fundamentally connected and that continued reliance on the environment as a limitless free source of natural resources or as a sink for wastes will not deliver sustainable development.

However, protection of the environment is not without cost. Every environmental protection measure has an opportunity cost, which is simply the foregone benefit of the measure, and is a fundamental tenet of economics. It can be illustrated by way of a simple example. A utility company laying a new pipeline can cut through a woodland or divert around it. The diversion, laying the pipe across agricultural land or in the public highway, would have increased cost due to the additional construction work, perhaps running into hundreds of thousands of pounds. It is appropriate to ask whether incurring this additional cost is worthwhile given that this expenditure could be invested in an alternative environmental protection measure, used to reduce customer charges, used to generate employment, or for some other beneficial purpose. As unpalatable as it may seem that such choices have to be made, some means of identifying the various costs and benefits of alternative project options is required to support decision makers aiming for sustainable development. Such analysis also allows them to make transparent and consistent trade-offs between economic, social and environmental objectives.

Environmental economics has emerged since the 1960s as a distinct branch of economics, although many of the essential principles can be traced far further back in time. Environmental economics revolves primarily around the failure of the market system to account for pollution and natural resource depletion. This failure manifests itself in the fact that developers are often not confronted with the full costs of their impact on the environment in market prices. In economic jargon, these impacts are known as externalities but as they affect third parties, it is important that they are taken into account. Essentially, environmental economics holds that the market failure needs to be addressed by 'getting the prices right': market prices should be corrected for external costs (or benefits) and, in response, developers will alter their consumption and/or production behaviour. For instance, over-abstraction of groundwater may have deleterious affects on wetland habitats and associated bird species. This may then have impacts on the level of recreation and tourism activities and on property values. The externality arises because the abstractor is not confronted with the costs of these impacts. Where such a market failure is corrected then, all other things being equal, increased costs will provide the incentive for reduced abstraction, for example by switching abstraction to a less damaging source.

Environmental economics is principally concerned with two aspects of such issues. Firstly the valuation of the externalities for subsequent use in the design of efficient policy measures and in project appraisal. Secondly the design of regulatory and incentive systems that include rewards and penalties that take these external values into account, e.g. pollution taxes and tradable permits. In both cases, the underlying framework is one of a formal analysis of costs and benefits. The objective is one of maximising net benefits to society, subject to other goals of public policy. Expressing environmental impacts in monetary terms allows a systematic comparison of costs and benefits. Such an approach allows a more rational judgement to be made of the balance between the costs and benefits of projects and policies, including environmental impacts.

Application of environmental economics can support the pursuit of sustainable development. Although there is no universally accepted definition of sustainable development, it is acknowledged that it involves balancing social, economic and environmental objectives of the current generation with those of future generations. This will unquestionably involve trade-offs between the different objectives over time. Environmental economics provides a robust framework for the illumination of these trade-offs, in particular between environmental and economic objectives.

Environmental Valuation

For conventional goods and services traded in markets identifying the costs and benefits is relatively straightforward as the prices of these goods and services are apparent. These prices signal the willingness to pay on the part of the buyer and the willingness to accept compensation on the part of the seller. However, because markets are absent for many of the goods and services provided by the environment, such as the capacities of rivers and the atmosphere to absorb pollution, prices cannot be directly observed. Therefore, in order to measure the costs and benefits of non-market environmental impacts environmental economists have developed a range of valuation techniques.

Revealed preference techniques allow the monetary value of the environmental impact to be derived through analysis of related markets. For example, all other things being equal, the prices of properties alongside polluted rivers will be lower than those adjacent to pristine rivers and the difference can be attributed to the value of the environmental impact. Given sufficient data, econometric models (known as hedonic pricing models) allow these values to be uncovered. In a similar vein, the money spent by individuals in visiting a recreation site may be used to infer the value of the site (this approach is known as the travel cost method). Revealed preference approaches have a major limitation however. By definition they can only capture use values, not the category of values known as non-use (or passive use) values. These values relate to the value that individuals hold for environmental goods and services independent of how much they actually use it. For instance, whilst econometric analysis can reveal the change in property values along a polluted watercourse, other individuals who do not live along, or visit, the watercourse may feel worse off just from knowledge of the pollution and its effects. All though non-use values are less tangible than use values they are nonetheless related to changes in individual well-being and it is therefore appropriate to include them in project and policy appraisal.

Because non-use values are, by definition, not reflected in any market environmental economists utilise stated preference techniques to measure them. The most common stated preference method is to conduct a 'contingent valuation' survey, where change in the level of provision of the environmental good or service in question is placed in a hypothetical market setting. This hypothetical scenario is presented to a sample of individuals from the affected population and they are invited to state their willingness to pay (or willingness to accept compensation) values as if they were trading in a conventional market. Statistical analysis of the survey responses allows environmental economists to calculate average willingness to pay values that can then be used to calculate the aggregate value for the entire population affected by the project or policy being assessed. Self-evidently, non-use values can extend over a wide population and thus frequently overshadow measures of use values in estimates of total economic value.

Environmental valuation is controversial. Critics question the ethics of placing monetary values on the environment from what they see as a purely selfish, human-centred motivation. The controversy could be lessened by understanding that it is not the environment itself that is being valued, rather individual preferences for the environment, being a measure of the well-being (or utility) that those affected attach to the goods or services provided by the environment. These preferences can be motivated by any number of factors, including altruism and concern for the rights of non-human species. Individuals may build into their valuation an element of intrinsic value, as they perceive an obligation on society to protect the environment for its own sake.

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. In the last decade there has been considerable progress in research in addressing these issues, prompted in a large part by the use of contingent valuation in estimating the environmental damage caused by the Exxon Valdez oil spill in Alaska in 1989. Following this event, a special commission established by the US government gave its qualified approval to use of contingent valuation in a legal context in the USA.³

Because of the importance of non-use values contingent valuation and other stated preference methods have become the preferred approach to environmental valuation. Because of the relative youthfulness, and significant costs, of applying many of these techniques there are relatively few site-specific surveys that have been conducted in the UK. This leads to problems of accuracy and reliability as there is a temptation to transfer the results of one survey to another project or area, so called 'benefit transfer'. Credible benefit transfer requires sufficient similarity between the two populations and sites, but given the small database of values for transfer this is often difficult and often little consideration is given to differences between the populations. Benefit transfer has often been undertaken in situations where site-specific studies are warranted, often for reasons of cost, but this can be a false economy, as the understanding of benefits will be reduced. This situation will however improve with time as more site-specific surveys are completed and more research is undertaken.

The Key Issues

Environmental economics is a relatively new science, particularly in the UK, and we need to get more experience of its value in the decision making process. Expressing environmental costs and benefits in monetary terms is far from simple, and the methods at present in use can deliver a wide spread of values. This tends to discourage confidence in the methods. Standard approaches need to be developed where appropriate, and used consistently in order to produce more repeatable results, though realising that there can be valid reasons why values between apparently similar populations exhibit significant divergence. The UK government recognises this and has commissioned comprehensive guidance on the application of stated preference techniques.⁴ Ultimately, more site-specific surveys will add to our confidence in the validity and application of the techniques.

Environmental economics raises the fundamental question of who pays for environmental protection and how. Should costs be reflected in commodity prices, or should they be met through local or general taxation? These are issues that need to be debated.

The Ciwem View On Environmental Economics

The Institution recognises the important contribution that environmental economics can make to the analysis of policies and projects relating to the environment. There are potentially major benefits to developers and society, whilst maximising environmental gain, from designing and implementing appropriate policies using economic instruments such as environmental taxes and tradable permits.

The Institution is aware of the technical challenges in environmental valuation, especially where stated preference methods are used. However it sees environmental valuation as a very important tool in assisting decision-makers in making rational decisions about the best options for development. It allows the needs of the environment to be balanced against those of the economy and society with a rigour that is not present in other approaches based on judgement alone and which in the past have manifestly not delivered the level of environmental protection that is required for sustainable development.

The Institution commends and supports the development of the science of environmental economics, and encourages the use of environmental valuation in the decision-making process relating to developments with environmental impacts. In particular, the increased use of site-specific valuation should be encouraged and promoted. This will not only provide information that is valid for the specific scheme itself, but also increase the information bank for the future and improve the reliability of benefit transfer. There is a case for making these valuations a statutory requirement within the regulations for the environmental assessment of major projects as well as policies.

The Institution supports and promotes the exchange of information and the development of knowledge in this important area and will seek to:

Sponsor conferences and events on the topic.
Sponsor a web site and discussion group to exchange information and knowledge.
Promote media awareness of the topic so that the public become more conscious of the issues.
Co-ordinate preparation of an "A" level information pack for students studying environmental and economics courses.

References

¹ L. Robbins, An Essay on the Nature and Significance of Economics Science (Macmillan, London, 1932).

²   R. Hahn, 'Getting more environmental protection for less money: a practioners guide', Oxford Review of Economic Policy (vol. 9, no. 4, pp. 112-123, 1993).

³  K. Arrow, R. Solow, P. Portney, E. Leamer, R. Radner and E. Schuman, 'Report of the NOAA panel on contingent valuation', Federal Register (vol. 58, pp. 4602-14, 1993).

⁴  Department of the Environment, Transport and the Regions, Guidance on Using Stated Preference Techniques for the

Economic Valuation of Non-Market Effects (The Stationery Office, London, 2001).