16 cost benefit analysis of the environment

COST BENEFIT ANALYSIS OF THE ENVIRONMENT

Prof Prabha Panth,

Osmania University,

Hyderabad

22/03/2015 1Prabha Panth

• Social and environmental costs and benefits are not included in Market Analysis.

• Only private costs and benefits are included, as they have monetary value.

• Environmental assets also have value, and degradation of the environment leads to various dis-benefits.

• Economic activity creates environmental costs.• Preserving the environment creates benefits.• These have to be measured to ascertain the

environmental CB of economic activity.

Social, Private and Environmental Costs/ Benefits (CB)


Environmental ValuesTotal

Economic Value of

Environment

1. User Value

i) Actual Use Value

ii) Option Value

a) Vicarious Value b) Bequeath Value

2. Intrinsic Value

Passive, Non-User or

Existence Value


1. User or Use Value

• User Value is the benefit that the individual derives from use of the environment.

• It is made up of two categories:

– A) Actual Use value: Value of environmental resources used directly from the environment,

– e.g. value of fish caught by fishermen from a lake, or value of wood cut down in forests.

– These can be measured in money terms

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• B) Option Value: People may not actually use the environment now, but may do so sometime, if it is still available.

• Option value consists of two categories:

1) Vicarious Value: the value of preserving the environment for themselves and others to use. E.g. people want the TajMahal to be protected, hoping to visit it one day.

2) Bequeath Value: Preserving the environmental for their children or future generations to use.

It can be seen that these values cannot be measured, least of all in money terms, as they are subjective in nature.


1. User or Use Value

2. Intrinsic Value

• Also called Non-User, or Passive Value.

• It includes all values placed on conservation of environmental quality.

• For e.g. people want to preserve certain species such as the Giant Panda, or the Gir Lion,

• Even though they may never see these creatures.

• Based on “altruism”, also called Existence Values.

• People are happy that the species, and other environmental assets are conserved.


Methods of Environmental CB analysis

• Two methods to measure environmental costs and benefits.

• They are:1) Direct Methods: Such as the CVM or Contingent

Valuation Method, and

2) Indirect Methods: a) Hedonic Pricing method,

b) Travel cost method,

c) Avoided Cost method, and

d) Dose response method


1. The Contingent Valuation MethodWe first look at the CVM method:-

• Assume that the government is going to conserve a lake or heritage building.

• It has to raise revenue through additional taxes. This is a Social Cost.

• Are people willing to pay the extra taxes to conserve that lake or building?

• They will pay if they perceive some benefit from the conservation programme.


1. The Contingent Valuation Method• The amount that they are Willing To Pay for the

conservation, can be taken as the environmental benefit they get from the lake or building.

• The amount they are WTP (Be) is compared with the tax levied by the government (Cm).

– So if Be > Cm, i.e.

– If Environmental Benefit Be is greater than the money costs (i.e. taxes) Cm,

– It is worthwhile to undertake the conservation project.

– Otherwise it should be rejected.


CVM• The CVM exercise creates a Surrogate Market for

environmental goods and services.• This is a purely hypothetical exercise, • to find out how much value an average person

places on an environmental good/ service.– If the environmental good is available, how much are

people willing to pay (WTP) to conserve it,– Or if it is destroyed, then how much compensation are

they willing to accept for the loss (WTA). – For example if a lake is filled up for ‘development’

purposes, then how much compensation are the affected fishermen willing to accept for their loss.


6 stages of the CVM exercise1) Hypothetical Market: • The hypothetical market is constructed through a Survey.

• It identifies the respondents, and stakeholders,• Prepares the questionnaires,• Elicits responses to arrive at WTA or WTP.

Respondents do not actually pay, but only express how much they are willing to pay.

2) Obtaining Bids:interviewing the public or those affected by the activity.Various methods of bidding can be used, to find out maximum WTP or minimum WTA of the public concerned.


• Bids can be obtained in any one or more of the following ways:

– Bidding game: Higher and higher amounts are suggested, and the bidder chooses one.

– Simple Yes or No, to a predetermined sum.

– Payment card: different values are written on the cards, and one is chosen by the respondent.

– Open ended question: they can give their own bid

– Protest bids are also important, and should be included.


3) Calculating average WTP/WTA:

• After collecting the data, the average WTP or WTA has to be estimated.

• Either Mean or Median is taken as an estimate.– But Mean > Median,

– Mean is affected by outriders

– Median may underestimate the average.

– Problems of Free Riders, who want the change, but are not willing to pay for it.

4) Estimating bid curves:

• To estimate how accurate and valid the bids are, some statistical analysis has to be done.

• To ascertain the impact of different factors on WTP or WTA.


• Taking WTP or WTA as the dependent variable, regress against a number of independent variables collected from the questionnaires.

• For example:

WTPi or WTAi = f(Yi, Ei, Ai, Qi,....)

Where i = respondent’s index, Yi = Income of respondent, Ai = Age, Ei = education, Qi = environmental quality

• To ascertain which of these has a higher impact on WTP or WTA.

• Bid curves useful to predict the valuation of changes in environmental quality, other than those suggested in the survey.

• Can be used to test sensitivity of WTP to variations in Qi.


5) Aggregating Data:

• To convert mean bids to population values, since the above is taken from a sample.

• Relevant population has to be determined, how many are affected by the action (e.g. filling up a lake, or restoring a building)

• Sample mean Population mean, but bias may remain.

• Choice of time period is important, since benefits are felt over a period of time.


Net Present Value (NVP) =xt __1__(1+r)t

NPV or xt = ΣBt __1__ − ΣCt __1__(1+r)t (1+r)t

Where Bt is flow of Benefits over time, and Ct is flow of Costs over time.

If NVP > 0, the project is acceptedIf NVP < 0, it is rejected

6) Evaluation:Finally, the CVM exercise has to be evaluated to

find out how successful it was.Policy suggestions could be given, based on the

findings of this exercise.22/03/2015 Prabha Panth 16

• Limitations:– Design of the survey, questionnaires, and bias

– Studies have shown that WTA > WTP (4 to 5 times more). Private benefit > social benefit

– Respondents should have some knowledge about environmental quality and impacts,

– Income distribution impacts responses,

– Social factors – education, types of respondents, age, etc. also affects the response.

– Choice of future generations is not considered, only present generation.

– Finally, difficult to monetise environmental benefits –these can be underestimated.


II. Indirect Methods

Are made up of a) “user” values on environmental assets, based on Consumer Behaviour, and b) Production function Approaches.

1a.1) User Values: The Hedonic Pricing Method (HP):• Based on Lancaster and Rosen’s theory of consumer behaviour,• Value or Benefit of a commodity depends not only on its price, but also on other characteristics, • E.g. value of a property or house depends on the surroundings also.• Such as clean air, peaceful and quiet, greenery, etc.• Better environmental quality – higher the price of the property.


Property value or House Price HP equals:HP = f(PV, NV, AV, EV)

PV = property variables – area, number of rooms, type of construction.

NV = types of neighbours, and neighbourhood,

AV = Accessibility variables, i.e. Bus stops, stations, schools, hospitals, banks, shops, etc

EV = Environmental variables i.e. clean air, water, trees, peace and quiet, etc.

Other things remaining constant, HP is higher with better environmental quality.

If EV, HP (direct relationship). Willing to pay more for better environmental quality.This gives an indirect measure of the benefits or utility

that people give to a clean environment.


• Limitations:– Does not cover all types of environmental services –

only housing. Non residential areas, such as ecosystems are ignored,

– Multi-collinearity – Variables are not independent of each other. E.g. increase in greenery, less dust, closer to airport or station, more noise.

– Inequalities – poor live in degraded environments, but cannot opt for better surroundings.

– Other values such as Existence values are ignored.

– Future generations requirements not addressed.

– Does not cover depletion of natural resources, loss of species, ecosystems, etc.


1a.2) User Values: The Travel Cost Method (TCM):• TCM used as a proxy for the value of outdoor

recreational sites.• Public values an environmental site (lakes,

mountains, wildlife sanctuaries, etc)• Are willing to pay to travel and see those sites Cost

of travel = WTP• A statistical relationship between observed visits

and cost of visiting, is drawn to derive a surrogate Demand curve of environmental quality.– Depends on a) distance to be travelled, b) Income of

respondent, c) Alternative sites available, d) Personal interest, e) recreational facilities available, and f) Cost of travel


V =f(C, S)P

Visits per capita is a function of C = travel costs, S = social variables,

C = Ti + Ei + FYTi = cost of travelling to the site, Ei = Entry fee, FY =

income of visitor, S = social status of visitor.Survey and questionnaires to visitors to environmental

sites.Data should be aggregated across similar respondents

(same Y, same distance travelled), More the visits, more distance travelled , more costs incurred in travelling.

The more they are willing to pay to see the site, the higher the value of that environmental asset.



Demand

Number of visits

Co

st o

f vi

sits

0 V

BC

Entbenefits

F

CFB is the consumer surplus of travelling to an environmental site

• Limitations:– More visits to the site, more overcrowding. Leads to

loss of environmental benefits. E.g. in a national park, or sanctuary.

– Sample not representative. Only high income groups. Low income groups do not go site seeing, their responses are not included.

– Protected areas where no human access is allowed, no travel costs, but have high environmental values of conservation.

– Local inhabitants visit, low costs!– Pilgrimage centres – over crowded, dirty, people still

do visit.– Many other environmental issues not addressed by

the TC method, such as costs of climate change, GM crops, and so on.


2) Production Function Approaches:

Changes in environmental quality affects both producers and households.

Both have to take measures to protect themselves against environmental impacts.

2b.1) The Avoided Cost Method (ACM) of the Averted Expenditure Method (AEM):

E.g. if there is a factory near a housing colony, creating dust and smoke, the households have to spend money to protect themselves against the pollution.

When pollution is high, households spend more money on glass windows, netting, water filters, etc.

This is the Cost of environmental quality degradation.


• In the figure, as pollution levels increase, costs to avoid the impacts, also increase.

• This amount could be taken as a proxy for the cost of environmental deterioration.


Avo

ided

C

ost

Pollution

• Limitations:1) Only households’ averted costs are included, not

others affected by pollution.2) Other types of environmental damages not

considered, e.g. deforestation.3) Pollution may affect areas without human

habitation. Causes environmental damages, but not estimated.

4) One type of protection creates another, e.g. houses may put up glass windows, but more air conditioners are needed, affecting ozone layer.

5) Environmental impacts > avoided costs. Hence leads to underestimation of the environment.

6) Avoided costs not taken up by poor income groups, but most affected by pollution.


2b.2) Dose Response Method:

Changes in environmental quality affects production of certain marketable goods.

• E.g. effluents affect fishing, or agricultural production.

• Twin effects: Leads to reduction in output, and increase in costs.

• Victim loses his income, or spends money to protect his assets.

• Loses his output and his profits are affected.


To measure: 1) single estimate of change in costs and change in output in money terms due to the pollution.2) Linear programming, optimising models – Q maximised subject to economic and environmental constraints.3) Econometric models: time series or spatial data to correlate pollution and loss to producers.


Ou

tpu

t

Pollution

In the figure, as pollution increases, output falls. The value of this decrease in output is the cost of environmental pollution.

• Limitations:

1) All environmental damages cannot be included, e.g. acid rains affects crops and can be measured. But also affects forests, grassland, water bodies, etc....immeasurable.

2) Pollution affects second and third levels also –e.g. pesticides enter food chain, affect consumers, passed on to next generation.

3) Long term effects of pollution cannot be measured.

4) Natural resources depletion is not included.


• It should be noticed that while the direct method measures the expected “benefits” of conservation, the indirect methods measure the “costs” of environmental degradation.

• So a combination of the above methods should be used, when they are compatible with each other.

• However,– All these methods underestimate environmental

costs, since these are spread over time and space,


– Costs to non-human species not included. What is the cost of an extinct animal such as the cheetah in India? What is the benefit of conserving the tiger?

– Costs to non living systems, such as climate, hydrogen cycle, etc. cannot be measured in money terms.

– Some costs are felt in the future, such as global warming, or radio activity.

– Actual benefits and welfare of environment > cost of averting, or WTP. For e.g. the ecological benefits of forests > cost of planting trees.


16 cost benefit analysis of the environment

Education

environmental benefit

environmental assets

passive value

value of fish

value of wood

vicarious value

monetary value

actual use value