Economics of Sustainability


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Economics of Sustainability

  1. 1. Life Cycle Sustainability1 Economics Wali Memon
  2. 2. Agenda How traditional economics falls short of sustainability: Tragedy of Commons & externalities Possible Solutions: Triple bottom line accounting Emissions trading systems Life cycle cost analysis Including environmental benefits in cost-benefit analysis2 Wali Memon
  3. 3. ObjectivesBy the end of this unit, students should be able to:1. Give an example of a Tragedy of the Commons and a possible solution.2. Give an example of pollution creating an externality and a possible solution.3. Compare advantages and disadvantages of triple bottom line accounting.4. Perform a life-cycle cost analysis.5. Explain how the value of environmental benefits could be determined. 3 Wali Memon
  4. 4. Objectives6. Perform a cost-benefit analysis that includes environmental benefits. 4 Wali Memon
  5. 5. Where traditional economics falls shortof sustainability:The Tragedy of the Commons Dilemma first described by Garrett Hardin in Science in 1968. Multiple individuals, acting independently, and solely and rationally consulting their own self-interest, will ultimately deplete a shared limited resource, even when it is clear that it is not in anyones long- term interest for this to happen.5 Wali Memon
  6. 6. Tragedy of the CommonsAssume a common-property resource(exclusion is difficult and joint useinvolves subtractability), I.e., noproperty rights.e.g. pasture open to allAssume each herdsman tries to keep asmany sheep as possible on thecommons. They each try to maximize 6gain. Wali Memon
  7. 7. Add those sheep! The rational herdsman concludes that he or she should add another sheep. And another… And another… And so does each herdsman “Ruin is the destination toward which all men rush, each7 Wali Memon pursuing his own best interest…”
  8. 8. Possible Tragic Commons?8 Wali Memon
  9. 9. Where traditional economics fallsshort of sustainability:Externalities Externalities are the effect of a decision on a third party that is not taken into account by the decision-maker. Externalities can be either positive or negative. Examples of environmental externalities:9 Wali Memon
  10. 10. Possible Solutions to Tragedy of theCommons/Externalities: Macro (national or state) scale: 1. Make it cheaper to treat than discharge harmful pollutants: emission fees 2. Create emissions trading systems Micro (project/company) scale: 1. Use triple bottom line accounting 2. Conduct life cycle cost analysis 2. Quantify environmental benefits 3. Use a lower discount rate10 Wali Memon
  11. 11. Possible Macro-Scale Solutions:Emissions Trading Systems Also known as cap and trade – market-based In order to pollute a specific amount (say 10 tons), companies have to hold that number of allowances, or credits (10 tons of credits). An overall regional cap is placed on the number of allowances, to ensure good air quality. Cap can be lowered over time to improve air quality. Companies that need to increase their emission allowances must buy credits from those who pollute less. The transfer of allowances is referred to as a trade. 11 Wali Memon
  12. 12. Possible Macro-Scale Solutions:Emissions Trading Systems Economic incentive to reduce emissions: If polluters reduce their emissions, they can sell the excess allowances at a profit. Economically efficient: Companies that can reduce their emissions most cost- effectively will do so (theoretically) and sell credits to companies that can’t reduce cheaply, achieving the pollution reduction at the lowest cost to society. Technologically efficient: Companies are free to use any means to reduce emissions (technology not mandated, as it can be in other regulatory approaches). 12 Wali Memon
  13. 13. Possible Macro-Scale Solutions:Emissions Trading SystemsExamples: U.S. national cap-and-trade system for sulfur dioxide, established under the Acid Rain Program of the 1990 Clean Air Act (first cap-and-trade system in the U.S.) Texas banking & trading system for precursors that form the air pollutant ground-level ozone (nitrogen oxides and volatile organic compounds) Baseline and credit program – each company has a regulatory limit. Companies can bank and sell credits if they reduce pollution below their regulatory limit. European Union trading scheme for greenhouse gases 13 Wali Memon
  14. 14. Possible Micro-Scale Solutions:Triple Bottom Line Accounting 3 Ps of the triple bottom line: Triple bottom line accounting: expanding the traditional reporting framework to take into account ecological and social performance in addition to financial performance Company’s responsibility is to stakeholders, not only shareholders. Requires a corporate commitment to social responsibility. Who would stakeholders be? 14 Wali Memon
  15. 15. Possible Macro-Scale Solutions:Triple Bottom Line Accounting Realistic? Examples Shell Foundation’s involvement in South Africa (helping grow local businesses to reduce poverty, reduce indoor air pollution, schools for children) McDonald’s Corporation – Ronald McDonald House Others 15 Wali Memon
  16. 16. Possible Macro-Scale Solutions:Triple Bottom Line Accounting Example reporting frameworks: AccountAbility’s AA1000 standard, based on Triple Bottom Line Global Reporting Initiative’s Sustainability Reporting Guidelines Potential benefits? Orlitzky, Schmidt, and Rynes found a correlation between social/environmental performance and financial performance Aid to employee recruitment and retention, particularly grad students Reputation risk management Brand differentiation Disadvantages? 16 Wali Memon
  17. 17. Economic Analysis: Methods ofComparing Alternatives 1. Life cycle cost analysis Present worth, annual payments, future worth analysis Break-even comparisons 3. Use a lower discount rate Rate of return (ROR), incremental rate of return (IROR) analysis Cost-benefit analysis 2. Quantify environmental benefits17 Wali Memon
  18. 18. Possible Micro-Scale Solutions: 1. Life Cycle Cost Analysis In choosing among engineering project/product alternatives, consider life cycle costs, or the total cost of ownership over the life of the project/product. Also called “cradle to grave" or "womb to tomb" costs. Useful in present worth, annual payments, and future worth analysis (methods that compare costs of alternatives), and in break-even comparisons if benefits are not included.18 Wali Memon
  19. 19. Possible Micro-Scale Solutions:1. Life Cycle Cost Analysis Phases of project/product life to consider: Planning Design Construction/production Operations Maintenance, renewal/rehabilitation Replacement or disposal 19 Wali Memon
  20. 20. Possible Micro-Scale Solutions:1. Life Cycle Cost Analysis What phases of project/product life cycle are traditionally considered in alternatives analysis? Why might using full life cycle cost analysis benefit the environment? 20 Wali Memon
  21. 21. Possible Micro-Scale Solutions:1. Life Cycle Cost AnalysisExample problem 21 Wali Memon
  22. 22. Possible Micro-Scale Solutions:2. Quantify Environmental BenefitsMethods of comparing alternatives that include benefits: Rate of return (ROR), incremental rate of return (IROR) analysis Cost-benefit analysisIn evaluating benefits, be sure to quantify environmental benefits so they are not excluded. 22 Wali Memon
  23. 23. Possible Micro-Scale Solutions:2. Quantify Environmental Benefits Suppose that a city is doing a cost-benefit analysis for how to use a piece of land. Two alternatives include: 1. Allowing a developer to construct a shopping mall, and 2. The “do nothing” alternative – leave the land as a forest. How would you quantify the costs associated with each alternative? How would you quantify the benefits associated with each alternative? 23 Wali Memon
  24. 24. Possible Micro-Scale Solutions:2. Quantify Environmental Benefits Quantifying environmental benefits is typically difficult, so environmental benefits historically have often been left out.Ways to quantify environmental benefits: Surrogate markets Surveys Willingness to pay to visit a park Willingness to pay to use an HOV lane 24 Wali Memon
  25. 25. Possible Micro-Scale Solutions:2. Quantify Environmental BenefitsWays to quantify environmental benefits: Health benefits Air pollution caused by an industry may cause people to miss work. A dollar value can be assigned to missed work using salaries. Installing an air pollution control device would have a quantifiable health benefit of fewer people missing work. Health care costs attributable to air quality Other 25 Wali Memon
  26. 26. Possible Micro-Scale Solutions:2. Quantify Environmental Benefits Cost-benefit analysis: Used to choose among engineering project/product alternatives For each project alternative, calculate the ratio of benefits to costs, with all benefits and costs adjusted for the time value of money (typically everything is adjusted to present). Choose the option with the highest benefit-cost ratio or net benefit 26 Wali Memon
  27. 27. Possible Micro-Scale Solutions:2. Quantify Environmental Benefits PVB (present value of benefits) PVC (present value of costs) BCR (benefit cost ratio) = PVB / PVC Net benefit = PVB - PVC 27 Wali Memon
  28. 28. Possible Micro-Scale Solutions:2. Quantify Environmental Benefits Example problem – Cost-benefit analysis 28 Wali Memon
  29. 29. Possible Micro-Scale Solutions:3. Use a Lower Discount Rate Another way to consider sustainability in all types of economic analysis: use a lower discount rate A high discount rate implies a very low value on the welfare of future generations 29 Wali Memon
  30. 30. Summary30 Wali Memon
  31. 31. ReferencesAllada, Venkat, “Introduction to Sustainable Practices in Design and Manufacturing,” PowerPoint Lecture Slides, Missouri University of Science and Technology, available at, assessed 3/2010Callender, Craig. “The Tragedy of the Commons”, PowerPoint Lecture Slides, Philosophy, USCD, accessed 3/2010.“Emissions trading.”, accessed 3/2010.Hardin, Garrett. ”The Tragedy of the Commons”, Science, Vol. 162, No. 3859 (December 13, 1968), pp. 1243-1248. 31 Wali Memon