valuation of natural resource

1. Chapter 6: Cost Benefit Analysis and
Valuation of Environmental Resources
Instructor: AschalewSh.
Department of Economics
PhDCandidate
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2. Costs Benefits Analysis (CBA)
• Social and environmental costs and benefits are not included in market analysis. Most of
the time, 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.
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3. Stages of CBA
• Stage 1: Definition of policy/project:
– The reallocation of resources being proposed
– The population of gainers and losers being considered
• Stage 2: Identification of policy/project impacts:
– Define all impacts that will result from policy/project implementation
– Consider additionality (net impacts) and displacement (crowding out)
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4. Cont’d
• Stage 3: Identification of economically relevant impacts:
Environmental impacts of a policy/project are relevant in CBA if either
– They change the utility of at least one person in the society
– They change the quantity or quality of the output of some positively valued
commodity
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5. Cont’d
Stage 4: Physical quantification of relevant impacts:
– Determine physical amounts of costs and benefits and when they occur
in time
– Use environmental impact analysis to estimate the impact of
policy/project on the environment
– Estimations will be made with uncertainty, calculate the expected value
of costs and benefits
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6. Cont’d
• Stage 5: Monetary valuation of relevant effects
– All physical measures of impacts should be valued in common units to be
comparable
– Common unit = money
– CBA analyst must
• Predict prices for value flows extending into the future
• Correct market prices where they are distorted
• Calculate prices where non exists using environmental valuation methods
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7. Cont’d
Stage 6: Discounting of costs and benefits:
– Once costs and benefits are expressed in monetary units they should be converted to present
value terms by discounting
– PV= Xt[(1+r)-t] where X= cost or benefit; r = discount rate; [(1+r)-t] discount factor; t= time
– The higher the value of t the lower the discount factor
– The higher the discount rate for a given t the lower the discount factor
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8. Cont’d
• Stage 7:Applying the net present value test:
– Apply NPV test to choose those policies and projects that are efficient in terms of
their use of resources
– Where Bt = benefits of the project at period t, Ct = the costs of the project at period
t, r = the discount rate, n = the number of years over which the project will operate
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9. Cont’d
– NPV is the present value of the project’s/policy’s net benefit stream, obtained by
discounting the stream of net benefits produced by the project/policy over its
lifetime, back to its value in the chosen base period, usually the present.
– If NPV>0 accept policy or project (Based in Kaldor-Hicks Criterion) since it
would improve social welfare
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10. Alternatives to NPV
1. Benefit – Cost ratio (BCR): It is the ratio of the sum of the project’s or
policy’s discounted benefits to the sum of its discounted costs. If BCR>1 go
ahead with the project/policy
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11. Cont’d
2. Internal Rate of Return (IRR): Rate of interest which if used as the discount rate for a
project/policy, would yield a NPV of zero. It is the discount rate at which it would be
just worthwhile doing the project/policy.
So the IRR is the discount rate, r*, at which:
• However, IRR is a flawed measure of resources allocation because many
projects/policies generate multiple IRRs and also because it cannot be used to compare
projects/policies.
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12. Cont’d
• Stage 8: Sensitivity analysis:
– NPV test gives relative efficiency of a project given the data on prices,
environmental and economic impacts and discount rate but any of these data
might change due to uncertainty
– Recalculate NPV when the key parameters change to discover which one(s)
of them the NPV is most sensitive to
– Once the most sensitive parameter is identified direct forecasting effort to
improve best guess and more effort to manage these parameters carefully
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13. Valuation of Environmental Resource
• What is meant by the term value?
• The term value can be classified into intrinsic value and instrumental value.
• According to philosophers, something has intrinsic value
– if it is valuable in and for itself—if its value is not derived from its utility, but is
independent of any use or function it may have in relation to something or
someone else.…an intrinsically valuable entity is said to be an ‘end-in-itself,’ not
just a ‘means’ to another’s ends”.
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14. Environmental Valuation
• It refers to the assignment of money values to non-marketed goods and services,
where the money values have a particular and precise meaning.
– Non-marketed goods and services refer to those which may not be directly bought
and sold in the market place.
– Examples are scenic views, coral reefs, mountain vistas, biodiversity.
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15. Cont’d
• Accident prevention would be an example of a service which is sometimes marketed
(purchase of safety equipment) and sometimes not (good driving behavior).
– If a good or service contributes positively to human wellbeing, it has economic
value.
• An individual’s wellbeing is determined by whether or not it satisfies that
individual’s preferences.
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16. Dimensions of value
• Total economic value (TEV), which explicitly recognizes that the economic
value of environmental good or service is composed of different parts—some
of which are tangible and directly used; some of which are intangible or very
remote. Diagram shows TEV
• Total Economic Value = Total User Value + Total Non-use Value
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17. Cont’d
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18. Use Values:
• Related to values derived from using the environmental good
– Direct use value: Value that come from the consumptive use of the
environmental good
– Indirect use value: Value that come from the non-consumptive use of the
environmental good
– Option value: values of conserving for the option of making use of the
environmental good in the future even though no current use is made of it.
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19. Non-use values:
• Unrelated to the value of current or planned use of the environmental good
– Bequest value: People may like to preserve resources, not necessarily for themselves
but to pass on to future generations.
• The amount they are willing to pay for this purpose is bequest value.
– Existence value: Value of knowing that the environmental good exists even if no one in this
generation or in the future generations will ever use it.
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20. Techniques of Estimating Economic Value
• Two broad methods
• Revealed Preference Approach: The revealed preference methods infer the value of
environmental goods by studying their actual or revealed behavior in closely related
markets. It includes:
Hedonic pricing method (HPM)
Travel cost method (TCM)
Production Factor Method (PFM)
Averting Behavior Method
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21. Cont’d
• Stated Preference Approach: This method comprise survey-based methods that
can be used either for those environmental goods that are not traded in any market
or for assessing individuals’ stated behavior in a hypothetical setting (Freeman,
1993).
– Contingent valuation method (CVM)
– Attribute Based Choice Modelling such as Choice Experiments
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22. Hedonic Price Methods (HPM)
• 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.
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23. Cont’d
• 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.
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24. Cont’d
• 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.
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25. Cont’d
• Hedonic Wage or wage rate differentials method for evaluating environmental quality at
workplaces.
– How much wage is a person sacrificing to work at a safer or better environmental
quality workplace?
– Risks to health or life at work places, arising from noise, pollution, or toxic substances,
give rise to differences in wages. Everything else the same, workers must be offered
higher wages to attract them to work in less desirable places.
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26. Cont’d
• Establishing relationship between environmental quality and wages
• Data on risk to health at a workplace and the wage at the place are collected for
many workplaces
• Wages are then regressed on risks to health and other differences in the nature of
jobs:
𝑤𝑎𝑔𝑒 = 𝛽0 + 𝛽1(𝑟𝑖𝑠𝑘 𝑙𝑒𝑣𝑒𝑙) + 𝛽2(𝑜𝑡ℎ𝑒𝑟 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑠 𝑜𝑓𝑗𝑜𝑏)
• Then, the incremental wage for an increment in risk shows the willingness to pay for
reducing the risk.
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27. Travel Cost Method (TCM)
• The travel cost method is used to estimate economic use values associated with
environmental goods and services that are used for recreation.
– Applicable when travel cost is a major component of total cost of acquiring recreational
benefits
• Time and monetary costs expended on travelling to a recreational site are taken as proxies
of price and, thus, as a measure of benefits of the site.
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28. Cont’d
• The TC method is a revealed preference technique for estimating use values, the
recreational benefits of environmental resources – national parks, forests, reserves,
fishing and hunting sites
• It is assumed that visitors react to variations in travel costs as they would to
admission fee variation.
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29. Cont’d
• TCM is a method of estimating demand for recreation in a site measured in terms of
annual number of visits (V) to the site,
– V = f (TC, X, Y), where
– TC -travel cost to reach the site ,
– X a vector of attributes of the site and its substitutes , and
– Y a vector of the x’cs of the visitors in case of “individual travel cost method (ITCM)”
or a vector of the x’cs of the zone (Y) from where recreators are arriving to the site in
case of “zonal travel cost method (ZTCM).”
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30. Production Factor Method (PFM)
• PFM is based on the fact that many natural resources, processes and qualities are
used as production factors. Improvement of natural quality may lead to a reduction
of production costs for the sector making use of the relevant quality.
• The PFM tries to value natural qualities by valuing their impacts on production
costs.
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31. Cont’d
• The PFM has been applied to value the effects of water quality on agriculture,
fishery and industry and the effects of air quality on buildings, crops and livestock.
• The method is meant to determine the value of changes in natural qualities on the
economic production system.
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32. Averting Behaviour Method(ABM)
• This is done by looking at expenditures made to avert or mitigate negative
effects from the reduction of a natural quality.
– For example, buying products such as hats and sun-cream to prevent
damage to their health.
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33. Cont’d
• The willingness to pay for a clean environment is deducted from people’s purchases
of products and services to avert the negative effects of pollution.
• ABM is a cost-based method, since the costs of purchasing these items are used to
value environmental qualities, even though the social preferences for a healthy
environment may be much greater than the expenditures on these products.
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34. Stated Preference Approach
• Contingent Valuation Method: simply ask people how much they are willing to pay for an
improvement in environmental quality. Or willingness to accept for deterioration in
environmental quality.
• It is called a "stated preference" approach as people state their preference for
environmental quality.
– No real market for environmental quality
– Respondents are presented with a hypothetical situation of how they would choose if
they were faced with a market for environmental quality.
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35. Cont’d
• Contingent valuation methods have been used for a number of environmental
factors.
– air quality, aesthetic beauty of natural sites, recreational quality of beaches,
preservation of wildlife species, hunting and fishing, toxic waste disposal, etc.
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36. Willingness To Pay and Willingness To Accept
• Willingness to pay (WTP): the maximum amount of income the individual will pay in
exchange for an improvement in circumstances Or
• The maximum amount he will pay to avoid a decline in circumstances
• Willingness to accept (WTA): the minimum amount of income the individual will
accept in exchange for a decline in circumstances
• Or
• The minimum amount he will accept to forego an improvement in circumstances
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37. Stages in a CVM exercise:
a) Set up the hypothetical market for environmental service or good
Inform respondents about the project:
- reason for needed payment
- bid vehicle (local tax, etc.)
- who will pay ultimately
- how environmental service will be restored/created
b) Obtain bids (proposed values)
Questionnaire, face-to-face interview, mailing, etc.
Ask people for their WTP
Different ways to obtain individual bids:
- bidding game: higher and higher amounts suggested until maximum WTP is reached
- closed-ended referendum: single payment suggested and response is YES/NO
- Payment card: range of values is presented, one chosen
- Open-ended question: « How much are you willing to… »
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38. c) Estimate mean WTP (and/or 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.
d) Estimate bid curves
Taking WTP or WTA as the dependent variable, regress against a number of
independent variables collected from the questionnaires.
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39. Cont’d
• 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.
e) Aggregate the data
• Convert bids or average bids to population total value figure Requires adequate
definition of relevant population
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40. Choice Experiments
• A choice experiments – CE – is a stated preference technique
• Respondents are presented with a number of discrete alternatives – in terms of a set of attributes - and
asked to state which they prefer.
• CE is growing in popularity because
• can deal with non-use values
• control of the experimental design is with the researcher
• avoids yea and nay-saying
• monetary values implicit – no WTP question
• can calculate WTP even if attribute levels change
• WTP values can be transferred across project analyses
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41. CE – an example 1
It is proposed that a forested area currently subject to some timber harvesting and uncontrolled recreational access becomes a bird
sanctuary with no logging and restricted recreational access
An ECBA is to be done. Is PV of WTP for environmental enhancement greater than foregone logging profits and lost recreational
opportunities?
Attributes of project are
number of bird species
area of old growth forest
permitted visitors each year
cost to average tax payer
Bird species 5 10 15
Old growth forest (hectares) 1500 1800 2000
Visitors per year 4000 3000 2000
Cost per taxpayer ($) 0 10 20
Table 12.5 Project attribute levels
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42. Why value environmental goods?
• Cost-benefit analysis (CBA) of projects/programs
• Environmental costing (environmental taxes etc.)
• Environmental accounting (at firm level and ”green national accounts)
• Natural Resource Damage Asssessmennt (NRDA)
• Land use planning:
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