CIV324 – Week 3 Jan 27, 2012

Monetary valuation of environmental and social benefits and costs Next week: How it all comes together! CBA and other multi-attribute decision-making tools & individual presentations Feb 10: Case-study of a CBA for high-speed rail in the Quebec-Windsor Corridor & guest lecture. Consumer surplus is back! Feb 17: Sample problems, wrapping-up evaluation stage

M. Hatzopoulou

Beyond monetary costs and benefits Internalizing the externalities

• Social cost-benefit analysis

• Full cost accounting

• Social costs accounting

• True cost...

– Refer to accounting systems that internalize sustainability factors into the evaluation of project alternatives. Often this is done by assigning a dollar value to impacts such as: climate change, air quality, ecosystem health, etc.

– Total costs = Private costs (e.g production) + external costs (e.g. environmental)

Basis for market economies

• Market economies are based on voluntary exchange: Agents (individuals, households, firms, etc.) trade some of their endowments (e.g. free time, money, competences, skills) for goods or services (e.g. salary, consumption items) provided by other agents in the economy

• Market prices of goods and services are determined by demand and supply forces

• Ideally, the market price would contain the full value of the good to consumers and its full cost to producers

Market failures

• Ideally, the market price would contain the full value of the good to consumers and its full cost to producers

– In reality this rarely happens

• Market failures refer to situations when markets fail to organize production or allocate goods in an efficient way Market prices do not reflect the value of the good to consumers or its cost to producers Too many or too few goods will be produced (or consumed)

• Market failures often occur due to the presence of externalities

The concept of externality

• Often defined as an “unintended action” caused by an economic agent and influencing another agent who is not participating directly in the market transaction

– e.g. Car manufacturing plant affects local air quality but neither car manufacturer nor buyer pay for the pollution which worsens the QoL of neighbourhood residents

• An externality can refer to a cost or a benefit

Processes and externalities in the Forest-Wood-Chain

Prokofieva, I., Lucas, B., Jellesmark Thorsen, B., Carlsen, K. 2011. Monetary values of environmental and social externalities for the purpose of cost-benefit analysis in the EFORWOOD project. European Forest Institute, Finland.

External costs of vehicle use

Lemp, J. And Kockelman, K. M. 2008. Quantifying the external costs of vehicle use: Evidence from America’s top selling light-duty models. Transportation research part D, 13: 491-504

Adapted from: Lemp, J. And Kockelman, K. M. 2008.

External costs of big box retail

External costs of big box retail • Increased costs for host

localities and neighbourhoods:

– Traffic and congestion costs

– Street and road maintenance costs

– Environmental costs (runoff, storm water)

– Depressed property values in nearby neighbourhoods

http://2500milesbarbwire.blogspot.com/2009/06/big-box-mentality.html

Total economic value

• An all-encompassing measure of the economic value of any environmental asset

• Relies on the notions of willingness to pay (WTP) and willingness to accept (WTA):

– WTP: maximum amount of money an individual is willing to give up to have that good

– WTA: minimum amount of compensation an individual requires in order to stop having the good

• TEV = SUM (WTP, WTA)project

TEV is often divided into use and non-use value

Stated-preference surveys which capture WTP values are often used to infer non-use values

Pearce, D., Atkinson, G., and Mourato, S. 2006. Cost-Benefit Analysis and the Environment. OECD Publishing.

FYI. Side note on the TEV

• The TEV relates to preferences of individual human beings (recall, WTP and WTA)

• Critics of CBA reject the notion that individual preferences should be the basis for valuing environmental assets

– They prefer the notion of intrinsic value

– Intrinsic value is independent of human preferences

• TEV cannot encompass intrinsic values

Different methods to measure the TEV

1. Use Value

• Revealed preference techniques

– Travel cost method

– Hedonic pricing

– Averting behaviour

– Cost of illness

2. Non-use value

• Stated preference techniques

– Choice models

– Contingent valuation

3. Value transfer or benefit transfer

Different methods to measure the TEV

1. Use Value

Revealed preference techniques

– Hedonic pricing

– Travel cost method

– Averting behaviour

– Cost of illness

2. Non-use value

• Stated preference techniques

– Choice models

– Contingent valuation

3. Value transfer or benefit transfer

Revealed Preference (RP) models

• Basis of RP methods is the valuation of non-market impacts by observing actual market behaviour (or purchases made)

• Infer the value of a non-market good (e.g. air quality) from observations of expenditures on some related market good (e.g. house)

• RP are based on actual decisions made by individuals or households (vs. SP which ask people about decisions they would make under hypothetical situations)

Hedonic Price Method

• The price of a good is a function of a bundle of characteristics e.g. the price of a house is a function of the number of rooms, house location, local environment

• Assume that people prefer quiet areas; since there is no market for “noise”, there is no direct evidence of the price of “quiet”

• But people who value quiet will purchase a house in a quiet area; a measure of the value of quiet is the premium that is paid for a quieter house compared with a noisier but otherwise identical one

Hedonic Price Method (2)

• Concerned with “unbundling” the contributions of each significant determinant of house price in order to “infer” the WTP for each characteristic

• Involves collecting large amounts of data on prices and characteristics of properties in an area, and applying statistical techniques to estimate an “hedonic price function”

• HPM models of the property market have been used to identify the value of nonmarket goods (or bads) such as road traffic and aircraft noise, air pollution, water quality, proximity to landfill sites, etc.

Example of a Hedonic Price Model

hiHouseiAgeiAreaiAcci AgeAreaAccp 1lnln1ln 0

pi: Price of dwelling unit i [100,000$]

Acc1i: Accessibility to jobs for the Zone to which i belongs.

Pi: Population of Zone i

Areai: Area of dwelling unit i

Agei: Age of dwelling unit i + 1 year

1hi: 1 if dwelling unit i is a house, 0 otherwise

The coefficients of the model were estimated as an

Ordinary Least Squares (OLS) regression

Estimate Std. Error t value

θ0 -3.592 0.03080 -116.6

θAcc 0.05211 0.001029 50.62

θArea 0.9423 0.006296 149.7

θAge -0.06481 0.002007 -32.29

θHouse 0.1672 0.01811 9.234

Different methods to measure the TEV

1. Use Value

Revealed preference techniques

Hedonic pricing

– Travel cost method

– Averting behaviour

– Cost of illness

2. Non-use value

• Stated preference techniques

– Choice models

– Contingent valuation

3. Value transfer or benefit transfer

Travel Cost Method (TCM)

• Adopted to value geographical areas and locations used for recreational purposes (e.g. Beaches, lakes, natural reserves).

• The recreational area itself does not have a market price but many of the factors employed in the generation of the “recreational experience” have market prices

• TCM derives from the observation that the value of the recreational area can be measured with reference to:

– The number of trips that an individual takes to visit the area

– The cost per trip

• Information is usually collected through surveys carried out at the recreational site

Travel Cost Method (2)

• The cost per trip is divided into 2 components:

– Costs in return fares or gasoline expenses, wear and tear and depreciation of the vehicle

– Cost of time spent travelling (value of time)

• Cost of time spent travelling

– Time spent travelling could be spent in some other activity (e.g. working)

– One possible value for the price of time to an individual is their wage rate: “If individuals can choose the number of hours they spend working then they will choose to work up to the point at which an extra hour spent at work is worth the same to them as an hour spent at leisure. At the margin, therefore, leisure time will be valued at the wage rate.”

Different methods to measure the TEV

1. Use Value

Revealed preference techniques

Hedonic pricing

Travel cost method

– Averting behaviour

– Cost of illness

2. Non-use value

• Stated preference techniques

– Choice models

– Contingent valuation

3. Value transfer or benefit transfer

Averting Behaviour • Individuals might be able to avoid exposure to non-market

“bads” via the purchase of a market good

• These financial outlays are known as “defensive expenditures”

• The value of each of these purchases represents an implicit price for the non-market good or bad in question

• e.g. Households installing double-glazed windows to decrease exposure to road traffic noise.

• If noise levels decrease as a result of a local authority’s implementation of traffic calming measures then households will spend less on these defensive outlays changes in expenditures on this substitute good provide a good measure of households’ valuations of traffic calming policies

Complications in the practical applications of averting behaviour

• Defensive expenditures typically represent a lower bound estimate of the value of the non-market bad

• In the double-glazing case, greater indoor tranquillity may be achieved, but gardens will still be exposed to road traffic noise, so double-glazing will not help homeowners avoid the costs of road traffic noise completely

• Many defensive expenditures create joint products. The double-glazing case creates energy conservation. It is the net cost of the expenditure that is, the cost after taking account of the value of energy savings which is the correct measure difficult to infer!

Different methods to measure the TEV

1. Use Value

Revealed preference techniques

Hedonic pricing

Travel cost method

Averting behaviour

– Cost of illness

2. Non-use value

• Stated preference techniques

– Choice models

– Contingent valuation

3. Value transfer or benefit transfer

Cost of Illness (COI)

• Focuses on expenditure on medical services and products made in response to morbidity and other health effects of non-market impacts

– e.g. costs of the health impacts of air pollution can be valued by looking at expenditure which affected individuals make on drugs to counter the resulting headaches, and other symptoms of some air pollutants

• The difference between the COI and defensive expenditure approaches is that the decision to incur these health care expenditures is not made by the individual alone, but by social administrators and ultimately the tax payer

• Rely on the development of “dose-response” functions

Different methods to measure the TEV

1. Use Value

Revealed preference techniques

Hedonic pricing

Travel cost method

Averting behaviour

Cost of illness

2. Non-use value

• Stated preference techniques

– Choice models

– Contingent valuation

3. Value transfer or benefit transfer

Stated Preference (SP) Models

• A range of costs and benefits – such as some of the categories of value of environmental resources – cannot be straightforwardly inferred using RP techniques. Analysts resort to SP approaches.

• SP methods offer a direct survey approach to estimate the WTP for changes in the provision of (non-market) goods

• By means of an appropriately designed questionnaire, a hypothetical market is described

• The contingent valuation method is perhaps the dominant stated preference method or survey-based technique. Extensively applied to a range of environmental effects.

Contingent Valuation Questionnaire

• At the heart of the CV questionnaire:

– The Contingent Scenario: A hypothetical scenario describing a situation where an increase or decrease of the non-market good occurs

• After the presentation of the hypothetical scenario, the provision mechanism and the payment mechanism, respondents are asked questions to determine how much they would value the good if confronted with the opportunity to obtain it, under the specified terms and conditions

Pearce et al., 2006

Contingent Valuation Questionnaire (2)

Pearce et al., 2006

Contingent Valuation Questionnaire (3)

Different methods to measure the TEV

1. Use Value

Revealed preference techniques

Hedonic pricing

Travel cost method

Averting behaviour

Cost of illness

2. Non-use value

• Stated preference techniques

– Choice models

Contingent valuation

3. Value transfer or benefit transfer

SP approaches – Choice Modelling (CM)

• Widely used in market research and transport literature; new to environmental valuation

• CM is a family of survey-based methodologies for modelling preferences for goods, where goods are described in terms of their attributes and of the levels that these attributes take

– Respondents are presented with alternative descriptions of a good, differentiated by their attributes and levels, and are asked to choose the preferred alternative

– By including price as one of the attributes of the good, WTP can be indirectly recovered from people’s choices

Gaker et al., 2011

Choice modelling alternatives include:

• Choice experiments

– Choose between 2 or more alternatives

• Contingent ranking

– Rank a series of alternatives

• Contingent rating

– Score alternative scenarios on a scale of 1-10

• Paired comparisons

– Score pairs of scenarios on a similar scale

Choice experiments

• The probability that any particular respondent prefers Option A to alternative options, can be expressed as the probability that the utility or well-being associated with Option A exceeds that associated with all other options

Utility of an alternative

• Utility or well-being (of the ith respondent for the jth alternatives in the choice set) depends on the attributes of the choices and unobserved factors:

Utility of an alternative (2)

Concepts related to choice modelling

(Board)

Different methods to measure the TEV

1. Use Value

Revealed preference techniques

Hedonic pricing

Travel cost method

Averting behaviour

Cost of illness

2. Non-use value

• Stated preference techniques

Choice models

Contingent valuation

3. Value transfer or benefit transfer

Value Transfer or Benefit Transfer

• New primary environmental valuation studies often cannot be performed prior to all important decisions

• Decision-makers are often forced to use the economic estimates of similar changes in environmental quality from previous studies

• Values from the original valuation study can be transferred: this procedure is often termed benefit transfer

• E.g. Unit value transfer:

– (WTP)new study = WTPprev.study x (Inew study/Iprev.study)

– I = per capita income

– = income elasticity of WTP for the good in question

• E WTP, I %WTP / %I

Next week’s debates

• Debate 1: Monetary valuation is essential in the project evaluation phase in order to bring environmental effects to the forefront of decision-making

• AGREE

– Participant 1: Martin

– Participant 2: Marly

– Participant 3: Mark

• DISAGREE

– Participant 1: Anna

– Participant 2: Garth

– Participant 3: Jessica

Next week’s debates

• Debate 2: Philosophical debate on the preservation of the environment based on the intrinsic value of natural resources vs. extrinsic value (i.e. value to humans)

• AGREE

– Participant 1: Raphael Dumas

– Participant 2: Graeme

– Participant 3: Rebecca

• DISAGREE

– Participant 1: Elle

– Participant 2: Thomas

– Participant 3: Alex