Economics of the Environment - Essay Example

Economics of the Environment Introduction: Environmental Economics is a subfield of economic concerned with Environmental issues. It undertakes theoretical or empirical studies of the economic effects of national or local Environmental policies around the world. Particular issues include the cost and benefits of alternative environmental policies to deal with air pollution, water quality, and toxic substances, Solid waste, and global warming (Hanely, Shogern & White, 2001). Some of the major projects, which have substantial environmental impacts, is Afforestation of Surplus agricultural land, hydroelectric schemes, Building, or widening roads, constructing a new Airport and Manufacturing cars. All the above projects are likely to generate substantial Environmental costs and/or benefits, and they can be considered as Potential Investment. Potential Investment: A Potential Investment can be defined as the Investment made by an investor for growth (profit) of his/her investments in a firm or in a project. Investors look for evidence that, we can really produce growth in our project, and they look for three important things before investing, excellent growth potential, exceptional return on investment, up to 25% to 45% and a way to get their money out. We have to show them how our opportunity will deliver all three, and doing so will be a potential investment made by an investor in our firm or in a project. A Potential Investment can also be a huge project, which has a substantial impact on the environment. It can be a Hydroelectric project, Afforestation project, Building or widening roads, constructing a new airport, and Manufacturing cars. As these projects, have many impacts such as on environment, for profit of an investor, public convenience and many more. When a project is been started, they are many calculation done for different purpose, such as profit, low initial cost, higher efficiency of the project, easy maintenance, etc... In addition, for doing such calculation different numerical, theoretical, ratio analysis and analytical methods such as CBA (cost beneficial analysis) and CEA (cost effectiveness analysis) are been use. For this assignment, we select Afforestation of surplus agricultural land as our major project, which deals with planting of trees on land that did not carry forest for centuries, i.e. Afforestation is a clear shift in land use of a certain area. Afforestation in form of planting trees and future maintenance is an investment for landowner, and possible forgone revenues from Agriculture need to be included. Afforestation of former arable land will have many positive environmental effects. The change from agriculture to forestry means less input of pesticides and Fertilizers that may possibly leach to ground water reserves and the establishment of habitat for species associated with forest. Forest's also able to better retain nitrogen from arable use in the ecosystem, thereby avoiding eutrophication of water reserves. In this paper, we show how CBA can be used as a decision support mechanism for the location of new (urban) forestland, starting from the multifunctional role of these new forests. We start with a simple presentation of the Cost-benefit analysis (CBA) technique. Key features of these evaluation techniques are that (i) assess the monetary value of all benefits and cost (ii) the issue of discounting and (iii) the decision rules used in CBA. Finally, we apply the CBA to a real life policy problem. We investigate the net benefits per Hectare of combinations of potential forests that meet the surface restriction of 540 ha. We show the importance of including recreation benefits in the evaluation of afforestation projects and more specifically the role of alternative forests (substitutes) in the valuation of one specific Forest. We find that this substitution effect is significant in the decision on the location of new forests and leads to a wide variation in the net benefits per hectare of different combinations. Cost Beneficial Analysis (CBA): Cost-Benefit Analysis is a very important technique used for project appraisal; it is the process of weighing the total expected costs against the total expected benefits of one or more actions in order to choose the best or most profitable option. CBA is been used for the following advantages: It addresses social concerns about the efficiency of resource allocation. It is been applied to the assessment of a wide range of project and policy impacts. CBA is been used for be at both, the projects and policy level to allocate resources across competing uses. It reflects both the direction and strength of preferences. In addition, it in principle is been applied to both market and non-market costs and benefits (Hanely, 2001). CBA involves monetary calculation of initial and on going expenses vs. expected returns. CBA attempts to put all relevant costs and benefits on a common temporal footing, a discount rate is been chosen, this is then used to compute all relevant future costs and benefits in present-value terms. A CBA calculation typically involves using time value of money formula. This is usually been done by converting the future expected streams of costs and benefits to a present value amount (Hanely & Spash, 1993). The principle objective of CBA is to determine whether a number of investment proposals P, Q, R, or S should be undertaken, and given that resources are limited, which one or more should be selected. .The CBA principle states that, for e.g. when we install a guardrail on a dangerous stretch of mountain road, and if the dollar cost of doing so is less than the implicit dollar value of the injuries, death, and property damage, it can thus be prevented. There are a number of important stages in undertaking CBA, which are been defined separately as follow: (i) Project/policy definition: This involves setting out what is been analyzed, and what is not, whose welfare is to be considered, and whose is not and over what time-period (and which period(s) are being excluded). (ii) Scoping report/Environmental Impact Assessment: Identifying the entire positive (benefits) and negative (costs) physical effects of a proposal, both internal (e.g. to the developer) in addition, external (e.g. to society). (iii) Estimate in quantity terms the magnitude and significance of effects arising from the project. (iv) Wherever possible convert the effects due to CBA into monetary values so that comparisons can be made. This includes the net opportunity cost of forgone alternatives. (v) A point of debate regarding which there are differing opinions: Those effects, which cannot be monetized, can be treated as sustainability constraints upon the project and handled with care. (vi) Subtract all the costs from the benefits to obtain net benefits. (vii) Select and apply an appropriate 'discount rate' to translate all the project's effects, which occur over time into a single present value. (viii) Increasingly common although far from universal: Conduct an analysis of the distributional implications of the project in terms of its intra-generational equity implications and (less common) its inter-generational impacts. (ix) Conduct a sensitivity analysis across any assumptions that have been made including discount rate, physical effects (positive and negative) of the projects, values of those benefits & Costs and project lifespan. (x) Repeat this analysis for all viable uses of the resources in question (even in theory there should be a limit to this process; in practice this may be a very summary review of other options). (xi) Deliver the CBA to the decision maker along with various summary statistics and outcomes of differing decision 'rules'. (Hanely, 2001). CBA is not directly concerned with the market value of a given project; rather it attempts to assess the net value to society of that project. CBA involves evaluating a range of costs and benefits, which are both internal and external. COSTS AND BENEFITS OF AFFORESTATION PROJECTS The most obvious benefits of a forest are timber production. In some forests, hunting permits are issued. On the cost side, plantation and management are the first costs that come to mind. All these costs and benefits are financial expenditures or revenues for the forest owners. A social CBA however takes into account costs and benefits for the whole society. This implies that impacts related to the afforestation project that do not directly accrue to the project promoters should be taken into account. A full overview of all costs and benefits related to afforestation projects on agricultural land are given in Table (Hanely, 2001). . COSTS BENEFITS Tree planting and forest management opportunity cost of afforestation: Loss of agricultural production Loss of manure deposition possibilities Use values: Direct use values; timber, hunting, recreation Indirect use values: ecosystem value (e.g. carbon fixation, biodiversity, ...) Non-use values: Existence value Bequest value COSTS AND BENEFITS OF AFFORESTATION ON AGRICULTURAL LAND All costs and benefits listed in Table were been included in the analysis. Most of the costs and benefits are fixed amounts per hectare of forestland and are independent both of the location of the potential forest area itself and the location of its substitutes. This applies to planting and Management costs, timber, hunting, carbon fixation and non-use values. Opportunity costs on the other hand differs according to the characteristics of the soil. This applies to the loss of agricultural production as well as the loss of manure deposition. Consequently, opportunity costs per hectare can differ between forests but are the same regardless of the combination of potential forest areas that particular forest belongs too. Recreation is the only benefit category that is assumed both dependent on the location of the forest and the location of its substitutes, which could be either existing or other new forests. The same forest will therefore have a different recreation value depending on the combination that is studied (Hanley, 2001). . COSTS Planting and Management 38.60 Loss of agricultural production 714- 362 Loss of manure deposition 457-590 BENEFITS Timber 28.50 Hunting 15 Carbon fixation 25 Non-use 3680 Recreation Average 1440 The monetary value of all benefits and costs: {it Bi, t. (1+S)-t - i,t Ci,t . (1+S) -t} > 0 or (Bi,t - Ci,t). (1+S)-t > 0 The notions of WTP & WTA need a little more exploration. A gain in an individual's well-being, utility, welfare, or well-being can be measured by the maximum amount of goods or service that he/she would be willing to give up or forego in order to obtain the change. Consider an individual in an initial state of well-being Uo that he/she achieves with a money income Yo and an environmental quality level of Eo: Uo (Yo, Eo) Suppose that there is a proposal to improve environmental quality from Eo to E1. This improvement would increase the individual's well-being to U1: U1 (Yo, E1). The individual adjusts WTP to the point at which these two combinations of income and environment quality yield equal well-being. At that point, WTP is been defined as the monetary value of the change in well-being, U1-Uo, resulting from the increase in environmental quality from E0 to E1. This WTP is termed the individual's compensating variation, and it is measured relative to the initial level of well-being, Uo. (Pearce, 1998) The decision rules used in CBA: (Pareto Optimality and the Hicks-Kaldor Criterion) Assuming that all the costs and benefits have been measured in terms of money, the next step in the CBA process is to subtract the former from the latter to evaluate the net benefit of a project. The aim of CBA is to guide the decision-maker into channeling scarce resources into projects that will yield the greatest gain in net benefits to society. Pareto Improvement: A reallocation of resources, which makes at least one person better off while making no one worse off, is been said to be a Pareto Improvement. Pareto Optimality: When the economy's resources and output are been allocated in such a way that no reallocation can make anyone better off without making at least one person worse off then a Pareto Optimum is said to exist. Decision rules in CBA can be explained by the following equations {i, t WTPGi.t. (1+S) -t - i, t WTPLi.t. (1+S) -t} > 0 Where i is the ith individual and t is time. In this formulation benefits are measured by WTP to secure the benefits (G refers to gainers), and costs are measured by WTP to avoid the cost (L refers to losers. If the "losers" from the project or policy have legitimate property rights to what they lose, then WTP should be replaced by WTA and the formulae will change to: {i, t WTPGi.t. (1+S) -t - i, t WTALi.t. (1+S) -t} > 0 The difference, then, is that losses in the second equation are been measured by WTA and not by WTP. In the first and the second equation, WTA and WTP are been discounted so that when summed over time the resulting magnitude is known as the present value (PV). A present value is simply the sum of the discounted future value. Might therefore be written conveniently as: PV (WTP) - PV (WTA) > 0. (H.M. Treasury, 2003) Discounting: The valuation in present day terms of the future costs and benefits arising from a project. Issues of Discounting: Progressively reduces the present value of future costs and benefits. This reduction is been intensified as we extend our appraisal further into the future (Pearce & Turner, 1990). Justifications for Discounting: Derivation of the Discount Rate Discounting merely reflects the preferences that the vast majority of individuals (i) Pure (Positive) Time Preference (): People prefer benefits now rather than later. This might be due to an expectation of being richer in the future consequently valuing future benefits lower than present benefits, or simply an expression of pure impatience, the result is the same. (ii) Catastrophe risk (L): "the likelihood that there will be some event so devastating that all returns from policies, programmers, or projects are eliminated, or at least radically and unpredictably altered. Adding together factors (i) and (ii) tells us about the discount rate if we assumed no increase in consumption. This combined effect is usually denoted by the symbol . (iii) The Productivity of Capital: This means that in the future we are likely to have more money than now, as expressed in the annual growth in per capita consumption (g) (iv) Diminishing marginal utility of consumption (): Empirical evidence suggests that there is not a unitary relationship between increases in consumption and corresponding increases in utility; increasing a rich person's consumption by 1 raises their utility less than the utility increases caused by raising a poor person's consumption by 1. We therefore multiply g by and add this to to obtain the discount rate (r) as follows: r = + .g (Pearce & Turner, 1990). Equity: Typically, practical CBA applications are concerned with efficiency, rather than distributional equity issues. Some support such an approach, arguing that by maximizing efficiency this will lead to a trickle down of benefits so improving the real welfare of all. Treasury guidelines for cost-benefit analysis, which state: The other important rationale for government intervention [alongside efficiency] is the achievement of equity objectives. Before acting, an assessment should be made of the extent of the inequality to be redressed, and the reasons it exists. CBA conveys social preferences, which in turn are composed of individuals valuations typically articulated as willingness to pay (WTP) for differing goods. However, WTP is constrained by the ability to pay. Unadjusted, CBA makes the implicit assumption that the current distribution of income is optimal i.e. CBA reflects the optimal decision given the current distribution of income. (H.M.Treasury, 2003) Bibliography/ List of Reference: Hanley, N., Shogren, J. & White, B. 2001, Introduction to Environmental Economics, Oxford University Press, U.K, Ch.4. Hanley, N. & Spash, C.L. 1993, Cost-Benefit Analysis and the Environment, Edward Elgar, Ch.1. Pearce, D.W. 1998, Cost-benefit Analysis and Environmental policy, Oxford Review of Economic Policy, 14(4): 84-100. Pearce, D.W. & Turner, R.K. 1990, Economics of Natural Resources and the Environment, Harvester Wheat sheaf. Treasury, H.M. 2003, The Green Book: Appraisal and Evaluation in central government 2nd. ed, Her Majesty's Stationery Office, London. Read More