Valuation and Cost-Benefit Analysis of the Environmental Resources

1.0. Introduction

There is often lack of information on the value and carrying limits of the Earth’s ecosystems.
Measurement of economic development and progress has often been linked to measures of economic
output such as Gross National Product (GNP). Such aggregate measurements do not consider the
depletion of natural capital caused by the consumption and production of goods-and-services. National
accounting systems need revision to better include the value of the changes in the environmental resource
base due to human activities. Environmental accounting: the preservation or loss of valuable
environmental resources should be factored into estimates of economic growth and well-being. This is
called green accounting. Valuing different goods-and-services involves comparisons across different sets
of things. There are different approaches to valuation, and how these approaches might be used to help
assess the impact of policies on environmental change and human well-being is also different. Valuation
presents a set of challenges beyond conflicting value systems or lack of existing market institutions. It
uses notional and proxy measures to estimate the economic values of tangible and intangible services
provided by the environment. An increasing body of valuation work has been undertaken on provisioning
services of ecosystems. It has produced estimates of the value of non-timber forest products, forestry, and
the health impacts of air pollution and water-borne diseases.

1.1. Valuation of the Environment

Environmental valuation is the process of valuing the environmental resources. There has been an
increasing demand for environmental valuation as the importance of environmental services increases.
Environmental valuation is a “practical” and empirical component of environmental economics.
Environmental valuation is used to construct measures (usually monetary measures, but not always) of
welfare arising from changes in the environment. Since most environmental goods and services are not
traded in markets, valuation requires that we go beyond simply measuring market demand functions. We
must identify links between market goods and environmental goods and use these links in evaluating the
welfare changes associated with changes in environmental quality, changes in the stock of natural
resources or changes in ecosystem services.

1 Cost–Benefit Analysis (CBA): Economists are engaged in CBA for a variety of projects and policies.
CBA for irrigation projects, water resource development projects, transportation infrastructure, and many
other public or private projects often involve significant non-market benefits (or costs). These non-market
values arise because the good or service is not traded in a market and thus the price system cannot signal
its value.

2 Damage assessments: As described above, the determination of compensation from environmental

damages is an important use of environmental valuation.

3 Regulatory analyses: Developing standards for environmental quality require the valuation of
environmental amenities for at least part of the process. Without information on the monetary values
associated with changes in the standards the process of balancing marginal benefits and marginal costs
cannot take place. Analysis of the costs and benefits of regulation, especially after the regulation has been
put in place, are common.
4 Land use planning: In exercises such as forest management planning or transportation planning
environmental issues often arise. In forest management the issue may be the optimal timing and location
of forest harvesting given that benefits arise from both forestry and recreation. Since recreation quality
(and thus value) may be affected by forest management the optimal management strategy would consider
both of these sources of benefits when evaluating management plans.

5 Natural resource accounting: It has been recognized that traditional measures of economic wellbeing
(GNP based measures) do not capture the depreciation of environmental or natural resource stocks, or
changes in the values of non-market values arising from the environment. New approaches to national
accounting, often called green accounting or natural resource accounting are being developed to attempt
to take into account such omissions to traditional GNP and in many cases require the use of
environmental valuation techniques.

6 Economic Sustainability: Bishop examines the concept of economic sustainability in considerable detail
and shows that in order to achieve sustainability it will be necessary to impose sustainability constraints,
typically constraints on industrial development, on our economic system. In this context he suggests that
environmental valuation will have an important role to play in evaluating the “opportunity costs of
sustainability constraints.”

1.1.1. Dimensions of value

Value of the environmental resource can be classified into two. These are the use value and non-use
values.

Use Value: use value is the value of the environmental resource to those who use it. For instance the
value of the forest is value to those who use it for timber harvesting, hunting, hiking, camping and
wildlife viewing. Timber harvesting, and hunting are consumptive uses. Hiking, camping and wildlife
viewing are non-consumptive uses of the forest. In addition, fishing, hunting, camping and wildlife
viewing are recreational uses of the forest. Suppose timber harvesting and recreations are competitive
uses of the forest. Then, reducing timber harvesting rates decreases timber values and increases
recreational value. Specifically, the proposed policy lowers income, employment and local taxes from
timber harvesting and raises income, employment and local taxes from recreation. One way to evaluate a
reduction in timber harvesting is in terms of an increase in the supply of recreational opportunities, which
lowers the price of recreation. Use value represents the utility enjoyed by people who directly use some
aspect of the environment. For example, a bird sanctuary yields use value to bird watchers and to those
who use the area as an open space (walking, jogging, and observing the view). Likewise, a backcountry
area provides use value to hunters, hikers, backpackers, and equestrians, and the ocean shore provides use
value to surfers and fishers.

Non-Use Value: Nonuse values, also known as passive-use values reflect value that people assign to
aspects of the natural environment that they care about but do not use in a commercial, recreational, or
other manner. For example, someone might value the existence of grizzly bear habitat in Alaska but have
no interest in actually visiting such wild land habitat. Non-use values are controversial because they are
difficult to measure. The non-use value can be option value, existence value, and bequest value. Option
Value: the resource may have use value in the future and we conserve it for the future possible value.
Option value is prominent when there is uncertainty over the ultimate environmental impact of a given
activity, and that impact is irreversible.

Existence value: Existence value refers to the satisfaction that some people derive from the preservation
of natural resources so that there remains a habitat for fish, plants, wildlife, and so on. In other words, it
refers to what people are willing to pay (demand) for preserving the ecological integrity of the natural
environment stewardship. Recent debt-for-nature swaps by several internationally renowned conservation
organizations for the purpose of protecting the tropical forest are examples of such an activity.

Bequest Value: Bequest value refers to the satisfaction that people gain from the knowledge that a
natural resource endowment is being preserved for future generations. Strictly speaking, bequest value is
an intergenerational component of the option value. Bequest value would have considerable relevance in
a situation where the natural resources under consideration are unique and irreversible, and there exists
uncertainty regarding future generations’ demand for and/ or the supply of these resources. Examples are
national parks, wilderness, tropical forests, aquifers, blue whales, coastal wetlands, coral reefs, and so on.
Basically, bequest demand exists to the extent that the present generation is willing to pay for preserving
natural resources for the use of future generations.

The general conceptual model that captures the essence of the discussion on value can be summarized by
Total value=Use value+ Nonuse value ; where

Nonuse value=Option value + Bequest value + Existence value

Diagram 1.1

1.1.2. Welfare foundations

Environmental valuation is based on individual-level welfare economics. In order to construct measures

of economic value associated with changes in environmental quality, the relationships between utility,
environmental quality, and monetary welfare measures must be defined. At this point it is necessary to
note that environmental values in an economic context are anthropocentric as the values ascribed to
changes in the environment are assumed to arise from human preferences. Non-anthropocentric or bio
centric value systems are generally not consistent with the economic notion of values and preferences
arising from individuals. That does not suggest that economic approaches are the only approaches that are
valid. However, in exploring environmental valuation in an economic context it is necessary to remain
consistent with economic theory. Environmental values are also utilitarian or based on utility theory.
Once again there are other theories of value that are not utilitarian. In beginning our discussion of
economic welfare measures we must also consider that we are “building from the ground up.” Aggregate
welfare change, or social welfare, is assumed to be the sum of the individual welfare changes. This arises
from the difficulty in making any other approach to social welfare measurement practical and defensible.
Economic theories tried to model the preferences of individuals and developed theoretical models that
help as to measure the welfare changes due to change in the environmental resources quality or quantity.
Measures of individual welfare changes due to change in the resources are derived from utility model.
Change in the welfare of an individual is analyzed through change in the utility of the individual. If the
utility of the individual rises the welfare (wellbeing) of the individual also improves. Given prices of the
goods and services and income of the consumer, optimal consumption of the goods or services that
maximize utility can be found in two ways (duality theory). That is through maximization of utility or
minimization of expenditure. Assume an individual consumes a vector of market commodities X=(x1, x2,
x3 ...) and a vector of non-market environmental resources denoted by Q= (q1, q2, q3 …). The
individual’s preferences for X and q are represented by ordinal utility function indifference curves
derived from the consumption of the two types of goods U(X,Q). The utility function is assumed to be
continuous, quasi-concave and non-decreasing as the consumption of both types of goods increases.
Quasi concavity assumption is for analytical convenience since it rules out corner solutions in which the
individuals are concentrated on just a few market commodities and environmental goods and services.
The market goods and services have a vector of prices P= (p1, p2, p3 …) for respective goods or services.
The environmental resources are assumed to be freely available. Another assumption is the individual
have a limited budget (income) which is ‘M’. The individual chooses and set the amount (bundle) of the
two goods that optimizes his/her utility, given the prices of the market goods and services, the fixed
income and the environmental resources. Max x U (X, Q) subject to PX≤M

Individual welfare measures of change

The models to estimate the welfare change are derived from the indirect utility function and the
expenditure function. The changes in the indirect utility function or the expenditure functions estimate the
welfare changes of the individual due to the change or proposed change. For a change in price, change in
quality/quantity of environmental good, there are two equally valid ways of describing monetary welfare
measures. These are the compensating and equivalent variations which are derived from the indirect
utility function and expenditure functions. Both ways of estimating the welfare changes considers the
change in income of the individual that can compensate or equivalent to the change.

Suppose the environmental resources quality or quantity changed from Q 0 to Q 1 where the change is
either an improvement (ΔU>0) or deterioration (ΔU <0). Then the compensation variation (Cv) and
equivalent variation (Ev) using the indirect utility function are defined respectively as follows

V (P, Q1, M−Cv) =V (P, Q0, M) Compensating variation

V (P, Q1, M) =V (P, Q0, M +Ev ) Equivalent variation

Where ‘M’ income of the individual, ‘P’ is price of the marketable goods and services, Q is the
environmental quality or quantity, ‘V’ is the indirect utility and the superscripts 0 and 1 represents the
situations before the change and after the change.

For improvement in the environmental resource, the equivalent variation measure shows the minimum
total amount of money the individual is willing to accept (WTA) to avoid the change and that makes the
individual as better as if the change has taken place. If the change had taken place the welfare of the
individual would have improved. However the welfare of the individual which is equivalent to the
welfare from the improvement of environmental resource can also be attained by increasing monetary
income of the individual where the improvement has not taken place. For deterioration in the
environmental resource the equivalent variation shows the maximum total amount of money the
individual is willing to pay (WTP) to avoid the change which affects (decrease) the indirect utility of the
individual by equivalent amount. Using the expenditure function Cv and Ev are the difference between
the money expenditure (E) functions of the individual before the change and after the change that make
the individual as better off as before, other things remaining constant.

Cv = E (P, Q0, U0) – E (P, Q1, U0) Compensation variation

Ev = E (P, Q0, U1) – E (P, Q1, U1) Equivalent variation

In the compensation variation (Cv), if the difference is positive Cv= WTP (in improvement case) and if it
is negative Cv= WTA (in deterioration case). On the other hand, equivalent variation for improvement
measures the amount of money that must be given to the individual to forgo the change and be as better of
as if the proposed change has taken place. Thus it is the minimum amount of money the individual is
willing to accept (WTA) to forgo the proposed change. For decline in the environmental resource it
measures the maximum amount of money that the individual is willing to pay (WTP) to forgo the
proposed change and be as better of as if the proposed change has taken place. In equivalent variation
case, EV is the difference between money expenditure functions of the individual before the change and
after the change that make the individual as better off as if the change has taken place, other things
remaining constant. If the difference is positive EV = WTA (in improvement case) and if is negative
EV=WTP (in deterioration case).

Hence, Cv and Ev measure the welfare of the individual for change in the environmental resources in
terms of money. WTA and WTP are the elicitation methods used to estimate the monetary value of the
welfare change due to the change. Thus, the WTA and WTP welfare measures are derived from the
compensating variation (Cv) and the equivalent variation (Ev) welfare measures. The Cv and Ev for
improvement in the environmental quality or quantity and deterioration are shown below graphically.
Assume prices of the market goods (P= 1) to easily express other goods in terms of money. Suppose we
measure other market goods on the vertical line and environmental goods on the horizontal axis. Since
income of an individual is limited, the individual will have limited budget for consumption of market
goods and consume a fixed amount of the goods x= (x −).

Figure1.1. WTP and WTA for increase in Q and for decrease in Q

6.1.3. Valuation Methods
Values of environmental goods
and services can be expressed
through their market price. Thus
we
can show the welfare effects of
change in environmental
resources through the change in
consumer
and producer surplus. However
many environmental resources
have no market. So their value
can
be elicited through market
prices of goods and services
related to the environmental
goods and
services (Revealed
Preferences) or Stated
Preferences. The Revealed
preference and stated
preference methods are the
widely used method of
valuation of environment. In
the above
discussion we have said that the
value of change in
environmental resource is
estimated using the
willingness to pay or
willingness to accept.
6.1.3. Valuation Methods
Values of environmental goods
and services can be expressed
through their market price. Thus
we
can show the welfare effects of
change in environmental
resources through the change in
consumer
and producer surplus. However
many environmental resources
have no market. So their value
can
be elicited through market
prices of goods and services
related to the environmental
goods and
services (Revealed
Preferences) or Stated
Preferences. The Revealed
preference and stated
preference methods are the
widely used method of
valuation of environment. In
the above
discussion we have said that the
value of change in
environmental resource is
estimated using the
willingness to pay or
willingness to accept.
6.1.3. Valuation Methods

Values of environmental goods and services can be expressed through their market price. Thus we can
show the welfare effects of change in environmental resources through the change in consumer and
producer surplus. However many environmental resources have no market. So their value can be elicited
through market prices of goods and services related to the environmental goods and services (Revealed
Preferences) or Stated Preferences. The Revealed preference and stated preference methods are the widely
used method of valuation of environment.

A) Revealed Preferences
Values associated with changes in environmental quality may be expressed through changes in
market behavior of related good. This market behavior may be the purchases of specific goods or
is jointly related to the environmental change. The willingness to pay is measured by using
market prices of substitutes and complementary goods and services traded through the ordinary
market.
  Hedonic Pricing: Variation in the price of housing or residential rental markets arising in part
from change in environmental quality. Prices of houses found in quality environment are
higher than prices in less quality environment, assuming that the houses are similar in other
attributes. Thus the value of environmental quality is estimated by the difference between
the prices of the houses. Methods used to evaluate such variation are referred to as “hedonic
methods.”
 Drawbacks:
- The approach is completely dependent on property values and as such has a limited
application. For example, it will not be applicable to measuring benefits relating to
national parks, endangered species, ozone depletion, and so on.
- It estimates the use value only
Travel Cost Method: The travel cost method is used to value recreational sites. This method
employs the cost of traveling to the site and entrance fee as a proxy for the value of the site
to the individual. The method measures the benefit (willingness to pay) stemming from a
recreational experience, by looking at households’ expenditures on the cost of travel to a
desired recreational site.
Drawbacks
- the application of the method is limited to the valuation of recreational sites

- visitors may go the site along their way to other site; so it is difficult take all their
expenditure on their way as their value for the site
- The cost depends on the length of time they spent at the site; thus if they stay longer at the
site the expenditure for the same site will increase.
- It measures use value only and the valuation itself is incomplete. People may still value a
Ecosystem Service Models: Changes in environmental conditions may affect industrial
production and cost. Values arising from changes in production can be considered as
responding to changes in ecological service flows. recreational area even if they themselves have
The replacement cost approach: This approach is used as a measure of benefit when the damage
that has been avoided as a result of improved environmental conditions can be approximated
by the market value of what it cost to restore or replace the damage in question.

B reveled preferences
The revealed preference approach measures only use value. However there are several attributes of the
natural environment from which individuals obtain satisfaction, and hence benefits. For
example, the value of wilderness cannot be measured only by its recreational values to current
users; it has nonuse values to the extent that there are people who are willing to pay to preserve
wilderness for future uses. Such nonuse value may not be captured by approaches that are
anthropocentric in their focus and confined to measuring the willingness to pay of resource users at a
point in time

Contingent valuation method: In the contingent valuation approach, willingness to pay is

elicited by conducting a survey. A carefully selected sample from the relevant population are
asked questions about their WTP or WTA for change or proposed change in environmental
resources. The survey is designed in such a way that individuals are faced with a hypothetical
market-like choice and are then asked about their willingness to pay for welfare Change
associated with the change in the environmental good or service. In the contingent valuation
method, the design of the questionnaire is extremely crucial.

Choice modeling /Attribute base/ methods : In contrast to contingent valuation methods,

attribute based methods divide the situation or valuation context into attributes and elicit
responses on choices of different bundles of attributes.