Guidance for Environmental Economics
Environmental economics is the application of microeconomic tools to environmental problems. These include an analytical framework for describing or modeling the economic conditions out of which environmental problems arise. These conditions are called externalities (i.e., when parties involved in a market transaction impose costs on others that are external to [not involved in] the transaction). For example, a factory in a neighborhood produces and sells goods but also fouls the air for nearby residents. This externality implies an external cost that is not borne by the factory or its customers but is shifted to the residents who incur health and welfare costs associated with breathing polluted air.
The optimal solution, from an economic perspective, must take into account both the burden of pollution on the community and the value of the output generated by the factory. At first glance this may seem unfair to the neighbors. However, consider the case of road noise pollution. The obvious way to ensure silence near large roads is to ban all traffic except for bicycles and pedestrians. Similar statements could be about safety; an expedient way to stop all loss of life in automobile accidents is to ban driving. Because most activities that have some undesirable consequences also have some value to society, either extreme is in some way detrimental to society. Thus, the solution must include trade-off(s).
One purpose of economic analysis is to tabulate trade-offs in an explicit way by putting monetary values on the harm done to the community and the environment, as well as the cost to the factory, the government, or others associated with mitigating the harm. If the cost to society of a specific plan for mitigating harm is greater than the harm itself (e.g., banning driving), that form of mitigation is not justifiable from an economic perspective. Monetization of the harm incurred from externalities is necessary to make this explicit.
Critics of environmental economics may argue that it puts the environment at a disadvantage because the costs of mitigation can often be easily expressed in monetary terms while the harm cannot be expressed that way (e.g., the value of the loss of a species). Economists might respond that attempting to place a value on the environment can often be more helpful than not. Moreover, environmental economic analysis is just one of several inputs to decision making. Other inputs, such as equity and political considerations, will also influence decisions.
Cost-benefit analysis (CBA) is a formal framework for comparing harm with the cost of mitigating harm. In CBA, explicit and implicit costs associated with pursuing a course of action are all included in making a decision. Costs can be in dollars or opportunity cost (i.e., the value of the next best use of the time and resources involved). Benefits for the purposes of CBA are all of the positive gains for society associated with a course of action, whether they are naturally expressed in monetary terms or not. This can become confusing because eliminating an external cost (e.g., the burden of pollution) is considered a benefit. To avoid this confusion, costs are considered everything that is given up associated with a policy or an investment; any benefits are all positive consequences for society. In making decisions about policies or investments that are not motivated by an environmental purpose, such as the addition of a runway at an airport, environmental consequences are typically considered costs.
The scope of a CBA is society at large. Ideally, geographic or categorical boundaries are only those determined by the scope of the expected impact of a decision. This means that government, individuals, and businesses, as well as natural or environmental amenities valued by society, should all be included in the analysis. Similarly, the timescale for the analysis should, as much as possible, encompass the full length of time over which costs and benefits occur. In general, benefits of environmental policy or investment take the form of harm avoided but may also provide other indirect positive outcomes for society. The U.S. Environmental Protection Agency notes that these benefits should be handled on an “effect by effect” basis (EPA, 2000, p. 59). Costs typically include private compliance costs (for regulation), government investment costs, government regulatory costs, social welfare losses (impacts that result in higher prices), and tran-
sitional costs associated with regulation (which may include job losses and other consequences) (EPA, 2000, p. 16).
Other types of economic analysis commonly used to inform policy and public investment decisions include distributional analysis and cost-effectiveness analysis. Cost-effectiveness analysis tabulates costs associated with different methods of accomplishing a specific goal. This may be an appropriate tool if all methods being considered result in very similar outcomes. Otherwise, “cost-effectiveness analysis does not necessarily reveal what level of control is reasonable, nor can it be used to directly compare situations with different benefit streams” (EPA, 2000, p. 178). Distributional analysis, which might also be called economic impact analysis, differs from CBA in that it focuses primarily on costs and on different segments of society, rather than on society as a whole. Equity assessment is a variant that focuses on impacts on vulnerable segments of society (EPA, 2000, p. 20).
Explicit direct costs are usually easy to capture monetarily, because they are included in the budget for the investment and its maintenance or the ongoing costs of enforcement and monitoring of a regulation. Broad social costs are typically easier to monetize than benefits because they may include an increase in production costs for firms, prices for consumers, or other factors that can be readily monetized.
Measuring the benefits of environmental policy or mitigation investments requires first understanding the direct physical impacts of the policy or investment, whether measured in tons of effluent, decibels, wildlife population, or any other direct environmental metric. For many types of environmental impact, the metric may require further analysis to translate it into relevant consequences, such as increased incidence of cancer or asthma as an impact for airborne emissions. In the case of noise, the initial physical impact may be on a geographic area; but it becomes relevant to a CBA when population exposure is involved.
Once the impact has been described, it can be monetized. EPA guidelines state: “To the extent feasible, and warranted by their contribution to the results, as many of the effects of a policy as possible should be monetized. This enhances the value of the conclusions to policy makers weighing the many, often disparate consequences of different policy options and alternatives” (EPA, 2000, p. 176). Thus, the rationale for monetizing environmental impacts is to put them in terms that can be compared to the cost of policies to improve environmental quality or the benefits of actions that cause environmental harm.
Projects and actions often have different environmental effects (changes in noise level, air quality, climate, water quality); thus, another reason for monetizing these changes is so they can be compared with one another. Comparing noise annoyance and sleep awakenings with the incidence of asthma or cardiopulmonary disease and the long-term harm of climate change can be difficult. However, ultimately these comparisons must be made, and making an attempt to quantify these effects in a single comparative measure (typically monetary), while carefully accounting for uncertainty in the estimates, can be a valuable aid in decision making.
The applicable economic concepts of value for environmental benefits are (1) willingness to pay (WTP) for environmental improvements and (2) willingness to accept (WTA) compensation to endure degraded environmental quality (EPA, 2000, p. 60). WTP and WTA are not necessarily equal. Both are based on how society feels about particular environmental amenities, whether in the form of nuisance, health, aesthetics, existence (of species or natural feature), or legacy value for future generations. In CBA, environmental features are not valued in themselves; they derive their value from how highly society values them.
An estimate of WTP for environmental improvements varies by the nature of the impact associated with the improvement. An environmental amenity has “use value” when the environmental feature interfaces with relevant members of society—the interfaces may be direct or indirect, as well as market or nonmarket (meaning a transaction takes place or does not) interfaces (EPA, 2000, p. 70). Nonuse value includes “existence value,” when society derives value from knowing an environmental amenity exists, and “legacy value,” when society values knowing that an environmental amenity will be available to future generations (EPA, 2000, p. 71). Typically, because use values are associated with direct interactions with the environment, they are easier to monetize.
Monetization methods can be divided into three categories: (1) market methods, (2) revealed preference, and (3) stated preference (EPA, 2000, p. 72). When a good is traded in a market, the market prices, as well as supply and demand curves, are used to value it, consistent with microeconomic principles. Even when a good or environmental amenity is not directly traded, there may be data on actual market transactions that can be used to infer WTP for it. A relevant example is lower housing values in areas with high noise compared to values in areas with lower noise.
Among the many types of revealed preference techniques, hedonic analysis is the most relevant for noise (EPA, 2000, pp. 73–83). Hedonic analysis attempts to statistically decompose the market price of a good into the segments of that price associated with features or characteristics of the good using regression analysis (EPA, 2000, p. 77). For instance, if two cars are identical except for color, but the market price of a red car is $1,000 more, society has WTP of $1,000 for red. In environmental noise studies, the relevant market data that drive the analysis are real estate transactions. Controlling for other property characteristics, the difference in price or rent between a quiet property and a noisy one reveals the value a community places on quiet.
Stated preference methods range from survey techniques to constructed market techniques that attempt to incorporate perceived economic gain and loss to make survey results more plausible. For example, one might survey residents in different noise environments to find out how much they
would value a reduction in noise compared to a more easily valued benefit (like a reduction in property taxes).
More than one monetization technique is used in a particular CBA because any survey may generate a collection of distinct use and non-use benefits. The benefits to a community associated with a reduction in road noise are typically use-oriented, nonmarket benefits (due to the direct experience of noise or quiet). Because market transactions can be used to infer the WTP for quiet versus noise, the road noise example is a good candidate for revealed preference methods.
Two other valuation methods may be considered relevant to the road noise problem. The first is known as the averting behavior method (EPA, 2000, p. 70), the cost people are willing to incur to defend against a particular environmental problem—for instance, wearing a filter mask when walking outdoors in a city with especially polluted air. In the case of road noise, this might be voluntary installation of sound insulation by a homeowner. The drawback of this method is that unless there are continuous, incremental opportunities, people will not be able to spend up to a level that expresses their true WTP.
The second alternative to hedonic analysis would be using either a hypothetical or government cost to purchase and install sound insulating material for homeowners (e.g., the Federal Aviation Administration Residential Sound Insulation Program). Because in either case the material would not be voluntarily paid for by the homeowner (if it were, it would be averting behavior), the price is even further disconnected from the actual WTP than the averting behavior technique because there is no evidence that the homeowner values quiet as highly as the cost of installing sound insulating materials.
Benefits transfer is the technique of applying benefits valuation estimates from past studies to new analyses (EPA, 2000, p. 85). However, given potential variations among communities, this technique should be used with care—although it should not be ruled out. Sometimes, budget constraints or the lack of relevant local data may make carrying out hedonic studies unrealistic. In that situation a benefits transfer analysis that takes into account uncertainty is preferable to no benefits study at all.
Both the EPA (EPA, 2000, p. 27) and the Office of Management and Budget (OMB, 1992, p. 10) guidelines cite the importance of being explicit and detailed in describing the sources and nature of uncertainties in an analysis, whether the uncertainties are about outcomes in the future or estimates of variables or parameters used in the analysis. Both EPA and OMB also suggest sensitivity analysis. EPA describes the use of probabilistic approaches such as a Monte Carlo analysis, as well as looking for “switch points” for important inputs to a CBA. For instance, if a CBA study were carried out using benefits transfer and a positive gain to society was found, a switch point would describe how much lower the community’s values would have to be relative to the community in the original study of benefits to reverse the conclusions of the study.
Beyond calculating benefits and costs on an effect-by-effect basis, and monetizing, there are a host of tabulation issues that must be handled sensitively, some of which may also be sources of uncertainty. To the extent that benefits and costs are incurred in streams across time, a discount rate must be applied to reduce future dollars into current dollars (because a dollar is worth more now than later). Inflation also has to be handled consistently to ensure that all final results in the analysis are present in the same constant-year dollars.
Although the trade-off of dollar values in the future for dollar values today over a time period within the current generation may be a small source of uncertainty, crossing generations introduces even more uncertainty (EPA, 2000, p. 48), partly because of the nature of the net present value calculation to carry out the discounting. The farther into the future an outcome is, the less it is worth. Mathematically, the differences can be dramatic, making it appear that society places almost zero value on consequences for our grandchildren’s grandchildren. EPA suggests doing a sensitivity analysis on the discount rate itself, including a presentation of a case with a zero discount rate, to address this problem. This particular guideline is more relevant for climate change studies than for noise, which has immediate effects. However, it does provide some perspective on uncertainty potentially relevant to highway studies. In the face of the enormous uncertainty about how to analytically trade off our own well-being against future generations, variations in a community’s value of noise and variances within the statistical estimates may not seem so daunting.
EPA. 2000. Guidelines for Preparing Economic Analyses. Available online at http://yosemite.epa.gov/ee/epa/eed.nsf/webpages/Guidelines.html.
OMB (Office of Management and Budget). 1992. Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs. Circular A-94. Washington, DC: OMB. Available online at http://www.whitehouse.gov/omb/circulars/a094/a094.pdf.