Chapter Six: Valuation and Cost-benefit Analysis of

Environmental Resources
• Valuation of the Environment
• Welfare foundations
6. • Dimensions of value
• Valuation methods
1

6. • Environmental analysis

2
1
 Valuation of the Environment
 The concept of valuation in the context of the environment
implies to assigning a monetary value to environmental goods
and services that are not traded in markets.
 This process is important because it allows us to understand the
economic value of environmental resources and ecosystem
services, which are often overlooked in traditional economic
analysis.
 Valuation helps us make informed decisions about how to
manage
2
and protect the environment.
 Cont…………
 If the individual prefer improved air quality to a new dress,
rationality requires her to consistently rank air quality over the
dress.
 Based on this foundation of rational choice, individuals are
assumed to be able to value changes in environmental services.
 If a change occurs such that the person believes she is better off
in some way, she may be willing to pay money to secure this
improvement.
 This willingness to pay (WTP) reflects her economic valuation
of improved environmental services.
 Alternatively, if the change makes her worse off, she might be
willing to accept compensation to allow this deterioration
(WTA).
3
Welfare Foundations
 The welfare foundations of valuation in the environment are
rooted in welfare economics, which is concerned with the
allocation of resources to maximize social welfare.
 In the context of the environment, valuation plays a crucial
role in determining the optimal level of environmental
quality that maximizes social welfare.
 An individual is assumed to have a set of preferences over
goods and services that can be ordered in a logical and
consistent manner.
 Axiomatic restrictions are imposed to define a consistent
preference ordering.
Preferences Utility Consumer
Surplus
4
 Monetary Measures for Environmental Quality Changes
Compensating Surplus Equivalent surplus

Improvement WTP for the change WTA compensation for the

occurring change not occurring

Deterioration WTA compensation for WTP for the change not to

the change occurring occur

5
 E0 E1
At A, WTP for E improvement = Q0 - Q2
Q=marketed goods is Compensating Surplus, CS
At A, WTA in lieu of E improvement =
Q1 – Q0 is Equivalent Surplus, ES
E1 E0
Q1 At B, WTP to avoid deterioration =
D Q0 - Q2 is Equivalent Surplus, ES
At B, WTA compensation for
deterioration = Q1 –Q0, Compensating
Q0 A B Surplus, CS

U1
Q2 C
U0 E=Environmental goods
E0 E1

6
Cont…
 The CS and ES show measure of welfare change due to
the change of environmental quality rather than changes in
price
 In this analysis, we can say that the non-marketed goods
and services can be evaluated in terms of marketed goods
and services.
 Since Q has a market price, the gain or forgone of a
certain amount of good Q can be changed into money
(because the WTP and WTA are measured in terms of the
quantity gain /forgone of Q).

7
Components of Environmental Value
 In the context of environmental values, the term
"components" implies the different aspects or elements that
make up the overall value that individuals or societies place
on the environment.
 Environmental values can be broadly categorized into several
components, reflecting the diverse ways in which individuals
and societies value the environment.
 These components represent the various ways in which people
perceive, appreciate, and derive value from the environment.
 Each component represents a different facet of environmental
value and can vary in importance depending on cultural,
social, economic, and personal factors.
8
 Cont…….

Total Economic Value

Use value Non-use value

Optio Indire Direct Existe Altrui Beque

n ct use use nce stic st
values values values value value values

Revealed preference methods Stated preference methods

9
 Non-use Value
 Bequest Value: The value that current generations place on
preserving environmental resources for the benefit of future
generations.
 Altruistic Value: Value of knowing that other individuals in
this generation benefit from the environmental good. The
concern for the well-being of others.
 Existence value: Environmental value that refers to the value
people place on knowing that a particular environmental
resource or species exists, even if they never use or directly
benefit from it.
 It is often associated with the intrinsic value of nature and
reflects a broader ethical or moral concern for the preservation
of biodiversity and natural ecosystems.
10
 Use Value
 Direct Use Value: The economic value derived from the
direct use or consumption of environmental resources. This
value is based on the tangible benefits that people receive.
 Indirect Use Value: Values derived from the indirect use of
the goods or services under consideration. It largely
comprises of the ecological functions such as watershed
protection and climate stabilization.
 Option Value: This component considers the value of
preserving environmental resources for future use or
enjoyment, even if their current use is not fully understood or
realized.

11
Environmental Valuation Methods
 There are several methods used to estimate the economic
value of environmental goods and services.
 These methods can be broadly categorized into two main
approaches: revealed preference methods and stated
preference methods.
 Revealed Preference Methods: These methods infer the
value of environmental goods and services based on actual
observable behavior in markets.
 Stated Preference Methods: These methods directly ask
individuals how much they would be willing to pay for a
particular environmental good or service, or how much
compensation they would require to accept changes in
environmental quality.
12
Revealed Preference Methods
 Production Function Approach: This approach estimates
the economic value of environmental resources by
examining how changes in environmental quality affect the
production process and output of firms.
 Travel Cost Method: The travel cost method estimates the
economic value of recreational sites by analyzing the travel
costs that people incur to visit them.
 Hedonic Price Method: The hedonic price method
estimates the economic value of environmental amenities by
analyzing the prices of goods that are influenced by the
quality of the environment.

13
 Stated Preference Methods
 Contingent Valuation Method (CVM): CVM involves
directly asking individuals how much they would be willing to
pay (WTP) for a specific environmental good or service, or
how much compensation they would require to accept a change
in environmental quality.
 Choice Modeling: Choice modeling is a stated preference
method that presents individuals with a series of hypothetical
choices between different environmental scenarios, each with
varying
14
levels of environmental quality and associated costs.
Travel Cost Method
 Travel costs incurred visiting a site vary across visitors.
 It is assumed that visitors react to variations in travel costs
as they would to admission fee variation.
 TC assumes weak complementarities, if site too expensive
for an individual and no visits, changes in the condition
and availability of the site do not affect the individual’s
utility.
 An individual may have non-use values regarding a site not
visited. TC cannot elicit such.
 TC can be used to estimate value of changes in quality of a
site
15
 TC Theoretical Basis
Maximise u ( x, r , q ) U=utility
subject to m  wtw x  cr X=consumption of
composite commodity
and t t w  tr r
r – visits to a recreational site
Substitute will get
m  wt x  (c  wtr )r q – site quality
Define the price of a trip as p c  wtr m – non-labour income

The first order condition is u w – wage rate

p
r
tw – time spent working
where λ is the marginal utility of money
c – round trip cost of visit
r r (m, w, p, q) P-price
is the demand function for visits tr- time spent for recreation
NOTE - the theory does not imply any particular
functional form for this demand function
16
 TC Zonal Model
 Define a set of i concentric zones surrounding the recreational
site of interest.
 Collect information on the annual number of visitors from
each zone by means of a survey.
 Calculate the visitation rate by dividing the number of visits
arising from each zone by the population of that zone.
 Using a standard value per unit distance travelled and a
standard value per unit of time calculate the return trip travel
cost from each zone.
 Estimate a regression equation linking the visitation rate (v)
 
to travel costs (c) i.e. vˆi   (ci  10)

17
Cont……….
 Use the equation to predict visitation rates with different
hypothetical entrance fees e.g. starting with 10
 Calculate total visitor numbers by multiplying the
predicted visitation rate by the zonal population and then
sum across all i zones yielding a point on a demand curve.
 Employ the same procedure to evaluate the effect of
imposing various other hypothetical admission charges to
identify additional points on the demand curve.
 The final step is to estimate the total economic benefit of
the site by calculating the area under the demand curve.

18
 TC Shortcomings
 In most TC applications travel costs are ‘researcher assigned travel
cost estimates’ and so ‘welfare estimates remain artefacts of the travel
cost accounting and specification conventions selected for imposition’.
 The determination of the opportunity cost of time spent travelling the
theoretical TC model assumes that work and travel time confer negative
utility and that individuals can choose how much they work. This would
value travel time at the wage rate. But these assumptions are not valid.
 The assignment of costs to the components of multi-purpose trips is
problematic.
 Substitute sites – a properly specified demand function for site i would
include as arguments the prices of all substitute sites. This is rarely done.

19
 TC The Individual Travel Cost Model
 Because number of trips must be Consumer surplus for i is given
a non-negative integer ITC by 
CSi e    c dc 0 1

model is estimated using a with definite integral c i

Poisson model for which  e   c 

c 
0 1 i

CSi  
Probability Density Function is   1  c c
which for β1 negative is i

e  i in  r
Pr( ri n)  CSi 
n! 1
where n = {0, 1, 2.....} and r is the
number of trips made by i. With λ as an Average CS per respondent is
exponential function of travel costs, c multiplied by the number of
i e (  0  1ci ) individuals living in the area
surveyed to determine the
The demand curve for the site is
(  0  1ci )
site’s current recreational
ri e value.
20
Hedonic Price Method
 The hedonic price method is widely-used revealed
preference valuation technique.
 HP is usually, but not exclusively, applied to the property
market within which many environmental goods are
implicitly traded.
 Households reveal their preferences for these goods through
their decision about where to locate.
 HP has been widely used to value household preferences for
noise nuisance, air quality, physical separation from locally-
undesirable land uses and the value of a statistical life.
 The hedonic price function describes the price of a quality-
differentiated commodity in terms of its quality attributes
21
Cont…..
 The hedonic price function describes the price of a
quality-differentiated commodity in terms of its quality
attributes.
 In fact the hedonic price function is the double envelope
of buyers’ bid functions and sellers’ offer curves.
 The precise shape of the hedonic price function
displayed is determined by aggregate supply and
demand for differing levels of the quality attributes
within the market.
 Offer curves show all those combinations of prices and
levels of the quality attribute that leave sellers with the
same profit.
22
 Cont……
 Bid curves show all those .
combinations of prices and
levels of the quality attribute
that leave the buyer at the
same level of utility.
 The slope of the bid function
represents the maximum
amount of money that the
individual is WTP for an extra
unit of the quality attribute.

23
 Production Function Approach
 We now consider valuation techniques in which the level of
environmental quality is an argument in firms’ production
functions.
 We consider the welfare impact of both marginal and non-marginal
changes in the level of environmental quality.
 The firm minimises cost=wz where w is the price of inputs and z is
the quantity of inputs.
 This is subject to the production function constraint q ( z , e) q
 q is output and e is environmental quality, and dq/de>0.
 This results in a series of conditional input demands for z.
 The optimised value of the function is the cost function c(w,q,e).

24
 Cont……….
 The contribution to social welfare arising from the production and
consumption of the good is given by W q p(q)dq  c( w, q, e)
0
 Taking the derivative of this expression with respect to the level of
environmental quality gives We  c( w,eq, e)
 This says that the value of a marginal improvement in
environmental quality is equal to the negative of the change in
production costs.
 This is equivalent to multiplying the change in production by the
price of output W  p q( z, e)
e e
 In the case of non-marginal changes in the level of environmental quality the
change in welfare is given by q1 q0
W  p(q)dq  c( w, q1 , e1 )   p(q)dq c(w, q , e )
0 0
0 0
In order to compute the welfare impact of non-marginal changes it is necessary to know the
effect of the change in production costs on the equilibrium level of output .
25
Contingent Valuation Method (CVM)
 CV is a survey stated preference technique
 CV can measure both Use and Non-use values
 CV provides theoretically correct WTP and WTA measures of
utility change
 CV is the most widely used valuation technique
applications
 air and water quality improvement
 preservation benefits of wilderness
 benefits of outdoor recreation opportunities
 benefits of reduced transport risks
 benefits of improvements in public utility reliability
 environmental damages
26
 The steps involved in conducting a CV study
Creating a survey instrument (i.e. questionnaire).
 identifying possible uses of and attitudes towards the environmental goods
 constructing the hypothetical scenario,
 deciding whether to ask about WTP or WTA,
 determining an appropriate payment vehicle,
 selecting an appropriate elicitation method
 collecting auxiliary information about the respondent.
Choosing an appropriate survey technique.
Identifying the population of interest and developing a sampling
strategy.
Analysing the responses to the survey.
Aggregating the WTP or WTA responses over the population of interest
Evaluating ex-post the success (or otherwise) of the CV exercise.
27
 CV - Creating the Survey Instrument
 Explanation of the purpose of the exercise
 Questions about respondent’s knowledge and attitudes
 Description of problem
 Description of project to address problem
 Statement of payment vehicle
 Reminders about substitutes and income constraints
 Ask about WTP (usually) via one of elicitation methods
 Follow-up questions ( to identify protest bids etc)
 Questions about respondent characteristics
28
 CV Elicitation Methods
 Open ended: ask ‘what is your maximum WTP for...?’
Avoids giving respondents cues, but difficult for them
 Bidding game: the respondent is asked if WTP a
sequence of increasing amounts until says ‘no’.
 Payment ladder: the respondent is asked to tick amount
would be WTP, cross amounts not WTP.
 Single bounded dichotomous choice: tell respondent if
referendum supports project it goes ahead and costs each
$x, which is varied across respondents.
 Double bounded dichotomous choice: if respondent
says
29
‘yes’ to $x, $x + $y? If ‘no’ to $x, $x - $y?.
 CV Analysing Responses
 The statistics of interest are the mean and the median WTP/WTA.
 Usually estimated after elimination of protest, and other
problematic, bids
 Appropriate method for analysis depends on how responses
generated elicitation method
 For open-ended questions , use a spread sheet
 For referendum dichotomous choice questions
 Parametric Estimation
Random Utility Model RUM and Random Expenditure Function
REF
 Non-parametric Estimation, The Turnbull estimator
30
 CV Reliability and Validity
 Establishing the success or failure of a CV study involves
weighing evidence of various kinds but there is usually no
entirely satisfactory way of validating the results.
 Face validity – does the survey ask the right questions about
the right scenario?
 Criterion validity compare with actual referendum outcome
 Convergent validity compare with results from another
valuation method
 Theoretical validity estimate a bid function ( a regression
equation) with arguments that explain the bid. Do the
coefficient signs agree with theory/expectations? Is, eg, WTP
positively related to income?
31
CV Types of Bias and Problems
 Part – whole bias  Sequence effects

 Hypothetical bias  Information bias

 Insensitivity to scope
 Interviewer bias
 Prominence bias
 Temporal embedding
 Strategic bias
 Starting point bias

32
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
33
 CE Conducting
 A CE involves many of the same steps involved in a CV
 Identifying a target population whose values are to be measured
 Developing the survey instrument using focus groups and a small-
scale pilot survey.
 Additional issues specific to CEs are.
 Enumeration of attributes
 Selection of levels for attributes at least two
 Full factorial design – all possible attribute levels
 Fractional factorial design – a subset of all possible combinations
 Randomly select from designs to create choice sets
 How many choice experiments in one interview?
34
 CE Analysing the Data
.CE survey data is analysed using the Random Utility Model (RUM).
This model assumes that respondents have consistently selected those
alternatives conferring the highest level of utility. If individual i chooses
choice g out of j=1,..,J alternatives it must be that: u u j  g
ig ij
Where u is the utility associated with the choice. If we further
assume that utility comprises a deterministic component v and a
stochastic component e then we can write: vig   ig vij   ijj  g
The error term ε is to account for unobservable variations in taste. If
it is also assumed that the error term follows the Gumbel
distribution (also known as the Type I Extreme Value distribution)
then the probability that individual i will select choice g out of the J
alternatives is given by Pr( j  g ) 
exp(v )
J
ig

 exp(v )
j 1
ij

35
 CE Problems and Extensions
 The most widely recognised drawback of CEs compared to
CV is that the former place greater strain on respondents’
cognitive abilities.
 The danger is that respondents then resort to simple rules of
thumb as a way of ‘solving’ the CE puzzle confronting them.
For example, individuals might choose on the basis of just
one attribute.
 Respondents might even select one alternative over another
regardless of its attributes.
 This frequently happens when a name or label naturally
appends to a particular alternative e.g. “the status quo
alternative” or “the environmentally friendly choice”.
36
 Cont…….
 Asking individuals about only their most preferred option is
potentially wasteful especially in view of the cost of
conducting interviews.
 If individuals can rank the alternatives giving their first,
second and subsequent choices it is possible to conduct a
Contingent Ranking (CR) experiment.
 A CR experiment is like a sequence of CEs with the first
choice being made from J alternatives; the second from the
remaining J-1 alternatives; the third from the remaining J-2
alternatives etc.
 CR experiments increase further the cognitive effort required
of the respondent and the choices may not always include the
status quo.
37
Environmental Analysis
 Environmental Analysis (EA) or Environmental Impact
Assessment (EIA) is the information gathering and analytical
process that helps to ensure environmentally sound
development.
 The EA process attempts to identify potential problems so
that economic feasibility (and environmental impact) of
alternative approaches can be assessed while there is still time
to make changes.
 As such, EA complements the conventional package of
engineering, socioeconomic, and financial and economic
analyses and provides practical advice to planners.
38
 Cont……..
 EIA consider environmental matters early in the project planning
process.
 The EIA process identifies, predicts, interprets and
communicates information about impacts of a proposed project.
 It seeks ways to maximize the societal benefits of a project.
 It examines alternative ways of carrying out a project.
 It provides a framework for gathering and documenting public
and external knowledge and opinion.
 It empowers decision-makers to make informed and
environmentally sound choices.
39
 The Main Advantages and Benefits of EIA are:
 Lower project costs in the long-term
 Increased project acceptance by the public and key
stakeholders;
 Improved project design;
 More informed decision-making;
 More environmentally sensitive decisions;
 Increased accountability and transparency during the
development process;
 Improved integration of projects into their environmental and
social setting;
 Reduced environmental damage
40
The Contents of an Impact Assessment
 Description of the project, focusing on possible sources of
environment impacts;
 Description of the environment situation before the implementation of
the project;
 Analysis and prediction of environment impacts resulting from the
project;
 Comparison / evaluation of environmental conditions with or without
the project;
 Out coming of mitigation measures needed to minimize adverse
impacts.
41
Environmental Assessment and the Project Cycle

Preparation
Identification Detailed Design

Completion Appraisal

Supervision Negotiation

Implementation
Loan Approval

42
 Action Stage Outcome
Review of projects to Assess if an Screening Decisions to proceed with
EIA is Necessary environment assessment
Identification of Major Scoping Potential and/or impacts of project
Environmental impacts of project to assessed and evaluated

Assessment of impacts, and Impact Magnitude and significance of

identification of Mitigation measures, Prediction and impacts and mitigation or
and Alternative options Evaluation enhancement measures

Preparation and consultation of draft Drafting of Environmental Impact Statement

and final EIS Environmental
Impact
Statement

Public and statutory Review of EIS, Review and Yes or no to project

and Decision on whether to Proceed Decision
Making
Monitoring of key Environmental Environmental Public reports (part of
variables, and auditing against Monitoring & environmental management
Auditing system

43
Project Decision
 There are many criteria that are frequently used to
evaluate the feasibility of a project.
 The two common criteria are the benefit-cost ratio and the
net present value (NPV) criteria.
 The decision rule for the former criterion implies that an
activity should be undertaken if the ratio of the present
value (PV) of benefits to PV of costs exceeds one.
 The decision rule for the second criterion implies that an
activity should be undertaken whenever the present values
of net benefits (NPV) is greater than zero.
44
 Cont……….
The present value of expenditures E is PV E  E1  E2  ...  ET
E 0
1  i  1  i 
2 T
1 i
R1 R2 RT
The present value of receipts R is PVR R0    ... 
1  i 1  i 2 1  i 
T

T T
RT Et
The present value of the project is NPV PVR  PVE    1i
1  i   
t t
0 0

N1 N2 NT
Which for N = R - E is NPV  N 0    ... 
1  i 1  i 2  
1  i
T

NPV including environmental cost

The project should go ahead if NPV≥0

45