Environmental Valuation II (Module 4)

Introduction

Environmental resources impart a complex set of values to individuals and various benefits to society. Environment valuation is based on the assumption that individuals are willing to pay for environmental gains and conversely, are willing to accept compensation for environmental losses. Individuals demonstrate preferences, which, in turn, place values on environmental resources. Environmental economists have developed a number of market and non-market-based techniques, based on the preferences, to value the environment.

These preferences can be either revealed preferences or stated preferences.

(I) Revealed Preference Methods or Surrogate Market Methods

In the absence of clearly defined markets, the value of environmental resources can be derived from information acquired through surrogate markets. The most common markets used as surrogates when monetizing environmental resources are those for property and labour. The surrogate market methods discussed below are the Hedonic Price method and the Travel Cost method.

a. Hedonic Pricing Method

The Hedonic Price method is based on consumer theory, which seeks to explain the value of a commodity as a bundle of various characteristics. Market goods are often regarded as intermediate inputs into the production of more basic attributes that the individuals really demand. It is based on the more general land value approach which decomposes real estate prices into components attributable to different characteristics like pollution, accessibility, proximity to schools, shops, parks, etc. The method seeks to determine the increased WTP for improved local environmental quality, as reflected in housing prices in cleaner surroundings. It assumes a competitive housing market, and its demands on information and tools of statistical analysis are high.

Multiple regression analysis is used to identify how much of a property differential is due to a particular environmental difference between properties. It has been found through several studies that multiple regression analyses in such cases over estimate the benefits by 2 to 3 times. The problem here is that most households are not aware of the costs or benefits of an environmental attribute and hence don’t know it when they adjust their residential locations due to a particular attribute.

Issues that arise while employing regression analysis in Hedonic Pricing Method:

• The choice of variables.
• The presence of multicollinearity (a statistical phenomenon in which two or more independent variables in a multiple regression model are highly correlated).
• Omitted variable bias (an independent variable that should be in the model is ignored).

b. Travel Cost Approach

The Travel Cost method is a method which attempts to deduce values from observed (i.e., revealed) behaviour. has been used to measure the value of an ecosystem used for recreational purposes, by surveying travellers on the economic costs they incur (time, out-of-pocket expenditures) when visiting the site from some distance away.

It determines the WTP for access to the recreational benefits provided by the site, as a function of variables like consumer income, price, and various socio-economic characteristics. The price is usually the sum of observed cost elements like a) entry price to the site; b) costs of traveling to the site; and c) foregone earnings or opportunity cost of time spent. The consumer surplus associated with the estimated demand curve provides a measure of the value of the recreational site in question. More sophisticated versions include comparisons across sites, where environmental quality is also included as a variable that affects demand.

The estimation of recreational benefits can be done through –

1. Continuous variable specifications where the number of visits to a site is the dependent variable and the household characteristics are the independent or explanatory variables.
2. Discrete variable specifications where the values are restricted to a predefined set and not all characteristics of a household are taken into account.

The issues that arise with Travel Cost approach are:

• Value attached to time – Estimated betas and estimated variables are highly sensitive to time.
• Truncation Bias – Estimated demand equation is based on data based on the household that visited the site while the households that did not visit the site are ignored.
• Limited in application – Captures only direct recreational benefits, and only when there are measurable travel costs.
• Difficult to separate the effects of different factors, eg. Landscape beauty and proximity to the ocean.
• Does not measure non-use or intrinsic values, nor commercial values.

(II) Stated Preference Methods or Non Market Methods

Stated Preference Methods seek to measure individuals’ value for environmental goods directly, by asking them to state their preferences for the environment. Unlike Revealed Preference Methods, these are used mainly to determine non-use values of the environment such as existence value, altruistic value and bequest value since these values do not turn up in any related markets. The importance of existence values was placed in the spotlight by John Krutilla’s seminal work “Conservation Reconsidered” (1967). Krutilla pointed out that certain “grand scenic wonders” and “unique natural environments” might be valued even by those who did not directly benefit from them.

Economists have traditionally been wary of stated preference methods to derive non-use values since there is wide scope for misreporting. Also, theoretically, practically everyone can claim to derive non-use values from a given environmental good. In practice however, it has been shown that the application of rigorous standards can go a long way in ensuring accuracy. The two most important (and rigorous) of these methods is the Contingent Valuation Method (CVM) and Choice Experiments (CE).

a. Contingent Valuation Method (CVM)

Contingent Valuation Method (CVM) was first used by Davis (1963) in a study of deer hunters in Maine. The CVM method to ascertain non-use values first came into the public spotlight in a significant way with the Exxon Valdez disaster of 1989. The National Oceanic and Atmospheric Administration (NOAA) of the US constituted a panel with Nobel laureates Kenneth Arrow and Robert Solow to determine whether CVM was a reliable way to ascertain lost existence values in the accident. Using the recommendations of the panel and several others, the NOAA conditionally accepted CVM as reliable, subject to elaborate guidelines for its use. Eventually an out-of-court settlement of 1.5 billion dollars was reached but a state-of-the-art CVM study pegged lost existence values alone at 3 billion dollars (Carson et al., 1992).

Most CVM exercises can be split into five stages (Hanley, Shogren and White, 2001):

Setting up a hypothetical market: This step consists of “framing” the environmental good by describing what exactly is at stake (say the destruction of an endangered species of plant due to excessive use by forest-dwellers), deciding how it would be remedied (placing a ban or limits on its use), calculating the costs entailed (resettling the forest-dwellers, providing them with alternate livelihoods) and deciding how funds would be raised (through taxes, trust fund payments).

Obtaining bids: This involves conveying the previous information to the respondents, preferably through personal interviews, and eliciting their WTP/WTA. Other information collected includes socio-economic data of the respondent and some de-briefing information. WTP/WTA information can be obtained by asking an open-ended question (respondents are asked their maximum WTP) or by a referendum-type question where respondents either answer yes or no in response to a particular payment amount. Referendums are most common.

Estimating WTP: For open-ended responses calculating mean or median WTP is simple. For referendums the WTP has to be estimated since the respondent does not reveal her maximum amount only whether or not she is willing to pay a given amount. Several approaches may be used which are beyond the scope of this article.

Aggregating the data: The mean bid or bids for the sample population must be converted into a population total value figure. This involves deciding who counts in the study – the local population, regional, national etc. Secondly is choice of the time period over which benefits should be aggregated. Here we are confronted with the limitations of using current preferences to estimate future preferences and the equity implications of discounting.

Carrying out validity checks: Several tests are carried to ascertain the robustness of the WTP figure obtained such as scope tests (is the scope of environmental change accurate?), convergent validity (is the WTP comparable to figures obtained from other methods?), are protest rates too high (those against putting a monetary value on the environmental good in question) etc.

Portney (1994) lists seven stringent guidelines issued by the NOAA (National Oceanic and Atmospheric Administration) to ensure that CVM is not misused to make offenders pay much than is fair. Some proponents of CVM were unhappy with this saying it would more often than not lead to an “underestimation” of lost existence values. Opponents of CVM claimed that CVM was altogether too arbitrary a method to give any reasonable estimate regardless of guidelines. Nevertheless CVM has become the most widely used estimate for non-use values of environmental goods owing to its simplicity, flexibility and cost-effectiveness.

The various issues that arise with the CVM method are:

• Hypothetical Bias – Difference in actual willingness to pay and willingness to pay revealed in a survey arising from the fact that in actual markets purchasers suffer real costs, while in surveys they do not.
• Information Bias – Distorted evaluation of information.
• Strategic Bias – Causes survey results to differ from actual willingness to pay because individual have an incentive to not reveal the truth because they can secure a benefit in excess of the costs they have to pay. This arises from the free rider problem.
• Discrepancy between WTP and WTA
• Choice of response mode – Open ended or closed questions, protest answers, ignoring income constraints etc.
• Voluntary versus Forced payments – Compensation issues.

b. Choice Experiments (CE)

In a choice experiment, individuals are given a hypothetical setting and asked to choose their preferred alternative among several alternatives in a choice set, and they are usually asked to perform a sequence of such choices. Each alternative is described by a number of attributes or characteristics. A monetary value is included as one of the attributes, along with other attributes of importance, when describing the profile of the alternative presented. Thus, when individuals make their choice, they implicitly make trade-offs between the levels of the attributes in the different alternatives presented in a choice set. This enables the researcher to derive the value of each of the different attributes of a particular alternative (Alpizar, Carlsson and Martinsson, 2001). CE involves considerable effort in the design of relevant scenarios with appropriate attributes and in the use of statistical methods.

Using CE, the WTP for specific “attributes” of the proposed environmental change or alternative can be derived. This disaggregation allows for the possibility of compensating the some attributes of the situational change in kind and others monetarily (Adamowicz et al., 2005). CE also enables much greater accuracy in framing the final alternative.

There are three important advantages that CE has over CVM (Alpizar, Carlsson and Martinsson, 2001): (i) reduction in some of the potential biases of CVM (ii) more information is elicited from the respondent compared to CVM and (iii) the potential of testing for internal consistency. The only major disadvantage of CE is that is it far more complex and expensive to administer compared to CVM.

(III) Other methods

Dose Response based Valuation

This is an indirect procedure of valuating environmental costs and benefits. Dose Response method analysis the relationship between say, pollution and an effect it has, for instance, health effects. It is the process of characterizing the relationship between the dose of an agent administered, and the occurrence of an adverse health effect amongst the exposed. The incidence of the effect is then estimated as a function of human exposure to the agent. ‘Dose’ indicates the amount of the agent while ‘response’ refers to the effect of the agent once administered. Dose-response relationships are determined graphically by determining the effect of varying the administered dose on the response. Generally, increasing the dose of a harmful agent will result in a proportional increase in both the incidence of an adverse effect as well as the severity of the effect. Dose Response method is usually administered when the exposed population is unaware of the effects of pollution because it is not direct; it is also employed in developing countries where there is lack of data for such valuation methods.

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Benefits Transfer

As valuation exercises are costly, researchers need some means of estimating non-market benefits without always having to undertake an individual study. Benefits Transfer is looked at as a way to make environmental valuation a standardized component of environmental Cost Benefit Analysis for policy making and environmental management. Benefits Transfer mainly works by taking estimates from one or more original studies, and transferring the results to a new context by adjusting for two factors: (a) differing socio-economic characteristics of beneficiaries, and (b) differing environmental characteristics of the two different contexts. There are two main approaches to benefit transfers:

1. Transfer of adjusted mean WTP values eg. Fishing – average mean WTP per fishing day.
2. Transfer of benefit functions, eg. Transfer bid curves estimated from other studies.

Usually, a meta-analysis (a statistical analysis of past valuation studies) is carried out. The transfer error is usually between 20-40% for the first method (absolute transfer error) and can go up to 228% for the second method (benefit function transfer error).

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Conclusion

Environmental valuation techniques are primarily driven by the principle that individuals are self-interested and demonstrate preferences that form the basis of market interactions. Existence values are not demonstrated in the marketplace and are at least somewhat based on unselfish motives making them problematic to environmental analysts. To quantify existence values accurately within the framework of environmental valuation is difficult; for example revealed preference methods, such as the travel cost method and hedonic pricing methods, measure the demand for the environmental resource by measuring the demand for associated market goods. Existence values are not adequately captured using these methods. Existence values are best revealed through surveys of individual willingness to pay for the environmental resource or willingness to accept compensation for environmental losses.

References

1. Portney, Paul R., The Contingent Valuation Debate: Why Economists Should Care. The Journal of Economic Perspectives, Vol. 8, No. 4, pp 3-17, 1994.
2. Cropper M., Has Economic Research Answered the Needs of Environmental Policy?. Journal of Environmental Economics and Management, Vol. 39, pp 328-350, 2000.
3. Pearce D., Cost Benefit Analysis and Environmental Policy. Oxford Review of Economic Policy, Vol. 14, No. 4, pp 84-100, 1998.
4. Markandya A., The value of the environment: a state of the art survey, The Earthscan reader in environmental economics, 1992
5. Kolstad C., Chapter 16 in Environmental Economics, 1999.
6. Hanley, N., J. Shogren, and B. White. Chapter 11 in Environmental Economics in Theory and Practice, 2007.
7. Adamowicz, Wiktor et al., Stated Preference Methods for Measuring Passive Use Values: Choice Experiments versus Contingent Valuation. Staff Papers, University of Alberta, 1995.
8. Alpizar F., Carlsson F. and Martinsson P., Using Choice Experiments for Non-market Valuation. Working Papers in Economic Issues, Vol. 8, pp 83-110, 2005.