Environmental Economics The Agrofood Chain, Unit S2M18 Alban THOMAS thomas@toulouse.inra.fr

1. Environmental EconomicsThe Agrofood Chain, Unit S2M18Alban THOMASthomas@toulouse.inra.fr

2. Course outline 3 – Resource use and pollution, key instruments for public policy 3.1 – Natural resources as production inputs or « not-so-basic » commodities 3.2 – Valuating amenities from natural resources and the environment 3.3 – A typology of pollutions and environmental damages 4 – Environmental and economic policies – Applications to agriculture and agrofood chain 4.1 – The need for regulating pollution and water use 4.2 – Welfare and abatement cost, a production-side approach 4.3 – Evaluating and regulating agrofood industrial emissions 4.4 – Regulating irrigation and emissions from agriculture

3. 3 – Resource use and pollution, key instruments for public policy Purpose: The link between human activity and the environment Definition of environmental values Typology of environmental damages Introduction to Cost-Benefit Analysis (CBA) Which policy instruments for which damages ? Keywords: Point and Nonpoint source pollution Environmental valuation Cost-Benefit Analysis Pigovian tax

4. 3.1 – Natural resources as production inputs or « not-so-basic » commodities «Anthropic » (man-oriented) vision : natural resources are used for production and consumption activities  The environment is considered a « service supplier » or a « good supplier »  Environmental damage is defined as a lack of services from the environment First step: define environmental goods and services supplied to producers, consumers,…

5. Environmental goods and services can either be Directly supplied (depend on location): - air quality - landscape beauty Note. Lack of such services are unavoidable damages: - acid rain, contaminated soils Supplied through production activities: - productive eco-systems: agriculture, fishery - production inputs: agro-food industry, tourism Supplied through consumption activities: - food quality - recreational activities (natural parks, etc.)

6. Value types of environmental services: • A/ Use values (related to economic activities, incurred damages) • direct use (consumption of a natural resource) • indirect use (environmental service, e.g., recreative fishing) B/ Nonuse values (passive values) - are not used but would be considered a loss if they disappeared - existence value (Bengali tiger) - legacy value (legacy to future generations) C/ Option value - for future use (consumer himself or future generations) - may be purely hypothetical (a new drug discovery from a remote environment)

7. TOTAL ECONOMIC VALUE (TEV) Use values Non-use values Direct values(goods) Indirect values (services) Option values Existence value Legacy value Value that may appear ultimately(pharmaceutical use,…) Knowing that the Pyrénées Brown Bear will survival (while never seeing him) Knowing that «something» will remain available for future generations Forestry firm,Agriculture,Fishery… Recreational activities, soil stabilisation…

8. 3.1.1 Value of environmental goods for production activities Producer: maximise profit under several constraints - economic constraints (input and output prices) - technical constraints (technology) - environmental constraints (state of the environment) Principle of valuation: Environmental constraint is a constraint like others  differences in environmental conditions indicate differences in profit  value of an environmental good: measured by its effect on firm’s profit

9. Example : agrofood production unit involving water input, own private well (W) quality requirements for W other inputs (X): assumed fixed Quality of water input W is random Assume bad quality of W occurs with some positive probability π Possible substitute for W: Z, with non-random quality

10. Technology Quality requirement Output price Input prices Value of environmental condition: change in expected profit / change in proba.

11. General framework: Comparative statics • Important: a change in environmental conditions (quality of inputs, …) • is affecting production conditions • Change in production cost • Change in output supply / output price ? Depending on market structure

12. For production activities, the value of environmental services can be inferred from (observed) production behaviour Changes in expenditure (production cost) are due to the need to substitute other inputs for changes in environmental conditions (quality) Hence, even if changes in environmental conditions are unobserved, the indirect value of environmental quality can be inferred because firm output is marketed Examples: - agricultural crop losses from ozone - change in production practices due to global warming

13. Assume perfectly competitive market: firms are price takers

14. Total profit (p > AC) Operational Profit (p > MC) Average and marginal production costs

15. Initial surplus Change in surplus Impact of a change in Z

16. 3.1.2. Application: biodiversity, a useful input Broadly defined as total variability of life on earth Important for future industrial use (medicine, agrofood industry, etc.) But: - All species are not equally valued - A species is more valued when it is less substitutable • It is easier to promote conservation of a species if its expected value • is higher How to build a decision rule for selecting species to conserve ?

17. Weitzman (1998): Consider the problem of ranking N programmes Each programme i, i=1, 2, …, N, is devoted to conservation of species i Empirical issue: estimation of components in formula above

18. 3.1.3 Value of environmental goods for consumption activities Need to define equivalent of profit for consumer Program for a consumer: maximise utility under - economic constraints (price of goods, income) - environmental constraints Revelation of preferences: how to infer values that consumers set on environmental and natural resources ? Important: environmental goods (and services) are non-market goods No observable demand, no consumer surplus, no price

19. Case of use-values: relationship between non-market and market demands Relationship between Value of Demand for market and non-market environmental market good good good Substitution ↑ Complementarity ↓ Neutrality  = Case of non-use values: direct approach for direct revelation Important: values can be defined for - amenities (positive effects) - damages (negative effects)

20. 3.2 – Valuating amenities from natural resources and the environment 3.2.1. Theoretical framework Distinction between private and public goods: the individual controls the quantities (x) vector q is exogenous

21. Individual is assumed to maximise utility subject to income y

22. Purpose: to measure the increment in income that makes the consumer indifferent to an exogenous change This change can be a - a price change - a quality change - a change in some public good For pure public goods (e.g., existence value), only indirect utility and expenditure functions are relevant

23. 3.2.2 Willingness To Pay and Willingness To Accept Willingness to pay (WTP): the maximum amount of income the individual will pay in exchange for an improvement in circumstances Or The maximum amount he will pay to avoid a decline in circumstances Willingness to accept (WTA): the minimum amount of income the individual will accept in exchange for a decline in circumstances Or The minimum amount he will accept to forego an improvement in circumstances Equivalent definitions: compensating variation and equivalent variation

24. Relationship between WTP, WTA and variations Equivalent vs. compensating variations differ according to the comparison between initial vs. final well-being: Equivalent variation Compensating variation Utility increases WTA WTP Utility decreases WTP WTA Formal definition of WTP for a public good: amount of income that compensates or is equivalent to an increase in public good q

25. WTP: amount of income that leaves the individual indifferent between income y and public good q (initial state) and income y – WTP and public good q* (final state) WTA: change in income that makes the individual indifferent between income y + WTA and public good q (initial state) and income y and public good q* (final state)

26. Important: WTP and WTA are useful measures for computing environmental values for amenities (positive effects) or negative effects on the environment (damage) 3.2.3 The Contingent Valuation Method (CVM) Very popular method for estimating values for non-market goods Produces its own data, is applicable to any situation (fictious markets)

27. Stages in a CVM exercise: • Set up the hypothetical market for environmental service or good • Inform respondents about the project: • - reason for needed payment • - bid vehicle (local tax, etc.) • - who will pay ultimately • - how environmental service will be restored/created • Obtain bids (proposed values) • Questionnaire, face-to-face interview, mailing, etc. • Ask people for their WTP • Different ways to obtain individual bids: • - bidding game: higher and higher amounts suggested • until maximum WTP is reached • - closed-ended referendum: single payment suggested • and response is YES/NO • - Payment card: range of values is presented, one chosen • - Open-ended question: « How much are you willing to… »

28. c) Estimate mean WTP (and/or WTA) - Average or median values computed from sample depending on choice to treat outliers - What to do with « protest bids » ? - What to do with « zero responses » in the case of open-ended questions ? d) Estimate bid curves Investigate the determinants of WTP/WTA Useful for aggregating results and predictions Estimating the relationship between WTP and individual characteristics e) Aggregate the data Convert bids or average bids to population total value figure Requires adequate definition of relevant population

29. 3.2.4 The Hedonic Pricing Method Typically used on house price data Tries to find a relationship between level of environmental service and price of a marketed good (a house) Lancaster-Rosen approach: characterstics theory of value Any commodity can be described by a vector of characteristics, Z

30. Rent differential: value of a marginal change in Z Consumer behaviour: equate marginal value for Z and its marginal cost

31. Rent differential Marginal value B Marginal value A Marginal cost Environmental service Individual equilibrium in housing market

32. Example: a CVM application for recreational services Site: South Platte River, Colorado, USA Survey: interview in person, N=95 Question: « If the South Platte River Restoration Fund was on the ballot in the next election, and it cost your household $__ each month in a higher water bill, would you vote in favor or against ? » Possible values: $ 1, 2, 3, 4, 8, 10, 12, 20, 30, 40 50, 100

33. Descriptive statistics

34. Income Individual characteristics Random term

36. Parameter estimates Notes. Logistic distribution, with standard deviation σ. Standard errors of parameter estimates are in parentheses.

37. 3.2.5 The Cost-Benefit Analysis (CBA) What is a Cost-Benefit Analysis: A tool for public policy assessment (for public policy-makers) Can also be used by a private decision-maker (a firm) Purpose: help in decision making when a (long-run) project is considered Especially used in the presence of risk or uncertainty Decide for or against a project by considering all possible outcomes Combination of scientific knowledge and society’s preferences over outcomes (in monetary units)

38. Example of needed components in the case of a project for reducing an environmental damage: - Probability of an environmental damage occuring - Nature and range of environmental damages • Cost of the public programme (e.g., for avoiding/restoring the • environment, avoiding a risk) - Probability of success for the public programme Notes. - Some events can have negative effects for some agents (damages) and positive effects for others. - Somes outcomes can benefit the environment and not society, and vice versa

39. Basic steps 1- Choice of agents to include in the analysis (costs and benefits for whom ?) 2- Choice of a set of possible policy instruments/options 3- Inventory of all potential impacts of policy options and the associated indicators to measure them 4- Quantitative prediction of project’s impacts 5- Give an economic value to all impacts 6- Discount future costs and benefits 7- Sum up discounted values of costs and benefits 8- Conduct a sensitivity analysis (confidence intervals) of predictions above 9- Recommend the policy option with the largest net social gains

40. Important things to remember with CBA A/ General principles Rule: accept every decision that leads to benefits higher than cost. With CBA, a decision is always evaluated with respect to an alternative decision: It may status quo, or postponing the decision at a later time The alternative decision also has consequences, which need to be evaluated All costs and benefits are to be compared, which implies that they be converted to monetary units (in general) This implies that health and environmental considerations, but also mortality can receive monetary values

41. All assumptions and specifications must be justified, and the CBA must be evaluated first by (multi-disciplinary) experts The computation of costs and benefits for a given situation can depend on the objective (private or public decision maker) B/ The CBA and the citizen Question: is the CBA technocratic or democratic ? It is by construction citizen-oriented, because information on preferences are collected directly from citizens (or by observing their choices). Problem: what if citizens behave irrationally or citizen risk perceptions are too emotionally-driven ?

42. Benefits to a project are collected to evaluate society’s preferences corresponding to different outcomes by different methods: - Revealed Preferences (observing real-life choices) - Stated Preferences (CVM, etc.) C/ Main criticisms addressed to the CBA Ethical perspective: give a monetary value to some goods or components of life, culture, etc. But in practice, one does not evaluate the value of life (Value of Statistical Life), but the trade-off between income and a reduction of a mortality risk.

43. A fugure often quoted: The Value of a Statistical Life is about 5 million $ in OECD countries. But this means in reality that - both income and a reduction in mortality rate are valuable to people - The WTP for a reduction of 1 / 1million in mortality risk is 5$ What about differentiated treatment of individuals ? Possible discrepancy between efficiency and equity, a policy option could be preferred for reasons other than efficiency A CBA should detail policy impacts for all categories of individuals, if heterogeneous effects. Difficult to adequately represent society’s preferences in terms of social justice for example.

44. D/ The use of ACB in practice Mostly in the US, Great-Britain and some Scandinavian countries Almost no applications in France CBA is recommended by most international organisms (World Health Org., UN Environmental Programme, etc.) In the US: used for over 25 years in regulatory decisions on the environment, consumer and food safety, health and safety regulations, etc. Executive orders 12044, 12291 and 12866, Presidents Reagan 1981 and Clinton 1993) Either by law and/or for projects with expected impacts > 10 million $

45. US federal administrations using recommendations based on CBA: USEPA (Environmental Protection Agency) USDEA (Drug Enforcement Agency, US Department of Justice) Differences between regulatory prevention levels in the US and Europe: Regulation is stronger (prevention level is higher) • In the US: • Alcohol • Tobacco • Pollution • Food • In Europe: • Energy • Transportation • Medicines • Work and building works

46. Carefulness when using CBA CBA has a normative feature: how to determine a socially efficient system for dealing with environmental protection, risk, etc. Different from the positive question: « How to organise the system such that economic agents make decisions that closely look like this efficient decision ?» CBA does not deal with positive aspects such as the relevant tax system to adopt, responsibility rules to establish, social and political acceptability or a policy decision, etc. « Couldn’t we decide for a less efficient policy option, but one that can more easily be implemented ? » Need for a unified framework (efficiency and implementation aspects).

47. The need for discounting values, and its consequences

48. Cost-benefit ratio

49. Example of a Cost-Benefit Analysis: Cardiff Bay Barrage

50. Background Estuarine area dividing South Wales from South-West England - One of the world’s greatest tidal range: up to 14 m. - Cardiff harbour inacessible at low tide for up to 14 hours a day. - Environmental services of the Bay: winter site for about 6000 wildfowl and waders, and resident birds (total 88,000) Project Development plan for a barrage across Cardiff Bay Conversion of the Bay from a tidal saltwater area to a freshwater lake (2 km2, 13 km. of waterfront)