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Environmental Valuation Methods in Economic Analysis

Research · July 1993

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Olivier Serrat
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Environmental
Valuation Methods
in Economic
Analysis

This unpublished précis showcases 10 environmental

valuation methods and stipulates the applicability of
each.

Olivier Serrat
31/07/1993
 1

Introduction

Economic development relies on natural resources and the productivity of natural systems. It
implies sustained improvements in human welfare derived from conventional goods and services,
the production of which often requires natural resources and productive natural systems. At the
same time, economic growth is often accompanied by increasing stress on natural systems and
adverse effects on environmental quality that may result in real losses in long-term development
potential.

Traditional project appraisal, based on cost–benefit analysis, largely failed to take adverse
environmental effects into account.1 The objective of maximizing net output or income encouraged
investment in projects regardless of environmental costs to the detriment of projects with
environmental benefits. Much present economic growth has environmental costs that are omitted
from national income accounts. These costs are real and increasingly tangible.

The purpose of environmental valuation is to ascribe an economic value in monetary terms to

natural resources and the environment to lay the rules for their optimal use. Valuation helps to
correct the balance between quantifiable and non-quantifiable effects in cost–benefit analysis. It
gives a more accurate gauge of economic performance and is essential for settling disputes
regarding environmental use and awarding compensation for environmental damage.

Environmental Valuation Methods

Several environmental valuation methods are introduced below.2 The selection of a method will
hinge on the environmental impact to be assessed and data availability. The methods are
presented in decreasing order of reliance upon market information and comprise: (i) methods
based on market information; (ii) methods based on surrogate market values; and (iii) methods
based on potential expenditure or willingness-to-pay. One should seek to place economic values
on all environmental functions that may be affected by a project.3

A. Market-Based Methods

The methods considered in this section are based directly on market prices or productivity. They
are applicable where a change in environmental quality affects actual production or production
capability.

1. Change-in-Productivity

This method estimates the impact of a change in the environment on output, e.g., the damage
from air pollution to crop yield, or the impact of soil erosion on farm output.

1 The Bank's Guidelines for Economic Analysis of Projects deal with environmental effects only briefly under the
category of externalities and in connection with the depletion of non-renewable natural resources.
2 In 1986, the Bank published an Economic Staff Paper, Economic Analysis of the Environmental Impacts of
Development Projects, which contributed to establishing the framework for quantification of environmental costs and
benefits. The forthcoming ADB Workbook of Economic Assessment of Environmental Impacts will combine case
studies with methodological summaries and provide operational guidance in the use of valuation methods.
3 Economic values consist of: (i) direct use values, derived from output that can be consumed directly; (ii) indirect use
values, derived from functional benefits; and (iii) non-use or preservation values.
 2

2. Loss of Earnings

This method measures the effects on health from environmental hazards such as air and pollution
or the use of pesticides based on the loss of earnings and the cost of medical care.

3. Defensive or Preventive Expenditures

This method infers the true value of protecting the environment from what people spend to
prevent the damage or to restore the environment afterwards, e.g., the cost of building terraces
and protecting bunds to prevent soil erosion.

B. Methods Based on Surrogate Market Value

The methods considered in this section use market information indirectly. Each has its particular
advantages and disadvantages, as well as specific requirements for data and resources.

1. Property Value

This method determines the implicit price of specific characteristics of properties to place a value
on improvements or deterioration in environmental quality, e.g., the effects of air pollution in
certain areas.

2. Wage Differential

This method is based on the theory that, in a competitive market, the demand for labor equals the
value of the marginal product and that the supply of labor varies with working and living conditions
in an area. A higher wage is therefore necessary to attract workers to a polluted area or to entice
them to perform risky work.

3. Travel Cost

This method infers people's valuation of an unpriced amenity, e.g., a beauty spot or a public
beach, from the time and cost they are observed to incur while travelling to the site.

4. Marketed Goods as Surrogates

This method approximates the value of environmental goods that have close market substitutes,
e.g., the value of a non-marketed fish species can be valued at the price of the most similar fish
being sold in local markets.

C. Methods Based on Potential Expenditure or Willingness-to-Pay

The benefits from environmental quality protection or improvements do not always lend
themselves to valuation. In some of these cases, it may be possible to estimate benefits by
calculating the costs of replacing the environmental services that have been or might be
destroyed by a project, or by estimating what people might be willing to pay to protect an
environmental asset. Care should be exercised to avoid improper evaluation.
 3

1. Replacement Cost

Under this method, the costs of replacing a damaged asset are estimated, e.g., the cost of the
fertilizer that would be needed to replace the nutrients lost through soil erosion.

2. Shadow Project

This method involves the design and costing of one or more shadow projects that would provide
substitute environmental services to compensate for the loss of the original assets.

3. Contingent Valuation

This method is a form of market research on what people would be willing to pay or willing to
accept for a change in environmental quality.

Discounting

The rate at which the cost and benefit streams are to be discounted is a general issue in cost–
benefit analysis but is particularly important with regard to environmental costs and benefits since
some of them will accrue in the long term. The opportunity cost, i.e., the benefit foregone by using
a scarce resource for one purpose instead of for its next best alternative use, increases the longer
the gestation period of a project.

For discounting to fulfill its purpose efficiently, it is recommended that: (i) the standard opportunity
cost of capital be used for environmental cost–benefit analyses; (ii) short-term and long-term costs
and benefits be estimated carefully; and (iii) a rigorous analysis be made on non-monetary
consequences to supplement standard cost–benefit analysis.

Limits to Environmental Valuation

Environmental valuation can satisfactorily cover only part of the field and has several important
limitations. The scientific and physical data supplied by the environmental sciences relate to
processes that are complex and not fully understood. In addition, notions of environmental costs
and benefits rest on concepts of sustainable development that need to be tested in operational
conditions. Accordingly, considerations relevant to the selection of valuation methods include data
requirements and availability, intelligibility and plausibility. Plausibility is frequently overlooked.
Environmental valuation methods should be credible as well as accurate. Examples of valuation
method application, outlining in each case the main data requirements and limitations of the
method concerned, are presented in the Appendix.

An Agenda for the Bank

The Asian Development Bank recognizes the need for sound management of the environment
and natural resources and incorporates, where relevant, considerations of environmental impact
into lending, technical assistance and policy activities. To ensure that economic development is
essentially sustainable, environmental valuation needs to be institutionalized and integrated into
project appraisal methodologies.

It is proposed that a Working Group on Environmental Valuation Methods be established to codify

the general approach to be followed in the economic analysis of environmental impacts. The
Working Group, building on the forthcoming ADB Workbook of Economic Assessment of
 4

Environmental Impacts, would formulate guidelines for environmental valuation for incorporation
into the Bank's Guidelines for Economic Analysis of Projects to ensure uniformity of analysis,
approach and coverage in all Bank projects.

The Working Group, involving staff from the Programs Departments, the Projects Departments,
the Economics and Development Resource Center, the Post-Evaluation Office, and the Office of
the Environment, would focus on those methods that can be most readily and plausibly applied
given the data and time limitations common to project analysis and the probable environmental
effects of standard types of development projects.

The views expressed in this précis are those of the author and do not necessarily reflect
the views and policies of the Asian Development Bank, or its Board of Governors or the
governments they represent.

VALUATION METHOD APPLICATION, DATA REQUIREMENTS, AND LIMITATIONS
Valuation Method Examples of Application
Change-in-Productivity Soil erosion, deforestation,
desertification, loss of
ecosystems, loss of
production from air and
water pollution
Loss of Earnings Air and water pollution,
water related diseases,
unsanitary living
conditions, unsafe or
unhealthy working
conditions, industrial
safety
Defensive or Preventive Soil erosion, siltation,
Expenditure noise, air and water
pollution, flood control,
coastal protection
Property Value Noise, air, water and odor
pollution, slum upgrading,
sewage projects, traffic
congestion
Wage Differential Risk of death from
industrial accidents, health
risks from pollution
Travel Cost Recreational sites,
benefits from tourism,
fuelwood and water supply
Market Goods as Sewage treatment as
Surrogates proxy for water purification
by ecosystems
Data Requirements
Physical impacts
quantified and attributed,
information on market
prices, production and
consumption responses to
changes prices, prices of
closest substitutes,
appreciation of the
behavioral adjustments of
producers and consumers
in response to
environmental damage
Economic value of lost
productive time quantified,
information on costs of
health care and the size of
the population at risk
Actual spending on
safeguards against
environmental risks,
willingness to pay against
environmental threat,
costing
Information on the
principal factors
influencing the value of
properties, specification
and calibration of
environmental variables
such as air and water
quality
Wages and benefits in
different occupations and
across locations,
categorization of
occupations according to
key attributes,
quantification of
environmental risks to
which workers are
exposed
Survey of the number of
visitors to the site, their
place of origin for the
journey, basic socio-
economic features,
computation of travel time,
expenses
Data requirements depend
on the surrogate selected
Appendix
Limitations
Physical relationships
between activities affecting
the environment are rarely
well-established, need to
assess the market
structure, elasticities and
supply and demand
responses when the effect
on markets is substantial
Multiple causative factors,
psychic cost
considerations, definition
of human productivity,
inapplicable for life
threatening impacts
Minimum valuation of
benefits, depends on
perception of the costs of
an environmental damage
by parties responsible or
their victims
Assumes a well-
functioning property
market and awareness by
households of all aspects
of environmental quality
Assumes a competitive
labor market, difficulty of
measuring occupational or
locational risks, degree of
risk-aversion varies among
individuals, difficulty of
measuring the damage to
health from pollution
Difficulty of valuing time
taken outside working
hours, travel may be part
of the pleasure, ignores
non-visitors or potential
visitors, some travels are
multipurpose
Environmental surrogates
may not exist or may not
be widely marketed
 6
Valuation Method Examples of Application
Replacement Cost See defensive or
preventive expenditures
Shadow Project Restoration of commercial
freshwater fisheries
damaged by discharges
Contingent Valuation Recreational sites, water
supply, sanitation, garbage
collection, cleaning up of
heavily polluted rivers or
waste dumps, relocation of
polluting industries,
conservation of forests
and biological diversity
Source: Author.
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Data Requirements Limitations
See defensive or See defensive or
preventive expenditures preventive expenditures
Data requirements depend Difficulty of compensating
on the type of project for the loss of complex
financed ecological systems,
difficulty of offsetting
complicated hydrological
or atmospheric effects,
shadow projects are likely
to have their own
environmental effects
Use of questionnaire Based on hypothetical, not
surveys to elicit people's actual behavior,
preferences for certain asymmetry between
environmental states and willingness to pay and
the money values they willingness to accept,
would put on them adding-up problems,
grossing up from sample
survey to the total
population is tricky