The Economist’s Approach to Sustainable Development

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For the latest thinking about the international financial system, monetary policy, economic development, poverty reduction, and other critical issues, subscribe to Finance & Development (F&D). This lively quarterly magazine brings you in-depth analyses of these and other subjects by the IMF’s own staff as well as by prominent international experts. Articles are written for lay readers who want to enrich their understanding of the workings of the global economy and the policies and activities of the IMF.

ENVIRONMENTAL economics helps move us closer to sustainable development by better incorporating environmental and social concerns into conventional decision making. It involves a novel synthesis of existing economic principles and their extensions.

Historically, the development of the industrialized world focused on economic output, so, not surprisingly, the postwar model adopted by developing countries was growth dominated. But in the 1960s, the equitable growth model was developed to incorporate social issues such as poverty alleviation and income redistribution. In the 1980s, the model was broadened again to embrace the concept of sustainable development—reflecting increasing concerns about the environment.

Economic growth still overshadows the other objectives, following the example of the industrialized countries that began to tackle their environmental problems only after achieving major economic objectives. But policymakers worldwide are increasingly trying to find sustainable options. The goal is to maximize the net welfare of economic activities, while maintaining or increasing the stock of economic, ecological, and sociocultural assets over time (to ensure the sustainability of income and intragenerational equity) and providing a safety net to meet basic needs and protect the poor (thereby advancing intragenerational equity). Environmental economics contributes to this search by helping to incorporate environmental and social concerns into economic decision making. It offers policymakers both a better way of tracing environmental and social impacts, and improved decisionmaking tools.

Environmental economics as a field is not really new. Over the past two decades, existing economic principles have been built on and extended, particularly in valuing environmental and social impacts that often are not well reflected in market transactions. But it is only recently that we have begun to apply these concepts to developing countries and, in the process, influence decision making mainly at the project level. In the past few years, environmental economists have also begun to take an interest in macroeconomic policies.

While the underlying basis of this approach is economic optimization and efficient resource allocation, practitioners recognize that these concepts may not be easy to apply to some environmental and social objectives—such as preserving the dynamic resilience of ecological systems to withstand shocks, promoting public participation, or reducing conflicts. In these cases, they often rely on other techniques, such as multicriteria analysis, to facilitate trade-offs among different goals.

Tracing impacts

The first way environmental economics improves policy analysis is by helping to trace the impacts of decisions at various levels.

Project level. Traditionally, economists have relied on cost-benefit analysis to help determine whether a project is worth undertaking. Following the Bank’s 1989 guidelines on environmental assessments and recent advances in valuing impacts, this type of analysis is being increasingly adapted to better account for environmental and social concerns, despite special problems.

First, some inputs and outputs are not correctly priced by the market. One example is externalities—the beneficial (or harmful) effects that are imposed on others but cannot be reimbursed by (or charged to) the originator. Unfortunately, externalities are often difficult to measure in physical and monetary terms. Another example is open-access resources—typically assets usable by all without payment, such as a lake or public highway—which are difficult to value and tend to be overexploited since user charges are negligible.

What can be done? The value of an externality can be assessed, based on its shadow price or economic opportunity cost, and a charge imposed. But if this is not possible, policymakers can impose regulations and standards that set physical limits on perceived external damages, or better define property rights—thereby encouraging improved natural resource management.

Second, with well over one billion poor worldwide living on less than $1 per day, national policymakers often seek to reduce the income gap between rich and poor groups. This may justify giving greater weight to benefits and costs that accrue to the poor relative to the rich. In practice, such formal weighting schemes have seldom been used in project evaluation. More direct methods, like poverty assessments and targeting disadvantaged groups, have proved more useful.

Sectoral level. Studies show that sector- wide actions—like water and energy pricing policies, investment programs involving a series of projects, or administrative measures such as improving land tenure—often have stronger environmental and social impacts than individual projects.

The basic rule for efficient pricing of a scarce resource (or service) such as water (or transport) is that price should equal the cost of providing a marginal (additional) unit of output. But in many countries, such resources are subsidized. Raising prices closer to efficient levels is essential to reducing their wasteful use, thereby realizing both economic savings and environmental gains.

Environmental-economic analysis has helped in this regard. First, it reinforces the need for both efficient pricing and additional charges to cover external impacts. For example, if automobile exhaust causes respiratory problems, marginal cost-based fuel prices should be supplemented by pollution taxes corresponding to the additional environmental or health damage. Second, this type of analysis encourages long-run, comprehensive resource planning.

Macroeconomic level. Economy wide policies (both sectoral and macroeconomic) have an effect on the natural resource base, but the complicated interactions are not well understood. No simple generalizations are possible, but many instances of environmental damage stem from market failures and policy distortions, exacerbated by poverty. Broad policy reforms that promote efficiency or reduce poverty should also help the environment, but some reforms may have negative environmental effects, depending on pre-existing (and often localized) constraints (i.e., inadequately defined property or resource rights).

The solution is not necessarily to modify the original broader policies (which have conventional socioeconomic goals), but rather to design complementary measures that will help mitigate the negative effects or enhance the positive impacts of the original policies on the environment (see “Are Economywide Policies Good for the Environment?” by Mohan Munasinghe, Wilfrido Cruz, and Jeremy Warford,” Finance & Development, September 1993).

Many aspects of macroeconomic policy are based on the standard system of national accounts (SNA). To incorporate hitherto neglected environmental impacts into GNP and other related measures of income and output, the SNA should be environmentally adjusted. A start has been made through satellite accounts containing environmental data that will supplement traditional SNA data (see “Measuring Environmentally Sustainable Development” in this issue).

International level. Regional impacts (e.g., acid rain) and global issues (e.g., ozone layer depletion, global warming, biodiversity loss, and pollution of international waters) have raised concerns. These pervasive and long-term problems have led to new ideas on uncertainty, irreversibility, and time discounting. For example, even when impacts are uncertain, sustainability suggests that limits should be imposed on resource degradation, particularly if future consequences could be irreversible and catastrophic. This precautionary approach underlies the emerging consensus on limiting greenhouse gas emissions to avoid possible global warming. Efforts are also under way to improve mitigation mechanisms to mobilize and allocate resources efficiently and equitably (e.g., the Global Environment Facility).

Multicriteria analysis: when valuation falls short

Multicriteria analysis offers policymakers an alternative when progress toward multiple objectives cannot be measured in terms of a single criterion (i.e., monetary values). Take the case of drinking water—an essential element of sustainable development—illustrated in this chart. While the economic value of water is measurable, its contribution to social and environmental goals is not easily valued monetarily. Outward movements along the axes trace improvements in three indicators: economic efficiency (net monetary benefits), social equity (service to the poor), and environmental pollution (water quality).

How are policy options assessed? First, triangle ABC describes the existing water supply where economic efficiency is moderate, social equity is low, and overall water quality is worst. Next, triangle DEF indicates a “win-win” future option in which all three indices improve, as could occur with a new water supply scheme that provided cleaner water, especially to the poor. The economic gains would include cheaper water and increased productivity from reductions in waterborne diseases; social gains would accrue from helping the disadvantaged; and wastewater treatment would reduce impure water discharges and overall water pollution.

After realizing such “win-win” gains, other available options would require tradeoffs. In triangle GIF, further environmental and social gains are attainable only at the expense of sharply increasing costs. In sharp contrast to the move from ABC to DEF, which is unambiguously desirable, a policymaker may not make a further shift from DEF to GIF without knowing the relative weights that society places on the three indices. Such preferences are often difficult to determine explicitly, but it is possible to narrow the options Suppose a small economic cost, FL, yields the full social gain DG, while a large economic cost, LI, is required to realize the environmental benefit EH. Here, the social gain may better justify the economic sacrifice. Further, if budgetary constraints limit costs to less than FK, then sufficient funds exist only to pay for the social benefits, and the environmental improvements will have to be deferred.

A recent Bank study of power system planning in Sri Lanka demonstrated the versatility of this technique. For example, end-use energy efficiency measures provided “win-win” options (i.e., they were superior to all other alternatives on the basis of air quality, biodiversity loss, and economic costs). Conversely, several prominent hydropower projects could be excluded because they performed poorly in terms of both biodiversity loss and economic costs.

Better decisionmaking tools

Environmental economics also offers policymakers a variety of tools to value impacts and improve development decisions.

Valuation techniques. The basic aim of environmental valuation is to determine the total economic value of a resource (see Chart 3 on pg. 8). Total economic value has two parts: use value and nonuse value. Use values can be broken down into three types: (1) direct use values, determined by the known contributions an environmental asset makes to production or consumption (e.g., food, recreation); (2) indirect use values, including the benefits derived from functional services that the environment provides to support current production and consumption (e.g., ecological functions); and (3) option values, or the willingness to pay now for future benefits expected from an existing asset (biodiversity). Nonuse values occur even though the valuer may have no intention of using a resource; one category—existence values—arises from the satisfaction of merely knowing that the asset exists (e.g., rare species).

The next hurdle is to estimate these values. The basic concept underlying valuation techniques is an individual’s willingness to pay for an environmental service or resource. (In economic terms, the area under the Hicksian demand curve that indicates how demand varies with price while keeping the user’s welfare level constant.) A related measure is what people are willing to accept as compensation for environmental damage. Valuation methods may be categorized, as shown in Table 1.

Table 1

Techniques for valuing the environment

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The most useful valuation methods look at how environmental changes affect directly observable behavior valued in conventional markets.Effect on production. Impacts valued by the effect on the quantity, quality, or production costs of marketed outputs.Effect on health. Impacts valued as output lost due to sickness or death, including foregone earnings and costs of health care or prevention.Defensive or preventive costs. Ex-post costs of mitigating damage caused by environmental impacts provide a minimum estimate of original damage costs (e.g., the extra costs of purifying polluted water).A second set of methods seeks to value intended actions in markets.Replacement cost. Future cost of replacing an impaired environmental resource by an equivalent asset, assuming that the original resource was at least as valuable as the replacement expense.Shadow project. Closely related to replacement cost—involving cost of special project designed to offset environmental damage caused by another project {e.g., cost of new reafforestation scheme to replace forest area inundated by hydro-dam).If direct market valuation is impossible, indirect market data may be used to determine Implicit values.Travel cost. Willingness of tourists to pay a surplus over the normal price to visit a recreational site. Demand (e.g., frequency of visits per year) is first related to variables like visitor income and price—including entry tees, travel costs, and opportunity value of time.Wage differences. Wage premium needed to compensate for working in polluted or hazardous environment, after first accounting for other wage determinants like age and skill level.Property value. Willingness of property buyers to pay extra for real estate in cleaner neighborhoods.Proxy goods. Market value of a substitute for an environmental asset that itself is not marketed.Where market data cannot be used, a final group of methods simulate market-like behavior, using marketing experiments or surveys.Artificial market. Willingness to pay for an environmental asset determined on an experimental market (e.g., home water purification kit marketed at various price levels to assess demand).Contingent valuation. Willingness to pay for an environmental asset or willingness to accept compensation for its loss, determined by direct questions. The method is most effective if respondents are familiar with the asset (e.g., drinking water quality).

Multicriteria analysis. Sometimes a single criterion—putting costs and benefits in monetary terms—cannot be used. This might be the case for biodiversity loss. Another approach, called multicriteria analysis, draws on nonmonetary measurements. It clarifies the most important attributes or goals, eliminates many irrelevant options, and makes the final trade-off process more transparent, while also providing the decisionmaker with more flexibility of choice (see chart).

Application. Currently, almost 200 World Bank projects are subjected to environmental analyses each year, of which about 60 undergo comprehensive environmental assessments. The practical use of a wide range of techniques is being tested in several Bank studies involving forestry, agriculture, energy, and water projects. One example is the study on Madagascar, which investigated forest management policies involving the proposed creation of the Mantadia National Park. The study demonstrated how a variety of valuation tools, including effects on production (opportunity cost), travel costs, and contingent valuation could be applied under difficult developing country conditions. The study found that:

• Using the land that would be set aside for the new park, the average local household produces 487 kilograms of rice worth about $128 per year from 1 to 2 hectares of land. Fuelwood, the only other economically important forest product collected, is worth about $38 per household per year. The net cost imposed on villagers by creating the park ranges from $90–110 per household per year, based on both the opportunity cost of foregone production and contingent valuation estimates.

• In the foreign tourist survey, the average visitor had 15 years of education, earned over $59,000 per year, and spent almost $2,900 per visit to Madagascar. Tourists were willing to pay $80–120 to visit the proposed new park, primarily to see lemurs unique to Madagascar.

• The net welfare loss to all villagers from creating the park was about $0.6 million, using a present value of 10 percent. For all foreign tourists, the corresponding benefit was over $2 million.

Results such as these will help determine how scarce forest and capital resources can be better allocated and provide guidance on future pricing policy for park protection, biodiversity management, and revenue generation. But they also highlight an interesting issue, particularly for a country that is both economically poor and ecologically rich. Willingness to pay is fundamental to the economic approach, but tends to overemphasize the greater ability to pay of richer foreign visitors. If conflicting claims to park access were determined purely on this basis, the tendency would be to exclude poor local villagers (with minimum monetary compensation). Here, the social-equity aspects of sustainable development can be invoked to protect the basic rights of local residents, perhaps by ensuring a minimum degree of access to park areas.

A unifying matrix

One tool that unifies the key elements of the environmental economist’s approach to sustainable development is the action impact matrix (Table 2 provides a greatly condensed version). The matrix promotes a more integrated view, by meshing economic decisions with environmental and social impacts. The organization of the table facilitates the tracing of impacts and coherent articulation of policies and projects, while the individual elements focus attention on valuation and other methods of assessing specific impacts to determine action priorities.

Table 2

Action impact matrix for policymakers1

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A few examples of typical policies and projects as well as key environmental and social issues are shown. To illustrate, some qualitative impact assessments are also indicated—thus + and - signify beneficial and harmful impacts, while H and M indicate high and moderate.

Devaluation increases profits from timber exports and leads to deforestation of open access lands.

Controlling access or assigning property rights to forest lands reduces deforestation.

Raising energy prices to reflect marginal costs reduces wasteful energy use and air pollution.

Charging air pollution taxes reinforces effects of marginal cost pricing.

Increasing financial accountability of state-owned enterprises forces them to react positively to energy price and pollution tax increases.

Hydroelectric dam inundates forested land and displaces local villagers, but reduces air pollution by replacing thermal power generation.

As a first step, a preliminary matrix may be prepared, using existing data to assess the most significant impacts (even qualitatively, as shown in Table 2). Next, the tools of environmental economists may be used to quantify and value the magnitudes of such impacts more precisely, refining the matrix. Then policies and projects may be systematically modified to make them more sustainable. For example, economywide reforms involving exchange rate depreciation may make timber exports more profitable and lead to severe deforestation of open access areas. Possible remedies might include introducing complementary policies that control access or assigning property rights to the forest, thereby encouraging better management. Project 1 (a hydroelectric dam) may also exacerbate forest loss through inundation. The answer would be perhaps to modify the dam or implement a shadow project to reafforest an equivalent area elsewhere. In this fashion, the table helps articulate a consistent set of more sustainable policies and projects that address serious issues at all levels, in order of priority.

For more information, see “Environmental Economics and Sustainable Development,” by the author, World Bank Environment Paper No. 3, July 1993.