Appendix F
Guidance for Environmental Economics

Environmental economics is the application of microeconomic tools to environmental problems. These include an analytical framework for describing or modeling the economic conditions out of which environmental problems arise. These conditions are called externalities (i.e., when parties involved in a market transaction impose costs on others that are external to [not involved in] the transaction). For example, a factory in a neighborhood produces and sells goods but also fouls the air for nearby residents. This externality implies an external cost that is not borne by the factory or its customers but is shifted to the residents who incur health and welfare costs associated with breathing polluted air.

The optimal solution, from an economic perspective, must take into account both the burden of pollution on the community and the value of the output generated by the factory. At first glance this may seem unfair to the neighbors. However, consider the case of road noise pollution. The obvious way to ensure silence near large roads is to ban all traffic except for bicycles and pedestrians. Similar statements could be about safety; an expedient way to stop all loss of life in automobile accidents is to ban driving. Because most activities that have some undesirable consequences also have some value to society, either extreme is in some way detrimental to society. Thus, the solution must include trade-off(s).

One purpose of economic analysis is to tabulate trade-offs in an explicit way by putting monetary values on the harm done to the community and the environment, as well as the cost to the factory, the government, or others associated with mitigating the harm. If the cost to society of a specific plan for mitigating harm is greater than the harm itself (e.g., banning driving), that form of mitigation is not justifiable from an economic perspective. Monetization of the harm incurred from externalities is necessary to make this explicit.

Critics of environmental economics may argue that it puts the environment at a disadvantage because the costs of mitigation can often be easily expressed in monetary terms while the harm cannot be expressed that way (e.g., the value of the loss of a species). Economists might respond that attempting to place a value on the environment can often be more helpful than not. Moreover, environmental economic analysis is just one of several inputs to decision making. Other inputs, such as equity and political considerations, will also influence decisions.

Cost-benefit analysis (CBA) is a formal framework for comparing harm with the cost of mitigating harm. In CBA, explicit and implicit costs associated with pursuing a course of action are all included in making a decision. Costs can be in dollars or opportunity cost (i.e., the value of the next best use of the time and resources involved). Benefits for the purposes of CBA are all of the positive gains for society associated with a course of action, whether they are naturally expressed in monetary terms or not. This can become confusing because eliminating an external cost (e.g., the burden of pollution) is considered a benefit. To avoid this confusion, costs are considered everything that is given up associated with a policy or an investment; any benefits are all positive consequences for society. In making decisions about policies or investments that are not motivated by an environmental purpose, such as the addition of a runway at an airport, environmental consequences are typically considered costs.

The scope of a CBA is society at large. Ideally, geographic or categorical boundaries are only those determined by the scope of the expected impact of a decision. This means that government, individuals, and businesses, as well as natural or environmental amenities valued by society, should all be included in the analysis. Similarly, the timescale for the analysis should, as much as possible, encompass the full length of time over which costs and benefits occur. In general, benefits of environmental policy or investment take the form of harm avoided but may also provide other indirect positive outcomes for society. The U.S. Environmental Protection Agency notes that these benefits should be handled on an “effect by effect” basis (EPA, 2000, p. 59). Costs typically include private compliance costs (for regulation), government investment costs, government regulatory costs, social welfare losses (impacts that result in higher prices), and tran-



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Appendix F guidance for Environmental Economics Environmental economics is the application of microeco- tempting to place a value on the environment can often be nomic tools to environmental problems. These include an an- more helpful than not. Moreover, environmental economic alytical framework for describing or modeling the economic analysis is just one of several inputs to decision making. conditions out of which environmental problems arise. These Other inputs, such as equity and political considerations, will conditions are called externalities (i.e., when parties involved also influence decisions. in a market transaction impose costs on others that are ex- Cost-benefit analysis (CBA) is a formal framework for ternal to [not involved in] the transaction). For example, a comparing harm with the cost of mitigating harm. In CBA, factory in a neighborhood produces and sells goods but also explicit and implicit costs associated with pursuing a course fouls the air for nearby residents. This externality implies an of action are all included in making a decision. Costs can external cost that is not borne by the factory or its customers be in dollars or opportunity cost (i.e., the value of the next but is shifted to the residents who incur health and welfare best use of the time and resources involved). Benefits for costs associated with breathing polluted air. the purposes of CBA are all of the positive gains for society The optimal solution, from an economic perspective, must associated with a course of action, whether they are naturally take into account both the burden of pollution on the commu- expressed in monetary terms or not. This can become confus- nity and the value of the output generated by the factory. At ing because eliminating an external cost (e.g., the burden of first glance this may seem unfair to the neighbors. However, pollution) is considered a benefit. To avoid this confusion, consider the case of road noise pollution. The obvious way to costs are considered everything that is given up associated ensure silence near large roads is to ban all traffic except for with a policy or an investment; any benefits are all positive bicycles and pedestrians. Similar statements could be about consequences for society. In making decisions about policies safety; an expedient way to stop all loss of life in automobile or investments that are not motivated by an environmental accidents is to ban driving. Because most activities that have purpose, such as the addition of a runway at an airport, envi- some undesirable consequences also have some value to so- ronmental consequences are typically considered costs. ciety, either extreme is in some way detrimental to society. The scope of a CBA is society at large. Ideally, geographic Thus, the solution must include trade-off(s). or categorical boundaries are only those determined by the One purpose of economic analysis is to tabulate trade-offs scope of the expected impact of a decision. This means that in an explicit way by putting monetary values on the harm government, individuals, and businesses, as well as natural done to the community and the environment, as well as the or environmental amenities valued by society, should all cost to the factory, the government, or others associated with be included in the analysis. Similarly, the timescale for the mitigating the harm. If the cost to society of a specific plan analysis should, as much as possible, encompass the full for mitigating harm is greater than the harm itself (e.g., ban- length of time over which costs and benefits occur. In gen- ning driving), that form of mitigation is not justifiable from eral, benefits of environmental policy or investment take the an economic perspective. Monetization of the harm incurred form of harm avoided but may also provide other indirect from externalities is necessary to make this explicit. positive outcomes for society. The U.S. Environmental Pro- Critics of environmental economics may argue that it tection Agency notes that these benefits should be handled on puts the environment at a disadvantage because the costs of an “effect by effect” basis (EPA, 2000, p. 59). Costs typically mitigation can often be easily expressed in monetary terms include private compliance costs (for regulation), govern- while the harm cannot be expressed that way (e.g., the value ment investment costs, government regulatory costs, social of the loss of a species). Economists might respond that at- welfare losses (impacts that result in higher prices), and tran- 6

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64 TECHNOLOGY FOR A QUIETER AMERICA sitional costs associated with regulation (which may include monetary), while carefully accounting for uncertainty in the job losses and other consequences) (EPA, 2000, p. 16). estimates, can be a valuable aid in decision making. Other types of economic analysis commonly used to The applicable economic concepts of value for environ- inform policy and public investment decisions include mental benefits are (1) willingness to pay (WTP) for environ- distributional analysis and cost-effectiveness analysis. Cost- mental improvements and (2) willingness to accept (WTA) effectiveness analysis tabulates costs associated with differ- compensation to endure degraded environmental quality ent methods of accomplishing a specific goal. This may be an (EPA, 2000, p. 60). WTP and WTA are not necessarily equal. appropriate tool if all methods being considered result in very Both are based on how society feels about particular environ- similar outcomes. Otherwise, “cost-effectiveness analysis mental amenities, whether in the form of nuisance, health, does not necessarily reveal what level of control is reason- aesthetics, existence (of species or natural feature), or legacy able, nor can it be used to directly compare situations with value for future generations. In CBA, environmental features different benefit streams” (EPA, 2000, p. 178). Distributional are not valued in themselves; they derive their value from analysis, which might also be called economic impact analy- how highly society values them. sis, differs from CBA in that it focuses primarily on costs and An estimate of WTP for environmental improvements on different segments of society, rather than on society as a varies by the nature of the impact associated with the im- whole. Equity assessment is a variant that focuses on impacts provement. An environmental amenity has “use value” when on vulnerable segments of society (EPA, 2000, p. 20). the environmental feature interfaces with relevant members Explicit direct costs are usually easy to capture monetari- of society—the interfaces may be direct or indirect, as well ly, because they are included in the budget for the investment as market or nonmarket (meaning a transaction takes place and its maintenance or the ongoing costs of enforcement and or does not) interfaces (EPA, 2000, p. 70). Nonuse value monitoring of a regulation. Broad social costs are typically includes “existence value,” when society derives value from easier to monetize than benefits because they may include an knowing an environmental amenity exists, and “legacy increase in production costs for firms, prices for consumers, value,” when society values knowing that an environmental or other factors that can be readily monetized. amenity will be available to future generations (EPA, 2000, Measuring the benefits of environmental policy or mitiga- p. 71). Typically, because use values are associated with tion investments requires first understanding the direct physi- direct interactions with the environment, they are easier to cal impacts of the policy or investment, whether measured in monetize. tons of effluent, decibels, wildlife population, or any other Monetization methods can be divided into three cat - direct environmental metric. For many types of environmen- egories: (1) market methods, (2) revealed preference, and tal impact, the metric may require further analysis to translate (3) stated preference (EPA, 2000, p. 72). When a good is it into relevant consequences, such as increased incidence traded in a market, the market prices, as well as supply and of cancer or asthma as an impact for airborne emissions. demand curves, are used to value it, consistent with micro- In the case of noise, the initial physical impact may be on economic principles. Even when a good or environmental a geographic area; but it becomes relevant to a CBA when amenity is not directly traded, there may be data on actual population exposure is involved. market transactions that can be used to infer WTP for it. A Once the impact has been described, it can be monetized. relevant example is lower housing values in areas with high EPA guidelines state: “To the extent feasible, and warranted noise compared to values in areas with lower noise. by their contribution to the results, as many of the effects of Among the many types of revealed preference techniques, a policy as possible should be monetized. This enhances the hedonic analysis is the most relevant for noise (EPA, 2000, value of the conclusions to policy makers weighing the many, pp. 73–83). Hedonic analysis attempts to statistically decom- often disparate consequences of different policy options and pose the market price of a good into the segments of that alternatives” (EPA, 2000, p. 176). Thus, the rationale for price associated with features or characteristics of the good monetizing environmental impacts is to put them in terms using regression analysis (EPA, 2000, p. 77). For instance, if that can be compared to the cost of policies to improve two cars are identical except for color, but the market price of environmental quality or the benefits of actions that cause a red car is $1,000 more, society has WTP of $1,000 for red. environmental harm. In environmental noise studies, the relevant market data that Projects and actions often have different environmental drive the analysis are real estate transactions. Controlling for effects (changes in noise level, air quality, climate, water other property characteristics, the difference in price or rent quality); thus, another reason for monetizing these changes between a quiet property and a noisy one reveals the value is so they can be compared with one another. Comparing a community places on quiet. noise annoyance and sleep awakenings with the incidence of Stated preference methods range from survey techniques asthma or cardiopulmonary disease and the long-term harm to constructed market techniques that attempt to incorporate of climate change can be difficult. However, ultimately these perceived economic gain and loss to make survey results comparisons must be made, and making an attempt to quan- more plausible. For example, one might survey residents tify these effects in a single comparative measure (typically in different noise environments to find out how much they

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6 APPENDIX F would value a reduction in noise compared to a more easily or estimates of variables or parameters used in the analysis. valued benefit (like a reduction in property taxes). Both EPA and OMB also suggest sensitivity analysis. EPA More than one monetization technique is used in a describes the use of probabilistic approaches such as a Monte particular CBA because any survey may generate a collec- Carlo analysis, as well as looking for “switch points” for tion of distinct use and non-use benefits. The benefits to a important inputs to a CBA. For instance, if a CBA study community associated with a reduction in road noise are were carried out using benefits transfer and a positive gain to typically use-oriented, nonmarket benefits (due to the direct society was found, a switch point would describe how much experience of noise or quiet). Because market transactions lower the community’s values would have to be relative to can be used to infer the WTP for quiet versus noise, the road the community in the original study of benefits to reverse the noise example is a good candidate for revealed preference conclusions of the study. methods. Beyond calculating benefits and costs on an effect-by- Two other valuation methods may be considered relevant effect basis, and monetizing, there are a host of tabulation to the road noise problem. The first is known as the avert- issues that must be handled sensitively, some of which may ing behavior method (EPA, 2000, p. 70), the cost people are also be sources of uncertainty. To the extent that benefits willing to incur to defend against a particular environmental and costs are incurred in streams across time, a discount rate problem—for instance, wearing a filter mask when walking must be applied to reduce future dollars into current dollars outdoors in a city with especially polluted air. In the case (because a dollar is worth more now than later). Inflation also of road noise, this might be voluntary installation of sound has to be handled consistently to ensure that all final results in insulation by a homeowner. The drawback of this method is the analysis are present in the same constant-year dollars. that unless there are continuous, incremental opportunities, Although the trade-off of dollar values in the future for people will not be able to spend up to a level that expresses dollar values today over a time period within the current their true WTP. generation may be a small source of uncertainty, crossing The second alternative to hedonic analysis would be us- generations introduces even more uncertainty (EPA, 2000, ing either a hypothetical or government cost to purchase and p. 48), partly because of the nature of the net present value install sound insulating material for homeowners (e.g., the calculation to carry out the discounting. The farther into Federal Aviation Administration Residential Sound Insula- the future an outcome is, the less it is worth. Mathemati- tion Program). Because in either case the material would cally, the differences can be dramatic, making it appear not be voluntarily paid for by the homeowner (if it were, it that society places almost zero value on consequences for would be averting behavior), the price is even further dis- our grandchildren’s grandchildren. EPA suggests doing a connected from the actual WTP than the averting behavior sensitivity analysis on the discount rate itself, including a technique because there is no evidence that the homeowner presentation of a case with a zero discount rate, to address values quiet as highly as the cost of installing sound insulat- this problem. This particular guideline is more relevant for ing materials. climate change studies than for noise, which has immediate Benefits transfer is the technique of applying benefits effects. However, it does provide some perspective on un- valuation estimates from past studies to new analyses (EPA, certainty potentially relevant to highway studies. In the face 2000, p. 85). However, given potential variations among of the enormous uncertainty about how to analytically trade communities, this technique should be used with care—al- off our own well-being against future generations, variations though it should not be ruled out. Sometimes, budget con- in a community’s value of noise and variances within the straints or the lack of relevant local data may make carrying statistical estimates may not seem so daunting. out hedonic studies unrealistic. In that situation a benefits transfer analysis that takes into account uncertainty is prefer- REFERENCES able to no benefits study at all. EPA. 2000. Guidelines for Preparing Economic Analyses. Available online Both the EPA (EPA, 2000, p. 27) and the Office of Man- at http://yosemite.epa.go/ee/epa/eed.nsf/webpages/Guidelines.html. agement and Budget (OMB, 1992, p. 10) guidelines cite OMB (Office of Management and Budget). 1992. Guidelines and Discount the importance of being explicit and detailed in describ- Rates for Benefit-Cost Analysis of Federal Programs. Circular A-94. ing the sources and nature of uncertainties in an analysis, Washington, DC: OMB. Available online at http://www.whitehouse. whether the uncertainties are about outcomes in the future go/omb/circulars/a04/a04.pdf.

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