August 8, 2017    5 minute read

A Brief Snapshot of Environmental Economics

Quantifying Nature    August 8, 2017    5 minute read

A Brief Snapshot of Environmental Economics

Environmental economics is the science that studies the effect of environmental policies on a country’s economy. In its analysis, it accounts for the long term loss suffered from adopting polluting policies, proposing solutions based on the dynamic efficiency principle, augmenting a regular cost-benefit analysis with an economics translation of the environmental patrimony.

It is important to give a clear definition of the latter:

Dynamic efficiency balances future uses of a depletable resource by maximizing the present value of the net benefits derived from its use. The dynamically efficient allocation of any resource has to satisfy the condition that the present value of the marginal benefit from consumption of the last unit in T1 equal that in T2, with T1 > T2. Given a maximum amount of any resource, then the dynamic allocation of a resource over  periods is the one that satisfies the maximization problem:

Mathematically speaking, dynamic efficiency can be understood in the following manner: given an inverse demand function  the total benefits from extracting an amount qt in year, t is then the integral of the following function:

Herein lies the first hurdle. Is it possible to perfectly reflect the value of something that is not priced in the market? How is the cost of cutting down a portion of the Amazon rainforest priced? These questions have been highly debated in the scientific community, but a common ground has been reached. The damage caused by pollution can take different forms. The first, and probably the most obvious, is the effect on human health. Other forms of loss include loss of enjoyment from outdoor activities and damage to vegetation, animals and materials. To assess the magnitude of these damages 4 (four) steps are needed:

  1. Identifying the affected categories;
  2. Estimating the physical relationship between the pollutant emissions and the damage caused to the affected categories;
  3. Estimating responses by the affected parties toward averting or mitigating some portion of the damage;
  4. Placing monetary value on the physical damages

Valuation Methods

Further, valuation methods can be distinguished into 2 (two) broad categories: Stated preference and Revealed preference. The former accounts for actual observable choices that allow resource value to be observed i.e. the observed decrease in profits enjoyed by local fisherman from an oil spill, while the latter series of surveys where key questions are posed to a population sample. All these concepts can be further organized into one simple idea: sustainability. This term can be defined following two different spectrums:

Sustainability is the property of biological systems to remain diverse and product indefinitely. In more general terms is the endurance of systems and processes.

By this definition, it is clear that sustainability can be seen as a self-reinforcing mechanism for which nothing is depleted. It can be seen as a portfolio of assets where only the interest earned on the principal is withdrawn from the account, i.e., leaving always the same principal, subject to the same interest rate. From this point of view, sustainability is a static state. However, attaching to it some economics, the definition adopts a different look.

Sustainability

Sustainability focuses on meeting the needs of the present without compromising the ability of future generations to meet their needs. It encourages business to frame decisions in terms of years and decades rather than on the next quarter’s earnings report and to consider more factors than simply the profit or loss involved.

From the definition, we can draw the conclusion that sustainability deals with solving the intertemporal consumption bundle problem in two periods, namely T1 and T2. To see this, we can think about the classic capital allocation problem where an initial endowment, W0, has to be allocated in two periods in order to maximize the utility of the agent. Now, instead of an initial endowment of capital, we have a finite amount of a natural resource that has to be allotted between two generations, the present and the future one, in order to maximize both utilities.

Following the theory proposed by John Hartwick allows us to see sustainability in a more operational way. He demonstrated that “a constant level of consumption could be maintained perpetually from an environmental endowment if all the scarcity rent derived from resources extracted from that endowment were invested in capital.” Scarcity rents are defined as the profits resulted from the depletion of a scarce good. The Hardwick rule is fundamental as it allows us to go back to the previous example of the “sustainable portfolio” and give a more concrete definition of the latter: given an allocation of capital, the said allocation is sustainable if and only if the value of the total capital stock is constant over time.

Conclusion

This allows us to judge an allocation based on the extent with which the capital invested declines over time. In a simple portfolio example, the scarcity rent would be the interest earned on the principal, and a sustainable portfolio would require the initial capital to remain constant over time. Including also natural capital inside the definition, defined as the world’s stock of natural resources, allows us to distinguish between 3 (three) different levels of sustainability, namely Weak, Strong and Environmental.

  • Weak sustainability requires that the resources used by previous generations should not exceed a level that would prevent future generations to enjoy that resource. It thus requires the total value of capital, natural + physical, to remain constant over time identifying the two as being perfect substitutes;
  • The Strong form instead starts from the assumption that natural and physical capital offer limited substitution possibilities. Furthermore, natural capital only should remain constant;
  • Under the Environmental threshold is the physical flow of individual resources that should be maintained constant, not merely the aggregate.
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