Chapter 1.

Introduction to
Environmental Economics

Assoc.Prof. Le Dinh Hai

 Chapter 1: Introduction to Env
Econ
Content:
• General understanding of Environmental
Economics
• Economy and environment
• Discussion: Global and local environmental
issues
1. General understanding of Env Econ
1.1. The concept of environmental economics
1.2. Economic analysis/CBA
1.3. Environment and development
1.4. Environment in the context of global change
 1.1. The concept of environmental
economics
• An economic science, developed from the 1960s
• Use economic analysis concepts and tools
• Concepts: scarcity, production capacity limit, trade-off,
supply, demand, marginal benefit, marginal cost,
economic efficiency, externalities. Public goods..
• Tools: Cost benefit analysis (CBA), cost effectiveness
analysis (CEA), evaluation tools, optimization...
• Explain and solve environmental problems (in a broad
sense, including natural resources and environmental
quality)
• Ensuring socio-economic efficiency in terms of
environment/ecosystem constraints
1.1. The concept of environmental
economics
• Environmental economics is the application of
economic principles to study the development and
management of environmental resources.
• Environmental economics is an economic science,
applying economic theories and analytical techniques
to explain and solve environmental problems in a way
that ensures the highest socio-economic efficiency in
environmental constraints or within the capacity of
ecosystems.
1.1. The concept of environmental
economics
• Two main branches:
• Natural resource economics: Solve problems
related to the exploitation and use of resources in
an economically efficient way, maximizing
economic welfare
• Environmental economics: Economic assessment
of environmental changes, explaining the economic
causes of pollution and degradation of natural
resources/environmental quality, and proposing
economic solutions to prevent, minimise, and
improve.
NR. Economics and Env. Economics

Natural resource Economics Environmental Economics

(look at flow from the Env to economy: (look at flow from economy
use of NR as inputs ) To the Env: damage caused)
 1.1. Concept of environmental
economics
The three core problems of environmental
economics:
• Assess the economic importance of environmental
changes
• Explain the economic causes of environmental
changes
• Proposing economic solutions to slow down, stop,
and even reverse changes that have negative
impacts on the environment
Environmental problems in the world
today
• Climate Change
• Environmental pollution
• Depression of enviroment
• Depletion of natural resources
 How are the above issues related to economic
activities?
20 main environmental problems in the
world today
1. Pollution
2. Soil Degradation
3. Global Warming
4. Overpopulation
5. Natural Resource Depletion
6. Generating Unsustainable Waste
7. Waste Disposal
8. Deforestation
9. Polar Ice Caps
10. Loss of Biodiversity
20 main environmental problems in the
world today
11. Climate Change
12. Ocean Acidification
13. The Nitrogen Cycle
14. Ozone Layer Depletion
15. Acid Rain
16. Water Pollution
17. Overfishing
18. Urban Sprawl
19. Public Health Issues
20. Genetic Engineering
(Source: https://www.conserve-energy-future.com/20-
current-environmental-problems.php)
Desertification
1.2. Principle of Economic Analysis
• In cost-effectiveness analysis, economists are
only concerned with the costs of achieving a
defined environmental goal.
• In cost-benefit analysis, both the benefits and
costs of a policy or program are measured and
expressed on a comparable basis.
• Economists use cost-benefit analysis as their
primary analytical tool to evaluate
environmental decisions.
1.2. Principle of Economic Analysis
• Cost – Effective Analysis
- A cost-effective analysis is undertaken when the objective
of a project/program has been decided and there are
number of ways to reach that objective.
- Cost-effective analysis is done by estimating the costs of
different alternatives, comparing the alternatives and
selecting the best way to reach the objective.
- Cost-effective is particularly useful in case where there is
wide agreement on the objective but not on how to reach
it.

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1.2. Principle of Economic Analysis
• Cost – Benefit Analysis
- To make a decision on whether or not invest to a certain
project, a private firm would want to study the commercial
feasibility of the project: estimate as clearly as possible
expected costs, expected revenues, compare and come to
a decision.

- Benefit-Cost Analysis (BCA) is an analogous exercise for

projects and programs undertaken in the public sector.
Rather than exploring commercial / financial feasibility,
BCA looks at social/economic feasibility.

16
1.2. Principle of Economic Analysis

Why is CBA useful?

• CBA examines costs and benefits from the
perspective of the community/society as a whole:
• it forces a wider view on decision makers
• promotes comparability and encourages
consistent decision making
• its aim is to maximize community net benefits
• CBA includes all costs and benefits – it tells the
whole story

17
1.2. Principle of Economic Analysis
Why is CBA useful?
• CBA provides a summary of the efficiency
effects of a policy

• But CBA can draw attention to equity issues

– by identifying who gains and who loses from
a regulatory proposal
– but it is up to decision makers to decide
whether distributional impacts/equity issues
are important and need addressing

18
1.2. Principle of Economic Analysis

When do you need to conduct CBA?

• Should be a greater focus on valuing impacts in

dollars for regulatory proposals, particularly
those with ‘significant’ impacts
• But non-monetised costs and benefits should not
be excluded from consideration in CBA
• Impacts should be reported in CBA as follows:
• monetised
• quantified, but not monetised
• qualitative, but not quantified or monetised

19
1.2. Principle of Economic Analysis
Existence of non-monetised costs and
benefits presents a challenge

• Agencies should consider non-monetised impacts

adequately but not overplay/overstate them
• If a proposal shows large monetised ‘net’ costs the
onus/duty is on the government agency to clearly
explain why non-monetised benefits would tip the
balance

20
Basic steps in conducting a CBA

1. Specify the set of policy options

2. Decide whose costs and benefits count

3. Catalogue the impacts and select measurement

indicators

4. Predict the impacts over the life of the

regulatory proposal

21
 Basic steps in conducting a
CBA
5. Monetise (attach dollar values to) impacts

6. Discount future costs and benefits to obtain

present values

7. Compute the net present value for each policy

option

8. Perform sensitivity analysis

9. Rank the policy options

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1. Specify the set of policy options

• Specify the set of policy options to solve a problem

• One of the options should always be ‘maintain

current arrangements’

• The number of potential options can be large

• Analysts typically analyse only a few feasible

options (usually < 6)

23
2. Decide whose costs and benefits
count

• Usually only take account of costs and benefits at

the national level – from the Vietnamese
community’s perspective

• Some argue costs and benefits to non-nationals

should also be included for international/global
issues

• However, for most regulatory proposals,

measuring national costs and benefits is
appropriate
24
3. Catalogue the impacts and select
measurement indicators

• Identify the full range of impacts of the regulatory

proposal

• Identify incremental costs and benefits relative to

the base case (i.e. ‘maintain current
arrangements’)

• Changes that would have occurred anyway should

not be attributed to the regulatory proposal

• Choice of measurement indicator depends on data

availability and ease of monetisation
25
4. Predict the impacts over the life
of the regulatory proposal

• Impacts should be quantified for each time period

over the life of the regulatory proposal

• Prediction of future impacts is difficult – there will

always be some uncertainty surrounding the
outcome of a regulatory proposal

• Forecasts of costs and benefits require some

assumptions to be made – these should be
justified and made transparent

26
5. Attach dollar values to all impacts

• We measure costs and benefits in dollar terms to

enable comparisons to be made

• Analysts must estimate impacts in a variety of

circumstances:
• competitive markets
• distorted markets (e.g. externalities)
• no market signals (e.g. human life)

• Problems arise where markets do not work well or do

not exist - in these cases techniques are available to
estimate impacts
• revealed preference techniques
• stated preference techniques

27
 6. Discount future benefits and
costs to obtain present values

• Costs and benefits of regulatory proposals are spread out

over time

• Positive market interest rates indicate that people value a

dollar in the future less than a dollar now

• To reflect this, future benefits and costs are discounted to

present values which expresses them as an equivalent
amount in today’s dollars

• In most cases preferred approach is to base the discount

rate on market-determined interest rates.
28
7. Compute the net present value
of each alternative policy option

• Net Present Value (NPV) is equal to present value

of benefits minus present value of costs:

NPV = PV(B) – PV(C)

• If all costs and benefits cannot be valued in

dollars, outline why non-monetised impacts are
large or small relative to monetised impacts

29
7. Compute the net present value
of each alternative policy option

Net Present Value:

Benefit-Cost Ratio:

Internal Rate of Return [IRR]

• IRR = Discounted rate at which NPV is zero.
• Identifies the actual return from a project.
30
8. Perform sensitivity analysis
• There is usually considerable uncertainty about
predicted costs and benefits

• Sensitivity analysis shows how these uncertainties

affect the CBA results

• Two types of sensitivity analysis:

• worst/best case analysis

• partial sensitivity analysis

• If the sign of the net benefits does not change

after considering the range of scenarios, there can
be confidence in the CBA results
31
9. Rank the policy options

• The analyst should specify which option is the

most efficient

• Generally, it will be the one with the largest NPV

• The recommendation should be clearly

presented

32
 CBA accuracy
• The usefulness of CBA depends on its accuracy

• Accuracy depends on how well the analyst

performs the nine steps

• Each step is subject to errors but most

important errors occur in steps 3, 4 & 5 relating
to:

• specifying the cost and benefit categories

• predicting the costs and benefits
• valuing the costs and benefits in dollars

33
 Common CBA pitfalls
• Downplaying or ignoring non-financial social
benefits and costs

• Double counting benefits

• ‘Before/after’ rather than ‘with/without’

• Selecting a discount rate to deliver a particular

result

• Ignoring uncertainty – no sensitivity analysis

34
 Consider the counterfactual – ‘with and
without’

Net benefits

With regulation

Without regulation

Time
Regulation
introduced

35
Determining impact valuations
from secondary sources

• Obtaining valuations is time consuming and

resource intensive

• Least-cost approach is to use previously estimated

valuations – don’t have to reinvent the wheel

• Refer to such estimates as ‘plug-ins’ or ‘benefits

transfer’ or ‘information transfer’

• Although catalogues of impact values are not

comprehensive, considerable progress has been
made
36
Frequently used ‘plug-ins’ include:
• Value of a statistical life or life year

• Value of travel time savings

• Value of recreational activities

• Value of nature (species or habitats)

• Cost of noise pollution

• Cost of air pollution

37
Valuing mortality risk reduction or the value
of a “statistical” life (VSL)

• How much would individuals pay to achieve a

small reduction in the probability of death?

• Revealed preference and stated preference studies

can provide estimates of willingness to pay for
small changes in mortality risk

38
VSL is not the value of an ‘identified’
life!

• VSL is the aggregate amount that a group of individuals are

WTP for a risk reduction

• If people are WTP, on average, $12 for a risk reduction from

5 in 500,000 to 4 in 500,000

• VSL = $12/0.000002 = $6 million

• It does not mean that an individual would pay $6m to avoid

(certain) death this year

• It does imply that 500,000 similar people would together pay

$6m to eliminate the risk that is expected to kill one of them
randomly this year 39
No set formula for attaching
dollar values to impacts
• High quality analysis may require professional
expertise – consultants can be useful

• Different impacts may call for different estimation

techniques

• Will depend on the nature and complexity of issue

and availability of information

40
CBA should be undertaken for all
‘significant’ regulatory proposals
• Definition of ‘significant’ requires some
judgement

• Scale of CBA should be commensurate/matched

with magnitude of problem

• Agencies should devote more resources to

problems where stakes are greater

41
Preparing proposals with a greater
focus on quantification: key challenges

• Proper resourcing

• Getting the right skills

• Collecting high quality information

• Consulting with stakeholders

42
Key messages
• CBA is a pragmatic tool for drawing attention to
the likely impacts of regulation

• Quantifying costs and benefits is challenging but

not impossible (given sufficient time, skill and
resources)

• CBA can play an important role in improving the

quality of regulatory proposals – even when
valuation is difficult

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A sobering thought …
• There are significant challenges in using
CBA

• Mainly because it is inherently difficult to

accurately measure benefits and costs in
dollar terms

• But even when it is difficult to measure

benefits and costs with any precision,
applying the CBA framework is important
and useful
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 For example: Tourism development project for
coastal area

Year Year Year Year Year Year Year Year

1 2 3 4 5 6 7 8
Initial investment costs 1200 0 0 0 0 0 0 0
Annual operating costs 0 500 600 700 800 900 1000 1100
Annual revenue 0 800 1000 1200 1400 1600 1800 2000
Environmental external 200 250 300 350 400 450 500 550
costs

1. Explain “environmental externality costs”

2. Evaluate project efficiency
- Business perspective (r = 10%)
- Social perspective (r = 12%)
3. Management policy for the project?
1.3. Environment and development
a. Growth, Development and Environment
• Growth: increase the scale of the economy, increase
average income per capita (GDP per capita)
• Development: the process of improving the quality of
human life in a certain period of time through
increasing the scale of economic activities and changing
the quality of socio-economic activities.
• Development = Growth + Socio-economic
restructuring towards progress
•  To grow & develop, it is necessary to use scarce
resources, including natural resources while creating
environmental impacts and Trade-offs???
1.3. Environment and development
b. Relationship between Environment and
Development:
The environment is the location and an important
necessary condition for development
Basic functions of the environment:
• Habitat
• Resources
• Information archives and supply
• Waste storage and cleaning
The Economic System and the Environment
1.3. Environment and development
Development: the process of using and changing the
environment
• Human impact in the development process can
degrade the environment, reduce environmental
functions, and negatively affect humans and
living things.
• Development also creates necessary conditions
(such as capital, technology, raising awareness
and consciousness...) for environmental
protection, developing resources, finding
alternative sources...  important positive
system
The environmental Kuznet curve
 Conventional view of economics
• Conventional
economics focuses
on production and
consumption
• Ignores the
environment
• The environment is
an external “factor
of production”
Environmental
view of economics

• Human economies
exist within, and
depend on, the
environment
• Without natural
resources, there
would be no
economies
 Environmental systems support
economies
• Ecosystem services = essential services support the life
that makes economic activities possible
* Soil formation * Pollination
* Water purification * Nutrient cycling
* Climate regulation * Waste treatment
• Economic activities affect the environment
• Deplete natural resources
• Produce too much pollution
 SOLAR
EARTH
CAPITAL

Goods and services

Heat
Human Capital Human
Economic
Depletion of
and nonrenewable resources
Cultural
Systems Degradation of
Natural Capital renewable resources

Pollution and waste

 NATURAL CAPITAL = NATURAL RESOURCES + NATURAL SERVICES
NATURAL RESOURCES NATURAL SERVICES

NATURAL GOODS NATURAL SERVICES

Air Air purification

Water purification
Water Water storage
Soil Soil renewal
Nutrient recycling
Land
Food production
Life (Biodiversity) Conservation of
NATURAL CAPITAL = + biodiversity
Nonrenewable Wildlife habitat
minerals
(iron, sand) Grassland and
forest renewal
Renewable energy Waste treatment
sun, wind, water
flows Climate control
Population control
Nonrenewable (species interactions
energy (fossil fuels,
nuclear power) Pest Control

Fig. 1-4, p. 9
 ENVIRONMENTAL GOODS AND SERVICES THAT GENERATES AN
ECOSYSTEM
Environmental Goods – Tangible Environmental Services – Ecosystemic
Products of the Nature (Raw materials) Functions that benefit Humans

- Water for Domestic use - Underground water supply

- Water for the Agriculture - Soil water retention/Preservation
- Water for Industrial use - Soil protection
- Wood - Carbon sequestration
- Medicine Plants - Flood control
- Firewood - Erosion control
- Seeds - Nutrients retention
- Food - Landscape attraction
- Plants and Fruits - Watershed protection
- Other products of the forest
- Biological raw material
- Flora and fauna
- Handicraft
- Cattle
- Agricultural products.