metadata: authors: 0: author: Ley,Eduardo
1: author: Tran,Ngoc-Bich
count: World
docna: 0: docna: Green prices
docty: Policy Research Working Paper
subtopic: Health Care Services Industry,Labor Markets,Hydrology,Energy Demand,Energy and Environment,Energy and Mining,Global Environment,Rural Labor Markets
teratopic: Environment,Transport,Macroeconomics and Economic Growth
abstracts: cdata!: "Getting the prices right" is
            a good starting point but is not sufficient for achieving
            environmentally efficient outcomes. Other policy
            interventions are often necessary to complement pricing
            policies. Moreover, when pricing is not at all feasible,
            regulatory and command-and-control policies must be used
            instead. This paper focuses on three interrelated themes at
            the core of the pricing problem. First, there is the
            incorporation of non-marketed activities with environmental
            consequences into aggregate measures of economic
            performance: the so-called "green-GDP." Second,
            there is the problem regarding the reliable estimation of
            the valuation of the shadow prices that properly reflect
            environmental externalities. Third, there is the issue of
            full-cost pricing that requires the pricing of environmental
            externalities for guiding both individual and public decision-making.
repnme: repnme: Green prices
display_title: Green prices
listing_relative_url: /research/2012/07/16506689/green-prices
topicv3: Labor Markets m1326488 855,Water m1326522 137,Energy and Extractives m1326595 507,Environment, Natural Resources and Blue
            Economy m1327391 566,Health m1504661 3480
publishtoextweb_dt: 2012-07-01T00:00:00Z
historic_topic: Environment,Transport,Macroeconomics and Economic Growth
no_of_pages: 30
author_keys: 0: author_key: 913182
1: author_key: 1010398
model_extractions: WPS6131 Policy Research Working Paper 6131

# Green Prices

_Ngoc Bich Tran Eduardo Ley_ The World Bank Poverty Reduction and Economic Management Network Economic Policy and Debt Department July 2012
Policy Research Working Paper 6131

# **Abstract**

“Getting the prices right” is a good starting point but is not sufficient for achieving environmentally efficient outcomes. Other policy interventions are often necessary to complement pricing policies. Moreover, when pricing is not at all feasible, regulatory and commandand-control policies must be used instead. This paper focuses on three interrelated themes at the core of the pricing problem. First, there is the incorporation of nonmarketed activities with environmental consequences into aggregate measures of economic performance: the so-called “green-GDP.” Second, there is the problem regarding the reliable estimation of the valuation of the shadow prices that properly reflect environmental externalities. Third, there is the issue of full-cost pricing that requires the pricing of environmental externalities for guiding both individual and public decision-making.

This paper is a product of the Economic Policy and Debt Department, Poverty Reduction and Economic Management Network. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The author may be contacted at eley@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# GREEN PRICES

Ngoc Bich Tran The World Bank Eduardo Ley The World Bank JEL Classification—Q510, E010 This paper builds on work prepared for the joint PREM-SDN Knowledge Platform on Green Growth. Alex Bowen, Milan Brahmbhatt, Mark Dutz, Antonio Estache, Marianne Fay, Adrian Fozzard, Stéphane Hallegatte, Kirk Hamilton, Geoffrey Heal, Urvashi Narain, Diego Rodriguez, David Treguer, Michael Toman, Jeff Vincent provided useful comments.
# 1. INTRODUCTION

Prices shape the constraints that economic agents face and guide their economic choices. In the absence of market failures, prices reflect social valuations and they summarize all that individual participants need to know in order to be able to make their economic decisions. Moreover, the outcome of all these decentralized decisions leads to a social optimum. However, when some prices are misaligned with social valuations, then the market equilibrium will no longer be optimal. In particular, when actions have environmental dimensions, very often there are unaccounted externalities leading to socially suboptimal outcomes. In this context, correcting prices may not be sufficient whenever behavior cannot respond significantly because there are not available alternatives. In these cases, complementary policies (e.g., regulatory, innovation and technology, sectoral policies) are needed to expand the range of options and bring positive changes.

There are three interrelated themes at the core of the pricing problem: (i) the incorporation of nonmarket activities with environmental consequences into aggregate measures of economic performance: the so-called “green accounting”; (ii) the reliable estimation of the valuation of these externalities (shadow prices); and (iii) the pricing of environmental externalities (e.g., in the electricity, transport, water sectors) for guiding individual and public decision-making.

1. The first issue, green accounting, has important consequences for policy-making, as Stiglitz and others (2010) so persuasively argue: “What we measure affects what we do; and if our measurements are flawed, decisions may be distorted. Choices between promoting GDP and protecting the environment may be false choices, once environmental degradation is appropriately included in our measurement of economic performance. So too, we often draw inferences about what are good policies by looking at what policies have promoted economic growth; but if our metrics of performance are flawed, so too may be the inferences that we draw.”

2. The second issue, shadow prices, deals with the estimation of the value of non-marketed flows (e.g., pollution), is at the foundation of any solution of the two other issues (1 and 3). In order to properly evaluate decisions and policies, adequate valuation of environmental effects is a prerequisite. Until estimates of _shadow prices_ (sometimes referred as social prices or accounting prices) are broadly perceived as reliable and grounded on solid facts and methodology, the incorporation of environmental externalities into social and individual decision-making will be met with skepticism and will have less impact than it deserves.

3. The third issue is the full-cost pricing. Provided that environmental externalities have been accounted (green accounting) and adequately valued (shadow prices), prices can be modified to induce behavioral changes. The mispricing of activities with environmental consequences has significant implications for individual and public decision-making. What gets and doesn’t get included in the agencies’, firms’ and individual (formal or informal) cost-benefit analyses determines the decisions that are made at the micro level. Distortionary pricing remains large in the energy sector—for example, in 2009, according to the International Energy Agency,
governments around the world spent some $300 billion on fossil fuel subsidies; more than thirty times what they spent on energy R&D. Billions more are spent by high income countries on agricultural subsidies and likely on more difficult to estimate supply-side energy subsides. Other examples abound—fisheries without property rights (zero prices); subsidized insurance policies that promote building in flood plains, etc.

As noted, for pricing mechanisms to be successful in addressing environmental issues it is required that feasible alternatives must be readily available, or easily brought to market. For instance, the US acid rain program successfully used SO2-emissions pricing because the required technologies already existed and were well understood (Zysman and Huberty, 2010). In this case, prices were a powerful incentive for the _adoption_ of existing alternative technologies. Prices, however, are not sufficient when the alternative is non-existing and must be “generated.” The alternative can be generated sometimes through innovation (e.g., alternative energy sources), and sometimes through complementary public interventions (e.g., public transportation network). These policy interventions increase the range of private options and, therefore, make individual behavior more responsive (elastic) to price signals. Other non-price policy interventions (e.g., regulatory standards) may instead reduce the range of options available to decisionmakers.

Thus, often price interventions must be complemented by other policies to achieve significant behavioral changes. Low price elasticity in the demand of motor fuels can be a manifestation that substitutes to private driving are unavailable. In this case, the creation of a public transportation network increases the motor fuel price elasticity. Note, however, that for the public transportation network to increase social welfare, it still must pass the appropriate social cost-benefit test. When it does not, then private driving may be the best social option; motor fuels should in any case be priced to reflect all their externalities (Parry and Small 2005). When investment choices are involved, may they be in physical capital or R&D, we may observe low response to pricing policies because there may be substantial uncertainty about future pricing policies. These are long-term decisions and expectations about the future economic context weigh significantly.

As noted, in some cases, non-price policies may be better suited than pricing policies. However, it is always useful to have (estimated) prices available to properly assess these interventions. Regulatory policies can provide the right incentives when the technological targets are well understood, and sometimes direct government action may be the appropriate policy intervention The rest of this paper is organized as follows. Section 2 briefly discusses the pricing of non-market transactions and its inclusion in measures of economic performance; what is known as green accounting. Section 3 discusses issues related to the estimation of shadow prices. Section 4 covers the full-cost pricing and tackles the issues of taxation and energy subsidies. Section 5 concludes.

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# 2. GREEN ACCOUNTING

Environmental accounting focuses on the measurement of natural wealth and the goods and services generated by this natural wealth. Accounting efforts have encompassed accounting for both flow of services, consumption or generating of pollutants and capital accounting—accounting of changes in the stock of natural resources or the condition of the natural environment (Abraham and Mackie, 2005). See also Nordhaus and Kokkelenberg (1999). Tracking natural wealth is key for sustainability. “The core of the idea of sustainability, then, is the concept that current decisions should not impair the prospects for maintaining or improving future living standards” Repetto (1986). Thus, sustainable national income is defined as the maximum amount that can be consumed while ensuring that all future generations can have living standards that are at least as high as that of the current generation.

“Concepts like GDP focus on easily measurable things, whilst omitting ecosystem services and other environmental factors on which life ultimately depends.”<sup>1</sup> Green GDP aims to include environmental degradation in the standard measure of aggregate economic performance, GDP. For this purpose, there exists an established methodology to incorporate environmental concerns into the national accounts grounded in the system of Standard National Accounts (SNA). The system of Environmental Economic Accounting (SEEA) is a satellite account of the SNA, which brings together economic and environmental information into a common framework to measure the contribution of the environment to the economy and the impact of the economy on the environment.

Among other things, the SEEA deals with how the existing SNA might be adjusted to account, in monetary terms, for the impact of the economy on the environment. Three sorts of adjustments are considered: those relating to resource depletion, those concerning defensive expenditures (e.g., protection expenditures), and those relating to environmental degradation (SSF, 2010).

Thus, the SEEA permits the calculation of “green GDP” as an extension of the concept of net domestic product adding the depletion of natural capital to the depreciation of physical capital. Furthermore, emissions of pollutants are assigned (negative) values and incorporated into an environmentallyadjusted Net Domestic Product. Therefore green GDP (g-GDP) is really _net_ and not _gross_ , and it should be better referred to as “green NDP.” However, since the term is widely used we shall continue the usual practice and use “g-GDP” here to denote an environmentally-adjusted NDP.<sup>2</sup> As noted in Abraham and Mackie (2005), the treatment of externalities is a central issue for environmental accounting, and the most important applications relate to air and water pollution. Whether failing to account explicitly for the potentially large negative externalities associated with pollution distorts measures of aggregate output depends on whether only market output or at least some nonmarket output is adversely affected. In the first case, aggregate output is measured correctly, though its allocation across sectors may be incorrect; in the second case, if pollution is considered a negatively valued product, even aggregate output is measured incorrectly (Nordhaus, 2004).

> 1 Lord Robert May; page iii in Dasgupta (2001). 2 See Dasgupta and SSF for the shortcomings of g-GDP as a sustainability indicator.

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There have been several attempts to incorporate environmental externalities into g-GDP by less developed countries. Most prominently, China assessed environmental damages around 3 percentage points of its GDP in 2004<sup>3</sup> (report published in 2006), but the effort was discontinued and the report for 2005 due in 2007 was never issued officially. More recently, India has committed to produce g-GDP by 2015<sup>4</sup> and a commission headed by Professor Partha Dasgupta has been established to that effect.<sup>5</sup> The list of countries doing green accounting includes Australia, Austria, Botswana, Brazil, Canada, Chile, Czech Rep. , Denmark, Estonia, Finland, France, Germany, Guatemala, Indonesia, Japan , Korea , Mexico, Namibia, Netherlands, Norway, New Zealand, Philippines, Slovak Rep., South Africa, Sweden, and the UK.

While the estimation of g-GDP may still be in its infancy and some of its elements still controversial, the conceptual framework is useful for thinking about green growth. Green growth can be understood as growth of a suitably defined g-GDP. Some apparent tradeoffs between environmental quality and GDP growth vanish off. In his Nobel lecture, Robert Solow gives an account of Edward Dennison’s growth accounting results. During the period 1929-1982 Denison identifies sources for 109 percent of the recorded growth, because miscellaneous factors then reduce the growth of output by 9 percent of the 3.1 annual growth, or 0.3 percent per year. Solow remarks “These negative factors could include such things as investment in environmental improvement, which uses resources but does not appear in measured output, though it may of course be very valuable.”<sup>6</sup> g-GDP attempts to remedy such an omission by providing a more comprehensive measure of output.

Consider, for example, a transportation project whose main payoff is the reduction of congestion. Thus, assume that, as is commonly the case, in the cost-benefit analysis, the main source of benefits stems from the value of travel-time savings. But this value of time is not included in GDP statistics. If we look at just first-round effects (or if we assumed that no change in behavior follows), then such a project, despite its positive net social value, could actually affect negatively GDP through motor-fuel savings. g- GDP accounting eliminates these apparent tradeoffs.

Muller and others (2011) present a framework to include externalities into a SNA using an integratedassessment model that includes air pollution, solid waste combustion, stone quarrying, marinas, oil- and coal-fired power plants etc. The largest industrial contributor to external costs is coal-fired electricity generation, their damages range from 0.8 to 5.6 times its value added. The implication of damages in excess of value-added is that closing down that industry would unequivocally increase g-GDP.

The policy implications are (i) to take a broad view of economic activity to eliminate tradeoffs that are more apparent than real; e.g., between environmental quality and economic performance; and (ii) Include all dimensions that are relevant for welfare in the corresponding cost-benefit analyses of policy interventions and perform sensitivity tests on the components that are measured with significant uncertainty (e.g., value of a statistical life).

> 3 - Report published in 2006, available at: http://www.gov.cn/english/2006 <u>09/11/content_384596.htm</u>

> 4 <u>http://www.financialexpress.com/news/India-to-release--green-GDP--data-from-2015/544338/</u>

> 5 <u>http://www.telegraphindia.com/1110510/jsp/nation/story_13962877.jsp</u>

> 6 Robert Solow, “Growth Theory and After,” Nobel Lecture, December 8, 1987.

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The biggest challenge in computing a g-GDP is on assigning accurate monetary values to outputs and activities that are not transacted in markets (i.e., the ‘second issue’ mentioned in the introduction). Cost associated with emissions of pollutants may include harm to human health, reduction agricultural productivity, damage to the environment, climate change etc. Putting a monetary value on these effects requires estimation methods outside the realm of standard SNA techniques, which rely on observable market transactions. The challenge is to reliably estimate the shadow values of these activities, i.e., the social valuation at the margin. The estimated prices associated with these externalities have been termed _soft_ prices in contrast with observable _hard_ market prices (Dasgupta, 2001). Section 3 discusses the estimation of these shadow prices.

# 3. SHADOW PRICES

Shadow prices are central for green accounting and for full-cost pricing, when market prices do not anymore reflect the social valuation of some goods or services. This is, in particular, the case when there are market failures, policy interventions in other markets, or in absence of some markets. The case of clean air is a typical example where no complete market exists. Endangered species or remote natural reserves are examples of environmental assets whose values are not fully captured by the market prices, which thus lead to undervaluation relative to the shadow price. Many of the green pricing issues are a consequence of the public good characteristics of environmental issues.

Pure public goods are non-rival in consumption, which means that can be consumed by everyone. The implication is that their value is the sum of all individual valuations. It is the dual context to the case of private goods where a single market price is shared by all and individual consumption varies with individuals. In the case of public goods, the same amount is consumed by all while valuations at the margin vary with each individual. Since “personalized” prices are generally unfeasible, decentralized provision of public goods normally results in under-provision (Bergstrom, Blume and Varian, 1986). Centralized provision requires knowledge of valuations at the margin, and truthful revelation of these individual valuations is difficult to achieve.

The economic _valuation_ of environmental quality, which is a public good, consists in assigning monetary values to environmental assets and flows. Expressing environmental impacts in monetary terms rather than in ecological terms has the advantage to be readily understood by decision makers and by the public. By using a common money-value metric it facilitates the comparison between different policy measures and spending allocated to environment protection with other public spending such as health or education.

The _Total Economic Value_ (TEV) framework allows for comprehensively quantifying several different aspects of the environment. The TEV proves to be particularly useful for determining the value of the total flow of benefits from ecosystems, evaluating the net benefits of interventions that alter ecosystem conditions, examining the distribution of the costs and benefits of ecosystems, and identifying the potential financing sources for conservation (Pagiola and others, 2005). After the _valuation_ stage, projects with environmental impacts or policy measures can then be properly _evaluated_ according to 6
<!-- Start of picture text --> Total Economic Value<br><!-- End of picture text --> <!-- Start of picture text --> Use Values Non-use Values<br><!-- End of picture text --> <!-- Start of picture text --> Direct use Values _ Indirect use Values Option Values Existence Values Bequest Values<br>(Structural values) — (Functional values)<br>*Production Function *ProductionFunction *Contingent Valuation *Contingent Valuation<br><!-- End of picture text -->

*Cost-based *Cost-based *Hedonic Prices approaches approaches *Hedonic Price «Contingent Valuation

- *Contingent Valuation

- *Travel costs
- forest, carbon sequestration by forest, recreation opportunities provided by parks and forest, visual aesthetic benefits from a landscape.

- (iii) _Option values_ are derived from the potential future use of a good. Not consuming an environmental asset gives the possibility of exploiting it in the future, or to keep conserving it depending on the information available in the future. The option values usually refer to the irreversible nature of specific resources. Hence a natural asset such as the Amazonian forest may appear uncertain today but as time elapses, new information related to bioprospecting for instance may lead to revaluate the asset.

# B. Non-Use Value

- (i) _Existence values_ are derived from the satisfaction that individuals gain by knowing that something exists, and the option for potential use is there available for others. Example of existence value is the conservation of a natural area that one is unlikely to visit.

- (ii) _Bequest values_ are derived from the satisfaction that individuals gain by knowing that something will be bequeathed to the next generation. Examples of existence values are given by the conservation of blue whales or panda bears.

# **3.1 Estimation of Shadow Prices**

Shadow prices can be used for _valuing_ overall decision or action of interest, or for _weighting_ the characterization factors, i.e. the contributions of each pollutant to a particular environmental impact (e.g, acid rain, climate change, etc.). Estimating the shadow prices for each contributing pollutant, together with their characterization factors, allows assigning monetary values to ecological impacts.<sup>7</sup> The methods used to infer the economic value of environmental goods and services that are not traded in actual markets can be classified into two groups according to whether the preferences are _revealed_ or _stated_ .

1. _Revealed preference methods_ are based on observable decisions made by individuals in existing or surrogate markets. Market information is used as indicator of peoples’ preferences to infer the implicit value of environmental goods and services that are not directly traded in actual markets. This approach is typically used to estimate direct or indirect use values, such as extractive or recreation values. These techniques include the production function method that estimate production losses consecutive to environmental damages and the cost-based methods such as the averting behavior and defensive expenditures, the travel cost method and the hedonic price method.

2. _Stated preference methods_ are based on hypothetical behaviors where values are derived from preferences _stated_ by individuals on hypothetical markets. The willingness to pay (WTP) or to

> 7 See Bolt, K; Ruta, G and M. Sarraf, Estimating the Cost of Environmental Degradation, 2005, The World Bank Environment Department; and Pearce, D.; Atkinson, G and S. Mourato, 2006, Cost-Benefit Analysis and the Environment: recent developments, OECD.

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accept (WTA) is inferred using these methods. This approach is particularly useful for valuation of non-use or option values. The methods include contingent valuation and choice modeling.

# **3.1.1 Revealed Preference Methods**

# _A. The Production-Function Method_

The production-function method measures the impacts from a change in environmental quality on the output of marketable goods (e.g. products from fishing activities, crops and agricultural products, etc..). The method is particularly used to assess the agricultural loss consecutive to environmental deterioration. See Hanley and Barbier (2009) for examples using this method<sup>8</sup> .

# _Conceptual Framework_

The method consists in inferring the value of unpriced environmental quality through their impact on marketed outcomes. The approach assumes that it exists substitute or complement goods to the intangible good to be valued that are traded and priced on the markets.

Considering the amenities and services provided by the environment as a factor of production, this approach measures the impacts from a change in environmental quality on the output of marketable goods (e.g. products from fishing activities, crops and agricultural products, etc.). The environmental changes are translated into changes in costs and quantities supplied in the market. The willingness to pay to conserve or improve environmental quality can then be measured through the sum of changes in consumer and producer surpluses.

The method is usually implemented in two steps. During the first stage, the physical effects of a marginal change in environment on the marketed outcomes are identified. In a second step, the

> 8 Examples provided by Hanley and Barbier (2009) encompass the analysis of maintenance of biodiversity and carbon sequestration in tropical forests (Boscolo and Vincent, 2003); nutrient impacts in the Baltic Sea (Gren and others, 1997) and the Gulf of Mexico (Smith, 2007); pollination by tropical forests supporting coffee production in Costa Rica (Ricketts and others, 2004); modelling joint production of timber and wildlife from forests (Nalle and others, 2004); substitution possibilities between pollution emissions, fuels, labor, and capital in electric power generation (Considine and Larson, 2006); mangrove deforestation affecting mangrove habitat– fishery linkages in Thailand (Barbier, 2003 and 2007); soil conservation improving reservoir services (Hansen and Hellerstein, 2007); tropical watershed protection services (Kaiser and Roumasset, 2002);  coral reef habitat support of marine fisheries in Kenya (Rodwell and others, 2002); marine reserves acting to enhance the ‘insurance value’ of protecting commercial fish species in Sicily (Mardle and others, 2004) and in the Northeast cod fisherry (Sumaila, 2002); and nutrient enrichment in the Black Sea affecting the balance  between invasive and beneficial species (Knowler and others, 2001; Knowler and Barbier, 2005); the analysis of salmon habitat restoration (Wu and others, 2003); eutrophication of small shallow lakes (Carpenter and others, 1999); changes in species diversity in a marine ecosystem (Finnoff and Tschirhart, 2003); introduction of exotic trout species (Settle and Shogren, 2002); rangeland management with dynamic interactions between livestock, grass, shrubs and fire (Janssen and others, 2004); and cattle stocking on rangeland threatened by invasive plants and nitrogen deposition (Finnoff and others, 2008).

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environmental impacts determined under the first step are valued at the market price in terms of the corresponding change in the output<sup>9</sup> . _Dose-response function_ and _change-in-productivity_ methods are variants of the production function and share the same methodology.

# _Assumptions and Limitations_

The main shortcoming of this method is that interrelated causes and multiples impacts make it difficult to value comprehensively the environmental impacts. The role of the environment is multiple and a single ecosystem can support various economic activities. Identifying the complex interrelationship between the environmental quality deterioration and the marketed goods and services is crucial and often subject to bias. Another shortcoming of this method is that it ignores costly actions undertaken by individuals to prevent or mitigate environmental damages. Defensive or mitigating expenditures methods assess this feature and account for averting behavior. Finally, this approach does not consider the non-use value, i.e the existence value or the visual aesthetic of a natural site. Therefore, the production function approach provides a lower bound estimate of the foregone opportunity cost.

# _Variants_

_Human capital cost methods_ as well as _damage and abatement costs methods_ are all variants of the production methods to the extent that intangible goods (or bads) are measured at the market value of the resulting economic losses using a “dose-response function”, “exposure-response function” or “production function”. When the production function is applied to the health context, the _human capital cost_ method consists in quantifying human capital loss by assessing assesses the value of mortality by assigning a monetary value to the loss in productivity and foregone lifetime income. This approach has been used for instance to calculate monetary compensation for an individual death to its heir. The main shortcoming is that individual values are purely measured in terms of their economic contribution, i.e. priced on the labor market. Valuing environmental effects on mortality for unemployed, children, elderly or individuals working in the informal sector is more critical as there is no wage rate.

The _abatement costs_ are the costs of the most expensive technology used to meet government targets. The costs are determined by the intersection between the marginal costs for each firms and the ceiling set by the public authorities. When the targets are aligned with the social optimum, the abatement costs amounts to the Pigovian tax where the externalities are internalized. The _damage costs_ encompass the physical costs caused by the deterioration in environmental quality. It is commonly assessed using the impact pathway approach, which tracks the release of pollutant and estimate the physical impacts using a _dispersion-dose-response_ function. The physical impacts, which include effects on human health, ecosystems services, agricultural output and physical capital, are then monetized at the market prices.

DeBruyn and others (2005) estimated two sets of shadow prices for the Netherlands in the period of 2008-09. The first set displays the _abatement costs,_ illustrating the supply function for environmental

> 9 In the impact pathway analysis literature, environmental impacts can be evaluated at the midpoint level, i.e. at the environmental theme encompassing climate change, acidification, euthrophication and at the endpoint level, i.e. the impact on human health and economic activity.

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quality and the second one the _damage costs,_ which corresponds to the demand function from industries to pollute and damage natural resources. One shortcoming is that as the marginal abatement costs depend on the technology used and available at each generation, technology progress will then affect the marginal cost of abatement costs, which will change over time. Similarly policy targets are based on the current scientific knowledge and set using political process and negotiation, which may potentially deviate from social preferences. Finally, a particular pollutant (e.g NOx) can contribute to different environmental issues (e.g acidification, climate change) and can potentially be subject to different regulations and emission caps. Computing the abatement costs for this specific pollutant becomes then more complex.

Environmental benefits can also have non-marketed services such as storm protection and flood mitigation provided by coastal wetlands or natural habitat. In this case, the production function method values the environmental input in terms of the _expected damages avoided_ . Damages that alter the environmental stocks (e.g., fishery and forestry population) can deteriorate significantly the long term provision of ecological services. As such, the current and future flow of benefits will thus be affected.

# _B. The defensive and mitigating expenditures method_

The defensive and mitigating expenditures method values the demand for intangible environmental bad by measuring the costs spent to avoid that bad. Defensive (or averting) and mitigating expenditures are actions undertaken that are priced in markets to either _avoid_ or _mitigate_ the effects of environmental degradation on health or productivity. The approach lies on the complementarities of some market and nonmarket goods. In the case of defensive expenditures, the purchase of a market good such as doubleglazed windows is measured as a substitute for a non-market bad such as road traffic noise. The purchase of safety helmets to reduce accident risk is an example of mitigating expenditures. See Garrod and Willis (1999) for an example using this method on the environmental benefits provided by doubleglazed windows.

# _Conceptual Framework_

The optimal level of defensive or mitigating expenditure is defined by the intersection between the cost of an additional protecting measure and the marginal benefit derived from the risk reduction. The resulting cost thus reveals individual’s valuation and provides an estimate of the implicit price for the non-market bad in question. When defensive actions are too costly to be undertaken, mitigating actions can then be taken on in order to reduce the impact of environmental degradations. The Figure below illustrates the relationship.

# Pollution  **Defensive Behavior**  Exposure **Mitigating Behavior**  Impact

The total cost of defensive or mitigating action encompasses the purchases of market goods and the opportunity cost of time spent to avoid or reduce exposure to non-market bad. This time costs valuation remains a critical issue, as it is itself an intangible good which is commonly valued at a proportion of the 11
wage rate. Moreover, the time spent on averting or defensive actions (opportunity cost of time) that is not used on other productive activities is rarely accounted for.

# _Assumptions and Limitations_

Estimating averting or mitigating costs rely on the assumption that (i) exposure to environmental hazards is known and understood by the population, (ii) the actions taken to prevent or to mitigate pollutions’ exposure are observed and measurable. The assumption that individuals perceive correctly the actual risks and undertake the measures that reflect their preferences to reduce or avoid the perceived risks is critical. Asymmetry of information may lead to overestimate (or underestimate) environmental risks and thus results in overinvestment (or underinvestment) in defensive expenditure compared to the optimal level. Moreover, defensive or mitigating expenditures might provide additional non-environmental benefits that are not accounted in the analysis or priced in markets. For instance, double-glazing windows not only reduce noise pollution but also improve energy conservation. Intangible benefits such as the time spent indoors avoiding air pollution is also used in productive and valuable ways, such as undertaking household chores, indoor leisure activities or working from home.

# _Variants_

_The cost of illness method_ is a particular application of defensive and mitigating expenditures to the health context. The approach values morbidity resulting from environmental quality deterioration by estimating the costs incurred to treat illness.

# _C. The travel cost method_

The travel cost method is used to estimate the recreational and scenic value of natural areas such as park, natural reserves, tourist center, fishing area etc. The approach is based on the complementarities of the costs of travel and the use value of natural areas for recreational purposes. It assumes that the travel time and costs individuals spent to visit un-priced natural sites correspond to at least to the value they assign to the site in order to infer recreational and aesthetic values. Monetary compensation to the population affected by environmental damages can be calculated using this method. See Choe and others. (1996) for an example using this method to estimate the welfare loss caused by the pollution of coastal water in Philippines<sup>10</sup> and Day (2002) to estimate the recreational value of games reserves in South Africa.

# _Conceptual Framework_

Travel costs are used as a proxy to derive the demand for natural sites based on their recreational or scenic qualities. We assume that individuals are willing to pay the costs of visiting a site corresponding at least to the value they assign to the site. Welfare loss due to environmental quality deterioration can be calculated by computing the aggregate demand curve before and after the environmental damages.

> 10 The study uses two nonmarket valuation techniques: the travel cost and the contingent valuation method. The estimates from both techniques are very similar.

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Recreational values are estimated using information on the trip frequencies to the site and their duration as well as the traveling costs which include i) the money spent to access the site, e.g. expenses on gas, railroad toll, vehicle maintenance and depreciation, public transportation fare and admission fees; ii) the expenditures spent on-site, e.g. accommodation, food, beverages, and finally iii) the _time cost_ spent traveling and whilst on-site. _Time cost_ is the opportunity cost of time spent in other activities such as working. A fraction of the wage rate has commonly been used as a proxy for time cost<sup>11</sup> . The data are collected through survey carried out at the recreational site. The consumer surplus illustrated by the area below the demand curve provides a sensible approximate of individual willingness-to-pay for the site of interest. Aggregating the individual demand curves for each site and summing up across all recreational sites offered by a region or country provide an estimate for recreational values

# _Assumptions and Limitations_

The travel cost method captures only the recreational and visual aesthetic quality of natural sites. Ecosystems services naturally provided by the site such as habitat for the fauna or watershed are thus neglected in the analysis. This approach tends then to underestimate the total value of such natural site.

Ignoring the time cost would also undervalue the recreational value of natural areas. Moreover, as traveling has a value in itself it can potentially differ from the wage rate as illustrated by Day (2002), which found that the opportunity cost of traveling is higher than the time cost spent on-site. This is explained by the disutility usually associated with the travel while recreational activities are entailed with higher utility.

Finally, travels with multiple purposes obscures the benefits directly generated by the site under scrutiny, as their specific costs are difficult to be disentangled from. Hence high travel costs for which only a small portion is allocated to the recreational site under analyses tend to overvalue the site. Similarly, households living closer to a recreational site with then lower travel costs do not necessarily reflect the true value individuals assign to the natural area and thus underestimate their true willingness to pay to conserve the site.

# _D. The Hedonic Price Method_

Considering the differentiated products traded on markets as a bundle of tangible and intangible attributes, the hedonic price method assumes that the market price is a function of those characteristics. Implicit value of the environmental quality can thus be inferred by deriving the indirect demand for noise pollution stemming from road or aircraft traffic, air pollution, water quality, etc. The method has been widely used to price environmental quality in the housing and the labor market. See Leggett and Bockstael (2000) for an example using this method to estimate the impact of water quality

> 11 In theory, individuals would choose the number of work for which an extra hour of work corresponds to an hour spent at leisure. Leisure time would thus be valued exactly at the wage rate. However in practice, due to rigidities in labor markets, individuals cannot optimally set their work hours, which affect the rate at which leisure time is valued. Empirical studies estimate the time cost to amount to a third or a half of the wage (Pearce and others, 2005 and Day, 2002). Day (2002) has distinguished the time cost spent traveling from the one spent enjoying recreational activities.

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on the value of waterside residential property and _Brookshire and others (1982)_ to estimate the benefits from air quality improvement in Los Angeles.

# _Conceptual Framework_

This method consists in estimating the contributions of each relevant determinant of market goods in order to identify marginal willingness to pay for each characteristic. This technique requires collecting large amounts of data on prices and characteristics of properties or wage determinants to estimate the _hedonic price function_ . Individuals are assumed to choose the levels of each characteristic which marginal implicit price corresponds to their marginal valuation of the attribute. The partial derivative (or slope) of the hedonic price function with respect to each characteristic corresponds thus to the implicit price.

Hedonic pricing is generally used on housing and labor market to estimate the shadow price of environmental quality. While in the real estate’s market, the shadow price reflects the willingness to _pay_ to enjoy a given environmental quality; in the labor market the willingness to _accept_ is estimated through the risk premium entailed in the salary rate to compensate for health risks. Different exposures to physical and health risks can be captured by wages differential on labor markets. The premium entailed to job salaries with higher risks corresponds to the market value an individual is willing to accept for a marginal change in injury or mortality. The hedonic price method allows thus to disentangle such risk premia from other wages determinants including gender, education, etc.

# _Assumptions and Limitations_

As the non-market values are inferred from the market prices, any price distortion in markets would bias the estimated shadow price and do not represent anymore individual willingness to pay. Moreover, the risks perceived by individuals are assumed to correspond to the actual risks so that the decisions observed on labor markets reflect their true valuation of risk. For instance, wage-risks choices from workers that underestimate accident risks due to overconfidence or lack of information do not reflect the real value of risk incurred. Finally, price determinants may be highly correlated which complicates the identification of net effects from environmental hazards (multicollinearity problems). This is for instance the case for housing close to roads that suffer from both noise and higher concentration on volatile particles.

# **3.1.2 Stated Preference Methods**

As we have seen in the previous section, intangible environmental goods and services are imperfectly traded in markets, when they exist. Although they are entailed with economic value, changes in quantity and in quality can hardly be valued through the market price mechanism. The revealed preference methods presented in the previous section exploit the fact that non-market goods and services are implicitly traded so that the related economic value reflected in market prices can be unveiled. In some instances, implicit values cannot be inferred using surrogate markets. Hypothetical markets are then used to elicit individual willingness to pay (WTP) or willingness to accept (WTA) compensation for a 14
change in environmental quality. The methods based on hypothetical markets are referred to _stated preferences methods_ .

The stated preference methods are based on individual preferences to infer monetary value to nonmarket good. In particular, the approach lies on constructed markets to analyze how individuals would hypothetically value changes in the provision of non-market goods. Two main valuation techniques considered in this section are the contingent valuation method (CVM) and choice modeling (CM). While CVM asks individuals about their WTP for a change in the provision of a given good or services (e.g., to protect endangered species), CM presents a menu of alternatives to be chosen by the individuals to further refine the WTP. CVM aims at valuing the total value while CM looks at the unit value for each attribute of the good. CM has the advantage of assessing a set of policy measures that changes the attributes simultaneously. See _T._ Hett et al (2003) for an example using these methods to investigate the environmental and financial sustainability of the Machu Picchu Sanctuary<sup>12</sup> .

The CVM and CM are applicable to all non-market goods and can capture current and future benefits stemming from the extractive and consumption use to the non-use values. The main concerns relates to the reliability and validity of the results found under those methodologies. As the methods are based on elicited WTP, the way in which the information is gathered and in particular the design of the questionnaire is subject to bias. In spite of those controversies, the stated preference methods are largely used in practice mainly due their wide range of application, e.g. the valuation of water and air quality, species and biodiversity preservation, health impacts, environmental risk reductions and waste management to list only a few examples.

# **3.1.3 Choice of Valuation Techniques**

The previous section has introduced the various valuation techniques used to estimate the shadow prices. Each of these techniques shows advantages and shortcomings in terms of data requirement and scope of analysis so much that no method particularly dominates the others. Understanding the context in which each of these techniques can be applied allows choosing the appropriate instruments that match the purpose of analysis (e.g. assessing a policy measure, performing a cost-benefit analysis or impact evaluation, etc.). This section provides a discussion on the choice of valuation techniques.

Table 1, based on Bolt and others (2005), Hanley and Barbier (2009), and Pagiola and others (2009), summarizes the scope of application, the theoretical framework, the advantages and shortcomings, and the data requirements for each technique.

> 12 The study investigates the optimal entrance fee level that maximizes the revenue from the visits to the Machu Picchu Sanctuary using the contingent valuation method to elicit visitors’ willingness to pay and derive the demand curve. The corresponding number of visits is then computed and help assessing the environmental damages made to the site.

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# - 4. RE ALIGNING PRICES

Full-cost pricing, which includes full social and environmental cost, is an essential tool for changing investments as well as consumption and production patterns while motivating innovations. Apart from reflecting social and environmental costs in prices through taxes, full-cost pricing also implies the phasing out of harmful subsidies, such as those on fossil fuels, fisheries, forestry, water use, land use, and agriculture. These subsidies not only encourage carbon emissions, resource depletion, and environmental degradation, but can also cause trade distortions and strain public finance (UN, 2011).

The prices of environmental external effects associated with individual or public actions (e.g., publicinvestment project) can be realigned to better reflect social valuations in the decision-making analysis. This can be accomplished by means of (i) taxes/subsidies, (ii) quantity limits (e.g., cap-and-trade), and (iii) direct regulation of standards (e.g., CAFE standards in the US).

## Box 1. Prices vs. Quantities

Seminal work by Weitzman (1974) established that uncertainty about compliance costs causes otherwise equivalent price and quantity controls to behave differently. Price controls (i.e., taxes) fix the marginal cost of compliance and lead to uncertain levels of compliance. Meanwhile quantity controls (i.e., tradable permits) fix the level of compliance but result in uncertain marginal costs. This fundamental difference in the face of cost uncertainty leads to different welfare outcomes for the two policy instruments.

For example, in the context of worldwide greenhouse gas (GHG) control, Pizer (1998) uses a global integrated climate economy model to simulate the consequences of uncertainty and to compare the efficiency of taxes and permits empirically. He finds that an optimal tax policy generates gains, which are five times higher than the optimal permit policy. This result follows from Weitzman’s original intuition that relatively flat marginal benefits/damages favor taxes, a feature that drops out of standard assumptions about the nature of climate damages. A hybrid policy, suggested by Roberts and Spence (1976), is also explored. Such a policy uses an initial distribution of tradable permits to set a target emission level, but then allows additional permits to be purchased at a fixed "trigger" price. The optimal hybrid policy leads to welfare benefits only slightly higher than the optimal tax policy. Perhaps more importantly for policy discussions, a sub-optimal hybrid policy, based on a stringent target and high trigger price, generates much better welfare outcomes than a straight permit system with the same target. Thus, a hybrid policy is a more attractive alternative to either a straight tax or permit system (Pizer 2005).

Recently Weisbach (2011) and Kaplow (2011) relax key assumptions in Weitzman (linear instruments and that policies cannot be revisited in the future) reaching new conclusions. Namely that either approach can be used and that they can be designed so that emissions are priced matching the carbon price continuously along any nonlinear damage curve. In contrast, in the context of carbon pricing, Strand (2011) presents an argument on why oil-importing countries may prefer taxes to permits. Which approach is used has implications for who captures the monopoly rents. Oil-importing countries improve their strategic position with taxes, while oil-exporting countries would prefer a quota system.

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OECD (2006) identified 375 environmentally related taxes in OECD countries in addition to about 250 environmentally-related fees and charges. All these change the prices that individuals face in an attempt to ‘internalize’ (i.e., properly account for) the external effects. Corrective taxes are often called Pigovian taxes since they were introduced by Pigou (1920). In a partial-equilibrium analysis, and assuming that the externality cost is known, a Pigovian tax (i.e., a correction to market prices by incorporating the value of the externality) is all that is needed to restore the optimality properties of decentralized decision-making. There is a large amount of work providing the theoretical basis for environmental taxes (Baumol, 1972; Baumol and Oates, 1971, 1988).

In practice, things are more complicated. First, it may not be administratively feasible to impose corrective (Pigovian) taxes for some goods and activities. Second, as it has been mentioned, there is the issue of ascertaining the value of the externality—an issue addressed with the shadow price. Third, once we take a general-equilibrium perspective and acknowledge that other distortions, beyond the externality that is the focus of attention, are present, then the theory of the second-best must be brought into the analysis. The theory of the Second Best (Lipsey and Lancaster, 1956) implies several counter-intuitive results relevant for corrective taxation:

- If there is a distortion in a particular sector, then it is no longer generally desirable to apply firstbest optimality conditions in the remaining sectors.

- If there are _n_ distortions, we cannot generally claim that the competitive equilibrium with _n_ - 1 distortions (i.e., when we remove one distortion) is Pareto better than the competitive equilibrium with all _n_ distortions.

Consequently, _the theory of the Second Best implies that nudging a particular price towards its social value is not always necessarily a good thing._ An example is useful to illustrate why this result holds. Railroads often enjoy a public subsidy, but removing such a subsidy will divert traffic to a typically more highly subsidized substitute: roads. The resulting increase in congestion and pollution leads to a worse social outcome. The lesson to be taken is that reflection must be made on how all the external effects work out, and what are going to be the general-equilibrium effects to the policy.

Similar considerations arise in relation to the double-dividend argument on taking into account the whole economic system. The double-dividend proponents argue that environmental taxation, in addition to the environmental dividend obtained by reducing socially damaging activities; there would be a second dividend by reducing other distortionary taxes (Oates, 1995). However, for the double dividend to exist, the taxes that substituted for the environmental tax need to be more distortionary. Thus, in the absence of environmental concerns, the tax reform would in any case be welfare improving. This second dividend is often unlikely because environmental taxes over narrow bases interacting with pre-existing distortions often lead to higher not lower welfare losses (i.e., the excess burden of taxation). Note however, even when the second dividend does not materialize, that the environmental tax still may well justified and welfare improving as long as the environmental gains overweigh the increased excess burden of the tax system. (Goulder, 1995; Parry 1995) A general-equilibrium approach is thus needed; but that does not always imply a high level of micro detail. For instance, Parry and Small (2005) consider a revenue-neutral tax reform, and they examine the 19
tradeoff between taxes on gasoline versus the rest of the tax system, aggregated as a tax on labor. In this general-equilibrium context, they estimate the second-best optimal gasoline tax taking into account the corresponding externalities (adjusted Pigovian tax), the balance between commodity taxation and labor taxation (Ramsey tax), and congestion feedback.

Thus, a comprehensive analysis must be carried out when considering policy options to ensure that the effects on the goods that display higher degrees of complementary and substitutability are included in the analysis.

# 4.1 ENERGY SUBSIDIES<sup>13</sup>

Many governments provide subsidies for energy, either explicitly or implicitly, to producers and consumers. The International Energy Agency (IEA) estimated that fossil fuel subsidies to consumers in 37 countries, representing 95 percent of the global fossil fuel consumption that is subsidized, reached $557 billion in 2008. The Global Subsidies Initiative estimated in 2009 that global subsidies to fossil fuel producers amounted to approximately $100 billion (GSI 2009). Coady and others (2010) estimated that globally consumer subsidies for petroleum products had been $57 billion in 2003, $519 billion in 2008, and $136 billion in 2009, while projecting a rebound to reach $240 billion in 2010. Including the tax subsidy—the effect of taxes set below optimal levels—the amount of petroleum product subsidies could reach $740 billion in 2010 according to the study. The year-to-year variation in these totals is largely due to changes in the international oil price.

Energy sector subsidies are large and widespread in both developed and developing countries. Consumer subsidies are particularly prominent in many developing countries. Petroleum product subsidies are known to be substantial in certain cases, especially in some major oil-exporting countries. Power sector subsidies that result from under-pricing, excessive losses, and bill collection failure are common in those developing countries for which detailed investigations have been conducted. However, more systematic information is needed to give a comprehensive picture.

While subsidies can conceivably have benefits in terms of support for the poor, job creation, industry protection, or energy security, they also carry costs. These can include fiscal costs and effects on the balance of payments, growth, and global externalities. In particular, in economies with large energy consumption, the extra demand for energy induced by the lower consumer prices can work against energy security and have global effects by possibly raising prices on the world market by increasing demand (in the case of widely traded fuels) and through higher GHG emissions resulting from consumption of more fossil fuels.

Victor (2009) offers some general lessons with respect to reforming petroleum product subsidies and that can be applied also to power sector subsidies.

> 13 This section draws from Bacon and others (2010) “Subsidies in the Energy Sector: An Overview” Background Paper for the World Bank Group Energy Strategy.

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1. _Reform strategy must address the political logic that led to subsidy creation._ The reform strategy must either compensate the political interest that would otherwise oppose the subsidy reduction or removal, or must find a way to insulate the reform from their opposition.

2. _Ensure transparency of the costs and purpose of the subsidy._ Reforming subsidy may be easier if all members of society are fully aware of the costs they are paying, and the extent to which they or others are benefitting.

3. _For essential subsidies ensure the best design to carry out the stated purpose._ Better subsidy design can reduce the overall costs to the economy, the excess demand for energy and the associated negative externalities. In particular, subsidy design should focus on long-term costs, use pre-announced conditions for subsidy recipients, should have explicit adjustment mechanisms, and should utilize performance targeting.

4. _Governments need to develop more selective policy instruments._ Broad-spectrum subsidies are less effective in meeting their stated purpose but are popular because they tend to spill over to a wider group of users, making it increasingly difficult to reverse such policies later.

Because of the potential cost of a subsidy scheme and of the different performance of alternative schemes, a full evaluation of costs and benefits should be made before making any changes to the status quo. Governments that have rushed subsidy reform without preparing the population for the changes, and without providing targeted support to particularly disadvantaged groups, have often had to reverse the policy in the face of widespread opposition.

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**Fig 2** . Energy Subsidies Decision Tree

Policy objectives **<mark>Step 1</mark>** <mark>: State the objective(s) of the subsidy</mark> <u><mark>policy</mark></u> Impact **<mark>Question 1</mark>** <mark>: Does the policy substantially achieve its</mark> No <mark>objectives?</mark> Yes Cost benefit analysis **<mark>Step 2</mark>** <mark>: Value costs and benefits of the</mark> Redesign or phase out Subsidy <mark>subsidy</mark> <u><mark>policy and its alternatives</mark></u> Cost effectiveness **<mark>Question 2</mark>** <mark>: Is the policy the most</mark> No <mark>socially efficient instrument to achieve its objectives?</mark> Yes No Global externalities **<mark>Question 3</mark>** <mark>: Does the policy avoid</mark> No Is the impact of the policy <mark>negative global externalities? consistent with the country’s</mark> overall strategy on GHG emissions? Yes yes **<mark>Question 4</mark>** <mark>: Is this use of funds a</mark> Priority of policy <mark>budgetary priority?</mark> objectives Yes No Retain (existing) or introduce (new) Redesign or phase out Subsidy subsidy Source: Bacon and others (2010) 22
# 5. CONCLUDING REMARKS

“Getting the prices right” is a good starting point albeit not sufficient for achieving environmentally efficient outcomes. Other policy interventions are often necessary to complement pricing policies, sometimes when pricing is not at all feasible, regulatory and command-and-control policies must be used instead.

This paper focused on three interrelated themes at the core of the pricing problem. First, there is the incorporation of non-marketed activities with environmental consequences into aggregate measures of economic performance: the so-called “green GDP.” As what we measure affects what we do, this issue has important consequences for policy-making. Some tradeoffs vanish away when the measure of economic performance is adequately defined.

Second, there is the problem regarding the reliable estimation of the valuation of the shadow prices that properly reflect environmental externalities. This is a challenging task but key to green growth. Until estimates of shadow prices are broadly perceived as reliable and grounded on solid facts and methodology, the incorporation of environmental externalities into social and individual decisionmaking will be met with skepticism and will have less impact than it deserves Third, there is the issue of full-cost pricing that requires the pricing of environmental externalities or guiding individual and public decision-making. The mispricing of activities with environmental consequences has significant implications for individual and public decision-making. What gets and doesn’t get included in the agencies’, firms’ and individual (formal or informal) cost-benefit analyses determines the decisions that are made at the micro level.

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