Project Analysis and Environmental Effects

Abstract

This chapter addresses how the environmental effects of projects can be incorporated in project analysis. It begins by briefly discussing the basis for environmental values used in project economics before explaining the main approaches in the literature for putting numerical values on these effects. These values need to be incorporated in a project resource statement and like other effects in the future need to be given a value in the present. How to discount environmental effects has been a topic of considerable debate and the chapter reviews the main alternatives for doing so.

Appendices

Appendix 1: Depletion Premium

Discussions of environmental valuation have refocused attention on the fact that development projects may use resources whether natural habitats and ozone layers or minerals or fossil fuels, which cannot be renewed or replaced. The point of principle is that the cost of using such resources is not just the cost of their extraction, but also the foregone opportunity of using them in the future arising from the fact that because of their finite supply current use means that future income (or future benefits that are equivalent to a value in income) from these resources are lost. The cost of this income forgone is what constitutes the depletion premium. The full economic cost of using a non-renewable resource is its cost of extraction plus the depletion premium, which captures the use-value that others forgo as a result of current use. Hence, an important part of environmental valuation relates to its estimation.

There are two issues here, one relating to ex ante appraisal and the other to pricing policy. First, the full economic cost of non-renewable natural resources must be included in the appraisal of any project using these resources. Unless the benefits from a resource extraction project are high enough to cover costs, including the depletion premium, by definition the project cannot be making the best use of the limited resources involved. Second, unless the depletion premium is included in the price charged for the resource, current users will not be paying a price that reflects the negative impact of their use of the resource on society’s future income.

Estimation of the depletion premium is based on the principle that for a particular rate of resource extraction to be justified the net unit value of the resource—that is, the price per unit minus the cost of extraction—must rise at the same rate as the discount rate. If the discount rate is an opportunity cost rate, the logic is that if the net unit value rises by less than the rate of discount it will pay to increase the extraction rate to obtain more resources and invest the proceeds from their sale at the discount rate. If the reverse holds and the price rise is greater than the rate of discount it will pay to extract less, keep the resource in its natural state and let it appreciate in value. Similar arguments apply if the discount rate is one of time preference. The interpretation is that if the appreciation in price is less than the cost of waiting it makes sense to extract the resource, and if the appreciation is greater than the cost of waiting it makes sense to keep it in its natural state.

The application of this principle allows the formulation of the depletion premium (DP) in any year t as:

$$ {DP}_t=\left({P}_{t+n}-{E}_{t+n}\right)/{\left(1+r\right)}^n $$

(11.3)

where

• P_t + n is the value of the resource at the time it is exhausted

• E_t + n is the extraction cost in the year of exhaustion

• r is the discount rate

• n is the number of years between year t and the point of resource exhaustion.⁵

The depletion premium is the per unit opportunity cost of the depletable resource. Equation (11.3) implies that in any year it is given by the future value of the resource at the point that it is fully depleted (P) minus the extraction cost saved (E), since the resource is no longer depleted, discounted back to the year in question. Hence there are four influences on the DP: the value placed on the resource at the time of its exhaustion, the extraction cost, the discount rate, and the length of life of the depletable resource.

Of these, in Eq. (11.3) the discount rate is that rate used for the project concerned, while extraction costs can be estimated from technical data. Of greater uncertainty are likely to be the length of life of the resource involved and the economic value of the latter at the point of depletion. In principle these latter parameters are interdependent and will also vary with the discount rate and extraction costs. Formally their correct valuation requires a programming model that solves for the different parameters simultaneously. In practice empirical estimation may be much more approximate.

A further complication is that the final value of the resource P can be defined in two alternative ways. Where the resource has a substitute, its unit value at the point of full depletion will be determined by the equivalent per unit cost of the substitute. The charge for the resource cannot go beyond this since by definition there will be a cheaper substitute available. For example, fuels have substitutes and the value of a natural gas deposit per million Btu at the point of depletion could be specified as the cost of the quantity of fuel oil required to give the same energy as a million Btu of gas. As a traded good, fuel oil should be valued at its world price. Hence, if the gas field is estimated to have roughly 15 years of working life, the forecast price of oil 15 years in the future gives the basis for the estimation of the value of gas at depletion.

However, there will be some non-renewable environmental resources with no substitutes. If environmental assets like wetlands and endangered species of animals or plants are treated as completely non-substitutable resources, so the value becomes infinite, and Eq. (11.3) cannot be applied. Hence where environmental assets have no replacement value, the concept of a depletion premium is meaningless. For non-renewable minerals and fossil fuels, where the terms in Eq. (11.3) are quantifiable, the policy concern is that users should pay the full cost of using the resource, including the depletion premium in the price they are charged. Moreover, there is a case for taxing the depletion premium component of the charge rather than letting it remain as profit in the hands of the resource owners. This is on the grounds that as tax revenue the income from the depletion premium can be set aside in a fund to finance the development of substitutes for the non-renewable resources that are currently being depleted.

These principles can be illustrated with a simple numerical example using the case of a natural gas field. Extraction cost of gas is $0.5 per mill Btu, while the field is estimated to have an approximate working life of 15 years on the basis of current projections of demand (although strictly these will vary with the price charged for the gas). Fuel oil is taken as the substitute fuel and after 15 years, the equivalent economic cost of fuel oil is estimated at $4.0 per mill Btu. The discount rate is 10%. It is assumed that both fuel oil and extraction costs are already at economic prices (including emissions effect) and thus reflect economic values. With this information Eq. (11.3) can be used to derive both the depletion premium and the full cost of using natural gas on new projects for each year from 1 to 15 (Table 11.8).

Table 11.8 Economic value of gas

In Table 11.8 the cost of using natural gas (and its economic value) rises gradually to the replacement cost of the gas in year 15 of $4.0 per million Btu. The increase in the cost of gas usage is due to the rise in the depletion premium at the rate of discount of 10% annually. The figures in the final column give the full economic value of gas. This is the figure for the cost of gas to be used in each year of the project calculations and also to be charged to gas users.

Appendix 2: Meta-Analysis Using Ecosystem Service Database (ESVD)

A meta-analysis is a more sophisticated version of a benefit function transfer, where the coefficients to be applied to project-specific data, come from a statistical analysis of data from a large number of studies in the literature, with control variables included for the methodology used in each study and checks on data consistency and quality. The existence of large databases on environmental values, such as the ESVD, make this approach possible. However, it will only be applicable for certain types of service where there is a large enough and sufficiently consistent literature and where benefits from the service can be defined clearly enough. Furthermore, there is the important question of whether a project study conducts an original meta-analysis or uses one from the literature. It is clearly more complicated to do the former.

De Groot et al. (2012) has a useful illustration of how the ESVD data can be used in meta-analysis to provide guidance values. They use the illustration of valuation of wetland services based on 244 studies from the database. The results from these studies are used in a cross-sectional regression of the form

$$ {lny}_{\mathrm{i}}=\mathrm{a}+ bw.{Xw}_{\mathrm{i}}+ bc.{Xc}_{\mathrm{i}}+ bs.{Xs}_{\mathrm{i}}+{\mathrm{u}}_{\mathrm{i}} $$

(11.4)

where i is 1 … 244 and refers to individual studies from the ESVD, yi is a vector of wetland service values from the ESVD, a is a constant, b is a vector of coefficients on the explanatory variables and u is a vector of residuals.

Three types of explanatory variables are included. Xw cover characteristics of the wetland involved, such as geographical area in hectares, and wetland types, such as freshwater, wooded or salt brackish marshes. Xc refer to socio-economic and geographic characteristics of the study site, such as GDP per capita, population within 50 kms radius of study site, and measures in hectares of wetland and rivers/lake abundance within 50 kms radius. Xs covers the estimation approach used in the different studies whose results are used in the analysis, with a dummy of 1.0 to reflect use of a particular method, such as hedonic pricing or production function. Hence to derive a site-specific value, the b coefficients from Eq. (11.4) must be combined with X values for the site concerned.

Table 11.9 reports the variables used and the results. Statistically significant results are found for the wetland area size (with a negative sign indicating diminishing returns per hectare as scale is increased); income per capita and population within the 50 km radius (with a positive sign indicating the value of services rise with income and population); dummies for certain types of wetland (with freshwater marshes appearing to generate a lower value of services); wetland abundance within 50 kms (with a negative sign indicating a substitution effect with some service benefits captured by adjacent wetlands); finally the negative signs on some of the dummies indicate that studies using these methods generate a lower value of services than that in the omitted method in the regression, which is contingent valuation).

Table 11.9 Illustration of meta-analysis

In a meta-analysis the data on an individual site can be combined with the coefficients from the cross-sectional study to give a first approximation estimate for a new location. However, the authors enter a series of caveats on the need to check the accuracy of this result. They stress values for services will be site and time-specific and that the type of averages reported in large databases will be illustrative not definitive. They caution that if environmental service valuation is critical to a project, it can be ‘duly informed’ by a transfer value, but this should not be a substitute for a detailed original calculation.