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GUIDELINES ON THE ECONOMIC VALUATIONOF THE ENVIRONMENTAL IMPACTS

FOR EIA PROJECTS

DEPARTMENT OF ENVIRONMENTMINISTRY OF NATURAL RESOURCES AND ENVIRONMENT

PUTRAJAYA

JUNE 2008


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PREFACE

The Guidelines on the Economic Valuation of the Environmental Impacts for EIAProjects Prescribed Activities contain advice and instructions to assist projectinitiators in the identification, quantification, and where possible the monetization

of the environmental impacts of the project. Project initiators should appointregistered consultants with the required expertise to implement these Guidelinesas such economic valuation of the environmental impacts of the projectconstitutes a component of EIA reports per requirements of the Handbook ofEnvironmental Impact Assessment Guidelines

These Guidelinesconsist of eight chapters as follows:

Chapter 1 This chapter provides the rationale and objective, and describes thecontent of these Guidelines;

Chapter 2 This chapter describes the concept of total economic value as thisconcept provides the overarching framework guiding the economicvaluation of environmental projects;

Chapter 3 This chapter discusses issues which need to be addressed at theoutset of the economic valuation process and are common to alleconomic valuation methodologies;

Chapter 4 This chapter presents an overview of the methodologies availableto undertake the economic valuation of environmental impacts

Chapter 5 This chapter discusses the principles and applications of thechange in productivity methodology;

Chapter 6 This chapter discusses the principles and applications of revealedpreferences methodologies which include the replacement costmethodology, the defensive expenditure methodology, the cost ofillness methodology, the travel cost methodology, and the hedonicpricing methodology;

Chapter 7 This chapter discusses the principles and applications of statedpreferences methodologies focusing on the contingent valuationmethodology;

Chapter 8 This chapter discusses the benefit-transfer methodology;

Chapter 9 This chapter provides a summary of the key recommendationspresented in these Guidelines.

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This is the first edition of the Guidelines on the Economic Valuation of theEnvironmental Impacts for EIA Projectsin Malaysia. As experience develops withtheir implementation, this edition will be updated as and when deemed necessaryby the Director General of Environmental Quality.

Director General of the Department of EnvironmentMalaysia

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TABLE OF CONTENTS

Preface iiTable of contents ivList of Tables viii

List of Figures ixList of Boxes xList of Acronyms xi

Chapter 1 Introduction 11.1 Background 11.2 Applicability of the Guidelines 21.3 Objective of the Guidelines 21.4 Content of the Guidelines 2

PART A INTRODUCTION TO THE ECONOMIC VALUATION OF

ENVIRONMENTAL IMPACTS

4

Chapter 2 The concept of total economic value 52.1 Ecosystems and economic values 52.2 Total economic value and its components 72.3 Measuring changes in economic values 122.4 Identification, quantification, and economic valuation 15

Chapter 3 Approaching the economic valuation of environmentalimpacts: Issues of common interest

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3.1 Scope of analysis 163.1.1 Geographical scoping 163.1.2 Stakeholders scoping 18

3.2 Choice of scenario: With project versus without project 183.3 Dealing with price changes: Nominal versus real 213.4 Accounting for time: Discounting 22

3.4.1 Discounting and present value 223.4.2 The mechanics of discounting 223.4.3 Selecting a discount rate 25

3.5 Selecting a time horizon 263.6 Conducting sensitivity analysis 273.7 Summary of recommendations to project initiators 28

3.7.1 With respect to the scope of analysis 283.7.2 With respect to the scenario of reference 293.7.3 With respect to inflation 293.7.4 With respect to the discount rate 293.7.5 With respect to selecting the time horizon 303.7.6 With respect to the conduct of sensitivity analysis 30

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PART B METHODOLOGIES FOR THE ECONOMIC VALUATION OF

ENVIRONMENTAL IMPACTS31

Chapter 4 Introduction to the methodologies for economic valuation 32

4.1 From environmental impacts to methodologies 324.2 Recommendations to project initiators 35

Chapter 5 Change of productivity methodology 365.1 When to use this methodology 365.2 How to use this methodology 37

5.2.1 Step 1: Quantify the impact on productivity 375.2.2 Step 2: Monetize the impact 38

5.3 Strengths and limitations of the methodology 395.3.1 Strengths 395.3.2 Limitations 39

5.4 Recommendations to project initiators 395.4.1 Quantify the impact on productivity 395.4.2 Monetize the impact 40

Chapter 6 Revealed preferences methodologies 426.1 Introduction to revealed preferences methodologies 426.2 The replacement cost methodology 44

6.2.1 When to use this methodology 446.2.2 How to use this methodology 476.2.3 Strengths and limitations of the methodology 47

(i) Strengths 47(ii) Limitations 48

6.2.4 Recommendations to project initiators 486.3 Defensive expenditure methodology 49



6.3.4 Recommendations to project initiators 516.4 Cost of illness methodology 52



6.4.4 Recommendations to project initiators 566.5 Hedonic pricing methodology 57

6.5.1 When to use this methodology 576.5.2 How to use this methodology 58

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6.5.3 Strengths and limitations of the methodology 60(i) Strengths 60(ii) Limitations 61

6.5.4 Recommendations to project initiators 616.6 Travel cost methodology 61

6.6.1 When to use this methodology 616.6.2 How to use this methodology 62(i) The zonal travel cost approach 64(ii) The individual travel cost approach 66(iii) The random utility approach 66


6.6.4 Recommendations to project initiators 68

Chapter 7 Stated preferences methodologies 69

7.1 Introduction to stated preferences methodologies 697.2 Contingent valuation methodology 697.2.1 When to use this methodology 697.2.2 How to use this methodology 70

(i) Steps in the application of the methodology 70(ii) Characteristics of a good application of the CVM 71


7.2.4 Recommendations to project initiators 73

Chapter 8 Benefits transfer methodology 758.1 When to use this methodology 758.2 How to use this methodology 75

8.2.1 Transfer without adjustment 768.2.2 Transfer with adjustment 778.2.3 Benefit function transfer 77

8.3 Strengths and limitations of this methodology 788.3.1 Strengths 788.3.2 Limitations 78

8.4 Recommendations to project initiators 78

PART C SUMMARY OF RECOMMENDATIONS 79

Chapter 9 Summary of recommendations 80

References 89Additional references 90Websites of interest 91Glossary 92

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Annex 1 Penang National Park travel cost survey 95Annex 2 Lake Sevan contingent valuation survey 107

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LIST OF TABLES

Table 3.1 Undiscounted stream of environmental costs and benefits 29Table 3.2 Present value of environmental costs and benefits

calculated for different discount rates30

Table 4.1 Environmental impacts and methodologies 34Table 6.1 Application of revealed preferences methodologies 43Table 9.1 Technical and economic expertise required 81Table 9.2 Summary of recommendations 82

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LIST OF FIGURES

Figure 2.1 From ecosystems to economic values 5Figure 2.2 Total economic value and its components 8Figure 2.3 Direct use value 9

Figure 2.4 Use value 10Figure 2.5 Non-use value 10Figure 2.6 Total economic value 10Figure 2.7 Measuring changes in economic values 13Figure 2.8 Environmental effect, impact, and human well-being 14Figure 2.9 Identification, quantification, economic valuation I 15Figure 3.1 Geographical scoping of environmental impacts 17Figure 3.2 With versus without project 20Figure 3.3 The mechanics of compounding 23Figure 3.4 The mechanics of discounting 23Figure 3.5 Presentation of environmental costs and benefits 24

Figure 4.1 Economic values and methodologies 33Figure 4.2 Identification, quantification and economic valuation II 35Figure 6.1 Defensive expenditure and cost of illness methodologies 52Figure 6.2 Components of the cost of illness 54Figure 6.3 Defining zones 65

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LIST OF BOXES

Box 2.1 Example of the total economic value framework applied towetlands

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Box 3.1 Example of with versus without project 21

Box 3.2 Discounting and inflation 26Box 3.3 Discount rate and the indefinite future 27Box 6.1 Sedimentation traps in Malaysia 42Box 6.2 The costs of river sedimentation: The case of Beaufort

(Sabah)45

Box 6.3 The Tenom Pangi hydropower plant in the Padas Rivercatchment (Sabah)

46

Box 6.4 Regression analysis with the hedonic pricing methodology 60

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LIST OF ACRONYMS

CVM Contingent valuation methodologyDOE Department of Environment (Malaysia)EIA Environmental impact assessment

NOAA National Oceanic and Atmospheric AdministrationNTFPs Non-timber forest productsTCM Travel cost methodologyVSL Value of a statistical life

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Chapter 1

Introduction

1.1 Background

In July 1987, Malaysias Department of Environment (DOE) published the firstedition of the Handbook of Environmental Impact Assessment Guidelines(hereafterEIA Guidelines). The EIA Guidelinesstate that:

The aim of environmental impact assessment in Malaysia is toassess the overall impact on the environment of developmentprojects proposed by the public and private sectors (Section 1.3.2)

To achieve this overall aim, the EIA Guidelineslist the following five objectives ofenvironmental impact assessment:

To examine and select the best from the project optionsavailable;

To identify and incorporate into the project plan appropriateabatement and mitigating measures;

To predict residual environmental impacts;

To determine the significance of the residual environmentalimpacts predicted; and

To identify the environmental costs and benefits of the project tothe community.

The last of the above five objectives clearly requires not only the identification ofthe (physical) environmental impacts of the project, but further requires that theseimpacts be monetized and transformed into environmental costs (negativeenvironmental impacts) and environmental benefits (positive environmentalimpacts).

It is of importance to note that the above five objectives do not call for the

undertaking of a cost-benefit analysis of the project. While not denying theimportance of cost-benefit analysis in guiding the allocation of scarce private andpublic sector resources, the focus of EIA lies in the identification, quantification,and monetization (economic valuation) of the environmental impacts of theproject. Undoubtedly, such economic valuation would in most circumstances be acomponent of a broader and more comprehensive cost-benefit analysis. But thiseconomic valuation in and by itself does not constitute a cost-benefit analysis.

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1.2 Applicability of the Guidelines

The need for economic valuation must be determined during the scopingexercise. The need shall be based on the projects expected impacts e.g on theproductivity of land (such as agricultural productivity) and water (such as fisheries

productivity). health and others. These impacts have to be clearly identified,quantified, and transformed into environmental costs or benefits following theprocedures described in these Guidelines.

1.3 Objective of the Guidelines

The overall objective of these Guidelines on the Economic Valuation of theEnvironmental Impacts of Prescribed Activities (henceforth Guidelines) is toprovide clear guidance as to the framework and methodologies allowing themonetization of the environmental impacts of the project into environmental costsand benefits. The Guidelines aim to provide practical advice to project initiators

and project assessors undertaking the economic valuation of environmentalimpacts of projects.

These Guidelinesaim to provide practical advice to project initiators on the topicof economic valuation of a projects environmental impacts, with theunderstanding that the expertise to undertake and review such economicvaluation is currently limited. It is foreseen that such capacity will increase withexperience, and that these Guidelineswill be reviewed accordingly.

1.4 Content of the Guidelines

Part A first presents the general framework guiding the economic valuation ofenvironmental impacts (Chapter 2). Part A also discusses issues common to allmethodologies. In particular, it discusses issues pertaining to choice of scope ofanalysis, both geographical and stakeholders. It also discusses the appropriatescenario setting for the identification and quantification of the environmentalimpacts of the project (with project versus without project). It describes thetechniques of discounting and shows how to consider changes in prices overtime. Finally, Part A discusses the necessity to undertake sensitivity analysis(Chapter 3).

Part B presents the various methodologies available to undertake the economicvaluation of the environmental impacts of the project. An introduction to themethodologies is presented in Chapter 4. Four types of methodologies aredescribed: the change of productivity methodology (Chapter 5), revealedpreferences methodologies (Chapter 6), stated preferences methodologies(Chapter 7), and the benefit-transfer methodology (Chapter 8).

In each chapter of Part B, the methodologies are first described in details.Second, specific recommendations are made to project initiators regarding the

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presentation and discussion of the results of their economic valuation in their EIAreports.

Concluding remarks and recommendations are presented in Chapter 9.

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PART A

INTRODUCTION TO THE ECONOMIC VALUATION OFENVIRONMENTAL IMPACTS

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Chapter 2

The concept of total economic value

2.1 Ecosystems and economic values

A general premise underlying the economic valuation of environmental impactsof projects is that the environment (or ecosystems) produces multiple goods andservices of a large variety of nature which are valued by human beings as thesegoods and services contribute to human welfare and well-being. To the extent ofthis contribution to human welfare and well-being, the environment produceseconomic values(Figure 2.1).

Figure 2.1From ecosystems to economic values

Ecosystems

Processes

Structure

Goods and services

Economic values

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Examples of services produced by ecosystems include:1

Purification of air and water;

Mitigation of floods and droughts;

Generation and renewal of soil and soil fertility;

Pollination of crops and natural vegetation; Control of agricultural pests;

Protection against the suns ultra-violet rays;

Stabilization of climate.

Similarly, surface waters provide a large number of goods and services,including:2

Drinking, cooking, washing, and other household uses;

Manufacturing and other industrial uses;

Power generation;

Irrigation of crops, parks, golf courses; Aquaculture;

Transportation;

Recreational swimming and boating.

To the extent that the above goods and services contribute to human welfare andwell-being, they are said to be source ofeconomic values.

A further premise is that changes in the flow of goods and services provided bythe environment impact the nature and extent of the economic values associatedwith these goods and services. More specifically, adverse changes in this flow ofgoods and services are associated with a reduction in economic values (andtherefore a reduction in human welfare), while positive changes in this flow areassociated with an increase in economic values (and therefore an increase inhuman welfare). In other words, adverse changes are considered as costs (orenvironmental costs), while positive changes are considered as benefits (orenvironmental benefits).

Such changes in the flow of goods and services provided by the environment areoccasionally triggered by natural events. For example, tropical storms mayadversely impact the flow of agricultural outputs.

Such changes may also be triggered by human actions. Such is the case withdevelopment projects which may positively or negatively impact the flow of goodsand services produced by the environment.3 For example, a development project

1Daily, G.C. (1997).

2Postel, S.L, and S. Carpenter (1997).

3Human action is not solely restricted to development projects (generally associated with

infrastructure projects). Human action also includes policies. However, given that these

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may impair the ambient quality of surfaced waters which may then reduce thepossibility of using the water for crop irrigation.

In such circumstances, a key issue is to identify and quantify the changes in theflow of goods and services produced by the environment which are impacted by

a development project, and then to monetize these changes into costs orbenefits.

If the environment produces a large number of goods and services which areused in a multiplicity of different ways, then different types of economic valueswill be associated with these good and services. As illustrated above, a body ofsurfaced water may be used in many different ways and produce many differenttypes of goods and services each with its own economic value. The totaleconomic value of the environment is made of the aggregation of all thesedifferent economic values.

2.2 Total economic value and its components

The concept of total economic value is now generally recognized as being themost suitable framework guiding the economic valuation of environmentalimpacts. As illustrated in Figure 2.2, the total economic value of the environmentis made of different types of economic values, each corresponding to thedifferent use that is made of the environment. We provide below a briefdescription of each of these economic values

Guidelinesare presented in the context of the EIA process in Malaysia, human action is hereunderstood to be development projects (or prescribed activities as defined by the EnvironmentalQuality Act).

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Figure 2.2Total economic value and its components

Total economic value

Non-consumptivedirect use value

Consumptivedirect use value

Directuse values

Indirectuse value

Usevalues

Non-usevalues

Bequestvalue

Existencevalue

Optionvalue

A distinction is made between use and non-use values.

Use values relate to the actual use of the good or service produced by theenvironment. This actual use (such as a visit to a protected area, or theextraction of non-timber forest products, or the transportation of goods by boatson surfaced waters) may be current or may remain a possibility in the future.

Use values are sub-divided into direct use values, indirect use value, and optionvalue. Direct use values are further sub-divided into consumptive direct use valueand non-consumptive direct use value.

Consumptive direct use value is perhaps the most intuitive of all values. Itrefers to the economic value of those goods and services produced by theenvironment which are actually extracted for purpose of consumption. Examplesof consumptive direct use, among numerous others, include:

Harvesting of fish either for commercial or recreational purposes;

Extracting of timber or non-timber forest products;

Harvesting of fruits from fruit trees;

Abstracting surface water or groundwater for domestic, agricultural, orindustrial purposes.

Each of these activities generates economic values which are then referred asthe consumptive direct use valueof the environment.

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Non-consumptive direct use valuerefers to the economic value of those goodsand services produced by the environment without actual extraction orabstraction taking place. Examples of non-consumptive direct use, amongnumerous others, include:

Using surface waters for purpose of transportation;

Recreational swimming;

Bird watching in a protected area;

Hydro-power production (in cases where the water is not diverted).

In each of these examples, note that the resource (water or bird) is not extractedor abstracted despite the direct use that is made of it. Each of these activitiesgenerates economic values which are then referred as non-consumptive direct

use values.

The sum of consumptive and non-consumptive direct use values defines thedirect use value of the environment.

Figure 2.3Direct use value

Directuse value


Consumptivedirect use value +=

Indirect use valueresults from the use ofservicesprovided by the environmentand ecosystems. Examples of indirect use (use of services), among numerousothers, include:

Storm and flooding protection services provided by mangrove swamps;

Water purification services provided by wetlands;

Watershed protection services provided by forest;

Ultra-violet protection services provided by the ozone layer;

Carbon sequestration services provided by forests.

In each of these examples, note that even though there may not be direct contactwith the resource, this resource (mangrove swamps, forest, or ozone layer in theabove examples) is producing a service which is actually use by human beings

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and is therefore source of economic values which are then referred as indirectuse values.

Option valuerefers to the benefit of potentially using a resource at a later pointin the future. For example, protected areas may be set aside for conservation

purposes not only for the direct and indirect values they may currently generate,but also for keeping the option possible (in the future) to conduct these or otheractivities.

The sum of direct, indirect, and option values defines the use value of theenvironment.

Figure 2.4Use value

Direct

use value

Indirect

use value

Option

value

Use

value= + +

Non-use values refer to the fact that some individuals in our societies obtainsatisfaction (welfare) simply from knowing that the existing flow of goods andservices produced by the environment is maintained as it currently is even ifthere is no current or potential use of these goods and services by themselves(existence value), or is maintained to keep the option opened for use by futuregenerations (bequest value).

Figure 2.5Non-use value

Bequestvalue

Existencevalue

Non-usevalue = +

The sum of use and non-use values defines the total economic value of the goodand services produced (delivered) by the environment.

Figure 2.6Total economic value

Total economicvalue =

Usevalue

Non-usevalue+

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Box 2.1 presents an example of the total economic value framework applied towetlands. A key issue pertains to the actual estimation of the economic valuespresented in this chapter. Part B is devoted to the presentation of methodologiesto do so. But before doing so, Chapter 3 discusses issues of interest to allvaluation methodologies.

Box 2.1Example of the total economic value framework applied to wetlands

Adapted from Turner et al. (2000)

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2.3 Measuring changes in economic values

Before proceeding with slightly more technical issues, it is of great importance tonote that the economic valuation of environmental impacts does not involvegiving a value to the environment.

The purpose when undertaking the economic valuation of environmental impactsis to assess in monetary terms changes in the flow of goods and servicesprovided by the environment.

For example (as illustrated in Figure 2.7), an increase in the discharge ofpollution into surfaced waters (from a new industrial project for example), willbring upon changes in the physical, chemical, and biological characteristics ofwater quality. These changes in turn will bring upon changes in the flow of goodsand services produced by the water which are of use (direct, indirect, etc.) tohuman beings. It is those changes that must be identified, quantified, and

measured in monetary terms to estimate the environmental costs of the increasein the discharge of pollution.

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Figure 2.7Measuring changes in economic values

(adapted from Freeman, 2003)

Increase in the discharge of industrial

pollution into surfaced waters

Changes in the physical andchemical characteristics of waterquality

Dissolved oxygen;

Temperature;

Turbidity;

Odor; Nutrients;

pH;

Etc.

Changes in the biologicalcharacteristics of water quality

Fish population;

Algae;

Zooplankton;

Bacteria;

Etc.

Changes in use that humanbeings make of the surfacewater:

Domestic water supply; Fisheries;

Recreation;

Crop irrigation;

Aesthetics;

Etc.

Changes in non-use

Future use of surfaced waters

Changes in use and non-use

measured in monetary terms(Changes in economic values)

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Note that it is not changes in the environment that is of interest, but insteadchanges in the use that human beings makes of the goods and servicesproduced by the environment.

This last point is clear when noting the definition of environmental effect and

environmental impact presented in the existing EIA Guidelines (Glossary ofTerms)

ENVIRONMENTAL EFFECTA process such as soil erosion, accumulation of pollutants, orrelocation of people that is modified by mans actions.

ENVIRONMENTAL IMPACTThe net change (good or bad) in mans health or well-being,including the ecosystems on which mans well-being depends, thatresults from an ENVIRONMENTAL EFFECT. Environmental impact

should take into account the change in environmental quality thatwould have occurred naturally, without mans action.

Figure 2.8Environmental effect, impact, and human well-being

ENVIRONMENTAL EFFECT:

Soil erosion;

Land conversion;

Reduction of air quality;

Reduction of water quality;

Pollution of groundwater; Increase in noise level;

Etc.ENVIRONMENTAL IMPACT:

Reduction in agricultural yield;

Reduction in fisheries yield;

Increase in the number of asthmaattacks;

Increase in the number of gastro-intestinal diseases;

Etc.

CHANGE IN HUMANWELL-BEING

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2.4 Identification, quantification, and economic valuation

It is appropriate in the context of the above discussion to conclude this chapterwith the following important warning.

The examples presented in Figure 2.7 and Figure 2.8 make very clear that beforeproceeding with the monetization of the environmental impacts of the project(economic valuation), these impacts must first be identified (e.g. adverse impactin water quality will lead to a reduction in nearby fisheries), and then quantified(e.g. quantity of fisheries yield lost). Environmental impacts which have not beenidentified cannot be, by definition, monetized. Similarly, any errors in thequantification of the impacts will necessarily lead to errors in the economicvaluation of these impacts.

The key point is that the economic valuation of the projects environmentalimpacts can only be so good as the identification and quantification of these

impacts. Hence, the request to proceed with the economic valuation of theprojects environmental impacts (as specified in the EIA Guidelines) does notrelieve project initiators from the needs of identifying and quantifying theseimpacts (as is currently the case in the EIA process), but in fact makes theseneeds even more important and should induce project initiators to pay even moreattention to this identification and quantification process.

Figure 2.9Identification, quantification, economic valuation I

STEP 1IDENTIFICATION OFENVIRONMENTAL IMPACTS

STEP 2QUANTIFICATION OF

ENVIRONMENTAL IMPACTS

STEP 3ECONOMIC VALUATION OFENVIRONMENTAL IMPACTS

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Chapter 3

Approaching the economic valuation ofenvironmental impacts: Issues of common interest

This chapter discusses issues which must be addressed at the outset of theeconomic valuation process and are common to all economic valuationmethodologies.

3.1 Scope of analysis

As indicated in Chapter 1, the EIA Guidelinesspecifies that one of the objectivesof environmental impact analysis in Malaysia is:

To identify the environmental costs and benefits of the project tothe community.

A key issue pertains to the identification of the community, or in other words ofwho to include (whose impacts to include; whose environmental costs andenvironmental benefits to include) in the analysis.

As indicated in the Glossary of Terms of the EIA Guidelines, the wordcommunity is understood to stand (most often) as an abbreviation of HumanCommunity, where Human Community is defined as:

Any diverse group of people sharing the environment. Thecommunity may be local as in village or international as for example

the Straits of Malacca. The community may be homogeneous(same race, same religion, same socio-economic position) orheterogeneous.

When considering the appropriate scope of analysis (who to include), bothgeographical scoping, and stakeholder scoping must be made very clear.

3.1.1 Geographical scoping

While environmental impacts may occasionally be limited to a narrowgeographical area in the vicinity of the project, in other circumstances these

impacts may extend well beyond a narrowly defined area to cover an entirewatershed, airshed, state, country, or even be global. Misspecifying thegeographical scope of the EIA (most often by limiting unduly the geographicalarea of interest) can lead to significant under-estimates of the environmentalcosts and environmental benefits of the project.

Unfortunately, there is no easy rule to guide the selection of the appropriategeographical scope of the EIA. While local governments may wish to limit the

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assessment of the environmental impacts solely to their local constituencies, thefederal government should typically want to address all environmental impacts ofthe project at least nationwide, irrespective of local jurisdictions or stateboundaries.

Of utmost importance is that the choice of geographical scope not be guided bystrategic considerations leading to under-estimating the nature and extent of thepossible adverse environmental impacts of the project, or over-estimating thenature and extent of the possible favorable environmental impacts of the project.

To better inform the discussion pertaining to the identification, quantification, andeconomic valuation of environmental impacts:

Group the environmental impacts (both positive and negative) into thoseoccurring: (1) Within the local community where the project is located; (2)On other local communities within the state where the project is located;

and (3) On other states of Malaysia (Figure 3.1);

Select the same geographical scoping for the identification of both thepositive and negative environmental impacts.

Figure 3.1Geographical scoping of environmental impacts

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3.1.2 Stakeholder scoping

An equally sensitive issue pertains to selecting whose costs and benefits toaccount for in the economic valuation. While the issue of stakeholder scopingmay occasionally coincide with the issue pertaining to geographical scoping, it is

different in that the environmental impacts of a project may impact differentgroups of people or households within a given geographical area.

This is of particular relevance when the environmental impacts of projects (suchas for example road improvement projects, bridge projects, coastal landreclamation projects among others) may have adverse or positive effects on thewell-being of non-nationals who may only temporarily reside within thegeographical area of interest (such as temporary workers or visitors).

As for the selection of the appropriate geographical scope, there is no easy ruleguiding the selection of the appropriate stakeholder scoping. Project initiators

should however clearly identify the groups of individuals or households who areincluded into the process of identifying, quantifying, and monetizing theenvironmental impacts of the project, and those who are excluded.

3.2 Choice of scenario: With project versus without project

Recall the definition of Environmental impact presented in the EIA Guidelines:

ENVIRONMENTAL IMPACTThe net change (good or bad) in mans health or well-being,including the ecosystems on which mans well-being depends, thatresults from an ENVIRONMENTAL EFFECT. Environmental impactshould take into account the change in environmental quality thatwould have occurred naturally, without mans action.

The last sentence of the above definition is of great importance. It points out thatin order to identify the environmental impacts of the project, one must comparewhat is likely to happen to the environment (and the resulting impacts on humanwell-being) with the project relative to what is likely to happen if there were to beno project. In order words, one must look into the future and ask (for the selectedgroup of stakeholders within the selected geographical scope): what is the futuregoing to look like without the project versus with the project.

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Note that in most circumstances, this is unlikely to be before and after theproject. The before and after comparison:

ignores or fails to account for future changes in environmental qualitywhich may happen even in the absence of the project; and

implicitly assumes that the environment in the future is going to remain thesame as it is today.

Suppose a road or bridge project aims to reduce traffic congestion between twocities of Peninsular Malaysia. Suppose further that this reduction in trafficcongestion is expected to have a positive impact on ambient air quality byreducing vehicular emissions of pollution. A key issue pertains to quantifying thisimprovement in ambient air quality. For this purpose, a reference scenario mustbe established.

As illustrated in Figure 3.2, without the project it may be unlikely that air pollutionconcentration would remain at existing levels. In fact, one may reasonably expectthat without the project, traffic congestion would get worse, and that air pollutionconcentration would concurrently get worse as well. In such situations, thescenario of reference is not the existing levels of pollution, but is instead theexpected level of pollution if there were to be no project.

Note in Figure 3.2 that even if pollution concentration were to be higher with theproject, one would not conclude that the project resulted in an increase ofpollution concentration. In the example presented in Figure 3.2, the project wouldstill reduce pollution concentration when compared to a scenario where there

were to be no project.

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Figure 3.2With project versus without project

Expected pollutionconcentration withproject

Expected pollution

concentrationwithout project

Existingpollutionconcentration

Today

Impact ofthe project

In order to identify and quantify the environmental impacts of projects, projectinitiators should clearly specify the:

Expected changes in environmental quality and the associatedenvironmental impacts if there were to be no project (without projectscenario);

And then compare the above scenario with the:

Expected changes in environmental quality and the associatedenvironmental impacts if there were to be a project (with project scenario).

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Box 3.1Example of with versus without project

In a detailed EIA report submitted to DOE, one read the following:

The project site is mainly under agriculture and secondary forest. Atlowers slopes, durian trees were planted (some still in production) and ata later stage other fruit trees as well as other agricultural cash crops wereadded.

There is expected to be a loss in terms of agricultural productivity as aresult of development in the area. Durian and other fruit crops will beremoved in the process of development but it is expected that this loss isinsignificant as the area has not been maintained and the crops that arepresent are old and near the end of their peak productivity.

While one may argue or disagree with the conclusion that this loss is

insignificant, the approach used to identify the potential loss of agriculturalproductivity is correct. Assuming indeed that the best use of this land is itsexisting land use, then the study aimed to identify what is likely to happen toagricultural productivity in the future without the project (the crops are old andnear the end of their peak productivity) versus with the project.

3.3 Dealing with price changes: Nominal versus real

The market price of a specific commodity may vary for two different reasons.

First, it may vary simply because of changes in the general price level and inmore or less the same proportion as these changes in the general price level(when this change in the general price level is upward, it is referred as inflation).Such changes are referred as changes in nominalprices.

Second, it may vary because of changes in the supply and/or demand for thecommodity. Such changes are referred as changes in realprices.4

Since inflation impacts all prices in more or less the same manner, there is noneed to incorporate inflation in the process of undertaking the economic valuation

of the environmental impacts of the project. As such, there is no need to attempt

4 For example, the significant increase in the price of oil observed over the period 2006-2008does not result from inflationary pressure but mostly from an increase in the demand for oil. Thischange in the price of oil is not a change in nominal price but is a change in real price. Note thatthe expressions real price and constant price are often used interchangeably. They should notbe. As the case of the price of oil shows clearly, there is no reason to expect that real prices areconstant.

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forecasting future inflation rates or future changes in prices, except for thosechanges in real prices. Specific recommendations are:

Conduct the economic valuation of the projects environmental impacts interms ofrealprices;

Do not incorporate in the economic valuation of the projectsenvironmental impacts changes in prices solely caused by inflation;

As a level of reference, use the level of prices as observed at the time ofpreparing the EIA report.

3.4 Accounting for time: Discounting

In this section we address issues which arise from the fact that environmentalcosts and environmental benefits may arise at different points in time, some in

the near future, and others in a more distant future. These issues arise fromobserving that RM 1 million of environmental costs or benefits today is not thesame as RM 1 million of environmental costs or benefits in 1 or 2 or 10 yearsfrom now.

3.4.1 Discounting and present value

Discounting is simply a technique which allows to measure in a common unit ofmeasurement (todays dollars) costs or benefits which are taking place atdifferent points in time. The value today of future environmental costs andbenefits is known at the present valueof these environmental costs and benefits.

3.4.2 The mechanics of discounting

Discounting is simply compound interest in reverse. The mechanics ofcompounding is presented in Figure 3.3. RM 100 earning 10% per year will beworth RM 110 in one year from now, 121 in two years from now, and moregenerally will be worth RM 100(1.1)t in t years from now. With compounding, oneestimates the future value of RM 100 received today.

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Figure 3.3The mechanics of compounding

Year 0 Year 1 Year 2 Year 3 Year 4

100 100(1+r) 100(1+r)(1+r)

100(1+r)2

100(1+r) (1+r)

100(1+r)3

100(1+r)(1+r)(1+r)

100(1+r) (1+r)(1+r)

100(1+r) (1+r)

100(1+r)(1+r)(1+r)(1+r)

100(1+r)

Discounting simply works in reverse as shown in Figure 3.4. Using a discount

rate of 10%, RM 100 received in 1 year from now is worth today RM 91 (100/1.1).Similarly, the present value of RM 100 received 4 years from now is RM 68.3(100/(1.1)4); RM 100 received t years from now is worth today (has a presentvalue of) 100/(1.1)t. More generally, using a discount rate of r, RM 100 receivedt years from now is worth today 100/(1+r) t.

Figure 3.4The mechanics of discounting

Year 0 Year 1 Year 2 Year 3 Year 4

100

100 / (1+r)

100

100 / (1+r)

100 / (1+r)

100 100

100 / (1+r)

100

In the above discussion:

r is referred as the discount rate;

1 / (1+r) is refered as the discount factor.

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Denote by Ct the economic value of the potential adverse environmental impactsof the project in period t (environmental costs). Denote by B t the economic valueof the potential positive environmental impacts of the project in period t(environmental benefits).

Where appropriate, these environmental costs and benefits must be presentedclearly in a manner similar to Figure 3.5 (the selection of T is discussed insection 3.5 below).

Figure 3.5Presentation of environmental costs and benefits

Year 0 Year 1 Year 2 Year 3 Year T

C0 C2 C3 CTC1

B0 B2 B3 BTB1

Once environmental costs and environmental benefits are presented in a mannersimilar to Figure 3.5, then the present value of these environmental costs andbenefits can be calculated as:5

Present value of

environmental costsT

T

r

C

r

C

r

C

r

CC

)1()1()1()1( 33

2

210

+++

++

++

++=

= +

=T

ttr

C

0

0

)1(

Present value of

environmental benefitsT

T

r

B

r

B

r

B

r

BB

)1()1()1()1( 33

2

210

+++

++

++

++=

= +=

T

ttr

B

0

0

)1(

5The function NPV in Excel Spreadsheet performs this calculation.

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3.4.3 Selecting a discount rate

The mechanics of discounting is relatively simple. However, choosing anappropriate discount rate remains a contentious and controversial issue as itappears to raise issues pertaining to inter-generational fairness or equity. Indeed,

suppose for example that a project potentially involves a cost of RM 1 billion in50 years from now (e.g. decommissioning of a large infrastructure facility). At a5% discount rate, the present value of this cost is RM 87.2 million; at a discountrate of 8%, the present value becomes only RM 21.3 million. Manyenvironmentalists have thus argued that discounting is inconsistent with theprinciple of sustainable development since future environmental costs, oncediscounted to their present values, are unlikely to significantly impact thedecision-making process.

On the other hand, not discounting (which in practice implies using a discountrate of 0%) as some would propose may not be an appropriate approach.

Indeed, using a 0% discount rate implies that a cost (or a benefit) of RM 100 in10, 50, 500 or 5000 years from now is worth exactly the same as if it were tohappen today. Furthermore, as the discount rate is reduced towards zero, itimplies that future generations consumption is worth more and more in presentvalue terms. This in turn implies that the current generation should reduce itsconsumption, and further increase its saving and investment as the discount rateis reduced towards zero. This raises its own ethical problem as in fact this impliesthat the current generation sacrifices more and more consumption today for thesake of increasing the consumption of unknown future generations.6

There is thus a discussion as to what should be the correct discount rate to usewhen calculating the present value of future environmental costs andenvironmental benefits. Hence, in practice, it is generally appropriate to calculatethe present value using a range of discount rateas opposed to a single discountrate.

Based on existing practice in studies undertaken in Malaysia and abroad,discount rates ranging from 3% to 8% are appropriate. Note that this discountrate is a discount rate in real terms, not in nominal terms. In other words, sinceenvironmental costs and environmental benefits are measured in real terms (seeSection 3.3 above), the discount rate must also be measured in real terms, anddoes not account for or include inflation (Box 3.2).

6Some economists have argued for the use of a time declining discount rate. Weitzman (1998)

and Gollier (2002) provide a rationale for the use of such discount rate.

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Box 3.2

Discounting and inflation

Suppose that the real discount rate is noted by r, while the nominal discount rate

is noted by m. Suppose further that prices are expected to rise at a constantrate g in future years (g is the expected inflation rate).

Then, if conducting the analysis in nominal terms, the present value of a flow ofbenefits from t = 0 to t = T is:

T

T

T

m

gB

m

gB

m

gB

m

gBBPV

)1(

)1(

)1(

)1(

)1(

)1(

)1(

)1(3

33

2

2

210

+

+++

+

++

+

++

+

++=

According to Fishers Law, )1)(1()1( grm ++=+ . Substituting this expression into

the above equation yields:

TT

T

T

gr

gB

gr

gB

gr

gB

gr

gBBPV

)1()1(

)1(

)1()1(

)1(

)1()1(

)1(

)1)(1(

)1(33

3

3

22

2

210

++

+++

++

++

++

++

++

++=

Which is the same as:

T

T

r

B

r

B

r

B

r

BBPV

)1()1()1()1( 33

2

210

+++

++

++

++=

Hence, doing the analysis in real terms (using prices and discount rate measuredin real terms) yields the same outcome as using nominal prices (without inflation)and a nominal discount rate. Doing the analysis in real terms has the advantagethat one does not need to forecast inflation rates in the distant future.

3.5 Selecting a time horizon

The formulas presented above to calculate the present value of a flow ofenvironmental costs and environmental benefits spread over time assumed anunspecified length of time of T years. An important issue (albeit not necessarily akey issue) pertains to the selection of the time horizon (T) for the purpose of theeconomic valuation of the environmental impacts.

In principle, all environmental costs and environmental benefits of the projectshould be accounted for, even when they extend in the indefinite future. Notehowever that as the discount rate increases (from 3% to 8%), costs and benefitsin the indefinite future counts less and less today as their present valuebecomes smaller and smaller (Box 3.3).

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Box 3.3

Discount rate and the indefinite future

Suppose that a project involves an environmental cost or benefit of RM 100

millions in 100 years from now. The present value of this cost or benefit will notbe very large for any discount rate between 3% and 8%, and would bedecreasing significantly as the discount rate increases from 3% to 8% as shownbelow.

Present value of RM 100 millions receivedin 100 years from now

Discount rate Present value (RM)

3% 5,203,283

4% 1,980,004

5% 760,0046% 294,722

7% 115,245

8% 45,459

A key issue is to recognize that though a project may be completed from anengineering point of view (for example, the construction of the road or bridge iscompleted), environmental costs and benefits may continue to arise for manymore years beyond the construction phase.

To this extent, the appropriate time horizon to select should coincide with theexpected duration (in time) of the environmental impacts of the project.

If some environmental impacts are expected to be of a temporary nature (forexample, during the construction phase of the project), then for these impacts theappropriate time horizon to select is the number of years these impacts areexpected to last. If some environmental impacts are expected to be permanent,then using a time horizon of between 30 to 50 years is generally sufficient toprovide an adequate estimate of the present value of these impacts.

3.6 Conducting sensitivity analysis

Each of the steps leading to the estimation of the environmental costs andbenefits of the project (identification, quantification, and monetization) isundertaken in a context of uncertainty as well as with incomplete and sometimesunreliable information. For this reason, it is always prudent to estimate costs andbenefits under a series of different assumptions as to what may be theenvironmental impacts of the project.

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The purpose of conducting a sensitivity analysis is to identify the variables whichinfluence most the present value of environmental costs and environmentalbenefits, and to quantify the impact of changes in these variables on the presentvalue of these costs and benefits.

There are two relatively straightforward ways of conducting sensitivity analysis.

One way, most often conducted in such analysis, is to assume that the impactsof the project (or the most important impacts of the project) are slightly higher orlower than those expected, and for each new assumption or scenario torecompute the present value of environmental costs and benefits.

An alternative way is to assume a worst case or a best case scenario.Establishing a worst case scenario is especially useful when the project hasadverse environmental impacts on the environment. For example, if a projectwere to have adverse impact on nearby fisheries or agricultural activities, a

worse case scenario would estimate the environmental costs assuming that allfisheries or all agricultural activities were to disappear forever.

After conducting the sensitivity analysis, the estimated present value ofenvironmental costs or environmental benefits will not be a point estimate (forexample, RM 100 million), but will be a range of values (for example, betweenRM 75 and RM 130 million). Such range will provide more useful informationpertaining to the likely impacts of the project on the environment.

3.7 Summary of recommendations to project initiators

Project initiators are not formally required to follow any specific format orinstructions when undertaking and presenting the economic valuation of theprojects environmental impacts in their EIA reports. However, in order tofacilitate the understanding of this economic valuation and discussions with DOE,the following recommendations are presented.

3.7.1 With respect to the scope of analysis

Aim first to identify the environmental impacts of the project, not to selectthe geographical scoping of the project;

Group the environmental impacts (both positive and negative) into thoseoccurring: (1) Within the local community where the project is located; (2)On other local communities within the state where the project is located;and (3) On other states of Malaysia. On the basis of this information,define the appropriate geographical scoping of the project for purpose ofthe EIA process;

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Identify clearly the groups of individuals or households who are includedand those who may be excluded from the process of identifying,quantifying, and monetizing the environmental impacts of the project.

3.7.2 With respect to the scenario of reference

In order to identify and quantify the extent of the projects environmentalimpacts, project initiators should clearly specify and compare the followingtwo scenarios:

Scenario 1: Expected changes in environmental quality and theassociated environmental impacts if there were to be no project(without project scenario)

Scenario 2: Expected changes in environmental quality and theassociated environmental impacts if there were to be a project (with

project scenario)

Present the undiscounted stream of environmental costs andenvironmental benefits of the project, in each of the period in these thecosts and benefits are taking place (as in Table 3.1 below);

Table 3.1Undiscounted stream of environmental costs and benefits

Year 0 Year 1 Year 2 Year 3 Year 4 Year T

EnvironmentalCosts

C0 C1 C2 C3 C4 CT

EnvironmentalBenefits

B0 B1 B2 B3 B4 BT

3.7.3 With respect to inflation

Conduct the economic evaluation of the projects environmental impacts interms ofrealprices;

Do not incorporate in the economic valuation of the projectsenvironmental impacts changes in prices solely caused by inflation;

As a level of reference, use the level of prices as observed at the time ofpreparing the EIA report.

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3.7.4 With respect to the discount rate

Discount rates ranging from 3% to 8% should be used to calculate thepresent value of the environmental costs and of the environmentalbenefits.

Calculate and display the present value of the environmental costs andenvironmental benefits using a discount rate ranging from 3% to 8% (as inTable 3.2 below);

Table 3.2Present value of environmental costs and benefits calculated for different

discount rates

Discount rate

3% 4% 5% 6% 7% 8%

PV of EnvironmentalCosts

PV of EnvironmentalBenefits

As indicated in Chapter 1, the economic valuation of environmentalimpacts is nota cost-benefit analysis. As such, the calculation of the netpresent value (present value of benefits minus present value of costs) isnot of direct relevance to this analysis.

3.7.5 With respect to the selection of time horizon

The appropriate time horizon to select should coincide with the expectedduration (in time) of the environmental impacts of the project.

If some environmental impacts are expected to be of a temporary nature(for example, during the construction phase of the project), then for theseimpacts the appropriate time horizon to select is the number of yearsthese impacts are expected to last.

If some environmental impacts are expected to be permanent, then usinga time horizon of between 30 to 50 years is generally sufficient to provide

an adequate estimate of the present value of these impacts.

3.7.6 With respect to the conduct of sensitivity analysis

Provide a range for the present value of environmental costs and thepresent value of environmental benefits depending on differentassumptions as to the impact of the project on the environment.

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PART B

METHODOLOGIES FOR THE ECONOMIC VALUATION OFENVIRONMENTAL IMPACTS

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Chapter 4

Introduction to the methodologies for economic valuation

4.1 From environmental impacts to methodologies

In this second part of these Guidelines, the purpose is to describe methodologiestypically used to undertake the economic valuation of environmental impacts.The following methodologies are presented and discussed:

Change of productivity methodology (Chapter 5);

Revealed preferences methodologies (Chapter 6);

Stated preferences methodologies (Chapter 7); and

Benefit-transfer methodology (Chapter 8).

Before discussing the details of these approaches, it is of importance to note thatthe choice of an economic valuation methodology depends on the nature of theenvironmental impacts one seeks to monetize. Recall that Figure 2.2 presentedthe concept of total economic value and of its components (use and non-usevalues, direct use, indirect use, etc.). Different economic valuation methodologiesare thus used to estimate different economic values as shown in Figure 4.1:

Changes in consumptive direct use values are typically estimated usingthe change in productivity methodology;

Changes in non-consumptive direct use as well as indirect use values aretypically estimated using revealed preferences methodologies. However,the change of productivity and stated preferences methodologies mayoccasionally be used for this purpose as well depending on the nature ofthe environmental impacts;

Changes in non-use values can only be estimated using statedpreferences methodologies.

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Figure 4.1Economic values and methodologies

Use value

Direct usevalue

Indirect usevalue

Non-usevalue

Bequestvalue

Existencevalue

Consumptivedirect use value


Change ofproductivity

Change ofproductivityRevealedpreferences andstated preferencesmethodologies

Stated preferencesmethodologies

Hence, the choice of an economic valuation methodology depends on the natureof the environmental impacts one seeks to monetize (Table 4.1). It is the natureof the environmental impacts which determines which methodology to use. Theremay occasionally be more than one methodology possible to undertake theeconomic valuation of a particular impact (Table 4.1). In such situations, theavailability (or lack) of data is more likely to determine which specificmethodology can be implemented.

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Table 4.1Environmental impacts and methodologies

Environmentaleffects

Examples ofenvironmental impacts

Economic valuationmethodologies

Air pollution Health impact Cost of illnessAverting behaviorContingent valuation

Infrastructure damages Cost of replacementHedonic prices

Amenity impacts Contingent valuation

Water pollution Health impact Cost of illnessAverting behaviorContingent valuation

Water resourcesdepletion

Agricultural losses Change of productivityCost of replacement

Soil erosion / degradation Agricultural losses Change of productivityCost of replacement

Increase vulnerability todisasters

Averting behaviorHedonic prices

Noise pollution Health impacts anddiscomfort

Hedonic pricesAverting behavior

Loss of forested areas Degraded forests Change of productivityReplacement costsTravel costContingent valuation

Loss of coastal

ecosystems

Degraded ecosystems Change of productivity

Travel costContingent valuation

Adapted from Bolt et al. (2005).

As shown in Figure 4.2, the process of identifying, quantifying, and monetizingthe environmental impacts of a project cannot be the sole task of the economist.In particular, technical and scientific experts are best positioned to identify thepossible nature of the environmental impacts of the project, and then to quantifysuch impacts. The key role and expertise of the economist is at the stage ofmonetization. This process is thus undertaken by a team of experts among whichthe economist plays a significant but not the only role.

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Figure 4.2Identification, quantification and economic valuation II

Identification of theenvironmental impacts

Quantification of theenvironmental impacts

Monetization of theenvironmental impacts

Task of technical / scientificexperts and economist

Task of economist

Task of technical / scientificexperts

4.2 Recommendations to project initiators

Identify all environmental impacts of the project and assess which data iscurrently available in order to quantify the environmental impacts (changesin physical terms);

Given the nature of the available data, determine which methodology isbest to use to undertake the economic valuation of the environmental

impacts, and depending on the selected methodology, proceed with(additional) data collection if necessary;

Ensure that the team of experts is appropriate to the task at hand and thatthe economist is a member of the team from the very outset of the EIAprocess to ensure that the data necessary for purpose of economicvaluation is indeed collected.

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Chapter 5

Change of productivity methodology

5.1 When to use this methodology

In a number of instances, changes in environmental quality lead to changes inthe quantity (or quality) of goods or services produced by the environment. Inother instances, one may think of environmental quality as an input (along withother inputs such as capital and labor) into the production of goods and services,such as in agriculture for example. In such instances, changes in environmentalquality may impact the flow (quantity or quality) of the goods and servicesproduced by the environment or may impact the productivity (yield) of the goodsproduced with the support of the environmental input. In such instances, thechange of productivity methodology may be used to transform the adversechanges in environmental quality into environmental costs, and the positive

changes in environmental quality into environmental benefits.7

Examples when the application of the change of productivity methodology isappropriate include:

Water pollution and water resources depletion. The quantity andquality of water diverted for irrigation purposes affects the agriculturalproductivity (yield) of irrigated land. Hence, changes in water quality orquantity is likely to have an impact on agricultural productivity or on thecost of conducting agricultural production;

Water pollution. The quality of water impacts fisheries productivity (yield).Hence, changes in water quality is likely to have an impact on fisheriesproductivity or on the cost of conducting fisheries activities;

Water resources depletion. In a number of instances, the depletion (orpollution) of the water resources impacts the productivity (quantity ofenergy produced) of hydro-power dams. Such use of the water resourcesis generally referred as an indirect use of the resource and producesindirect use value. The economic value of the lost energy production is acost to society;

Soil erosion (on-site impact). The quantity and quality of soil affectsagricultural productivity. Hence, the loss of soil (erosion) is likely to havean impact on agricultural productivity or on the cost of conductingagricultural production;

7In order to avoid unduly burdening the text with both adverse and positive environmental

impacts, most of the text will directly address adverse environmental impacts as these may bemore appropriate given the context in which these Guidelinesare going to be used.

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Soil erosion (off-site impact). Soil erosion in a watershed often leads toriver sedimentation downstream. This in turn may have impact on theproductivity of fisheries downstream (as a result of the sedimentation), onthe productivity of agricultural production (for example as a result of anincrease in the incidence of flooding), and on the productivity of hydro-

power dams (to the extent that reservoirs may have to be dredged or theproductive lifetime of the dam be shortened);

Air pollution. Some types of air pollutants (such as ground-level ozoneresulting from the emissions of air pollution by road transport) are knownto have impact on agricultural productivity. Hence, changes in the ambientconcentration of such pollutants may impact agricultural productivity in theair shed;

Salinity. Increases in the salinity of croplands (resulting, for example, fromrising groundwater levels) may adversely impact agricultural productivity

or the costs of conducting agricultural production;

Coastal resource depletion. Mangroves serve as ecological support andhabitat to fish populations. Depletion (clearance) of the mangroveresource may thus have an adverse impact on fish populations and onfisheries;

Deforestation. Forests provide habitat to a large number of non-timberforest products (NTFPs) such as fruits, mushrooms, wildlife, etc some ofwhich being harvested and sold (legally) on markets. Deforestationgenerally has an adverse impact on the flow (quantity) of these products.

In all of the above examples, note that the goods or services produced by theenvironment are used (with other inputs such as labor and capital for example) toproduce goods which are commercially transacted (rice, fruits, fish, electricity,etc.) and for which there exists market prices. One way (but not the only way) toprovide an economic valuation of the environmental impact is to assess the neteconomic value of the lost output (net economic value of the fisheries lost; netvalue of the agricultural production lost; net value of the hydro-power lost, etc.).8 I

5.2 How to use this methodology

The implementation of this methodology takes place in two steps.

5.2.1 Step 1: Quantify the impact on productivity

In order to apply the change in productivity methodology, the very first step is tomeasure the impact of the change in environmental quality or quantity on the

8An alternative way is discussed later in Chapter 6.

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productivity of the resource. This may be the most difficult step whenimplementing this methodology. It consists in asking and attempting to answerquestions such as (for example):

How much agricultural yield would be lost (in quantity terms) if ambient

water quality were to degrade as a result of wastewater discharges fromthe proposed project?

How much fisheries would be lost (in quantity terms) if ambient waterquality were to degrade as a result of wastewater discharges from theproposed project?

How much agricultural yield would be lost (in quantity terms) if the projectwere to increase soil erosion?

How much energy from the downstream hydro power dam would be lost if

the project were to increase soil erosion upstream?

In technical terms, this amounts to establishing a dose-response function(sometimes also called a exposure-response function) between the change inenvironmental quality (dose) and the resulting impact on productivity (response).

In some instances, estimating the lost productivity may be relatively simple (forexample, if a project were to convert existing agricultural land, then the lost ofproductivity could be simply estimated as the difference between the existingproductivity and zero a complete loss).9

In other instances, this may be relatively difficult (for example, if a project has anadverse but temporary impact on water quality, assessing the impact on fisheriesproductivity may be relatively difficult). This explains the need to conductcomprehensive sensitivity analysis.

5.2.2 Step 2: Monetize the impact

Once the environmental impacts have been quantified in physical terms, theseimpacts then need to be monetized.

In a number of cases, market prices (as they are simply observed on the

markets) are used to estimate the net economic value (revenues minusproduction costs) of the change in productivity.

However, in a number of instances, market prices may be somewhat misleadingmarket prices may also reflect the presence of taxes, subsidies, importrestrictions, etc. Hence, before using market prices, it is important to adjust these

9Under the assumption that future land productivity were to be equal to the existing level of

productivity.

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prices to remove the impacts of such policies. In circumstances where thecommodity is transacted internationally, world prices may serve as a goodestimate of the economic value of the commodity.

5.3 Strengths and limitations of the methodology

5.3.1 Strengths

Of all the economic valuation methodologies available, the change of productivitymethodology is perhaps the least demanding in terms of data analysis and therequired economic expertise.

The results from applying the change of productivity methodology are also ofimmediate use in the context of the EIA process as the estimated change ineconomic value often translates in lost or increased income to those exploitingthe resources (fishermen, farmers, etc.). To this extent, the assessment of

environmental costs which results from applying the change of productivitymethodology is often better explained and better understood by stakeholders anddecision-makers.

5.3.2 Limitations

The key difficulty when applying the change of productivity methodology is toassess the impact of the change in environmental quality or quantity on thequantity (or quality) of the goods produced with the help of the environment. In anumber of instances, the dose-response functions are not well-known or willprovide a wide range of possible productivity impacts resulting from the changein environmental quality or quantity. The technical (or scientific) expertiserequired may be relatively significant.

It is also important to note that the change in productivity methodology providesthe economic value of the goods and services produced by the environment onlyas these goods and services are used to produce marketed products. To theextent that the goods and services produced by the environment are also used inmany other ways, the economic value estimated from applying the change inproductivity methodology will under-estimate the total economic value of thesegoods and services.

5.4 Recommendations to project initiators

5.4.1 Quantify the impact on productivity

In almost all cases, estimating the effect of the environmental impacts onproductivity will involve the following:

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Estimate the existing annual level (on average) of productivity (by meansof time series data over the last 5 years approximately);

Establish what may be expected to happen to the future level ofproductivity if there were to be no project (one possible scenario

(hypothesis) is that the future level of productivity would be equal onaverage to the recently observed level of productivity). This is the withoutprojectscenario;

Establish what may be expected to happen to the future level ofproductivity if there were to be a project. This is the with projectscenario;

Indicate clearly if the impacts are expected to be temporary (for exampleoccurring only during the construction phase of the project) or permanent.If temporary, indicate clearly for how many years the impacts are expectedto occur, and how productivity (in quantitative terms) is expected to

recover over time to the level that is expected to exist without project;

Estimate the impact on productivity by calculating the difference betweenthe without project and with project scenarios;

Construct alternative scenarios including a worst case scenario (whereappropriate) to give a possible range of the impact of the project onproductivity (sensitivity analysis).

5.4.2 Step 2: Monetize the impact

In almost all cases, monetizing the estimated change in productivity will involvethe following:

Collect information about recent and existing market prices for thecommodity whose productivity is impacted, as well as for the inputsnecessary to the production of this commodity (e.g. labor, machinery,etc.);

Before using market prices, adjust these prices at least for the presence oftaxes, and if possible of subsidies and any other policies which mayimpact market prices;

Calculate the net economic value of the change (decrease or increase) inproductivity per unit of output (for example, per kilogram or ton of product;or per hectares of lost agricultural land);

Multiply the net economic value per unit of output by the total estimatedquantity of lost (or gained) output in any given year;

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Calculate the present value of the change in productivity using a discountrate ranging between 3% and 8%;

Given the outcome of the sensitivity analysis, give a possible rangefor theestimated economic value of the change in productivity.

The examples presented in Appendix 1 and 2 are illustrative of the application ofthe change of productivity methodology.

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Chapter 6

Revealed preferences methodologies

6.1 Introduction to revealed preferences methodologies

In a number of circumstances, instead of letting the change in environmentalquality or quantity impact the productivity of their resource, individuals (such asfarmers for example) may seek to undertake activities (such as, for example,using additional quantities of fertilizers, or working longer hours) to offset(partially or totally) this potential impact (Box 6.1)

Box 6.1Sedimentation ponds in Malaysia

In a large number of instances in Peninsular and Eastern Malaysia, farmers mustremove large quantities of sediments from surface waters before using the waterto irrigate their field. For this purpose, farmers generally use sedimentation pondsin which water lies still for a period of time sufficiently long to let the sedimentsfall at the bottom of the pond (which is most often simply a large hole dug in theground). This represents one type of activity undertaken by farmers to offset thepresence of large quantities of sediments in surface waters.

Moreover, unlike the types of situations covered in Chapter 5, in a number ofcircumstances the change in environmental quality may not have a direct impact

on the productivity of a resource such as land (e.g. agricultural yield) or water(e.g. fisheries). For example:

Individuals may seek to offset adverse changes in water quality by treatingthe water (e.g. boiling) before its consumption;

Increases in air or noise pollution may adversely impact the market valueof surrounding properties;

An increase in water pollution or deforestation may adversely impactrecreational opportunities on a beach or forest.

In each of the above examples, one observes individuals changing their behavioras a result of the change in environmental quality. The economic costsassociated with this change in behavior may reveal the extent to whichindividuals wish to avoid the negative change in environmental quality.

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Five methodologies are generally considered to fall within the group of revealedpreferences methodologies. These are:

Replacement cost methodology;

Defensive expenditure methodology;

Cost of illness methodology;

Hedonic pricing methodology;

Travel cost methodology.

In principle, there may not be significant methodological differences between thereplacement cost methodology and the defensive expenditure methodology. Inboth cases, individuals are undertaking activities to offset the potential impact of

an adverse change in environmental quality. Both methodologies rely onassessing the costs of undertaking these activities. However, it has becomecustomary to apply the replacement cost methodology when changes inenvironmental quality have an impact on the productivity of the resources, and toapply the defensive expenditure methodology when changes in environmentalquality have an impact on health.

As explained previously, the choice of the methodology depends on the nature ofthe environmental impact, as illustrated in Table 6.1.

Table 6.1

Application of revealed preferences methodologies

Types of application Revealed behavior Methodology

Health: Morbidity Cost of treating illness Cost of illness

Health: Morbidity andmortality

Cost of avoiding illness Defensive expenditure

Resource productivity(agricultural, fisheries)

Cost of avoidingreduction in productivity

Replacement cost

Property value Changes in propertyvalues

Hedonic pricing

Recreational sites Participation inrecreational activity at thesite

Travel cost

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We discuss in some details each of these methodologies below.

6.2 Replacement cost methodology

6.2.1 When to use this methodology

In a number of instances, producers (such as farmers, fishermen, hydropoweroperators, water supply providers, etc), may seek to offset (compensate) for theloss of environmental quality or quantity by undertaking activities which aim tokeep production (or production costs) more or less constant, despite the adversechange in environmental quality.

In such instances, it may be possible and of interest to attempt estimating:

(1) the costs (for the farmers, fishermen, hydropower operators, or watersupply providers) of undertaking these activities which they would not

need to undertake if environmental quality were not to deteriorate; or

(2) the benefits (for the farmers, fishermen, hydropower operators, or watersupply providers) of not undertaking these activities anymore ifenvironmental quality were to improve.

Examples when the application of the change of productivity methodology isappropriate include:

Wetlands degradation. It is well known that wetlands provide a largenumber of ecological services including water purification services (seeBox 2.1 in Chapter 2). It may be possible to estimate the economic valueof this particular service provided by wetlands by estimating the cost ofproviding clean water with alternative purifying methods such as filteringand chemical treatment. If the wetlands were to be degraded or todisappear (as a result of urban expansion for example), and if the samelevel of water quality were to be desired, then society would have to investthis additional cost to obtain purified water from alternative means insteadof being freely provided by wetlands;

Deforestation - Sedimentation. Poorly managed logging practices oftenleads to river sedimentation of river catchments. As a result, water supplyproviders in the effected catchments may have to incur additionaloperational costs directly associated with the presence of sediments in thesource of water supply. Alternatively, the costs of undertaking theseadditional activities may be a measure of the benefits of implementinglogging practices which would prevent such sedimentation (Box 6.2);

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Box 6.2The costs of river sedimentation:

The case of Beaufort (Sabah)

Beaufort is located downstream the Padas River catchment in Sabah. As a result

of numerous activities including logging upstream the catchment, the PadasRiver experiences high levels of sedimentation. In order to remove the sedimentsfrom the water before it be provided to its customer, the Beaufort Water SupplyCompany must use large quantities of alum and lime. Over the period 2001-2005the following expenditures have been incurred:

Alum and lime expenditures in Beaufort

Alum Lime

Quantity(kg)

Expenditures(RM)

Quantity(kg)

Expenditures(RM)

2001 549,000 424,267 177,025 84,264

2002 593,950 459,004 189,750 90,321

2003 782,100 600,736 250,475 119,226

2004 782,100 604,406 307,675 146,453

2005 786,400 607,729 389,675 185,485

Total quantity 3,493,550 1,314,600

Average annualexpenditures

539,228 125,150

In addition to the above costs, the water intake must be cleaned as sludgeaccumulates and reduces the water flow. Over the period 2001 2005,desludging took place 8 times for an annual average cost of approximately

RM8,800. Finally, during periods of shutdowns (for desludging purposes), thecompany is under the obligation of providing water to its domestic customers. Itdoes so by trucking water to households. Over the period 2001 2005, theannual average cost of this activity reached RM375,040.

On the basis of the above estimates, the presence of high concentration ofsediments in the Padas River costs the Beaufort Water Supply Companyapproximately RM1.05 million per year. This economic cost is a part (and in alllikelihood not the only component) of the total cost of river sedimentation in thePadas Catchment. It may also be interpreted as the potential benefit of a project(or policy) which would aim to reduce river sedimentation in the Padas River.

Water pollution. As a result of the significant presence of debris insurfaced waters, hydropower dams may have to shut down on a regularbasis to allow for the removal of the debris. In addition to the direct costsof debris removal activities, energy production may either be lost (changein productivity) or may have to be produced by alternative means ofproduction. The costs of replacing hydropower with power produced from

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these alternative means of production may serve as an estimate of thecosts of debris in surfaced waters (Box 6.3).

Box 6.3

The Tenom Pangi hydropower plant in thePadas River Catchment (Sabah)

The hydro power station at Tenom Pangi is the largest hydro power station inSabah. It is a run-of-river plant commissioned in 1984. It is situated on the bankof the Padas River on the outskirts of Tenom City. It has an installed capacity of66 MW made of 3 turbines of 22 MW each.

Since its commissioning, the power station has experienced significant difficultiesresulting from the presence of large quantities of debris and silt which, when insufficient quantity, blocks the stations water intake. Over the period 2001 2005,

the Tenom Pangi station has experienced a total of 115 shutdowns, ranging from10 in 2003 up to 40 shutdowns in 2005. Over this five-year period, a total of19,686 MWh were lost as a result of these shutdowns.

The thermal replacement value has been estimated at RM400 per MWh by themanagers of the Tenom Pangi hydro station. According to these estimates, thetotal replacement costwould have reached approximately RM1.6 million on anannual basis.

Coastal degradation. Coastal wetlands and mangroves provide a largenumber of ecological services including storm protection services. The

degradation of these coastal resources may significantly impede theircapacity to deliver these important services. In the event of suchdegradation, additional or alternative investments (such as buildingretaining walls) may have to be undertaken in order to provide stormprotection services. The costs of building retaining walls may thus serveas an estimate of the storm protection services provided by coastalwetlands and mangroves.

It is of importance to note that the replacement cost methodology does not trulyprovide an assessment of the economic value of purified water, or electricity, orstorm protection services. It simply provides an assessment of the economic cost(or benefit) of producing the same services (which may or may not be desired)with alternative means of production. To the extent that the services is desiredand that the least-cost alternative means of producing this service is examined,this cost may provide a minimum economic value of these services (since societywould be willing to invest at least this amount to continue providing the service).

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6.2.2 How to use this methodology

The replacement cost methodology is relatively simple to implement from both atechnical point of view, and economic point of view.

There are essentially three steps involved.

Step 1:The fist step is of a technical or scientific nature and consists in undertaking anecological assessment of the nature and extent of the services provided by t

f the environmental impacts for eia projects

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