Environmental Valuation as part of Project Appraisal by the World Bank

Table of Contents

List of Illustrations
Tables
Figure

Abstract

Acknowledgements

Declaration

Abbreviations

Chapter One Introduction

Chapter Two Literature Review and Methodological Framework
Chapter Two One - Project Appraisal
Chapter Two Two - Cost­Benefit Analysis
Chapter Two Three - Valuation of Environmental Goods and Services

Chapter Three Valuation of Environmental Goods and Services by the World Bank
Chapter Three One - Relevant World Bank Guidelines
Chapter Three Two - Case Study: Croatia Coastal Reconstruction & Protection Project

Chapter Four Analysis of the Environmental Valuation at the World Bank
Chapter Four One - Analysis of the Case Study
Chapter Four Two - What the Case Study tells about the World Bank

Chapter Five Conclusion

References

List of Illustrations

Tables

Table 1: Total Economic Value Classification (Tietenberg and Lewis 2008, p. 37)

Table 2: Total Economic Value Classification (Edwards­Jones et al. 2000, p. 86)

Table 3: Total Economic Value Classification at the World Bank (Pagiola et al. 2004, p. 17)

Table 4: Characteristics of Stated Preference Nonmarket Valuation Methods (Brown 2003, p 101)

Table 5: Revealed Preference Valuation Methods (Boyle 2003a, p. 261)

Table 6: Relevant Operational Policies in Environmental Context (Adjusted from the World Bank 2009, p. 61­117)

Table 7: World Bank Staff Appraisal Report (Adjusted from the World Bank 2009, p. 321)

Table 8: Coastal Forest Benefits in Croatia (Adjusted from the World Bank 1996b, p. 1­4)

Table 9: Expected Benefits at the proposed reforestation sites (adjusted from the World Bank 1996b, p. 9­10)

Table 10: Visible landscape benefits of reforestation (US$/ha) (World Bank 1996b, p. 10)

Table 11: Sensitivity Analysis of ERR because of lower WTP, and tourism recovery (World Bank 1996b, p. 17)

Table 12: Total Economic Valuation for the Croatian Case Study

Figure

Figure 1: Expected and observed tourism recovery in Croatia from 1995 to 2001

Abstract

In face of scarce resources and growing population, sustainability became the term used to consider the needs of future generations in the decision making process referring projects. The World Bank, as one of the major players in the field of development research and practice, aggregates information from different areas in the project appraisal document (PAD) in order to allow for sustainability. One of the approaches used to measure environmental impacts of a project is economic valuation of environmental goods and services. The results of this approach flow into the cost­ benefit analysis, which is part of the economic analysis. Although substantial critique has been expressed over the last decades, environmental valuation and cost­benefit analysis are considered sensible tools in the context of decision making over project funding. This is especially the case because of tremendous development of these techniques over the last decades.

This study shows that the World Bank, as one of the leading institutions in the world, treats this topic from two different perspectives. First, there is the theoretical side. Here the World Bank sets out ideal procedures, under their rules and guidelines, and publishes papers and reports with respect to further development of underlying methods. The aim here is to allow for measurement of total social welfare, or in other words measurement of the complete picture of environmental costs and benefits associated with a project. Second there is the practical side, were the World Bank adjusts environmental valuation techniques in order to understand the most important costs and benefits associated with a project, where measurement of the total social welfare of a project is not the target. In this case the aim is to collect sufficient information to allow making a funding decision, rather than understanding the complete picture. This impression is caused by findings from the case study which showed that during project appraisal obvious environmental benefits have not been measured.

Key words: Contingent valuation method, cost benefit analysis, environmental valuation, project appraisal, sustainability, World Bank.

Acknowledgements

I would like to thank Dr. Admos Chimhowu for his patient thoughts and supervision during creation of this dissertation. My thanks as well go to Prof. Dan Rigby, who first sparked my interest in the topic of environmental economics. It needed both of these inspiring people to make this dissertation possible.

Furthermore I am particularly grateful for my friends who have managed to keep contact over a long period of time and distance, which has always been irreplaceable to me. And most importantly, thank you to my family. To my mum Helene, my brother David, his wife Taraneh, and their son Elias, and to my brothers Johannes, and Wolfgang, who have all constantly shown to me how much they care. I hope I make you proud.

Declaration

I hereby declare that no portion of the work referred to in this dissertation has been submitted in support of an application for another degree or qualification of this or any other university or other institute of learning.

Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Abbreviations for economic formulae

Abbildung in dieser Leseprobe nicht enthalten

Chapter One Introduction

Ever since its emergence, mankind has been dependent on natural resources. This dependency remains the case during times of increased pressure on natural resources because of a growing population¹. Most people agree that the current residents of the planet have a responsibility towards future generations. This responsibility is to provide them with the chance for a high quality of life. This is often referred to as ‘sustainability’. Discussion about sustainability has created two main groups of followers, the neoclassical and the ecological. The neoclassicalists regard natural capital and created capital as substitutes in production, those favouring the ecological view point consider them as fundamental complements, i.e. they are used together in production and have low substitutability (Goodstein 2008, p. 90).

Thomas Malthus was among the first to express concerns about the possibility of resource shortages on a global scale and is therefore regarded as the founder of ecological economy. His followers are for that reason often referred to as neo­ malthusians (Goodstein 2008, p. 120). As early as 1798, Malthus famously wondered in his ‘Essay on the Principles of Population’, about the future of mankind if the population keeps growing at a geometrical ratio, when subsistence for man only grows at an arithmetical ratio (Rodgers et al. 2008, p. 20). What seems so obvious nowadays was a revolutionary discovery at that time.

Malthus’ statement was followed by a long lasting discussion, centring on the question of the limits in resources and its consequences. In 1972 a group of individuals from different backgrounds, called The Club of Rome published a report entitled ‘The Limits of Growth’, reviving this discussion. Malthus has been proved incorrect in several ways (Rao 2000, p. 5), and The Club of Rome found itself critiqued for several conclusions (Krupp 1987, p.49); however the finiteness of the earth’s natural resources themselves rightly remained unquestioned. In 1992, 20 years after publication of ‘The Limits of Growth’, The Club of Rome published a report called ‘Beyond the Limit’, where it was argued, that despite some action undertaken, “humanity had essentially transgressed the limits of growth and was even then beyond the zone of sustainability” (Danilov­Danil’yan et al. 2009, p. 85).

Through fast moving technological development in so many fields the dependency on natural resources has changed, but it has not ceased to exist. According to the Malthusian approach this dependency can not possibly be solved by technological advancement (referred to as technological pessimism). In view of this, what is yet unknown, is the “potential for human development for the growing population” (Rodgers et al. 2008, p. 21) in face of the resource finiteness, as “the relationship between resources and human welfare remains somewhat of a puzzle” (Tilton and Skinner 1987, p. 13).

Sustainable development is the term chosen to bridge between development and the environment (Rodgers et al. 2008, p. 22). In this context the famous Brundtland Report, ‘Our Common Future’, defined sustainability as development that “meets the needs of the present without compromising the ability of future generations to meet their own needs” (UN 1987, p. 24). Critics formulated numerous relevant arguments in response to this definition of sustainability, of which three critiques will be briefly discussed below. Firstly, it is often argued that the definition of sustainability is imprecise about what exactly is meant by the needs of future generations, as these needs may be very diverse. This has not yet been resolved although some authors have provided an interpretation. For example, van Pelt has a generic explanation, describing needs as something that “may be interpreted in terms of social welfare levels” (van Pelt 1993a, p. 2), and continues to explain, that often it is assumed that the preferences of future generations are similar to ours (van Pelt 1993a, p. 29). Secondly, how sustainability should be practically implemented (Danilov­Danil’yan et al. 2009, p.165; van Pelt 1993a, p. 3), and thirdly that the approach is entirely human­centred (George 2000, p. 67).

Although this and many other criticisms have been applied to sustainable development, the underlying idea is widely accepted. For example, great thinkers like Nobel laureate Stiglitz stressed the importance of sustainability for development and warned of resource depletion and environmental degradation (see for example Stiglitz in López and Toman 2006, p. xv). The interdependence of economic progress, social development, and environmental sustainability consequently led to compilation of the Millennium Development Goals (MDGs) in 2002 by the United Nations, and further reports such as the ‘Stern Review: The Economics of Climate Change’, which was published in 2007. The MDGs as well as these very influential reports aimed at achieving sustainable development, to allow a bright future for coming generations.

One of the most powerful tools in order to attain sustainable development is by employing environmental valuation, which has a potential value that has already been identified by Jacobs and Stadler in 1989 (George 2000, p. 65), shortly after publication of the Brundtland Report. Environmental valuation has been around for several decades and has evolved dramatically since the early 1970s. Economists now claim to have a sufficiently wide range of methods to provide monetary valuations of environmental goods and services which can be used in the decision making process (Common 2000, p. 53). This is what is effectively done nowadays. Environmental valuation as part of project appraisal serves as a key decision making tool to decide which project qualifies for funding.

The World Bank shares the belief that the methodologies available for environmental valuation have evolved sufficiently to be used in project appraisal. In this study, an analysis will take place that will focus on, how the World Bank uses environmental valuation in the decision making process of which project should receive funds. This is of interest and relevance as the World Bank is considered to be one of the globally leading actors in the field of development, as well as a funding and a research institution. The key focus therefore will be given to the following questions: (1) how does the World Bank do environmental valuation? (2) What are the main shortcomings? And (3) how is the result of the environmental valuation reflected in the project appraisal?

In Chapter Two, a literature review will start with discussing the aims and origins of the project appraisal methodology. This will be followed by a critical view at cost­benefit analysis, which is the method used for gathering data of environmental valuation. After this, the concept of environmental valuation and available methods will be examined. Chapter Three will contain a presentation of the case study. In Chapter Four an analysis of the case study will take place and findings will be aggregated. In Chapter Five final conclusions will be drawn.

Chapter Two Literature Review and Conceptual Framework

The current chapter covers the framework for this study. Starting off from the project appraisal level, the Cost­Benefit Analysis will follow and lead to valuation of environmental services as the operational level. This takes place in order to explain and discuss the underlying approaches from a theoretical perspective, and how they developed over time.

Chapter Two One - Project Appraisal

A project can serve several purposes and accordingly has to be analysed from different points of view, also dependent on the aim of the project. Although some authors argue that a satisfactory definition of a project does not exist (e.g. van Pelt 1993a, p. 41), a wide range of definitions can be found in the literature. For the purpose of this study a project can either be generically defined as “a temporary endeavour undertaken to create a unique product or service” (PMI in Maylor 2005, p. 4), or in accordance with Baum and Tolbert, it can be understood as “a discrete package of investments, policy measures, and institutional and other actions designed to achieve a specific development objective (or set of objectives) within a designated period” (Baum and Tolbert 1985, p. 8 in van Pelt 1993a, p. 41).

Before a project can effectively start, a project appraisal (usually) takes place in order to identify the best alternative for funding (Brzozkowska 2007, p. 78). Identification of this best alternative is required as financial restrictions prevent realisation of all projects where benefits exceed costs. For that reason, those in charge for project selection have to make sure that the chosen project provides the maximum social welfare (UN 2003, p. 1).

The project appraisal methodology consists of a range of methods put together with the aim of providing the decision maker with increasingly detailed information on the overall impact of a project (i.e. social, economic, and environmental) (Edwards­Jones et al. 2000, p. 136). With evolvement of methods available, the understanding of what is meant by project appraisal expanded dramatically, since its very beginning more than 80 years ago. The basic methodology of project appraisal was developed in the 1930s in the United States, along with the first steps of estimating costs and benefits of a project (Curry and Weiss 1993, p. 1). Since the late 1960s, early 1970s Cost­Benefit Analysis (CBA) was regarded as the standard project appraisal method for public­sector investment choice (Kirkpatrick and Weiss 1996, p. 3; Pearce et al. 2006, p. 16, Brzozkowska 2007, p. 80).

In 1974 Little and Mirrlees published a paper which made them pioneers in the field of project appraisal in the development environment (Little and Mirrlees 1974). Since that time major global developing agencies like the UN and the World Bank picked up the project appraisal methodology and increasingly used it as a standard. However, at that point of time, the project appraisal approach still needed further evolvement in order to provide sufficient flexibility. During the 1970s some work was done to introduce for instance shadow pricing, nevertheless this theoretical development slowed down until end of the 1980s (Kirkpatrick and Weiss 1996, p. 3). After publication of the Brundtland Report in 1987, until the early 1990s, the idea of sustainability became an essential part of project appraisal. However it has predominantly been emphasized at a global or national level, with less attention given to regional or project level (van Pelt 1993a, p. 3).

The project appraisal approach in general, CBA in special has been repeatedly critiqued from perspectives outside economics; in particular the social and environmental limitations have been discussed in much detail (e.g. Sagoff 2004; Hanely 1992; Brzozowska 2007). In spite of all well argued and intelligent critique, most authors conclude that it is however a valuable approach to assess the impact of a project as will be shown in the following.

Chapter Two Two - Cost­Benefit Analysis

One input factor in nowadays project appraisal is the CBA approach. It serves as a standardized approach to evaluate costs and benefits of impacts of a project. In combination with the economic approach of environmental valuation, CBA is the tool which allows measuring costs and benefits of a project’s environmental impact.

Cost­benefit analysis is the term used to describe a method which aims to select projects based on their efficient use of resources. Over the last decades CBA has moved into the focus increasingly as a vehicle for appraisal of public projects (Brzozkowska 2007, p. 78), and has especially started to being used to valuate environmental impacts of projects (Edwards­Jones et al. 2000; van Pelt 1993a and 1993b; Common 2000; Kirkpatrick and Weiss 1996). However, results from CBA themselves are not the only source of information, but CBA summary results feed into the overall project appraisal (UN 2003, p. 14)

The idea of CBA is simple. If all costs and benefits associated with a project can be monetised ­ whereby realisation of financial returns is not a criterion, the impact of a project can be expressed as a rate of return, or more usually, as a benefit­cost ratio (BCR) (Vickerman 2007, p. 599). The theoretical foundations of this approach date back to the Italian economist Vilfredo Pareto in the late 19th century who developed the microeconomic basis of welfare economics (Edwards­Jones et al. 2000, p. 18). Welfare economics as it is known today can be traced back mainly to Hicks and Kaldor. Their work around the 1940s led to the so­called Hicks­Kaldor “compensation principle”, which added the idea of “hypothetical compensation as a practical rule” for project decision making (Pearce et al. 2006, p. 32). Later, Harberger declared this principle one of the three basic postulates of applied welfare economics (Harberger 1971). Boardway additionally explained in 1974 that aggregate money gains and losses measure the efficiency gains of a project (Boardway 1974, p. 926); meaning that if the aggregate is positive (i.e. benefits exceed costs), the gainers could compensate the losers, if it is negative, the project failed the compensation test and should not be undertaken. However, actual compensation itself is not required. CBA allows identification of potential Pareto improvements² by adding up all costs and benefits of a project. It therefore allows measuring the difference between gains and losses, which serves as a basis in the decision making process.

Since its first appearance, CBA has caused lively discussions among experts. In order to outline some of this discussion, it might be useful to form two, partially overlapping, groups, i.e. (1) the group of critics of the theoretical framework, and (2) the group of critics of the approaches practical applicability.

Those belonging to the first group criticised the theoretical framework of the CBA concept. Samuelson (1942) argued that consumer surplus³ has no practical validity as one can not assume that the marginal utility of income is constant (Pearce et al. 2006, p. 32). This describes the problem that measurement of benefits and costs from individuals has to take place at a certain time, in this case before the project. The information gathered will then be held constant and serves as one input factor in the decision making process. However, preference changes with income and accordingly it is possible for willingness­to­pay (WTP) and willingness­to­accept (WTA) to change with it. So the assumption of constant marginal utility of income, which serves as a basis, is not necessarily the case.

According to Pearce et al. another fundamental critique comes from Little who provided “all­round attacks on welfare economics” (Pearce et al. 2006, p. 32), which serves as the microeconomic basis of CBA. This interpretation seems correct on a high level, but especially for CBA Little leaves the door open when he concludes, that “as a rough guide, to what ought to be done, [welfare economics] is undoubtedly useful” (Little 1950, p. 272).

One further critique refers to the aggregation of preferences. The underlying theory of CBA states that individual preferences can be added up and ranked, and the aggregate of all individual preferences will serve as a basis for decision making, which finally is equivalent to the social choice. Arrow criticised this and developed his standpoint in 1951 and defended it in 1963 when he argued that individual preferences themselves can not be satisfactorily aggregated. For two reasons, he argues, i.e. (1) because of the problem of the ordinal scale of options, i.e. that the distance or degree of how much one option is preferred over another is unclear. And (2) that all options available are potentially valued differently per individual, which is referred to as impossibility of interpersonal comparison of utility and goes back to Bergson in the late 1930s (Arrow 1963, p. 109­113). Pearce et al. conclude Arrows argument and state that, if “cardinal utility and interpersonal comparison both apply, then CBA would appear to be valid since preferences can be aggregated” (Pearce et al. 2006, p. 33).

The second group consists of those dealing with the applicability of CBA. Just recently Brzozkowska remarked about the discussion around CBA, that it does not make the decision, but only serves as a basis for decision making (Brzozkowska 2007, p. 79). Apart from this all too obvious comment about a decision making tool, literature provides more, and more valuable critics about the practical issues of CBA.

CBA has been criticised for several practical issues. Three of which will be outlined in the following. However, this list does neither claim to be a complete selection of critics, nor does it represent an independent set of issues, quite the contrary, they are highly interdependent. These three issues are (1) discounting, (2) uncertainty, and (3) inequality.

The discount rate controversy is caused by the long­term character of benefits and costs, which is typical especially for environmental impacts of a project (van Pelt 1993b, p. 29). This means that the present value (PV) of costs and benefits in the distant future - which will finally be aggregated and flow into the final appraisal, is highly dependent on selection of the discount rate. Although enormous work has been done dealing with calculation of the correct discount rate, Heal clarifies that “The discount rate is nothing we measure, it is something we choose” (Heal 1981 in Hanley 1992, p. 49). This is supported also by Vickerman who talks about choosing and not measuring a discount rate (Vickerman 2007, p. 609). Hanley echoes this and concludes that “[t]he choice of discount rate, especially in public sector projects impacting on the environment, has become a political issue” (Hanley 1992, p. 39), i.e. it is qualified to implicitly reduce the objectivity of CBA as a decision making tool. Yohe goes one step further, when on a meta­level, he questions discounting as a whole, and with it pure time preference with respect to environmental resources (Yohe 2003, p. 235).

[...]

¹ The latest statistics from the United Nations (UN) estimate the current global population to having reached thenumber of 6.8 billions people already, with future population estimations for the year 2050 ranging between around8 to about 10 billions people (UN 2009, p. 1), this 20%gapcan be explained by the possible statistical range of fertility development.

² Pareto improvements are defined as ways in which some people could gain and nobody would lose (Edwards­Jones et al. 2000, p. 18).

³ Consumer surplus is the difference between what a consumer is willing to pay (e.g. for an environmental good) and actually has to pay (Edwards­Jones et al. 2000, p. 41).