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Chapter IV - Methods for environmental cost-benefit analysis for agricultural lending

A contingent valuation model of environmental cost-benefit analysis

The social, economic, and environmental con sequences of lending are seldom incorporated into lending decisions. To do so would require the use of techniques such as cost-benefit analysis or a somewhat less rigorous, more intuitive Environmental Impact Assessment (EA).

The issue of environmental cost benefit accounting is currently the subject of considerable study and debate. A number of different methodologies to incorporate environment factors into the economic costs and benefits of a project have been put forward. No single current methodology is universally accepted, nor is any single methodology applicable to all cases.

In some projects, especially those involving intensification of agricultural production, market based methods are useful, when market prices can be assigned to production and productivity changes arising from changes in environmental quality. Other market based methods include loss of earnings, where projects affect human health, and changes in productivity, where environ mental remediation affects production and productivity (i.e., soil conservation positively affecting income streams).

In other cases, surrogate market values may be useful in clarifying some of the environmental costs of a given project. One could, for example, use property values to price productive land in a flood-prone area and the equivalent land in an area not subject to floods as part of a cost benefit analysis of reforestation. Wage differential and surrogate goods analysis have also been applied with varying degrees of utility.

The benefits of protection or remediation cannot always be estimated easily. This is especially the case when the cost to the environment is over and above the environmental services performed by natural capital. In these cases, a replacement cost approach may be useful. If, for example, trees were felled as part of a project, one could estimate the potential economic loss to the environment as the cost of restoring these same trees.

Contingent valuation methods are useful in the absence of price information and of competitive markets. It is often very difficult, if not impossible, to determine the worth of an environmental service. As we have pointed out, these services are not valued in the market place. They are considered free goods due to the failure of the market. However, such intangibles do have "value" in the sense that people are able to assign a value to them if directly questioned as to how much compensation they would want for tolerating a situation brought on by environ mental degradation or how much they would pay for avoiding it. 13 In contingent valuations, the values are generally derived from a survey instrument which questions people in an area affected by environmental degradation on how much compensation they would want for tolerating these problems or what they would be willing to pay to avoid them. While this methodology is highly subjective, there is some preliminary evidence that intersubjective agreement can be obtained at a moderately high level. 14

13 A word of caution is in order. People when asked how much they would pay for the preservation of a natural resource, often give a different answer than when asked how much they would consider fair compensation for the loss of a natural resource. Individual wealth is finite, individual desire for compensation is not. See Michael Hanemann, "willingness to Pay and Willingness to Accept: How Much Can They Differ?", American Economic Review, June 1991.

14 D. Pearce and A. Markandya, Economic Policy Benefits: Monetary Valuation, OECD, Paris, 1989

In many cases, the value is a "non-use" value arising from the preservation instead of the exploitation of the resource. For example, the Australian Resource Assessment Commission applied contingent valuation to determine that the non-use valuation exceeded the value of minerals to be extracted from the Kakadu National Park.

For resources intended to be left unused, but subsequently "used" through pollution, contingent valuation can often be used to assign values post hoc to the damage done by the party which has illicitly consumed part of society's natural capital. Civil, and perhaps criminal, penalties will be determined in part in the upcoming legal trial of the Exxon Corporation for the Prince William Sound oil spill. 15

15 However different contingent valuation models in this case have derived different non-use values depending upon whether Alaskans were asked how much they would pay for the nonuse of the sound or whether they were asked how much compensation they desired for its pollution.

Currently, there is no universally accepted methodology for environmental cost benefit analysis; indeed, not all methodologies are equally useful in all cases. Nevertheless, there is general agreement on the necessary content for such an analysis. These analyses must be multifaceted and multidisciplinary in their approach to the problem of environmental degradation. They should focus upon the effects of the project on the broader environment and the cost of the damage of destroying a resource to the broader society.

A contingent valuation model of environmental cost-benefit analysis

The contingent valuation method can be used to illustrate how banks can apply environmental cost-benefit analysis to their loan decision process. The failure to cost environmental benefits and goods means that current development strategies tend to be narrowly focused on maximizing short-term gains with very little regard being given to proper resource management. It is essential that financial institutions not only weigh up the immediate tangible economic returns derived from projects, but also make a fuller assessment of the longer-term ecological impact. Cost-benefit analysis (CBA) overcomes market shortfalls by attributing monetary values to naturally occurring goods which are directly related to the use value society bestows upon them. The relevant criteria when looking at a decision-making process become the cost of a project, the benefits of a project, and the total economic value that is lost by the development. On a very simplistic level, the following rulings can be applied:

1) Banks proceed with investment if

(Bd - Cd - Bp) > 0

2) Banks do not proceed with investment if

(Bd - Cd - Bp) < 0


Bd refers to the benefits of the development

Cd refers to the costs of the development

Bp refers to the benefits of preserving the environment by not developing the area or by not intensifying agricultural production.

This form of accounting can quite simply be taken a stage further by taking into consideration the factor of time, so that project appraisals can be carried out with regard to future, as well as present scenarios.

Bt - Ct - Et (1 + r) - t > 0 or < 0


Bt is the benefit in time t
Ct is the cost in time t
Et is the environmental damage done by the project (if there is an environmental improvement, the -E is replaced by +E)
r is the discount rate 16

16 D. Pierce, et al. Blueprint for a Green Economy. Earthscan Publications Limited, London, 1989.

This simplified model is more heuristic than operational. It is presented here as a means to permit the reader to think in a systematic manner about the environmental costs and benefits of loan decisions in the context or "real world" banking and its daily pressures. In Chapter Five, we will offer a more complete discussion of the issues of CBA and EA.

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