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Environmental Economics Research Paper No.4
This report was prepared by consultants
Francis Grey Consulting Economist At Large and Associates for the Department of the Environment, Sport and Territories.
© Commonwealth of Australia, 1996
ISBN 0 642 24863 X
The objectives of this report are to:
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Forestry debates present society with several choices that need evaluation. The task is to estimate the value in each of the choices presented. The purpose of this paper is to establish a framework that will allow each environmental policy option to be systematically and comprehensively assessed for its impact on the total economic welfare of the community.
Such a framework consists of ensuring that the non financial values, financial values and alternative financial values derived from the forest are accurately evaluated, and hence given their full and due consideration.
There are presently significant barriers to the achievement of this objective. The three barriers identified in this report are:
Removal of these impediments, which is an exercise in microeconomic reform, will bring improvements in the financial efficiency of the Australian economy, whilst improving the overall quality of life for Australians in general. The first two impediments can be removed by the utilisation of some fairly common methods. With specific reference to the third impediment, however, there are many approaches by which appraisal of non financial values can occur.
Some of these are specific methodologies such as contingent valuation and public ranking of options. Other methods centre around public involvement in the assessment of options. Yet other methods are based on using 'rules of thumb' to account for non financial values. Among the reports surveyed, some techniques are mentioned quite frequently. These included public participation as a key necessity for getting non financial values properly assessed. Surveying of public opinion, systematic reviews of natural features and the use of experts also seemed to be relatively common.
The task therefore becomes one of finding an appropriate route through the range of techniques offered.
Section 3 of this report briefly outlines the relationship between the concepts of externalities, economic value and community well being. The absolute requirement of good economic analysis is the need to accurately appraise all values, including externalities (non financial values) in any assessment framework. Economics provides the theoretical standard by which the existing assessment frameworks can be judged.
Section 4 reviews several major forest reports in order to identify four significant components of forest project appraisal. These include the values of the forest, the valuation methodologies proposed for assessing values, the pricing/ financial valuation of forestry and alternative activities, and the assessment framework for appraising policy options in the search for the socially best outcome.
In particular, Section 4 examines the role of pricing in the appraisal of forest policy options. The existing assessment processes and the various forest reports (apparently on the grounds of practicality) adopt a 'compartmentalised' approach to pricing. In other words, protection of non financial values is carried out prior to, and separate from, the pricing of forest timber. If the appraisal process is incomplete, then the pricing of timber is inadequate by definition. Pricing policy is significant for estimating value to the extent that it partly determines the financial value of forest timber.
Section 5 then describes weaknesses in the existing appraisal processes. These flaws range from a broad neglect of non financial values in project assessment to more specific issues. These include the failure to comprehensively identify and value non financial values, often even in the form of physical impacts; failure to identify or consider alternative financial values and alternative project options; and the failure to provide accurate statements about the financial viability of projects.
This report makes clear that there is indeed evidence of serious weaknesses in the determination of the financial values of native forest timber. Our analysis indicates the very strong likelihood that native forest timber harvesting, as a commercial activity, is being subsidised (eg. low cost public sector loans, no commercial charges for land), is inefficient (eg.. there are better returns to be had from harvesting water in at least one case) and poorly managed (eg. the agencies are unable to provide appropriate accounting information on their commercial activities). Consequently, a significant microeconomic reform process needs to be undertaken, if the correct financial values for native timber sales are to be determined.
Inappropriate appraisal of financial values may also be suppressing economic growth in the private forestry and agroforestry sectors (and other alternative/substitute financial values). The lack of a 'level playing field', with respect to the cost of business inputs (eg. land and capital) between the public and private forest managers, suppresses investment in private forestry at a lower level than that which could normally be expected.
If financial values and alternative financial values of the forest were to be appropriately appraised, this may identify alternative revenue streams and investment opportunities for hard pressed forestry commissions.
Summarised, inaccurate financial values and a limited knowledge of alternative financial values combine to undermine the basis of comparison between the financial and non financial values of the forest. This problem is compounded by the lack of a methodology for determining the relative worth of non financial values.
In conclusion, it must be reiterated that any assessment of the social benefits and costs in forest policy must include three pieces of vital data: an accurate appraisal of financial values, alternative financial values and non financial values. Without reference to such data, environmental decisions become less an attribute of good management, than of reliance on sheer blind luck.
Resolving these problems will contribute to better environmental management, greater financial performance and more jobs. This makes reform in this area a key part of the process of microeconomic change, resulting in better environmental and economic policy.
|ACF||Australian Conservation Foundation.|
|AFC||Australian Forestry Council.|
|AG||Auditor General of the State of Victoria.|
|AHC||Australian Heritage Commission.|
|AMC||Australian Manufacturing Council|
|BIE||Bureau of Industry Economics.|
|BNA||Bureau of National Affairs ,Washington USA.|
|CALM||Department of Conservation and Land Management, Western Australia.|
|CFL||Department for Conservation Forests and Lands.|
|CPS||Centre for Policy Studies.|
|CSIRO||Commonwealth Scientific and Industrial Research Organisation.|
|CWA||Commonwealth of Australia.|
|DAHE||Department of Arts, Heritage and Environment.|
|DASETT||Dept. Art ,Sport, Environment, Tourism and Territories. (Now known as DEST)|
|DEST||Department of Environment, Sports and Territories|
|DHAE||Department of Home Affairs and Environment.|
|DMAEIS||Dorrigo Management Area Environmental Impact Statement.|
|EPAC||Economic Planning and Advisory Council.|
|ESD||Ecologically Sustainable Development.|
|ESRC||Economic and Social Research Council.|
|FCNSW||Forestry Commission New South Wales.|
|GBRMPA||Great Barrier Reef Marine Park Authority.|
|IUCN||The World Conservation Union/International Union for the Conservation of Nature.|
|JSC||Joint Scientific Committee.|
|LCC||Land Conservation Council.|
|NEPP||National Environment Policy Plan.|
|NFPS||National Forest Policy Statement.|
|NPAC||National Plantations Advisory Committee.|
|OECD||Organisation for Economic Co-operation and Development.|
|PAC||Public Accounts Committee, Parliament of New South Wales.|
|RAC||Resource Assessment Commission|
|UNCED||United Nations Conference on Environment and Development.|
|UNEP||United Nations Environment Programme.|
|WWF||World Wide Fund for Nature.|
|WCED||World Commission on Environment and Development|
It is stating the obvious to note that the native forest estate is increasingly the centre of considerable public controversy. The debate over forests is a microcosm of the broader debate surrounding environmental issues because it continually confronts society with complex choices.
Each choice offers a variety of paths to the future, and in turn, each path provides net 'value' to society. Net 'Value' is comprised of a mix of quantities and types of 'values' which individually and collectively meet the needs of society. Differing 'paths to the future' confront society with the need to estimate the net value likely to be derived from each route. In economic analysis, and (it is assumed) society at large, the path which offers the most value to present and future citizens is the preferred choice.
Many complex social choices are decided in the realm of politics with some choices arbitrated on a more technical, arms length basis by designated officials. Choices in environmental policy historically combine technical, 'objective', elements and qualitative, 'subjective', elements. As a result, the choices are subject to a range of pressures that may not beset other types of decisions. In this context, it follows that estimating the value, or total 'economic welfare', of different paths within environmental policy may be more difficult than the simpler financial trade offs common to economic decision making.
'Optimising the benefits to the community' has been identified as a key objective in forest policy. In order to achieve this goal, it is necessary to identify the contribution that different policy options can make to the welfare of the community. In other words, we must determine which path to the future offers the greatest 'net value', and which combination of values acts to create that path.
This discussion examines the relationship between financial values derived from timber harvesting, the financial values derived from alternative uses of the forest (eg. water, tourism etc), the financial values derived from plantation timber and the non financial values of the forest (eg. environmental amenity) through the reviewing of a series of reports on native forests.
The Ecologically Sustainable Development Working Group on Forest Use specified three main requirements for sustainable forest use:
maintaining the ecological processes with in forests (the formation of soil, energy flows, and the carbon, nutrient and water cycles);
maintaining the biological diversity of forests;
and optimising the benefits to the community from all uses of forests within ecological constraints. The National Forest Policy Statement adopts these principles as the basis for ecologically sustainable development. (National Forest Policy Statement (NFPS), 1992:47) (Emphasis added.)
Economic theory sets a standard by which the outcomes are measured, and informs us as to what are 'good' and 'bad' ways of making choices. Economic theory also provides an important underlying philosophy which specifies that changes should be to the net benefit of society at large.
Economic theory is often seen as a method, or science, of analysing impacts on the financial e c o n o m y. When properly and rigorously deployed, however, it is elevated to the 'art ' of choice. Thorough economic analysis concerns itself with how to make choices that provide the greatest net benefit to the community, where 'benefit' implies consideration of all social values. It is for this reason that economic theory, incorporating such concepts as externalities and public goods, has come to play a significant role in decision making processes. The following sections briefly outline the relationship between the concepts of externalities, economic value and economic decision making.
Economics is centred on the allocation of scarce resources to competing ends, in order to achieve the most value for human society. In this instance, economic analysis seeks to identify the flows of value that can be derived from 'uses' and 'non uses' of the forest. This process of analysis seeks the combination of uses and non uses that most meets the value preferences of society, both now and in the future. The process is intended to be value neutral in the sense that it is based on the given or expected values of society - whatever those values may be.
Traditionally, economic theory uses the 'market' as its benchmark of efficient resource allocation; that is, an allocation of resources that creates the greatest benefit for society. This 'pure' model, however, admits that its results hold true only under very tight and specific conditions. If any of these conditions are breached, then there can be no presumption that the free market outcome is the best one.
Externalities arise when certain conditions of a free market do not hold. They arise when the free market fails to include, or take account of goods and services provided incidentally by the completion of another transaction. An externality can be compared to an auction where the main transaction is completed between two parties, but where additional goods and services, not provided for in the original transaction, are subsequently delivered. These can be delivered either to the main parties or to third parties who were not involved in the original deal, and who, indeed, may even be unaware of the original transaction. For example, if a tree is cut down in the forest for timber, the loss of that tree may adversely affect the view of a home owner, who subsequently experiences a loss in his/her property value.
Externalities and public goods are both expressions of market failure. 'Public goods' refers to a value from whose benefit others cannot be excluded. Thus, deriving pleasure from knowing of the existence of a forest is an externality, because others cannot be excluded from deriving the same pleasure. At the same time, the phenomenon is also a public good because it is non rival in consumption; that is, many can consume the item without reducing the consumption of others. In order to avoid confusion, all such values are called 'non financial values' since they cannot, by definition, be traded in a market place, and hence be expressed in terms of financial value. Where environmental issues are concerned, the market cannot be relied upon to produce an optimal allocation of resources - ie. the greatest overall benefit to the community - because there is no venue, no 'global auction room', in which the community (in particular future generations) can express its preferences over the items it values.
The 'items of value' in this discussion are the 'values' or 'benefits' that flow from the 'use' of 'objects'. Normally, economic analysis talks of objects such as goods and services when the real interest is in the values that flow from these objects. It makes little sense to talk, for instance, of a 'forest' per se. Are we referring to the wood alone, the biological species that reside there, the pleasure that bushwalkers derive, or its function in absorbing greenhouse gases? The term clearly has no operational meaning unless we refer explicitly to its various use values and benefits. In order to avoid any ambiguity, the remainder of this paper will generally use the term 'values' rather than 'goods' or 'products' (as 'values' is a more inclusive term).
An understanding of externalities is central to quality economic decision making, particularly in the context of the environment - simply because in the real world, there are many items of value (fresh air, knowing that an old growth forest exists, etc) that cannot be bought and sold in the market. The exclusion of these items from the 'economic equation' means that the overall equation is miscalculated. Miscalculations of the total economic equation generally lead to a misallocation of economic resources, and to an overall loss to society.
The practical significance of identifying externalities and public commodities relates to their impact on markets. It is impossible for a market alone to systematically produce the socially optimal outcome when externalities and public commodities are present, as they are in the case of the natural environment 1 .
In economic theory, the price of an item can represent one of three circumstances for the owner.
The price of wood must also reflect the different type of values generated by the wood and the portion of forest which is altered by its extraction.
Hence, if the 'public citizen' 2 offers a logging coupe for sale, by definition the value anticipated from the sale must at least exceed the value expected from any alternative use. And additionally, the price needs to equal:
This pricing method ensures that timber with values exceeding the market price will not be sold. However, the significance of NFV's is that they make up a considerable proportion of the value of timber. When NFV's are destroyed, the loss of value is not felt by one person alone, but is likely to be felt by every Australian citizen, every international citizen and everyone yet to be born. When logging occurs, each of these people experiences a change in the value they derive from the forest, and hence each should be compensated. The price of timber needs to be able to compensate all losers if policy is to be socially optimal. The pricing of timber is crucial to determining the pattern of logging in the forest. In order to implement a solution, the present approach of forestry commissions uses regulation to separate logging areas from non logging areas. This approach could be assuming one of two things. Firstly, it could be assuming that royalties are sufficient compensation for the loss of NFV's 3 . In this case, it remains to be demonstrated by those who set royalty levels that they have evaluated the worth of the lost NFV's, and thus set royalty levels accordingly. In the absence of information about how NFV's are determined, it could be assumed that non financial values in the logged areas are considered insignificant to the extent that the Australian community will not require compensation for the losses in NFV's which result. In theory, logging will then occur, in the areas set aside, if the cost of production and capital makes it a financially rational exercise.
Pricing policy is, thus, conducted on a 'compartmentalised basis'. In other words the forest is surveyed for its values, and those areas where NFV's are deemed 'small enough' to avoid the need for compensation, are made available for logging. The remainder is put aside for conservation. Thus, if we use a 'compartmentalised' approach, timber is valued in a two stage process. The forest is allocated to different uses depending on the scale of NFV's in different areas. Forest that is to be subject to logging is then priced on a commercial basis. Pricing takes place on the assumption that the coupes have already been surveyed, and the NFV's have been found to be minor; ie very close to zero.
1. See Russell and Wilkinson, 1979 for the full theoretical discussion.
2. A person representing the public whose values reflect exactly those of society at large, and who seeks the greatest value for society from any decision.
In any public decision over the net benefits of forests, externalities and public commodities, along with project and alternative financial values, need to be taken into account, as part of the value provided by a 'resource'. In analysing different resource options, a total listing and weighting of values, both private and 'externalised', must be provided for each option.
When an economist is comparing alternative social arrangements, the proper procedure is to compare the total social product yielded by these different arrangements... In devising and choosing between social arrangements we should have regard to the total effect. This, above all, is the change in approach which I am advocating. (Coase, 1960: 34 & 44)
Coase refers to 'total social product' which we have renamed 'total economic value' in the tradition established by Pearce (1989). In order to compare the total economic value of differing policy options, it is necessary to aggregate for each option all the values (financial, aesthetic, spiritual, etc.) that would be produced for the community if a particular policy option were to be undertaken.
Traditional project evaluation normally compares one option against another option, and chooses that which has the most value. In the presence of market imperfections such as externalities, the total economic value (the project's total costs and benefits to society) can be severely miscalculated in at least two ways. First, proper economic evaluation needs to consider the financial impact that one project may have on other parties, not simply whether it is profitable when considered in isolation. Suppose, for example, that the government is requested to give its approval for the establishment of a factory on a river bank. Viewed in isolation, the proposal is attractive: it is expected to provide jobs for 100 local unemployed young people and will contribute an extra $5 million to tax revenues. Viewed from a wider perspective, however, the project's net financial value would be seen to be negative if the poisonous effluent it emits cause the bankruptcy of downstream fish farms and tourist resorts which together generate 200 jobs and $10 million in tax revenues. These 'down stream' financial values are often overlooked by traditional project evaluation methodologies.
The second weakness of the traditional evaluation approach is that it gives little consideration to non financial values. To continue with the illustrative example above, the factory's pollution may poison wildlife and household pets, ruin a picnic spot favoured by thousands of local residents, etc. These types of costs are real and relevant, notwithstanding the fact that they are of a 'non financial' nature.
Resolving the first problem is easier, since it may be possible to obtain the relevant financial data if appropriate economic modelling is conducted. The second problem is more difficult because non financial values are not traded in markets. In other words, there is no 'objective dollar price' which can provide a yardstick with which to compare non financial and financial values. Environmental economists have been working on providing techniques to evaluate non financial values.
As a society, and as individuals, we are constantly evaluating and rejecting options. A social cost benefit analysis is, in effect, the act of making choices. Social cost benefit analysis becomes a conceptual framework that expresses the less formal processes we use to make choices.
While the National Forest Policy Statement leaves open the practical question of assessment, it identifies the need for evaluation of policy options. In Diagram 1 we have listed all the values, in the tradition of Pearce (1989) and Young (1992) that appear to be provided by the native forest. Table 1 describes each type of value, and where relevant, their relationship to each other. Total economic value (TEV) analysis would require that each policy option would receive a 'score' in each cell of an evaluation matrix (see Table 5 for an example). Scores are aggregated by a means yet to be determined which then enables decisions over differing options to be made.
Economic decision making seeks to choose between the differing options on the basis of determining that which provides the greatest net social benefit. The means of deciding which option has the greatest net social benefit where 'scores' cannot be aggregated into a single numeraire is, of course, highly contentious.
There are three channels through which resources can be allocated. These are the markets, institutional processes and executive decision making. Markets, however, as decision making institutions, are largely unavailable in the circumstances covered in this report because we are dealing specifically with instances of market failure. However, modified markets (ie. markets subject to government intervention) are included as a means of policy implementation. The choice between government modified markets and 'pure' market measures should be justified on the grounds of net social benefits.
The irony is that if market measures are to be chosen as the decision making process, then it is a decision that will have to be made by government anyway, and hence does not relieve the public decision making process of the need to evaluate the optimality of value flows from the forests under differing policy options. In other words, choosing to 'do nothing' is as much a decision as choosing to 'do something'. The lesson is that if optimal social benefits are sought, then market failure automatically triggers government decision making processes - even if that results in a decision to 'do nothing'.
The creation of a formalised process for considering environmental values and other externalities requires a clear understanding of the integrated structure of externalities, economic value and economic decision making. All values - financial, ethical, ecological, etc - must be accounted for, if different policy options are to be compared on a equal basis. The different values (identified in Diagram 1 and defined in Table 1) that comprise each policy option, need to be integrated in some manner which enables socially optimal choices to be made.
© Commonwealth of Australia, 1996
ISBN 0 642 24863 X
This work is copyright. Apart from any use as permitted under the Copyright Act 1968, no part may be reproduced by any process without prior written permission from the Commonwealth Department of the Environment, Sport and Territories. Requests and inquiries concerning reproduction rights should be directed to the Commonwealth Department of the Environment, Sport and Territories.
Department of the Environment, Sport and Territories
GPO Box 787, Canberra ACT 2601.
Telephone: (06) 274 1111 Facsimile (06) 274 1123
This report was prepared by consultants Francis Grey Consulting Economist At Large and Associates for the Department of the Environment, Sport and Territories. Its conclusions are those of the authors and do not necessarily represent the views of the Department.
Original Design: Rochfort Art and Design, Canberra
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