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Ecosystem Goods and Services Series: Valuation 101

(A collaborative series by Hassan Masum, David Zaks, and Chad Monfreda.)

How much is a pristine lake worth?  A clean atmosphere?  An oil field?

Answering these questions takes us from the heart of economic philosophy to the frontiers of analytical science.  It turns out to be very difficult to give objective monetary values, even in principle.  But as our analytical capabilities and understanding of ecosystem services increases, we're developing useful valuation methods that will form the basis for future policy and financial activities.

Our last post explained the biophysical basis of ecosystem services.  In this post, our goal is to explain how people come up with those intriguing currency figures for ecosystem values, and look at a couple of examples.  This is the "macro-economics of ecosystem service valuation", which aims to help policy-makers, investors, and citizens to internalize the value of our shared natural heritage.

At the same time, currency-based measures of value have their limits.  Where monetary measures fall short, valuation can be done in a number of complementary ways.  It's only by understanding the strengths and weaknesses of each that we can make appropriate use of these tools, to put knowledge about the ways ecosystems work into practical, everyday use.

Valuation is not just an analytical exercise.  Since the point of valuation is to create an input for decision-making, one needs to examine both the way numbers are made and how effectively they help shape policy decisions that can be widely accepted.

So how can the benefits of ecosystem services be valued?  One fundamental distinction is between methods that come up with currency-based values for a particular ecosystem's worth, and those that use other metrics and indicators.


Limits and Alternatives to Monetary Valuation

Surely restricting ourselves to the no-nonsense world of dollars and euros makes ecosystem valuation clear and objective?  After all, we've seen estimates for ecosystem service value that pin dollar figures on boreal forests and many other ecosystems ?

Well...it's not so simple.  Valuation figures do help by assigning non-zero values to services that are clearly worth something.  At the same time, they can give a misleading impression of precision.  Currency-based valuation has limitations, as can be seen by thinking about what "worth" means:

  • Worth to whom?  we place varying levels of importance on a given good or service, so a price reflecting a sort of averaged demand level may hide wide differences of opinion.  And benefits from current ecosystem overuse can accrue to a small coterie.
  • Worth when?  how can current costs be balanced against future benefits?
  • "Hierarchy of needs":  a bushel of wheat can be cheap in currency terms, yet life-saving to a destitute family.  What moral calculus can put the two on the same scale?
  • Limitations of prices:  prices do not magically encapsulate all known knowledge about the value of a commodity in a single number.  You can readily look up how much it will cost to go and buy a ton of oil today, but future prices depend on a host of issues from geopolitical to technological to environmental.  As can be seen from the history of futures and option prices, markets are often not good predictors.  So if prices are unstable enough, how useful are they in measuring underlying reality?
  • Obvious vs subtle worth: a scenic mountain might draw more visitors, tourist revenue, and public appreciation than a boggy wetland, even if the latter provides more indirect benefits.  We might be willing to pay more to preserve the mountain now, yet suffer more from loss of the wetland in the long run.

The first point, 'worth to whom?' can be generalized to cut across several of these points.  What weight does a particular valuation place on populations outside of the developed economies, or less-well off people within them?  On our children and future generations?  On people who are educated about the issues but, from the same actions on ecosystems, may assess current benefits or future impacts differently?

There is a vast literature making it clear how complex coming up with a "value" can be.  One place to look for further discussion is the U.S. National Research Council's Valuing Ecosystem Services: Toward Better Environmental Decision-making (which also discusses a number of valuation methods in detail).  A couple of books which consider price limitations more generally are Everything for Sale: The Virtues and Limits of Markets and Priceless: On Knowing the Price of Everything and the Value of Nothing (interestingly critiqued).

So what are some useful non-monetary approaches?

Relative valuation: where the valuation is being done to support a decision, show that one option is better than another, even if you can't fully quantify benefits in either case.

Indicators:  maybe you can't convert everything to a dollar value, but you can come up with a summary set of measurable statistics which, taken together and in context, encapsulate the value of an ecosystem.  In this way, the "vector of values" can be tracked over time or compared between different future scenarios.  The flexibility of indicators is both a blessing and a curse:  beneficial by explicitly revealing various facets of value that can be weighted differently by each decision-maker, but potentially a barrier to consensus and widespread use if indicators are poorly chosen or not standardized.

Environmental Accounting:  Honest and competent accounting lies at the heart of traditional financial valuation; a similar sort of accounting for natural assets would radically ease coming up with ecosystem and natural resource values.  Indeed, accurate measurement of stocks and flows is itself a kind of valuation of natural wealth.  The SEEA environmental and economic accounting framework is the place to start for detailed consensus how-to in this field - it's an ambitious attempt to bring together theory and practice into a common policy framework, and make environmental and resource statistics as accessible as economic statistics are today.

A fourth "data-driven" approach might consider models and underlying data summaries themselves as more complex forms of valuation.  The Millennium Ecosystem Assessment, by giving baselines and insights into ecosystem function and interaction, was one of many efforts helping to converge on a shared understanding of what the core "life support" parts of the ecosystem are that are most in need of protection.  So in a sense, it was doing directly a function that dollar figures do by proxy.  Money is just one way to measure value - and often not the best way.

Imagine mashing up some of the best data and visualization tools we have, to include multiscale data on ecosystem goods and services, summaries, and trends.  Where specific values are available, they can be highlighted, but with limitations noted; where the values are too uncertain, we can fall back to the underlying data.

The ecological economics community is in sync with these ideas - they look first at underlying ecological and physical limits to come up with a "sustainable scale" for ecosystem service use, and then use that scientific reality as the "axioms" from which other kinds of value follow.  For example, if we agree that 450 parts per million of CO2 is an appropriate limit, then that would be taken as a limit which policies must ensure; the value of (say) carbon emission permits might then follow from a combination of this data-derived cap along with market-based emission trading.  Macro-limits, micro-flexibility.

So do these non-currency valuation methods really belong in the same framework as the currency-based methods we're used to thinking of as valuation models?  Yes, for several reasons.  First, many economists (and in particular ecological economists) do use these non-currency-based tools, and recognize that monetary valuation is just one kind of valuation.  Second, these tools are useful for practical decision-making.

Third, a big reason why we do valuation in the first place is to estimate how much differing goods and services are "worth", in order to help choose courses of action (i.e. "this is worth more than that").  "Summarizing" an ecosystem service by a monetary value lets one rank current and future cost-benefit along a common scale, but the monetary values are less stable through time, and (as we'll soon see) hide a lot of assumptions about the underlying reality.  Summarizing by a non-monetary value (e.g. a set of indicators or preferences) makes it harder to compare costs and benefits, but since the valuation is more directly tied to the underlying system, it may be more objective (and more stable through time).

Think again of the barrel of oil example:  the market price of oil fluctuates a great deal, but the actual energetic supply of oil (as measured in joules, say) changes much less.  To simplify, the former is more useful when we want to trade oil for other market-traded items.  But the latter is useful when we want to think about long-term energy supply and demand, and tie energy supply more directly to large-scale usage - to think about how much oil is "worth" as a global energy source in coming decades.

This distinction is central when one asks, "what should be counted in Green GDP?"  Those working on implementation recognize that defining "ecological units of account" (following ideas from the SEEA and others) helps in creating a useful measure.  Indeed, in China Green GDP is being prototyped with a view to nation-wide application.  (On a side note, the Chinese National Bureau of Statistics recently announced it would develop a "happiness index", which might complement GDP as a figure to maximize - we'll come back to the idea of happiness, cultural, and spiritual values of ecosystem services in a future post.)


Currency-based valuation

Currency-based methods (concisely introduced at the Ecosystem Valuation site) can be subdivided according to whether the benefits they measure are traded in markets or not.  An example of a market-traded benefit would be a forest's timber value, which itself turns out to hide a lot of assumptions: what is the future price path of timber going to be over coming decades? What discount rate and time horizon should be considered to value future benefits?

Once you make your assumptions, you can come up with values using standard financial tools.  A (relatively) simple way that's often used in valuing investment opportunities is to estimate the stream of future costs and benefits, and then discount each cost or benefit back to the present day, so that they can all be added up in constant dollars and compared.  Appropriate values to use in discounting have been debated for decades, though.  On one hand, "a bird in the hand is worth two in the bush", so a dollar now should be worth more than a dollar 20 years from now.  On the other hand, should the value of clean air today really be treated vastly differently from the value of clean air to your grandchild in 50 years?  Why or why not?

Typically, some discount rate does wind up being used, but the particular rate used makes a big difference to the model outcomes (especially for longer time horizons).  Note that in measuring a quantity like national income (to estimate GDP), this difficulty doesn't really arise, since currency values of production, trades, sales, imports, and so forth can be directly observed.

The key warning here is that the currency values which an ecosystem service model comes up with can be highly model dependent...so part of the "due diligence" for using such values is to look at what assumptions, data, and models went into coming up with the figures.  (This is no different from valuing a company or investment opportunity - objective-seeming accounting figures can hide a great deal of ambiguity, or even outright fabrication.)

We'll go into more detail in a future policy-oriented post, but this point is worth repeating:  what seem like objective currency values can actually range from "the best estimate we can make with available data" to "manipulating the data and model to suit a pre-existing agenda".  There's a fundamental tension between this observed reality, and the fact that placing some reasonable values on ecosystem services seems like a really good way to get policy-makers, business people, and the public at large to pay attention and not destroy natural capital without a good reason.

Currency-based valuation for goods and services that are not market-traded try to come up with an imputed dollar value by various means.  Here are a few of the ways you might try to estimate the "value" of a park, given that parks are not bought and sold in markets:

  • Market proxies:  recreational values of a park might be estimated from visitor revenues, as well as the travel and time costs that visitors "spend" to use the park.  This is easy, but  often vastly underestimates values.
  • Stated preference:  in "willingness to pay" or other choice-based methods, people are asked to value the park's worth or make trade-offs between the park and some other benefit.  Although flexible and applicable in principle to many goods and services, weaknesses include the validity and degree of informedness of stated opinions, and wide variations in results depending on how questions are asked.
  • Revealed preference: asking people their opinion should be taken with a dose of skepticism, since our stated preferences can differ from preferences "revealed" by our actions.  Telling a friend "I prefer preserving our climate to the freedom to travel as I wish" is a stated preference.  But if you then go and fly to a vacation spot halfway around the world, your "revealed preference" is different.  In the case of the park, maybe everybody says they like a certain park, but few actually visit.
  • Contingent choice: instead of being asked to measure the park's value in dollars directly, people are asked to choose among a set of choices (e.g. park stays untouched, vs part of park is developed but taxes go down).  The distribution of choices is then used to infer a currency value.
  • Replacement cost: how much would it cost to set up a new park?  (This method would be more applicable to cases where it's obvious that the service in question needs to be maintained, e.g. water quality - if other means must be used to replace a damaged ecosystem service, the ecosystem service must logically be worth at least the cost of those other means.)
  • Health impacts: public health interventions often use the "DALY" (Disability-Adjusted Life Year) framework to compare the benefits of different courses of action.  If the health impacts of ecosystem service damage can be estimated accurately, this can be a useful metric, as with air pollution.  Maybe visiting this wonderful, serene park stimulates you to exercise more and live longer...

Just as polling and surveys have their limitations, one downside of using preferences as a decision-making tool is that "averaged current demand" may not accurately reflect long-term or non-obvious values of the ecosystem in question.  What we "want" today may not be what's best in the long run.  (Market-based valuation arguably has similar limitations in this regard, though some might counter-argue that good investors get financial rewards for predicting long-term value, and hence their 'weight' tends to increase over time.)

It's also worth mentioning that some market-based methods are best thought of as coming up with lower bounds, as they often don't consider the harder-to-value components of an ecosystem's worth.  (Think, for example, of valuing a park by the visitor and recreation service revenues, while leaving out biodiversity benefits.)

One special case of interest is trying to estimate what a critical ecosystem service would cost if it wasn't provided by nature - a service, like clean air or water, which is clearly essential to life.  These estimates can use a variety of methods, from looking at market prices for substitute service delivery (clean water from desalination, say) to measuring human harm if the service is degraded (deaths and damage from flooding, or health impacts of dirty air).

The error bounds on estimates get larger where our knowledge of a particular ecosystem service and its substitutes is less.  And estimates have ranges of validity, just as engineering principles do - once you get to the largest scale of considering the whole planet, or get to the "extreme harm" case of ecosystem degradation severe enough that large fractions of humanity can no longer survive, the approximations and assumptions break down and dollar figures may no longer be meaningful.  This was one of many criticisms of Costanza et al's 1997 $33 trillion estimate for global ecosystem service value.

Think of an extreme example.  At the current point in time, we can't replicate the Earth's vegetative cover by artificial means, so the hypothetical price we might put on macroscale vegetation is unbounded - no amount of money is worth losing something essential to life.  But at the microscale, a blade of grass or twig has effectively zero value.  We can't scale the value of a blade of grass up, or the value of all of Earth's vegetative cover down, to come up with a value for intermediate scales:  the valuation of ecosystem goods and services is scale-dependent.

Indeed, as the Environmental Economics blog explains, extrapolation of values from local to global scales is a fundamental misuse of marginal cost.  If a developing country might be willing to accept a given level of compensating benefit to lose 1% of its forest, one can't just multiply by 100 to get the total value of the forest - maybe the remaining forest gets more valuable as less is left, or maybe there's some point past which knock-on effects kick in (like biodiversity loss or soil erosion).  Monetary values at the largest scales are insufficient as cost-benefit analysis tools, although if done properly they may help point out cases where financial benefits can be gained from ecosystems more sustainably.

(Incidentally, Costanza and colleagues are now working on modeling local values of ecosystem services.  They've also inspired Earth Inc: "Imagine the Earth as a business and you're a shareholder. We're all shareholders. Future generations are entitled to a share too. How do we maximize the benefit every shareholder receives from the Earth? How do we maximize human wellbeing?"  Carrying the metaphor further, they have mock-ups of the Earth shareholder report that is being developed.)


Where next?

Monetary estimates are easy to comprehend, but hide assumptions, approximations, and simplifications.  They're also valid only at particular scales, and measure only certain kinds of value.  On the other hand, they integrate information about supply and demand, however imperfectly - something more data-oriented valuation such as indicators or ecosystem models don't do explicitly.

A marriage of the two may be the way forward.  When monetary values are used, misleading precision should be eschewed, and model assumptions clearly stated and summarized up front.  And where monetary values are not useful, we need to develop comprehensive models with understandable summary statistics and indicators, that can be used directly to make policy tradeoffs without going through the intermediary monetary stage.

It's easy and comfortable to add up costs and benefits in a single, seemingly universal framework, and then to compare net benefits of different avenues of action to choose which way to go.  But sometimes costs and benefits can't be translated into single values - too much is lost in the transition.

A more nuanced idea of valuation will let us use the powerful tools of financial planning where appropriate.  And where financial planning is inappropriate, we can use indicators, models, and simulation approaches to compare the benefits of alternative courses of action in terms more directly linked to human well-being.  At the end of the day, the challenges in really comprehending the true value of resources or the environment (or of an idea or social capital) should be approached with humility...as a long process of advancement, as our knowledge, wisdom, and experience grow.

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Comments

Timely post and great conclusions. I have been struggling with the valuation question for years, and just recently revisited "The Indicators Paradox" as a post on our Ecological Economics blog. My critiques of Cost Benefit Analysis, along with other related posts including "The Indicators Paradox" are rolled-up here:
http://forestpolicy.typepad.com/ecoecon/costbenefit_analysis/index.html


Posted by: Dave Iverson on 13 Feb 07

Wow -- a great installment, guys!


Posted by: Jon Foley on 13 Feb 07

Big conference coming up!

United States Society for Ecological Economics (USSEE)

USSEE/Pace Conference in New York City, 23-27 June 2007 ‚ÄúCreating Sustainability Within Our Midst: Challenge for the 21st Century‚Ä?


Posted by: dbs on 14 Feb 07

Thanks for this detailed overview and clear explanation. I'm working on an MBA in Sustainable Business (at Bainbridge Graduate Institute
Posted by: Kim on 16 Feb 07




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