Measuring the transition towards a green economy : indicators to measure environmentally sustainable development of wellbeing

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Author Stijn W. Schep M.v.B. Bastiaansestraat 6 1054RX Amsterdam E: Stijn_schep@hotmail.com T: +31 6 41386442 Student number: 5823846 Supervisor D.J.M. Veestraeten Second reader N.L. Leefmans

Measuring the transition

towards a green economy

Indicators to measure environmentally sustainable

development of wellbeing

Stijn Schep

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2 This document is written by Student Stijn W. Schep who declares to take full

responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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1 Introduction

Policymakers are assumed to maximize the wellbeing of the people they represent. To do so, they require indicators to measure the level of wellbeing in their societies. In the 20th century, Gross Domestic Product (GDP) evolved to be the most commonly used indicator for societal wellbeing. Nowadays, there is an increase in voices pleading for a different measure for the quality of life (amongst many others: UNEP, 2011a; Slingerlandt et al. 2014; European Parliament, 2011; Stiglitz, Sen and Fitoussi, 2009). Although the level of wealth in a country (measured by GDP) is an important determinant of wellbeing, it must not be the only one. As Simon Kuznets already noted when he first introduced the current standard for the GDP, the latter indicator does not reflect important social and environmental aspects that determine the quality of life, such as education, health, income distribution and the value of natural resources that are not traded in markets (Stiglitz, Sen and Fitoussi, 2009).

1.1 Problem definition

In this thesis, I will refer to the narrower sense of material wellbeing, as “wealth”. Wealth can be expressed in monetary terms and can be used to acquire goods and services produced in an economy. The broader concept of human wellbeing, on the other hand, includes intangible aspects of the quality of life that are not traded in markets. Examples are health, voluntary work and social relations. In this thesis, I will refer to this broader concept as “wellbeing”.

In order to measure wellbeing, a generally accepted contribution to the GDP is the Human Development Index (HDI), which combines the key elements that determine human development (and thereby wellbeing): education, life expectancy and wealth/income. Although this might be a step in the right direction, the indicator fails to incorporate important social and environmental aspects that also have an impact on wellbeing (OECD, 2014). In this thesis, I will focus on the environmental aspects that contribute to wellbeing. I identify two categories of environmental benefits that contribute to human wellbeing:

1. Direct benefits to wellbeing: The natural environment provides mankind with goods and services that affect wellbeing directly. Clean air and drinking water are fundamental requirements for human development and many people around the world rely on natural resources for their subsistence (e.g. fish, forest products, crops etc.). For recreation and spiritual purposes natural areas are of great importance.

2. Indirect benefits to wellbeing: Both social and economic constituents of wellbeing are affected by changes in environmental quality. The economic system depends heavily on natural renewable and non-renewable resources as input for production. The consumption of this production is an important part of human wellbeing. Furthermore, social aspects of wellbeing can be significantly affected by changes in the natural environment. Poverty levels and health, for example, can be influenced by environmental degradation. Furthermore, the focus on maximizing GDP has had deteriorating effects on the natural environment (the same natural environment that provides these important services). Error! Reference source not found. demonstrates the positive orrelation between the level of human development and environmental pressure as

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5 measured by the per capita footprint. The per capita footprint represents the amount of land that is required to sustain the current consumption level of a citizen of a particular country. This demand for productive land can be compared to the available productive land that can sustain the world’s population indefinitely: the biological capacity. The figure shows that countries that have reached a high level of human development (United Nations Development Program, 2009) are in general demanding more of the natural resources per capita than the planet can sustainably supply.

This overexploitation as a result of human development can cause negative externalities. Externalities occur if the activities of one person or party affect the wellbeing of others that did not choose to incur that effect (Buchanan and Stubblebine, 1962). In other words, people’s wellbeing can be negatively affected by externalities of the production or consumption of others who make use of natural resources. Unfortunately, these negative effects are often not taken into account by currently used measures for wellbeing. Externalities result in social demand or supply curves that are different from the private supply and demand curves of the actors within the market. The difference between the social and private preferences leads to suboptimal market equilibria and in the case of environmental externalities to a loss in wellbeing. An example of an environmental externality is pollution that is emitted during a production process and that causes health problems to the surrounding community. If the external costs of this pollution are not accounted for, more than the socially optimal amount of pollution will be produced.

Figure 1 the relation between the inequality adjusted Human Development Index and the ecological footprint (WWF, 2014). Note: the red arrows are not part of the original figure.

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6 In the case of open-access resources there is the problem of non-excludability. Although users cannot be excluded from the resource, the use itself has a rival nature (i.e. natural resources extracted by one user, cannot be extracted by the next user). Because optimal extraction levels from the perspective of individual users are often higher than the socially optimal extraction levels, open-access resources tend to become overexploited. For example, an open access fish stock might become overfished when the total catch of fish exceeds the ability of the stock to regenerate. This type of market failure is also referred to as the “tragedy of the commons” (Hardin, 1968). Both types of market failure (externalities and non-excludability) are characterized by an undervaluation of natural resources and, thereby, lead to overexploitation of the natural environment. The overexploitation threatens a sustained level of wellbeing for future generations.

Welfare losses that are caused by both types of market failures are not reflected in the GDP, the HDI or other macro-economic performance indicators that are currently used by policymakers. To effectively measure human wellbeing, it is therefore desirable to develop complementary indicators that provide insight in the benefits of the natural environment.

During the United Nations Rio+20 Conference on Sustainable Development in 20121 participants agreed to implement “green economy” policies, which were considered to contribute to sustainable development. The goal of green economy policies is to increase the level of human development, whilst keeping the exploitation of natural capital limited to a level that can be sustained indefinitely (UNDESA, 2012). See the red arrows in figure 1 for a graphical representation of the green economy goal. In general, these policies acknowledge the presence of environmental market failures that and the inability of currently used indicators such as GDP and HDI to measure wellbeing effectively.

To evaluate whether economic development is moving in a direction that is consistent with the green economy theory (i.e. increasing human development and decreasing environmental pressures), various organizations have developed indexes or sets of indicators to measure “green” economic performance. The indexes are characterized by being alternatives to GDP in terms of measuring wellbeing and by taking into account environmental sustainability. The indicators used in these sets can be roughly categorized in indicators that give insight in the contribution to wellbeing through economic processes, social processes and environmental benefits. Also, the sets often include indicators for the sustainable us of natural resources. Slingerland et al. (2014) identify seven indicator sets to monitor “green” economic performance, or “green growth”. The identified indicator sets are developed by the UNEP, OECD, World Bank, Global Green Growth Institute (GGGI), the Green Growth Knowledge Platform (GGKP), the Dutch Central Bureau of Statistics (CBS) and Dual Citizen. Also Porter et al. (2013) developed an extensive index to measure wellbeing and the sustainability of wellbeing that is mentioned by Slingerland et al. (2014).

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7 Figure 2 Proposed framework for including environmental indicators to measure wellbeing. Framework was created for this thesis.

The purpose of this study is to evaluate the ability of these indicator sets to incorporate the shortcomings of the GDP in incorporating environmental benefits. To do so, environmental benefits are assessed that determine wellbeing directly or indirectly (Figure 2). The direct environmental indicators reflect environmental benefits that are contributing directly to wellbeing. Indirect indicators reflect environmental values that contribute to wellbeing through production processes or by influencing indicators for social equity. Additionally, an indicator can provide insight in environmental externalities caused by production processes that have a negative impact on the natural environment.

Because the direct impact of the social and economic processes on wellbeing has received most attention in academic research, the focus of the study will be primarily on the environmental indicators that influence wellbeing directly and indirectly. Also green economy indicators that give insight in the environmental market failures that occur in the economic dimension will be evaluated. Based on these indicators can be assessed whether growth of wellbeing is a realistic scenario. This leads to the following research question:

How to assess wellbeing with a focus on environmental indicators and the possibility of green growth?

To answer this question I propose the following structure of this thesis. Chapter 2 will start with the definition of the concept of wellbeing and the translation of that concept into quantitative indicators for empirical analysis. In the third chapter, the different ways in which the natural environment contributes to human wellbeing are investigated. Also, the extent to which GDP incorporates these environmental benefits is discussed. In the fourth chapter, green economy indicators are assessed on their ability to assess complement indicators such as GDP and HDI to measure wellbeing more comprehensively. Based on these indicators there will be a discussion about the feasibility of an eternal growth of wellbeing given a limited amount of natural resources.

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2 Measuring wellbeing

Before going into measuring the link between the natural environment and human wellbeing, I will start with a disquisition on the measurement of wellbeing in general. In this chapter, two approaches to measure wellbeing are discussed: the utility and the capabilities approach. Before going into these approaches, we need to define the actual concept of wellbeing more specifically.

2.1 Definitions of wellbeing and economic welfare

The Oxford English Dictionary (2014) defines wellbeing as “the state of being or

doing well in life; happy, healthy, or prosperous condition; moral or physical welfare (of a person or community)”. It should be noted here that there are various aspects

that contribute to the wellbeing of a group or person. These definitions relate closely to the definition of welfare in the same dictionary: “The state or condition of doing or

being well; wellbeing, prosperity, success; the health, happiness, and fortunes of a person or group”. According to the dictionary, the two words can even be considered

synonyms. Both concepts are defined as a measure for the quality of life in which a higher level of wellbeing or welfare is related to a higher level of satisfaction.

In 1890, Alfred Marshall defined the term welfare within the economic science in a narrower sense: referring to material wellbeing. Within the field of welfare economics, the term welfare refers to the utility that is obtained by acquiring goods and services. This is also referred to as “material welfare” or “wealth” by Stiglitz, Sen and Fitoussi (2009) and refers to the part of the narrower concept of wellbeing that can be obtained by participating in economic activities. In other words, material wellbeing can be expressed in goods or services that are tradable (Samuelson and Nordhaus, 2004). In this thesis, I will refer to the latter and narrower sense of welfare as

economic welfare. The broader concept of welfare as defined by the Oxford English

Dictionary, including all non-traded aspects that contribute to one’s state or condition of doing or being well, will be referred to as wellbeing.

2.2 Objective and subjective wellbeing measures

In the literature, there are various approaches to measuring wellbeing. First of all, researchers have been trying to measure wellbeing quantitatively by investigating subjective measures of wellbeing. Within an interdisciplinary field of economics and psychology, researchers have been looking at the relationship between different aspects of daily life and self-reported measures for life satisfaction. Although there is no empirical consensus about most factors that correlate with subjective wellbeing measures, there is evidence that various socioeconomic indicators have important effects on reported happiness.

Kahneman and Krueger (2006) evaluate various explanatory variables for self-reported happiness. Next to some physical characteristics such as the smiling frequency and indicators for health, also social relations, education and high income correlate with a higher self-reported happiness. Interestingly, the authors note that especially a high income compared to peers is important for self-reported happiness. Personal circumstances tend to have an effect on self-reported happiness in the case of recent changes.

Objective measures for wellbeing, on the other hand, rely on the idea that if people have the opportunity to choose what makes them happy, they will do so. These opportunities are generally created by the living standards and the freedom to make choices. Measures for objective wellbeing therefore focus on the level of these two

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9 aspects within various domains of a society (Stiglitz, Sen and Fitoussi, 2009). Marshall (1920) states that people’s desires cannot be measured directly, but that explanatory variables of wellbeing are often observable. Estimates of wellbeing are therefore generally calculated by quantifying explanatory variables of wellbeing objectively.

The two main theoretical frameworks that can be identified to assess the quality of life are the utility and capabilities approaches. The utility approach finds its roots within the classic economic welfare theory, a field within the economic science that is concerned with the efficient allocation of goods and services within an economic system. Utility is used as a quantifiable measure for the level of satisfaction that is derived from the resources that are available to an individual. When the concept of utility is applied to assess welfare, the explanatory variables for wellbeing (as specified by 𝐶!" in equation (1)) represent resources that are available to an individual or group. The sum of utility that is derived from the resources can be aggregated to a total measure for wellbeing.

Graham (2008) specifies a theoretical micro-economic equation for individual wellbeing:

(1) 𝑊_!" = 𝛽𝐶_!"+ 𝜀_!"

In the equation, 𝑊_!" is a measure for wellbeing for individual i at time t and 𝐶!" represents a vector of variables that explain that level of wellbeing. The equation assumes here that there is a universal measure for wellbeing that can be compared between individuals. In practice, this measure is not easily determined. Wellbeing is an abstract concept that reflects a mental state of being and is not directly observable. Direct estimates of wellbeing levels are thus only possible by relying on self-reported happiness measures. It remains problematic that there is no measurement unit for happiness. This means that only changes or comparisons in self reported happiness provide insight in actual wellbeing. A certain level of wellbeing specified by the number 𝑊_!" is too abstract to interpret. If this level is compared to other points in time or among different individuals the numbers start to make more sense. Comparisons can show relative happiness between individuals or groups, changes in wellbeing demonstrate whether people become happier or not, for example, 𝑊a1 < 𝑊a2 one can draw the conclusion that the level of wellbeing has increased between moment t=1 and t=2 for individual a.

Sen (1985) criticizes this classical economic approach by stating that one’s wellbeing is not solely depending on the resources that are available. He introduces the capability approach to human welfare. According to the capabilities approach, the level of wellbeing should not be determined by looking at the available resources and utility that is derived from these. Sen defines wellbeing as “....the ability to achieve valuable functionings” (Sen, 1985; 200). These functionings are certain states of being or activities that people value and can range from rudimentary values such as being safe and sufficiently fed to more complex states of being, such as having political freedom, being able to exercise a profession as an expressive artist or enjoying the participation in a soccer match. Sen refers to capabilities as a set of functionings that an individual or group can achieve. Note that such a set reflects the freedom to choose functionings. So even if somebody is not conducting a specific activity (e.g. voting for national elections) the possibility to be able to do so is still valuable (even if the person is not going to vote).

When comparing the capability and utility approaches there are two important differences: The capability approach acknowledges the importance of available

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10 resources to support the functionings, but they are not what increases wellbeing directly. The resources enable certain functionings. According to this theory, the amount of resources (money, wealth) does not make people happy, but the functionings (activities or states of being) that they will be able to afford because of those resources do. For example, the presence of a theatre and dance performers (i.e. resources) does not directly contribute to ones wellbeing, while the enjoyment of a dance performance does. Secondly, there is the question of commensurability between different aspects of wellbeing: The utility approach implies that every resource that contributes to wellbeing can be reduced to a single quantitative variable or unit that reflects one’s state of wellbeing (i.e. a measure for utility). According to the capability approach, it is not possible to compare all different variables that contribute to wellbeing. For example, the possibility to buy food in the supermarket might not compare and/or be interchangeable to the ability to vote for a political party. Commensurability implies that the same level of welfare could be reached by trading the ability to vote for goods in a supermarket. Sen, however, rejects the idea that the contribution of different variables to wellbeing can be measured with a common variable and that the explanatory variables for wellbeing are therefore not commensurable. He proposes a multidimensional approach to measuring human wellbeing (Alkire, 2008; Kuklys, 2005).

2.3 Determinants versus constituents of wellbeing

Although the utility and capability approaches may be different, they are not necessarily incompatible. A way to combine these two theories is by looking at the constituents of wellbeing and the factors that determine wellbeing (Dasgupta and Weal, 1992). The constituents of wellbeing can be defined as the values in which the quality of life can be expressed. Health, wealth and freedom of choice are examples of such values and are comparable to the functionings that form the basis for the capabilities approach to measuring wellbeing. The constituents, however, are facilitated by determinants of wellbeing. These can be compared to the resources that are identified within the utility theory. Being healthy, for example, is a functioning that is supported by resources such as healthcare facilities, sanitation and access to clean drinking water. The supporting resources can be categorized as determinants of wellbeing. Building on equation (1) this means a second equation can be introduced:

(2) 𝐶_!" = 𝛾𝑅_!"+ 𝜀_!"

In which 𝐶!" is a vector that contains the variables that measure the constituents of wellbeing. 𝑅!" is a vector that contains the variables that reflect the determinants of these constituents (resources). If we assume that that the constituents of wellbeing are commensurable to each other, 𝐶_!" is equal to the vector of explanatory variables specified in equation (1) and can be used to estimate the aggregate level of wellbeing in a single variable (𝑊!" ). Note that although the equations show a linear relationship between determinants of wellbeing and the dependent variables, this might be a simplified reflection of reality. In fact, given the concept of decreasing marginal utility, relations are likely to be non-linear because the marginal contribution to wellbeing decreases as the quantity of a determinant rises.

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2.4 Constituents of wellbeing

As part of the Commission on the Measurement of Economic Performance and Social Progress2 Stiglitz, Sen and Fitoussi (2009) identified eight constituents of human wellbeing. It is important to note that there is a high level of interrelatedness between the different constituents of wellbeing. This means that constituents can affect wellbeing through other constituents, thereby acting as a determinant of wellbeing. The domains that are outlined by the report are:

• Material living standards (income, consumption and wealth): The rationale is that more wealth leads to the ability to consume more resources that provide utility. Higher levels of wealth also enable to change the focus of personal activities from achieving basic living standards to activities that contribute to higher levels of wellbeing (like investing in healthcare, or spending time on education) (Ul Haq, 2003)

• Health: Mortality and morbidity determine the length and the physical quality of life. Next to being able to enjoy other constituents of wellbeing more if you are healthy, the overall health of a society furthermore contributes to an increased productivity of human capital and the ability to enjoy personal activities. On the other hand, health is very much dependent on some of the other constituents of wellbeing. For example, the environment, or consumption patterns have a strong impact on physical health. (Stiglitz, Sen and Fitoussi, 2009)

• Education: higher education has a demonstrated positive effect on reported subjective wellbeing. Besides that, research indicates that education has a high positive correlation with increased opportunities in other constituent dimensions of wellbeing. For example, educated people tend to have better jobs, a better health status and a greater engagement in civic and political life. Although the causality between these indicators is not always clear (for example: are higher educated people healthier because of their more extensive knowledge on healthcare, or do sick people miss school more often?) (Stiglitz, Sen and Fitoussi, 2009).

• Personal activities (including work) have most extensively been linked to subjective quality of life measures. These activities can fall in categories of work for pay, domestic work, commuting and spending leisure time. Various activities within these categories have been shown to have important impacts on subjective wellbeing (Kahneman and Krueger, 2006).

• Political voice and governance: According to Stiglitz, Sen and Fittoussi (2009) having a political voice and the sense of contributing to governance in a society gives people the sense of full citizenship and contributes to life satisfaction in itself. Furthermore, increased participation by citizens is likely to increase the efficient management in the other dimensions of wellbeing as well. Active citizenship enables policymakers to make decisions that are catering to the needs of society.

• Social connections and relationships: as human beings are social creatures and socializing has been proven to be one of the most important personal activities, it comes as no surprise that that the quantity and quality of social connections contribute significantly to wellbeing (Stiglitz, Sen and Fitoussi,

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The commission was initiated by president Sarkozy of France in 2008 to evaluate concerns that had been raised regarding the adequacy of currently used measures for economic performance. For more information please visit: http://www.stiglitz-sen-fitoussi.fr/en/index.htm

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12 2009).

• Environment (present and future conditions): Apart from being important to sustain the level of wellbeing in the future, a healthy environment has strong implications for other dimensions of wellbeing (e.g. pollution for health, clean drinking water for living standards, the environment enables certain personal activities and security from natural disasters) there are also environmental amenities (and disamenities) that directly appeal to people.

• Insecurity of an economic as well as a physical nature has proven to have significant negative effects on subjective wellbeing measures (Stiglitz, Sen and Fitoussi, 2009). As people tend to be risk averse, higher levels of uncertainty lead to lower levels of wellbeing. For example, a farmer that is subject to high flood risks has an insecure future in economic and physical terms.

When wellbeing on the national level is assessed, Stiglitz, Sen and Fittoussi (2009) state that equality is an issue of importance within each constituent of wellbeing. Although the constituents reflect sets of explanatory variables that measure wellbeing on an individual level, these are often used to measure wellbeing of a society. In this case, indicators remain the same, but reflect averages of that society. Therefore, the distribution within these societies is not considered. The concept of decreasing marginal utility implies that societies with the same level of resources reach higher levels of aggregate wellbeing if resources are distributed more even (Riley, 2008). Apart from reaching a higher aggregate level of utility, inequality can also have a negative impact on individual wellbeing. People tend to compare themselves with their peers. In the case of wellbeing, people evaluate their personal levels of wellbeing based on the levels of the people surrounding them. As Kahneman and Krueger (2006) point out, inequality with respect to income has a positive effect on subjective wellbeing of the richer person. On the other hand, Diener et al. (1995) show that equality would lead to a sense of injustice or inequity that can be negatively valued by society as a whole.

2.5 Quantifying the level of wellbeing in practice

Together with the development of macroeconomic theory, the calculations of national accounts have grown to be the most important measures for the assessment of welfare on a macroeconomic level. National accounts represent the records of aggregate production, income and expenditure within a country. Capital and financial accounts are kept to keep track of changes in asset stocks within a specific period. Standards for calculation of the national accounts are provided by the System of National Accounts that are developed by the United Nations Commission Statistical Commission (UNSC, 2008).

The Gross Domestic Product (GDP) or Gross National Income (GNI), which reflect the value goods and services that are traded within an economic system, have been widely used to assess the development of nations. However, GDP and GNI only reflect the part of the economic welfare that is recorded in official market transactions. There are many goods and services that are not officially traded but do contribute to wellbeing: think of a carrot from your neighbor’s garden or voluntary work. As some goods and services are not traded in markets, these are not incorporated in the calculations of the national accounts. This means that the national accounts provide an incomplete picture of resources available to a society. This bias is relatively larger in countries with big informal economies. Furthermore, the indicators do not include many of the non-material components of wellbeing that are discussed in the previous paragraph.

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13 In the past century, policies have focused on the growth of an indicator that does not incorporate all relevant constituents of our wellbeing. Although focusing on the growth of the production of our economies might have been important in the first decades after the Second World War, when the level of material wellbeing (or wealth) was still relatively low. Nowadays, especially the West has seen a strong increase in wealth. According to the concept of decreasing marginal utility, it can be argued that the growth of wealth per capita is becoming less important compared to the other constituents that contribute to our wellbeing. As we become wealthier, the marginal utility of additional units of wealth is decreasing. Although other constituents of wellbeing might also be subject to a decreasing marginal utility, these constituents have not been growing at a similar pace. Focusing on the environmental constituent of wellbeing, one can conclude that some aspects have improved (e.g. air pollution, water quality) while others have not developed in favor of humanity (e.g. natural areas, green house gas emissions). It is important to keep in mind this is likely to be different for the developing world, where much lower levels of material wellbeing are observed and often the most basic material needs are not satisfied. However, even wellbeing of the poorest is not determined solely by wealth, merely the relative importance compared to other constituents of wellbeing changes. Measuring wellbeing with GDP is therefore becoming less important as material wellbeing grows.

Despite the limited ability of our national accounts to estimate the level of wellbeing, no comprehensive indicators have been institutionalized comparably to the GDP and GNI. Although many statistics are available to assess states of wellbeing within its different constituents, there is no generally accepted framework to combine indicators in order to determine wellbeing comprehensively. Arguably the most widely accepted gauges that measure various constituents of wellbeing are the Human Development Index (HDI) and its successor the Inequality-adjusted HDI (IHDI), both developed by the United Nations Development Program. The HDI is a weighted index of life expectancy, GNI and education as measured by years of schooling (Malik, 2013). The IHDI corrects the HDI for inequality across its three components.

The HDI and the Human Development Report led to the formulation of the Millennium Development Goals (MDG), which aim to increase wellbeing worldwide (especially in the developing world) across multiple dimensions of wellbeing. All countries of the United Nations committed to trying to achieve the goals that were specified during the conference in the year 2000. The goals that were supposed to be achieved before the end of the year 2015 included:

• Eradicating extreme poverty; • Achieving universal education; • Promoting gender equality; • Reducing child mortality; • Improving maternal health;

• Combat HIV/AIDS, malaria and other diseases; • Ensuring environmental sustainability;

• Developing a partnership for development.

The MDGs have been criticized for the fact that, although they address important issues within several dimensions of wellbeing, other important issues within these domains are not taken into account. The MDGs also focus on increasing minimum levels, thereby not providing a useful guideline for middle- and high-income countries (United Nations, 2012). The environmental target especially has been criticized for a lack of concrete sub- targets and governments face difficulties in measuring the

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14 progress towards achieving environmental sustainability (Levy, 2011; Aryeetey et al. 2012)

Also the implementation of comprehensive wellbeing measures by national governments is limited. The European Parliament (2011) has officially published its intentions to implement a statistical system that aims to monitor wellbeing based on the dimensions as specified by Stiglitz, Sen and Fitoussi (2009). However, what this system will look like exactly remains uncertain. The only institutionalized measure for wellbeing can be found in the country of Bhutan, where Gross National Happiness (GNH) is used as a development measure by the country’s national government. GNH is determined by conducting surveys among residents in which their satisfaction in nine domains of wellbeing is investigated based on a mix of qualitative and quantitative indicators. These domains are comparable to the constituents of wellbeing: psychological wellbeing, health, time use, education, cultural diversity and resilience, good governance, community vitality, ecological diversity and resilience, and living standard. The responses to these questions are than used to calculate the GNH Index, which reflects the overall life satisfaction for an individual household or a community.

Looking at the HDI and MDGs, it becomes clear that material wellbeing and social issues, such as education and health, have been the focus for policymakers to measure non- material wellbeing in the past. The natural environment as a constituent of wellbeing has not received much attention on a macroeconomic policy level. Under the label green economy, various international initiatives developed indicator sets that claim to be measuring progress towards all-inclusive economic development (i.e. considering all constituents of wellbeing) with a focus on environmental sustainability. Although governments have adopted none of these indicator sets, they provide promising possibilities to quantify and monitor wellbeing. In the next chapter of this thesis, these indicator sets will be reviewed on their ability to address the gaps in the measurement of wellbeing that are created by currently adopted macroeconomic monitoring systems.

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3 Alternative measurements for wellbeing with a

focus on environmental sustainability

Before going into the shortcomings of our current national accounting system as an indicator for our wellbeing with regard to environmental aspects, we should first specify how the natural environment contributes to human prosperity. As discussed in the previous chapter, the natural environment contributes to wellbeing in two ways: directly and indirectly through other constituents of wellbeing. The following section introduces a framework for the assessment of environmental benefits.

3.1 How does the natural environment contribute to human wellbeing?

The mere existence of the natural environment provides mankind with amenities that directly contribute to our satisfaction in life and even enable our existence: we require the oxygen produced by healthy vegetation and, less drastic, we visit natural areas for recreational activities. Indirectly, natural resources and ecosystems contribute to our material wellbeing as raw materials that are used as input for economic production processes. Also non-material constituents of wellbeing are dependent on the natural environment. Our health, for an example of the latter, is affected by changes and the state of our surrounding natural environment, such as water and air pollution.

In 2000, the Secretary General of the United Nations at that time, Kofi Annan, called for the Millennium Ecosystem Assessment (MEA)3. The aim of this project was to assess the consequences of changes in the natural environment for human wellbeing. The approach of the assessment was based on the concept of Ecosystem

Services. The rationale behind this concept is that the natural environment provides

us with goods and services that contribute to our wellbeing. As part of the assessment a framework was developed that categorizes different ecosystem services based on their contribution to the constituents of wellbeing. These ecosystem services can therefore be seen as the determinants of wellbeing that were specified in chapter 2. The report produced under the assessment specifies three categories that directly contribute to human wellbeing: provisioning services, regulating services and cultural services (MEA, 2005).

• Provisioning services can be seen as the physical resources that contribute to our material wellbeing, such as agricultural products, freshwater, timber, etc.;

• Regulating services can be seen as the benefits we obtain from having stable ecosystem processes, such as purification of freshwater supplies or the regulation of disease outbreaks.

• Cultural services are the services that contribute to the non-material constituents of wellbeing, such as recreation or spiritual values of nature. While the three categories mentioned above have a direct effect on the constituents of our wellbeing, these are supported by various ecological processes. These processes are called supporting services in the framework, but basically provide an insight in the status of environmental quality. Although the supporting services are indirectly beneficial for human wellbeing, people do not directly make use of them. A

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16 mangrove forest, for example, might function as a nursery for commercial fisheries by providing shelter to juvenile fish. Although a healthy mangrove forest increases the fish stock and catch, the ecosystem itself does not provide direct benefits for the fishermen.

Although the categorization of the constituents of wellbeing in the MEA framework is somewhat less elaborate than the eight categories specified by Stiglitz, Sen and Fitoussi (2009) that were discussed in Chapter 2, the approach towards determining wellbeing is similar as the capabilities approach to human wellbeing. Although Sen’s capabilities approach lists eight key capabilities and the MEA four, both frameworks describe wellbeing as the ability and freedom of people to make the choices that enhance their wellbeing.

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3.2 How to value ecosystem services?

Pascual et al. (2010) provide a framework to assess ecosystem values that relate to the categorization of ecosystem services provided by the MEA. The authors distinguish between direct use values, indirect use values, non-use values and

optional values.

• Direct use values can be specified as benefits that are obtained by consumptive use of ecosystems. It is important to note that one has to be physically present to enjoy these benefits and that increasing use of the ecosystem services would lead to an increased level of wellbeing. Provisioning ecosystem services always provide use values. Recreational activities are also considered direct use values. Ecosystem services in this category can be considered as monotonic commodities, meaning that increase in consumption is desired by rational consumers (Hervés-Beloso and Monteiro, 2010).

• Indirect use values are provided by ecosystem services that we do not consume directly. Examples are ecosystem services that are used as intermediate inputs for the production of other goods and services. Examples are dunes or coral reefs that protect our shores from storms and waves, or insects that pollinate our crops. People, in the end, benefit from these services. Most of the regulating and supporting services fall into this category.

• Non-use values can be divided into altruistic values and existence values. The first are referring to benefits that are obtained by knowing that other people and future generations are able to benefit from well functioning ecosystems. The latter represents the value that people attach to the health of the natural environment, regardless whether it provides us with any of the other values. For example, a person might value the idea that polar bears do not go extinct, regardless whether this person will ever visit the arctic or purchase the fur of a polar bear. These types of values are usually provided by the cultural services in Figure 3.

• The final category is the so-called optional value, which reflects the possible (but yet unknown) benefits of ecosystems. An example can be given by the potential usefulness of a certain (protected) plant species for the production of medicine. Optional values can materialize in either non-use or use values.

3.3 Optimizing the use of ecosystem services

It is important to indicate that the optimal use of different ecosystem services requires different levels of exploitation of the natural environment. In order to benefit from natural resources such as fish, timber and agricultural products the natural environment needs to be impacted and/or developed. However, when the natural environment is impacted too much and is not able to regenerate sufficiently, the utility derived from ecosystem services will decrease. This means that there is an optimal level of ecosystem use for each ecosystem service. Generally speaking, the regulating and cultural ecosystem services (such as water regulation, spiritual services and recreation) reach their optimum at much lower levels of exploitation compared to provisioning services (timber, fish catch, etc.). In other words, there are externalities between different types of ecosystem services: use of one ecosystem service can affect the use of other ecosystem services.

Consider an example with different types of ecosystem services that are provided by a forest. The value of these services depends on the level of exploitation of the

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18 forest, which in Figure 4 increases along the x-axis. A(x) represents the utility derived from timber production, an extractive ecosystem service. B(x) represents the utility derived by hiking, a recreational service. C(x) represents value the forest holds for the cultural heritage of the indigenous communities. The timber production has an optimal level of exploitation of the forest that is more intensive than the optimal levels for B(x) and C(x). Trees have to be logged, whereas the other two ecosystem services are not extractive. Hiking, however, still requires some level of development or exploitation of the forest, since trails have to be developed for a pleasurable hiking experience. The value of the ecosystem for the cultural heritage, however, reaches its optimum when the forest is at its most pristine (not exploited) state. U(x) represents the aggregate value of the ecosystem services. The optimization of the aggregate ecosystem service utility function (U’(x) = 0) leads to the societal optimum.

Figure 4 Optimizing the use of ecosystem services for the example of a forest.

3.4 How does GDP incorporate ecosystem services

The Gross Domestic Product is defined as the aggregate measure of production. There are three methods to calculate the GDP. First, it can be calculated through the sum of the gross added values of resident institutional units engaged in production plus the net taxes (taxes – subsidies). Secondly, it can be defined as the sum of output in terms of all final goods and services used in an economy expressed in consumer prices, minus net imports. According to this expenditure approach, GDP can be defined as:

𝐺𝐷𝑃 = 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 + (𝐸𝑥𝑝𝑜𝑟𝑡𝑠 – 𝐼𝑚𝑝𝑜𝑟𝑡) Finally, the income method is defined as the sum of all primary incomes plus net taxes. All three methods have the same outcome. Important to note is that all methods rely on records of transactions within an economy. This means that, for example, grey economic activities and voluntary work are not incorporated (Mankiw and Taylor, 2011).

On the other hand, the GDP does represent part of the ecological benefits that U(x) = A(x) +B(x) + C(x)

A(x): Timber production

B(x): Hiking Level of exploitation Utility C(x): cultural heritage 0

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19 contribute to our wellbeing. National accounts measure those ecosystem goods and services that are traded in markets. Natural capital can in this case be seen as an input to the production process, like industrial capital and labour. The World Bank (2006) analyzes a range of aggregate national production functions that include natural resources. A CES production function the following form is used:

(3) 𝑃=𝐹(𝑃abc(A,𝐵,𝐶),𝐷)

In this formula, the level of production (P) depends on a function (F) of various inputs

A, B, C and D. The researchers analyse 4 different inputs to production: produced

capital, human capital, non-renewable natural resources and renewable natural resources and rotate the four types of inputs between the variables A, B, C and D in the equation. The advantage of this functional form is the possibility of various marginal rates of technical substitution between the different inputs to production. The final contribution to aggregate national wellbeing is given by P, the aggregate level of production. The researchers of the World Bank find that all four inputs are significant for national production.

3.5 Shortcomings of GDP in incorporating the natural environment

3.5.1 Snapshot in time

Van der Bergh (2008) stresses that the GDP is a snapshot in time and does not represent our future wellbeing. It is problematic in this sense that threats to the natural environment as a result current economic processes materialize over time. For example, polluting a lake today as a result of industrial production, affects the fish stock in that lake next year, thereby affecting the fisheries active on the lake. GDP captures the current production, but not a loss in welfare through a decrease in fish catch. Especially impacts on ecological processes tend to materialize over longer periods of time, so effects on future wellbeing are important to consider.

3.5.2 Externalities

Economic agents maximize their personal utility while making use of natural resources. Figure 4, however, identified that the societally optimal use of an ecosystem service is not determined by maximizing the benefits of one user or one group of users. This means that other stakeholders that do not engage in the economic activity of one agent, are affected by his or her activities. If the activity of one stakeholder affects the wellbeing of other stakeholders that did not choose to incur that effect, we talk about externalities (Buchanan and Stubblebine, 1962). Lets assume that the wellbeing of individual i (𝑊!) is similar to the utility 𝑈! that is derived from personal use of natural resources (𝑋!) as well as the use of others (𝑋!, 𝑋!), then: (4) 𝑊_! = 𝑈_!(𝑋_!, 𝑋_!, 𝑋_!)

The externalities caused of the use of the individuals j and k can have either positive or negative contributions to the wellbeing of individual i. The function indicates that the utility of individual i does not depend on the utility of the other individuals (j and

k), which means that if individual i maximizes his own utility, he does not incorporate

the effects of his actions 𝑋!for the utility of the other individuals (j and k). In other words, i does not incorporate the externalities of his own actions and only assesses his private costs and benefits.

Social costs and benefits, on the other hand represent the positive and negative effects of an economic activity for a society, thus including the effects of i’s actions on persons j and k in the example. If the social costs of an economic activity are higher than the private costs, we have a negative externality. If the social benefits are higher

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20 than the private benefits, there are positive externalities (Pigou, 1920).

With respect to natural resources, negative externalities often occur in the form of pollution or the (over)exploitation of ecosystems. Ecosystems are usually beneficial to more stakeholders than the ones conducting the activity that causes the pollution or leads to exploitation (Tietenberg, 1974). In the example in Figure 4 this is expressed as the level of exploitation. If the producer of timber in Figure 4 has the power to maximize his own utility, the level of exploitation of the ecosystem will exceed the level of exploitation that is optimal for the stakeholders that benefit from the other two ecosystem services (hiking and cultural heritage). Because of the negative effects of timber production on the quality of the forest, the actions of the logging company will have a negative impact on the wellbeing of stakeholders that come to hike or attach spiritual values to the forest.

On the other hand, economic activity can also cause positive externalities through impacts on the natural environment (Varian, 2010). Consider a beekeeper that operates a honey factory. The beekeeper uses the bee colonies as a production factor in his production process and therefore optimizes the amount of bees he keeps in order to optimize his own production. The neighbouring farmer depends on the beekeeper for the pollination of his crops. If the farmer benefits from an increase in beekeeping activities, the benefits of the farmer and the beekeeper (social benefits) are higher compared to the activities of the beekeeper alone (private benefits). The GDP does take the private value of natural resources for our production processes into account. Externalities, however, are not accounted for since these are not part of existing money flows. Externalities are values that only become visible as a financial flow if the market failure that causes the externality is solved. This can either be done by government institutions by taxing or subsidizing negative and positive externalities, or by private arrangements between stakeholders. For example, the farmer can pay the beekeeper for its services. As GDP calculations make use of records of transactions that have already taken place, GDP does not identify the potential level of social welfare if market failures were to be solved.

3.5.3

Free access and the tragedy of the commons

Many ecosystems can be characterized as semi-public goods: goods that are freely accessible to users, but of which the use of that good is rival to other users. Environmental goods and services used in production processes are often freely available. Furthermore, users can often not be excluded from using environmental resources. Examples of such natural resources are fish stocks or farmers that depend on non-commercial bee colonies that pollinate crops for agricultural production. The free access to the natural resources means that by definition these are not accounted for as inputs in production processes. Only part of the natural production inputs are reflected in the aggregate indicators for production that are used to calculate the national accounts, which results from the fact that natural assets are not fully observable by policymakers.

Combine this free access to resources with the assumed intention of economic agents within a society to maximize the private production that they derive from their production inputs and the so-called “tragedy of the commons” is born (Hardin, 1968). According to this theory, there is a difference between the privately and socially optimal use of a resource. The rationale behind the theory is that society benefits if all economic agents make use the natural resource in a sustainable manner (the socially optimal situation in which the marginal social costs equal the marginal social benefits of exploitation). In the socially optimal situation, however, private marginal costs of exploitation are lower than the private marginal benefits, thereby providing

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21 an incentive for individual users to exploit more of the resource than is socially optimal.

The classical example of the “tragedy of the commons” involves a common grazing area on which two farmers feed their cattle. The story can be analysed by using the framework of a prisoner’s dilemma (Figure 5). If the two farmers use the commons intensively to feed their cattle, the grassland will be destroyed and will not recover sufficiently, which is an unfavourable result for both farmers. In the fictional example in Figure 5, both farmers earn 5. If the two farmers decide to limit the grazing of their cattle on the commons, the grazing area will remain intact, which would lead to the maximum aggregate production for both farmers (8 for each farmer). However, there is an incentive for both farmers to deviate from the socially optimal outcome, because overgrazing by just one farmer increases the profits for the farmer who deviates. The profits for the other farmer, however, decrease as the quality of the commons deteriorates and his personal use is still not intensive. Now, the deviating farmer earns 10, while the sustainable user earns 3. Intensive use of the commons therefore becomes a dominant strategy (Gibbons, 1992) for both farmers. This means that no matter what the other farmer chooses, intensive use yields the highest individual profits. A Nash-equilibrium is reached where both farmers decide on the intensive use of the common resource and degrade the farmland; the situation where they both earn five (encircled). The societal welfare in the situation where both farmers use the commons sustainably (8 + 8 =16) exceeds the welfare in the equilibrium (5 + 5 = 10). Unregulated public goods are therefore likely to contribute less to wellbeing than regulated public goods. A prisoner’s dilemma of this sort might in practice prove to be relatively easily manageable as the farmers might commit to agreements that can even have juridical consequences. However, the more farmers start using the farmland, the harder it becomes to reach these agreements. Ostrom (2000) provides several reasons that indicate that an unstable composition of the group of users will lead to a lower probability of successful management of the resource. She also mentions that empirical research demonstrates that increased competition is more likely to lead to a situation such as the tragedy of the commons. Also a lack of information leads to a higher probability that public goods will be managed unsustainably: a lack of information makes (self)regulation more difficult. Effective indicators that reflect the state and trends of natural resources can therefore prove to be supportive of sustainable outcomes in the situations such as the tragedy of the

commons.

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3.6

Complementary indicators to GDP

The issue of externalities is strongly related to the common pool resources that lead to overexploitation: the incentive to deviate from socially optimal behaviour to maximize personal gains. Classical economists, starting with Pigou (1920), have argued that the incentive to deviate from socially optimal behaviour can only be compensated through governmental interference. Options to intervene include taxes, subsidies or juridical consequences that mime respectively the externalities of ones actions that are not incorporated by the individual actors. Due to intervention, the externalities are internalized in the utility function that individuals maximize:

(5) 𝑌! = 𝑈!(𝑋!, 𝑋!, 𝑋!, 𝑇!, 𝑇!)

In this function 𝑇!and 𝑇! represent governmental interventions that equal the externalities of the actions of individual i on individuals j and k. The downside of these interventions is the fact that administrative costs are involved. These costs are partly caused by investigating what the quantity of the externalities is. The more difficult it is to assess the externalities, the higher the costs. Since many of the environmental goods and services are not traded in markets and are therefore not incorporated by accounting systems and the GDP, it is hard to determine the impact of the externalities and the appropriate level of intervention (Tietenberg, 1974). Ostrom (2000), on the other hand, argues that empirical evidence demonstrates the possibility of communal behaviour that regulates the use of (semi-)public goods. Her research supports that communities are often very capable of regulating their common pool resources and that governmental intervention might even result in stress within the self-regulating system. Self-regulating systems are usually built on trust between stakeholders that has evolved over generations. Intervention can create uncertainty and thereby threaten the basis self-regulation.

She distinguishes between different types of people: rational egoists, who only maximize their own utility; conditional co- operators, who cooperate until they encounter rational egoists; and unconditional co- operators, who cooperate no matter what the others do. According to the Ostrom (2000), the largest part of the common resource users initially tends to incorporate the utility of others in their decisions and cooperate. Over time they might learn to apply a punishment system in which rational egoists are forced to do so as well. She argues that this is supported by genetic and evolutionary research that indicates that there might be an evolutionary benefit for cooperative behaviour.

Cooperation is largely based on trust between different actors that make use of the same natural resource. Trust that is facilitated by personal interaction and steady circumstances within the community that self-regulates the resource (Ostrom, 1990). This suggests that as the group of users becomes larger, interaction between the users will become less frequent, thereby decreasing the probability that self-regulation will become successful. Ostrom therefore advocates a decentralized environmental management system. Environmental resources, however, vary in size and geographical extent. Some ecosystems (such as a small lake) are benefitting a small community and are therefore more easily self-regulated. Larger ecosystems that benefit people across borders and can require the cooperation of billions of people (climate regulation for instance).

Increasing information about the other agent’s actions will according to Güth and Kliemt (1998) lead to more cooperation. Information about behavior of others can be provided through insight the use of environmental resources and the presence of environmental externalities. Also for governmental intervention this information

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23 seems to be important, as quantitative information about externalities leads to more efficient determination of the socially optimal outcome of resource use. As discussed in section 3.5, GDP and its underlying accounting system fail to provide the information needed to assess externalities and market failure in the allocation of public goods. Additional indicators are therefore complementary to GDP and might guide policymakers to reach higher levels of societal wellbeing.

3.7

Do the green economy indicators provide accurate information to

compensate for the shortcomings of the GDP?

Following the United Nations Rio +20 Conference on Sustainable development, various international organisations and governments adopted the concept of “green economy” (albeit not entirely similar). UNEP initially defined green growth as “an increase in human wellbeing and social equity, while significantly decreasing environmental risks and ecological scarcities” (UNEP, 2011a). The OECD defined it as economic growth that does not compromise the important natural resources and environmental services that contribute to our wellbeing (OECD, 2011). Both definitions imply that environmental externalities should be incorporated in decision-making and that environmental resources as public goods should be regulated. However, both definitions are particularly vague on the ecological boundaries of economic development. A later document published by the Green Growth Knowledge Platform (2013) identifies at least 8 different definitions for green growth that seem to be a rephrase of the definition for sustainable development. Based on these the initial definitions of UNEP and OECD can be slightly adapted to the following definition for green economic development: an increase in wellbeing, within the carrying capacity of the planetary boundaries of the planet.

The last definition clearly aligns with the shortcomings of our national accounts that were discussed earlier in this chapter: 1) Measuring wellbeing instead of wealth as measured by the GDP. 2) Making sure that the level of wellbeing will be sustained in the future. 3) Incorporating environmental externalities in decision-making. This can be done by assessing and monitoring the stocks of our natural resources and measuring the threats to these natural resources. This also suggests that a single indicator will not be sufficient to measure sustainable development. As a matter of fact, it suggests that we at least need two types of indicators: indicators for wellbeing, and indicators that measure the state of our natural resources. Various initiatives do provide a specific set of indicators to measure green growth including environmental determinants of wellbeing. It is because of this more specific practical application of the green growth concept, that various governments and international organizations adopted the concept as a substitute for sustainable development (Jacobs, 2012). Although these indicator sets specify indicators in the domains of various constituents of wellbeing, we will focus on the indicators regarding the natural environment. Table 1 provides an overview of the categories of different indicators that are used by the leading international organizations that promote green growth indicators (Slingerland et al. 2014). Based on table 1 it appears that the shortcomings of traditional indicators are addressed. By assessing the value of ecosystem services, both marketed and non- marketed goods and services that contribute to wellbeing are evaluated. This complements the GDP as also non-marketed ecosystem services are recorded. By assessing the status of physical resource stocks and the threats to these resources, information is provided on the status of environmental public goods and environmental externalities. This information can be used for effective management by authorities or communities in charge of managing these public goods and regulating markets that face externalities.

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24 Table 1 Environmental indicators included in various green economy indicator sets (source: Slingerland et al. 2014)

SEEA4 UNEP OECD (2014)

GGGI5 GGKP (2013)

Ecosystem services

Value of ecosystem services Resource stocks Resource use Biodiversity Ecological footprint Environmental threats GHG emissions Waste production

Measuring wellbeing through green economy indicators enables to incorporate environmental externalities and public goods better into policy processes. It also enables to specify more carefully what kind of development we aim to achieve. Our definition of green economic development implies that wellbeing should increase, while the use of natural resources remains the same. This means that our indicators for wealth (GDP and the value of ecosystem services) increase, while natural resource stocks do not deplete and environmental threats decrease or remain the same. Slingerland et al. (2014) state that this indicates the level of “decoupling” between our wellbeing and the use of natural resources. This would mean that our production process would have to depend for a larger extent on the other production factors than natural resources. UNEP and the OECD refer to this form of development as green growth. In the next chapter, the concept of green growth will be assessed and the possibility of decoupling between wellbeing and the use of our natural capital will be discussed.

4

System of Environmental Economic Accounting, standard environmental accounting used by the World Bank and the United Nations

5

Global Green Growth Institute, an international organization of which various stakeholders and countries are members (http://gggi.org/about-gggi/background/organizational-overview/)

Measuring the transition towards a green economy : indicators to measure environmentally sustainable development of wellbeing