University of Amsterdam
Faculty of Economics and Business
Bachelor’s Thesis and Thesis Seminar Economics, size 12 EC,
Conducted between April 1
stand June 27
th2017
A literature review on recent developments in economic
internalization techniques.
An overview of three different European monetary valuation methods and evaluations.
Author: Course Director:
Derek ter Haar Dhr. Dr. D.F. Damsma Student number: Supervisor: 10576622 Dhr. Junze Sun
Abstract
This literature review looks at the current trends in economic internalization techniques. First, the theory of externalities is explained, and the relevance of the need to internalize externalities is shown. The economic instruments to tackle externalities are presented, and three different European monetary valuation methods are extensively discussed. The EPS 2000, Stepwise 2006, and Ecotax method are analyzed and evaluated by a selection of appropriate criteria on their strengths and weaknesses. This overview clearly illustrates the differences in their methodological approaches. To strengthen the paper’s argument, a case study is used to clarify the main differences of the three monetary valuation methods. This literature review attempts to provide the reader with a clear view of the recent developments in internalizing
externalities in theory and practice.
Table of Content 1 Introduction
1.1 Externalities 1
1.2 Relevance 2
1.3 Internalization 3
1.4 Differences in economic instruments 4
1.5 Structure of the paper 5
2 Literature Review 2.1 The design of and implementation of environmental policies 6
2.1.1 Command and Control regulation 6
2.2 Monetary valuation of environmental costs 7
2.3 Introduction of valuation methods 7
2.3.1 EPS 2000 8
2.3.2 Stepwise 2006 9
2.3.3 Ecotax 10
2.4 Evaluation of the three valuation methods 12
2.4.1 Challenges 12
2.4.2 Approaches and definitions 13
2.4.3 Selection criteria 14
2.4.4 Strengths and weaknesses analysis 15
2.4.5 Selection criteria analysis 16
2.5 Overview and scores of the three methods 17
3 Implementation of the three monetary valuation models: Case study 3.1 Introduction of the study case 18
3.2 Case study structure 18
3.3 Score per method 19
3.3.1 EPS 2000 20
3.3.2 Stepwise 2006 20
3.3.3 Ecotax 20
3.4 Analysis and Evaluation of scores per method 23
3.5 Scores connected with tax per method 24
4 Conclusion 25
5 Discussion 26
Statement of Originality
This document is written by Student Derek ter Haar 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.
1 Introduction
The European Commission developed the 7th Environment Action Program in January 2014, which sets out a long-term sustainability vision for the
economy. The program states, “In 2050, we live well, within the planet’s ecological limits. Our prosperity and healthy environment stem from an innovative, circular economy where nothing is wasted and where natural resources are managed sustainably, and biodiversity is protected, valued and restored in ways that enhance our society’s resilience. Our low-carbon growth has long been decoupled from resource use, setting the pace for a safe and sustainable global society” (European Commission, 2016).
1.1 Externalities
This literature review looks at a particular market failure that, if rectified, will contribute to the long-term vision of the European Commission. There are six major market failures according to Siglitz and Rosengard (2000) and Nguyen, Laratte, Guillaume, & Hua (2016): imperfect competition, incomplete markets, public goods, imperfect information, unemployment, and
externalities. This literature review focuses on the market failure of externalities. The theoretical background is explained in subsequent paragraphs.
First, what is externality and where did it originate? In 1920, the British economist Arthur C. Pigou wrote the book The economics of welfare, in which he examined the costs and benefits of economic activities beyond their direct impacts. Pigou argued that the free market often fails to provide adequate incentives to eliminate the negative or positive consequences of economic activities. Later, in the 1960s, the neoclassical welfare economic view of environmental economics emerged, whose economic theories were built around a main pillar that stressed the importance of ecosystems and their value to the economy. This laid the foundation for the origin of externality. An externality is a consequence of an economic activity experienced by unrelated third parties. Externalities occur in an economy where production or consumption of a certain good affects other parties that are not directly related to the consumption or production of that good. Essentially an
externality is the misalignment between individual and social costs/benefits. Externalities can be positive or negative, and almost all externalities are technical or environmental externalities (Piecyk, McKinnon, & Allen, 2010).
1.2 Relevance
Why is the misalignment between individual and social interests problematic? The effects of not including the “true price” of products can be devastating to ecosystems and society. The true price is established when the individual and social costs related to a product are equal. An example will clarify this market failure.
Consider the example of palm oil production. Palm oil is widely used in the production of cosmetic and food products. A total of 47% of the world’s palm oil is produced in Malaysia (Sumathi, Chai, & Mohamed, 2008). The demand for palm oil is rising, according to Sumathi et al. (2008). The sale of palm oil and the rising demand for it are leading to deforestation in Malaysia. In fact, Malaysia has the highest deforestation rate, 14.4%, in the world (Rhett, 2013). The process of cultivating forests for palm oil production is leading to multiple negative external effects: loss of biodiversity, habitat loss for animals, air pollution, contribution to climate change, and soil erosion (Sumathi et al., 2008). The rainforest in Malaysia is an essential ecosystem for the world. Therefore, the indirect external effects of the consumption of palm oil are causing severe problems, which have not been accounted for in the price of palm oil. It is in the interest of society and the environment to deal with these negative externalities, but individual producers think differently. They act according to individual maximizing utility behavior. This example illustrates the misalignment between individual and social interests and their related costs.
According to Nguyen et al. (2016), there is a need for economic institutions to address the problems of externalities properly and to preserve the environment. A part of the externality theory requires economic agents to “internalize” (negative) externalities to balance the true costs of producing a specific product (Piecyk et al., 2010).
The failure to account for the actual environmental costs associated with economic activities that have a negative effect on society indicates the importance of internalization. Internalization refers to regulation aiming to correct all misalignments between individual and social interests to achieve efficient resource allocation (Piecyk et al., 2010). Figure 1 illustrates these misalignments, and they will be thoroughly explained in the next section. Economists and environmental pressure groups have campaigned for many years for full internalization of external costs. They have argued that, in the absence of such internalization, markets will be distorted to the further detriment to the environment, sometimes in irreversible ways (Binder, & Neumayer, 2005). The European Commission aims to ensure that all external damage caused by business and private economic activities is accounted for in
a “fair and efficient pricing” model. It argues that pricing should be fair, meaning that “polluters” should be obligated to pay the marginal social costs, thus giving them the economic incentive to reduce the negative effects of their activities (European Commission, 2016).
Cropper and Oates (1992) point out that independent adjustment is needed to tackle externalities and move to a Nash equilibrium (see Figure 1). As Cropper and Oates stated, “this is a Pigouvian cure for the externality malady”. The “polluter pays principle” is central to Cropper and Oates their ‘cure’ for externalities.
1.3 Internalization
The way to resolve externalities is to internalize externalities. Internalization of externalities is thus a part of this environmental economic theory, and ultimately, all internalization methods aim to determine people’s preferences expressed through their willingness to pay (WTP) for environmental goods and services (Söderholm, 2003). People’s preferences can be identified by using monetary valuation techniques. Monetary valuation is strictly related to the concept of externalities in welfare economics. Moreover, to assign monetary values to external side effects is difficult (Pizzol, Weidema, Brandão, & Osset, 2015). Monetary valuation refers to quantitatively evaluating social impact in terms of monetary units of environmental activities. It is a method used to find the true price of a product. True cost accounting is a difficult activity according to Cropper and Oates (1992) because an interdisciplinary approach is needed in complex situations.
Different instruments are used to internalize externalities. However, the core aim of all these instruments is to confront polluting agents with a price that equals the marginal external costs of their contaminating activities. Consequently, they are forced to internalize the total social costs of their activities. In essence, the marginal individual cost and benefit curves should equal the social optimal cost and benefit curves. To set the right instrumental policy, policy makers should give individuals an economic incentive to
maximize their utility behavior that equals the social optimum utility (point p2;x2 in Figure 1) (see Figure 1; Nicholson, & Snyder, 2011).
Figure 1: Graphic analysis of an externality (figure 19.1) (Nicholson, & Snyder, 2011).
1.4 Differences in economic instruments
According to Cropper and Oates, there are three possible instruments to control externalities: effluent fees (unit tax), unit subsidies, and marketable emission permits. It depends which instruments works best regarding which agent the environmental authority (government) wants to address.
Policy instruments tend to have different implications for the
mechanism and profitability of the production in a polluting sector. Subsidies tend to increase profits, while taxes decrease them. In short, the subsidy approach shifts the industry supply curve to the right and ultimately results in a higher industry output and higher number of firms. A Pigouvian tax, however, tends to shift the industry supply curve to the left, resulting in a lower output (from x1 to x2) and a higher price (from p1 to p2) in the polluting industry (Figure 1). Therefore, the subsidy approach has the consequence of increasing the total quantity of the polluting sector. In sum, a unit subsidy does not entirely satisfy the requirements for an alternative approach to the Pigouvian tax approach according to Cropper and Oates (1992).
In a complete information situation, marketable emission permits are in principle a fully competitive alternative to an effluent fee. The government
(i.e. an environmental authority) can issue emission permits equal to an efficient quantity of emissions and allow firms to bid on those permits. Then, the market can sort out the most efficient outcome where the technology in a sector is most effective in dealing with abatement strategies (Cropper & Oates, 1992,). The regulator can set both the “price” and “quantity” to achieve the preferred results. Regardless of the equivalence between marketable emission permits and effluent fee, the assumption that perfect knowledge is available is rarely satisfied in reality. Especially when the exact abatement costs of environmental damage is not known. In theory, when the costs of polluting activities are uncertain, the instrumental policy (tax or permit) depends on the relative steepness of the marginal benefit and cost curves. A combination of permits and taxes can, in the setting of imperfect information, provide larger welfare gain than the approach of relying on one of the policy instruments (Cropper & Oates, 1992). Economic instruments play a vital role in incentivizing agencies to acquire information on the polluting costs of individual activities.
1.5 Structure of the paper
Now that the theory of externalities has been explained, the goal of this literature review is to give insights into three European monetary valuation methods and their implementation in the energy sector. This paper does not focus on coming up with a decision-making scheme of potential polices but on conducting a comprehensive practical analysis on three monetary valuation methods, which is essential in internalizing externalities.
The remainder of the paper is organized as follows. Section 2
introduces and discusses three monetary valuation techniques and compares their performances in various aspects. Section 3 explains the differences in the three monetary valuation methods in practice in the energy sector through a case study done by Nguyen, Hermansen, and Mogensen (2013). The focus is on the structure and implementation of realistic measures for environmental management. Section 4 concludes the paper, and section 5 discusses
2 Literature review
2.1 The design and implementation of environmental policies As indicated in the previous section, externalities are most often not taken into account in policy measurements. Internalization aims to correct this misalignment by adjusting the price of economic activities according to the proportion of all the relevant environmental and social costs (Piecyk et al., 2010). When internalizing, placing an appropriate value on the external costs associated with a polluting activity is fundamental in the theory of
externalities (Beuthe, Degrandsart, Geerts, & Jourquin, 2002). 2.1.1 Command and Control regulation
Command and Control (CAC) regulation can be expressed as the direct regulation of an industry or an economic activity by legislation that states what is acceptable and permitted (Baldwin, Cave, & Lodge, 2012). Besides its great applications in other fields of research, it forms the basis for most of the European environmental policy-making developments.
CAC covers a variety of methods, with the goal being to influence economic behavior through incentives, threats, laws, contracts and social agreements. The CAC approach relies on the use of standards to ensure that improvements in the quality of the environment will be sustained. The government (i.e. environmental institutions) sets a “command.” In other words, it sets conditions for reducing polluting activities. Now, a difficult task is evaluating the environmental costs of certain polluting activities (monetary valuation). After this is done, the installation of the right emission levels or taxes must be done. In other words, the “control” factor needs to be installed. Finally, the right institutes to regulate the measurements that have been put in place by the environmental authority need to be addressed. The CAC method is characterized by three different types of standards (Baldwin et al., 2012).
Environmental standards: They determine the centralized goals that are the basis of the measurements. They define the acceptability of environmental degradation and balance it with economic welfare objectives.
Target standards: Central in this standard is the condition of the environment into which a pollutant enters. It can be divided into two standards: ambient and receptor standards. The ambient standard
establishes a set of targets that are allocated to the policy makers and regulators, and the receptor standards describe what specific maximum should not be exceeded.
Performance standards: This standard determines the specific assigned acceptability of contamination of a pollutant.
2.2 Monetary valuation of environmental costs
This paper will focus on a combination of the first two standards of the CAC approach. However, it will not provide a decision-making framework for internalizing policies. Internalization aims to adjust the price of economic activities according to the proportion of all relevant environmental social costs. Additionally, when setting the right internalizing environmental policies, all costs must be quantified. Monetary valuation methods aim to quantify all relevant external social environmental costs. Thus, all
environmental policies are based on monetary valuation methods. These methods are the essence of all environmental policies. Thus, the core aim of this paper is to examine different monetary valuation methods used in
practice in environmental economics. There are multiple valuation approaches to attaching monetary values to environmental externalities. In the
monetizing process of valuating environmental impacts, the difficult part is determining what is important. In section 2.3, different methods are explored, and after every method is discussed, a comparison analysis is conducted to show the main differences in the effectiveness of the methods (section 2.4 and 2.5). Finally, a case study shows how the implementation of the three
different valuation methods is done in the energy sector and what the main differences between them are (section 3).
2.3 Introduction of monetary valuation methods
Monetary valuation methods try to address the problem of imperfect information and thus equal the marginal individual and social costs curves. Because the European Commission emphasized the need to implement internalization techniques in 1995, multiple approaches were developed in environmental economics (Piecyk et al., 2015). The ExternE methodology, funded by the European Commission, was one of the first. The ExternE method is a “green accounting framework” that aims to cover the full cause-to-effect chain from burdens or emission to environmental damage and impact (Krewitt, 2002). However, according to Krewitt (2002), this method is
relatively outdated. For that reason, this paper will analyze and compare three more recent European monetization models: EPS 2000 (Steen, 1999),
Stepwise 2006 (Weidema, 2009), and Ecotax (Finnveden et al., 2006). An explanation of the concepts behinds the methods and of their measurement approaches will provide good insight into the main components of the methods.
2.3.1 EPS 2000
The present version of the Environmental Priorities Strategies 2000, or EPS 2000, method was developed by the Centre for the Environmental Assessment of Products and Material Systems (Steen, 1999). This model concentrates on the whole product process, from “cradle to grave.” The EPS valuation method is designed to address comparisons of environmental impacts amongst product developments. The EPS method is incorporated into the SimaPro software1. EPS uses a top-down principle to assign priority ranks to the effectiveness of an environmental impact and is based on the endpoint principle2 (Nguyen et al, 2016). Besides the top-down principle, two other principles are the basis of the EPS system. The default principle, an operative method, is necessary to recommend how to proceed in the EPS valuation method, and the uncertainty principle estimates the uncertainty of input data on a scale of 0 to 10 (Nguyen et al, 2016; Steen, 1999). There are three methods used in the EPS model: namely, market price, contingent valuation, and the abatement method. In the evaluation section (2.4), these will be elaborated (Pizzol et al., 2015).
As illustrated in Table 1, the EPS system applies inventory data, characterization, and weighting factors to calculate the external costs of products per damage category (Nguyen et al, 2016). In the EPS 2000 method, monetary weighting factors are characterized by impact categories. Impact categories consist of four key damage classifications: human health, ecosystem production capacity, abiotic stock resources, and biodiversity (Steen, 1999). Contaminations to these key damage classifications are evaluated on a
monetary basis based on the WTP principle to prevent changes to the current condition of the environment (Nguyen et al, 2016). The EPS 2000 method does not include discount rates but uses the marginal effects of input factors to assess potential harm to the environment. The model is intended to improve the environmental performance of products, and thus it focuses on the utility perspective of a product developer (Steen, 1999).
1 SimaPro software is a professional tool used to collect, analyze, calculate, and
monitor sustainable performance data.
2 The endpoint principle represents complex processes affecting a specific target
Table 1: EPS 2000 monetary weighting factors (Nguyen et al, 2016; Steen, 1999).
2.3.2 Stepwise 2006
The Stepwise method uses a new approach to monetization that avoids some of the problems of the earlier practicability of cost-benefit analysis and aims to reduce previously encountered incompleteness and high uncertainties in relation to the monetization of environmental impacts (Weidema, 2009). Stepwise 2006 combines the best-performing characterization models from two previous life cycle impact assessment methods, EIDP 2003 and IMPACT 2002. These methods were themselves built on previous work (Ecoindicator 1999 and EDIP 1997, respectively). These two pillar methods are used to calculate characterized results at midpoint level3 for category impacts and one monetary unit expressed in a single score. Stepwise 2000 method has been incorporated in the SimaPro software. Weidema has grouped the results into three damage categories: ecosystem quality, human health, and resource productivity (Weidema, 2009). The physical scores have been redefined in units of quality adjusted life years (QALY) and biodiversity adjusted hectare years (BAHY), which are aggregated into a single score characterized by a EUR unit. QALY measures the impact on human well-being, whereas BAHY measures the impact on nature and monetary units for influences in economic production (Nguyen et al., 2016). The monetary value of QALY is limited by an upper budget constraint, which illustrates the maximum average annual income that an average person can pay for an additional life year. The annual economic production per capita is determined to be 74.000 EUR2003, with an uncertainty gap of 62.000 to 84.000 EUR2003 (Weidema, 2009). This monetary value corresponds well to the WTP of an estimate regarding the ExternE project. The monetary value for ecosystem quality is defined as a marginal fraction of human well-being—or, in other words, what people are willing to
3 Midpoints are considered to be linked in the cause-effect chain (environmental
mechanism) of an impact category from which characterization factors or indicators can be derived to reflect the relative importance of emissions (Bare et al, 2000).
sacrifice to protect the ecosystem. All physical impacts can be expressed in a single score. In line with a modeling study (Itsubo, Sakagami, Washida, Kokubu, & Inaba, 2004) the temporary proxy value of 1400 EUR/BAHY was calculated, with an uncertainty gap of 350 to 3500 EUR/BAHY (Weidema, 2009). Table 2 summarizes the monetary weighting factors for midpoint impacts categories and single scores in the Stepwise 2006 method.
Table 2: Stepwise 2006 weighting factors for midpoint impact categories expressed in damage scores in three damage categories and aggregated into a single score (Pizzol et al., 2015; Weidema, 2009).
2.3.3 Ecotax
The Ecotax is another European monetary valuation method, and it is based on weighted factors that are derived from taxes (fees) on emissions and resource use in Sweden. Johansson developed this valuation method in 1999. Finnveden updated it in 2006. In theory, the tax level should be optimally based on government objectives. The Ecotax should reflect the social value per unit of environmental intervention (Nguyen et al, 2016). The Ecotax method uses a mid- and endpoint approach in most cases. The development of the Ecotax method consists of three principal steps, according to Eldh,
Johansson, and Finnveden (2006):
1) Choice of impact categories: Taxes are used as weighting factors to weigh different impact categories against each other. The Dutch guideline on Life Cycle Assessment (LCA) (Guinée, 2002) is used as a baseline to implement the SimaPro software (Ecotax is not
implemented in the SimaPro software). Apart from resource analysis, a thermodynamic approach is used as well (Finnveden & Ostlund, 1997). 2) Identification of suitable taxes and fees: A list of environmental taxes
and fees can be found in the Swedish environmental protection agency’s publication (Naturvårdsverket, 2001). The tax and fees are set through comparative studies in terms of tax structure, revenues, base, etc. (SCB, 2000).
3) Connecting taxes and impact categories: This step requires connecting taxes to the right impacts. For some cases, there is a direct connection. Meanwhile, some taxes are a part of multiple impact categories, and to allocate the right tax to the right impact, a technical recalculation is needed. Finnveden has extensively explained this in his paper (2006). The Ecotax method is constructed on the WTP principle, which represents the political value of WTP as society desire to resolve externalities. Therefore, the method is based on the assumption that individuals reveal their
preferences in market behavior strategies (Eldh et al., 2006). According to Pizzol et al. (2013), this method is called the averting behavior method and will be elaborated in the evaluation section (section 2.4) of this literature review. The Ecotax method uses minimum and maximum values to tackle the problem of imperfect information. In some cases, there is no difference in tax levels due to certainty, but in other cases, there are differences due to a level of uncertainty (Eldh et al., 2006). Table 3 summarizes the weighted factors derived by the Ecotax.
Table 3: Ecotax weighting factors derived from environmental taxes and fees in Sweden. (Pizzol, et al., 2015; Eldh, P., & Johansson, J. 2006).
2.4 Evaluation of the three valuation methods
To evaluate the three monetary valuation methods properly, this research review will (i) compare the various monetary valuation methods in a
methodological and theoretical manner (section 2.4.1 until 2.5) and then (ii) for illustration and further clarification, through a case study, the literature review will show the differences in the monetary valuation techniques in practice (section 3).
2.4.1 Challenges
First, monetizing can be extremely difficult when quantifying ethical manners. Some values are nontradable, and it is a mistake to assume that monetary valuation can attach a monetary value to, for example, human life or
biodiversity in absolute terms. The scope of monetary valuation is limited to estimating the value of marginal changes in the availability of nonmarket goods. If the availability changes, it then concerns both the changes in the amount and quality of that good and the service it provides to society.
Therefore, what is actually measured by the monetary valuation method? The answer is the individual WTP for avoiding the changes (Pizzol et al., 2015).
A challenge in making a comparison between the different applications of monetary valuations affecting quantifications is that some nonmarket values have a high level of abstraction. This means that the impacts do not relate to specific situations but are generalized. This is because of two reasons. First, emissions from different process/activities are combined over space and time. The different methods have different discount rates, and the EPS 2000 does not use discount rates. Thus, the monetary valuation of potential
impacts should be interpreted broadly. The second reason is that the different methods use midpoint and endpoint modeling impacts (Pizzol et al., 2015). Midpoints are considered to be the link in the cause-effect chain
(environmental mechanism) of an impact category, prior to the endpoints, at which characterization factors or indicators can be derived to reflect the relative importance of emissions. Examples of midpoint characterizations factors include climate change, ozone depletion, and acidification, whereas endpoints represent complex processes affecting a specific target like damage to ecosystems or damage to ecosystem services. Accordingly, midpoint impact assessments are usually conducted with a bottom-up approach. They focus on the firm quantitative relation between an emission and its midpoint impact. Meanwhile, the top-down approach stresses the relation of an area protection to its endpoints. In the process of pointing out the differences in monetary valuation methods in the mid- and endpoint approaches, it can be difficult to
conclude which is preferred over the other (Bare, Hofstetter, Pennington, & De Haes, 2000). Because of this complexity, the main focus is on examining what kind of approaches are used in monetary valuation methods. On the basis of this, the next section will specify the exact definitions and
approaches.
2.4.2 Approaches and Definitions
Monetary valuation methods are defined in various versions of the same monetary valuation approach but are based on principles that differ in technical aspects or in practical implementation (Pizzol et al., 2015). For preciseness and clarity, Table 4 will provide the exact definitions of the approaches and methods used in the three different valuation methods. The EPS 2000 model uses the market price, continuing valuation, and abatement costs method. The Stepwise 2006 model uses the budget constraint method for determining the correct value. The Ecotax model uses the averting behavior method as a dominant strategy for monetizing the correct Ecotax. The relevant terminologies are in Table 4. The next section will list the selection criteria for assessing three different monetary valuation methods.
Table 4: Classification and definitions of monetary valuation approaches and methods (Pizzol et al., 2015).
Approach Principle Method Definition
Observed preferences (EPS 2000)
Determining willingness To pay (WTP) in an existing market for a good
Market price A monetary valuation method where the marginal value of a good is identified on the basis of its market price Abatement cost
(EPS 2000)
Determining potential costs for marginal abatement or replacement activity
Abatement cost A cost estimation method where the change in availability of a nonmarket good is assessed in terms of the potential costs of the marginal counter-balancing change (replacement) or marginal measure that prevents the change Stated preferences
(EPS 2000)
Determining WTP in hypothetical markets or trade-off situations
Contingent valuation A stated preference valuation method where the marginal value of a nonmarket good is identified from the stated WTP or compensation is accepted for a specified change in the availability of the good
Budget constraint (Stepwise 2006)
Determining WTP for an additional quality-adjusted life year in a hypothetical situation without externalities
Budget constraint A monetary valuation method where the marginal value of a quality-adjusted life year is identified on the basis of the potential economic production per capita per year
Revealed preferences (Ecotax)
Determining the WTP in surrogate markets
Averting behavior A revealed preference valuation method where the marginal value of a nonmarket good is identified on the basis of the expenses actually made for markets goods that are required to prevent or offset the change in availability of the nonmarket good
2.4.3 Selection criteria
The objective is to formulate a comprehensive set of criteria that analyzes the different valuation methods. Each monetary valuation method is evaluated based on a fixed set of assessment criteria. The selection of criteria is intended to (i) be as comprehensive as possible so that all relevant features are
discussed (for a strengths and weaknesses analysis, see section 2.4.4) and (ii) address issues of general relevance in the critical evaluation of any scientific method (see section 2.4.5) (Pizzol et al., 2015). This set of criteria is
constructed based on two former research questionnaire designs. One is the International Reference Life Cycle Data System Handbook, and the other is a similar assessment of monetary valuation methods papers written by Hoyos (2010) and Nijkamp, Vindigni and Nunes (2008). The list of the main criteria is shown in Table 5. For clarification, the relevant research question behind each of the criteria components is mentioned.
Now that the terminology has been clarified, the next section will evaluate the key features of the monetary valuation methods and underline the strengths and weaknesses of each.
Table 5: Key criteria and related research questions (Pizzol et al., 2015).
Scientific foundation What is the science behind the
development of the method?
Documentation Does the documentation allow for
understanding and reproducing the method?
Completeness What is the overall scientific relevance of
the method?
Uncertainty How are the uncertainties of the method
addressed and described?
Complexity What knowledge is required to apply the
method in practice?
2.4.4 Strengths and Weaknesses analysis of the different methods The EPS 2000 method uses the market price, abatement cost, and contingent valuation methods. In this mixture of strategies, there are some strengths and weaknesses that coexist within the methods. The market price method, for example, avoids uncertainty because it uses directly related measurements instead of indirect measurements. This works well, although the strategy is limited to public goods and the use value of goods for which a market has to exist. This implies that market themselves cause externalities so that prices are influenced by market failure and fluctuate in the short term. Further, market prices are geographically specified, whereas the credibility of the method does not extend to every area or product (Steen, 1999).
Regarding the abatement cost method, the strength of this method is that it can be applied to assess policy targets. Thus, it is a control technique that works quite well. Its main drawback is that it is only partly based on the WTP principle, because it does not value individual utility losses but rather reflects a political WTP. For this reason, the abatement cost method does not refer to a social optimum (Pizzol et al., 2015).
The last method that is extensively used in the EPS 2000 method is the contingent valuation method. This method is suited for well-specified goods. For such goods, it is possible to visualize a hypothetical market, like ecosystem services or a safe drinking water market. The method is based on the WTP principle, and the WTP is determined through interviews (survey) conducted by respondents. If the survey is set up properly, then potential biases in the questionnaire design will be practically eliminated. However, in this assumption lies the major weakness of this method, because if the questionnaire design fails to adequately address respondents, then it could
become the victim of potential bias. If there are complex end points to assess, then the hypothetical market will become statically mediocre and unreliable (Steen, 1999; Hoyos, 2010).
The Stepwise 2006 method uses a unique budget constraint method that expresses the value of human well-being in QALY and impact on the environment in BAHY. In theory, when applying a budget constraint, the uncertainty factor is decreased effectively, but the unique single value that this method provides does not reveal or state the WTP. It provides a number that refers to a WTP based on the accounting principle that what is earned must be spend (Pizzol et al., 2015). Further, the credibility of this single value is dependent on the data used. A small mistake in the calculation can affect the end result quite harshly (Weidema, 2009).
The Ecotax method uses the averting behavior method. This method is used in the valuation of reductions in goods availability (Eldh et al., 2006). This method observes the actual behavior of individuals. If the averting behavior is directly connected to the good, then strong assumptions can be made regarding monetary values. The weakness of this method is that it is dependent on how honestly the respondents answer the questionnaire.
Examples such as self-selection bias or omitted variable bias can emerge when using this method (Pizzol et al., 2015).
2.4.5 Selection criteria analysis
When analyzing the scientific foundation of the various methods, all three monetary valuation methods appear to exist out off a solid scientific framework. All the methods have been peer reviewed and tested against specific hypothesis regarding each method multiple times.
The three methods are well documented and have been published online. In the published reports, the methods are comprehensively elaborated and described in great detail.
When assessing the completeness of the models, the conclusion has to be made that all the methods are rather incomplete. Regarding the
applicability of the methods in every situation, it would be difficult to consistently use them for every product or external effect.
When evaluating uncertainties, the focus is on how to address the quality degree of the uncertainties. The EPS 2000 method attaches an uncertainty quality indicator (on a scale of 0 to 10) to every statistical external effect. The Ecotax method uses the averting behavior method and determines the quality of uncertainty by assigning a minimum or maximum
tax (emission) level to an impact category. Stepwise 2006 is characterized by a single score assigned to each impact category. Because of that single score, an uncertainty gap can be estimated.
It is difficult to evaluate the differences in complexity between the monetary valuation methods because every method contains complex parts. The methods allocate weighting factors differently and the determine impact categories differently.
2.5 Overview and scores of the three methods
To clarify the above-mentioned selection criteria, Table 6 will summarize the key scores of the methods in the different selection criteria. This table is based on Pizzol et al. (2015). For further elaboration of this table, a 5-point
evaluation scale is applied where (1) stands for no compliance, (2) for little compliance, (3) for compliance in some aspects, (4) for compliance in the essential aspects, and (5) for full compliance. This evaluation table does not include an overall score for the three monetary evaluation methods but highlights the characteristic scores of the selection criteria because a single overall score per method would not reflect a meaningful value. The three methods excel differently; therefore, it is too difficult to evaluate them using a single score.
Table 6: Overview and scores of the three monetary valuation models (Pizzol et al., 2015). Model Reference Approach Method Scientific
foundation
Documentation Completeness Uncertainty Complexity EPS 2000 (Steen, 1999) Mixture Market price, Contingent valuation, Abatement costs 3.00 4.70 3.92 3.75 4.00 Stepwise 2006 (Weidema,
2009) Budget constraint Budget constraint 4.50 4.80 4.08 3.50 4.40
Ecotax (Eldh, Johansson, and Finnveden 2006) Revealed preferences Averting behavior 3.67 4.20 3.17 2.63 4.40
3 Implementation of the three monetary valuation
methods: Case study
3.1 Introduction of the case study
This section will illustrate how environmental externalities, evaluated by the three monetary valuation methods, are internalized through a case study. The three European methods: EPS 2000 (Steen, 1999), Stepwise 2006 (Weidema, 2009), and Ecotax (Eldh et al., 2006) will be applied to environmental
externalities of electricity from both nonrenewable and renewable sources. For nonrenewable sources, oil, gas and coal will be examined by the three
methods, and for renewable sources, biomass will be examined. Nguyen et al. (2013) did the case study. For further elaboration on the tables and
calculations, reviewing Nguyen et al (2013) would be advisable.
The purpose of this section is to amplify the differences in the three valuation methods through a clear research design and implementation of the three methods in practice. Moreover, the methodological evaluation done in section 2 will become clearer in this section. Please note that this literature review will not provide a decision-making advice strategy for any of these methods. The structure of this section is as follows: first, the case study on environmental externalities of electricity will be discussed; second, the three monetary valuation methods will be applied to the case, and the scores will give a comprehensive illustration of each method; and third, the scores will be converted to a Pigouvian tax, and the results for each method will be
evaluated.
3.2 Case study structure
This section will be short but explicit. The goal is to analyze the three
methods instead of the research design of the study case. The objective of the study was to illustrate the performance of energy sources for electricity when evaluated by the three valuation methods. The internalization of externalities was examined by quantifying environmental costs and benefits for renewable (e.g., biomass) and nonrenewable (e.g., coal, gas and oil) energy sources.
A brief summary of the renewable energy sources will be given to explain the production process of biomass. The input for the biomass source is straw, which is a by-product of cereal production, and by incinerating it, electricity is produced. An advantage of using crop residuals (e.g. straw) as an energy source is that there is no land competition because no agricultural land is involved in the production process. The production process consists of three
steps: straw removal, straw collection and pre-processing, and straw
combustion in combined heat and power plant (Nguyen et al., 2016). In this biomass-to-energy chain, there are some activities that contaminate the environment, but when compared to conventional fossil fuels, these are
relatively low. This will be clear when analyzing the energy sources according to the valuation methods in the case study.
In the quantifying process of attaching monetary values to the
polluting activities, the SimaPro software is used4. As a result, all quantified monetary values derived from the different methods are found significantly appropriate for analysis and comparison (Nguyen et al., 2013). In this case study, all the weighted scores are measured in EUR/MWh. This way, the data can be converted into a single score. Thus, a Pigouvian tax can be extracted from all the measurements done. Note that the case study was conducted in Denmark, where biomass plants have become quite competitive towards fossil fuel plants. According to Nguyen et al. (2016), this is beneficial for this research because fair comparisons can be made when geographical factors play a role. Again, for further clarification and exact approaches, review the case study done Nguyen et al. (2013).
3.3 Score per method
The key results per valuation method are summarized in this section. For each method, the construction of the figures is explained, and the main features are put forward. Using weighting factors, single scores per impact category are derived for nonrenewable energy sources. This is also done for three possible biomass scenarios to decide which scenario scores best for the interpretation of the scores (see section 3.4). All impact categories are summed up in a single score, and in this way, a Pigouvian tax is attached to each method.
3.3.1 EPS 2000
When interpreting the EPS weighted scores depicted in Table 7, it is found that straw biomass has the lowest external costs compared with the three
4 SimaPro software is a professional tool to collect, analyze, calculate and monitor sustainable performance data. The methods EPS 2000 and Stepwise 2006 are implemented within the SimaPro software. However, the Ecotax method is not. Therefore as an attempt to monetize environmental externalities based on the Ecotax method, the case study used the CML 2002 baseline characterization method
(Guinée, 2002) to calculate the midpoint impacts in order to multiply them with weighting factors, min and max values.
nonrenewable energy sources. Observing the nonrenewable energy sources, coal scores the best, closely followed by oil, and the highest score is for natural gas when calculating the external costs. The explanation for the high score for natural gas in the EPS method lies in the fact that the impact of “abiotic stock resource depletion” is of great importance in the method. The EPS 2000 method considers natural gas more valuable in comparison with oil and coal because higher costs are associated with producing “biogas” than with producing vegetable oil or charcoal on a per kg basis (Nguyen, T. et al., 2016). The reason for this is that the value of “abiotic recourses” is set equal to the sum of the total WTP for impacts from emissions from the use of resources and the direct costs of producing renewable alternatives (e.g. vegetable oil, rapeseed oil, biogas, charcoal as substitutions for fossil fuels) (Steen, 1999). Furthermore, the human health impact factor scores relatively high in all energy sources.
3.3.2 Stepwise 2006
The results of the Stepwise method (Table 8) reveal another ranking score compared with the EPS 2000 method. Natural gas scores significantly
different. Natural gas scores better in the summed single score than two other alternatives in the straw biomass scenarios. This large disagreement originates from the weighting factor given to the depletion of fossil fuels in the Stepwise methods. Stepwise assigns a weighting factor of zero to that impact category, whereas the EPS method gives a relatively high importance factor to the depletion of fossil fuels (Nguyen et al., 2016). Additionally, coal scores higher than oil, and global warming factor is of great importance in the Stepwise 2006 method.
3.3.3 Ecotax
The Ecotax method partly agrees with the Stepwise 2006 method because natural gas is valued considerably different compared with other
nonrenewable sources. In fact, natural gas scores lower on environmental costs than any of the three possible scenarios for renewable energy sources. The single score of natural gas is valued the lowest, followed by the renewable sources, and then followed by coal and oil. When adding all midpoint impacts together after weighting, it is noticeable that “fresh water aquatic ecotoxicity” contributes the most to the single score (e.g., particularly coal, oil, and straw biomass). Looking at natural gas, the impact of the category of “global warming” contributes the most to the single score and is also the second largest contributor to all the other energy sources. Remarkably, in the
valuation of the Ecotax method, the valuation of coal is extremely high compared with the other methods. The factor of “fresh water aquatic ecotoxicity” determines this by 88%. In the Ecotax method, there is a high weighting value devoted to this impact category. For clarification, see Table 9.
Table 7: EPS 2000; the weighted scores per MWh electricity for straw biomass and the three fossil fuel types (Nguyen et al., 2013; Steen, 1999).
Table 8: Stepwise 2006; the weighted scores per MWh electricity for straw biomass and the three fossil fuel types (Nguyen et al., 2013; Weidema, 2009).
Table 9: Ecotax; the weighted scores per MWh electricity for straw biomass and the three fossil fuel types (Nguyen et al., 2013; Eldh et al., 2006).
3.4 Analysis and Evaluation of scores per method
Table 10 summarizes the key results obtained from the three monetary valuation methods. When interpreting the differences in the single scores of the three monetary valuation methods, one important aspect has to be mentioned. Despite the fact that all the methods are designed for the same purpose, the assigning of weighting factors to the impact/damage categories determines the main differences in valuation of environmental costs for energy sources for electricity.
For instance, the EPS method derives the weighting factor for the midpoint impact category “depletion of fossil fuel resources” as the total costs of the process of producing renewable alternatives to fossil fuels. It derives the sum of the WTP for impacts from emissions, use of resources, and direct costs as alternatives to the total costs (Steen, 1999), whereas the Stepwise 2006 regards the weighting factors for impact categories as future marginal costs of extracting energy from alternative sources (Weidema, 2009). The theory used in the Ecotax method that determines the weighting factors can be considered as controversial. Here, environmental taxes are used as weighting factors, which raises the question of subjectivity because environmental taxes are designed to tax “unfriendly” products or services. Besides this potential bias, the tax system used for determining weighting factors is destined to go together with time and geographical location, meaning that measurements of environmental externalities change depending on the region (Nguyen et al., 2016).
As one can see in the comments section in Table 10, the largest contributor to the impact categories is mentioned to give perspective to some of the high values of single scores evaluated by the methods. Therefore, the Ecotax method is mostly determined by the “fresh water aquatic” mid-point impact category. The EPS method is balanced by two important impact categories: namely, human health and resources. Finally, Stepwise is obviously determined by the valuation of the Ecosystem impact factor (Nguyen et al., 2013). It is left for the policy makers to decide what is evaluated most important in making a decision for implementing one of these monetary valuation methods for environmental external costs.
According to Nguyen et al. (2013), when interpreting the overall scores of each method, the result from the comparison among the three monetization methods illustrate that the selection of methods can be significantly influenced not only by the absolute value of a single score of a single product but also by the relative ranking amongst alternatives in the same product category.
According to the Ecotax and Stepwise method, natural gas scores better than the biomass baseline score, but the EPS 2000 method contradicts this and
assigns natural gas as the most polluting energy source in this case. To better underline these differences, the next section will provide a Pigouvian tax according to the assigned single values by the different methods.
Table 10: Summary of the key results obtained from the three monetization methods (Nguyen et al., 2013).
3.5 Scores connected with tax per method
In Table 11, the differences in monetizing external environmental costs are adjusted to a Pigouvian corrective tax. This provides a way to include the marginal private costs of a good such that the externalities are internalized when examining electrical energy, for example. Nguyen et al. (2013) took the marginal private costs of producing 1 kWh electricity from coal, oil, natural gas and biomass CHP obtained from Drudy (2011) and used the three monetization methods to value the externalities (marginal costs). The converted results are shown in Table 11.
For simplicity, the results obtained from the scenario of straw from ALT2 are included in this table, because ALT2 is ranked the best among the three straw scenarios (according to the EPS 2000 and Ecotax method)
(Nguyen et al., 2013). Without a corrective Pigouvian tax, the marginal costs of biomass for electricity appear to be more expensive than fossil fuels. When introducing a corrective tax, the marginal external costs change the relative price of the energy source to the benefits of biomass. When examining the EPS method, the tax “corrects” for the externalities associated with the different energy sources and concludes that 15 euro-cents/kWh should be paid for biomass. Respectively, the total marginal costs of coal, oil, and natural gas are 25, 25, and 29 euro-cents/kWh. The social external costs of fossil fuels consist roughly of 70%, whereas for biomass, the contribution of external social costs is 27% (Nguyen et al., 2013; Nguyen et al., 2016). This makes the renewable biomass energy source cheaper than conventional fossil fuels if corrected through internalization of the negative externalities imposed on society.
The Stepwise 2006 method shows that, through the use of a corrective tax, the price of biomass should be adjusted by 15 euro-cents/kWh. The marginal social costs associated with coal, oil, and natural gas are 16.5, 15, 12 euro-cents/kWh. Respectively, the social external costs for coal, oil, and natural gas account for 58%, 53%, and 34%, whereas the social external costs for biomass account for 27% (Nguyen et al., 2013; Nguyen, et al., 2016). This makes biomass a compatible energy source for the production of electricity.
The Ecotax method reveals an adjusted price for biomass of 18 euro-cents/kWh, whereas the adjusted values for coal, oil and natural gas are 99, 49, and 14.1 euro-cents/kWh. The Ecotax method prefers natural gas and biomass above all other energy sources. This is clear from the fact that the social external costs for natural gas and biomass account for 40% to 44%, which is a large but not dominant. The external social costs for coal and oil are 93% and 86%, which are dominant figures (Nguyen et al., 2013; Nguyen, et al., 2016). Therefore, natural gas and biomass are favorable according to the Ecotax method, while coal and natural gas are considered as extreme contaminating energy sources.
Table 11: Internalizing environmental externalities by imposing a corrective Pigouvian tax. Values given in euro-cents/kWh (Nguyen et al., 2013).
4 Conclusion
In conclusion, this literature review’s purpose was to provide the reader with a clear and comprehensive vision of recent developments in three European monetary valuation techniques. The EPS 2000, Stepwise 2006, and Ecotax were evaluated by their methodological approach of internalizing externalities. Furthermore, through a case study done by Nguyen et al. (2013), a clear illustration of the practical implementation was provided. The goal was to give the reader a proper update on the three European valuation methods without including a decision-making analysis framework. Thus, by
emphasizing the different aspects of all the three methods, a thorough understanding was created of where further internalization research benefits from.
The EPS 2000 method uses a mix of strategies in an approach that scores second best in the methodological analysis and that illustrates through practical implementation that biomass is a cheaper energy source than
conventional sources.
The Stepwise 2006 method uses a unique budget constraint approach that is evaluated best by the methodological section. The case study shows that by using the stepwise method, biomass becomes compatible when external costs of the energy sources are internalized.
The Ecotax method scored third in the methodological section of this literature review but that was mostly determined by the limitation of this method to its applicability to Scandinavian countries. It is thus concluded that natural gas is the most efficient energy source, followed slightly by biomass. Coal and oil production are extremely contaminating energy sources according to the Ecotax method.
All three monetary valuation methods are scientifically valid for implementation and can be used by policy makers using the CAC regulation approach. In spite of some uncertainties underlying the analysis, it appears that when externalities are taken into account, the social costs of producing electricity from biomass is compatible with that of electricity produced from conventional fossil fuels. According to Nguyen et al. (2016), this is clearly not the current situation, and so the internalization of the externalities into electricity prices would significantly change the market. It is concluded that internalization techniques should be implemented in the energy sector to move to a more sustainable economy and pay fair prices.
5 Discussion
When discussing this literature review, one important thing to remember is that there are always winners and losers when judging the market failure to address externalities. The need to do so, however, is very clear indeed. The trade-off between sustainability and market mechanism is interesting because it raises the question of what is the necessary trade-off for sustainability. Monetary valuation methods can be used for analyzing externalities, but every product and good requires different approaches. To tackle externalities, a complex interdisciplinary system has to be applied, which makes it difficult to engage every agent into the discussion.
As a side note, it is necessary to clarify that the Ecotax is based on the valuation of the Swedish tax system, and so both cultural and environmental conditional differences may not apply to geographical terms elsewhere.
However, Stepwise 2006 and EPS 2000 have a global scope, and so these methods have more value for the global environmental economic community. The case study research was conducted in Denmark, where straw biomass plants are already up and running. This is also one of the reasons for the applicability of the Ecotax method in this paper. The reason for not including a decision-making policy scheme is simply that it did not fit the context of this paper due to its limitation of 9000 words. To fully analyze a decision-making scheme, more research should be conducted. Additionally, looking at implementation strategies, every situation or product requires different approaches and techniques. One more aspect that deserves attention is the distribution of tax revenues through the Pigouvian tax on environmental externalities. The revenues should be directed to solving the environmental problems associated with the true price of a product and not end up in the general state treasury.
Despite certain limitations and uncertainties, there will always be questions about the true value of nontradable and nonmarket goods. It was for this reason that this paper attempted to adequately address the need for further research on internalizing external social costs.
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