Managing Natural Capital in England

Posted on June 3, 2013 by

England has established a Natural Capital Committee to advise the government on the efficient and sustainable management of the country’s natural wealth.  In April 2013 the committee published its first report and invited comments.  Below is an abbreviated version of my submission.

“I am writing in reponse to the invitation to provide feedback on the Natural Capital Committee’s  The State of Natural Capital Report (1).  I welcome the report and would like to comment on Recommendations 1, 2, 9 and 12.  In addition to the report itself I refer below to the UNU-IDHP UNEP Inclusive Wealth Report 2012 (IWR) (2).

Recommendation 1 (pp 6-7)
“The development of a framework within which to define and measure natural capital…”

This is sensible and indeed an essential foundation for many of the report’s other recommendations.

Assets lying deep underground – minerals of various kinds, and groundwater – receive limited attention in the report. For example there are 46 mentions of fish, fisheries, etc and 3 of coal.  There is much reference to ‘sustainable use’, an important concept but one which makes most sense in relation to biological and other renewable assets.  For non-renewable assets such as minerals, no rate of use is sustainable indefinitely.  Instead, key questions are whether the rate of depletion has regard to the needs of both present and future generations, and whether profits from extraction are invested to provide for the future.

England’s mineral energy sources – not only those currently recoverable but also those which may become recoverable through technological advance – are a key part of its natural capital.  Alternative energy sources – imported fossil fuels, nuclear power, hydroelectricity, wind and solar power – all have their risks and limitations.

Groundwater aquifers may be either renewable or non-renewable, depending on rainfall and geological conditions.  Groundwater in England is a major source of domestic water supply.  It is also used extensively by industry, and to irrigate cropland in drier parts of the country. The availability of groundwater indirectly benefits ecosystems in drier areas by relieving pressures for over-extraction from surface water bodies.

Recommendation 2 (p 7)
“The development of a ‘risk register’ for natural capital assets ….”

Such a risk register could be extremely valuable. Its merits include:

  1. Focussing on specific risks rather than abstractions such as ‘genuine savings’ or ‘inclusive wealth’ would by-pass some of the theoretical arguments associated with the latter.  A risk register could more easily gain credibility with politicians and the public.
  2. As a list, a risk register would be robust in the sense that an error or contentious assumption in respect of one risk would not ‘infect’ all the other risks in the register.  This is in contrast to economic aggregates, where an error in the valuation of one asset has the potential to ‘infect’ any aggregates in which it is included.
  3. A risk register, while not determining policy, would be a clear step towards development of policies on natural capital.
  4. Listing risks together in a register should encourage a sense of proportion and facilitate informed judgments on priorities where it is not practicable to address all risks at once.

A risk register should include risks of all kinds relating to natural assets, eg unsustainable use of renewable assets, over-optimal depletion of non-renewable assets, and degradation of assets.  It should also include realistic assessments of ‘upside risks’ associated with possible technical progress, eg whether carbon capture and storage (CCS) can be made to work on an economic scale, which would reduce climate change risk and increase the value of England’s large coal reserves.

The time dimension is important in assessing risks.  For many risks, eg those associated with climate change, the probability of an outcome of given severity is likely to increase with the length of time considered.  For any asset class, the register should include not only the most immediate risks but also potentially more serious longer term risks.

Recommendation 9 (p 9)
“In addition to conventional indicators, the Government develops measures of economic growth, net of the depreciation of natural and other forms of capital as well as more comprehensive metrics of saving and inclusive wealth.”

That any new measures should be additional to conventional indicators is important.  One reason is the limited progress internationally in the development of economic performance indicators reflecting depreciation of natural capital. Another is the continuing usefulness, despite their limitations, of conventional indicators.

Even within conventional economics, it is accepted that multiple indicators are needed to assess a country’s economic performance: not only GDP and its variants such as gross national product and net national income, but also capital stock, employment, inflation, the balance of payments, and income distribution.  Adding to this list some indicators that have regard to natural capital would be an evolutionary change which politicians and the public could in time come to accept.

By contrast, dropping GDP altogether would be undesirable. Despite its limitations, it serves important purposes in the management of an economy and as a long-term performance indicator. International comparisons show strong correlations between GDP and indicators of development such as life expectancy and literacy.

The Inclusive Wealth Report represents one of the most sophisticated attempts to date to bring natural capital within the framework of macroeconomic statistics.  However, it has some important limitations:

  1. Its estimates of inclusive wealth explictly include at most 5 (and for some countries including the UK only 3) classes of natural assets. Ecosystem services, for example, are not explicitly included.  Part of their value is reflected in the price of agricultural land (IWR p 146), a significant point if the sole aim is to monitor trends in a single figure representing total inclusive wealth.  However, for practical purposes it is also important to monitor trends in the values of particular asset classes.  One would like to know the trend in the value of ecosystem services, not just to know that part of it is reflected in another figure.
  2. The discount rate applied to future benefits appears to be 5% per annum (IWR p 283), implying that benefits in 15 years time are valued at only half as much as benefits today.  While some such assumption is hard to avoid, the results are very sensitive to the rate chosen, and any particular rate is likely to be contentious.
  3. The methodology of inclusive wealth is focused on prices which – whether market prices or shadow prices – relate to marginal units of assets (IWR p 18).  There is no mention of the concept of consumer surplus, which reflects the value of intra-marginal units of a good.  This is surprising since in the academic literature on valuation of non-market assets using revealed and stated preference techniques it is standard practice to measure asset values in terms of consumer surplus (or its Hicksian variants). The value to a consumer of the first few units of a good is often much higher than the value of the marginal unit, especially for goods essential to life such as food and water.  If the value of the ecosystem services on which food and water supplies depend were measured in a way that reflected the value to consumers of intra-marginal units, it is likely that the overall value of natural capital relative to other forms of capital would be much larger than the inclusive wealth figures suggest.  This is not to say that the inclusive wealth approach is wrong: it may be that different value concepts are useful for different purposes.

These limitations  suggest that there remains a long way to go before we have reliable, well understood and timely measures of the value of natural capital or overall wealth.  Successful implementation of Recommendation 9 will be a long-term project.

Recommendation 12 (p 9)
“The Government reviews the extent to which natural capital is being effectively priced, in particular examining the scope for reducing perverse subsidies.….”

Underlying mis-pricing is often an absence or attenuation of property rights.  The report makes no mention of property rights.  However, it is widely recognized that the difficulty of addressing climate change is closely connected to the fact that there are no property rights over the atmosphere.  Less dramatic, though still important, is the precise definition of rights associated with land ownership.  One reason for the rapid exploitation of shale gas in the US is that landowners often have rights over the assets below their land, and therefore a strong incentive to allow their exploitation.  Whether or not the UK should be exploiting its shale gas is contentious, but the example illustrates how a country’s definition of property rights can have a major impact on its management of its natural capital.  Where there are judged to be serious risks to a particular class of natural asset, it should always be considered whether property rights, or their absence, are among the causes.“

Notes and References

1. Natural Capital Committee (2013), The State of Natural Capital: Towards a Framework for Measurement and Valuation. http://www.defra.gov.uk/naturalcapitalcommittee/files/State-of-Natural-Capital-Report-2013.pdf

2. United Nations University International Human Dimensions Programme (UNU-IDHP) and United Nations Environment Programme (UNEP) (2012), Inclusive Wealth Report 2012. Measuring progress toward sustainability. Cambridge: Cambridge University Press. http://www.unep.org/pdf/IWR_2012.pdf

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The Economics of Urban Rainwater

Posted on May 2, 2013 by

Lack of natural drainage in urban environments can lead to flooding and pollution.   Economics can help find appropriate solutions.

There is a furore in Maryland, USA, where many residents will soon have to pay a “stormwater management fee” based on the area of impervious surface on and around their homes (roofs, driveways, car parks, etc).  The measure is prompted by the condition of Chesapeake Bay, an important fishery and recreational resource that has been degraded by polluted rainwater run-off.  Critics have dubbed it a “rain tax”: the first word is perhaps misleading, but as for the second, if it looks like a tax and smells like a tax … For a flavour of the debate, here is a news item (1), a case for (2), and one against (3).

Let’s look at the issue of urban rainwater run-off from an economic perspective.  Run-off from A’s property to B’s can affect B’s welfare.  There is an externality, with the following characteristics:

  1. The amount and pollutedness of water running off from A’s land to B’s depend partly on variables outside A’s control.  But A can affect it in several ways.  One is by having impervious surfaces, which prevent natural drainage and, less obviously, result in pollution of run-off by deposits of airborne pollutants originating from cars and power stations (4).
  2. What matters for B’s welfare is the aggregate effect of the water arriving from all sources. Small amounts of water from each of many sources can combine to flood B’s land.
  3. Downstream, run-off from many sources may come together in large flows with the characteristics of a “public bad”.  If B’s land is flooded then his same-level neighbours’ will be too, regardless of some having interfered with their natural drainage less than others.
  4. Eventually, run-off may arrive at a large water body such as a lake or river estuary.  Here the aggregation of pollutants brought by water from many sources may, as in Chesapeake Bay, degrade the natural ecosystem with adverse consequences for users.

What policy instruments can address such a complex externality?  A network of stormwater sewers funded by charges to households can significantly reduce the risk of flooding.  Economies of scale in network provision point to local monopoly provision, with regulation to ensure standards and prevent over-charging.  Given the externality and “public bad” characteristics of run-off, individual households should be required to pay and to connect to the network except in unusual circumstances.  Without compulsion, many upstream households at little risk of flooding would opt out, rendering the network less effective in preventing flooding and/or increasing costs to other households.

Here in London, a household which can show that none of its rainwater enters the public sewer network can obtain a “surface water drainage rebate”, meaning that it need not pay the stormwater drainage element within its overall water services charge (5).  The justice of this is dubious, since the sewer network may still protect such a household from flooding by run-off from higher ground, and if its rainwater runs instead into a natural stream, it could contribute to downstream flooding.  To allow such a rebate is to treat the sewer network simply as a service to those households whose rainwater it carries away.  Instead, it should be regarded as a practical response to a complex externality.

An unintended effect of a sewer network is to transport any pollutants carried by the rainwater into the water body in which it discharges (I ignore here situations in which combined sewers carry both rainwater and domestic sewage to a treatment plant prior to discharge).  For serious pollutants such as hazardous chemicals, a combination of regulation and liability law is warranted to prevent their entry to the network.  What can be difficult is to find an appropriate policy for low-level pollutants such as nitrogen from garden fertilizers and atmospheric deposition which can cause harm when channelled in large quantities into a water body.  This problem appears to be particularly challenging in the circumstances of Chesapeake Bay, which has a population of 16 million within its watershed and only a narrow outlet to the open sea, limiting dispersion of its pollutants (6).

A key question is whether in an economic sense the water body is over-polluted.  The relevant test, in principle, is whether the damage to the water body from a marginal unit of pollutant exceeds the benefit from the marginal activity resulting in that unit of pollutant.   Damage here should include both economic loss to users of the water body and loss of non-market values relating to recreation, ecosystem services and biodiversity. For a pollutant that may cause harm over many years, damage should be calculated on a present value basis, with allowance for its rate of decay or dispersion and an appropriate rate of time preference.  This test is not easy to apply.  It requires: reliable scientific knowledge quantifying the links between activity and pollutant and between pollutant and harm; reliable estimates of non-market values; and identification of marginal activity where there are many sources of pollutant involving different types of commercial and household activity.

Where a water body is assessed as over-polluted, an appropriate policy objective in most cases will be a reduction in the amount of pollutant entering the water body, bringing about a progressive reduction in the stock of pollutant it contains and eventually reaching a position in which, so far as can be assessed, marginal damage roughly equals marginal benefit.  In some cases this may usefully be accompanied by the sort of restoration suggested by the term “clean-up”, involving the application of physical, chemical or biological processes to the water body.  It is unlikely to be economically optimal to reduce the stock of pollutant as fast as possible.  Where polluting activities are subject to diminishing returns or diminishing marginal utility, a given reduction in pollutant will reduce their benefits by less overall if spread over several years than if concentrated in one year (compare having a 20% smaller car park for five years with having no car park at all for one year). An optimal restoration path will balance the benefit saved by spreading the reduction in pollutant against the extra damage from a longer period of over-pollution (7).

Taxes are likely to be the most suitable policy instruments to reduce the scale of the polluting activities.  Regulation would be too inflexible and heavy-handed for matters such as the area of a household’s driveway.  As a market-based instrument, a tax on areas of impervious surface would allow a household to have a large driveway and pay the associated tax if it wished.  Another household for which a driveway was of less value given its lifestyle might choose a smaller one or none at all.  Alternative market-based instruments are marketable permits and subsidies.  The former are probably too complicated to use at the level of individual households.  Subsidies could have a role to play in supporting activities which reduce run-off, such as soakaways and tree cultivation, and could also work in conjunction with taxes (see this post), but are unlikely to be the main policy instrument.

However, taxes do have disadvantages.  The extent to which a given rate of tax will reduce polluting activity will not be known.  Achieving a desired reduction may require a trial-and-error approach to rate-setting with consequent uncertainty for taxpayers.  Taxes needs to be suitably targeted, and for some polluting activities a suitable target may not be available.  Provided that the science linking impervious surfaces to pollution is well-established, area of impervious surface is an appropriate target: relevant to the objective;  easy to measure; and hard to conceal.  It is difficult however to identify a suitable target relating to garden fertilizers.  A tax on quantity used would be impossible to enforce, and a tax on sales, limited to the relevant watershed, could be easily avoided by buying elsewhere.  This creates a problem.  Considering an activity in isolation, it may seem that an economically appropriate rate of tax per unit of activity should roughly equal (with allowance for the needs of any restoration path) the damage resulting from the pollutant associated with a marginal unit of activity.  However, if some types of polluting activity are difficult to tax at all, there could be (although the economic assessment would be quite complex)  a “second-best” case for a higher rate of tax on those that can be taxed.  Addressing polluting activities that are difficult to tax through education and product labelling could perhaps mitigate this sort of situation.

One point about a tax is clear.  An economic case for a tax designed to reduce polluting activity need make no reference to how the tax revenue would be used.  Using it to pay for schools or reduce a deficit would not prevent a well-designed tax from being an effective policy to reduce pollution. There should be no presumption that revenue from a tax on current polluting activity should be spent on cleaning up the effects of past pollution.  Any expenditure on clean-up activity or other pollution-related purposes should be justified in cost-benefit terms in comparison with alternative uses of the funds.

Notes and References

1. The Baltimore Sun, 29 March 2013  Howard council approves new stormwater fee 
http://www.baltimoresun.com/news/maryland/howard/ellicott-city/ph-council-stormwater-fee-20130328,0,7762933.story

2. The Washington Times 23/4/13 Chesmar J Chesapeake Bay Foundation on Maryland Rain Tax: Time to own up
http://www.washingtontimes.com/news/2013/apr/23/chesapeake-bay-foundation-maryland-rain-tax-time-o/

3. Gazette.Net Maryland Community News Online, 5 April 2013  Lee B The’Rain Tax’
http://www.gazette.net/article/20130405/NEWS/130409397/-1/the-x2018-rain-tax-x2019&template=gazette

4. US Environmental Protection Agency 2007 Development Growth Outpacing Progress in Watershed Efforts to Restore the Chesapeake Bay Report No. 2007-P-00031 p 5  
http://www.epa.gov/oig/reports/2007/20070910-2007-P-00031.pdf

5. Thames Water  Apply for a surface water drainage rebate 
https://secure.thameswater.co.uk/dynamic/cps/rde/xchg/corp/hs.xsl/15757.htm

6. US EPA, as above p 2

7. The dynamic stock pollution model applied in this paragraph is set out in Perman R, Ma Y, McGilvray J & Common M 3rd edn 2003  Natural Resource and Environmental Economics  pp 548-553

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A Fallacy about Trade

Posted on April 10, 2013 by

What determines the production quantities and relative prices of internationally-traded goods?  Some textbooks suggest a misleading answer.

An old textbook I have on my shelves (Wells 1969 (1)) has a diagram similar to Diagram 1 below, showing the production possibility frontiers of two countries A and B producing two goods X and Y.  The book suggests by the way the diagram is drawn that under free trade the ratio of the price of X to the price of Y is represented by the common tangent (shown in red). Consequently the points of tangency, PA and PB, represent the combinations of goods produced by each country.Trade Fallacy Diagram 1

This method of finding the free trade price ratio cannot be generally correct.  Here are two reasons:

  1. Suppose country B is small, so that its production frontier is PPFB*, lying entirely within PPFA.  Then the method cannot be applied since it is impossible to draw a straight line tangential to both PPFA and PPFB*.  Given free trade, however, A and B will still engage in trade, provided only that their respective price ratios in the absence of trade are different, creating scope for gains from trade.
  2. Suppose consumers in both countries have a strong preference for X over Y, implying near-vertical social indifference curves.  Then the method leads to wrong conclusions since production in that case will not be at PA and PB.  It will be approximately at QA and QB, with both countries producing close to their maximum possible quantity of X.

This may seem to be labouring an obvious point.  But perhaps it isn’t so obvious, since a modern textbook (Koo & Kennedy 2005 (2)) uses a similar diagram (with some additions), identifying the production quantities under trade equilibrium as the equivalent of PA and PB in Diagram 1.  This is surprising since, only a few pages before, Koo & Kennedy give a correct explanation of the determination of the free trade price ratio in the 2-country 2-good case (3).  Given each country’s production frontier and social indifference curves, this involves constructing a diagram showing their respective offer curves.  The point of intersection of the offer curves then indicates the equilibrium import / export quantities and the price ratio.

It then remains to find the associated production quantities.  One way is to apply the free trade price ratio to a diagram showing the production frontiers.  The point that is perhaps easy to miss is that one cannot in general draw a line of given slope that is tangent to both the production frontiers.  In general two parallel lines must be shown, one for each country.  It is the slope of a line, not its position, that represents a price ratio, so parallel lines represent the same price ratio.  Diagram 2 shows how this works for the case of the large and small country.Trade Fallacy Diagram 2

R shows the slope of the price ratio, assumed to be inferred from an offer curve diagram.  To find A’s production quantities, we find the point PA on its production frontier at which the tangent, RA, is parallel to R.  Similarly B will produce at point PB on its production frontier, at which the tangent RB is parallel to R.  Given A’s import and export quantities from the offer curve diagram, we can also find the point CA on RA representing A’s consumption quantities.  Similarly we can find point CB on PB representing B’s consumption quantities.

A geometric proposition that is generally valid, whether or not the production frontiers overlap, is that the four production and consumption points (PA, PB, CA, CB) form the corners of a parallelogram.  But for the two tangents to coincide, as in Diagram 1, so that all four points lie in a straight line, would just be a coincidence.  It looks neat but has no economic significance.

Notes and References

1. Wells S J (1969)  International Economics  George Allen & Unwin, London  p 42

2. Koo W W & Kennedy P L (2005)  International Trade and Agriculture  Blackwell Publishing  pp 50-51

3. Koo & Kennedy, as above  pp 41-43

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Lessons from the Industrial Revolution

Posted on March 7, 2013 by

The economics of energy in the 18th century offers lessons for the present.

I recently read Robert Allen’s The British Industrial Revolution in Global Perspective (1), a fascinating analysis of why the industrial revolution happened, why it happened in Britain, and why other countries industrialized only later.  Had I been asked beforehand for answers to these questions, I might have listed the following features of 18th century Britain:

  1. Large and accessible coal deposits.
  2. Ingenuity of its inventors, exploiting the scientific knowledge of the enlightenment.
  3. Relatively good governance by the standards of the time.
  4. Rural land reform (enclosure) facilitating higher food production to support growing cities.

According to Allen, however, 1 and 2 were not unique to Britain, and 3 and 4 are dubious.  His analysis focuses instead on relative prices.  And his main conclusion is this: in 18th century Britain, a combination of relatively high wages and cheap energy from coal made it profitable to substitute steam power for labour, even though the steam engines of the time were very inefficient (2).  Allen presents detailed evidence showing that the wages of labourers in 18th century Britain were much higher than those in most of Europe, India and China, and comparable only with those in the Netherlands and parts of North America (3).   Only Britain had significantly exploited coal at that time, and the price of energy in British coalfield regions was the lowest in the world.

How had this situation come about?  The reasons are complex and Allen’s explanation goes back several centuries (4).  Prominent in his account are: Britain’s success in exporting woollen cloth, supported by improvements in sheep farming; its economic gains from mercantilism and empire; the growth of London beyond the point at which its energy needs could be met at reasonable transport cost by wood; the development (via what Allen terms ‘collective invention’ by London builders) of houses designed to be heated by coal; and the consequent stimulation of coal mining around Newcastle, from where London was supplied by ship.

The development of steam power was financed by businesses and entrepreneurs. Innovation was facilitated by business clusters such as tin mines in Cornwall (another case of collective invention).  The power obtained from steam engines per ton of coal increased tenfold between 1730 and 1850 (5).  Steam power became profitable at progressively lower wage / coal-price ratios, and around 1850 was rapidly adopted in other European countries and the US.  These countries had not been without coal deposits, inventors or entrepreneurs, but profitability at their prices determined the timing of adoption. Since moreover they were able to adopt the latest and most efficient technology, they did not need to waste resources repeating Britain’s long experimentation with early steam engines.

Allen’s book is a work of economic history, and does not attempt to draw lessons for the present.  It does however offer much material suggestive of present-day parallels.

In most developed countries today, labour and energy costs are both high (taking costs to include the social costs of pollution and climate change associated with fossil fuels).  A resource that is cheap by historic standards is information and communication technology (ICT).  Developments such as smart meters and smart electricity grids can be viewed as attempts to substitute that cheap resource for high-cost labour and energy.  Whether the energy cost savings from these developments can be more than marginal is debatable.  But the application of ICT directly to energy supply is only one way to use it to reduce energy costs.    Take electronic books, for example.  They do not just reduce the cost of books by saving on physical material costs.  They also facilitate space-saving wherever buildings contain shelves of books, and that saving in space could permit smaller buildings requiring less energy to heat.

Blue-sky thinking suggests other ways in which ICT might be harnessed to save energy. Driverless freight vehicles could not only reduce labour costs but also, by avoiding the need to transport drivers as well as goods, reduce weight and therefore fuel costs.  Automated kitchens could save energy by selecting the most energy-efficient method to cook any dish, heating the minimum quantity of water for boiling or steaming, and facilitating more enclosed cookware with less heat loss.  Kitchen automation could be linked to just-in-time delivery systems from food suppliers, reducing the need for homes to keep large stocks of food in energy-hungry and space-occupying fridges and freezers.  Just as in early modern times the home was re-designed, replacing a central wood-burning fire with fireplaces and chimneys designed for coal, so perhaps homes now need to be re-designed for energy efficiency.  The home of the future could be smaller but much more functional, with sophisticated systems managing any processes that use energy.

Another parallel relates to the development of renewable energy.  The example of steam power suggests that the most promising route is for countries to specialise in the development of those types of renewables that are or could soon be profitable in their particular circumstances. That probably means solar power in hot dry countries, biofuels in tropical countries with suitable soil and rainfall, and wind power in countries with fairly steady winds. Such specialisation reduces the need for investment to be subsidised by government, and increases opportunities for collective invention.  Countries in which a particular energy source is only available at high cost (such as solar power in northern Europe) might do best to ignore that source until development elsewhere has improved efficiency and reduced costs, just as many countries in the 18th century ignored steam power because for them it was too expensive.

Notes and References

  1. Allen R C (2009) The British Industrial Revolution in Global Perspective  Cambridge University Press  331pp
  2. Allen pp 138-40 & 156-7
  3. Allen Chapter 2
  4. Allen Chapters 4 & 5
  5. Allen p 165
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