Wednesday, February 16, 2011

Environmental dimensions of macroeconomic measurement


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Figure 1: Macroeconomics in Context. (Source: Global Development And Environment Institute, Tufts University)

The traditional macroeconomic model portrays a hypothetical economy in which only businesses engage in production, and in which the natural environment plays no role. Increasingly, however, people have raised questions about whether this gives an adequate picture of the macroeconomy.

People have come to realize that economic activity actually takes place within the context of human social institutions which in turn are inextricably embedded in the natural environment. This embeddedness is illustrated by the outer rings labeled “Social Context” and “Physical Context” in Figure 1. In addition, the contributions to production of households and community groups (within the core sphere), and of non-profit as well as government institutions (within the public purpose sphere) have recently received more attention, as illustrated in the center of Figure 1. Of course, the role of businesses, both foreign and domestic, is recognized in both the traditional and newer approaches.

Many researchers argue that national governments need to start gathering new kinds of data in order to face the challenges of 21st century concerns. Building on these new kinds of information, some researchers are concentrating on developing refined measures of national assets and production, keeping as close as possible to the framework of the National Income and Product Accounts (NIPA).

Other researchers make it their aim to design indicators that more directly measure social and economic well-being. Rather than seeking to measure the volume of production, these researchers seek to develop indicators of the quality of life.

Accounting for the Environment

The natural environment plays roles that are indispensable to economic life. Environmental economists describe these under the headings of three functions:

  1. Resource functions: the natural environment provides natural resources that are inputs into human production processes. These include such things as mineral ores, crude petroleum, fish, and forests. Some of these resources, such as fish and forests, are renewable while others, such as minerals and petroleum, are not.
  2. Environmental service functions: the natural environment provides the basic habitat of clean air, drinkable water, and suitable climate that directly support all forms of life on the planet. Water filtration provided by wetlands and erosion control provided by tree-covered hillsides are other examples of services provided by ecosystems. People enjoy the services of the natural environment directly when they enjoy pleasant scenery or outdoor recreation.
  3. Sink functions: the natural environment serves as a “sink” which absorbs (up to a point) the pollution and wastes generated by economic activity. Car exhaust dissipates into the atmosphere, for example, while used packaging goes into landfills and fluid industrial wastes end up in rivers and oceans. Some wastes break down relatively quickly into harmless substances. Others are toxic and/or accumulate over time, eventually compromising the quality of the environment. The way in which the natural environment provides the resources and environmental services that sustain economic activity is illustrated by the arrow on the left in Figure 1, showing inflows into economic activity. The way in which economic activity puts waste products into environmental sinks is illustrated by the arrow on the right in Figure 1, showing the economy generating flows back into the environment.

While for centuries these three environmental functions were treated as though they were provided “free” and in unlimited amounts, more recently the problems of depletion of resources, degradation of environmental services, and overuse of environmental sink functions have become increasingly apparent.

Physical Accounts

A first step towards accounting for the environment is simply to attempt to quantify some of the major environmental effects of economic activity in physical terms, such as in terms of proportions of fish stocks lost or tons of coal burned.

Many governments have already committed in principle to creating such accounts for their own nation, at least on one issue of major concern. The burning of fossil fuels and the resulting release of carbon dioxide (CO2) into the atmosphere has been scientifically linked to global changes in climate that may, if not halted, have catastrophic results within the next few decades. In 1997 the Kyoto Protocol on Greenhouse Gas Emissions was drafted. It aims to reduce climate-change-causing greenhouse gas emissions (like that of CO2) to 5 to 7 percent below 1990 levels by 2012. Individual goals were set for different countries. By 2004, 125 parties, including most industrialized countries such as Canada, United Kingdom, France, Germany, Italy, Spain, Switzerland, Sweden, Norway, Japan, the Republic of Korea, and New Zealand (as well as many less industrialized countries including China and Mexico) had ratified the agreement.

Of course, for a country to know if it is complying with its promise, it needs to know what its how many tons of greenhouse gases it released into the atmosphere in 1990 and how many tons it is releasing currently. The gathering of scientific and economic information necessary to measure such environmental variables, aggregated to a national level, is thus a new and expanding field.

Natural Assets and the National Accounts

The Bureau of Economic Analysis currently counts only manufactured assets in its tables of national assets, and only investment in manufactured assets in its calculation of investment (and savings). The 1999 National Research Council report pointed out that:

Natural resources such as petroleum, minerals, clean water, and fertile soils are assets of the economy in much the same way as are computers, homes, and trucks. An important part of the economic picture is therefore missing if natural assets are omitted in creating the national balance sheet. Likewise, consuming stocks of valuable subsoil assets such as fossil fuels or water or cutting first-growth forests is just as much a drawdown on the national wealth as is consuming aboveground stocks of wheat, cutting commercially-managed forests, or driving a truck.
(Nature’s Numbers: Expanding the National Income Accounts to Include the Environment, National Research Council, 1999, pp. 19-20)

In principle, then, this panel concluded, the value of a nation’s natural resources should be added to the value of its manufactured capital stock in accounting for national assets.

Measures of the natural capital stock of a country should also include the value of assets related to environmental service and sink functions. An old-growth forest, for example, not only provides timber resources, but also environmental services such as water retention, habitat provision, and carbon sequestration, as well as recreational and esthetic value. Ideally, then, tables in the national accounts that look at a country’s assets should be much expanded.

Asset tables measure stock values. That is, the value of assets is measured as of a point in time. But more importantly, perhaps, for immediate policy purposes, is the issue of taking into account changes in the level of national environmental assets. When, over the course of a year, nonrenewable resources are depleted, or the environment’s capacities to provide service flows or function as an effective sink are degraded, the nation’s ability to produce in the future is reduced. The natural capital stock has depreciated. This is a flow variable — the amount of “disinvestment” that occurs measured over the course of a year.

In concept, then, whenever the depreciation of manufactured capital is subtracted in the national accounts, depreciation of natural capital should be subtracted as well. For example, the 2003 version of the United Nations System of Integrated Environmental and Economic Accounts discusses a measure called environmentally adjusted net domestic product (eaNDP), or gross domestic product (GDP) less both these kinds of depreciation.

−- Depreciation of manufactured capital
−- Depreciation of natural capital

This measure should more accurately reflect the full picture of production and depreciation in a given year.

Similarly, The World Bank in 1995 proposed that saving less both kinds of depreciation be called Genuine Saving:

Genuine saving = (Gross) Saving
-– Depreciation of manufactured capital
-– Depreciation of natural capital

Under standard measures of net saving, a country only needs to save a little more than the amount it needs to replace its worn out manufactured capital in order to appear to be saving for the future. The genuine saving measure points out that countries that run down their natural capital may be making things worse for the future, even if their manufactured investment seems to be keeping a healthy pace.

National Accounts and What Nature Produces

The adjustments we just discussed relate to the asset or stock value of natural assets, and how the value of these assets can depreciate over time. But, you might have noticed, in calculating eaNDP we started with the traditional measure of the flow of production over a year, GDP. Should we also adjust the measures of the flow of national production to account for environmental factors? Should GDP itself be “environmentally adjusted”?

In an ideal accounting system, we might think of the natural environment as yet another productive sphere or sector. The ecosystem, unless severely disturbed, generates over the course of any year such goods and services as new plants in forests and fields, new livestock and fish, clean air and water, spectacular scenery, an amazing diversity of plant and animal species, and services such as protection from solar radiation—often without any effort on the part of humans. Many of these natural processes add to human well-being, and humans could not survive and flourish without them. In theory, then, accounts of production relevant to human well-being should include all the flows of new goods and services that nature generates.

Most economists agree, however, that compiling comprehensive accounts for all that nature does for us over the course of a year would be an over-ambitious task. In fact, for productive flows as for stocks of assets, what we really want to know about for policy purposes are the ways that the economy and environment interact, particularly when this interaction leads to undesirable outcomes.

For example, suppose a hillside is stripped of its forest covering, and the wood is sold as pulp for papermaking. The lack of vegetation now means that runoff from rain increases and a town downstream from the hillside suffers flooding and has to repair many buildings. Even if the vegetation should grow back by the end of the year, something has happened. In the national accounts as currently constructed, the logging activity contributes to GDP in this year (in the form of valuable wood products) and the activity of repairing buildings is counted as an economic activity that also adds to GDP in this year. It would seem that the more damage we do to the environment, the more “productive” the economy is!

Or consider an alternative scenario, in which the town realizes that flooding is likely, and fills sandbags to line its riverbank. It thereby avoids costly repairs. But, again, both the logging and the sandbag-making are counted as adding to GDP.

What is wrong with this, of course, is that the initial environmental services of the forest in terms of water retention were not counted as part of GDP. If they had been, we would have noticed that the efforts of the town did not reflect new production so much as a shift in production from the “nature sector” to the human sector. Had we included the “nature sector” from the beginning, our national accounts would have shown a decrease in the production of that sector (decreased water retention) offsetting the increase in production of the human sector (that is, repairing buildings or constructing sandbag barriers), netting out in something closer to a wash.

Expenditures that are made simply to compensate for or defend against harmful events are called defensive expenditures. The town’s expenditures on repairs or floodwalls in our example were simply necessary to maintain the status quo.

Clearly, including defensive expenditures as positive additions to GDP, while not taking into account the loss of environmental service production that made them necessary, can result in misleading numbers. We will similarly be mislead if our GDP accounts include the rising cost of hospital services to treat asthma attacks made worse by pollution, or the cost of additional fuel required by the fishing industry as boats must travel farther and farther from port so find ever-scarcer fish.

Reductions in “natural sector production” also often have direct impacts on human well-being without being reflected in measurable defensive expenditures. For example, a person who suffers pain or dies from pollution-aggravated asthma or from contamination of their water by toxic chemicals is harmed by the fall-off in the quality of environmental services, whether or not they “add to GDP” through expenditures on medical treatment.

The Problem of Valuation

Even if we were able to compile very good information on environmental assets and production in physical terms, there is a very big problem currently standing in the way of directly incorporating environmental accounting into the National Income and Product Accounts (NIPA). This is the problem of monetary valuation. In the NIPA, all assets and flows are counted in dollar terms, based on market prices or some imputation that approximates market prices. We cannot add tons of lumber directly to grams of mercury and come up with a meaningful number. Only if all quantities can be converted to a common measure—in the case of NIPA accounts, dollars—can they be added and subtracted to come up with numbers like “depreciation” or “production.”

Putting a dollar value on an asset is tricky even in the simplest case. Many conventions have been adopted to try to standardize the accounts, but they are only conventions, not truths. For example, to really know the value of a piece of machinery, one would need to know exactly how long it will last and what the availability and prices of all inputs and outputs related to it will be for as long into the future as the piece of machinery is used. Since we never know the future, we can only make educated guesses. The current NIPA accounts rely on many conventions about, for example, how long various types of machinery are expected to be in use and how fast they will depreciate. The resulting estimates may, of course, often be proved wrong as the future unfolds. A computer, for example, may be expected to hold most of its value for two years, but instead, due to the unexpected invention of a new technology, it could be obsolete within two months.

If assigning a monetary value to manufactured assets that are used for only a few years is difficult, think about how much more difficult it is to get a dollar measure for natural assets! Consider, for example, the value of uranium reserves still in the ground. Perhaps uranium will become more valuable 100 years in the future because countries turn increasingly to nuclear power. Or the price of uranium may fall in the future as countries, concerned about safety and the disposal of nuclear wastes, explore other energy sources instead. The discovery of previously unknown mineral deposits, changes in policies, shifts in consumer demand, and new technologies are among the factors that make predicting the future over the long haul very difficult, and thus make it very hard to determine the value of many assets.

Other assets are difficult to value because, while we have a sense that overall ecological balance is important to human as well as other life on the planet, a specific form of natural capital may have no apparent market value. Biologists tell us, for example, that in recent decades there has a been a shocking decline in populations of frogs, toads and salamanders worldwide, and a large increase in deformities in these animals. Clearly degradation of the natural environment is occurring. But since the market value of most frog species is zero, there are wide disagreements about how—or even whether—a dollar value could be put on these losses.

Another factor making valuation difficult is the issue of the discount rate. People with a “high time discount rate” tend to put relatively little value on the future, while people with a “low time discount rate” are willing to set aside present enjoyment for future rewards. In an environmental context, the future that is relevant includes all generations to come! Yet coming up with a numerical dollar value for assets requires that a decision be made about how much future generations should count in present decision-making.

Nevertheless, some agencies have attempted to make at least rough calculations of the value of natural capital or its depreciation. World Bank estimates of genuine saving, for example, yielded negative numbers for some less developed countries, particularly in the Middle East and North Africa. Rather than saving for the future, such countries seem to be financing some of current consumption by running down their natural assets—particularly their petroleum.

Turning from the topic of environmental assets (stocks) and their depreciation to the topic of production (flows) of environmental goods and services, the prospect for accounting is mixed. For some environmental production, a valuation in market prices could be determined relatively straightforwardly. For example, the firewood collected free in forests or the fish caught non-commercially during a year, currently not counted in GDP, could be valued at the price of their market equivalents. But for other cases the problem is more difficult.

Take, for example, the logging and flooding story from the last section. Normally, economists would try to value the production of water retention services by an existing forest by looking at some places in which this value has been translated into dollar terms. Let’s imagine towns A, B, and C that are all identical, and identically situated relative to forested hillsides. Near town A, the hillside is logged and the town sustains flood damage. The hillside near town B is also logged, but town B spends on sandbagging and avoids damage. The hillside near town C has not been logged. What, then, is the dollar value of a year’s worth of water retention services provided by the forest near town C?

Suppose the cost of repairs in Town A, which did nothing to prevent flooding, was $5 million. If you estimate the value of the water retention services of the hillside forest near town C using the damage cost approach, you would say that the services are worth $5 million—the standing forest prevents town C from suffering an estimated $5 million in damage.

What if we use town B as the comparison instead? Suppose it spent $100,000 averting damage by building sandbag barriers. Estimating the value of the forest’s services using the equally plausible maintenance cost approach you would say that the value of the forest’s services is $100,000. Having the forest standing on the hillside near town C provides equivalent services as having a sandbag barrier costing $100,000 (abstracting, of course, from animal habitat damage and other concerns). As you can see, the two approaches may not agree—the value of the forest’s services to town C could be estimated at either $5 million or $100,000.

Another example would be whether to measure the value of unpolluted air in terms of effects of pollution on human health (damage) or in terms of the cost of pollution-control devices (maintenance). So far, some national and international agencies have adopted one convention and some the other in their experimental environmental accounts.

If the withdrawal of environmental services makes people suffer or die, then you enter the even more controversial area of trying to assign dollar values to human suffering and human lives. And many environmental effects cross national lines. What is the monetary value of a global “public good” such as a stable climate? On whose account should we tally the loss of deep sea fisheries located in international waters?

The idea of an environmentally adjusted or “greened” GDP appeals to many who are concerned about the problems of a GDP measure that omits important environmental issues. It has proved difficult, however, to arrive at a single estimate of “Green GDP”.

Making Changes: Satellite Accounts

As an alternative to defining a “greened” GDP, many nations have chosen to create supplementary or satellite accounts that record changes in important environmental and resource sectors in physical rather than monetary terms. Satellite accounts can give a detailed picture of areas such as forest cover, water resources, mineral assets, land quality, pollution emissions, and pollution control measures, without assigning specific monetary values.

Countries whose national incomes are derived in large part from exports of mineral or forestry resources, for example, can assess their stocks of ore and count up their remaining timber acreage. Others, with different concerns, can create input-output accounts to get a better idea of where resources are used, where pollution comes from, and which domestic economic sectors are most reliant on imported resources. These accounts are linked to the existing national accounts: for example, economic production of oil is associated with depletion of petroleum reserves, and physical flows of pollutants are related to the output of pollution-generating industries.

The advantage of using satellite accounts is that an extensive database of environmental information can be created, and related to existing GDP sectors, without having to determine a precise monetary value for each category. Transforming physical into monetary measures is not ruled out, however, and can be done whenever reliable and generally accepted techniques for environmental valuation exist. The United Nations has published a systematic guide to integrated economic and environmental accounting using the satellite approach, and many countries have established such accounts.

Unfortunately for the progress of environmental accounting in the United States, funding for the Commerce Department's Integrated Environmental and Economic Accounts (IEESA) was terminated by Congress in 1994, and was not restored in spite of the encouragement given by the National Research Council panel in 1999. The United States has also been the only major industrialized country, other than Russia, that has not ratified the Kyoto Protocol. In June 2001 President Bush withdrew U.S. support for the Kyoto Protocol, citing doubt about the scientific evidence on climate change, unfairness in the application of prescribed cutbacks, and the “negative impact” compliance with the prescribed reductions in greenhouse gas emissions would have on the U.S. economy. While environmental accounting is moving ahead in many other nations, attention to environmental issues seems to be lagging behind in the United States.

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