Select Committee on Environmental Audit Written Evidence


APPENDIX 8

Memorandum from Professor David Pearce, Economics, University College London and Environmental Science and Technology, Imperial College London

PREAMBLE

  I have worked on the links between economics and environmental issues for nearly 40 years and have been closely associated with past government policy on the economic valuation of environmental impacts, the design of economic instruments, and other issues. I acted as a Special Advisor to two Secretaries of State for the Environment, 1989-92. Of relevance to the EAC Inquiry, I am the co-author, with my colleague Brian Pearce (who is lead author), of a paper on the probable size of an aviation tax (Pearce and Pearce, 2002) which has been used within government and which is referred to in the HM Treasury and Department for Transport document Aviation and the Environment: Using Economic Instruments (HM Treasury and DfT, 2003). With my colleague, Dr Dieter Helm of New College, Oxford University, I am currently co-authoring a comprehensive review and critical analysis of UK government policy on market-based environmental policy, due for publication in 2004 (Helm and Pearce, 2004). I am also a Member of DEFRA's "Academic Panel" which airs and debates economic aspects of UK environmental policy.

THE EAC 2002 PRE-BUDGET REPORT

  Since paras 44-62 of the EAC 2002 Budget Report (EAC, 2002-03) are directly relevant to the issues of controlling aviation externalities and to EAC's specific questions noted in their Press Release of 1 April 2003, I briefly comment on some of the issues raised there. These comments should help to explain my answers to the questions raised by EAC.

  While I share some of EAC's disappointment with the Treasury document Tax and the Environment (HM Treasury, 2003), we should not overlook the fact that a document of this kind exists at all. It seems to me that it is a reasonably brave attempt to continue the stated policy of using market-based approaches to environmental policy. I agree it is not a detailed "Strategy", but a worked-out Strategy is hard to develop in advance of the immense complications—political, legal and economic—that arises when introducing market-based instruments (MBIs), and these difficulties cannot always be foreseen in advance of detailed appraisal of specific proposals. Many of those problems arise from the fact that MBIs have to be superimposed on existing regulatory policies: we do not have the textbook luxury of introducing MBIs in a policy vacuum. The "case by case" approach may seem frustrating, but no country has actually embarked on a major programme of MBIs with a detailed strategy, and I suggest this reflects the practical difficulties of doing so.

  It is true that current government policy attempts to meet too many inconsistent policy goals—liberalised energy markets are not consistent with keeping energy prices high to signal environmental scarcity, policy of water metering in the interests of vulnerable customers is not consistent with treating water as a scarce good, and so on. In short, whatever the protestations to the contrary, we do not have "joined up" government. Since this will be one of the running themes in the treatise by Helm and myself, I will not dwell on these issues any further here. However, it is worth reflecting on the fact that, in the last ten years, the UK has done far more by way of introducing MBIs than almost any other country. This is no mean achievement and it is a credit to government economists that they have pursued the issues as far as they have.

  The EAC Inquiry asks if the full environmental costs of aviation can be identified. I have taken this to mean measured, as it seems to me that we are very clear on the nature of the nuisances and impacts in question. I hope the Committee will not mind too much if I suggest that Paras 56-57 of EAC's 2002 Pre-Budget Report read as if the Committee has already made up its collective mind on the issue of measurement. If I am wrong, all to the good. If I am right, I think that is unfortunate that any firm view should be taken if the arguments in favour of it are as weak as those expounded in Paras 56-57. Space forbids a detailed rebuttal. However, one or two points can be raised. All decisions imply monetary values of benefits (or damages). This is because all decisions have money costs, and hence acceptance of a policy implies that the money value of the policy benefits exceed those costs. The reverse is true if the policy is rejected. Saying that a policy is acceptable logically implies that society is willing to meet the costs of that policy, which is all that monetisation implies. It is, however, highly informative to test the proposition, rather than simply assuming it is true. Second, costs and benefits are obverses: a cost is a negative benefit and a benefit is a negative cost, and these equivalences arise because of the way costs and benefits are defined in economics, namely as losses and gains in human wellbeing. Rejecting monetisation of benefits whilst accepting the monetisation of costs is then internally inconsistent. These fundamental features of monetisation were pointed out many years ago by Harold Thomas in a classic paper which, sadly, generations after mine seem not to have read (Thomas, 1963). As a further example of limited argument, the EAC Report says that monetisation involves "issues of principle" but no explanation is offered on the meaning of this criticism, so the remark seems to be without substance. The reference to the goal of "preventing irreversible environmental damage" is more than problematic. It is not, for example, government policy, nor could it be. For example, it is not conceivable that further biodiversity loss can be prevented in face of world population change and the consequent land use change, which in turn is the main reason for biodiversity loss. Nor could one prevent irreversible loss in the UK: the government's housing policy, for example, would automatically fail such a test, as would its transport policy, etc etc While we may regret the losses, as I do, it is fanciful to think that reality is otherwise. Hence any "policy" goal of rejecting irreversible change is itself fanciful[22]. There are trade-offs and they cannot be avoided. Once trade-offs are acknowledged, monetisation follows.

  One other generic issue is relevant to the issue of deciding on appropriate MBIs for aviation (or for anything else). The Treasury-DfT document Aviation and the Environment (Para 2.4) lists the criteria that Government should use when selecting economic instruments. Absent from the list is the issue of the baseline. If we choose not to have a MBI for aviation then we must choose something else, or do nothing. By assumption, doing nothing is not relevant. Hence the choice is between a MBI or some other regulatory instrument, ie what I am calling the baseline. It follows that the criteria with which we appraise MBIs must be applied to the alternative instruments. But the Treasury's Tax and the Environment document and the Treasury-DfT document Aviation and the Environment read as if only MBIs are to be evaluated in this way. In personal exchanges, Treasury assure me that they wish to be even-handed in this respect, but it seems a shame that this even-handedness is not transparent in these documents. The issue is important. For example, MBIs are often criticised as being potential inhibitors of "competitiveness" (though quite what this means is never clear), or a "drag" on economic growth. Even if there was any truth in these criticisms, the baseline issue reminds us that the same effects, if they exist, should be evaluated for the alternative policy. For example, if we think resultant cost increases (which is, after all, what MBIs are designed to achieve) are "unacceptable", how much more or less unacceptable are they compared to the cost increases arising from alternative forms of regulation? If we cannot address this question, we cannot give even remotely sensible answers to questions about the desirability of MBIs in the aviation sector, or anywhere else.

AVIATION EXTERNALITIES

  Can aviation externalities be identified? As noted above, we are well aware of the issues—noise, local and global pollution, disamenity. The more interesting question is whether they can credibly be valued in money terms. The operative word is "can". If valuations do not currently exist, it need not follow that we cannot find them with properly conducted research. Economists do not have a data store of unit values for everything, so we should not be surprised if we do not have values for some things. Indeed, valuation exercises usually respond to policy questions, so if the question has not been asked before, valuation studies are unlikely to exist. Additionally, we should not be surprised if values change as research improves over time. Some critics of valuation have adopted intellectually very curious arguments to the effect that if different valuations exist, none of them can be correct. (We do not argue that our lack of knowledge of the final cost of building major infrastructure renders cost unimportant, yet such costs are very often poorly predicted).

THE COST OF CARBON

  I thought it was somewhat disappointing that the HM Treasury—DfT Consultation document did not offer more comprehensive estimates of the externalities from aircraft. Pearce and Pearce (2002), for example, provide estimates for CO2, SO2 , low and high altitude NOX, VOCs (other than benzene), and noise. Their analysis was unfunded so it was carried out with very limited resources. HMT-DfT go into detail only on the costs of carbon dioxide emissions, but even here the estimates are shown only for a representative aircraft journey rather than per passenger. Lack of time has prevented a detailed comparison of the estimates in Pearce and Pearce (2002) and those suggested in the HMT-DfT Consultation. However, it seems that the Consultation document has used an early (2000) version of the Pearce and Pearce paper. The figures have been revised since then. For example, in their summary of Pearce-Pearce with respect to noise, HMT-DfT state "The total cost of impacts for all airports has been estimated at around £25 million for 2000" (para E.3). But the Pearce-Pearce estimate for noise costs for Heathrow alone are £27-66 million per annum. It would therefore be worth encouraging Treasury and DfT to check the source of the estimates they have quoted.

  One central difference between the Pearce and Pearce and HMT-DfT estimates of externality is the unit value for carbon. Pearce and Pearce uses £29/tC and HMT-DfT use £70/tC. In a subsequent review of climate damage models, I conclude that there are two main reasons to doubt the £70/tC figure (and, by implication, the £29 figure—Pearce, 2003). The first is that the study it is based on (Clarkson and Deyes, 2002) is not a comprehensive review of the models and also fails to distinguish early models and late models. The later models include adaptation to climate change, whereas the early models do not. It does not seem very likely that populations will simply observe climate change without doing something to adapt to it, so that the later models are more credible in my view. However, there is room for disagreement. Perhaps the most telling study is one just released by Professor Richard Tol of Hamburg University and the Free University of Amsterdam (Tol, 2003). Whereas Pearce (2003) offers a judgemental view that the range of credible estimates of global warming damage is UK£2-15 tC using a conventional discounting procedure (see below)[23], Tol's study is a sophisticated meta-analysis and therefore more rigorously based. It is worth stating Tol's conclusion:

    ". . . for all practical purposes, climate change impacts may be very uncertain but [it] is very unlikely that the marginal costs of carbon dioxide emissions exceed $50 tC [£31 tC], and [are] likely to be substantially smaller than that" (Tol, 2003). (Italics added).

  Work by Professor Robert Mendelsohn at Yale University argues that the relevant values are very small and may not differ much from zero. However, it is worth noting that these values relate to one point in time, corresponding to 2xCO2.

  All the models agree that a critical determining factor is the discount rate. Discounting is a procedure whereby a given unit gain or loss in the future is given a lower value than the same unit value today. The rationale for discounting is given in HM Treasury's Green Book (HM Treasury, 2003). Basically, it reflects the facts that (a) people prefer the present to the future and (b) future people are likely to be richer than today's people, and they will therefore attach less importance to an extra £1 compared to an extra £1 today. A related but separate rationale derives from the existence of positive interest rates. The choice between £1 next year and £1 now is really a choice between £1/(1+r) now and £1 now where r is the interest rate. Hence the two £1s are not equally valuable. In the UK, HM Treasury has a discount rate of 3.5% but, in light of very recent research, it does hold open the possibility that this discount rate declines with time. The relevant arguments for "time varying" discount rates are to be found in OXERA (2002), Groom et al. (2003) and Pearce et al. (2003). It needs to be noted that none of the climate models surveyed in Pearce (2003) or in Tol (2003) includes time-varying discount rates. If the discount rate falls with time, future warming damages will be more important than if they are discounted at a constant rate. Precisely what happens to the damage cost of carbon depends on the choice of trajectory of the discount rate over time. The available literature suggests that the relevant value could rise by a factor of about 80%. If so, and if the argument is accepted, then the government's £70 tC figure would rise to, say, £130 tC, Pearce's £2-15 tC range would rise to £4-27 tC, and Tol's upper limit would rise to £50 tC. It is also worth noting that many economists regard time-declining discount rates as being inconsistent with the design of optimal policy. Unfortunately, the arguments are too complex to be explained here—see Pearce et al. (2003).

  A second reason for doubting high figures for carbon damage arises from the policy implications. DEFRA has rightly issued guidance which says that, whatever the right value of carbon, it needs to be used consistently across decision-making. In their case, this implies that £70 tC should be used. But Pearce (2003) shows that this would have formidable implications. For example, it would provide a substantial social credit to nuclear power (at around 0.8 p kWh relative togas), would justify a virtual doubling of the Climate Change Levy, would negate the economic rationale for the Renewables Obligation[24], and would justify vast programmes of afforestation. I would be content to entertain the possibility that all of these might be desirable, but adopting a particular figure implies that it is adopted consistently and that its implications are acted upon. My view is that the implications of the £70 tC figure were not thought through.

SORTING OUT THE CARBON VALUE

  Para 58 of the EAC 2002-03 Budget Report takes note of the array of valuations of carbon. Oddly, it then seems to imply that if we cannot get a consensus on the value, no value should be used at all. As noted above, this is not a logically tenable position. Moreover, if the implication is that we should adopt whatever the "consensus" policy is, regardless of what it costs, the entire purpose of policy analysis is negated and we are reduced to a Panglossian world in which whatever is decided by the "democratic process" is what is justified. Policy analysis—of which cost-benefit analysis is one branch—exists to check up on the political process, not to acquiesce in whatever it comes up with. Neither is it very sensible to argue that because we are uncertain about economic values, we have added to the uncertainty of decision-making by adopting values. It is not valuing things that creates the added uncertainty since we simply sacrifice valuable information. That the information itself is uncertain cannot then imply that we reduce uncertainty by not allowing the information to be considered.

  The same paragraph hints that some consensus is needed and the EAC may already have been informed that DEFRA is convening a high-level expert meeting on the valuation of carbon damage on July 7. Amongst others, international experts such as Professor Tol, who has done more research on this issue than anyone else in the world, and Professor Mendelsohn will be attending.

CATASTROPHE

  EAC asks if valuation can cope adequately with catastrophe. As noted above, if we take certain actions because we think there is a risk of a catastrophe at some point in the future, then we imply a value for the catastrophe, whatever it is. The sheer existence of a catastrophe occurring with some probability greater than zero cannot itself be a justification for taking action now regardless of cost. Suppose the catastrophe has a one in a million chance of occurring and will not occur in less than 300 years time. How many people would make a financial sacrifice now to avoid such an outcome? If, on the other hand, the chance is 1 in one hundred and it could happen in the next 10 years, we might take a very different view. Much also depends on what we think the catastrophe implies: the ending of civilisation as we know it, or some major regional event? As Richard Tol has point in another of his papers (Tol, 2002), monetary valuation (self evidently) assumes the variance of the estimates of damage is bounded. If it is unbounded, then marginal damage is infinite. But anyone wishing to argue this has some duty to show that damage at the margin would be infinite. In addition, they would need to persuade the rest of us that our "coefficient of concern" extends to periods of time well beyond what we currently consider to be the limits. No-one behaves as if people 1000 years hence are as important as people today[25]. Nor, for that matter, do we behave as if people 1000 miles distant from us are as important as people nearby. If we did, we would not spend more on the National Health Service than we do on foreign aid (if everyone is equal and it is cheaper to save lives abroad than at home, expenditure on saving lives abroad logically must exceed expenditure saving lives at home). It is quite possible to think up ethical theories that would make everyone "equal" in time and space (for example, Professor John Broome argues an eloquent case for this: Broome, 1991. For a critique, see Freeman and de Divita, 2001). It is quite another to suggest that we could persuade anyone to act in accordance with that view. Once again, it is a matter of thinking through the consequences of adopting such views.

ON THE CHOICE OF MBI

  I have not dwelled upon the choice of the appropriate MBI, eg tradable permits versus taxes. I have no very strong views on this subject. I do not know if tradable permits could be designed efficiently. Given that we do have some reasonable estimates of the externalities from aviation in Pearce and Pearce (2002), and since we have a landing charge system at all airports, I think I would be inclined to favour a tax at least approximately equal to the marginal damage from aviation. Additionally, since the chances of auctioning permits are probably small (although auctions for airport slots set a precedent) it is important to have an MBI that generates revenues. In my view these should be used to compensate those who suffer the externalities. I am not convinced that using revenues to reduce other taxes is the right way to proceed, not least because it opens up further policy inconsistencies (such as using the revenues to lower NIC and then raising the level of NIC across the board), nor am I convinced that "trust funds", such as those associated with the landfill tax and the aggregates levy, are as effective environmentally as they should be.

  I am clear that some form of MBI is required. One of the problems of embracing the "Polluter Pays Principle" is that who pays depends on who has the property rights. This question is not always easily answered—witness the "countryside" debate where some people seem to think country communities "own" the countryside, or at least have rights to use it as they see fit. However, I do not see a case for arguing that airlines, airports and air travellers have rights to pollute or cause nuisance and hence I would argue that the polluter pays principle should operate.

  The UK is unique, I believe, is having two environmental taxes that were informed by estimates of marginal damage (the landfill tax and the aggregates levy, although the former has been "hybridised" to become a revenue raising tax that is probably higher than would be justified on environmental grounds). An aviation tax could be the third such tax.

ON AIRPORT LOCATION

  Finally, care has to be taken in the use to which an MBI is put. The externalities from existing airports differ from those for new or expanded airports. The difference is that the latter take up additional land, which has to be mainly greenfield land. This involves a loss of amenity, landscape and biodiversity. None of the externality estimates in Pearce and Pearce (2002), for example, allows for these effects. They are likely to be very important since (a) airport expansion options are currently focused on areas where such greenfield loss will be significant and highly valued, and (b) the losses in wellbeing are not confined to those who reside in or visit such areas. There are added "non-use" values which are lost. DEFRA currently has some consultancy work under commission which hopefully might throw some light on non-user, non-resident valuations of such losses as well as on local valuations. What is important is that valuations of externalities from existing airports should not be applied to new or expanded airport options without making an effort to include the additional, and I suspect, substantial, external costs arising from the development of greenfield land[26].

April 2003

References

  Bohnringer, C. 2003. Will Kyoto work? Oxford Review of Economic Policy, forthcoming.

  Broome, J. 1991. Counting the Cost of Global Warming. Cambridge: White Horse Press

  Clarkson, R and Deyes, K. 2002. Estimating the Social Cost of Carbon Emissions. GES Working Paper 140. London: HM Treasury. Available at www.hm-treasury.gov.uk/documents/taxation work and welfare/taxation and the environment

  Environmental Audit Committee, 2002. Pre-Budget Report 2002. HC 167 of Session 2002-03

  Freeman, A.M and de Civita, P. 2001. On Discounting Statistical Lives. Economic Issues Note: Health Canada.

  Groom, B., Hepburn, C., Koundouri, P and Pearce, D.W. 2003. Discounting—the long and short of it. Economics, University College London. Mimeo

  Helm, D and Pearce, D.W. 2004. Market-based Environmental Policy in the United Kingdom: History and Critique. Forthcoming.

  HM Treasury and Department for Transport, 2003. Aviation and the Environment: Using Economic Instruments. London: HMT and DfT

  Miles. D. 2000. Housebuilding in the South East of England: Planning the way to misery, World Economics, 1, 2, 1-11.

  OXERA, 2002. A Social Time Preference Rate for Use in Long-term Discounting. London: Office of the Deputy Prime Minister, Department for Transport, and Department for the Environment, Food and Rural Affairs.

  Pearce, D.W. 2003. The social cost of carbon and its policy implications, forthcoming Oxford Review of Economic Policy.

  Pearce, B and Pearce, D.W. 2002. Setting environmental taxes for aircraft: a case study of the UK. Forthcoming in D.W.Pearce and C.Santoro (eds), Valuing the Environment: Case Studies from Developed Economies. Cheltenham: Edward Elgar.

  Pearce, D.W., Groom, B., Hepburn, C and Koundouri, P. 2003. Valuing the future—recent advances in social discounting. World Economics, forthcoming

  Thomas, H.A. 1963. The animal farm: a mathematical model for the discussion of social standards for control of the environment. Quarterly Journal of Economics, 1963

  Tol, R. 2002. Is the uncertainty about climate change too large for expected cost-benefit analysis? Centre for Marine and Climate Research, Hamburg University. Mimeo.

  Tol, R. 2003. The Marginal Costs of Carbon Dioxide Emissions: An Assessment of the Uncertainties. Centre for Marine and Climate Research, Hamburg University. Mimeo.


22   The correct approach to irreversibility and the so-called "precautionary principle" is to be found in the theory of option value in the investment literature, or "quasi option value" in the environmental economics literature. This does not produce the infeasible result that all irreversible losses are to be avoided. One might add that climate change will not be prevented. The Kyoto Protocol, for example, makes virtually no difference to rates of global warming as a number of commentators have pointed out-see, for example, Bhringer (2003). The UK "60%" target for greenhouse gas emissions reduction is also misleading. It is a target conditional on other countries achieving the same target. The reasons why countries will not agree to targets of this kind are evident when one looks at the Kyoto Protocol, and are brilliantly analysed in Scott Barrett's Environment and Statecraft, Oxford University Press, 2003. Back

23   The range in Pearce (2003) is below the figure used in Pearce and Pearce (2002), reflecting the wider literature available for the later assessment. Back

24   Because the Renewables Obligation implies a shadow price of carbon of around £300 tC-see Pearce (2003). Back

25   Some commentators on "sustainability" confuse maximising the survival time of humans on Earth with sustainability. They are not the same. The former could readily be achieved by reducing incomes across the world to subsistence levels for all generations save the "last" one, a result that has long been demonstrated in the economics literature. Back

26   This is not the proper place to comment on the Government's options for airport expansion and residential development in the South-East: in my view, and the view of others, they are poorly thought out-see Miles (2000). Back


 
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