A ‘component-based’ approach to discounting for natural resource damage assessment

Ecological Economics 99 (2014) 1–9

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Ecological Economics journal homepage: www.elsevier.com/locate/ecolecon

Analysis

A ‘component-based’ approach to discounting for natural resource damage assessment Edi Defrancesco a,⁎, Paola Gatto a,1, Paolo Rosato b,2 a b

Department TESAF - Territorio e Sistemi Agro-forestali, University of Padova, Agripolis, Viale dell'Università, 16, 35020 Legnaro, PD, Italy Department DICAr - Ingegneria e Architettura, University of Trieste, Piazzale Europa 1, 34127 Trieste, Italy

a r t i c l e

i n f o

Article history: Received 12 April 2013 Received in revised form 23 December 2013 Accepted 30 December 2013 Available online 24 January 2014 Keywords: Damage compensation Remediation Environmental liability Social discount rate Dual discounting Declining discounting

a b s t r a c t The paper proposes a ‘component-based’ approach to guide the choice of the social discount rate in natural resources damage assessment, where time and discounting are key features. It is a multi-rate discounting scheme, which draws on concepts from dual-rate and time-declining approaches. Each damage component is discounted at a component-specific constant rate, related to its time-trajectory. Assuming a normatively defined declining schedule of rates as a starting reference, components with longer time profiles – generally represented by welfare losses – are discounted at lower rates than short-term damage components — mainly remedial costs. The rationale behind this choice is that the longer the duration of the damage component, the higher the related nonincident specific uncertainty on the resource values and the more relevant the equity issues. When estimating the total damage, the resulting implicit average discount rate depends on the duration of each component and its relative relevance in the total damage in each moment. From an operational point of view, anchoring the rates to government prescriptions would support the robustness of the damage estimates in a court of law, whereas the dual-based environmental discount rate is based on ad-hoc assumptions that are more difficult to justify. © 2014 Elsevier B.V. All rights reserved.

1. Introduction Natural Resource Damage Assessment (NRDA) is the process through which injuries to natural resources are identified and measured and actions defined in order to compensate the public for the loss of ecosystem services. The approach has been enforced by normative acts — the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) for the USA (NOAA, 1999) and the Environmental Liability Directive (ELD) for the European Union (2004/35/CE). The basic principles underpinning both the US and EU legislation are the definition of damage liability and the rights of injured parties – the authorities acting as trustees for natural resources on behalf of society – to receive compensation. The preferred form of compensation is full restoration, when possible, of the injured resources, defined by the ELD as primary remediation; when interim and/or permanent losses occur, compensatory and/or complementary remediation measures should also be undertaken, even off-site, to cover those losses. The costs incurred in these actions, together with the damage response and assessment costs, represent ‘the measure’ of damage (Dumax and Rozan, 2011; Jones and Pease, 1997; Thur, 2007; Zafonte and Hampton, 2007).

⁎ Corresponding author. Tel.: +39 049 8272721; fax: +39 049 8272750. E-mail addresses: [email protected] (E. Defrancesco), [email protected] (P. Gatto), [email protected] (P. Rosato). 1 Tel.: +39 049 8272719; fax: +39 049 8272750. 2 Tel.: +39 040 5588092; fax: +39 040 558358. 0921-8009/$ – see front matter © 2014 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.ecolecon.2013.12.017

Habitat Equivalency Analysis (HEA) (Dunford et al., 2004; NOAA, 2006; Roach and Wade, 2006), now refined in Resource Equivalency Analysis (REA) (Zafonte and Hampton, 2007) is the method used to assess equivalency between discounted values of restoration gains and interim losses until full remediation is reached, when possible (NOAA, 2006). If the costs of the actions are a measure of the damage, HEA/REA allow grading of the remediation project to the appropriate spatial scale. Although greeted as a ‘paradigm shift’ from approaches based solely on a monetary evaluation of ecosystem services (Flores and Thacher, 2002) and allowing law courts' difficulties in using evidence from Contingent Valuation studies in NRDA to be overcome (Thompson, 2002), there have recently been criticisms about the use of HEA/REA. Indeed, HEA/REA are based on the implicit assumption that ‘the public is willing to accept a one-to-one trade-off between a unit of lost habitat services and a unit of restoration project services’ (NOAA, 2006 p. 3), thus, under certain circumstances, dispensing with the problem of measuring monetary values for these trade-offs. However, in the real world, this assumption may not hold, mostly for three reasons (Zafonte and Hampton, 2007): i) differences in type and quality between restored/ replaced resources and those injured; ii) variation in time preferences and iii) heterogeneity of preferences. To put it simply, HEA/REA do not fully take into account ‘human welfare considerations’ (Martin-Ortega et al., 2011). Conversely, it has been claimed that monetary evaluation allows heterogeneity of preferences and their variations over time to be considered (Flores and Thacher, 2002), including both efficiency and equity concerns in the assessment process. Operational purposes

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also call for a measure of the damage in economic terms, on the grounds that this allows judgement of whether compensation is adequate or, on the contrary, the costs of the restoration project are ‘disproportionate’ to the benefits obtained (Flores and Thacher, 2002). This is also in line with some normative approaches, for example the Italian legislation permits compensation via monetary equivalent when primary, compensatory and/or complementary remediation is technically or economically unfeasible (Article 2058 of Italian Civil Code). Based on the claim that evaluation of the economic dimension of damage still has a key-role to play in NRDA, various theoretical papers and case studies have been published attempting to complement HEA/REA with economic analysis (Brouwer and Martin-Ortega, 2012; Brown Gaddis et al., 2007; Dumax and Rozan, 2011; Kosugi et al., 2009; Loureiro et al., 2009; MartinOrtega et al., 2011; Thur, 2007), or working specifically on violations of HEA/REA assumptions (Zafonte and Hampton, 2007). In line with the ideas expressed by these papers, the monetary evaluation in NRDA is also central in this work. All approaches based only on HEA/REA, as well as those coupling REA with economic approaches and, even more so, strict monetary approaches to damage evaluation, emphasise that a key feature of damage and its remediation process is its time-dimension. Time passes between the injury and the start of the remediation process and time is needed for the complete (or partial) re-establishment of the baseline conditions and for completing complementary/compensatory projects. In a given ecosystem, depending on the extent and gravity of the damage, it may happen that more than one resource and more than one service are impaired or lost because of the injury. In order to return to the baseline condition, each resource and/or service may have a specific recovery trajectory, stretching over a different time-scale. Each NRDA is thus characterised by a specific time-profile, whose complexity depends on the starting conditions, the extent and gravity of the damage, the possibility of undertaking mitigation and/or remediation actions, and the specific recovery trajectory of each affected resource component and/ or service. Damage components' time-profiles and how they can be framed in the NRDA context is the first issue discussed in this paper. Intertwined with the issue of time-profiles is the problem of identifying present values of the damage components, which implies choosing an appropriate discount rate. This choice is critical, given the several cost and welfare elements with different time-profiles (short, medium, long – and sometimes perpetual – term) that have to be taken into account (Boyd, 2000; Defrancesco et al., 2008; EU Commission, 2001; Howe, 1990; Ofiara, 2002). The setting of an appropriate social discount rate has long been debated in the Cost Benefit Analysis (CBA) literature. Controversy has arisen over the theoretical foundation of the standard exponential discounting approach and the use of single-rate discounting – mainly when valuing projects with a very long time horizon – which arguably substantially under-evaluates events in the distant future. In the last decades there has been a strong upsurge of interest in social discounting issues when the debate on sustainable growth and prominent environmental problems, e.g. the climate change related risks, has arisen in the policy arena, and relevant intergenerational equity issues have emerged. Given this increased interest, in more recent years theoretical and empirical justifications have been provided for timedeclining discounting (for a review, see: Oxera, 2002; Pearce et al., 2003; Groom et al., 2005; Hepburn, 2007, among others). In line with the literature findings – starting with the Ramsey (1928) argument in favour of a zero utility discount rate – developed countries have generally reduced the recommended rates to adopt when valuing public projects (Harrison, 2010). Alternatively, discrete time-declining discount rates have been set (HM Treasury, 2003; Lowe, 2008), helping to achieve a trade-off between intergenerational equity and efficiency issues (Hepburn, 2007). Given the richness of contributions and operational indications provided in the CBA context on the choice of the discount rate and also its relevance in the damage assessment context (Kopp, 1994), our paper draws on concepts from dual rate discounting and from time-

declining discounting approaches and proposes a hybrid ‘componentbased’ approach to discounting in NRDA. With this approach each damage component is discounted at a component-specific constant rate, which is related to the component's time trajectory. Assuming as a starting reference a normatively defined stepwise-declining schedule of rates, components with longer time profiles – generally represented by individuals' welfare losses – are discounted at lower rates than short-term damage components — mainly remediation costs. When estimating the total damage, the resulting implicit average social discount rate depends on the duration of each damage component and its relative relevance on the total damage measure at each time t. The approach is developed within the rationale of monetary damage evaluation, but is also consistent with a HEA/REA perspective. The ‘component-based’ approach is exemplified through a case-study referring to a coastal contamination that occurred in Northern Italy. 2. Damage Components and NRDA Time-Profile The theoretical framework of reference for the monetary evaluation in NRDA lies in individuals' utility theory (Jones and Pease, 1997; Flores and Thacher, 2002; Defrancesco et al., 2008) and looks at environmental damage as an event diminishing the welfare of the affected individuals. Welfare losses can be assessed through observation of changes in the expenditure function (Nicholson, 1995) and are at least equal to the costs that society is willing to pay in order to stop the damage, mitigate its effect, restore the resource or substitute the environmental goods and services lost because of the injury (World Bank, 1998). An additional source of complexity in NRDA lies in two attributes, one accruing to the damage and the other to the affected resource, namely the damage reversibility and resource remediability. The former is considered here in relation to the capacity of the damaged resource to recover, i.e. to return spontaneously to the baseline condition prior to the injury.3 Instead, resource remediability means the possibility of catalysing, accelerating the process and fully or partially resolving the damage through human intervention. With both a monetary evaluation approach and HEA/REA, combined damage and resource attributes produce composite damage scenarios, which also depend on the specific features of the remedial process. Table 1 presents four scenarios referred to one resource providing one service. The defensive costs – i.e. the costs met for measures taken in response to an event with a view to preventing or minimising the damages – and the damage monitoring and assessment costs are components that occur in any scenario. Other additional components are scenario-specific: i) if the resource is remediable, the damage components include the cost for remedying the injured environmental resource and the interim (temporary) welfare losses. The human intervention can compensate for lack of capacity of spontaneous natural regeneration or accelerate it; ii) if the resource is not remediable, two cases can occur: a) the damage is reversible, i.e. the resource is capable of spontaneous recovery: interim welfare losses occur; b) the damage is irreversible: there are permanent welfare losses. The occurrence of either interim or permanent welfare losses implies the adoption of compensatory/complementary remedial actions in HEA/REA and, more generally, generates substitution costs. Finally, not only can the damage components be of different types linked to damage and resource characteristics, but they can also have

3 This characteristic is, to a certain extent, what the ELD calls ‘capacity for natural regeneration’, defined as the capacity to ‘recover, within a short time and without intervention, […] to the baseline condition […], solely by virtue of the dynamics of the species or habitat’, with no direct human intervention in the recovery process.

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Table 1 Damage components according to four scenarios linked to damage reversibility and resource remediability. Resource

Damage

Reversible

Irreversible

Remediable

Not remediable

–Defensive costs –Monitoring and assessment costs –Remediation costs –Interim welfare losses (compensatory remediation) –Defensive costs –Monitoring and assessment costs –Remediation costs –Interim welfare losses (compensatory remediation)

–Defensive costs –Monitoring and assessment costs

different time trajectories. In other words, they can emerge and terminate at different times and also overlap for some periods. This adds a further dimension to the discussion of the damage components – i.e. the damage time-profile – as depicted in Fig. 1. The time axis represents the baseline condition, i.e. the status quo without the damage. In order to deal with the complexity of components and time trajectories from an operational point of view, three moments are relevant: 0, the moment of damage occurrence; m, the moment of the claim for compensation; n the threshold between the temporary phase and the permanent phase of damage. These are defined as: i) temporary phase (time 0–n), during which the capacity of the damaged resource to provide public goods and services is lower than the baseline and society meets the costs to mitigate the damage and remediate or compensate for its effects (Fig. 2). This phase is characterised by the variability of some damage components over time, as a consequence of the time trajectories of the primary, compensatory and/or complementary remediation. During this phase, individuals may suffer interim welfare losses – linked to use values and possibly also to option values – and permanent welfare losses (Fig. 1). After moment n the baseline conditions are regained and the damage streams end or, alternatively, an infinite stream of constant welfare losses continues into the permanent phase. From an operational point of view, as m is the moment of the claim for compensation and, consequently, the reference time of the analysis (Kopp, 1994), the temporary phase can be divided in two subperiods marked by the moment m. ii) permanent phase (n–∞), if any, during which only the permanent welfare losses – due to use and passive values – remain and are constant over time. This phase, even if possible, is relatively uncommon in most damage cases (Thur, 2007). It occurs only when the damage is irreversible and the resource not fully remediable; it is characterised by annual permanent welfare losses that do not vary over time. When the permanent losses do vary, the permanent phase does not occur. Under the monetary approach, the estimated environmental damage present value DPVm is the sum of all the K components compounded

–Interim welfare losses (compensatory remediation) –Defensive costs –Monitoring and assessment costs –Permanent welfare losses (complementary remediation)

or discounted to the moment m of the claim for compensation. The general formulation, which applies to any injury scenario, is: DPV m ¼

n X K X

m−t

Dtk ð1 þ r Þ

t¼0 k¼1

þ

D∞ m−n ð1 þ r Þ r

ð1Þ

where: Dtk is the expected value of the damage component k at time t in the temporary phase (cost, interim or permanent welfare loss); D∞ is the expected value of the annual permanent welfare loss in the permanent phase; r is the social discount rate. Under the HEA approach, the NOAA (2006) general formula ‘equating the sum of the present discounted value of the services lost at the damaged site with the sum of the present discounted value of the services provided at the replacement site’ is:  3 2 3 2 j n b j −xtj b j −xt¼nþ1 X m−t 5þ4 5 1 ð1 þ r Þm−n ¼ JV j 4ð1 þ r Þ r bj bj t¼0

ð2Þ where: J is the extent of the injury (in physical terms); Vj is the expected value of the annual unit value of the services provided by the damaged resource; P is the number of compensatory/complementary units; Vp is the expected value of the annual unit value of the services provided by the compensatory/complementary project; bj is the baseline level of services provided by the injured resource; xtj is the level of services provided per unit by the injured resource at time t; bp is the initial level of services provided by the resources at the compensatory/ complementary site; xpt is the level of services provided per unit by the resources at the compensatory/complementary site at time t; l is the time when the compensatory/complementary project reaches full maturity – i.e. maximum services provision is reached and the services provision continues perpetually – or the compensatory/complementary project senesces.

Fig. 1. Damage time-profile: interim and permanent welfare losses.

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Fig. 2. Damage time-profile: defensive and remediation costs.

The restoration scale P is obtained from Eq. (2):  3 2 3 2 j n b j −xtj b j −xt¼nþ1 X 4ð1 þ r Þm−t 5þ4 5 1 ð1 þ r Þm−n r bj bj V j t¼0  3 : ð3Þ P¼J 2 " #  p Vp X p l xpt¼lþ1 −bp 1 m−t xt −b m−l 4 5 þ ð1 þ rÞ ð1 þ rÞ r bj bj t¼1

3. A ‘Component-based’ Approach to Discounting The debate about the social discount is very critical, from the theoretical and operational point of view, especially when intergenerational equity problems arise (Hepburn, 2007; Portney and Weyant, 1999) — as in the case of permanent welfare losses due to environmental damage. This paper lacks the space to adequately summarise the current theoretical and operational debate on social discounting. Relevant theoretical and empirical reasons justifying a time-declining approach to discounting over a long time horizon have been provided in the last years, and numerous papers have critically reviewed this issue (Oxera, 2002; Pearce et al., 2003; Groom et al., 2005; Rambaud and Torrecillas, 2006; Stern et al., 2006; Hepburn, 2007; Almansa and Calatrava, 2007, among others). In a nutshell, the theoretical and empirical foundations of time-declining discounting are mainly related to: i) the uncertainty about the future state of the world, namely, the future path and persistency of the discount rate (Newell and Pizer, 2003; Weitzman, 1998, 2001), the future growth rate of consumption (Gollier, 2002, 2010, 2011) and life expectancy (Kula, 1984, among others); ii) the sustainability and intergenerational equity issues that are explicitly taken into account in order to avoid the dictatorship of one generation (present or future) over the others (Chichilnisky, 1997; Chichilnisky and Heal, 1997; Li and Löfgren, 2000); and iii) the increasing experimental evidence that individuals discount hyperbolically when making intertemporal choices (for an overview, see Frederick et al., 2002). Persuasive theoretical and empirical arguments apart, declining discounting may help to ‘reduce the tension between intergenerational equity and efficiency’, even if it does not eliminate the problem (Hepburn, 2007). However, the risk of time-inconsistency (Strotz, 1955) of the time-varying rates has been underlined (Oxera, 2002), while the effective seriousness of the problem is debated (Henderson and Bateman, 1995; Pearce et al., 2003). In line with the theoretical findings, the UK government has provided a schedule of declining discount rates over a long time horizon in its Green Book on government project and policy appraisal: 3.5% for the years between 0 and 30; 3% for the year-range 31–75; 2.5% for 76–125; 2% for 126–200; 1.5% for 201–300 and 1% for the years beyond the 300th (HM Treasury, 2003). Weitzman (1998) and Newell and Pizer

(2003), among others, addressed the rationale of applying a constant exponential discounting to the time horizon up to 30 years. For the former, the uncertainty on the discount rate begins beyond the limits of the financial markets, while for the latter the short-term rate forecasts are relatively constant, though persistent uncertainty starts immediately. More recently, and according to Stern et al. (2006), the declining rates have been further lowered when major environmental impacts of climate change are expected and irreversible wealth transfers occur between generations, raising relevant intergenerational ethical issues (Lowe, 2008). A related strand in the recent literature on CBA of climate change refers to the dual-rate discount approach, which proposes to discount the whole stream of environmental costs and benefits with an Environmental Discount Rate (EDR) lower than the social discount rate used for financial flows. The rationale of the approach (that can be traced back to Fisher and Krutilla's (1975) contribution, despite the fact that those authors did not use dual rates) is related to the growing scarcity of natural resources, which increases individual willingness to pay for environmental services. Dual-rate discounting has also been justified by the non-substitutability between natural and man-made capital (Kögel, 2009; Neumayer, 1999) and on the grounds of the need to acknowledge adaptive management of ecosystems (Carpenter et al., 2007). More recently, the theoretical foundations of an EDR lower than the social discount rate reflecting non-renewable resources depletion and the related rise in willingness to pay for environmental quality have been analysed by Yang (2003), Tol (2004), Almansa and Calatrava (2007), Kula and Evans (2011), Almansa and Martinez Paz (2011), among others. Traeger (2007, 2011) and Kögel (2009) have explored the conditions under which both the EDR and the social discount rate decline over time. However, the specific choice of EDR has been questioned as being based on ad hoc assumptions that are difficult to justify (Tol, 2004). Specifically within NRDA, literature on the choice of the discount rate has mostly an operational nature. Kopp (1994) frames the issue in a general analysis, while also pointing out the NRDA specificities; he discusses the discounting choices and provides operational indications according to the different damage components, seeming to suggest that different components need different discounting rationales. The debate continues under a regulatory perspective: recommendations are provided to discount the damage cost components and welfare losses at different rates: the former have to be discounted at the ‘rate on US Treasury securities of comparable maturities to the length of restoration and assessment’, while a lower social discount rate (3%) is suggested for the latter (NOAA, 1999; US Federal Register, 1996a and b). In the European Union context, REMEDE (2008) recommends referring exclusively to the official guidelines on social discounting provided by the member countries. Finally, a number of papers discuss the issue by specifically incorporating it into the HEA/REA approach (Dunford et al., 2004; Moilanen et al., 2009, among others).

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However, judging from the literature, the debate on discounting in NRDA seems to have received less attention than in the parallel CBA context. This is despite the choice of r being equally important, as it may significantly affect both the DPVm under the monetary approach and the scale P of compensatory and/or complementary remedial actions under HEA/REA. This apparently scarce consideration could be explained on the grounds that the underlying theoretical basis on discounting is common to CBA and NRDA, or that the legal context of the latter requires that social discount rates are decided upon by public authorities' guidance documents. Whatever the reasons, we feel that the choice of the social discount rate deserves to be more specifically addressed in the specific context of NRDA. Our paper proposes a ‘component-based’ approach to social discounting in NRDA that is a hybrid approach combining the rationale of dual-rate discounting with that of time-declining social discounting, the latter being the one currently prevailing in the CBA context. Sharing the theoretical justifications of the dual-rate discounting, our approach draws the idea from it that different discount rates should be used when considering either tangible (cost components) or medium-long term intangible effects (i.e. welfare losses). In addition, NRDA focuses on a specific illegal action causing an injury to the environment: consequently, lowering the discount rate allows the incorporation of the uncertainty related to imperfect information on the resource values outside the incident-specific losses. From a NRDA operational point of view, this solution is a more feasible alternative than modelling the impact on values of e.g. the increasing resource scarcity or reduced availability of substitutes (Yang, 2003; Kögel, 2009, among others in the CBA context). General uncertainty about the future income growth rate, life expectancy and discount rate as well as sustainability and intergenerational equity issues, which support declining discounting, are also relevant in the NRDA context. Our hybrid approach links all these ‘off-site’ non environmental- and environmental-related uncertainty issues, as well as the intra- and inter-generational equity ones, to the specific time-span of each damage component via the choice of component-specific rates: the longer the duration of the damage component the higher the uncertainty. Conversely, most of the literature indicates that the damage-specific uncertainty about predicted outcomes should preferably be taken into account by properly incorporating it into the values of losses due to the injury and gains from the restoration project (NOAA, 1999; Dunford et al., 2004; Moilanen et al., 2009, among others). However, the literature suggests that a lower discount rate can be chosen when a specific damage component, including a cost, is persistently uncertain – and therefore difficult to evaluate – because of its very long timespan. Consequently, the ‘component-based’ approach discounts each damage component with a constant separate rate chosen from a menu of declining rates. The choice criterion is the duration of the damage component: the longer the damage effect, the lower the associated rate. Using constant separate rates for the different damage components qualifies our approach as a multi-rate discounting scheme, in principle an extension of the dual-rate approach, as it shares its theoretical foundations. However, the specific legal context of NRDA requires that the chosen rates are anchored to social discount rates recommended by public authorities, especially when societal value judgments based on equity issues are incorporated, as is the case of rates associated to welfare losses. To our knowledge, no prescriptions on dual-rates are provided by governments, apart from in the USA (NOAA, 1999; US Federal Register, 1996a and b). The ‘component-based’ approach fills this gap by making reference to country-specific declining – either continuous or approximated by a discrete schedule – rates, which are recommended in some CBA national frameworks. This link provides a robust operational support to the choice of the discount rate associated to each damage component.

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Formally, each damage component k is discounted with a selected social rate rk chosen according to its length among those prescribed by the public authority: the chosen rate is that associated to the last year in which the significant effect occurs. When occurring, the whole permanent welfare losses stream – which constantly continues after moment n and equals D∞ – is discounted at the lowest social rate rklo. Under these assumptions, and according to the monetary approach to NRDA, Eq. (1) becomes: DPV m ¼

n X K X

m−t

Dtk ð1 þ r k Þ

þ

t¼0 k¼1

D∞ m−n ð1 þ r klo Þ : r klo

ð4Þ

Let us focus on the temporary phase, the first part of Eq. (4), and define the total damage at time t: 

Dt ¼

K X

Dtk :

ð5Þ

k¼1

Multiplying and dividing the temporary phase part of Eq. (4) by D⁎t , DPVm becomes: DPV m ¼

n X t¼0



Dt

K X k¼1

m−t

ð1 þ r k Þ

Dtk Dt

! þ

D∞ m−n ð1 þ r klo Þ : r klo

ð6Þ

So, within the temporary phase, at a given time t the total damage (D⁎t ) is discounted with an implicit average discount factor d⁎t that is the weighted average of the discount factors associated to the damage components (Dtk); the weight associated to each Dtk equals its share in the total observed damage (D⁎t ): K X    m−t m−t Dtk ð1 þ r k Þ ¼ dt ¼ 1 þ r t Dt k¼1

ð7Þ

while, at each time t, the ‘implicit average social discount rate’ r⁎t is the solution to Eq. (7). Consequently, the resulting implicit average rate r⁎t varies over time according to the time-profile and to the relative weight on the estimated total damage (D⁎t ) of each component of the damage under evaluation. Thus, when an environmental damage occurs that has no relevant long-term interim or permanent welfare losses, r⁎t is relatively high over the damage time path – the cost components of the damage prevailing – while r⁎t is reduced when longterm interim welfare losses are relevant; r⁎t is equal to r klo in the permanent phase, where most ethical issues arise. It is interesting to note that in some frequently-occurring environmental damage cases a not increasing profile of each damage component is generally observed4 and the most relevant costs are usually concentrated at the initial stage of the temporary phase, while the interim losses damage components show a longer time-profile than that of the remedial costs. It follows that, in several typical environmental damage cases, a substantially time-declining profile of the implicit average rate is obtained. Our proposed approach can also be adopted under HEA/REA. On the one hand, in frequent cases, the time-profile of the primary remediation costs determines a cost-specific time-varying r⁎t , where r is constant if the remedial measures are undertaken within a limited length of time (e.g. 30 years when HM Treasury social rates schedule is adopted). On the other, the scale P of the compensatory and/or complementary remediation measures is determined adopting differentiated social rates rk chosen according to the partial or total damage remediation trajectories and the maturation functions of the compensatory and complementary 4 Increasing restoration and/or substitution costs can be observed when t is very close to 0, so rt⁎ might increase for a limited length of time.

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projects. So Eq. (3) is replaced by Eq. (8) in order to determine the scale P of the compensatory/complementary actions:  3 2 3 2 j n  m−t b j −xtj  m−n b j −xt¼nþ1 X 4 1 þ rj 5þ4 5 1 1 þ rj j j r b b j V j t¼0 3 : P¼J 2 p " #   p Vp X l  m−t xp −bp  m−l xt¼lþ1 −b 1 t 5 þ4 1 þ rp 1 þ rp rp bj bj t¼1 ð8Þ When the injured resource provides the baseline services at the end of the temporary phase, the second part of the numerator equals zero and rj is chosen according to the length of recovery time, while rj = rklo when permanent welfare losses occur. Similarly, in the denominator, rp is selected according to the compensatory/complementary maturation function. If the project senesces at time l, the second part of the denominator equals zero, while rj = rklo when the service provision continues perpetually. Consequently, a damage-specific time-varying discount rate is implicitly determined by the NRDA. However, when compared to the monetary approach, HEA/REA requires an additional source of uncertainty to be considered linked to the non-monetary nature of the remediation actions, since the effectiveness of both primary and compensatory/complementary measures is not fully guaranteed. Moilanen et al. (2009) have thoroughly explored this issue and proposed a framework to incorporate this source of uncertainty when estimating a ‘robustly fair’ P. As already pointed out under the monetary case, solving this problem by adjusting the rate (e.g. increasing it when the uncertainty regards the success of the compensatory actions) is not a recommended option. Stemming from the theoretical discussion of the ‘component-based’ approach, some operational rules to help in the choice of the discount rates rk can be sketched out: • each damage component has to be identified, as well as the duration of its significant effects; • the damage-specific uncertainty about predicted outcomes should preferably be taken into account by incorporating it into the estimations; • the ‘off-site’ non-environmental and environmental related uncertainty, as well as the intra- and inter-generational equity issues, are resolved through the choice of component-specific rates: the longer the duration of the damage component, the higher the uncertainty and the equity issues arising and the lower the associated rate; • given the specific legal context, using social rates recommended by public authorities lends robustness to the selected rates. Country specific discrete schedules of declining rates could provide a credible operational reference to support the choice of the discount rate to be associated to each damage component: the chosen rate being that associated to the last year in which its significant effect occurs; • the choice of the specific reference schedule, from those recommended by the government (as in the case of the UK), can be strictly related to the specific damage context: while the HM Treasury (2003) rates can be generally considered, the lowest schedule of declining rates (Lowe, 2008) is recommended only when the extent and/or intensity of the injury to the environment affects intergenerational welfare in a very relevant way.

(2.8 ha) to protect part of the coastline from storm surges. According to the project prescriptions, the embankment had to be built using blocks of natural rock obtained from excavation works and/or inert material coming from building demolition. In order to create a seaside recreational area, the project required turfing the embankment, planting trees and building some kiosks. Violating the prescriptions, the building company used wastes classified as ‘special’ and ‘hazardous’ according to the Italian waste disposal law5 as material for the embankment. This illegal action caused environmental damage. An investigation of the material in the embankment was commissioned by the local council in order to identify the specific sources of pollution (Bevilacqua, 2010; Dazzan et al., 2010) and to assess the risk of dispersion of pollutants into water and air (Bevilacqua and D'Aprile, 2011). The results led to the zoning of the embankment into four differently polluted sub-areas. An in-depth CBA (Massiani, 2010; Massiani and Barbieri, 2013) was performed in order to choose the best remediation activities with the aim of regaining, as fully as possible, the recreational uses. Two actions were undertaken on the whole area (Table 2) in order to reduce the risk generated by the polluted materials, namely: (i) the construction of a permanent steel sheet pile on the sea front to avoid the pollutants being washed out by the waves; (ii) the implementation of a monitoring system of the contaminant leaching into the groundwater and the sea. In addition, other specific defensive and remedial actions were designed for each sub-area according to the type and extent of contamination. Table 2 also highlights the original recreational uses of the different sub-areas (‘without the damage’— representing the baseline) and the present ‘with the damage’ ones, after the remedial actions. Four damage components having different time trajectories and characteristics are identified (Table 3): i) several defensive and remedial actions, which occur in the first two years; ii) monitoring of pollutants, which occurs till year 50; iii) permanent recreational welfare losses affecting both present and future generations, starting at year 2, when the remedial actions finish; and iv) interim welfare recreational losses, which affect the present generation from year 2 to 35. The occurrence of damages, and the moment in which they emerge, are of course determined by comparing the ‘with the damage’ scenario to the ‘without the damage’ baseline.6 Under a monetary approach to NRDA, the values have been estimated and subsequently discounted to the reference time for the analysis m, which in our case coincides with the damage occurrence (m = 0). The following values have been considered: (i) the defensive and remedial costs, assessed on the basis of the project estimates; (ii) the costs for monitoring of pollutants, estimated as € 1500 per year. This long-term monitoring is needed to control the risk of pollutant losses until recovery stabilisation; (iii) the permanent recreational welfare losses, due to the unavailability of sub-area 3 for sporting activities, sun-bathing and swimming. Only 25% of sub-area 3 is affected by these losses, while the remaining 75% would anyway have been used for infrastructure and services, even without the damage. Massiani (2010) has estimated the permanent recreational losses for the area using a Value Transfer approach (Spash and Vatn, 2006). The willingness to pay for sporting activities/sun-bathing/ swimming in the area is € 4.90 per person-day in the high season (May–September). With the more conservative estimate, around 16,000 person-days per year were lost in sub-area 3, giving permanent welfare losses of almost 78,000 €/year;

4. An Exemplificative Case-Study The discount rate decisions across a schedule of declining rates under the ‘component-based’ approach are exemplified through a case-study located in Italy, on the Northern Adriatic Sea coast. It refers to the building of an embankment 800 m long and 35 m wide

5 Legislative Decree 152/2006 prescribes that these types of wastes must only be disposed of in appropriate landfills and cannot be used for building purposes. 6 Even without the damage, the recreational activities could not have taken place for the first two years, since the original project would also have required two years to complete.

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7

Table 2 The defensive and remedial actions and the sub-areas uses with and without the damage.

Size (m2)

Sub-area 1

Sub-area 2

Sub-area 3

Sub-area 4

13,500

2500

5000

7000

Actions

With-the-damage uses

Removal and disposal of thespecial and hazardous wastes and replacement with clean topsoil Sports, sun-bathing and swimming

Without-the-damage uses (after remediation)

Sports, sun-bathing and swimming

(iv) the interim recreational welfare losses in the other sub-areas, due to the temporary loss of reputation of the site caused by pollution. It is well-known that a polluted site, even after remediation, is affected by a loss of appreciation by users (Easterling, 1997; Levi and Kocher, 2006; Miller and Sinclair, 2012) for a length of time that depends on their risk aversion. The remediation of the site does not achieve the complete removal of contaminants: consequently, we have assumed a rather slow ‘reputation recovery’. Under a conservative assumption, we have considered that risk aversion affects only one third of the total users and that it exponentially diminishes over time: the initial value of the interim welfare losses is € 503,067 (102,667 lost person-days at 4.90 €/person-day) becoming negligible after the 35th year.

Construction of a steel sheet pile Implementation of a monitoring system Capping (hard)

Sports, sun-bathing and swimming + Services Parking + Services

Capping (light)

Sports, sun-bathing and swimming Sports, sun-bathing and swimming

‘component-based’ approach is compared with that obtained using different approaches in Table 4. With our approach, the DPVm equals € 12.3 million, while directly adopting the Green Book (HM Treasury, 2003) declining rate, it reduces to nearly € 8 million. The latter is significantly lower as the discount rate is the same for all the damage components in each moment and therefore the rate declines more slowly over time when compared to the implicit average rate of our approach. Finally, the DPVm obtained by discounting all the damage components at the 3.5% constant rate (EU Commission, 2008) provides the lowest damage estimate (€ 6.7 million). These results are obviously case-specific, depending on the time trajectories of the damage components.

5. Conclusions The next step of our ‘component-based’ approach requires the duration of each damage component to be analysed and to associate an appropriate discount rate to each of them. The rates choice problem has been solved according to the provided operational rules. With reference to the rates menu of declining rates recommended by HM Treasury (2003), we have chosen the rates reported in the last column of Table 3, namely 3.5% for duration until 30 years; 3% for duration until 75 years and 1% for permanently persisting welfare losses. This environmental damage example shows a rather common time profile, with the majority of the costs arising within a limited time horizon and the welfare losses spanning a longer period of time. In similar cases, the environmental and economic uncertainty over the future state of the world affects the welfare-related values in a more relevant way than the remedial costs. Therefore, lower discount rates are justified for the former. In our case, discounting the permanent recreational welfare losses at a lower rate than the interim ones – to account for the higher off-site uncertainty and the intergenerational equity issues affecting them – is even more justified since the same expected annual unit value is used for both. Fig. 3 shows the time profile of the implicit average social discount rate, which, in our example, is declining. The DPVm estimated with the

The ‘component-based’ approach provides a rationale for social discounting within the NRDA framework, where the issue of discounting has not been adequately explored, despite the key role played by the discount rate in the context of environmental damage being undeniable. Indeed, it can dramatically influence the DPVm when a monetary approach is adopted, but also the scale P of compensatory and/or complementary remedial actions under HEA/REA approaches. The proposed approach is a combination of some theoretical foundations of dual-rate discounting and time-declining social discounting. The former provides the principle that different discount rates should be used when considering either tangible (cost components) or medium-long term intangible effects (i.e. welfare losses), the latter that uncertainty and intergenerational equity issues play in favour of time-declining social discount rates. Our approach agrees on the principle that very long-term welfare losses, e.g. the permanent components of the damage, have to be discounted at a low rate in order to mitigate the ‘tyranny of the present’ effect and take into account the relevant uncertainty affecting the values. Conversely, when the interim welfare losses time-profile does not exceed the present generation's lifetime, a

Table 3 The damage components, their time trajectories and the associated discount rates. Damage component

Defensive and remedial actions: Construction of steel sheet pile Removal/disposal of special wastes (sub-area 1) Removal/disposal of hazardous wastes (sub-area 2) Covering with clean topsoil (sub-areas 1 and 2) Capping (hard) (sub-area 3) Capping (light) (sub-area 4) Monitoring of pollutants Interim welfare losses Permanent welfare losses

Cost / value (€)

800,000 918,000 300,000 480,000 500,000 420,000 1500 503,067 77,794

Time-trajectory

Discount rate (%)

Frequency

Duration

Single sum Single sum Single sum Single sum Single sum Single sum Constant annuity Annually declining Constant annuity

0 0 0 1 1 1 0–50 2–35 2–∞

3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.0% 3.0% 1.0%

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Implicit average discount rate

8 4.0%

References

3.5%

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3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

0

10

20

30

40

50

Years Fig. 3. Time profile of the implicit average social discount rate in the case-study.

higher social rate is considered. The rationale behind this choice is that the interim welfare losses are mainly due to temporarily reduced values of the damaged resource and individuals may generally adapt their behaviour to the temporary change, so the ‘tyranny of the future’ effect could be mitigated. Overall, our ‘component-based’ approach discounts each damage component with a constant separate rate chosen from a menu of declining rates prescribed by the government: the choice of the rate is anchored to the damage component duration. Thus, an implicit average social discount rate rt⁎ is derived that varies over time. The distinctive characteristic of our approach is that the rt⁎ switch from one rate to another, which characterises the discrete time-declining approach – and its value at a given time t – are tailored to each specific damage profile. In other words, given the chosen time-declining r – which reflects the social rate of time preferences – rt⁎ time-varying profile (which is declining in some frequently-occurring cases of environmental damage) is more intrinsically related to the specific time-profile of each damage component. When the recommended rates incorporate societal value judgements based on equity issues (Baum, 2009) and general uncertainty about the future, rt⁎ is adapted, in a sense, to the relative relevance and duration of the welfare losses of the affected individuals. An additional advantage of the proposed approach is that anchoring the choice of the rates to government prescriptions may help to support the robustness of NRDA estimates in a court of law, while EDR is based on ad-hoc assumptions that are more difficult to justify.

Acknowledgements The authors are grateful to the anonymous reviewers for their valuable comments and suggestions for improving earlier versions of the paper. The usual disclaimer applies. They also thank Paolo Bevilacqua and Bruno Della Vedova of the Department of Engineering and Architecture at the University of Trieste for the technical information provided on the case study.

Table 4 The environmental damage present value (DPVm) under various discounting approaches. Discounting approach

DPVm (€)

‘Component-based’ Green Book (HM Treasury, 2003) EU Commission, 2008

12,339,724 7,981,238 6,747,865

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