CHAPTER 1
PART I
Economics of Sustainability: The Environmental Dimension
Overview Essay
by Jonathan M. Harris
Serious consideration of sustainable development requires a rethinking of major elements of economic theory. The standard economic perspective must be broadened to take into account environmental and social perspectives. In this essay, we address primarily the environmental issues, then move to the social perspective in Part II.
To some extent, principles of environmental sustainability can be expressed in standard economic terms. For example, economic theory provides for the internalization of environmental costs, and natural resource economics recognizes the concept of sustainable yield in natural resource systems. But to consider the full implications of sustainability we need to look beyond these formulations to consider the social and ecological contexts of economic activity. This in turn leads to a re-examination of some of the fundamental theoretical frameworks of economics. Among the concepts that need to be reexamined are capital, valuation, distribution, savings, investment, and economic growth. As a result, both the categories of analysis and the policy implications derived from that analysis change significantly when we take sustainability seriously.
A Broader View of Capital and Production
Standard economic theory treats manufactured capital as the key to development, with some attention also to human capital (skills and knowledge embodied in individuals). Although natural resources are acknowledged as an input to the productive process, they are not an important feature of most economic models. In addition, the social and institutional arrangements that provide the basis for economic activity remain very much in the background. Economic theories of sustainability are based on a more expansive concept of capital. Viewing capital broadly as any stock that produces or contributes to a flow of output, we can identify four kinds of capital: manufactured, natural, human, and social.
Manufactured capital is what is ordinarily referred to simply as "capital" in most economic theory. Natural capital corresponds to what standard economic theory traditionally defined as "land"; the reason for the different terminology is to emphasize the essential productive role of this factor, and to broaden the concept to include all environmental functions. Human capital refers to education and skills possessed by individuals. Social capital is used to refer to knowledge and rules embedded in culture and institutions, such as the legal system or the concept of property rights. All four kinds of capital and essential to economic activity, although standard economic theory emphasizes primarily manufactured and human capital.
Manufactured capital is maintained and accumulated through investment. This process, of course, is central to standard models of economic growth. There is a clear and reciprocal relationship between manufactured capital and economic production: more capital makes it possible to expand economic production, and the devotion of a share of production to investment makes it possible to accumulate more capital. The relationship can be defined in mathematical terms, using concepts such as the savings rate and the capital /output ratio, and is easily amenable to measurement and econometric analysis.
Human capital is also fairly well represented in economic models of the labor market and plays an important role in modern growth models. The dynamics of natural and social capital present more problems, and these kinds of capital have received less recognition and attention from economists. Yet for true sustainability to be achieved, all four kinds of capital must be maintained at levels that allow both human well-being and healthy ecosystems.
Manufactured and Natural Capital
In the first article summarized here, Robert Costanza and Herman Daly set forth the basic conditions for the maintenance of natural as well as manufactured capital. They point out that neoclassical economics usually treats natural and manufactured capital as fully substitutable. If this approach is accepted, there is no particular reason to conserve natural capital so long as manufactured capital is augmented by a value equal to or greater than the depletion of natural capital. For example, it would be acceptable for a country to cut down its forests if the economic proceeds from the timber sales are used for investment in industrial development.
Even in the neoclassical perspective, however, the principle of weak sustainability is appropriate. A well-known principle derived from work by Solow and Hartwick (the "Hartwick rule") states that consumption may remain constant, or increase, with declining nonrenewable resources provided that the rents from these resources are reinvested in reproducible capital (Hartwick 1977; Solow 1986). In this approach, sustainability requires that the total value of the two forms of capital remain constant over time. El Serafy has pointed out that in order to assess this value, there must be a full accounting for natural capital depletion (El Serafy, 1993; also see article by El Serafy summarized below).
A strong sustainability approach is based on the idea that substitutability between natural and manufactured capital is limited. Rather, the two are seen as complements—factors that must be used together to be productive. For example, a fleet of fishing boats is of no use without a stock of fish. In the case of critical natural capital—for example, essential water supplies—substitutability is close to zero. While it may be possible, for example, to compensate for some water pollution with purification systems, life and economic activity are essentially impossible without access to water. The strong sustainability approach implies that specific measures distinct from the ordinary market process are necessary for the conservation of natural capital. It also implies limits on macroeconomic scale. The economic system cannot grow beyond the limitations set by the regeneration and waste-absorption capacities of the ecosystem.
Costanza and Daly suggest that a minimum necessary condition for sustainability can be expressed in terms of the conservation of natural capital. This policy goal leads to two decision rules: one for renewable and the other for nonrenewable resources. For renewables, the rule is to limit resource consumption to sustainable yield levels; for nonrenewables, the rule is to reinvest the proceeds from nonrenewable resource exploitation into renewable substitutes. Following these two rules will maintain a constant stock of natural capital. To maintain a constant per capita stock of natural capital also requires a stable level of human population, a factor that Daly has emphasized elsewhere (Daly 1991).
The rules suggested by Costanza and Daly for natural capital conservation are rough guides rather than precise theoretical principles. Nicholas Georgescu-Roegen, whose pathbreaking work The Entropy Law and the Economic Process outlined the dependence of the economic system on biophysical systems, argued that it is ultimately impossible to maintain a constant stock of natural capital, since all planetary resources will eventually degrade or be used up according to the Second Law of Thermodynamics (Georgescu-Roegen 1971, 1993). But at a more practical level he proposed an approach similar to Costanza and Daly's, reasoning that "the enormous disproportionality between the flow of solar energy and the much more limited stock of terrestrial free energy suggests a bioeconomic program emphasizing such factors as solar energy, organic agriculture, population limitation, product durability, moderate consumption, and international equity" (Georgescu-Roegen 1993; summarized in Krishnan et al. 1995).
The issue of conserving natural capital is part of a broader debate on reconceptualizing economic theory. Giuseppe Munda places the issue of natural capital conservation in the context of a contrast between the two economic paradigms of neoclassical and ecological economics. Whereas neoclassical environmental economics seeks to apply the categories of economic theory to the environment, ecological economics attempts to modify the conception of the economic system to acknowledge its role as a subsystem of a broader planetary ecosystem. In this view, standard economic approaches such as valuation in monetary terms can give at best only a partial view of reality. An analytical pluralism that takes into account social and environmental dynamics is essential to the ecological economics paradigm (Norgaard 1989, 1994). For an extensive treatment of the principles of ecological economics, see Volume I in this series, A Survey of Ecological Economics (Krishnan et al. 1995). Economic and ecological perspectives on sustainability are discussed in Common and Perrings (1992). A recent evaluation of issues in ecological economics can be found in the articles by Wackernagel, Herendeen, and others in Ecological Economics 29 (1999).
The social basis for the conservation of natural capital is explored further in the summarized article by Talbot Page. Page suggests that natural capital conservation requires specific recognition in law regarding the "standing" of natural capital as a social asset. He offers an analogy to constitutional law: fundamental social principles must determine the broad outlines of natural resource management. The sphere of "purely" economic analysis is thus limited to more specific decisions within this general framework.
The importance of social capital in natural resource management is evident when "marketization" breaks down traditional social institutions that have governed the use of common property resources such as forests or fisheries. In such cases, it is essential either to find ways to maintain the traditional common property management institutions, or to replace them with effective new institutions. Unfortunately, the development process frequently creates a situation in which neither traditional nor modern forms of social control over resources are effective, resulting in rapid and destructive resource exploitation.
Failures of social capital development are also at the root of many inequities and much human suffering in the development process. This is a central aspect of sustainability that is neglected in standard economic theory and only partly addressed in ecological economics. In Part II of this volume, we address issues of social capital and development in depth.
Intergenerational Equity
Sustainability is sometimes defined as intergenerational equity—ensuring that future generations have an inheritance of natural, social, manufactured, and human capital at least equal to that of the present generation. From the point of view of neoclassical economic theory, sustainability can be defined in terms of the maximization of human welfare over time. Most economists simplify further by identifying the maximization of welfare with the maximization of utility derived from consumption. This formulation certainly includes many important elements of human welfare (food, clothing, housing, transportation, health and education services, etc.) and has the analytical advantage of reducing the problem to a measurable single-dimensional indicator. But it is open to criticism as a serious oversimplification of the nature of human wellbeing (see, for example, Sen 1999 and Ackerman et al. 1997).
Using the neoclassical definition of welfare maximization, a formal economic analysis raises the question of whether sustainability has any validity as an economic concept. According to standard economic theory, efficient resource allocation should have the effect of maximizing utility from consumption. If we accept the use of time discounting as a method of comparing the economic values of consumption in different time periods, then sustainability appears to mean nothing more than efficient resource allocation—a concept already well established in economics.
One line of criticism of this reductionist approach to sustainability centers on the use of a discount rate to compare present and future costs and benefits. Discounting has been subject to numerous critiques on account of its present bias, especially as the time period under consideration becomes longer (see overview essay for Part VI and summarized article by Lind and Schuler in that section).
A simple example demonstrates the general point. At a discount rate of 10 percent, typically used for cost-benefit analysis, the value of $1 million one hundred years from now is the same as a mere $72 today. Thus it would apparently be justifiable to impose costs of up to $1 million on people 100 years from now in order to enjoy $72 worth of consumption today. By this logic, much resource depletion and environmental damage could be considered acceptable, and even optimal, according to a criterion of economic efficiency.
The problem is that by accepting the use of a discount rate we have implicitly imposed a specific pattern of preferences regarding the relative welfare of present and future generations. Howarth and Norgaard have argued that the use of a discount rate is appropriate for the efficient allocation of this generation's resources but is inappropriate when the rights of future generations are at issue (Howarth and Norgaard 1993). Use of a current market discount rate gives undue weight to the preferences of current consumers. This creates a strong bias against sustainability in the context of issues such as soil erosion or atmospheric buildup of greenhouse gases, where the most damaging impacts are felt over decades or generations.
To achieve intergenerational equity, we need some kind of sustainability rule regarding resource use and environmental impacts. The solution of what Norgaard and Howarth (1991) refer to as "the conservationist's dilemma" is not easy. By imposing a low discount rate for decision-making, we can place a higher value on the future. For example, with a low discount rate future costs associated with soil degradation or global climate change would be weighed more heavily. But at the same time, the use of a low discount rate encourages excessive current investment in manufactured capital (for example, the construction of large dams or nuclear power plants), to the likely detriment of natural capital. It is, of course, possible to use different discount rates for different planning purposes. But such an apparently arbitrary choice has little theoretical justification.
Michael Toman suggests that the issue may be resolved by recognizing that some issues can be appropriately dealt with through neoclassical market efficiency, while others require the application of a "safe minimum standard" approach to protect essential resources and environmental functions. He suggests that the criteria of possible severity and irreversibility of ecological damages should be used to decide which theoretical framework is more appropriate. Others have referred to this approach as the use of a "precautionary principle," which should supersede economic analysis when there is uncertainty about possible outcomes and large potential ecological damage is at issue (Perrings 1991).
The adoption of this reasonable suggestion would have far-reaching implications for economic theory and policy. Note the essential role of "moral imperatives," "public decision making," and "the formation of social values" in Toman's suggested decision framework. None of these appear in the neoclassical economic model, where markets are presumed to be the best resource allocators, and the occasional correction of a "market imperfection" the only appropriate role for government. Thus Toman is in effect asserting the importance of sustainability as a concept independent of standard neoclassical economic analysis, one that requires an explicitly normative and socially determined process of decision-making.
This represents a fundamental shift in the economic paradigm. Much as the Keynesian revolution validated the concept of government intervention to achieve macroeconomic balance, the acceptance of sustainability as a valid social goal places a new complexion on all policy issues concerning the relationship between human economic activity and the environment. Markets may be valuable and essential means, but they cannot determine the ends, which must be arrived at by a social decision process informed by different disciplinary viewpoints. This will require an unaccustomed humility on the part of economists, and a willingness to work together with other social and natural scientists.
Issues of Distribution and Valuation
The advocacy of intergenerational equity also has implications for equity and property rights in the current generation. It makes little sense to talk about equity between generations without acknowledging the great current inequalities of wealth and income. In terms of natural capital and environmental assets, many questions arise as to private and social property "rights" over these assets. Who, for example, has rights to genetic resources, fish stocks, forests, or water? These issues are interlinked with distributional questions. A more equitable distribution of income would have major implications for the use and conservation of water resources, since clean water is a major unmet need in many areas of the developing world. (In neoclassical terms, the "demand" for water is not an "effective demand" if people lack income to back it up.)
