Payment for environmental services in multi-output production processes 

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Production and externalities

The theory of (negative) externalities is in the core of environmental economics (van den Bergh, 2001). Externalities exist when the private costs (or benefits) to the producers (or purchasers) of goods or services differ from the total social costs (or benefits) entailed in the production (or consumption) of the goods or services (Pigou, 1920). Let us take an example: a firm produces a product A that is sold on the market, and during the production process, it alters the provision of service B which produces neither a cost nor a profit for the firm but does benefit society. B is an externality in the production of A. The theory of externalities started with Pigou (1920) who highlighted a possible divergence between private and social products. The goal of most companies is to maximize their own profit, not to benefit society. In a market economy, the highest social welfare can consequently only be attained if social and private benefits coincide. Pigou concluded that rules must be established to transfer the social liability of the service B to the producers. This would result in an internalization of B in the objectives of the private producer (B and A would be two outputs of the production process).
Knight (1924) proposed another view of the problem: the failure of the market to maximize public wealth comes from the absence of payment for public services. Coase (1960) introduced the role of positive transaction costs into Pigou’s examples. He showed that – in case of perfect competition – maximum social wealth can be achieved without any liability to the producer if society takes measures to reduce the potential loss in the output B resulting from the firm’s production process to supply A. Although the debate concerning liability is still open (Demsetz, 2010), the conflicts between private and public interests and the concept of externality are more than ever in the forefront of the debate on production, essentially because of the rise in environmental concerns. Environmental services are often good examples of externalities either because they are naturally produced without human intervention but are affected by human activities (e.g. biodiversity, water quality, carbon storage in forests. . . ), or because they result from an interaction between a human activity and the environment (e.g. recreation, landscape amenities). These services often benefit society, but are not marketed and have no monetary value either for the producer or for the purchaser of the product. Hardin (1968) introduced the notion of externality in the framework of pollution and showed, through his “tragedy of the commons” theory, that since pollution is shared by the entire society while the profit is individual, the impact of the production process on the environment is often underestimated, or even ignored as long as it remains imperceptible. Attempting to increase everyone’s individual benefits leads to choices that reduce the global wealth.
Following Pigou (1920)’s approach, if the externality is negative (e.g. water or air pollution), then the producer does not support the total cost of production; the part of the cost related to the externality is supported by society. For example, a plane flight is a valuable service to the traveler, but it generates air pollution which badly affects society and is ignored in the ticket pricing. Such a situation may create conflicts between the private interests of the producer or consumer and the public interests. In effect, market failure results because the externality is incorrectly valued.
When the production process creates a positive externality that is a public service (private and public goods are complementary), society has a stake in the production of private goods. If society does not pay for it (free ride), then the producer has no interest in maintaining the level of service. If the producer finds a production process which increases his profits but reduces the availability of a public service, then the producer will prefer the new process, unless the loss in profits due to the higher production of public service is monetarily compensated for. For example, the owner of a broadleaved forest might switch to coniferous forest, which is usually more profitable. This change in management will reduce the recreation service because coniferous forests are less attractive (Colson et al., 2010). In order to keep the level of service, the society can compensate the forest owner for the loss in profit resulting from keeping the broadleaved forest. The provision of public service becomes then privately valuable. In other words, externalities are internalized.
If the economy runs at the Pareto optimum without taking care of the externalities, then the provision of externalities, including environmental services, is uncontrolled. This may lead to a reduction in public services and possibly in the total wealth (the sum of all individual and social wealth). An interaction between society and firms is therefore required to limit the production of negative externalities and to ensure the provision of positive externalities.

Joint production: the core of the problem of ES undersupply

Externalities are usually unintended outputs in a production process. They result from the production technology used to produce desired goods or services when the costs of production of the desired output and the externality are not separable. Two outputs from the same process are said to be joint when it is impossible to identify the production costs for each output individually (Mill, 1848). Joint production is common in many economic fields. For example, Chizmar and Zak (1983) showed that education can be seen as a two-output function: a cognitive achievement and an attitude towards the field taught (economics, in their example). Many other authors have considered multiple outputs in farm production (Mundlak, 1963; Just et al., 1983; OECD, 2001) and more recently in the forestry sector (Hof et al., 1985; Arthaud and Rose, 1996; Pattanayak et al., 2002). Let us take an example in the field of forestry: when trees are cut in a forest to supply both timber and fuel wood, the same initial operations of cutting and extraction are required and production costs cannot be split between the two products.
Three cases of jointness exist:
• products are complementary: an increase in the production of one of the outputs implies an increase in the production of the second;
• products are substitutes: an increase in the production of one output requires a decrease in the production of the other;
• products are neutral: the production of one output may be increased or decreased without affecting the other.
In environmental economics, joint production has often been studied in attempt to analyze the causes of pollution generated by production processes, as in Hardin (1968). For example, traditional pig breeding leads to water pollution by nitrates (Piot-Lepetit and Le Moing, 2007); salmon aquaculture simultaneously generates a beneficial output –salmon– and a harmful output –pollution– (Liu and Sumaila, 2010). If the technology is already efficiently operated, then reducing pollution requires a decrease in production or a change in technology, which in turn, might increase production costs.
When beneficial and harmful outputs are produced simultaneously, two hypotheses are commonly made: (1) the outputs are weakly disposable: this means that if given quantities of outputs can be produced using limited quantities of inputs, then any proportional reduction in the quantities of outputs can also be produced (Shephard, 1970); (2) the beneficial outputs are nulljoint with the harmful ones: this implies that zero harmful production can only be achieved when zero goods are produced (Färe and Jansson, 1976). These two hypotheses are particularly relevant when harmful outputs correspond to a reduction in environmental services or a pollution1. Therefore, the study of environmental externalities must partly focus on increasing our knowledge of the joint production of goods and externalities.

Environmental and ecosystem services

The environment has value to human beings because it provides environmental services – also called environmental benefits – such as clean air, potable water and so on. These services result from the natural presence of a combination of physical, chemical or biological characteristics. These characteristics are affected by both natural and artificial production systems. For example, if an industrial manufacturing process simultaneously produces goods and pollutes the air, then it reduces the environmental benefits from clean air (Baumgärtner et al., 2001). These environmental services are not necessarily related to the functioning of ecosystems, but they can be. As an example of a natural ecosystem production system, forests are often presented as positive providers of environmental services (Forest Europe, 2011). The environmental services are in this case mostly non-marketed outputs of the ecosystem (biodiversity, soil protection, amenities, etc.).
Ecosystems contribute to environmental services, but also to the production of goods such as food, raw materials (fiber, wood and fuel wood), medicinal resources, etc. (see Figure 1.1). The benefits people obtain from ecosystems are called ecosystem services (Millennium Ecosystem Assessment, 2005). These include all goods and services provided by ecosystems, only one part of which is captured on the commercial market (Costanza et al., 1997). The other part of the goods and services provided by ecosystems contributes mostly to environmental services. So, an environmental service – provided by the environment – can be an ecosystem service – provided by an ecosystem – and conversely, but it is not mandatory.
Many environmental services such as the preservation of biodiversity are substitutes for the production of marketed goods (see e.g. Hauer et al., 2007). The free market does not properly value environmental services, especially when these services are public goods (Aldy et al., 1998). Similarly to the case of externalities2, market failure results in an under-provision of environmental services (Bator, 1958). To preserve or increase the provision of environmental services, some authors have suggested a mechanism called Payment for Environmental Services (PES, see Pagiola and Platais, 2002; Wunder, 2005). Some schemes, such as payment to ensure the preservation of landscapes resulting from agricultural activities, had already been developed in the 1990s in many countries (e.g. Norway, Switzerland, Japan, the European Union; see OECD, 2009). Although the PES mechanism mostly concerns services provided by ecosystems, it is called Payment for Environmental Services because it aims at increasing the provision of the services in the intersection of the set of environmental and ecosystem services. Other ecosystem products are supposed to be properly supplied by the conventional market.

Private forestry: a typical multi-output process with externalities

The definitions given in the previous section are applicable to the provision of environmental services in the forest sector. Forestry is an activity which is closely related to the environment. First, the wood production process results from the interaction between a biological process (tree growth) and human intervention (plantation, pruning, thinning, harvesting). Second, wood harvesting impacts crown cover, number and age of standing stems and many other forest characteristics which are relevant to the provision of environmental services, e.g. the preservation of biodiversity, carbon storage, landscape quality, protection from erosion, avalanches and rockfall. Third, the forest is a semi-natural space in which numerous stakeholders are involved: scientific experts, investors, ecologists, and public – all of whom may have conflicting interests. The management of privately owned forests is a particularly clear example of a multiple production system subject to competing interests and stakes.

Forest ecosystems produce wood and amenities

Forests produce multiple goods and services which de Groot et al. (2002) classified into three categories: 1. economic goods (e.g. wood products, hunting leases), 2. environmental services (e.g. biodiversity protection, carbon storage, protection against natural hazards, improvement of the water quality), and 3. socio-cultural values (e.g. recreation, scenery, history).
Among the economic goods, wood products generally are the main source of revenue. In the European Union, harvested wood products generate and average of 146 euros per year and per hectare of forest available for wood supply (Forest Europe, 2011). However, harvested wood products only account for a small part of the total value of forest productions (e.g. Montagné et al., 2009, state that harvested wood products correspond to 20% of the total value of French forests). Other products like fruits, nuts, mushrooms, game meat, wild honey, bees-wax, cork, etc., account for less than 10% of the total value of all forest products combined.
Other than products or materials, forests produce many services; however, only a few of them are economically rewarded. Hunting is the only service which is a source of significant income today. In France, the total value of hunting leases in 2003 was 72.5 million euros, equivalent to nearly 4% of the total income from harvested wood (MAP, 2006). However, this share of hunting leases over the total forest income is subject to huge disparities between properties. Due to restrictive regulations, hunting is leased on less than 15% of the private forested properties. Therefore, in these properties, hunting can generate higher revenues than wood production, especially when the potential for wood production is low.
Near large cities, forest recreation is an important service which is often supplied by public forests. Indeed, providing recreational opportunities to the public is one of the objectives stated in the contract between the state or local community – the forest owner – and the managing agency (in France, the National Forest Service – ONF). In these contracts, the community often accepts a reduction in income from forest harvesting to finance recreation facilities in the forest.
Many other environmental services provided by forests such as landscape quality, biodiversity preservation, water purification, carbon storage. . . are rarely subject to payment3. These public services are externalities of forest management and are provided free of charge. Consequently, if forest owners’ main objective is to maximize profit (industrial forest owner), they will manage their forest to produce the highest possible net income (from wood or hunting). The negative or positive impact of their decisions on the provision of environmental services will have no influence on their choices. Moreover, their management plan will not take into account the potential increase in the provision of services even if it would not cost.
This may result in a low provision of social amenities and lead to globally lower social wealth. Figure 1.2 shows the envelope of a production possibility set – the envelope of the set of all possible combinations of outputs subject to a limited quantity of inputs – for private products and public services. If private products and public services are substitutes and the manager maximizes his private utility function – composed of profits and other amenities benefiting to the manager –, then production will not be optimum for society because the provision of public services will be too low. Maximizing the provision of public services may not provide optimum results either, because society values both public and private wealth.
The part of the production possibility set between AE and A2 on the envelope corresponds to the best combination of outputs: it is not possible to produce more of any of the outputs without reducing another output or increasing inputs. This subset of the envelope is the production possibility frontier (PPF). Note that the optimal provision of private and public services is obtained when operating the technology at the point where the production possibility frontier intersects the highest iso-utility curve.

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Varied production objectives of forest owners

Many private forest owners belong to the so-called category of Non-Industrial Private Forest Owners (NIPFs). They do not maximize their profits, but rather their utility. In this case, the utility function includes profits and some of the services called amenities, for example recreation, hunting, etc. (Binkley, 1981). These NIPFs are considered as household producers because they produce goods and services in their forests for their own consumption (Becker, 1965). In fact, they benefit in part from the public services supplied by the forest4 (Max and Lehman, 1988). They might therefore be willing to participate in the provision of environmental services (Raunikar and Buongiorno, 2006) and to adopt management methods for multipurpose forestry. The divergence between the optimum social level of production and the actual level of services supplied by the forest may be reduced if the same environmental services, or complementary ones, are of interest to private forest owners and the public. For example, if owners value wood products but also the aesthetics of their forests, and if landscape has value to the public, then these owners will provide more public services than if their goal was to maximize their profits. In Figure 1.3, an environmentalist would produce more environmental services than the social optimum and a multifunctional producer willing to make limited compromises to favor environmental services (“profit multifunctional manager”) would produce slightly fewer environmental services than the social optimum.
Interestingly, certain combinations of different forestry practices can lead to a global supply of externalities which is close to the social optimum. However, if a forest is not optimally managed (not on the PPF), the social optimum cannot be reached. The PPF presented in Figure 1.3 is convex. In this case, the combination of outputs from the different producers – if they operate efficiently – is inside the set delimited by the PPF and the segment AE AP , but the social optimum cannot be reached unless every forest owner produces the same combination of outputs as the social optimum AS . If the PPF for individual producers is not convex, then the variety of management types creates opportunities to increase the overall utility compared to standardized or uniform management (Boscolo and Vincent, 2003). Various management types may increase social utility and displace the profit/environmental services mix corresponding to the optimum social provision of profits and services (Figure 1.4).
The conciliation of private and public interests to achieve the highest social welfare is the duty of public policy makers. It is a complicated task because of the multiplicity of stakes and cases. Proposing appropriate policy solutions for a better supply of environmental services requires:
• identifying the public and private needs and determining their utility functions;
• knowing the production processes and evaluating the current practices;
• designing adapted tools to attain higher social wealth.
This approach can be extended to other production processes where producers can obtain non-marketed environmental or public benefits. A good example is the beneficial effect on farmers’ health of a reduction in pesticides in organic farming.

Identification of the demand for environmental services

Now, let us investigate the social and private needs for environmental products and services that have been identified to date, with the forest as an example. As mentioned previously, two types of demand for environmental goods coexist: a social demand and a private demand. Social demand is identified by policy makers in both governmental and nongovernmental organizations and is recorded in international and national agreements. Private producers’ demand can be determined by analyzing the current status of production and consumption on the market. In the next section, we explore these two sources of information (institutional agreements on the one side and market based statistics on the other) and point out the consistencies and discrepancies between social and private demand which mainly stems from the society’s interest in externalities and benefits. Furthermore, we emphasize the importance of a better understanding of production possibilities to satisfy both types of demand.

International environmental commitments and social needs

In the second half of the twentieth century, many countries enjoyed exceptional economic growth: the post-World War II economic expansion. Economic prosperity together with full employment and increased leisure time created opportunities for the development of a new perception of human well-being. It was during this period that the impact of human activities on the environment became a major concern. This concern led to the recognition of the benefits of the environment to human beings in the Declaration of the Conference of the United Nations on the Human Environment in Stockholm in 1972.
Since then, environmental issues have been discussed during numerous international confer-ences and new approaches to environmental protection have been developed. One of the most important conferences was the Earth Summit in Rio in 1992 where the concept of sustainable development was first introduced. This concept arose from the awareness that unbridled economic development might ruin the capability of future generations to develop and to continue to benefit from the ecosystem services we currently enjoy. The question was how to reduce the impact of human activities. The two main international agreements which resulted from the Rio Summit were the Convention on Biological Diversity (CBD) and the United Nations Framework Convention on Climate Change (UNFCCC). The CBD came into force in December, 1993, and aims to preserve biological diversity and promote sustainable use of biological resources (United Nations, 1992a). The goal of the UNFCCC is to stabilize “greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system” (United Nations, 1992b). Within this framework, in 1998, 84 parties adopted the Kyoto Protocol which came into force in 2005. Currently, 192 parties (191 nations) are involved in this Kyoto protocol. The signatory nations thus clearly expressed their intention to reduce the impact of human activities on the environment in order to preserve ecosystem viability and the services they provide over the long term.
One difficulty that policy makers encounter when dealing with environmental services is the estimation of the benefits from these services. To be able to take political decisions with an environmental dimension, policy makers agree on the need for means to estimate the production of environmental services and their economic value. Two major reports illustrate such valuation approaches: the Millennium Ecosystem Assessment (MEA, 2005) and the Economics of Ecosystems and Biodiversity (TEEB, 2010). The MEA showed that ecosystems do indeed provide services which benefit society. The assessment further showed that the provision of ecosystem services has globally decreased over the last 50 years, and is likely to continue decreasing in the near future. Action is therefore required. Following this assessment, TEEB identified one of the most critical parameters identified in the MEA: the interaction between ecosystem services can multiply the value of some services which appear to have little value at first. The report also showed that poor people are more dependent on ecosystem goods. Finally, TEEB provides several concrete examples where the value of ecosystem services is estimated. The report does not propose an overall estimate of ecosystem benefits because of the complexity and variability of the situations, but it does give practical guidelines. Ecosystem services do have a value and before decision-makers act, they must be provided with an estimate of the possible impact of their decisions on the future provision of these services.

Forestry’s special place in environmental commitments

Forest management has a special place in international environmental conventions because forestry practices can be either a threat to or an opportunity for the provision of environmental services. For example, the massive deforestation prior to planting oil palm trees and the illegal logging of highly valuable trees (high-grading) have resulted in losses of biodiversity, a reduction in forest carbon stocks and soil degradation. On the other hand, afforestation and appropriate forest management practices can increase carbon storage capacity, reduce land-slide risks, create recreational opportunities and contribute to local economic development.
Biodiversity During the 2010 CBD conference, a specific decision concerning forest biodiversity was adopted by the participants (COP 10 Decision X/36.Forest biodiversity). Ninety-two parties agreed on the need to preserve forest biodiversity and resources. As a first step, the countries and certain international organizations such as the Food and Agriculture Organization of the United Nations (FAO) agreed to assess the current state of forest diversity and list recommendations to preserve or improve biodiversity. Official means of cooperation between countries will then be established to protect the forest biodiversity.
Greenhouse gases Forests were also at the forefront of the UNFCCC negotiations because trees store large quantities of carbon (638 Gt C) and play an important role in carbon fluxes. On the one hand, deforestation and forest degradation release considerable quantities of carbon into the atmosphere every year (1.2 Pg C.yr−1 ). This corresponds to nearly 12% of total annual anthropic emissions (van der Werf et al., 2009). On the other hand, afforestation and forest restoration are among the few options available to sequester CO2 and to reduce net emissions. To increase carbon sequestration service in forests and to avoid large carbon releases due to deforestation, the policy makers at UNFCCC agreed on incentive mechanisms, for example the CDM (Clean Development Mechanism) in the framework of REDD (Reducing Emissions from Deforestation in Developing Countries).
The wood and forest sector also plays a role in the global anthropic greenhouse gas (GHG) balance. Wood is a renewable material which, in many cases, emits less GHG than alternative materials during its life cycle. This is obvious in the building sector when steel or concrete is replaced by wood (Börjesson and Gustavsson, 2000; Adalberth, 1999). Furthermore, as a source of energy, wood is renewable and virtually nearly carbon-neutral and can therefore help reduce net carbon emissions (Schlamadinger et al., 1997). Although the effect of wood use on GHG is not explicitly mentioned in the UNFCCC agreement, it was taken into account in the total estimated balance which includes, among others, emissions from the energy and manufacturing sectors. To sum up, the wood and forest sector is subject to two contradictory pressures: to store more carbon and to supply more wood. Fortunately, an appropriate balance between these two objectives can create conditions favorable to meeting the goal of reducing GHG emissions (Taverna et al., 2007).

Table of contents :

I Questions and methodology 
1 Increasing stakes of the supply of environmental services 
1.1 ES: private and social interests
1.1.1 Private and public goods
1.1.2 Production and externalities
1.1.3 Joint production: the core of the problem of ES undersupply
1.1.4 Environmental and ecosystem services
1.2 Private forestry: a typical multi-output process with externalities
1.2.1 Forest ecosystems produce wood and amenities
1.2.2 Varied production objectives of forest owners
1.3 Identification of the demand for environmental services
1.3.1 International environmental commitments and social needs
1.3.2 Forestry’s special place in environmental commitments
1.3.3 Public demand for forest environmental services in France
1.4 Supply of environmental services in private forests
1.4.1 Household producers
1.4.2 Survey of French forest owners’ expectations
1.4.3 Intentions to produce wood and non-wood services
1.5 Defining appropriate policies
1.5.1 Public environmental policies
1.5.2 Converting externalities into privately valuable products
2 Payment for environmental services in multi-output production processes 
2.1 Possible costs of environmental services (ES)
2.1.1 Valuing ESs
2.1.2 The marginal costs: A technical estimate of ES value
2.2 Opportunity costs of ES provision: an analytical approach
2.2.1 Single ES transformation function
2.2.2 Double ES transformation function
2.2.3 Envelope of the maximum profit possibilities
2.2.4 Impact of the joint ES production on the opportunity cost of a single ES provision
2.3 Joint ES production and the maximum profit equation
2.3.1 Relationship between outputs is a key factor
2.3.2 When ESs have independent opportunity costs
2.3.3 When there is a synergy in ES provision
2.3.4 When ESs conflict
2.3.5 Characteristics of the profit function in the boundary of the ES set
2.4 Impact of PES designs on multiple ES provision
2.4.1 Underlying hypotheses
2.4.2 Payment for a single service
2.4.3 Bundling or stacking PES?
2.4.4 PES portfolio strategies
3 ES production possibilities and costs 
3.1 Variation in the profit function with ES supply
3.1.1 From production possibility sets to profit functions
3.1.2 Particularities of ES provision by ecosystems
3.1.3 Determining the production possibility set using surveys
3.1.4 Modeling as a surrogate for surveys
3.2 PPS envelopment
3.2.1 Parametric modeling
3.2.2 Non-parametrical methods
3.3 Enveloping a non-convex production set with weakly disposable outputs
II Application to high oak forests 
4 Estimating ecosystem production 
4.1 Estimation of directly measurable outputs
4.1.1 Wood volume and stumpage value
4.1.2 Global change mitigation
4.2 Estimation of ES provision using indicators
4.2.1 A scenic beauty indicator to estimate the recreation function
4.2.2 Evaluating the contribution of a stand to biodiversity
4.3 Comparing production when rotation periods differ
4.3.1 Average profits and service provision
4.3.2 Discounted quantities
5 Modeling stand level profit possibilities 
5.1 Modeling multipurpose high oak forest management
5.1.1 Forest management: an interaction between man and nature
5.1.2 Growth and yield simulation with Fagacées
5.1.3 Simulation of multipurpose forest management
5.2 Calculating the profit possibility frontier
5.2.1 Relations between management practices and outputs: exploring the PPS
5.2.2 Stability of the estimations using the model
5.3 Synergies and tradeoffs in the production of ecosystem services
5.3.1 Impossibility to define an optimum scenario for all outputs
5.3.2 Envelope of the multiple production set and tradeoff analysis
5.4 Sensitivity analysis
5.4.1 Increasing the discount rate shrinks the PPS
5.4.2 Suppressing the ES relative value variation factor increases the opportunity costs
5.4.3 Increasing fuel wood price would not alter the optimum decisions
5.4.4 Low site index forests more suitable for recreation
5.4.5 Limits of the simulation approach
5.5 Conclusion
6 Conclusions 
6.1 Contribution to understanding multipurpose forest management
6.1.1 An original stand level multipurpose analysis
6.1.2 Integrated analysis of multipurpose forest management
6.1.3 Difficulties and solutions to estimate ES provision in the long run
6.2 Implications for decision makers
6.2.1 Preservation and restoration of environmental services: between markets and regulation
6.2.2 Recommendations
6.2.3 Payment as an incentive to forest owners for ES provision?
6.3 Extension of the modeling approach
6.3.1 Modeling the Production Possibility Set envelope at various stages
6.3.2 Production possibility sets and uncertainties
6.3.3 From the stand to the landscape scale
6.4 Conclusion
Appendix 
A Forest Europe criteria and indicators
B Forest owner survey questionnaire
C R scripts
C.1 Script calculating the discounted value of services and gathering simulation results
C.2 Script to determine and display the envelope of the PPS
Glossary

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