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FONDAZIONE ENl ENRICO MATIEI (FEEM) SERIES ON ECONOMICS, ENERGY AND ENVIRONMENT This series serves as an outlet for the main results of FEEM's research programmes in the areas of economics, energy and environment. The Scientific Advisory Board of the series is composed as follows: Kenneth J. Arrow Department of Economics, Stanford University, Stanford, California, USA William J. Baumol C.V. Starr Center for Applied Economics, New York University, New York City, USA Partha Dasgupta Cambridge University, Cambridge, United Kingdom Siro Lombardini University of Turin, Turin, Italy Karl-Goran Maler The Beijer Institute, Stockholm, Sweden Ignazio Musu University of Venice, Venice, Italy James M. Poterba Department of Economics, Massachusetts Institute of Technology, Cambridge, Massachusetts, USA Domenico Siniscalco (Series Editor) Director, Fondazione Eni Enrico Mattei, Milan, Italy and University of Turin, Turin, Italy Giorgjo Barba Navatetti (Series Associate Editor) Fondazione Eni Enrico Mattei and University of Milan, Milan, Italy

The titles published in this series are listed at the end of this volume.

Sustainability: Dynamics and Uncertainty edited by




Library of Congress Cataloging-in-Publication Data Susta1nab111ty : dynam1cs and uncerta1nty / ed1ted by Grac1ela Ch1ch11n1sky, Geoffrey Heal, and Alessandro Vercelli. p. cm. -- (EconomJ~s, energy and env1ronment ; 9) Inc 1udes 1ndex. ISBN 978-94-010-6051-6 ISBN 978-94-011-4892-4 (eBook) DOI 10.1007/978-94-011-4892-4 1. Susta1nable development. 2. Environ.ental po11cy. 3. Economic development--Env1ronmental aspects. 1. Chichiln1sky, GraC1ela. II. Heal, G. M. III. Vercel11, Alessandro. IV. Ser1es. HC79.E5S8664 1997 97-23951 338.9--dc21 ISBN 978-94-010-6051-6

Printed on acid-free paper

AU rights reserved © 1998 Springer Science+Business Media Dordrecht OriginaUy published by Kluwer Academic Publishers in 1998 Softcover reprint of the hardcover 1st edition 1998 No part of the material protected by this copyright notice may be reproduced or utilized in any form or by any means, electronic or mechanica1, including photocopying, recording or by any information storage and retrieval system, without written permission from the copyright owner.

Table of Contents

Editors' Introduction


List of Contributors




1.1. Interpreting Sustainability, G. M. Heal


1.2. Global Environmental Risks, G. Chichilnisky and G. M. Heal




2.1. Sustainable Use of Renewable Resources, A. Beltratti, G. Chichilnisky and G. M. Heal


2.2. North South Trade and the Dynamics of the Environment, R. Abraham, G. Chichilnisky and R. Record


2.3. Trade, Migration, and Environment: A General Equilibrium Analysis, G. Chichilnisky and M. Di Matteo


2.4. A Simple Model of Optimal Sustainable Growth, G. Cazzavillan and I. Musu


2.5. Environmental Externalities, Disconnected Generations and Policy, G. Marini and P. Scaramozzino


2.6. Stochastic Sustainability, M. P. Tucci


2.7. Sustainable Development and the Freedom of Future Generations, A. Vercelli




Table of Contents



3.1. Hard Uncertainty and Environmental Policy, A. Vercelli


3.2. Environmental Option Values, Uncertainty Aversion and Learning, M. Basili and A. Vercelli


3.3. Environmental Bonds: A Critical Assessment, L. Torsello and A. Vercelli


3.4. Uncertain Future Preferences and Conservation, A. Beltratti, G. Chichilnisky and G. M. Heal


3.5. Financial Markets for Unknown Risks, G. Chichilnisky and G. M. Heal


3.6. Stochastic Sustainability in the Presence of Unknown Parameters, M. P. Tucci


3.7. Climate Change and Emission Permits, A. Beltratti




What is sustainable development? A fashionable phrase, certainly: but are there substantive issues behind it? There are, in fact, several. This volume is organized about two of them, one relating to long-run dynamics, and the other to uncertainty. The adjective "sustainable" derives from the following concern: Can our current patterns of economic activity be continued over long periods without disastrous consequences for the environment, or for us? Do existing institutions and decision criteria lead us to select patterns of activity which we can safely continue over very long periods of time, or are they somehow too "myopic" to detect and avoid harmful long-run consequences? Most of the non-economic discussions of sustainability are concerned about this dimension: they address the issue of discriminating against the future, of depriving future generations of certain environmentally-based benefits which we enjoy today, or of destruction by the present generation of the environmental and ecological infrastructures which support important aspects of human activity. In a much-quoted phrase the Brundtland Report (1987) refers to sustainable development as "development that meets the needs of the present without compromising the ability of future generations to meet their own needs." Sustainability is anchored in the concept of basic needs, introduced in Chichilnisky (1977). Current threats to the ecological infrastructures of human activities are reviewed by McMichael (1993) and Daily (1997). Underlying such concerns is the issue of modelling and evaluating alternative long-term dynamic paths open to an economy which in an essential way is dependent on environmental inputs. How to model and evaluate alternative development paths of an economic-environmental system, especially with reference to their long-run properties, is the theme of the papers in Section 2 of this volume. Evidently, a concern about the long-run, and especially about environment in the long-term, must acknowledge uncertainty about many of the underlying processes and relationships. What is the nature of this uncertainty? How do we model it? What does it mean to enquire whether patterns of economic activity vii

viii G. Chichilnisky et al. will lead to disastrous environmental consequences when we are uncertain of some of the underlying relationships? How should such a question be posed? This is the subject matter of the papers in Section 3. Both of these topics - sustainability and long-run dynamics, and sustainability and uncertainty - are hard to model and analyze. There is a paucity of analytical work on sustainability, particularly relative to the volume of applied and policy-oriented discussion. So in some respects the collection here aims to break new ground by addressing the issue of sustainability within mainstream analytical economic models, using tools from welfare economics, a broad range of resource allocation theory and decision theory. The paper by Heal in Section I reviews some strands of the earlier literature on dynamics and sustainability: however, mention should also be made here of the important earlier contributions by Asheim (1994), Barbier and Markandya (1994), Hartwick (1977), Pearce et al. (1990) and Pezzey (1989), who are amongst the first to have worked to bring some formal precision to the concept of sustainable development. Section I contains two papers - "Interpreting Sustainability" and "Global Environmental Risks" - which provide non-technical overviews of some of the key questions in each of the areas of dynamics and uncertainty, respectively. Rather than repeat that material here, the reader is referred to those papers for general introductions to the two fields. What conclusions emerge from this collection of studies? A thorough analysis of sustainability requires that we understand better how economic and environmental (i.e., ecological or biological) systems interact over the long run. The paper by Abraham, Chichilnisky and Record shows that, even for the very simplest ecological and economic systems, these interactions can be so complex as to span the entire range of known dynamic behaviors, including phenomena not previously noted in economics, such as fractal attractor basins. They show that the nature of the interactions between the economic and ecological systems depends on the system of property rights in effect. III defined property rights induce chaotic dynamics. Confronted with such a range of outcomes, we clearly need to know more precisely what kinds of systems and what ranges of parameter values are reasonable. Only then can we have an idea of the types of dynamic behavior which we need to study in evaluating the long-run responses oflinked economic and ecological systems to alternative policies. The Abraham-Chichilnisky-Record paper is purely descriptive: it does not seek to define an "optimal" or "sustainable" path. But what it describes, namely the set of possible dynamics for interacting economic and ecological systems, provides the choice set from which a best path must be chosen. Formally, and very simplistically, we have a set of economic variables e whose values at time t are represented by the vector et and similarly a vector



of ecological (also biological) variables bt which interact in their dynamic evolution: det

dt = f

(et, bt)'


dt = 9 (et, bt )·

Among the solution paths to this interaction between economic and ecological variables, we look for those which are sustainable. Sustainable paths are typically those along which the values of certain key stocks are always positive, these key stocks being important environmental resources. The types of paths on which certain variables can be positive forever include stationary solutions with appropriate positivity conditions, or limit cycles or chaotic attractors satisfying the same positivity conditions. These paths, and the paths which approach them, constitute the set of sustainable paths. From amongst these we have to choose one or more which are in some sense the best. Note that rather than imposing positivity of certain stocks in the long run as a condition for sustainability, we would prefer to derive this as a characteristic of optimal solutions from more fundamental judgements about the valuation of stocks and flows: this is the route pursued by the papers in this volume. The introductory paper by Heal in Section I reviews these matters in general terms, not going into technical details: it discusses the precedents for a concept of sustainability in welfare economics, and reviews alternative optimality concepts and their connection to sustainability. The paper by Beltratti, Chichilnisky and Heal in Section 2 then focuses in detail on the problem of characterizing optimal paths which are in some sense sustainable when a renewable resource interacts with a standard neoclassical one sector model of economic growth, a model simpler than the two sector economic growth model in the paper by Abraham, Chichilnisky and Record (which is drawn from Chichilnisky, 1981). Beltratti, Chichilnisky and Heal reach the interesting conclusion that for such a model to yield a well-defined sustainable optimal path in the sense of Chichilnisky (1996a), it is necessary that the rate at which future benefits are discounted relative to the present should fall asymptotically to zero. This is a conclusion surprisingly consonant, as Heal points out, with a growing body of empirical evidence on individual attitudes towards the future. This body of evidence (see, for example, Lowenstein and Thaler, 1989, or Cropper et al., 1994) suggests that individuals do not discount the future at a constant rate: rather, they practice what has come to be called "hyperbolic discounting" (Henderson and Bateman, 1995) or "slow discounting" (Harvey, 1994). The discount rate which they apply falls with the length of the period to which they apply it. As the papers by Heal and Beltratti, Chichilnisky and Heal note, recognizing the contributions made by biological resource stocks to human welfare, and so the need to preserve positive quantities of these stocks, is also a key move in analyzing options for sustainable development. These two papers, and that ofCazzavillan and Musu, pursue this matter. They address the implications of recognizing that the stock of a resource, which may be renewable or


G. Chichilnisky et al.

exhaustible, can itself be a source of value to society, in addition to the flow of goods and services derived by consuming it. The Beltratti-Chichilnisky-Heal paper on uncertain preferences also addresses the importance of environmental stocks as a source of social value, in this case in the context of uncertainty and option values. The paper by Cazzavillan and Musu is also of interest in that it explores the issue of sustainability in the context of an endogenous growth model, a category of model which has recently been fashionable but within which little attention has been paid to environmental matters. The chapter by Tucci on stochastic sustainability works out a simple dynamic model which combines an economic system with a climate system incorporating stochastic elements. Contrary to much of the literature in this area, which is interested in the optimal sustainable development over an infinite horizon, the goal here is to find a stochastically sustainable development period by period. Therefore, no maximization is needed and no assumptions about the existence of an intergenerational social welfare function are required. The paper by Marini and Scaramozzino broadens further the types of dynamic model considered, pursuing the issue of sustainability in the context of an overlapping generations model. It raises important dynamic issues which relate more directly to public finance and taxation policy. And that of Chichilnisky and diMatteo places on the economic agenda a new and powerful issue, one already concerning political scientists: the link between environmental abuse and international migration, a link which leads directly to discussions of environmental conflicts and international security. As they note in their introduction, migration induced by environmental pressures is today a very real phenomenon in may of the poorer parts of the world, and is an increasing source of global political stress. The paper by Vercelli on sustainability suggests a new formalization of sustainability: development is considered sustainable when it does not reduce the range of options open to future generations. In the area of uncertainty and sustainability, the contributors also raise complex and important questions, several of which connect with issues raised by the discussion of dynamics and sustainability. The papers by Vercelli, Basili and Vercelli, and Torsello and Vercelli explore the impact that different hypotheses about uncertainty may have on the themes discussed in this book. The authors of these chapters stress the crucial importance of the distinction between two basic kinds of uncertainty faced by the decision-maker when she looks for the solution to environmental problems. Uncertainty is here considered to be "soft" when it is possible to represent the beliefs of the decision-maker in terms of a unique additive, fully reliable, probability distribution, and "hard" when it is possible to represent the beliefs of the decision-maker only in terms of a non-additive probability distribution, or of a plurality of priors none of which can be considered as fully reliable. Particular emphasis is put by the authors of the these chapters on the case of hard



uncertainty because it is their conviction that environmental problems involve this sort of uncertainty. Problems of this type are completely neglected by the standard approach of environmental economics since it is based on the traditional decision theory which routinely assumes soft uncertainty. The first paper of the third section of the book ("Hard Uncertainty and Environmental Policy") surveys recent contributions to decision theory which explore the foundations of decision theory under hard uncertainty. These theories have implications for environmental policy which are briefly outlined by the author. A first example is the paper by Vercelli mentioned above ("Sustainable Development and the Freedom of Future Generations") where some implications of hard uncertainty for the definition of sustainable development are briefly indicated; in particular the author maintains that hard uncertainty about the preferences of future generations suggests a definition of long-run sustainability based upon the conservation of the freedom of future generations. In the paper by Basili and Vercelli ("Environmental Option Values, Irreversibility and Learning") it is shown that the distinction between soft and hard uncertainty also affects the valuation of environmental goods. In particular the authors argue that the presence of hard uncertainty adds to the option value two further components based upon the aversion towards hard uncertainty and upon potential structural learning under irreversibility. The paper by Torsello and Vercelli is a case study of one interesting instrument of environmental policy recently advocated by Perrings and Costanza for countering environmental risks. Also in this case the distinction between soft and hard uncertainty proves to be crucial. While Perrings and Costanza believe that environmental bonds are designed exactly to cope with situations characterized by hard uncertainty, the debate about the limits of the applicability of e-bonds has often assumed the more traditional case of soft uncertainty. A clear distinction between the above types of uncertainty may help to clarifY the issues raised in the debate. Chichilnisky and Heal, in "Global Environmental Risks" in Section 1, also make an argument for the distinctiveness of environmental uncertainty, in this case in terms of the novelty and indeed uniqueness of some of the risks involved. In their subsequent paper "Financial Markets for Unknown Risks" in Section 3, they suggest how conventional risk-management institutions must be altered in order to provide economic mechanisms for insurance in the face of such risks. In simple terms, they recommend a securitization of the insurance function in the face of catastrophic environmental risks, something which is right now being actively considered by the insurance and investment banking industries (see Chichilnisky, 1996b). A second main theme of the papers on uncertainty, is the importance of "option values", a classic concept introduced into the environmental conservation literature by Arrow and Fisher (1974) and Henry (1974a, b). The essence of this concept is, of course, well known. The basic point is that if we are uncertain about the value of an asset, and may learn more about that value


G. Chichilnisky et a/.

with the passage of time, then there is value in holding on to it until we have learned as much as we can. This point was originally developed in a series of relatively simple, two-period models: the papers by Beltratti, Chichilnisky and Heal, and Basili and Vercelli in Section 3 investigate the robustness of this conclusion and survey the literature on this matter. The contributions of Tucci address a very fundamental matter: how can we define sustainability in the presence of substantial uncertainty about the underlying economic and ecological relationships? He shows that an ingenious application of statistical concepts can give some rather powerful insights into this matter. In particular he presents a simulation based on Nordhaus (1994). The papers in this volume cover many aspects of the dynamics and uncertainty associated with sustainability. What else would be needed to offer complete coverage of the analytical dimension of sustainability? Two topics come to mind. One is the management ofthe "global commons", by which we refer to the assignment of property rights in and management of the use of global public goods such as the atmosphere, the oceans and reserves of biodiversity. There are many complex and interesting economic issues which arise when one considers how best to manage these. They are, of course, public goods, so that we have to be concerned about the possibility of "free riding": they are in fact a very particular type of public goods, namely privately produced public goods. They are privately produced in that the amounts of carbon dioxide or of chlorofluorocarbons in the atmosphere are the results of large numbers of decisions made by individuals and firms about life-styles, technologies, etc. This introduces an element into the attainment of efficient allocations which is absent from conventional public goods such as defence or law and order, and has interesting implications for the use of tradeable permits, a method of establishing property rights and harnessing market forces in the service of the environment which is rapidly gaining attention. In particular, it implies that the initial distribution of property rights amongst participants in the permit market determines whether or not the equilibrium attained by the market after trading will be Pareto efficient. (There is an echo here of the significance of property rights in the Abraham-Chichilnisky-Record paper.) These issues are studied in detail in Chichilnisky and Heal (1994) and Chichilnisky et al. (1993). In this volume, only Beltratti's paper in Section 2 addresses the behavior of permit markets. In keeping with the theme of the volume, it focuses on the behavior of these markets in the long run, and under conditions of uncertainty, aspects which had hitherto been completely neglected in the literature. A second set of issues which are integral to any complete understanding of sustainability, and which we do not study in detail in this volume, are those relating to national income accounting and to project evaluation. There is a general recognition that the way we measure national income does not properly account for interactions between economy and environment: an influential early study of this was that by Nordhaus and Tobin in 1972,



and subsequently there has been a growing literature addressing the need to refonn national accounting systems to reflect the consumption of non-market environmental assets. Contributions here include those by Dasgupta and Heal (1979), Repetto (1987), Pearce (1990) and others. The intellectual basis for refonn of national income accounting lies in an analysis of the shadow prices associated with environmental resources, and these shadow prices arise from models such as those of Beltratti, Chichilnisky and Heal, Cazzavillan and Musu, and Marini and Scarramozzini. So the type of models studied here can provide an important input to the design of conventions for measuring national income properly. This issue is discussed at length by Heal (1996). The same is true of cost-benefit analysis: again, the intellectual basis lies in the study of optimal development models and the shadow prices associated with their solutions, so that the models studied in Section 2 can contribute to the development of a new environmentally conscious foundation of costbenefit analysis, even though they do not themselves discuss the methods of cost-benefit analysis. Again, these issues are developed at length in Heal (1996). This volume has evolved over five years as the outcome of a series of research projects and workshops sponsored by the Fondazione ENI Enrico Mattei, begun initially in 1991, with workshops in Milan in 1992 and 1994. The enthusiasm and support of the staff and research associates of the Fondazione, and especially the intellectual and organizational input of Andrea Beltratti, have been invaluable.

References 1.

2. 3. 4. 5. 6. 7. 8. 9.

Arrow, K. J. and A. C. Fisher (1974). "Environmental Preservation, Uncertainty and Irreversibility", Quarterly Journal ofEconomics 88, 312-319. Asheim, G. B. (1994). "Net National Product as an Indicator of Sustainability", Scandinavian Journal ofEconomics 1994, 96. Barbier, E. and A. Markandya (1990). "The Conditions for Achieving Environmentally Sustainable Development", European Economic Review 34(2-3), 659--669. Chichilnisky, G. (1977). "Economic Development and Efficiency Criteria in the Satisfaction of Basic Needs", Applied Mathematical Modelling 1,290-297. Chichilnisky, G. (1981). "Terms of Trade and Domestic Distribution: Export-Lead Growth with Abundant Labor", Journal ofDevelopment Economics 8, 163-192. Chichilnisky, G. (1996a). "Sustainable Development: An Axiomatic Approach", Social Choice and Welfare 13(2), 231-257. Chichilnisky, G. (1996b). "Catastrophe Bundles Hedge Unknown Risks", Best's Review, February, 44-48. Chichilnisky, G. and G. M. Heal (1994). "Who Should Abate Carbon Emissions? An International Viewpoint", Economics Letters 44, 443-449. Chichilnisky, G., G. M. Heal and D. Starrett (1993). "International Emission Permits: Equity and Efficiency", Working Paper, Stanford Institute for Theoretical Economics. Forthcoming in Environmental Markets, G. Chilchilnisky and G. M. Heal (eds.).

xiv G. Chichilnisky et al. 10.

Cropper, M. L., S. K. Aydede and P. R. Portney (1994). "Preferences for Life-Saving Programs: How the Public Discounts Time and Age", Journal of Risk and Uncertainty 8,243-265. 11. Daily, G. (1997). Nature Services: Societal Dependence on Natural Ecosystems, Island Press, Washington DC. 12. Dasgupta, Partha S. and Geoffrey Heal (1979). Economic Theory and Exhaustible Resources, Cambridge University Press. 13. Hartwick, J. M. (1977). "Intergenerational Equity and Investing the Rents from Exhaustible Resources", American Economic Review 66, 972-974. 14. Harvey, C. (1994). "The Reasonableness of Non-Constant Discount Rates", Journal of Public Economics 53, 31-51. 15. Heal, G. M. (1995). Valuing the Future: Economic Theory and Sustainability, Lief Johansen Lectures, University of Oslo. Circulated as a working paper of the Department of Economics, University of Oslo, Columbia University Press, forthcoming. 16. Henderson, N. and I. Bateman (1995). "Empirical and Public Choice Evidence for Hyperbolic Social Discount Rates and the Implications for Intergenerational Discounting", Environmental and Resource Economics 5, 413-423. 17. Henry, C. (1974a). "Option Values in the Economics ofIrreplaceable Assets", Review of Economic Studies, Symposium on the Economics ofExhaustible Resources, 89-104. 18. Henry, C. (1974b). "Investment Decisions under Uncertainty: The Irreversibility Effect", American Economic Review 64,1005-1012. 19. Lowenstein, G. and R. Thaler (1989). "Intertemporal Choice", Journal of Economic Perspectives 3, 181-193. 20. McMichael, A. J. (1993). Planetary Overload, Cambridge University Press. 21. Nordhaus, W. D. (1994). Managing the Global Commons: The Economics of the Greenhouse Effect, Cambridge, MA, MIT Press. 22. Nordhaus, W. D. and J. Tobin (1972). "Is Economic Growth Obsolete?" in Economic Growth, 5th Anniversary Colloquium, National Bureau of Economic Research. 23. Repetto, R., M. Wells, C. Beer and F. Rossini (1987). Natural Resource Accountingfor Indonesia, Washington, DC, World Resource Institute. 24. Pearce, D. w., A. Markandya and E. Barbier (1990). Sustainable Development: Economy and Environment in the Third World, London, Earthscan Publications. 25. Pezzey, J. (1989). Economic Analysis of Sustainable Growth and Sustainable Development, Washington, DC, The World Banle Now reprinted as Pezzey, J. (1992). Sustainable Development Concepts: An Economic Analysis, World Bank Environment Paper No.2. 26. Solow, R. M. (1992). "An Almost Practical Step Towards Sustainability", Invited Lecture on the Occasion of the Fortieth Anniversary of Resources for the Future, Resources and Conservation Center, Washington, DC. 27. Thaler, R. (1981). "Some Empirical Evidence on Dynamic Inconsistency", Economics Letters 8, 201-207. 28. World Commission on Environment and Development (1987). Our Common Future (The Brundtland Report), Oxford, Oxford University Press.


List of Contributors

R. H. Abraham, Visual Math Institute, Mathematics Department, 303 Potrero Street 63, Santa Cruz, CA 96060, U.S.A. M. Basili, Dipartimento Economia Politica, Universita di Siena, Piazza S. Francesco 7, 53100 Siena, Italy A. Beltratti, Istituto di Economia Politica, Facolta di Economia e Commercio, Universita di Torino, Corso Unione Sovietica 218 Bis, 10134 Torino (TO), Italy G. Cazzavillan, Dipartimento Scienze Economiche, Universita Ca' Foscari, Fondmento S. Giobbe, Canneregio 873, 30121 Venezia, Italy G. Chichilnisky, Program on Information and Resources, Columbia University, 405 Low Library, New York, NY 10027, U.S.A. M. Di Matteo, Dipartimento Economia Politica, Universita di Siena, Piazza S. Francesco 7, 53100 Siena, Italy G. M. Heal, Graduate School of Business, Columbia University, 405 Low Memorial Library, New York, NY 10027, U.S.A. \ G. Marini, Dipartimento Economia E Istit., Universita degli Studi di Roma "Tor Vergata", Via di Tor Vergata, 00133 Roma, Italy

I. Musu, Dipartimento di Economia, Universita di Venezia, Ca Fosari, Dorsoduro 3246, 1-30123 Venezia, Italy

R. Record, The Santa Cruz Operation Inc., Santa Cruz, California, U.S.A.


xvi List of Contributors

P. Scaramozzino, Department of Economics, University College London, Gower Street, London WCIE 6BT, U.K. L. Torsello, Dipartimento di Economia Politica, Istituto di Economia, Universita degli Studi di Siena, Piazza S. Francesco 7, 53100 Siena, Italy M. P. Tucci, Facolta di Scienze Economiche e Sociali, Universita di Siena, Piazza S. Francesco 7, 53100 Siena, Italy A. Vercelli, Dipartimento Economia Politica, Universita di Siena, Piazza S. Francesco 7,53100 Siena, Italy

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