Project Evaluation and the Depletion of Natural Capital: An Application of the Sustainability Principle

Joachim von Amsberg

In conventional economic analysis, the costs of natural capital are systematically underestimated due to individual short-term incentives of decision makers, the presence of externalities and the large uncertainties about the functioning of the biosphere. In addition, decision making is systematically biased against the interests of future generations. Inter-generational efficiency and justice require that future generations be actually, not only potentially, compensated for costs imposed on them by previous generations. To remedy the biases against proper valuation of natural capital and to reflect a cautious approach toward depletion of natural capital, the default value of natural capital should be the cost of providing a sustainable substitute. The rents from depletion of natural capital should be shared equally with all future generations who need to be adequately compensated for depletion. Following from these considerations, this paper proposes a sustainability constraint on current economic activities. This constraint would require that the value of every group of functionally substituting types of natural and human-made capital be left intact. The sustainability constraint should be reflected in the shadow prices used to evaluate natural capital depletion. From the sustainability constraint, a sustainable supply rule is derived that is operational and can be applied to the depletion of non-renewable resources and the consumption of the biosphere's limited capacity to absorb waste products. This rule requires that a sustainable price, derived from a sustainable supply curve, be used for depletion of natural capital. The sustainable supply curve is constructed by dividing the economic rents from the depletion of natural capital into an income and a compensation component. The compensation component must be invested into the production of the closest sustainable substitute for the depleting natural resource. The compensation component should be sufficient to provide the same quantity of the sustainable substitute at the sustainable price forever after depletion. The income component could then be sustained after depletion. While the approach has been developed for project analysis, it is easily extended to the determination of an appropriate resource tax. The analysis of several recently appraised World Bank projects shows a very low level of completeness and sophistication in the evaluation of environmental costs. In particular, most project analyses do not include a depletion premium for the extraction of a natural resource. Deficiencies are also prevalent in the determination of an opportunity cost for land and of the damage from air pollution generated by the project. The sustainable supply rule is applied to several of these World Bank projects and the impacts for the evaluation of the selected projects is shown.

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