The welfare gains from diversified environmental policies

This paper provides a utility-theoretic framework for allocating a budget across multiple environmental projects with uncertain outcomes. We utilize portfolio theory to derive the price of a risk (i.e., variance) reduction, then we estimate willingness to pay for the same risk reduction by analyzing stated preference data using a mean-variance specification for utility. The welfare-maximizing budget allocation is determined by equating price and willingness to pay. We use our framework to make two points. First, the welfare gains from a diversified environmental policy (i.e., one composed of multiple environmental projects) depend on society's willingness to pay for policy risk reduction and the price of a risk reduction determined by the covariance between projects. In an application to salmon restoration in Maine, we find that the welfare gains from policy diversification are equal to 5 % of society's willingness to pay for salmon restoration overall. In addition, failing to account for aversion to outcome variance may lead to underestimates of willingness to pay for environmental projects and over-investment in the riskiest projects. Failing to account for aversion to variance in the number of salmon underestimates the welfare associated with salmon restoration by over 80 % and funnels all restoration into the watershed where successful restoration is most uncertain.