Sunshine, the value of housing and compensation for externalities

In ECON110 today, we discussed hedonic demand theory (or hedonic pricing). Hedonic pricing recognises that when you buy some (or most?) goods you aren't so much buying a single item but really a bundle of characteristics, and each of those characteristics has value. The value of the whole product is the sum of the value of the characteristics that make it up. For example, when you buy a house, you are buying its characteristics (number of bedrooms, number of bathrooms, floor area, land area, location, etc.). When you buy land, you are buying land area, soil quality, slope, location and access to amenities, etc.

In a new Motu working paper, David Fleming, Arthur Grimes, Laurent Lebreton, Dave Maré, and Peter Nunns show that sunshine is one of the important characteristics that contributes to house values. The New Zealand Herald reported a couple of weeks ago:

Motu Economic and Public Policy Research Trust has released what it calls the first research carried out anywhere in the world to specifically evaluate the extra value house buyers put on extra sunshine hours.

Arthur Grimes, a senior fellow at Motu and co-author of the study, said there was a direct correlation between more sunshine and higher values and the study was precise about how much extra value is added.

"Direct sunlight exposure is a valued attribute for residential property buyers, perhaps especially in a cool-climate city such as Wellington. However, natural and man-made features may block sunlight for some houses, leading to a loss in value for those dwellings," the study said.

The effect is quite large. Quoting from the paper:

...each additional hour of direct sunlight exposure for a house per day (on average across the year) adds 2.4% to a dwelling’s market value.

The paper also has some interesting implications in terms of negative externalities. If a high-rise apartment development will block the sunlight from nearby houses, then it will reduce the value of those houses. This constitutes a negative externality imposed on the affected homeowners. Fleming et al. note that these externalities could be dealt with through compensation:

At a policy level, our estimates may be used to facilitate price-based instruments rather than regulatory restrictions to deal with overshadowing caused by new developments. For instance, consider a new multi-storey development that will block three hours of direct sunlight exposure per day (on average across the year) on two houses, each valued at $1,000,000. The resulting loss in value to the house owners is in the order of $144,000. Instead of regulating building heights or the site envelope for the new development, the developer could be required to reimburse each house owner $72,000. In return, the developer would be otherwise unrestricted (for sunlight purposes) in the nature of development. If the development cannot bear the $144,000 then the efficient outcome is that the development does not proceed. Conversely, if the development can bear that sum, then the socially optimal outcome is for the development to occur and, from an equity perspective, the neighbours are compensated for their loss of sunlight exposure.

The idea that compensation can be used to deal with externalities relies on the Coase Theorem - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In the case of a bargaining solution to an externality based on the Coase Theorem, the solution depends crucially on the distribution of entitlements (property rights and liability rules). In this case, the homeowners have existing rights to sunlight and because an apartment development would infringe on those rights, the developer would be expected to pay compensation to the affected homeowners. This will only be viable if the total amount of compensation paid to affected homeowners is not so great that it makes the development unprofitable.

The study was based on data from Wellington. Given that development in Auckland is happening faster and involves increasing density and greater numbers of taller mixed-use buildings, it would be interesting to see if the results hold there as well. As noted in the New Zealand Herald story:

"For places other than Wellington, the value of sunshine hours may be higher or lower depending on factors such as climate, topography, city size and incomes. Nevertheless, our approach can be replicated in studies for other cities to help price the value of sunlight in those settings," Grimes said. 

So the approach is transferable, even if the results are not. It's almost certainly extendable to considering the value of volcanic viewshafts in Auckland, and hopefully someone is already thinking about undertaking that work.