dgwilkinson

September 16, 2014

Ecosystem Limits to Sustainable Economic Output and the Use of Tradable Quotas – An Essential Lesson

A mistake often made in carbon markets and elsewhere is to impose predetermined permit/obligation prices, which have indeterminate effects on the environmental objective. The following stylised heuristic highlights the importance of setting quotas on externalities with reference to the environmental objectives that are to be met, and leaving the determination of a clearing price for such permits and/or obligations to the market. Provided property rights to the relevant factors of production are well defined and enforced, by establishing a quota on the production of externalities at or below the capacity of the ecosystem, and by providing tradable permits and/or obligations to produce those externalities, the market will determine a clearing price.

The following figure provides a simple representation of the relationship between economic output and the capacity limits of the ecosystem.

Ecosystem Limits Graph

The Transformational Efficiency Boundary (TEB) represents the most efficient available means of transforming natural capital and ecosystem services into goods and services.

T 0: Transformational Efficiency Boundary at time 0

T 1: Transformational Efficiency Boundary at time 1

An economy can function above the TEB, but not below it.

As an economy grows it moves along the TEB, while technical change shifts the TEB downward.

Technical change can include socio-economic and organizational improvements, as well as technological changes, that increase the efficiency by which natural capital and ecosystem services are used by the economy to produce goods and services.

The market price of permits and/or obligations will cause such technical changes to occur – T 0 shifts toward T 1 – and ensure the maximum level of environmentally sustainable economic output.

Conclusion: Rather than setting a price for permits/obligations that has unknown effects on the environmental issue, set the quota to deliver the environmental objectives and leave the market to find the clearing price for the permits/obligations.

May 7, 2009

PRIVATE SOLUTIONS TO PUBLIC PROBLEMS An Introduction to Environmental Markets

 

Foreword

Over the coming decades, there is a serious risk of global demand for food surpassing the ability of producers to supply it.  By 2050 the world population is forecast to be approaching 9 billion, or some 2.5 billion more than at present.  More importantly, ongoing economic development is improving the incomes of a growing number of the people who spend on average two-thirds of their extra income on food – compared with only 10% in the UK – and whose diets change as they get richer.  With increased income, diets not only increase in the volume consumed, but also change from a largely plant-based diet to one that includes more meats and dairy products, which have substantially higher requirements for land and water.  At the same time, concerns about energy security and climate change, have brought about policies encouraging the development of bio-fuels that use food crops, placing additional demand on limited food supplies.  According to the FAO, some 10% of the recent dramatic increase in food prices can be explained by the increased demand from biofuels, while the IMF and IFPRI suggest the impact may be more like 20% to 30%.

Assuming incomes grow by only 1 percent per year, food demand could be 50% higher within the next 25 years and more than double by the end of the century.

This outlook on global food supply is estimated on the basis of current land and water use and with current yield growth rates.  This shows a significant short-fall developing within the next 10 to 15 years.  Factoring in the expected negative affects of climate change on yields, the outlook for supply is even more worrying.

Climate change will have even more effects on supply than by affecting yields.  The temperature and precipitation effects will vary greatly around the planet, with many of the poorest areas worst affected.  Increasingly volatile and extreme weather can be expected, while flooding and coastal erosion will affect most of the most productive lands.  Heat stress will affect livestock production, while plant and animal diseases will be increasingly prevalent.  Even without the problems of climate change, the availability of suitable additional land and water, together with the necessary infrastructure, pose significant and growing constraints on supply.

The Environmental Security Challenge:

Advances in food production over much of the past century or so has been enormous but with unintended environmental costs in terms of both natural resource depletion and pollution.  Evidence of the impacts in the EU on soils, water atmosphere, and biodiversity, for example, is widely available.  Far worse damages have occurred elsewhere in the world.  These problems have caused regulatory responses by governments at all levels.

In light of the food security challenge, there is a real risk of unnecessary regulation being imposed by governments who fear that, as farmers respond to increasing global food demand, nutrient leaching into water supplies will increase, a range of water stresses will increase, soils will be further degraded, and biodiversity will be reduced.  Because the productivity of agriculture is fundamentally dependent on the health of the natural ecosystems, this would lead to lower yields and thus to a downward spiral.

It is essential that we find a way of avoiding such a counterproductive downward spiral for three key reasons:  natural ecosystems are reaching limits that must be respected, a healthy natural environment is essential to achieving the improved productivity required to meet the food security challenge, and regulation can impair the ability of businesses to respond to food security concerns.  It is imperative that we find an integrated approach to meeting both the food and environmental challenges.

The Great 21st Century Land Challenge:

The Great 21st Century Land Challenge is to deliver both food security and environmental security – to improve the productivity of the land while increasing our stewardship of the environment – at the same time!

 

Developing environmental markets

All around the world, the breadth and severity of environmental problems is growing.  For the most part, governments have responded to this by implementing a range of regulations and by incentivising and taxing private businesses.  Is this response sufficient?  In light of great challenges such as climate change, resource degradation, and threats to species and whole habitats, it can be argued that, while necessary, the current range of responses is not sufficient; to have any chance of meeting the great environmental challenges of our age we must investigate every possible tool and technique that may be of help.  One such alternate possibility is the development and implementation of environmental markets; harnessing the creativity, energy and resourcefulness of private enterprise.

 

How Environmental Markets Work

A significant cause of many environmental problems is the failure of markets in environmental goods and services to arise naturally.  This is because, for a wide range of environmental services, no one has sufficient self-interest in their production or preservation.  In the traditional calculus of commerce, the environment has little value. Of course many people selflessly look after the environment in many ways. Sometimes they do so by contributing to the work of environmental groups.  The International Union for Conservation of Nature   (IUCN) estimates that around $10billion is spent globally in this way each year.  Sometimes they do so by the consumption choices that they make, and sometimes directly with land that they own or over which they have control.  As the growing concern over the degradation of the environment shows, this is not enough.

’Turning a cost on my business into a new profit centre makes sense to me.’

Properly regulated and with the right legal structures in place, self interest – the powerful driving force behind markets – can be harnessed to create new markets to support the delivery of environmental outcomes.  In fact, there are a number of ways of introducing market forces into the delivery of a wide range of desirable environmental goods and services, as well as a growing and international body of practical experience with working programmes.

Indirect Markets:  Considerable environmental benefit is already being delivered through indirect environmental markets.  A growing number of businesses capture for their products or services the marketing and added value benefits of beneficial environmental stewardship.  Certified food and forestry products are examples of such “contained” benefits, which the IUCN estimates attracts globally $75billion of consumer spending each year.  Alternatively, environmental benefits may be delivered through the production of a co-product or service.  Private forests or moorlands may be managed to a very high environmental standard, not directly for their own sake, but indirectly to enable their fitness for a hunting or shooting business. Ecotourism businesses, when done well, provide further examples.

Direct Environmental Markets:  While markets for the specific or direct provision of environmental stewardship have not arisen naturally, under the right condition they can be created.

 

  • Cap & Trade:   constrains environmentally “damaging” activities

This requires setting a maximum total amount or quota of either a homogeneous environmental “bad” such as carbon dioxide emissions or an agricultural nutrient that can be emitted into the environment, or of a homogeneous environmental “good” such as water that can be extracted from the environment.  Participants in this market must have clearly determinable emissions or abstractions of the affected factor.

‘For issues as diverse as water quality and climate change mitigation, cap and trade is a powerful tool.’

Participants then get allowances to make the emissions or abstractions, preferably by auction but sometimes they are simply given them, such that the sum of all allowances equals the total quota set.  Participants who use less than their allowance can sell any excess to those who use more than their allowance.  Alternately, participants may be able to generate new tradable allowances by engaging in activities that permanently add to the environmental benefits provided by the total quota.  Examples of this are the tradable allowances or credits that are issued for sequestering carbon, or for generating power without emitting carbon dioxide.

 

  • Floor & Trade:  encourages environmentally “beneficial” activities

This is quite similar to Cap & Trade, but the other way around. It requires setting a minimum total amount or quota of some homogeneous environment “good”, such as a land management practice, that must be produced, or of some homogeneous environmental “bad” that must be reduced.  An example of an environmental good would be a requirement on land managers to manage a percentage of their land in a particular way – perhaps for the benefit of particular species.  Each separate business is required to deliver a share of the total quota and those delivering more than their minimum requirement can sell the excess to businesses that deliver less than their requirement.  When applied to the delivery of an

‘Floor and trade can make a significant contribution to delivering both food and environmental security.’

environmental good, it encourages the development of professional environmental producers, leading to higher quality outcomes because of the benefits of connectivity and scale, as well as the improved environmental management skills of professional producers.  When applied to the reduction of an environmental bad, it encourages the development and use of environmentally friendly practices and techniques.

This technique will work best when there is a wide range of environmental performance from one region to another, one farm to another, and especially if there is a wide range of costs of delivery of the pollution abatement or the service delivery.  When the costs vary widely then there is great scope for trade and mutual benefits.

But note also that these systems will work best for environmental services where everyone is happy that market participants decide where they are produced.  The extreme example of this is CO2 as we do not care where the abatement occurs.  But it is weakest, or does not work at all for specific habitat which only exists at specific geographical locations.   These conditions also apply to “offsets”

 

  • Offsets:  assure no net loss of environmental assets from economic development

Offsets permit a business to “offset” any degradation of natural resources that may result from the development or other use of land by purchasing improvements to a similar parcel of land somewhere else.  It facilitates economic development while ensuring no net loss of wetlands, sensitive habitat, biodiversity or other environmental feature.  In the US it has been used for some 30 years to ensure the protection of wetlands, and has

‘Markets for wetlands credits and pollution

permits are not yet on the radar screens of

most rural property owners. Why not?’

more recently been used more widely for a range of habitats and the protection of endangered species.  Australia also has considerable experience of the use of offsets, including the highly-specified, large-scale “Bio-Banking” and “BushBroker” projects.

BioBanking – the Biodiversity Banking and Offsets Scheme – has been designed to address the loss of biodiversity in New South Wales, Australia.  Its purpose is to avoid the degradation of land that is important for its ecosystem or biodiversity value by offsetting the impacts of economic developments on that land by environmental improvements to land in other areas.  The scheme requires developers to meet an “improve or maintain test” based on the impact of their proposed development.

“When offset credits are created the landowner, who establishes a biobank site, commits to enhancing and protecting biodiversity.  The credits represent an improvement in the condition of the biodiversity values such as an improvement in the habitat or an increase in the habitat or population of a threatened species.  The scheme creates a market for the credits.  Landowners can sell the credits to provide income and fund the future management of the site.  Developers can buy the credits to offset impacts from their development and to meet the improve and maintain test.”

BioBanking: Scheme Overview, November 2007, Department of Environment and Climate Change, New South Wales

“BushBroker is a system designed by the Australian state of Victoria to register and trade native vegetation credits.  A native vegetation credit is a gain in the quality and/or quantity of native vegetation that is subject to a secure and ongoing agreement.  Native vegetation credits are listed on the BushBroker register and these can be bought by another party and subsequently used as an offset for an approved clearing of native vegetation.

“The trading of native vegetation credits provides benefits for landholders, developers and other land managers, the economy and the environment.”

 – BushBroker Information Paper, March 2006, Department of Sustainability and the Environment, Victoria.

In Europe, offsetting the biodiversity or habitat losses of economic developments – to the extent they cannot be avoided – is a requirement of the EU Birds and Habitats Directives, while, within the UK planning context, Section 106 of the TCP Act and of  PPS-9 envisage the use of mitigation for the preservation of biodiversity.

Conservation banking, including wetland[1] and habitat[2] banking, is a concept first introduced more than 10 years ago in California.  Typically it refers to large parcels of land that are managed in perpetuity for the enhancement and preservation of its natural resource values.  In exchange for permanently managing the land in this way, the conservation bank owner is allowed to sell habitat offset credits to parties that need to satisfy a legal requirement in connection with the environmental aspects of a commercial development project.

‘Mitigation has often proven a boon for the environment and the wallet. In the Meadowlands Mitigation Bank, for example, the cost to restore the swampland came in at $65,000 per acre. This meant that more than  $13million was spent to repair the 206 acres of wetlands, a significant amount of cash….The mitigation bank subsequently sold credits for $150,000 per mitigated acre, nearly three times the cost of the work, netting them nearly $31million.’

 

Key Legislation and Guidance Applicable in the UK – an overview:

EU Directives:

  • Habitats
  • Birds
  • Strategic Environmental Assessment
  • Environmental Impact Assessment
  • Environmental Liability

UK Legislation and Guidance:

  • Section 106, Town and Country Planning Act
  • PPS 9:  Biodiversity and Geological Conservation
  • PPS 11:  Regional Spatial Strategies
  • PPS 12:  Local Spatial Strategies
  • Community Infrastructure Levy
  • Conservation and Rights of Way Act (CROW)
  • Natural Environment and Local Communities (NERC)

 

The US Offsets Market:           

Mitigation Banks

Number of Banks

122

Species Credit Types

89

Habitat Credit Types

50

States with Banks

14

Land Area Protected (ha.)

54,907

Range of Credit Prices ($ per ha.)

1,200 – 300,000

Estimated Market Value ($)

one billion

Source:  speciesbanking.com; Shell/IUCN 2008

 

  • Contracts for Services:            can reduce cost and improve effectiveness of resource protection or management

Contracts for services are simply where a government or a private company contracts with a private company to deliver some environmental service.  In the US, for example, water treatment plants have used this technique to purchase from other businesses reductions in their pollution

‘Growing numbers of landowners are coming

to view endangered species or wetlands on

their land as a set of conservation opportunities

rather than obligations or costs on their businesses.’

of a water supply because it is cheaper to do that than it is to clean the water directly.  Another example might be where contracts for services are negotiated directly between a land manager and an environmental service buyer such as the insurance industry or local authority.  Examples include contracts for the purchase of a range of water management services, including flood risk mitigation.

 

Water quality trading is a market-based approach to improving water quality that is being used in some states in the US.  It is a tool that connects industrial or municipal facilities subject to wastewater permit requirements (referred to as point sources) with agricultural producers (referred to as non-point sources) to achieve water quality improvements. The catalyst for trading could stem from very specific measurable goals to reduce the amount of pollutants entering the watershed.  If they exist, the catalyst for water trading might exist. Through water quality trading, a point source, such as a waste water treatment plant facing relatively high costs to remove excessive amounts of a substance, such as nitrogen and phosphorous, will compensate another party – either another point source or a non-point source, such as a farm – for less costly, yet equivalent, pollutant reduction. The trading partners enter into a contractual trading agreement, where both will benefit financially, and water quality will be improved.  For a market to exist, the point source and the non-point source must have different opportunities and costs for pollutant reduction.

“With the cost of the 2007 floods in England an estimated £7 billion, the range of water management services that can be provided by landowners must be looked at seriously.”.

 

  • Reverse Auctions:  can reduce cost and improve effectiveness of resource protection or management

Reverse auctions normally have a single buyer – usually the government –  seeking bids from a number of potential suppliers for the delivery of a specified environmental outcome.  This can involve either a defined increase in the output of some environmental “good”, or a defined decrease in some environmental “bad”. The Australian “BushTender” programme is an example of a reverse auction.

 

Under the original BushTender trials of 2001-2003, private landholders were contracted to improve native vegetation on their land.  Those contracts were awarded through competitive tendering on a best-value-for-money basis.  The trial demonstrated that auctions provide a process that recognises the diversity of landlords, costs and biodiversity values across the landscape and provides and standard method for measuring and reporting both biodiversity and financial outcomes.

The success of BushTender has seen the development of the approach to secure other environmental outcomes such as reduced salinity and improved river health.

 – BushTender: Rethinking investment for native vegetation outcomes, May 2008, Department of Sustainability and the Environment, Victoria.

Similarly, a reverse auction for the reduction of phosphorous in the Conestoga watershed in the US state of Pennsylvania resulted in a dramatic reduction in the cost of removing a unit of phosphorus.

Summary of the Conestoga Watershed Reverse Auction:

Programme

Number of Participants

Total Cost

 ($)

Total Estimated Reduction in Phosphorous

(lbs of P)

Cost-effectiveness

($/lb P removed)

EQUIP[3]

13

275,552

10,502

26.19

Reverse Auction

7

292,635

80,787

3.62

Source: World Resources Institute Policy Note Number 5, June 2008

 

Stacking:  Appropriately regulated, a landowner could maximise the commercial benefit of environmental land management by using more than one of these techniques on the same piece of land – a process called stacking.  For example, in principle, a landowner could use a given piece of land for conservation banking credits, wetland credits, carbon credits, and water quality credits.

‘Being able to access more than one market is sometimes the key to making the project profitable, and usually leads to improved environmental outcomes.’

Stacking of benefits in this way could facilitate cross-subsidisation of environmental service provision, and it could lower the sale price of individual credits.  Crucially, it could raise the prospective business return to a point where conservation can compete with development – especially in areas of greatest development pressure.

 

Delivering Environmental Benefits

There appears to be a growing body of theoretical and practical evidence that markets can make a significant contribution to addressing some of the most important environmental issues that we face; they can help to ameliorate the environmental consequences of economic development.  These include:

  • Habitat maintenance services,
  • Species protection services,
  • Water quality management services, and
  • Water quantity management services.

They can also help to address the challenges of climate change by providing such services as:

  • Flood risk management services,
  • Carbon sequestration services, and
  • GHG emissions reduction services.

 

Environmental market techniques can be a win, win, win:

  • a win for the environment – by providing higher quality environmental goods and services, as well as enhanced resource protection, and more efficient use of land and other natural resources;
  • a win for rural businesses – by enabling economic development generally and, for land managers specifically, by providing substantial new stable commercial opportunities to counter increasing agricultural market volatility, and declining and uncertain public payments, and
  • a win for the environmental regulators – by greatly simplifying the inspection and verification of the environmental outcomes as a result of working with fewer, more professional, environmental producers.

 

‘What else do we need to do to help make environmental markets happen?  We don’t have all the answers, but that shouldn’t stop us from moving forward.  To succeed over coming years we need to be on the cutting edge of thinking about harmonising economic development and the environment – and that means embracing market-based approaches to conservation.’

 

Key Issues Outstanding:

While there may be theoretical and practical evidence that private markets, if they are developed, implemented and regulated appropriately, can offer great potential benefits for a wide range of environmental problems, four issues are critical to success:

  1. Scope:  Much work needs to be done to understand better the environmental and business scope of environmental markets.  Leaders of key stakeholders must take all available opportunities to advocate the rigorous exploration and, wherever possible, the development and implementation of environmental markets.
  2. Measuring Biodiversity:  Markets work best when the traded good or service is homogenous.  By contrast, many environmental issues involve complex arrays of heterogeneous elements.  Crucial to the success of environmental markets, therefore, will be clarity about what is needed and the outcomes delivered.  This will require agreed, practical definitions, measures and indicators of ecosystem attributes and characteristics.
  3. Regulatory Environment:  For private businesses to take up the challenges and opportunities of environmental markets a clear enabling policy and regulatory environment needs to be developed.  This includes an objective, common system of outcomes verification and certification,  and contract enforcement.
  4. Financing:  Environmental markets may be seen as unusual or high risk ventures by some business finance providers.  This is all the more likely in light of the current economic difficulties.  The range of methods for government to improve the attractiveness to lenders of providing capital to businesses seeking to participate in environmental markets should be explored

UK Biodiversity Business Partnership:

To address these key outstanding issues, the UK Government should convene a Biodiversity Business Partnership, governed by a board of all key stakeholders.  This BBP would be responsible for coordinating and ensuring the completion of the further analytical and development work needed to ensure all potential benefits of markets are captured, and all risks are contained.  It would have three key functions:  Initially as a Think Tank to investigate the business and environmental scope of markets and, in light of that analysis, to identify and promote opportunities to develop appropriate policy, legal and fiscal regimes, as well as addressing such issues as metrics and indicators.  Building on its work as a think tank, the BBP would also act as a Business Advisory service to help businesses new to the market develop and initiate viable business plans.  Finally, it could serve as a facilitator of Finance to ensure that businesses operating in environmental markets have access to adequate capital on reasonable commercial terms.


[1] Refers to the application of offsets to wetlands

[2] Typically used for the protection of specific species

[3] USDA Environmental Quality Incentives Program

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