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.


August 2, 2014

Developing Businesses for Better Environmental Stewardship

Over the past few decades environmentalists have produced a great wealth of evidence of a growing range of environmental problems. As a consequence, they have often advocated a moral case to encouraged people to behave differently; appealed to their “better nature”. We have heard calls to respect the inherent values in nature and to improve intergenerational equity; to “save the planet”. Despite this, virtually all the growing body of indicators show continued deterioration of the natural environment. It is increasingly obvious that this strategy is inadequate on its own.
Although many in the environmentalist community remain suspicious, more recently it has been increasingly recognised that a business case for more environmentally sustainable behaviour, can also be made; that by appealing to people’s self-interest rather than to their sense of morality and/or the common good, a range of environmental problems can be successfully addressed. From this, three additional approaches are being developed: the valuation of ecosystem services to the economy and for individual businesses; the development and integration of natural capital accounting to enable better resource and environmental risk management; and the development of novel markets for the delivery of specific environmental outcomes.

The markets within which the private sector operates lead to particular outcomes because of the structure of commercial incentives and disincentives. In most markets there has been no incentive to consider the effects of commercial activities on the natural environment, and often there has been a disincentive to do so, in that doing so individually would raise costs and depress competitiveness. As a result businesses externalise environmental costs; they disregard them. Modifying these incentives and disincentives, so that the environmental consequences of commercial activities are internalized and brought into the commercial decision-making process, can create novel environmental markets. The creation of carbon markets is a simple case in point.
Presently, it seems to me that two issues need urgent attention to progress the development of the market-based approach, and of novel environmental markets in particular.
First more work needs to be undertaken on the theoretical underpinnings of the various novel environment markets and other market-based techniques to understand better which work for what sorts of environmental issues, and under what circumstances. Trading, offsets, caps and floors, auctions, payment for services, and others all have strengths and weaknesses that need to be better understood from both environmental and business perspectives. I suspect that we would find that there is a very wide range of environmental issues to which market-based techniques could make an important contribution. There will also be many significant issues for which they would be inappropriate, and we need to have a clear idea of which are which and why.
Second, to date much of the work done on the linkages and crosswalks between ecology and economics, between the natural world and the world of business, has been led by the environmentalist community, with increasing support from the legal and large corporate communities. As a consequence, this work tends to emphasise the potential environmental benefits and/or threats of market-based approaches; the strengths and weaknesses from an environmentalists perspective.
While the environmental consequences are critically important, if the wider business community is to engage more fully with this debate, it seems to me that it would be helpful if detailed examples and case studies were used to identify the specific benefits for businesses; to articulate the many and varied positive opportunities for businesses of delivering improved environmental outcomes. Most businesses are interested in exploring opportunities to improve their financial performance, and proposals that can be articulated in such terms will find a wider and more receptive audience. To do this, more firm-level case studies that show the detailed calculations of costs and benefits for the business that will deliver the environmental outcomes need to be made available. While large companies have the capacity to dedicate personnel to engage in this debate, most firms remain unclear about the “bottomline” benefits for them of undertaking their activities in a way that would benefit biodiversity and ecosystem services. This is all the more the case in the current difficult economic climate. In short, there is an urgent need for these issues and proposed techniques to be examined from the firm-level perspective of the businesses that will make them happen – otherwise they are less likely to happen at all.

I am certainly not advocating some sort of unregulated free-for-all, and more work needs to be done to ensure that the techniques employed are fit for purpose, but if we can harness the power of millions of private decision-makers we might get more done, more effectively, more efficiently, cheaper, and with more enthusiasm than programmes and schemes that are publicly financed and administered. It seems to me that it is a prize worth serious consideration and exploration.

Blog at WordPress.com.