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Bringing Efficient and Effective Ecosystem Markets to Scale: Challenges & Solutions

Walsh, Sheila 10/26/2011

Ecosystem markets often are touted as an efficient and effective way to solve environmental problems. As interest in market solutions grows both within the Conservancy and in the private and public sector, it is critical to know when markets deliver better environmental results at a lower cost than alternative approaches — and how to scale them up when they do.

In Part I (Part II) of this piece, I outline some of the general challenges and issues around creating efficient and effective ecosystem markets — including transaction costs, property rights, competition, and verifiable outcomes — and how those challenges and issues vary by the type of market strategy. Some regulatory markets have largely overcome these challenges and resulted in arguably the greatest environmental success story of the last two decades: significant reductions of SO2 emissions and acid rain. Excitement from the success of regulatory markets has turned attention to direct (e.g. voluntary) markets and payments for ecosystem services (PES). Although the Conservancy pioneered market-based conservation strategies by buying land (long before the term PES existed), we should consider the new and remaining challenges for market-based strategies that target individual or bundled ecosystem services using regulatory markets, direct markets or PES.

The Market Solution and the Problem of Transaction Costs
Ecosystems generate important benefits to society in the form of public goods, such as clean drinking water, clean air, climate regulation or areas for recreation. Ecosystems also benefit people by acting as sinks for pollution or providing food and fiber for harvest. Use of ecosystems as pollution sinks or for food and fiber production services, however, limits the ability of society to enjoy other services from these ecosystems, and vice versa.

The Coase Theorem suggests that the problem of how to allocate ecosystem services to different desirable uses can be solved efficiently through markets. Regardless of whether the polluter has the right to pollute or an individual has the right to consume clean water, says the theorem, multiple parties should be able to come to a mutually beneficial solution through bargaining, if there are no transaction costs. In reality, the transaction costs associated with establishing agreed-upon resource-use levels among multiple parties are usually very high for individuals relative to the benefits they get from those resources, which leads to economically inefficient resource use that reduces the total benefits to society.

Governments can help overcome these high transaction costs to individuals by representing the collective "willingness to pay" for ecosystem services. For example, the U.S. Conservation Reserve Program pays farmers to not grow crops in order to increase water filtration services or biodiversity, which benefit the public. Similarly, by purchasing land for conservation, the Conservancy and other land trusts represent their members’ demand for the services the land provides. In contrast, regulatory (i.e., established via regulation) markets, such as emissions markets or fisheries catch shares, force large resource users to carry the burden of transaction costs rather than individuals, who would face especially large costs to organize.

The Problem of Market Formation for Public Goods
In order for markets to form, they need well-established and complete property rights and a signal of scarcity. Ecosystem services that are public goods, such as clean air for breathing or genetic resources, do not fit these criteria. Property rights cannot easily be established for clean air because people cannot be excluded from enjoying it and because one person breathing clean air does not effectively limit another person's ability to do so. In contrast, in the case of common-pool resources (such as pelagic fish stocks outside of a country’s 200-mile exclusive economic zone), use by one person does limit other people's ability to use the resource. Yet the creation of property rights for this kind of resource is still extremely challenging.

Regulatory markets have gotten around these challenges by focusing on harm to these resources. By limiting the rights to extract or pollute, the government indirectly protects the rights of society to healthy fish populations or clean air, for example. Users then buy or sell their right to extract or pollute within the limit set by the government. In contrast to command-and-control regulations that prescribe specific actions for all regulated individuals, regulatory markets in many cases should be more cost-effective because individuals are free to find innovative solutions to achieve target levels of use or pollution through decentralized decision-making. For example, the SO2 emissions market, the largest regulatory market in the United States, is estimated to have resulted in $1 billion in reduced costs annually (Carlson et al. 2000).

Issues Around Creating Efficient and Effective Ecosystem Markets
The greater efficiency of ecosystem markets over command-and-control solutions depends on the markets being competitive as well as on enforcement of regulations.1 A competitive market needs lots of buyers and sellers trading homogenous goods with low transaction costs, good information and no uncompensated effects on third parties. This combination of requirements sets a high bar. Markets for industrial air or atmospheric pollutants, however, may fit most of these requirements. For example, greenhouse gas emissions reductions in one place, theoretically, should offset emissions anywhere else in the world. Based on this principle, voluntary markets for forest carbon have already been created, and regulatory markets are emerging (e.g. in California). In contrast, nutrients in a river, wetlands, or habitats for endangered species are not equivalent from one place to the next. Many mitigation, offset or trading programs have addressed this problem by limiting the geographic area in which transactions may occur. For example, nutrient trading in the Chesapeake Bay may only occur within major tributaries (Branosky et al. 2011). Although this limitation makes it less likely that some tributaries would get most of the nutrient pollution, it also limits the number of buyers and sellers.

However, even competitive markets may not be effective if they do not verifiably deliver ecosystem services. Most markets are not actually markets for the ecosystem services (or disservices) but markets for actions that should increase the service. Even with some actions that are directly linked to the ecosystem, such as wetland restoration, there is concern over whether these restoration efforts really result in the projected levels of ecosystem services.

Beyond Regulatory Markets: Direct Markets and Payment for Services
Despite some of these challenges, the success of regulatory markets has generated interest in direct markets for ecosystem services. Direct markets are where the user of the ecosystem service pays voluntarily rather the polluter paying to comply with regulations. However, as noted above, forming direct markets for public and even common goods is problematic because of their attributes. Even when common goods show signs of scarcity, it's difficult to motivate users to pay because others can benefit from their action through free-riding.

Voluntary engagement in direct markets may result from philanthropic motivations, a sense of social responsibility, or a perceived opportunity to generate private value or minimize risk (especially in preparation for regulatory markets). The Conservancy and other non-profit organizations have made significant impacts through buying land and, increasingly, for-profit organizations are participating in voluntary carbon markets. Despite political uncertainty over regulatory markets for carbon, 2010 saw the largest volume of trading in voluntary carbon markets, with 29% of credits coming from REDD (Peters-Stanley 2011). However, participation may decline if regulations are never created; and philanthropy or social responsibility will likely not be sufficient to keep pace with the increasing magnitude and scale of environmental problems.

Payments for ecosystem services, which are not markets but agreements (usually between one or a few buyers and a few sellers), are prone to greater inefficiencies than markets but may still provide better solutions in certain situations. For instance, PES may not increase ecosystem services if payments are biased towards individuals who were least likely to clear forest on their land, for example, or if they increase resource degradation in other places by displacing effort or increasing resource prices. These issues are referred to as additionality and leakage, respectively. Recent careful evaluations of a PES scheme in Costa Rica to reduce deforestation and of the clean development mechanism in China showed these efforts resulted in far less additional conservation or reductions in greenhouse gases and other pollutants, respectively, than was expected (Zhang and Wang 2011; Pfaff et al. 2008). In fact the study in Costa Rica estimates that the PES scheme resulted in avoidance of only about 0.08% per year of deforestation, onethird of what might have been expected (Pfaff et al. 2008).

In addition to not always producing the expected results, PES may not be costeffective. In contrast to environmental taxes that both reduce the undesired activity and generate revenue, publicly funded payments for ecosystem services may be less efficient because they tax desirable activities to pay for reductions in undesirable activities (Jaeger 2011). Yet, PES may be a more efficient solution when the harm occurs outside of the jurisdiction of the people that enjoy the ecosystem service. For example, a government may use PES for international environmental issues, while non-profit organizations or individuals may use PES to have influence without ownership. PES may also be more desirable when payments also decrease income inequality. For example, the Conservancy's Guandu Water Producer Project pays low-income landowners to maintain or restore forests with fees collected from water users in Rio de Jainero.

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In order to bring efficient and effective ecosystem service markets to scale, the Conservancy needs to overcome or avoid the pitfalls and understand the limitations of markets or PES, use science and policy evaluation to improve market design and demonstrate opportunities to generate value, communicate this science to involve new actors and ecosystem services, and help build the policy and infrastructure to support markets. I’ll outline how the Conservancy can and is addressing these challenges in Part II next month.

 

References
Branosky, E., C. Jones, and M. Selman. 2011. Comparison tables of state nutrient trading programs in the Chesapeake Bay watershed. World Resources Institute: Washington, D.C. http://www.wri.org/publication/comparison-tables-of-statechesapeake-bay-nutrient-trading-programs

Carlson, C., D. Burtraw, M. Cropper, and K.L. Palmer. 2000. Sulfur dioxide control by electric utilities: What are the gains from trade? Journal of Political Economy 108(6): 1292–1326.

Jaeger, W.K. 2011. The welfare effects of environmental taxation. Environmental and Resource Economics 49(1):101–119.

Russell, C.S. 2001. Monitoring, enforcement, and the choice of environmental policy instruments. Regional Environmental Change 2:73-76.

Peters-Stanley, M., K. Hamilton, T. Marcello, and M. Sjardin. 2011. Back to the future: State of the voluntary carbon markets 2011. Ecosystem Marketplace/Forest Trends and Bloomberg New Energy Finance. www.forest-trends.org.

Pffaf, A., J.A. Robalino, and G.A. Sanchez-Azofeifa. 2008. Payments for environmental services: Empirical analysis for Costa Rica. Terry Sanford Institute of Public Policy, Duke: Working Paper Series SAN08-05

Zhang, J. and C. Wang. 2011. Co-benefits and additionality of the clean development mechanism: an empricical analysis. Journal of Environmental Economics and Management 62:140-154.


1There is some research that shows that compliance monitoring requirements and costs are higher for market-based approaches (measuring actual emissions over time vs. checking if the mandated filter is installed and in good condition) (e.g. Russell 2001).

Image: Fresh market of Kota Bharu, Malaysia. Image credit: paularps/Flickr.