Environmental Markets – Part Two

Environmental pollutants and the depletion of natural resources are relevant to supply chain leaders as many industries are reliant on these ecosystem goods and services. Industry is also subject to regulatory compliance requirements and many investors care about a firm’s activities throughout the supply chain that contribute to pollution and natural resource extraction. Last month, we discussed market mechanisms as policy instruments to curb environmental degradation and to preserve the ecosystem services (ES) that we, as a society, derive from functioning ecosystems. Market-based instruments (MBIs) are policy instruments that provide market-wide economic incentives to foster social benefits. Examples are environmental markets like cap-and-trade, carbon taxes, and conservation subsidies like USDA’s Conservation Reserve Program. Here, we explore the effects of policies that intend to maintain the provision of ESs and curb their depletion as they apply to supply chain entities and industry leaders.

We first ask when solutions are needed for collective action problems and we explore instances in which government has intervened to better account for the value of collective goods in markets. Next, we discuss the benefits and costs of various approaches to mitigate environmental harm and related considerations for the industry. Next month, we continue this discussion and conclude with some emerging developments that affect environmental markets and actions that supply chain and industry leaders are taking in response.

When is intervention in collective action problems needed?

In the traditional, laissez-faire approach to production, producers and consumers are largely free to function according to the supply and demand for goods and services. This approach creates externalities, where the cost of damage to public goods (e.g., resource depletion and environmental degradation) is borne by the broader community, rather than by the entity causing those damages. In last month’s article on environmental markets, we discussed how market-based policy instruments offer an approach to incorporating the value of public goods into economic markets, thereby incentivizing companies and other entities to preserve, not damage, public goods. Various interests among actors impact how and when policy interventions are implemented to ensure the provision of public goods.

The development of the modern sewage system was borne from the collective demand for sanitation and clean water. Prior to the advent of modern sewer systems, typically the nearest river or water body was used as a conveyance for untreated wastewater from communities, fouling the water and causing severe disease outbreaks. As an understanding of the correlation between disease and water quality emerged, it instigated the development of treatment processes. When and how should the government implement a regulation or create an environmental market for clean air or water? What form should the policy take? These questions concern property rights. Who owns the right to pollute? Who has the right to a clean environment? Who should pay for public goods and services? This is the theoretical underpinning of market policies for ecosystem goods and services. Crafting these policies and understanding the intended and unintended consequences of them gets complicated quickly, because the providers and beneficiaries of public goods (and harms) are many and disparate, and the potential impact on and responses of the multitude of actors is hard to predict. This table below and the following discussion review how approaches to environmental policy affect various dimensions of firms’ interests.

Effects on Supply Chain Industries Affected by Environmental Policy

	Business as Usual/ Voluntary Markets	Government Regulation	Market-based Instruments
Reputation	Public response is dependent on firms’ decisions, absent any policy driver, to advance CSR / ESG in goods and service production	May be benefits of emissions / environmental harm reductions to firms’ public relations	May be benefits of emissions / environmental harm reductions to firms’ public relations
Flexibility / Constraints	Ultimate flexibility in the short run until collective harms are realized but lack of intentionality yields no assured environmental improvement from status quo. Less flexibility / increased constraints in the long run if / when environmental degradation increases	Some flexibility/constraints in meeting emission targets depending on regulation structure. More certainty about future environmental conditions due to regulations’ intentional ES provision	Variation among regulated firms allows some to reduce emissions / environmental harms more cheaply than others, creating the drivers for market exchanges. More certainty about future environmental conditions due to intentionality in MBIs’ ES provision
Environmental Damages and Risk Management	Firms incur costs as risks to environmental goods and services upon which they are dependent and to reputation if not advancing conservation and environmental stewardship	Reduces firms’ risk of environmental services loss. Can incorporate compliance into CSR / ESG strategies	Reduces firms’ risk of environmental services loss. Can incorporate compliance into CSR / ESG strategies
Financial Cost of Compliance	Zero	Two sides – barrier to entry to those already complying but generally, firms incur compliance costs to adjust production to meet pollution/emission limits	Most efficient allocation of price and quantity for environmental goods and services
Financial Benefits of Compliance	Savings by using fewer resources to comply with regulation. Flexibility to decide if / how much to curtail/adjust production	Savings often derive from efficiency gains from using fewer resources as well as time savings. Shared environmental benefits of ecosystem services (clean air, water, climate stabilization, etc.) contribute to production return on investment	Potential for savings from both efficiency and shared ecosystem service provision. Firms’ flexibility to reduce their own emissions or purchase offsets yields additional, increased savings over regulation

Benefits and Costs

Environmental markets are not the only viable approach to responding to environmental public goods issues. These market-based mechanisms are contrasted with ‘business as usual’ (BAU) and direct regulation. BAU refers to staying the course by not implementing far-reaching, corrective policies to environmental threats. Command and control regulation is the most direct and historically common approach to reducing environmental harm to nature and the public. Given those alternatives, which is in the best interest of different companies and their supply chains? To answer this, we can assess general trends in the observed and anticipated effects of these three different approaches to addressing collective action problems. Gaining an understanding of these aspects of policy structure can help industry actors advocate for the approach that best aligns with their interests in public policy discourse. Additionally, understanding some of the nuances of market mechanisms is useful in discerning the best options for meeting permit limits or as a potential income stream selling credits.

Reputation – CSR/ESG

Corporate Social Responsibility (CSR) and Environmental Social Governance (ESG) concern the responsibilities firms have to the public. A significant portion of consumers are adamant that they prefer to purchase goods and services that are produced in line with their ethical principles.^[1] Common examples include fairly-traded coffee, dolphin-safe tuna, and organic produce. Public perception and investor support are increasingly linked to companies‘ sustainability initiatives.^[2][3]

Some buyers are willing to use their purchasing power to vote with their wallets for practices that align with their values when the information is accessible and trusted. In the food and beverage industry, for example, a 2020 study by the International Food Information Council^[4] finds that while they find the transparency of companies’ environmental sustainability commitments lacking, over 40% of Americans include a commitment to sustainability and environmentally-responsible farming practices among valuable attributes in a food and beverage supplier. Importantly, 34% note that “environmental sustainability” impacts their purchasing choices.^[5] However, the correlation between buyer opinion and purchasing is not overwhelming given the challenge to transparency and therefore, the ability for consumers to know how sustainably their products are made and transported.

Investor support is less ambiguous. Investors are interested in companies’ commitments from an ethical perspective^[6] as well as the financial benefits of ESG investments.^[7] They see wide impacts of companies’ ESG performance on obvious cost factors such as efficiency gains and collective benefits of ESs. Investors are also increasingly expanding their views of ESG value to be more holistic, incorporating overall returns on investment such as social impact, community improvements, and stakeholder relationships.^[8] In this way, the concept of “value” more accurately reflects the interdependence of human and natural systems. Smart investment decisions cannot ignore the ways that production, transport, and consumption affect communities, corporate governance, and the environment and are similarly affected.

In terms of policy support, some activists strongly oppose the use of markets to provide goods that they believe to be universal rights while others, such as EDF (formerly Environmental Defense Fund) were instrumental in the creation of California’s cap-and-trade market. The public generally thinks regulation is ultimately needed to achieve substantial improvements in environmental quality,^[9] however, studies show that the public is most supportive of MBIs following an introductory education on the cost-effectiveness of markets.^[10] In fact, many cross-country surveys show support for market mechanisms when given empirical and policy context.^[11]

Creative action at COP23 protesting the rise of carbon markets, organized by Friends of the Earth International. Bonn, 17 November 2017.

One clue to discern environmental markets’ effects on ESG compared to direct regulation may derive from the necessity for transparency and credibility in functioning MBIs. As discussed in last month’s article, market-based policies must provide additional environmental benefits and consumers and investors must know and care about the accruing collective benefits. Therefore, transparency is both critical to effective environmental markets^[12] as well as strongly linked to successful CSR^[13] because consumers and investors can hold companies accountable for their stewardship.

It is clear that public opinion of environmental markets improves when the market is likely to provide health and environmental co-benefits and when market profits are re-distributed to other collective goods like education and healthcare.^[14] Despite the absence of a compliance requirement, in laissez-faire conditions, companies can choose to invest in environmental credit offsets through voluntary markets which confer benefits to public perception.^[15] Whether consumer preference for companies’ goods and services and investor support for their ESG strategies vary based on the policy approach driving the value-aligned activities is unclear and unlikely. 

When government intervention is necessary to better incorporate the value of ecosystem services is not always evident. How government should intervene is even more complicated. Integrating the complexities of environmental systems’ interdependence with both communities as well as goods and service production into economic, market exchanges requires thorough consideration. This article discussed the benefits and costs of business as usual, regulation, and market-based instrument approaches to environmental policy to companies’ reputations among consumers, investors, and the public. Next month, we explore and compare additional dimensions (flexibility, risk, cost of compliance, benefits of compliance) of these different approaches’ impacts on supply chain industries and aspects of the current environmental market landscape relevant to decision-makers.

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