Environmental Markets – Part One

Regulations vs. Environmental Markets

Whether driven by a doctrine of shareholder supremacy or by accountability to a broader set of stakeholders, supply chain leaders have a duty to make decisions that are in the best interest of the stakeholders they serve.
Supply chain practitioners therefore have an obligation to formulate and advocate a position and policy regarding the best course of action for tackling ‘tragedy of the commons’ challenges.

The promise of cap-and-trade to alleviate climate change consistently made headlines in the early 2000s, but a thriving market was hindered in the U.S. by political opposition. Though a nationwide carbon market did not materialize, the European Union has a functioning cap-and-trade market^[1] and there are a handful of regional or state-based trading regimes for carbon as well as other environmental goods.^[2] Relative to government regulation, environmental markets, also called Market Based Instruments (MBIs), offer an efficient approach to addressing today’s greatest environmental threats to industry and the public. This is because these markets strive to incorporate the value of environmental costs and benefits into markets.

The goal of environmental markets is to attain environmental goals more cost-effectively than through direct regulations, also called regulatory drivers or command and control mechanisms, with the same intention to achieve environmental benefits. In efforts to avoid some of the drawbacks of regulation, MBIs seek to offer more flexibility to meet environmental goals and to increase the transparency of environmental costs and benefits.^[3] There are lasting lessons and potential applications of market mechanisms to curb environmental challenges that threaten businesses, communities, and ecosystems. Examples include carbon emission trading, nutrient credit markets, and storm and flood crediting. We explore how these types of mechanisms work, examples of issues in which markets have been implemented, and tradeoffs among costs and benefits of the market-driven approach to ecosystem service provision for various stakeholders.

Market Mechanisms – The Basics

The Tragedy of the Commons concept encapsulates the root issue from which many environmental challenges arise. Most environmental goods and services such as clean air and water, a stable climate, and healthy river and forest systems are public goods and as such, do not carry a direct cost of consumption. A common example of the Tragedy of the Commons is a shared pasture where cattle owners allow their cows to graze. With no cost to the owners to add additional cattle to the community resource, the pasture will be overgrazed. Access to public goods like clean air to breathe and water to drink, national security protections, and public radio cannot exclude actors’ access, but provide great collective benefit to businesses and consumers alike. Therefore, market actors are incentivized to consume more than the social optimum leading to the depletion of these resources, such that all individuals’ access declines.  

The Tragedy of the Commons applies to many natural resource issues. Natural resources provide ecosystem services (ESs) that deliver incredible social value. The benefits provided by ecological services are many. Clean water is a critical input for numerous sectors such as food and beverage, pharmaceutical, and energy, and few industries escape risks from climate disruptions. Noted benefits of natural ecosystems include vast employment around the globe, the basis of world nutrition and food security, and disease prevention and treatment among other services.^[5]

The value provided by these ESs (ecosystem services) is not accounted for in traditional market mechanisms. Consequently, ESs are frequently depleted, polluted, or deteriorated by individuals, companies, and governments. The public, government, and industry all rely on these resources, so when their abuse and overuse externalize private costs to others, the economic and non-economic impacts can be substantial and widespread.

Nutrient Pollution

One example surrounds the abatement and environmental costs of nutrient pollution entering waterways. Although fertilizer ingredients such as nitrogen and phosphorus provide nutrients that help plants grow, these nutrients can become pollutants when they enter into water systems. While there are also natural causes of nutrient inputs in farming, society incurs considerable costs of nutrient pollution from human activities. A primary input in farm fertilizers and prevalent in wastewater, nitrogen and phosphorus are common nutrients that impair water quality, particularly in agricultural watersheds, and in rivers and lakes near wastewater treatment plants, and those that receive substantial urban stormwater runoff. Benefits of farm production accrue to farmers and agricultural landowners while the costs of water quality issues are dispersed between the public and other private interests. Similarly, nutrient reduction practices in wastewater treatment provide opportunities for the recovery of benefits.^[6]

US EPA has attempted to quantify the costs derived from nutrient pollution. Drinking water pollutants are harmful to human health, recreation tourism declines when it is unsafe to swim and paddle, and property values and commercial fishing also suffer financially when water quality is threatened.^[7] Demonstrating the non-trivial nature of nutrient pollution costs, examples provided in the EPA report include $13 million for 2 years of drinking water treatment following a nutrient-caused algae bloom in an Ohio lake and $47 million in lost tourism revenue resulting from a second algae bloom, also in Ohio.

Flooding and ESs – Wetlands and Floodplains

Flooding abatement is an environmental service provided by floodplains adjacent to rivers and wetlands throughout the landscape. Periodically or seasonally inundated low-lying land areas, floodplains and wetlands act as reservoirs and sponges, storing and absorbing stormwater, filtering pollutants, supporting aquatic habitat, and sequestering climate change-causing greenhouse gases.^[8] Climate change and vast non-pervious surfaces from continued urban development increase flooding risks while at the same time, river management for navigation disconnects river channels from their floodplains with levees and flood walls. In this way, causes of flooding continue to increase while the availability of natural resources that mitigate flood damage declines.

The immense benefits of freshwater aquatic systems including floodplains and wetlands provide ESs that support economic benefits for society and throughout production supply chains.^[10] These services—e.g., clean drinking water, abating detrimental impacts to environmental services the public and industry rely on, and facilitating recreation—have been quantified in a number of studies. Studies quantifying estimates on the flood reduction benefits of one hectare of wetlands lost to development or agricultural production range from $8,000^[11] to $12,000 per year cost to surrounding communities in flood protection, concluding that conserving wetlands is worth the cost as the approximate value in flood protection of U.S. wetlands to society is $1.2-$2.9 trillion.^[12] The 2019 Mississippi River flood is estimated to have caused nearly $20 billion in losses including almost $1 billion in losses to agricultural producers.^[13] Since any individual landowner may benefit from converting these wetlands and disconnecting floodplains from the main channel, there is a case for environmental payments and markets to account for this dispersed value lost to the public and other sectors.

Demand for environmental goods and services like these across supply chains and communities makes monitoring and responsible consumption of these goods and services critical to ensuring continued access for supply chain actors and the public. Market-driven policies to enhance ecosystem services such as carbon sequestration and increased water quality are touted as having the potential to provide opportunities to accomplish both necessary conservation as well as continued access to these vital goods and services.^[14]

When pollution or natural resource threats require action, governments can set a pollution limit to instigate environmental quality provision at an efficient price and quantity. Following the imposition of the cap, those who must meet the limit can choose to reduce environmental impacts to meet their limits or, alternatively, purchase additional credits or “offsets” to fund others’ reductions. Below are examples of environmental markets.

Climate – The EU, U.S. and Canadian States/Provinces, China, and the Paris Agreement

The climate was the first space in which industry leaders and governments undertook serious and large-scale efforts to enact emissions trading. The United Nations’ Paris Agreement’s goal to limit global temperature increases due to climate change to 1.5°C drove the development of international greenhouse gas emissions trading schemes (ETSs) which allow carbon emitters to choose to reduce their emissions or purchase allowances from other emitters.^[15] Due to the global nature of climate change, emissions can also be traded among countries and across large geographic areas. European Union has maintained the earliest functioning emissions trading market in the world and China’s ETS began functioning in 2021.^[16] In the U.S., California has been a leader in establishing a state-based carbon market.^[17] Several Canadian provinces have linked up with California’s market and actors within the multiple regions traded credits within the Western Climate Initiative.^[18] Since 2005, the twelve states in the eastern U.S. participate in the Regional Greenhouse Gas Initiative (RGGI),^[19] the first mandatory market-based greenhouse gas emission reduction program in the U.S.

Water Quality – Nutrient Credit Trading

Less known, water quality credit trading (WQT) works similarly to carbon markets in that a pollution limit (water quality floor in this case) is set as the market cap. Companies can choose to reduce their own contributions or purchase credits from other emitters who can do so more cheaply. In the U.S., some states and watersheds have implemented credit trading based on allocated permit limits under the Clean Water Act (CWA)’s Water Quality Standards.^[20] While WQT approaches can control various pollutants, nutrients are a well-known example of the potential benefits of credit trading market policies.

Nutrient trading (i.e., capping the amount of nutrients discharged as a pollutant into water supplies) is an interesting case study because the agricultural industry has the potential to substantially reduce nitrogen and phosphorus inputs (and thereby runoff) but are not permitted entities under the CWA and therefore, outside the cap.^[22] Agricultural producers can participate in markets by voluntarily selling land-based offsets, earning them additional income in exchange for reducing nutrient runoff. Offset practices include reducing fertilizer application or planting cover crops which are less expensive than many different permitted industries’ options for technical solutions.

As previously noted, wetlands perform critical nutrient cycling, provide river-adjacent habitat, and hold storm and flood waters providing quantifiable benefits, but land development in various industries frequently includes filling in wetlands prior to construction. An early version of the market concept to abate impacts of wetland loss with restoration and establishment elsewhere derived from the Clean Water Act (CWA) of 1972’s wetland mitigation requirement. Section 404 of the CWA requires permitted entities to “offset” these impacts by restoring wetland habitat elsewhere.^[23] Private wetland mitigation banks, staffed with ecologists and hydrologists, engineer projects to create and restore healthy, functioning wetland systems and subsequently, sell credits to companies needing to meet permitting requirements.

In a similar concept, stormwater storage and floodplain protections are ecosystem services valuable to society. Increased urbanization is accompanied by parking lots, streets, and sidewalks, surfaces that do not store or absorb stormwater following rain events, as well as river management projects (such as levies) that facilitate river transport but reduce flood storage lands adjacent to the riverbed. Nature-based solutions like storing excess water on floodplains and urban green infrastructure projects offer flood risk reduction and other ecosystem service provisions but require additional research and efforts to move towards effective compensation schemes for market-based mechanisms.^[24]

What is necessary for functioning market-based policies?

While not a panacea for industry and supply chain actors, the US Department of Agriculture notes that market mechanisms for environmental quality offer “innovative policy approaches to leverage funding for environmental conservation on private lands”.^[25] Market-based policy instruments are often contrasted with regulation, however, these markets also require government intervention.

The market is virtually always much ‘smarter’ than individual regulators and experts at determining the most efficient solutions to mitigate the abuse of shared natural resources.

The production of goods and services without incorporating the collective environmental impacts is an inefficient market in which all costs are not incorporated. To correct market failures, governments can intervene to prohibit or limit these impacts directly through regulation. Regulations can be costly to the regulated industries and often inefficient and/or have unintended side effects, and oftentimes thereby are not generally popular. Furthermore, regulations require government regulators to design specific regulatory rules to attempt to meet the policy goals. It is practically guaranteed that the rulemaking process results in a suboptimal method to meeting the policy goals, even when regulators diligently incorporate lots of input from experts in the industry. The market is virtually always much ‘smarter’ than individual regulators and experts at determining the most efficient solution to the problem. Credit trading and taxes are often more popular as they leave more autonomy to actors along the supply chain while accomplishing environmental service provision.

There are benefits to market policies such as allowing industry flexibility and choice in how to meet their permitting limits and enhancing environmental goods and services provision for companies and the public. However, involving numerous actors and the exchange of value is more complicated than traditional command and control regulation and requires several market attributes to achieve cost-effectiveness for companies throughout the supply chain as well as to effectively attain collective environmental quality goals. Several of these attributes are presented below.

Property Rights – The Price (tax) versus Quantity (cap-and-trade) Debate

The structures of these market policies are determined, in part, by the establishment of property rights. Who has the right to produce, transport, and supply goods? Do producers have the right to pollute and who has the right to clean water and air? This is the fundamental distinction between two versions of market mechanisms in ecosystem service policies: tax instruments vs. cap-and-trade compensation schemes. A “green tax” or price mechanism, where emissions are taxed directly at a rate determined by regulators, which increases the cost to industry of the detrimental impacts they impose on the environment. Emitters absorb the additional expense of the tax into their cost of production, thereby motivating them to seek ways to reduce their detrimental environmental impact. Alternatively, regulators determine the market cap, based on policy goals, and the market (via everyone buying and selling credits) sets the price to meet that cap. This allows companies who are subject to the cap to improve efficiencies, invest in technological solutions, or pay others to offset environmental impacts. An efficient market naturally finds the most efficient solution to the problem.

Voluntary and Compulsory Policies

Relatedly, market-driven environmental quality trading can be voluntary or compulsory. In voluntary markets, companies invest in projects by purchasing carbon or environmental quality credits, offsetting adverse environmental impacts. Companies may voluntarily engage in markets to reduce barriers to entry prior to anticipated required compliance, to support their own corporate social responsibility goals, and because companies realize that they too rely on these ecosystem services and recognize the need to preserve them.

Compliance markets are those in which the “cap” is determined by government regulation. Often this looks like a permitted allocation, developed and enacted by the government. Basic economics suggests that price settles where demand for goods or services meets supply. Markets seek to incorporate the collective environmental cost of production into the market, essentially shifting the supply curve for the production of goods and services to the left. This shifting of the curve provides a new market equilibrium that includes the social cost of environmental quality (figure 4 below).

Discussions of market-driven ecosystem service policies and their design would be incomplete without mention of baselines, externalities, and environmental co-benefits.

In order to achieve meaningful environmental quality provision through these mechanisms, it is essential to establish accurate baselines and for credited projects to meet ‘additionality’ standards. Only pollution abatement activities that result in additional ecosystem service benefits contribute to enhancing environmental quality. To be additional, reductions in carbon emissions or other pollutants would not have occurred in the absence of the environmental market. For example, a company may be required to reduce its environmental impact by a regulation or permit. If the reduction was already legally required, crediting the reduction does not contribute to additional environmental quality.

Inflated baselines or non-additional emissions reduction activities do not contribute meaningfully to enhancing environmental quality.^[27] This is often a critical piece of market design and is essential to ensure an effective market. Policies that accurately assess environmental baselines and verify that technologies and solutions are additional ensure that environmental markets benefit the public good.

Externalities

The case for market-driven environmental policies derives from externalities, market impacts that are unintended and not included in production costs. Pollution and resource depletion impose additional costs to a collective society, but they impose little or no additional costs to producers; i.e., the market price fails to incorporate the cost to society. Externalities are also relevant to consider in the design of these mechanisms. For example, the installation of a particular pollution abatement technology may provide carbon abatement or water quality enhancement, but it also requires more intensive energy inputs. Since energy production is fossil fuel intensive, there is a tradeoff between the environmental benefit of the technology and increased energy use.

Lastly, the concept of co-benefits recognizes the complex web of interdependencies of environmental and societal systems. Changes that are implemented to meet one specific environmental goal can have other positive benefits, as well as some negative impacts, on the environment and society. These co-benefits should be taken into consideration when designing policies.

Retiring agricultural commodity production land to conservation sequesters carbon, reduces nutrient inputs into nearby waterways, and may provide flood water storage. Similarly, wetland conversion is a substantial contributor to greenhouse gas emissions and in addition to climate stabilization benefits, their preservation provides functioning nutrient cycling, stormwater storage, and habitat provision. In some scenarios, it is more advantageous to the public good to incentivize land conservation than to install scrubbers to filter industrial toxins from air or water emissions. Therefore, another important market policy design consideration is the accurate assessment of co-benefits.

Industry Benefits

Industry benefits from familiarity with market-driven environmental markets, as opportunities for less costly environmental compliance and for recognition of its conservation initiatives. Importantly, industry actors are also corporate citizens dependent on natural resources themselves who also benefit from their conservation. More efficient than government regulation, ecosystem service credit trading harnesses the power of the market to entice consumers to purchase offsets from producers of environmental quality when it is more cost-effective to do so.

Part Two will discuss these costs and benefits and the relevance of market-based environmental policies to industry and supply chain leaders.