Environmental Markets – Part Three

Part Two of this series on environmental markets examined the pros and cons of market-based policies compared to more traditional environmental regulation. Here, in Part Three, we continue to explore the benefits and costs to supply chain companies of market-based policies compared to other environmental policy approaches. This article concludes the series with a high-level review of the current market-based policy landscape to address environmental threats to the collective good. Due to the interdependence of human and natural systems, there is substantial uncertainty inherent in estimating environmental outcomes, making it challenging to evaluate and compare the benefits and costs to individual companies of various environmental policy options. Nevertheless, supply chain practitioners need to understand the alternatives in order to take an informed stance on these important policy decisions.

Benefits and Costs of Environmental Markets, Regulation, and Business As Usual (continued from Part Two)

Financial Benefits and Costs of Compliance

Cost of compliance may be the most direct measure of the impact that policies have on industry. The US Environmental Protection Agency (EPA) oversees regulations affecting various businesses.¹ Since the wave of environmental legislation was enacted in the United States in the 1970s (Clean Air Act, Clean Water Act, and National Environmental Policy Act) and the creation of US EPA, it has been debated as to whether regulation negatively affects companies’ bottom lines² and others noting that the environmental and health benefits outweigh the costs of compliance to industry.³ The argument that regulations are “job killers” or otherwise harmful to the economy has been espoused since Ronald Reagan’s presidential campaign, but studies find otherwise. While compliance with environmental regulations can cause a decline in employment in some sectors, studies show, the overall effect on employment rates are negligible or positive.⁴ Studies that incorporate social benefits accrued from environmental improvements (such as reduced pollution’s impacts on outside worker productivity) suggest that the overall economy improves.⁵                      

There are mixed findings regarding the effects of regulation on the competitiveness of regulated firms and its ability to spur clean technology choices and innovation to meet compliance targets.⁶ Transitions to environmentally-compliant technologies can improve production efficiencies, yielding financial benefit to companies implementing the technology. Ideally, regulation also stimulates technological innovation such that firms develop less costly processes to meet the emission limitations of the regulation while improving production efficiency. Studies show that innovation following regulation is fostered in specific conditions such as scenarios in which compliance is anticipated to be costly, regulatory enforcement is legitimate and robust, and opportunities for firms to relocate production to less-strictly or non-regulated jurisdictions (also called pollution “leakage”) is limited.⁷ It has also been noted that the cost of compliance and capital to innovate to meet regulations can inhibit competition when larger firms are more easily able to comply.⁸ That is one reason that larger firms sometimes welcome regulation and may want to keep in place costly regulations, if they have already made those costly investments to comply.

Relative to regulation, markets offer economic benefits to industry as their “textbook result is an efficient market equilibrium in which a pollution target is achieved at lowest cost, or a resource is used in a way that yields the most value to society”.⁹ Environmental markets provide an advantage to industry as a cheaper avenue to meet emission permit limits. MBIs (Market-Based Instruments) rely on market forces and therefore, more efficiently achieve provision of ecosystem goods and services like pollution reduction. These markets allow firms to choose the least expensive compliance option between meeting permit limits or paying others to offset their emission contributions. Firms that can reduce emissions more cheaply can sell permit credits to those firms for which reductions are more costly, incentivizing pollution reduction and the innovation of pollution-reduction technologies.

Flexibility

Markets allow regulated firms flexibility. They may innovate and alter their own production practices such that they meet their emission allowance, or they can purchase “offsets” or emission reductions from others. The US sulfur dioxide market is often referenced as a successful cap-and-trade policy from which we can draw lessons for carbon and other environmental markets.¹⁰ Sulfur dioxide emissions, largely from coal plants, was causing acid rain, harming aquatic life, and killing large swatches of forest and other vegetation. The 1990 iteration of the Clean Water Act instituted a sulfur emissions trading market. Exploiting variation among plants such as their age and proximity to low-sulfur coal, firms that could reduce emissions more cost-effectively than others were able to sell excess allowances for a profit. In this way, markets’ costs of compliance are generally less than that of regulation.

Risk / Resilience

Risk and resilience are concepts applicable to supply chain compliance generally and to climate stability and other ES specifically. Many parts of supply networks are steeped in compliance requirements and supply chain leaders work to reduce compliance requirements’ challenges to firms’ profitability. Firms assess economic, political, environmental, and ethical threats to their companies and network partners. The structures of regulatory or market-based policy mechanisms and the resulting risk to companies is an interesting and complex issue.

Supply chain entities can be both buyers and sellers in the same environmental market, purchasing credits from other companies (or aggregators) or selling allowances to others.  Risks can include low supply/demand for credits, and failure to meet regulatory requirements that could result in penalties or reputational impacts.¹²

A 2016 Duke University study explored the risks’ of MBI’s (Market-Based Instruments) across many dimensions by examining several examples: (1) wetland mitigation banking, (2) conservation banking for wildlife, (3) California’s carbon market, and (4) water quality trading at the state level.¹³ The paper found that the largest determinant of risk variation was based on whether environmental credits reflected permanent vs. temporary impacts.¹⁴ Permanent environmental impacts (such as filling a wetland for development) and ongoing/temporary impacts (such as water treatment plant’s ongoing wastewater releases or a manufacturing plant’s ongoing greenhouse gas emissions) present different risk profiles. Permanent credit offsets are typically sold one time and for a specific clearly delineated project. Ongoing offset exchanges are often included in a market where emitters have annual emissions limits and firms can buy or sell credits yearly.

Regulatory uncertainty, extreme events, and importantly, how market policies assign liability for compliance (to the credit buyer or seller) are among other considerations affecting firms’ risk in buying and selling credits through MBIs.¹⁵

Industry is dependent on environmental goods and services just as the public is. Therefore, inaction is a risk for industry as well as the public. For example, the oil industry is both reliant on clean water sources throughout its production supply network to extract, process, and produce petrochemicals and products¹⁶ as well as one of the largest contributors to water pollution.¹⁷ Similarly, the industrial agriculture sector largely contributes to the greenhouse gas emissions that cause climate change while simultaneously being highly affected by climate disruption and its resulting natural disasters and weather pattern changes such as more extreme droughts, floods, and permanent significant changes to seasonal temperature and precipitation patterns in agricultural regions.

Effective policy that curbs environmental degradation reduces firms’ risk to effects of environmental harm whether derived from direct regulation or market participation. Risk management can be built into these market policy mechanisms. For example, some markets allow for credit banking in which firms can save allowances for use later, reducing firms’ risk of unexpected costs. Stakeholders can advocate for inclusion of risk-reduction mechanisms in the market development process.

The Current Environmental Market Policy Landscape

A country-wide carbon emissions cap-and-trade market was defeated in the US Congress in 2010 and a large-scale attempt to instate a carbon market has not moved forward in the United States. Other, smaller-scale, regional and state-level markets have been created to curb GHG emissions with varying levels of success. Most recently, Washington state has capped carbon dioxide emissions and began auctioning allowances in February 2023.¹⁸ The policy applies to firms that emit more than 25,000 annual tons of carbon. Globally, the European Union has had a functioning carbon market since 2005.

While climate markets are perhaps the most well-known, market policies exist for various environmental services including wetland mitigation banks in which wetland restoration and creation project credits are aggregated and sold to permit-holders developing wetlands elsewhere. Water quality trading schemes have been enacted in US states to allow non-regulated businesses (most notably, agricultural producers) to sell nitrogen and phosphorus reduction credits to others to meet permit limits.

An important distinction between a watershed-based credit trading program and a cap-and-trade carbon market is the scale of the environmental issue. The global nature of climate change means that offsets in one area of the globe have the same climate change mitigation effect locally as globally. For example, a factory in the US can purchase carbon credits from an entity planting trees in the Amazon in Brazil. The same is not true for water or air quality trading. In order to see meaningful reductions in nutrient inputs, for example, a sewage treatment plant would have to purchase offset credits from an agricultural producer in the same watershed since water pollution is a local issue that primarily affects water quality downstream from the source of pollution inputs. Pollution sources are then more traceable. This scale dimension is relevant to how actors consider free riding. Since the scale of GHG inputs is global, many countries and companies may view others’ efforts to reduce emissions as permission to avoid reducing their own emissions. Similarly, they may be reluctant to reduce emissions when they see that some other nations or firms are not yet reducing their emissions equivalently.

As is the case with most complex social and environmental phenomena, opinions on the success of markets as a solution varies among stakeholders. The limits of the effectiveness,¹⁹ integrity,²⁰ and scalability²¹ of voluntary markets has been widely noted. Despite clear limitations and unsuccessful markets, investors continue to invest in markets²² and prominent environmental market scholars call for optimism after assessing the over three decades of data from carbon and other markets.²³

There may be a return to calls for a US carbon market as many firms will be required to report on financial impacts of climate change as well as their carbon footprint under the SEC’s Climate Disclosure Rule,²⁴ set to be phased in over the next three years. The rule’s requirement to disclose emissions from upstream and downstream activities in firms’ value chains are of particular interest to supply chain leaders and practitioners. As emissions through supply chains become more transparent through this process, it may entice companies to support an MBI approach. Companies that are unable to reduce emissions cost effectively may start to see the benefits of an MBI, where they could buy credits to offset their carbon emissions and achieve carbon neutrality or at least lower net emissions. Companies that are able to reduce emissions at a lower cost should be very interested in the opportunity to sell their carbon credits and make additional revenue.

Investor, industry, and the public signal interest in incorporating the value of ecosystem services in economic exchanges

This three-part series on environmental markets has demonstrated the realities of addressing collective action problems. The above discussion has outlined some key dimensions of environmental market policies as approaches to ensure the provision of public goods and services when their value is not overtly included in economic markets. The plethora of attempts to establish MBIs for ESs (Ecosystem Services) and the modest number of successfully developed markets reinforces the challenge of implementing MBIs, and how the complexity of these mechanisms can have widely differing outcomes for regulated firms and credit sellers. Similarly, the structure and nuances of environmental policies affect the ability of the mechanism to provide environmental quality. Despite the complexity, the persistence of grave environmental quandaries and collective action problems requires continued attention to incorporate the social value of ecosystem services missing from economic markets.

The interdependencies of human and natural systems muddy the ability to clearly assess success metrics of environmental markets. However, leaders in many sectors have made it clear that ESG (Environmental, Social, and Corporate Governance) and corporate sustainability are only becoming more enshrined in the global business landscape.²⁵ Renewable energy investment neared $500bn in 2022 and over $40bn was invested in climate start-ups.²⁶ Never before has the collective call for environmental protections been greater, in large part due to the growing recognition that industry is dependent on the natural world and there is substantial economic value to ecosystem services. Whether or not environmental markets are the best way forward, it is clear that the impetus to save the planet is not just a benevolent act, but also makes smart business sense.

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