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Using financial incentives and market-based schemes to promote global environmental objectives: some cautionary considerations

By David Friedman - posted Saturday, 15 July 2000


A surprising consensus has emerged among financial theorists, investors, trade economists, regulators and environmental advocates that international financial and market mechanisms should be utilized to promote global environmental objectives. Emissions trading, green funds, investment credits and similar approaches are now seen as essential for protecting human health and critical habitats endangered by world investment.

Such enthusiasm contrasts sharply with the skeptical reaction normally afforded market-based pollution control schemes in domestic contexts. Emissions trading, offsets, conservation banks and the like, it is often asserted, result in "phantom" pollution reductions with little real benefit.

This paper urges that market-based solutions to global environmental concerns be approached with caution. Most significantly, it assumes that markets efficiently and aggressively reallocate whatever chemical constituents, pollution rights or other assets they are designed to exchange. Any health or ecological benefits markets might realize, however, are profoundly dependent on the precision with which their ultimate objectives are defined.

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There are good reasons for thinking that these risks are of particular concern as environmental objectives are married with international financial and market regimes. In the international arena, these policy characteristics can generate four potentially adverse consequences:

  1. Imprecise or inaccurate definition of the specific constituents, rights or other "goods" to be traded in markets or fostered though incentives can result in net ecological harm and resource misallocation.
  2. Market-based and fiscal incentive regimes create increasingly vested interests over time that impede future adaptation and flexibility.
  3. Market-based proposals often generate pre-market information that reveals mitigation option marginal costs, a result that makes actual market implementation less desirable.
  4. Structuring international institutions in pursuit of imprecise, contentious objectives can stimulate social conflict and undermine the global financial regime’s legitimacy.

I. Environmental goal definition and interest-group advocacy

The process by which proposed international emissions trading or conservation goals are defined is rarely examined. The most recent analyses suggest that environmental advocates, to an extent generally unmatched by most other interest groups, are sustained by an affluent political base and able to advance objectives subject to fewer serious substantive challenges over time. As their potential opponents’ confidence and effectiveness declines, the risk that imprecisely defined goals will be articulated and pursued correspondingly rises.

There is striking evidence, for instance, that American environmental and related advocacy organizations have adeptly out-maneuvered competing groups and dramatically transformed the tenor and focus of the nation’s politics. From 1963 to 1991 American congressional policy debates, including hearings and legislative committee agendas have shifted focus from matters of economic and material enhancement such as trade, agricultural subsidies, labor policy, and technology development to a "postmaterial" agenda advanced largely by environmental organizations. Rather than consider measures to increase economic opportunities or wealth, Congressional legislative debate profoundly shifted to address the "quality of life" and "postmaterial" issues of concern to the country’s more affluent social classes

Several factors explain these trends. Environmental groups in particular are comprised of, and supported by richer, white, suburban donors who provide them with a stable and generous supply of funds. They are staffed by highly-educated personnel drawn from the same social classes who can afford to make long-term commitments to lobby and curry media support. Most other interest groups seeking space on the national agenda cannot compete with these advantages.

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Modern interest groups also increasingly tend to polarize opinion. People with moderate perspectives or who dissent from views advanced by more vocal advocates find that the personal costs of expressing their beliefs are too high. Today, even those oversight entities like the federal Environmental Protection Agency that are charged with rational policy development concede their priorities are determined much more by what the most aggressive activists demand than the risk-based, scientific assessments performed by their own technical experts.

None of this means that environmental concerns are unimportant or inherently illegitimate. An appreciation of how interest group advocacy can generate suboptimal policy goals, however, is critical to the effective design of market-based systems. If program objectives are inaccurately specified, international financial and market mechanisms will almost certainly generate unintended, adverse consequences.

II. Problems with pursuing environmental goals through international market mechanisms

A. Market-based regimes can be more costly and result in greater environmental damage when control objectives are poorly defined

Market-based and financial-incentive schemes to reduce pollution are highly dependent on the precision with which pollutants and pollutant rights are identified, measured, and traded. When there is divergence between the traded constituents and their bioactive variants – the form of the constituents that actually cause health or ecological damage – market-based regimes can readily generate much greater harm and cost than other regulatory options.

Market-based regimes rigorously, but thoughtlessly, function as programmed. If the objectives to which they are deployed are imprecise or inaccurate, they will reallocate rights and resources in ways that their designers may not have anticipated. When they are accurately deployed to control specific, bioactive substances of concern, they can achieve dramatic environmental benefits at very low costs.

The problem of imprecise goal definition bedevils domestic American market and financial incentive regimes, including trading schemes proposed for numerous watersheds to comply with federal Clean Water Act discharge requirements. In most instances, the constituents that dischargers are eventually allowed to trade (usually only after a lengthy and contentious political process) are not focused specifically, if at all, on bioactive substances. The distinction between gross and bioactive substance control has, in fact, become a critical problem in virtually all Clean Water Act load control programs.

Potential international trading schemes may face similar challenges. Given the often-politicized climate in which such policies are created, the possibilities that the harmful agents to be controlled will be misspecified, or that worldwide resources will be misallocated, may be particularly high.

Consider proposals to reduce greenhouse gas emissions by means of trans-national carbon rights trades. There is apparent agreement among most concerned advocates that reducing CO2 emissions is the overarching policy objective of any such program. Yet, as scientific analyses of the nuances of global warming improve, it may be that other gases (such as CFCs, which by some estimates have 10,000 times the greenhouse effects of CO2) are far more critical to control. A carbon market will work exactly as designed, but anticipated health and environmental benefits will not be realized.

B. Market and financial incentive schemes can exacerbate policy inflexibility and constrain adaptability

Once market-based and financial incentive programs are established, they are increasingly difficult to modify as circumstances warrant. Those who were skeptical of market-related measures in the first place usually view any future modification as an attempt by dischargers to backslide from initial commitments. Holders, buyers and sellers of emission rights or entitlements will typically resist system changes that could devalue their investments or financial expectations.

It is not unusual, of course, for basic goals and objectives to change in public policy. Some implementation approaches, however, can accommodate change more easily than others can. Market-based regimes are not only less flexible than most policy options, they are extremely sensitive to relatively small information and data variations.

Assume, for instance, that those who believe human carbon emissions are causing global warming are correct. In the early 1990s, the Intergovernmental Panel on Climate Change (IPCC) estimated worldwide temperatures would increase from four to six degrees by 2060 alone. Most international carbon trading regime proposals are founded on the IPCC’s or similarly pessimistic scenarios. Should a trading system be implemented consistent with these predictions and global warming occur at a less rapid pace, the self-interested calculus that is supposed to drive the carbon market will not function as planned. It will almost certainly, however, prove very difficult to modify an existing regime to account for changed priorities.

These problems are even more apparent in areas such as rainforest conservation where the factual predicates behind popular concerns are scientifically controversial and severely obscured by high-profile celebrities. Efforts to acquire and permanently conserve the world’s rainforest assets, for example, have, like Tibet, become celebrity preoccupations.

One of the founders of Greenpeace recently launched a media campaign to show that the world’s rainforest habitats are stable, regenerating, and up to 90% intact even in supposedly denuded areas like the Amazon. Celebrity and media attention on rainforests, he contends, diverts resources from far more important ecological problems, such as ocean pollution. Contemporary forestry research also indicates that the high rate of rainforest vegetative decay likely generates, rather than absorbs, net atmospheric carbon loads.

A system of global incentives to preserve rainforest assets in the event current perceptions are overstated would severely misallocate funds and priorities. To assure against such adverse outcomes, any market-based or incentive effort must be able to accommodate changed facts and circumstances, even to the extent of eventually scrapping the program itself. It is, however, extremely difficult to redirect financial incentives schemes in this fashion. Unless carefully considered when established and dispassionately managed thereafter, market-based regimes can become more an instrument of fashion than a serious tool to address environmental priorities.

C. The process of creating market-based regimes can reveal marginal cost differentials and make markets superfluous

Market-based solutions to environmental issues appeal in part because they are based on an analogy with conventional consumer markets. It is an economic truism that voluntary exchanges among buyers and sellers under such circumstances generate demonstrable efficiency gains compared with other methods of allocation.

Proponents of international trading and fiscal incentive regimes often speak as if markets for environmental "goods" will generate comparable efficiencies by similar means. In a mature market system, however, producers and consumers do not have to grapple with crucial foundational matters such as the rules that govern their transactions before buying and selling goods. In contrast, any emissions or pollution rights trading proposal must concern itself first with creating background trading institutions.

To mollify skeptical advocates and regulators, project proponents almost always invest substantial time and money in developing information that verifies mitigation option marginal cost differentials and illustrates how exchanges will beneficially achieve regulatory goals. Dischargers, in effect, establish up-front what markets will do. They produce extremely detailed studies of marginal costs and anticipated market performance that, with more or less accuracy, clarifies how different compliance options compare.

In many instances, pre-market studies generate new information that allows for substantial regulatory compliance without any market trading taking place. To be sure, the pre-market studies contributed to knowledge about the problem of concern, but, ironically enough, they made actual market implementation far less imperative.

Similar considerations will likely emerge as international pollution rights trading programs are pursued. Once a reasonably defensible model of efficient CO2 emissions trading outcomes is available, however, the attractiveness of ever building a functioning carbon market is substantially reduced. Armed with an understanding of how nations would sell and buy carbon rights if allowed to do so, global negotiators may achieve much more, at less political cost, to negotiate for and impose cutbacks based on market simulations rather than gamble global trading might someday comparable results. Enlightened policy must recognize and respond to such opportunities as they emerge.

D. Market-based regimes can undermine the legitimacy of the global financial system

Environmental controls are typically highly regressive. The few studies that have seriously examined the relative burdens imposed by major environmental programs demonstrate that large-scale programs burden poorer families and households much more than others.

Market-based regimes can also create "hot spots", places where cost differentials or other factors make clustering emission and discharge sources more likely. Marginal cost differentials for various mitigation options, moreover, are inescapably a function of the political power and wealth of the affected communities. Well-organized, influential, and richer societies can insist on domestic rules and constraints that drive up pollution costs in the regions they inhabit. Market-based systems will naturally exploit these differentials and locate less desirable emission activities in areas where the affected population is least able to protest.

There is a growing suspicion among many less advantaged groups and nations that environmental concerns in general address relatively slight risks that may matter to a privileged few but divert attention and resources from more pressing matters with far more significant health and ecological consequences. The costs associated with toxic emission controls are much higher per life saved, or illness averted, than almost any other regulatory expenditure option, including medical interventions and improved consumer and blue-collar workplace safety regulations. These facts have recently stimulated a powerful critique of the class bias latent in the environmental movement that might easily be extended to the international arena.

Market regimes address social inequities, if at all, by reducing mitigation costs. They do not eliminate the problem of justifying and prioritizing among various issues and choosing those of greatest urgency and concern. If controversial or poorly justified market regime objectives are married with world-wide financial and market institutions, faith in global finance more generally will likely suffer.

III. Potential guidelines for fashioning international market-based environmental regimes

The precautionary considerations discussed above suggest that proposals to use market-based and financial regimes in pursuit of global environmental objectives be moderated with a cautious understanding of their limitations. Modern environmental policies arise from complex social and political calculations.

If market-based environmental protection and conservation programs are to be incorporated into the international financial system, under what circumstances are they more likely to succeed? Effective guidelines would almost certainly include the following:

  1. Market-based regimes are more likely to succeed to the extent bioactive constituents of concern are fully understood and precisely defined.
  2. Market-based regimes should anticipate the possibility of changed goals and priorities
  3. .
  4. Market institutions are comparatively less attractive to the extent pre-market verification clarifies cost and compliance options.
  5. Markets should address environmental issues about which there is general consensus or which can be defended on the basis of comparative risk assessment.

It is possible that the application of these basic principles could preclude immediate deployment of currently popular proposals, including global CO2 trading or rainforest preservation incentive schemes. Whether such programs should be advanced depends on the accuracy with which they have been specified, the extent to which they can be modified in the future, the relative gains that might be realized from markets versus mandated results, and the extent of agreement on program priority. When this set of initial considerations is satisfied, market-based programs are generally defensible. In such cases, it is likely that global finance can usefully address environmental problems while potentially adverse, unanticipated consequences are minimized.

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This is an edited extract of a paper commissioned for the New America Foundation Workshop on the Environmental Dimensions of Global Financial Architecture and presented on July 14, 2000.



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About the Author

David Friedman is Markle Senior Fellow in the New America Foundation.

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