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

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.