Why do environmental markets fail?

Environmental markets are being developed worldwide, on the faith that they will help solve environmental degradation.

Two major factors have driven this enthusiasm in the developed world: conscious national environmental policy movements toward market-based instruments, and rising demand for environmental goods and services. Developing nations have also geared up towards this direction.

The reasons for setting up markets are many. First, markets help discover the right price for the environmental resource and aid their allocation and distribution, and offer means of achieving social optimality in consumption and production. Second, markets help raise funds for sustainable development financing.

Third, market institutions are supposed to make the common man understand the value of services that the ecosystem provides to the economy as a whole, the incidence of economic activity on the ecosystem and its repercussions on life. Fourth, as scarcity of ecosystem services comes to the fore, the roles of creating markets and market values become important, as government instruments fail.

Fifth, markets work well at providing rewards and encouraging resource managers to properly manage natural resources.

When one looks at the value chain of marketed commodities, one realises goods extracted from ecosystems have long been traded in markets. The services provided by ecosystems have been used for just as long, but have remained beyond markets and largely un-priced.

Resources with poorly defined or undefined property rights (including forests, water, or grasslands), if not regulated in their use, can be accessed by all and used until exhaustion. But just as in any market, an emerging scarcity can make them tradable.

So the question arises: why do environmental markets fail so often? The most recent instance includes the emergence and failure of carbon markets. Despite the initial successes of environmental markets, some quarters have criticised them for lacking even basic safeguards against fraud, and not really resulting in emissions reductions. The overarching objective of environmental protection depends on whether the markets are really helping the realisation of efficient prices. Ideally, the price of a commodity in a market should reflect its scarcity value.

In theory, the market interaction between the demand and supply forces leads to equilibrium prices. There is an important assumption here. This is about the consumer being aware of the “utility” of the commodity.

The situation is, however, a bit difficult for environment or ecosystem as a commodity. An efficient market price should ideally reflect the scarcity value of a resource. Under perfect market conditions, prices become equal to the scarcity value. For the environmental market, information is the missing element.

So far, even ecological scientists have failed to decipher the range of ecosystem services provided by nature. There is clear lack of knowledge among the public about what will be the entire range of effects from trans-boundary air or water pollution. Here, it is difficult for market prices to reflect the true scarcity value.

It has been argued in some quarters that during the recent financial meltdown, carbon credit prices or more precisely Certified Emission Reduction (CER) prices diminished, and that is precisely because the demand for CER, as a commodity in the consumer’s utility bundle, fell.

This is because consumers preferred other commodities to CERs. Does that mean that the value of environmental damage has diminished? Of course not.

Pollution keeps on doing the same damage during a recession, as it does during prosperous times. Mangroves provide the same ecosystem benefits that get translated into our economic welfare function during recession, as during a boom.

This means there is a clear divorce between prices and value when it comes to environment. Buyers of environmental services are only aware of a minuscule portion of the entire range of services that the ecosystem can offer. It is only this minuscule portion that enters their utility bundle and gets realised in market prices.

Let us now look at the supply side. Ecosystem services of nature are independent of the environmental market. Nature will continue with its provision of ecosystem goods and services of gas regulation, waste treatment, climate control, biological control, water regulation, pollination, food production, soil formation, nutrient cycling and other functions, unless disturbed by extreme anthropogenic forces or external stimuli.

This makes prices essentially demand-determined. Unfortunately, the entire problem is with the demand function of environmental services. No doubt, the crucial problem here lies with knowledge. In sum, unless there is adequate information about the environment and ecosystem, it is not possible for markets to discover right prices.

The writer is Acting President, Indian Society for Ecological Economics. The views are personal.