Forging Environmental Markets

To achieve a truly sustainable environment, we must recognize that environmental improvement and economic growth can and do go hand in hand–that environmental improvement is a market just like any other. Indeed, if environmental improvement is approached as a market, then many of its presumed conflicts with economic growth evaporate. For businesses, environmental improvement can provide lower costs and growing worldwide economic opportunity. For the public, it provides trillions of dollars worth of benefits, plus significant insurance against major disasters.

Normally, business leaders and economists would welcome such a huge market–already roughly $180 billion in the United States and more than $500 billion worldwide–as a major opportunity. For comparison, the world market for semiconductors in 1999 was about $150 million. But the terminology and rhetoric of the environmental field have so confused and polarized thinking that this fact and its implications are generally overlooked. Despite the huge economic gains shown by virtually every careful study, environmental improvement generally is referred to as a “cost” by most business executives, political figures, and policymakers. Yet, like other industries, environmental improvement responds to a valid demand, and it creates jobs, business opportunities, investment returns, tax revenues, profits, and positive benefits to citizens. In short, environmental improvement is a market rather than a cost.

The terminology used in national economic accounts and policy dialogues often is seriously misleading. National accounts neither recognize the lost values and actual costs currently incurred by pollution nor measure and offset returns from environmental improvements against the investments that created them. Further, in political discussions, attempts to force companies and users to bear the full costs of their actions are generally termed “taxes,” not “cost recovery.” Those who oppose internalization of such costs argue that environmental improvements “decrease national productivity and competitiveness” and hence reduce job opportunities and growth. But far from decreasing competitiveness, environmental improvements have greatly reduced costs for most businesses. A widely accepted Environmental Protection Agency (EPA) report, The Benefits and Costs of the Clean Air Act of 1970 to 1990, estimated that every dollar spent on “depollution” reduced health costs by $20, and that the U.S. economy experienced gains of $6.4 trillion (with a credible range of $2.3 trillion to $14.2 trillion) as a result of the initial 1970 act alone.

Terminology matters. When the media report an act of mass violence, perceptions change greatly if the actor is called a “terrorist” as opposed to a “freedom fighter.” The case is similar with the terminology of “costs” (implying losses) versus “markets” (implying gains). Ignoring the real costs of existing environmental degradation and the overwhelming contributions that improvements make to productivity skews public perceptions and focuses the environmental debate around wrong issues and data. Thinking and structuring data in terms of “environmental markets,” where all parties internalize their full costs and satisfy a real public demand, can enable a more reasoned dialogue, make environmental investments easier for the public and policymakers to comprehend, place alternative uses of resources (that is, for environmental improvement versus product manufacture or public transfer payments) on a sounder basis, and help allocate national resources more effectively.

The past two decades have proved the social and growth benefits of private markets for most societies. The true effectiveness of a market-driven economy, however, depends largely on: 1) fair pricing of various alternatives based on their real total cost, 2) transparency and information about the value and cost of alternatives, and 3) relatively equal capacity to purchase and innovate in each market. Properly developed, environmental markets stimulate all three components of market efficiency, thus improving overall economic efficiency. Unfortunately, the past practice of considering environmental conditions as “externalities” has seriously distorted resource allocations through implicit subsidies to producers and users of polluting systems.

Such subsidies encourage underpricing and overuse of the polluting industry’s products while discouraging innovation both in that and competing industries. When marketlike structures and incentives are used, innovation in these and supporting industries generally creates environmental results that are higher than initially expected at costs that are significantly lower than expected. Entire new industries–for advanced sensors, new fertilizers and farm technologies, large-scale modeling, lightweight materials, and high-performance engines, to name but a few–often have been stimulated, along with improved environmental outputs, most of which are not captured by national account data.

Recognizing environmental improvement as a market dramatically changes the calculus justifying environmental expenditures. Policy discussions generally have demanded that environmental expenditures be justified on the basis of “lower costs” for the society. But no analyst would demand that the automobile, fashion, entertainment, or furniture industries justify themselves in terms of “cost savings.” These are merely valid demands calling for the resources for their satisfaction, relative to other demands. Similarly, environmental improvement satisfies real demands (for clean air, water, etc.) and creates major new markets for supplier industries.

Indeed, environmental markets drive today’s demand for many new technologies. In many areas, environmental targets even have replaced traditional consumer product, industrial process, or military technological goals as drivers of scientific and entrepreneurial endeavor. And these technologies will undoubtedly create hosts of unexpected new free-standing market opportunities. Properly developed, environmental markets stimulate real economic growth.

Growth opportunities

Any opportunity, public or private, that calls forth previously uncommitted energies and resources can create growth. The only difference between environmental markets and private markets is that demand from many private individuals must be aggregated to purchase environmental amenities. Joint purchases (or “public markets”) create exactly the same growth opportunities as private markets. For example, when an individual works harder to buy an automobile, that private action stimulates growth. If he and his neighbors jointly buy the same car for a carpool, they provide an equal stimulus to the economy. If 1,000 citizens buy a vehicle as a public school bus, they create the same direct sales and jobs.

Generally, two conditions must be present for public markets to create real growth. First, there must be some underemployment of people and capital in the society–conditions that exist in the United States today, given that there are underemployed people ready to work, unused technologies that could free people for other tasks, and undertrained and poorly managed work forces that produce less than they could. Second, the demand must be valid–people must want the publicly purchased amenity more than other goods and services they could buy as individuals with the same resources. Although such preferences are hard to measure explicitly, they often can be determined within reason by marketlike choice mechanisms. Or, the benefits to citizens can be so clearly within the government’s constitutional charter that it would be remiss not to create these markets on its own. Together, public markets (aside from defense) are very large. We estimate that public markets accounted for over $2 trillion (27 percent) of the 1995 U.S. economy, including such things as health care, education, pollution abatement, law enforcement, and public transportation expenditures.

Importantly, studies repeatedly show that citizens prefer environmental improvement to many other public programs. Economists identify several classes of large environmental benefits that consumers would be willing to pay for. These include:

Consumptive benefits. People draw on a wide variety of natural “products,” such as lumber, fish, and drinking water. In addition to the raw value of these products, there are multiplier values of between about 1.4 and about 4 in translating sales of harvested outputs into use values. For example, in the fish and lumber areas, there are 40 to 300 percent more service jobs supporting these industries than there are jobs for commercial fishers and loggers. Product output can be maintained in perpetuity if the rate of biological resource growth matches that of harvesting. Unfortunately, because the asset values of the environment are neither properly recognized nor priced, they are frequently liquidated without their decline showing in national accounts.

Health benefits. It is estimated that environmentally related diseases (mostly due to water pollution) kill some 11 million children worldwide each year. Chemicals in the air are estimated to kill from 200,000 to 575,000 people per year. Many more individuals suffer poor health, which increases their health care costs, reduces job productivity, and lowers economic well-being. Conversely, studies show that many knowledge-intensive companies choose to locate in areas of the United States–such as Seattle, San Francisco, Phoenix, Denver, Boston, Minneapolis, or Raleigh-Durham–where the surrounding environment is attractive, thus creating higher property values and economic growth.

Ecosystem services. Ecosystem services are natural processes, such as forests absorbing pollutants or moderating rain runoff and erosion, that would have to be replaced artificially if natural habitats were removed or degraded. The value of these environmental amenities can be very large. For example, the market value to cities and farms of clean water running out of the Sierra Nevada mountains in California is approximately twice the value of the Sierra timber, grazing, and tourist industries combined.

Nonmarket benefits. Nonmarket benefits are amenities that are not generally sold or consumed directly but for which consumers are nevertheless willing to pay. Such benefits include, for example, the aesthetic appeal of a scenic location or of viewable wildlife. Environmental economists often classify these benefits into several categories: existence values (satisfaction in knowing that nature is protected); stewardship values (maintaining nature for future generations); option values (for example, preserving a forest because pharmaceutical substances may later be discovered in some of its species); and avoidance of risk (preserving the natural state to avoid the unpredictable effects of perceived alternatives).

Private impacts of public markets

Unfortunately, those who seem to benefit most directly from environmental improvements are often not those who must make the initial expenditures to achieve it. For example, automobile companies initially resisted 1970s air quality (and safety) regulations they thought would disastrously decrease auto markets. In retrospect, there is little evidence that the overall industry suffered large continuous losses, although brand switching toward innovators was common at first. However, there is much evidence that the regulations’ primary long-term effects were to stimulate enormous innovation in automobiles to lighten their structures, improve fuel efficiency, and add new features to the automobiles themselves. Profitable supplier industries and individual automobile companies grew to provide catalytic converters, airbags, seat belts, lighter metals and plastics, and fuel-saving features; and some companies became niche players in the “efficient” or “safe” car markets. New competitors, such as Honda and Orbital Engines, came in to exploit the need for higher engine efficiencies, driving the rest of the industry to match their performance. A further wave of innovation swept through the fuels industry to improve combustion without the use of noxious lead products.

As a result of such shifts in this “public market,” between 1970 and 1990 the United States saw a 40 percent emission reduction in sulfur oxide, a 45 percent reduction in volatile organic compounds, and a 50 percent reduction in carbon monoxide. Ozone concentrations decreased by 15 percent, airborne lead by 99 percent, and primary suspended particles by 75 percent. And largely because of other public market activities, such as the adoption of improved automobile safety features and the construction of superhighways, U.S. traffic fatalities dropped from 54,589 in 1972 to 40,115 in 1993–even though the period saw an increase of 60 million licensed drivers, collectively logging more than a trillion more miles per year. These gains, mostly unmeasured in national economic accounts, represented real benefits for individuals.

When regulations are proposed, the affected industries tend to exaggerate potential hardships. Cost estimates based on practices at the time of imposition are generally too high, as innovations almost always quickly lower costs. If regulations use flexibly designed market mechanisms and reward higher performance achievements–as opposed to specifying particular technologies or existing “best practices”–innovators often create solutions that generate both better outputs and lower costs than anyone could forecast at the time.

The town of Trenton, Michigan, presents a classic example. In the early 1950s, when the town refused to allow McLouth Steel to install Bessemer converters because they produced too much air pollution, the company began a search for alternative processes. This led to the first major U.S. installation of the so-called basic oxygen process for making steel. When diffused through the steel industry, the cost savings and value gains of this innovation alone would more than pay for the industry’s highly touted air depollution costs, forcing further innovations in competing processes as well.

Creating public markets effectively

Large-scale studies have shown that governments can promote economic growth by intervening to create parity between environmental and other markets. How to optimize the benefit in social, business, and economic growth terms is the crucial issue.

Many economists and policymakers are beginning to stress marketlike incentive mechanisms to create environmental markets. Special problems exist in this marketplace: Benefits may be highly diffuse or not accrue directly to those who must make needed expenditures; front-end costs appear measurably apparent whereas benefits are often hard to quantify; and no one knows, at the outset, what potential solutions really exist and how other systems or the public may ultimately respond. Most of these (with the exception of the lack of match-up between payers and beneficiaries) are precisely the elements that markets handle best. The major problem is understanding and aggregating the frequently diffuse demands for environmental improvement in a way that minimizes actual costs while optimizing their balance with competing demands.

Economists use two starting points to establish demand potentials in a public market. The first approach is direct: Economists ask and analyze preference questions. The simplest questions are: How much money would you be willing to pay to have a defined level of cleaner water, air, etc.? What amount of money would you demand to allow someone else to decrease the quality of that resource by a specified amount? The problems of achieving accuracy in such surveys are well known, but most studies show that people would demand between two and six times more to accept a loss in current quality-of-life levels than they would be willing to pay to achieve or improve these levels. The second approach is indirect, but typically proves more precise: Economists try to create a real-world market in which interested parties buy and sell real or surrogate assets and solutions. In this way, economists can analyze how people actually perform in trade-off market situations. For example, how much do people pay to vacation in a national park or fish in a clean wilderness area rather than fish or picnic locally? Such studies can include aesthetic (noncost) factors and provide initial baselines for reasonable environmental expenditures. However, they do not measure the value nonusers might place on the resource.

Because of the very high potential values of the environment and the tendencies of affected players to distort their estimates of costs and effects of changes (up or down), careful baseline data studies are crucial to sound analysis and policy. Markets operate most effectively when data are abundant and transparent. As in finance and trade, governments have a critical role to play in providing a reliable and neutral framework of environmental data under which private parties can appropriately value resources, examine trade-offs, and evaluate trends.

Advances in data warehousing technology and information searching have begun to make digital archives of national environmental information available and useful to nonspecialists. But databases are only as useful as the consistency, coverage, and quality control of their contents. Unfortunately, the newness of the field and the number and fragmented nature of interested parties have delayed the development of cohesive definitions, standards, methods, and technologies for environmental data. Since no coherent international standards exist, most countries’ environmental data systems are like giant libraries without a useful catalog.

Accessible, objective data are especially important where pollutants can be invisible, valuable resources (such as fish, rare plants, or unknown chemicals) are difficult to observe or identify, monetary values are not usually explicit, and options may be wide-ranging. It often takes considerable information, education, and time to evaluate alternative choices objectively. For example, the U.S. public appears to be much more concerned about low-level radioactive wastes, such as those from hospital laboratories, than about radon. Yet the National Research Council estimates that in the United States, radon causes 2,100 to 2,900 cancer deaths per year in nonsmokers and contributes to approximately 10 times that many deaths in smokers. By contrast, there have been few if any clear demonstrations of individuals in the United States dying from environmental exposure to low-level radioactive wastes.

Some observers would argue that such skewed risk perceptions are inherent in a market system. The challenge to government and business is to develop environmental incentives and mechanisms that are based on data and that address the important sources of market failure, prevent major disasters, and promote overall market efficiency. Important in the latter is finding mechanisms to publicize successes, improve understanding of trade-offs, and avoid media distortions of fear and false claims. Education and objective data are the best hopes.

Creating marketlike mechanisms

For practical political reasons, governments have tended to introduce approaches to achieving environmental improvement in the following general order: practicing direct top-down regulation, taxing undesirable actions, creating property rights to environmental benefits, providing insurance against regulatory or legal risks, and empowering “stakeholder” negotiations. Each, to some extent, addresses various common causes of market failure–externalized costs, failure to aggregate demand, fairness, and information–but each has its own peculiar strengths and weaknesses. Only in the late 1980s and 1990s have national governments enthusiastically embraced marketlike (rather than regulatory) strategies.

Direct regulation. The National Environmental Protection Act, the Clean Water Act, the Clean Air Act, and the Endangered Species Act of the early 1970s are at their heart top-down regulatory approaches to environmental protection. Although generally resisted by industry, which had no incentive (other than avoiding penalties) to comply, direct regulation forced more rapid responses than might otherwise have occurred, eliminated many egregious acts of environmental dumping, and started a series of learning processes about how to measure effluents, estimate effects, and stimulate desired responses in industry. The government soon learned that it had to provide longer lead times, create a stable regulatory environment, and spend extensive energy to monitor and enforce its regulations. Nevertheless, the mandates forced polluters to internalize more of their pollution costs, enforced greater fairness in distribution of benefits and costs, and aggregated demand for a better environment through the political process.

But top-down regulations often proved inefficient because regulators ignored marginal costing. They routinely demanded that “the best available technology” be applied regardless of cost. The assumption behind such regulation was punitive: that producers were maliciously avoiding depollution investments and had to be punished for their recalcitrance. This approach often backfired, because it discouraged innovation that might lead to better results or lower costs. In a current example, regulations first passed in California in 1990 require that automobile companies selling in that state must produce a substantial number of “zero-emission vehicles” by 2003. To ensure access to the country’s largest auto market, manufacturers have essentially been obligated to develop battery-powered electric cars. If enforced, the specification of a particular technology will result in uneconomical vehicles that will require subsidies, pose high contamination risks from battery disposal, and promote increased effluents from power stations needed to produce electricity for recharging. Resources spent on battery-powered cars become less available for potentially more promising solutions, such as new engine designs, public transit, increased use of bicycles, and better traffic control capabilities.

Despite such flaws, the genius of all four laws turned out to be their information requirements. Both agencies and industry are required to publicly state the potential environmental consequences of their actions in ways that allow the public or interveners to evaluate them and to use political or court processes to challenge actions. Although not always efficient, these processes have created much more objective awareness by all parties of environmental effects and a method to resolve issues.

Targeted taxation. A more marketlike alternative, which is particularly effective when the impact of effluents is highly diffuse either in production or consumption, is to tax undesired actions on a unit purchase (or user fee) basis to increase their cost. A unit fee such as that on fuels (set at a level where total revenue generated just offsets total externalities created) makes the total market economy more efficient as well as providing incentives for producers and consumers to make more cost-effective decisions. In addition, unit fees provide funds to monitor actions and to cover costs for innocent parties injured by pollution. Such fees are most useful when pollution moves from many diffuse sources toward many diffuse recipients, as does auto air pollution, solid wastes created by packaging, home fuels consumption, or runoff from farms. User fees clearly are not appropriate for other situations involving point sources of emissions or extremely intensive downstream concentrations of damage from emissions (such as sewage or smokestack toxins). In these cases, localized monitoring, effluent fees, or release penalties may provide much more direct market responses and match-ups of compensation versus injury.

Unit charges set at a level where total revenues just offset total externalities make the total market more efficient and provide added incentives for producer innovations and voluntary consumer choices of more cost-effective products or services. Assessing fees or taxes on those who are currently or potentially charging the society for their support (for example, energy, water, fertilizer, or gasoline consumers) makes more economic sense than do general sales or income taxes, which affect those selling services or products at full cost. Since relatively small environmental-use taxes, such as carbon or gasoline taxes, can raise very large amounts of money, they can be used to decrease the level of personal income taxes or other sales taxes, thus encouraging further growth and entrepreneurship in more socially responsible areas.

Creating property rights. An interesting extension of marketlike approaches is to convert some component of emissions into private property rights that can be bought or sold. Individually tradable quotas for releasing certain classes of pollutants are an example. Highly toxic pollutants must, of course, be absolutely prohibited. For other pollutants, whose danger increases with exposure, polluters receive a permit to release a fixed quantity of the pollutant depending on a combination of their current production of the effluent and an aggregate standard that, if implemented, would achieve desired health effects in a reasonable cost-benefit fashion. If the producer can reduce its emissions, it can sell the balance of its quota to another party. If it wishes to increase pollution, it must buy rights from a willing seller. New entrants must purchase quotas from existing holders.

The net result is that the amount of pollution is, at a minimum, held constant at current cost-benefit ratios. But each party has an incentive to improve performance. Those who can reduce performance inexpensively have an incentive to do so and to sell the amount saved at a higher price to someone whose reduction costs are high. The government, aggregating the demands of consumers, can decide on the total level of pollution by adjusting quotas over time. Participants in the market decide on the value of rights and seek the least expensive way to reach goals. Although at first attacked as granting “rights to pollute,” tradable permits are gaining wide acceptance among business and environmental interests.

Similar approaches are being taken to develop markets for privatized environmental amenities. Water supply, particularly in the arid U.S. West, has long relied on a system in which individuals own the rights to use certain amounts of water from rivers and reservoirs. Until recently, however, it was difficult for an “owner” to sell low-cost water rights to other users who wanted it for more valuable purposes. For example, farmers who sold such rights might lose them, since the sale would show that they did not need all they were allocated. But in the past several years, the U.S. Department of the Interior has begun to promote public water right purchases as a solution for developing adequate water supplies for cities and for wildlife, including in the San Francisco estuary, where the department assured farmers that the government would purchase water in an effort to help preserve some threatened fish species. Farmers responded by planting crops, such as wine grapes, that had higher value and required less water and by installing efficient drip irrigation systems. Together, such steps have led to the release of more than a million acre-feet of water for sale to urban and environmental users.

There also are other ways to assign property rights, each of which has substantial economic consequences. A well-known example is the assignment of ownership rights for potential pharmaceutical products discovered in nature but developed privately. But under current U.S. law, naturally occurring chemicals cannot be patented, meaning that if a cure for cancer were discovered in a rainforest, it could be freely copied, making it difficult for those protecting the rainforest to profit from any new products made available through that protection. The Convention on Biodiversity calls for countries of origin to own rights to natural products found within their borders, which assists conservation but removes the incentives for drug companies to undertake the expensive task of isolating potential drugs and bringing them to market. In one effort to bypass this problem, Costa Rica has agreed to facilitate bioprospecting by the U.S. drug company Merck in exchange for royalties from any marketable drugs developed. However, it is unclear what protection either will have for natural products developed in the partnership.

Insurancelike mechanisms. A relatively new class of insurancelike mechanisms offers other opportunities, particularly for protecting endangered species. Rather than limiting activities on all lands containing endangered species, agencies now can encourage landowners and neighbors to develop Habitat Conservation Plans (HCPs) to voluntarily set aside enough land to plausibly protect the species in the long run. In some cases, these are multispecies, multihabitat plans that cover not only the species now enumerated in the law but also species that might be protected in the future. In exchange for agreeing not to use some of their land commercially, the landowners obtain long-term contracts (termed “no-surprises agreements”) with the Interior Department agreeing not to impose new regulations on them, typically for 100 years. The use of HCPs has exploded, from 14 created from 1982 to 1992, mostly on small urban tracts, to more than 300 HCPs today.

But improvements in this area are needed, and proper controls for these plans are evolving. A recent National Science Foundation study, which involved 119 scientists from eight universities, examined 208 HCPs. The researchers found that the plans typically lacked enough scientific data to determine whether they provided adequate protections, and that few if any of the plans had mechanisms for monitoring their success or modifying them if they failed. A longer-term risk of this approach is the possibility of collusion between government administrators and industry–not unknown in the past management of U.S. forests.

Ideally, private parties, not the government, would provide environmental insurance. For example, company A could anticipate external costs (increased pollution or local species losses) that might be caused by its planned expansions and prepurchase offsetting reductions from company B. Company A then has an incentive to invest in environmental benefits early, before they become of regulatory concern and the price rises. Company B, which has set aside the land, has an interest in stronger regulation, which would increase the value of its environmental assets. Government’s role in such transactions would be in agreeing that the “insurance” meets regulatory requirements in preventing collusion or misrepresentation by the companies and in ensuring that adequate sanctions exist in the event of either party’s failure, perhaps in the form of reinsurance by third parties.

Empowering stakeholders. Because of the distractions and costs of having governments directly stimulate and enforce the terms of environmental markets, there is a growing political consensus that bypassing centralized regulatory approaches and fostering more direct conflict resolution among stakeholders (such as landowners, local businesses, local governments, and environmentalists) at ecologically relevant scales (such as watersheds) is the wave of the future. Of course, some regulatory involvement will remain critical: The incentive for warring local interest groups to negotiate is often that if they cannot reach a consensus, a distant bureaucrat will impose rules on them. For example, the 1995 San Francisco Bay-Delta Accord launched the 30-year, multibilion-dollar “CalFed” effort to restore water quality and fisheries in the San Francisco estuary. The agreement was signed by often-warring water interests only hours before a deadline set by the federal EPA, after which EPA was prepared to impose its own water-quality plan to protect threatened fish under the auspices of the Clean Water Act.

Unfortunately, in most localities there often is insufficient objective information or technical expertise to balance in a comprehensive way the costs and benefits of land use, water quality, rare species, population growth, chemical pollution, risks of flood and fire, and so on. To the degree that this information exists at all, it is likely to be held at multiple levels and points within different government units and in different formats. Recognizing that stakeholder negotiations typically get nowhere until industry, environmentalists, and government agree on common facts, the Clinton administration has been active in developing shared standards for environmental data sets and in requiring agencies to make their data available over the Internet. For example, the Federal Geographic Data Committee, representing all environmental research and land management agencies, has set mandatory standards for remote federal sensing and mapped data. In addition, access to biological data is being centralized under the National Biological Information Infrastructure, and most agencies have extensive Web sites permitting the public to browse their data holdings. Unfortunately, data collection has not kept pace with improvements in access. Over the past decade, the federal government has substantially curtailed field monitoring by major environmental data collection agencies such as EPA and the U.S. Geological Survey.

Taken together, then, some important pieces are in place to move the nation away from its past punitive approaches to environmental improvement, which often have led to high costs in terms of both pollution and cures. To foster the growth of environmental markets, the research, standard-setting, and regulatory functions of government will be critical, just as they have been in the development of many other markets, such as pharmaceuticals, communications, transportation, and the food industries. Developing environmental markets further requires improved science and data capabilities, sophisticated monitoring systems, new marketlike incentives, and strong constituencies to maintain the intended balances between economic and public environmental benefits.

But at the very heart of the matter, parties on all sides must work to create a new intellectual framework and terminology: that environmental improvement is a valid market whose demands and satisfaction ought to compete fairly with all other consumer and commercial markets. Properly managed, that market can create great economic growth opportunities for the future.