Woodward, Richard T.

English

Research Papers in Economics

CHOICES
The magazine of food, farm, and resource issues
1st Quarter 2005 • 20(1) CHOICES 49
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1st Quarter 2005 • 20(1)
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Markets for the Environment
Richard T. Woodward
Markets are increasingly being used and proposed as a
way to address environmental problems and manage natu-
ral resources. Functioning markets exist for water rights
and sulfur dioxide credits can even be purchased via the
Internet. Markets are being developed for trading water
quality credits, greenhouse gas emissions, and many other
environmental services. In this paper, I examine why such
markets are being widely proposed, give some background
on their history, and speculate on their future. The other
papers in this Choices theme provide an overview of what
is really happening “on the ground,” discussing how well
the promise of these new markets has been met in reality.
Background
Most economists are quite enthusiastic about markets;
they make buyers and sellers better off and create incen-
tives for innovation. These benefits can also be achieved
when applied to the environment. Markets can help
reduce the cost of achieving environmental goals and
move resource usage permits to those that value them
most. However, Adam Smith’s invisible hand does not
magically materialize to provide clean air, protect endan-
gered species, or even ensure the best use of fresh water. If
markets are to be used to address these issues, then the
rights to be transacted must be intentionally defined.
The advantages of markets have led economists to look
for ways to harness market forces for the management of
the environment and our natural resources. After being
promoted for decades by economists, this policy tool is
beginning to have some notable successes. Costs of con-
trolling sulfur dioxide have fallen dramatically, and water
quantity trading is now routine in some regions. It might
even be argued that the development and implementation
of environmental markets constitutes the single most valu-
able contribution of environmental economists to date,
having saved billions of dollars in the SO2 program alone.
Today markets are being promoted as part of the solution
to an ever-increasing range of environmental problems,
including overfishing, urban sprawl, and global climate
change.
What are the Economic Benefits of Environmental 
Markets?
The theory behind market-based approaches to deal with
pollution problems arose in the late 1960s in work by
Dales (1968) and Crocker (1966). In such a system, rights
to emit pollutants or use natural resources would be dis-
tributed to stakeholders but could then be sold. Market
negotiations between potential permit buyers and sellers
would occur and result in the reallocation of these permits
across the stakeholders. In the textbook version of such a
program, a cap is first placed on total pollution emissions.
Second, permits equal to the cap are distributed to the pol-
luters. Finally, a market develops in which the sellers are
those firms with relatively low abatement costs who end
up reducing emissions by more than initially required;
buyers are those with relatively high abatement costs who
end up reducing emissions by less than initially required.
Regardless of the aspect of the environment being consid-
ered, the market-based approach requires that transferable
rights be defined and protected (typically by government),
an initial allocation is set, and trade in these permits is
allowed. The textbook result is an efficient market equilib-
rium 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.
At least, that is how it is supposed to work—the sim-
plest theoretical models never quite work in practice. For
Articles in this Theme:
Markets for the Environment . . . . . . . . . . . . . . . . . . . . . . . . . 49
Lessons Learned from SO2 Allowance Trading. . . . . . . . . . . 53
The Evolving Western Water Markets . . . . . . . . . . . . . . . . . . 59
The Future of Wetlands Mitigation Banking . . . . . . . . . . . . 65
Crunch Time for Water Quality Trading. . . . . . . . . . . . . . . . . 7150 CHOICES 1st Quarter 2005 • 20(1)
example, Dales’ original proposal was
to use transferable rights to improve
water quality. Coincidentally, one of
the earliest applications involved
markets for water pollution on the
Fox River in Wisconsin. However,
significant barriers to market trades
arose because the difficulty in obtain-
ing regulatory authority for trades
and the persistent concerns about
“hot spots”—locally high concentra-
tions of the pollutants. In the end,
the Fox River program, established in
1981, did not give rise to a single
trade during the first 14 years of its
existence.
Challenges to Market Design
As the Fox River example makes
clear, the design of environmental
markets is not without challenges.
Numerous decisions must be made
when such markets are put in place.
The nature of the rights must be
carefully defined so that environmen-
tal goals are met but market flexibil-
ity remains. The initial allocation of
rights must be established, sometimes
being handed out based on historical
precedents and other times being
auctioned by the government. These
decisions, and many others, can be
politically contentious and can affect
the success of the market.
Whether they are used to address
pollution problems or fisheries man-
agement, all transferable rights pro-
grams require that an institution
(typically the government) certify the
validity and transferability of the
property right. In addition to defin-
ing the rights and obligations associ-
ated with the permit, the oversight
agency must monitor compliance.
This is more difficult than in stan-
dard markets. When someone pur-
chases an apple at the supermarket,
they know the purchase is complete
when they walk out of the store; if
the apple is rotten they can usually
return it for a refund. When some-
one purchases a pollution permit,
they know that it is legitimate when
the government informs them that
they are allowed to increase their pol-
lution, but they usually have no way
to know (or reason to care) if the
seller of the permit actually reduced
its pollution to generate the offset-
ting environmental benefit. Compli-
ance must be enforced by the
government. Monitoring and
enforcement is also needed to create
demand for the rights to be trans-
acted. Permits will be valued only if
polluters know that they are required
by the government. As Dennis King
puts it in his paper in this series, “the
‘invisible hand’ will not work with-
out the ‘visible foot’ of a regulator
insuring compliance.”
Further inhibiting the perfor-
mance of environmental markets is
the fact that they usually grow out of
more traditional regulatory pro-
grams and often carry excess baggage
as a result. As Robert Hahn (1990)
noted, “In the real world, regulatory
systems are rarely discarded and
replaced wholesale. Rather, reform of
regulatory systems proceeds in an
incremental fashion.” Hence, the ear-
liest transferable rights programs in
pollution are hardly identifiable as
market-based systems at all. In some
cases flexibility arises over time, but
such evolution is not automatic. As
Leonard Shabman and Paul Scodari
argue in their paper in this series, the
level of flexibility that has been intro-
duced in the management of our
nation’s wetlands is so limited that
the program can not even qualify as
truly market based.
A Brief History of Environmental 
Markets
The development of the institutions
needed to support transferable rights
is more natural in some instances
than in others. The buying and sell-
ing of water rights, which is centuries
old, is a natural improvement over
fights that inevitably arise over this
scarce resource. As governments
became more involved in resource
management, however, they often
created barriers to trades that made
transactions more difficult. Govern-
ment control of water, environmental
regulations, and restrictions on the
rights to use water often made water
trading quite difficult. However, as
Richard Howitt notes in his paper in
this series, in recent years there have
been efforts to encourage markets by
modifying laws to facilitate trading.
Fierce battles are still being fought,
but pressed by rising scarcity, there
has been substantial growth in water
markets.
For pollution and environmental
services, there is no natural tendency
for markets to arise; the initiation
had to come from the regulatory
branch. In the 1970s, the US Envi-
ronmental Protection Agency started
down the path toward market-based
instruments when it began introduc-
ing some flexibility into its air quality
programs. The 1980s saw an expan-
sion in the use of this tool: Trading
was allowed as part of the rules that
removed lead from refined gasoline
and as part of the US approach to
controlling chlorofluorocarbons.
That decade also saw the develop-
ment of a number of small-scale mar-
ket-based programs to address water-
quality: the Fox River program noted
above, programs in Lake Dillon and
Cherry Creek Reservoir in Colo-
rado, and on the Tar Pamlico River
in North Carolina. By the 1990s, the1st Quarter 2005 • 20(1) CHOICES 51
number and scope of market-based
programs was expanding rapidly. The
national SO2 program, started in
1990, has proven that a program can
work in textbook-like fashion. Cali-
fornia introduced an ambitious trad-
ing program in air pollutants, and
water pollution programs have
sprouted up around the nation.
In addition, it appears that inter-
est in market-based mechanisms is as
strong as ever. In fact, it often appears
today that when environmental pol-
icy is discussed in the US, market-
based approaches are assumed desir-
able unless proven otherwise.
Why this Issue?
Today there are many proposed mar-
kets, and we can observe a number of
successful and unsuccessful efforts. It
is a good time to take stock of where
we are. In this collection of articles,
Choices explores the reality of envi-
ronmental markets in the United
States today. In this package of
papers:
• Robert Stavins reviews the mar-
ket for permits to emit sulfur
dioxide, which is widely viewed
as an enormous success;
• Richard Howitt and Kristiana
Hansen look at the emerging
markets for water in the West,
where markets remain quite lim-
ited despite the fact that there
seems to be great potential for
gains from trade;
• Leonard Shabman and Paul Sco-
dari look at wetlands mitigation
banking, which, they argue, is so
restricted that it is like any other
offset program and cannot legiti-
mately be called a market-based
program; and
• Dennis King looks at the prob-
lem of water quality markets and
finds that the potential in this
arena has yet to materialize; and
it may never do so unless govern-
ment plays a stronger role.
What Do the Papers Tell Us?
A constant theme repeated through-
out these papers is that details matter
and the creation of markets for natu-
ral resources and environmental ser-
vices is no small task. As we look to
the future, it may be prudent to
avoid exuberant predictions of huge
economic benefits from trading.
Although it is clear that these instru-
ments will continue to be part of the
policy landscape for years to come,
they will also face challenges and set-
backs, and markets may not be
appropriate in every setting. Over
time, market-based instruments may
take a less prominent place in the
p o l i c y  m i x ,  t o  b e  s e e n  a s  o n e  t o o l
among many that can be used for
improved management of the envi-
ronment and natural resources.
For More Information
Crocker, T.D. (1966). The structur-
ing of atmospheric pollution con-
trol systems. In H. Wolozin 
(Ed.), The Economics of air pollu-
tion (61-68). New York: W.W. 
Norton & Co.
Dales, J.H. (1968). Land, water, and 
ownership. The Canadian Journal 
of Economics, 1(4), 791-804.
Hahn, R.W. (1990). Regulatory con-
straints on environmental mar-
kets. Journal of Public Economics, 
42, 149-75.
Stavins, R.N. (1998). What can we 
learn from the grand policy 
experiment? Lessons from SO2 
allowance trading. Journal of Eco-
nomic Perspectives, 12, 69-88.

Markets for the Environment

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