Economics, Environment, Latest

384. Biodiversity offset prices and biodiversity values

Increasingly, governments require developers to buy credits to offset any losses of biodiversity caused by their developments. In some cases, biodiversity offset credits  can be traded in specially created markets. As a result of trade in these credits, we end up with a price being attached to biodiversity. Does that mean that, in some sense, the price of a credit represents the value of biodiversity?

I was asked this question recently by a colleague who was interested in whether credit prices could be used this way in an analysis he was doing. It would be convenient if they could, because information about offset prices is readily available. In short, the answer is no. Here is why. I’m going to set aside the various challenges in making an offset market work and just assume that it does work well.

Biodiversity offset credits are generated by landholders who do some actions on their land that protect or enhance biodiversity. The actions have to be things that they would not do in a business-as-usual situation – they are doing them in response to the opportunity to earn extra income from selling the credits. The government evaluates the actions and issues an appropriate number of credits. Doing the actions means that the landholders bear additional costs relative to business as usual, so they need to be compensated (paid) to be willing to undertake the actions.

Biodiversity offset credits are bought by developers because it is beneficial for them to do so. They can get a financial benefit because buying the required number of credits allows them to proceed with their economic developments, which make them money.

The price of credits in the market is then determined by two factors: the cost of generating credits (the supply side of the credit market) and the benefits of using credits (the demand side of the market). Assuming that the market is operating reasonably well (there are plenty of buyers and sellers, and there is a good system for connecting buyers and sellers and completing trades), then the price will be approximately where marginal cost equals marginal benefit or, in other words, where supply equals demand.

The marginal cost of generating a credit is the cost, at the margin, of generating an extra credit. Conceptually, imagine estimating the cost of providing every possible credit, ranking them from cheapest to most expensive, and then finding the cost that corresponds a particular quantity of credits. That is the marginal cost for that quantity. The higher the quantity, the higher the marginal cost.

For the marginal benefit, start by imagining there was only one credit available. It would get snapped up and used for the most profitable development, and that high profitability would represent the marginal benefit of that credit. As the availability of credits increased, they would get used for steadily less profitable developments, so the marginal benefit would fall.

At some quantity of credits, the marginal cost would equal the marginal benefit, and that would be the quantity of credits in the market (see the figure above). The price of those credits would equal the marginal cost and the marginal benefit at that quantity. Landholders won’t provide more credits than that because they cannot sell the extra credits at a price that would cover their costs.

Note that the price is not determined by the value of biodiversity to the community (which I’ll take to be the community’s willingness to pay to protect or enhance biodiversity). The value to the community depends on how much people care about protecting or enhancing biodiversity. In a normal market, how much they care is reflected in their willingness to pay for the good in the market, and so the market price gives us some information about value. (Market price is not the full story, even in this case. I’ll come back to that.)

In the market for biodiversity offset credits, the prices that buyers are willing to pay are not determined by how much the community cares about protecting or enhancing biodiversity. Instead, they are determined by how much money developers can make from their developments. There could be a big gap between the two.

Even for a normal market good, the market price alone doesn’t tell us the value of the good, except for the marginal unit of the good – the last unit consumed. For all the other units consumed, the marginal value is higher than the market price. To get the value of all the consumed units of a good, we need to know the shape of the marginal benefits curve, which we can use to estimate the “consumer surplus”, which is the overall benefit of consuming that good.

So clearly, the price of biodiversity credits doesn’t tell us this. It doesn’t even tell us the value of the marginal unit of biodiversity except in the extremely unlikely case where the current trajectory for biodiversity is the optimal trajectory. That’s because the explicit goal of an offset scheme is to maintain biodiversity on its existing trajectory. Even if the trajectory is declining, an offset scheme doesn’t fix that, it just stops it from getting any worse than it already would have done.

From that perspective, an offset scheme is not intended to help biodiversity at all. It’s intended to help development. The only exception to that would be if you think that in the absence of an offset scheme, the development would have been allowed to proceed anyway and the biodiversity would be lost. Compared to that scenario, having an offset scheme is better, but it’s clearly not a solution to our biodiversity-decline problems.