Economics, Environment, Latest, Natural resource management, Water

394. Creating an environmental market

There are many different bits and pieces that need to be sorted out when creating a new environmental market. What are the key things that need to be done?

In PD392 I outlined some reasons why environmental markets have not emerged spontaneously but markets for some other things have: lack of property rights and high transaction costs of various types. Obviously, these issues have to be addressed when creating a market, but there are some other requirements as well.

The creation of the market for irrigation water in the Murray-Darlin Basin is a good example because it has been so well documented and studied (e.g., National Water Commission, 2011; Rolfe 2008). Here are some of the key things they had to do to get the new market working well.

  • Establish a cap on extractions. This was a step in the creation of tradeable property rights. Previously, farmers in aggregate had the right to extract more water than existed in the rivers.
  • Separate water rights from land rights. Previously the only way to buy water was to buy the land it was assigned to. As a result, the value of irrigation water was built into the price of land and the ability to trade water was severely inhibited.
  • Define specific property rights (ownership, volume, reliability, transferability) and establish those rights in law. In the case of water, the way that property rights are defined needs to allow for the fact that there is a different amount of water available each year.
  • Create water registers and accounts. For a product like, say, wheat grain, there is no need to keep track of who in the world owns all the existing wheat. It is really obvious who owns it, as it is sitting in their silos. For goods that would otherwise be public goods, like water, converting them into private goods so that they can be traded requires a system to keep track of who owns which water rights at any point in time.
  • Install meters. This is another requirement to convert water from a public good to a private good: be clear about how much water is being provided and consumed.
  • Ensure compliance and enforcement. People who cheat the system need to be identified and punished so that people have an incentive to buy the product rather than steal it.
  • Create trading platforms. There needs to be an efficient, inexpensive way for buyers and sellers to find each other, to find out the prices of other trades, and to reach agreement on the price for a new trade. For water, this all happens online.
Irrigating cotton in New South Wales.

Some environmental markets have even more requirements than that because what is being traded is not a physical product like water. For example, markets that are intended to encourage biodiversity conservation don’t involve people buying and selling animals and plants in a physical sense, and carbon markets don’t involve people buying and selling CO2.

Instead, these participants in these markets buy and sell promises. I promise that I have taken certain actions to conserve biodiversity, or I promise that I have reduced my emissions by a certain amount. For anyone to be willing to buy such a promise, they need to have confidence that they can believe it and that the promise will deliver the outcomes they are interested in. So to provide that confidence, this type of market has some extra requirements.

  • Define actions that qualify. What can the landholder do that will qualify as generating a credit that can be sold in the market? In the Emissions Reduction Fund in Australia, “Methods” are published that describe the answers to these questions in great detail. The Reef Credits scheme in Queensland also uses Methods, and I presume that the forthcoming Nature Repair Market will do so as well.
  • Ensure scheme integrity. What does the landholder have to do before her promises will be believed? This relates to issues such as additionality, permanence, and leakage (Thamo and Pannell 2016). These details are also provided in the Methods.

Creating a successful market with high integrity is all about getting the rules right and implementing them extremely well. In other words, it’s all about the governance of the market scheme (Zadek and Herr 2023).

History says that when you create a new market, you need to expect that you won’t get all the details right the first time. There will be glitches you didn’t foresee that will need to be fixed.

For example, the European Union Emissions Trading Scheme was the first major scheme of its type, so it required a lot of learning by doing. There were significant problems in its early phases, resulting in low prices and hence little incentive to cut emissions. But to give the scheme managers credit, they’ve made a series of important reforms to the market over about 15 years, and it now seems to work quite well.

The water market in the Murray Darling had a broadly similar history. When first introduced, there were some serious glitches, notably the problem of “sleeper and dozer licenses”. There were landholders who had the right to use water but chose not to do so. The market gave them the opportunity to sell those rights, and the people who bought them did use the water, so pressure on the rivers actually increased. It took a couple of rounds of major reform over the course of decades to iron out all the kinks.

Some of the current enthusiasm for environmental markets seems rather naive. Creating a market from scratch is a difficult thing to pull off, requiring persistence, learning and flexibility. It’s also the case that markets are not the best solution to every problem. The challenges and costs of creating and running a market need to be weighed up against the benefits and compared with other policy approaches.

Further reading

National Water Commission (2011). Water Markets in Australia: A Short History Here

Rolfe, J. 2008. Water Trading and Market Design. In: Water Policy in Australia: The Impact of Change and Uncertainty, ed. Lin Crase, 202-215. Washington: Resources for the Future.

Thamo, T. and Pannell, D.J. (2016). Challenges in developing effective policy for soil carbon sequestration: perspectives on additionality, leakage, and permanence, Climate Policy 16, 973–992. Journal web page * Accepted version of the paper

Zadek, S. and Herr, D. (2023). The Future of Biodiversity Credit Markets: Governing High-Performance Biodiversity Credit Markets, Consultation Paper, Nature Finance and Taskforce on Nature Markets. Here