Greens take a cue from financiers

Environmental ‘derivatives’ encourage creative, proactive conservation.

David McLain/Getty image/FILE
Giving individual commercial fishermen in the Gulf of Mexico a share of the overall yearly catch of this fish cut the bycatch (fish caught but discarded) dramatically, while making the fishery more profitable.

In 1990, Congress amended the Clean Air Act to address the problem of acid rain. Allowable emissions for sulfur dioxide (SO2) and nitrogen oxides (NOx), two major components of acid rain, were capped. Emitters then traded a shrinking number of permits – the right to emit these pollutants – on a market. Supply and demand dictated the price.

By 2002, SO2 emissions from power plants had dropped by 41 percent compared with 1980. NOx emissions fell by one-third com­pared with 1990. Overall, emissions were reduced much more quickly and cheaply than doomsayers had forecast. A 2003 study by the Office of Management and Budget found that the program had produced more measurable benefits to human health than any other major federal regulatory program of the previous decade. Benefits surpassed costs by more than 40 to 1.

Today, the cap-and-trade program is widely cited as proof that the efficiency and creativity of a free market can be harnessed to protect the environment. Its success seems to indicate that environmental regulation need not squelch economic growth. Many now anticipate a similar approach to – and success with – the much larger-scale problem of carbon emissions.

Some also urge that more market tools be applied to conservation. The environmental problems facing humanity are so large that traditional approaches no longer suffice, they say. Market-based tools that incentivize conservation before situations become dire must be developed and applied.

One such tool from the financial world: derivatives. Derivative-like products could help manage the risks and costs of habitat degradation and species extinction, for example, by providing insurance of sorts should an at-risk critter experience further decline. An approach like the cap-and-trade program that curbed acid rain might also lessen bycatch in fisheries. But most important, say proponents, putting a price on “green infrastructure” – the natural world – makes businesses include clean air, clean water, carbon sequestration, and biodiversity in their operating costs.

Driving this trend, say experts, is a growing awareness that natural resources are not infinite. The significance of the now-ubiquitous images of melting ice caps has sunk in, they say. Adam Davis, president of Solano Partners Inc., an environmental investment consulting firm in San Rafael, Calif., says businesses are realizing that scientists’ warnings were correct: Human well-being depends on healthy, functioning natural systems.

Among those who view stewardship of nature as a moral obligation, there’s some skepticism about market-based approaches. Why should anyone profit from doing the right thing? Proponents counter that these approaches aren’t meant to supplant those obligations, but to provide an additional avenue for action.

“I wouldn’t want to get rid of the ethic to conserve,” says James Mandel, lead author of a recent paper on biodiversity derivatives in the journal Frontiers in Ecology and the Environment. “We just want to make the process more efficient.”

The traditional approaches to conservation – philanthropy and government intervention – no longer suffice.

“The scale of the problem is so enormous that our traditional philanthropic approach is not even going to make a dent,” says Nathaniel Carrol, project director at Ecosystem Marketplace, an information aggregator. Where to get the extra funding? Investors. And, says Mr. Davis: “if private capital is going to come in, you’ve got to have a fair return on the investment.”

Saving land and being paid for it
Conservation banking – where a third party restores or preserves endangered habitats, like wetlands, and then sells credits to developers to offset their destruction of similar habitat – is established and growing. Businesses spend some $3.5 billion yearly to comply with the Endangered Species Act and Clean Water Act. Before new regulations, 15 percent of the money spent to comply with the Clean Water Act went to mitigation bankers, says Davis. With new regulations, that figure will probably increase, he says.

And there’s evidence of movement toward standardizing this market. Last December, the US Department of Agriculture opened an office of Ecosystem Services and Markets. Its mission: to develop tools by which to measure and price biodiversity.

Other examples come from fisheries management, where the “tragedy of the commons” has too often prevailed historically.

For decades, economists have noted that the best-managed fisheries – off Iceland, New Zealand, and Alaska, among others – use catch-share systems: Fishers get a percentage of the year’s total allowable catch. Economists theorize that, like employees who own shares in their company, owning a percentage of the stock incentivizes efficiency – good fishing practices. If the company (fish stock) does well, then the share value (what a fisher can catch) goes up.

A paper in the journal Science last September – one of the first systematic reviews of global catch-share programs – found that they could halt, even reverse, a fishery’s collapse. A World Bank study titled “The Sunken Billions” highlights what’s at stake: It puts the amount lost to poor fishery management at $50 billion yearly. That’s $2 trillion over the past three decades or so.

In 2007, the Gulf of Mexico’s commercial red snapper fishery began operating under an Individual Fishing Quota (IFQ) program, a kind of catch share. Several things happened quickly after that, says Pam Baker, the Environmental Defense Fund’s ocean policy director for the Gulf Region. Fishers could take their time and keep what they caught, which dramatically decreased bycatch. A government review of the IFQ program after its first year estimated a 70 percent reduction in the ratio of discards to landings. Previously, discards were estimated at 2 million pounds in a fishery with a 4.5 million-pound limit on red snapper overall. And because they could fish when market conditions were favorable – when snapper prices were high – fishers began getting more for their catches.

“By all measures, it’s an overwhelming success,” says Ms. Baker. “All the things that people anticipated, both in terms of conservation benefits and that fishermen would stay within their catch limits … happened immediately and continue” to happen.

Pollock vs. salmon in Alaska
George Sugihara, a professor of natural science at Scripps Institution of Oceanography, University of California at San Diego, proposes adding another level of sophistication to fisheries management: an arrangement akin to a cap-and-trade system. Alaska’s pollock fishery is generally considered well managed. But occasionally pollock fishers accidentally catch chinook salmon.

Chinook fishers have called for a hard cap on allowable bycatch of salmon in the pollock fishery. If chinook bycatch rises beyond a certain limit, then shut down the pollock fishery, they say.

That’s a bad idea for several reasons, says Professor Sugihara. Shutting down the pollock fishery – America’s largest by volume – would hurt the state’s entire economy. Hard caps might also provide a “perverse incentive,” he says: Fishers will hit the cap only during years of abundant chinook, when the fish don’t need protection. But when the salmon are having a bad year and need protection, pollock fishers will never reach the cap. A hard cap might further degrade an already weakened stock.

A better idea, he says: Issue bycatch credits that fishers can trade among themselves. Fishers who can easily lessen bycatch will earn more by selling credits. Those who can’t will fish, but at a price set by the market.

“What you want is a price signal of what is the real cost of bycatch,” he says. “Ultimately, the cost of bycatch is not being able to harvest the pollock you’re allowed.”

In a recent paper in the journal Frontiers in Ecology and the Environment, other scientists propose using a derivative for conserving threatened species. Josh Donlan, coauthor on the paper and director of Advanced Conservation Strategies in Midway, Utah, gives the example of a hypothetical solar company. The company wants to install panels on a swath of Nevada desert. But that land is home to a rare tortoise. How do you encourage the company to conserve the tortoise?

Either the government or a nongovernmental organization issues an “extinction derivative.” The solar company pays $100, say, with the agreement that, after a certain interval, if tortoises remain on the land, the company gets that $100 back, plus interest. The company can positively affect the outcome of its investment, and ultimately profit from more tortoises.

Either way, the hypothetical tortoise wins
If the tortoises vanish, on the other hand, the company loses its money. In that case, the issuer applies the funds to conservation – before the species is on the brink of disappearing. In either case, the tortoise benefits.

“You want to compensate people for preemptive conservation and penalize them when the government has to assume the cost of conservation,” says Mr. Mandel. “You figure the government is on the hook for conservation either way.”

Several analogs to this approach exist. Weather derivatives – companies insuring themselves against lower profits brought on by weather events – have grown into a multibillion-dollar industry in the past decade. (After reaching $45.2 billion in 2006, the value of weather derivatives traded was $19.2 billion in 2007.)

Perhaps more relevant, derivative-like tools are being used in humanitarian efforts.

In 2006, the World Food Program (WFP) issued “drought derivatives” to Ethiopia, a pilot project. If rainfall remained below a certain threshold by a given time in the growing season – meaning crop failure was imminent – insurance would kick in. The scheme would make money available for aid before drought led to humanitarian disaster.

“In the traditional approach, you wait for drought to occur, see what losses have occurred in the country, and apply aid,” says Richard Wilcox, WFP’s director of Business Planning in Rome, who dreamed up the idea. But “by the time those funds have been mobilized, we’re four or five months into” the crisis, he says.

The World Bank has adopted the idea. Last year, for the first time, it offered drought derivatives to Malawi.

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