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Environmental economics

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Apr 21st 2005 | PANAMA CITY
From The Economist print edition

Environmental entries are starting to appear on the balance sheet. Perhaps soon, the best things in life will not be free

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AT THE Miraflores lock on the Panama Canal it is possible to watch the heartbeat of international trade in action. One by one, giant ships piled high with multi-coloured containers creep through the lock's narrow confines and are disgorged neatly on the other side. If it were not for the canal, these ships would have to make a two-to-three-week detour around South America. That would have a significant effect on the price of goods around much of the world. It is therefore sobering to consider that each ship requires 200m litres of fresh water to operate the locks of the canal and that, over the years, this water has been drying up.

Scientists at the Smithsonian Tropical Research Institute, in Panama, think that reforesting the canal's denuded watershed would help regulate the supply. One of them, Robert Stallard, a hydrologist and biogeochemist who also works for the United States Geological Survey in Boulder, Colorado, has operated in the country for two decades, and knows the terrain well. A deforested, grass-covered watershed would release far more water in total than a forested one, he admits, but that water would arrive in useless surges rather than as a useful steady stream. A forested watershed makes a lot more sense.

Another problem caused by deforestation is that it allows more sediment and nutrients to flow into the canal. Sediment clogs the channel directly. Nutrients do so indirectly, by stimulating the growth of waterweeds. Both phenomena require regular, and expensive, dredging. More trees would ameliorate these difficulties, trapping sediments and nutrients as well as regulating the supply of fresh water. Planting forests around the Panama Canal would thus have the same effect as building vast reservoirs and filtration beds.

Viewed this way, any scheme to reforest the canal's watershed is, in fact, an investment in infrastructure. Normally, this would be provided by the owner. But in this case the owner is the Panamanian government, and Panama is in debt, has a poor credit rating and finds it expensive to borrow money. And yet investing in the canal's watershed clearly makes economic sense. Who will pay?

In the case of the Panama Canal, the answer may turn out to be John Forgach, an entrepreneur, banker and chairman of ForestRe, a forestry insurance company based in London. Mr Forgach's plan is to use the financial markets to arrange for companies dependent on the canal to pay for the reforestation. Working in collaboration with several as-yet-unnamed insurance and reinsurance companies, Mr Forgach is trying to put together a deal in which these companies would underwrite a 25-year bond that would pay for the forest to be replanted. The companies would then ask those of their big clients who use the canal to buy the bond. Firms such as Wal-Mart, and a number of Asian carmakers, which currently insure against the huge losses they would suffer if the canal were closed, would pay a reduced premium if they bought forest bonds.

This is meant to be a good business deal, but it is structured in a way that brings environmental and social benefits, too. The forest will have a diverse mixture of species that the Smithsonian's scientists have demonstrated grow well (thus pleasing environmentalists), are valuable, and which local people have deemed to be useful for food and medicine. It is also a test case for Mr Forgach. If he succeeds, he will try it elsewhere because he thinks there is an opportunity in treating the regulation of water and climate as a utility—in other words, as a service for which people will pay money. This, he says, should be a perfectly viable investment.

In from the cold

In the case of the canal, the financial value of reforestation is clear even if who pays for it is not. But putting a cash value on what are called variously “environmental”, “ecosystem” or “ecological” services has, historically, been a fraught process.

Early attempts at such valuation resulted in impressive but unsound figures that were seized on by environmental advocates and then, when they were discredited, used by opponents to tar the whole idea. Now, though, things have improved.

First of all, science is producing abundant evidence that the natural environment provides a wide range of economic benefits beyond the obvious ones of timber and fish. Ecologists now know a great deal more than they used to about how ecosystems work, which habitats deliver which services, and in what quantity those services are supplied. Last month, for example, saw the publication of the Millennium Ecosystem Assessment, the first global survey of ecological services. Its authors warn that attention will have to be paid to these services if global development goals are to be met.

But the only way this can happen is if ecological services have sound, real (and realistic) values attached to them. As “Valuing Ecosystem Services”, a report written recently for America's National Research Council, points out, the difficult part is providing a precise description of the links between the structures and functions of various bits of the environment, so that proper values can be calculated. What this means is that the more there is known about the ecology of, say, a forest, the better the valuation of the services it provides will be. Fortunately, according to two reports published by the World Bank at the end of 2004, significant progress has been made towards developing techniques for valuing environmental costs and benefits. There is, says one of these reports, no longer any excuse for considering them unquantifiable.

The turning point for this way of looking at things was in 1997. In that year, the city government of New York realised that changing agricultural practices meant it would need to act to preserve the quality of the city's drinking water. One way to have done this would have been to install new water-filtration plants, but that would have cost $4 billion-6 billion up front, together with annual running costs of $250m. Instead, the government is paying to preserve the rural nature of the Catskill Mountains from which New York gets most of its water. It is spending $250m on buying land to prevent development, and paying farmers $100m a year to minimise water pollution.

Many of the valuation studies done since then have involved water, probably because it is so obviously a valuable ecological service. Forests and swamps (or “wetlands”, to give the latter their politically correct modern moniker) filter and purify water, and act as reservoirs to capture rain and melting snow. When such areas become degraded, it may be necessary to make expensive investments in treatment plants, dams and other flood-control measures. Several other American cities, following in New York's footsteps, have calculated that every dollar invested in environmental protection would save anywhere from $7.50 to $200 on the cost of what would otherwise have to be spent on filtration and water-treatment facilities.

Nor it is it only rich countries that benefit. In 2003, Muthurajawela wetland sanctuary, just north of Colombo in Sri Lanka, was calculated by the World Conservation Union to be providing services worth $8m a year—or $260,000 per square kilometre. These services include the cleaning of sewage and waste water from industry, as well as flood attenuation and the support of downstream fisheries. At the same time, the waste-water-processing capacity of a swamp in Uganda was calculated to be even more valuable than this, at least per unit area. Its 5.5 square kilometres provided a service worth $2m.

When valuation has been done, payment can follow. In Cape Town, South Africa, for example, it proved cheaper to restore the town's watershed to its native vegetation than to divert water from elsewhere, or to create reservoirs. And there are a wide range of other cities and towns in the poor world that use ecological payments to protect their water supplies—from Quito in Ecuador with 1.2m people to Yamabal in El Salvador with only 3,800.

More complex benefits can be paid for in more complex ways. A scheme in Costa Rica, which costs $57m a year, is paid for partly by hydroelectric-power producers, who receive services such as stream-flow regulation, sediment retention and erosion control, partly by private consumers of water, who use it for irrigation, and partly by the country's government, in order to supply towns with water and maintain the area's scenic beauty for recreation and ecotourism.

Meanwhile in Colombia and France, there are schemes financed entirely by the private sector. Large agricultural producers in the Cauca Valley pay fees for watershed-management projects, such as erosion control and reforestation. And Perrier-Vittel, a bottler of mineral water, has found it necessary to reforest parts of heavily farmed watersheds and also to pay farmers to switch to modern facilities and organic farming in order to preserve the quality of some of its products.

Valuing ecosystem services can also point to places where inaction is best. After fires in Croatia had damaged many forests, a study was done to see if restoration was worthwhile given their value to the tourist industry. Examination of 11 sites revealed that the net benefits varied significantly (see chart). Some sites were not worthy candidates and were dropped.

As scientific understanding of ecological services improves, new financial opportunities emerge. For example, the importance of insect pollination to the quality and quantity of agricultural crops such as coffee, almonds and apples, has only recently become appreciated. Last year, a study in Costa Rica found that on one farm alone the natural pollination of coffee by insects was worth $60,000. Coffee yields were 20% higher on plots that lay within a kilometre of natural forest.

Simply having this kind of information could change the way that coffee farmers view areas such as forest and wild grasslands on or near their property. Looked at another way, it might encourage owners of forests that help to pollinate a neighbour's crops to demand payment. Indeed, a version of this sort of blackmail already happens on an international scale. Elliot Morley, Britain's minister for the environment, says that developing countries sometimes say to him, “give us the money or the forest gets it”.

The bee's knees

Putting a proper value on ecological services is bound up with another economic anomaly that haunts environmental economics. This is the creation of what economists term externalities—economic impacts made when those taking a decision do not bear all the costs (or reap all the gains) of their actions. When a piece of natural habitat is ploughed, for example, the conversion may make sense to the land owner, but it may also damage fisheries downstream, increase flooding and clog rivers with sediment. This makes those who lose out angry. It can also, in some circumstances, subtract from, rather than add to, a country's total wealth.

The problems discussed above all involve externalities as well as the need to price ecological services correctly. If Catskill farmers had not changed their methods, for example, New York City's government would not have faced the question of how to keep its water potable. But when an externality affects only a relatively small, recognisable group of people, negotiation between the parties can often resolve the matter. If, however, an externality is a public “bad” (ie, the opposite of a public good), such deals are not possible.

Public goods are those which are in everybody's interest to have, but in no one's interest to provide. Clean air, for example, or, more controversially, the preservation of rare species of plant or animal.

In such situations, the first reaction is frequently to legislate to try to ban the externality. But a more efficient solution can often be what is known as a cap and trade scheme, in which legislation creates both an overall limit to the amount of the externality in question, whether it be a polluting chemical or the destruction of a type of habitat, and a market in the right to impose the externality within that limit.

Cap and trade schemes are best known in the context of polluting gases. Sulphur-dioxide-emission rights have been traded in America for years, and in countries that have signed up to the Kyoto protocol on climate change a market is starting to develop in carbon dioxide. But cap and trade can work in other contexts as well. Fisheries are a well-tested example, while in Australia, farmers who use irrigation (which increases soil salinity) can buy “transpiration credits” from forest owners whose trees, by sucking up water in the process known as transpiration, reduce salinity.

In America, similar markets in wetlands and endangered species have arisen. These are run through so-called mitigation banks. Such banks are created by permanently protecting privately owned swamps, or land that is inhabited by endangered species. This creates a supply of environmental “credits”. Those who want to destroy wetlands, or species-rich habitats, for agricultural or development purposes are able to buy credits from a mitigation bank allowing them to do so. New federal guidelines mean that mitigation banking is becoming popular in many American states. Indeed, it is even starting to finance the emergence of companies dedicated to restoring wetlands, or building them from scratch.

Such liquid markets are different from the fee-for-service arrangements that pertain to such things as watershed management. And, as if to underscore the arrival of environmental trading in the marketplace, two recent publications have been launched to track the field. Platts, best known for newsletters that report prices in energy markets, started a newsletter called Emissions Daily in February. This covers the carbon-dioxide market in Europe, and the sulphur-dioxide and nitrogen-oxide markets in America, publishing daily price assessments for the leading contracts. The second publication is a website called the Ecosystem Marketplace, which tracks markets and payment schemes for ecological services such as water quality, carbon sequestration (planting trees as a way of absorbing carbon dioxide from the atmosphere) and habitat preservation.

The principle having been established, traders are now looking for other opportunities to arbitrage pollution. One promising area is the trading of nitrate emissions between factories and farmers. Farmers' emissions are generally less regulated than those of factories but—probably because of that—farmers can often reduce their nitrate output at a fraction of the cost that a factory would have to incur. Trading between the two means that pollution standards can be met more cheaply.

The greening of the City

All these payments and new markets have not gone unnoticed in the City of London, and other financial centres. People there are watching closely for new financial opportunities, particularly within carbon-dioxide markets—and banks such as ABN AMRO plan to start selling “new environmental financial products”. While the City has little interest these days in specifically “green” investments, there is something of a greenward shift in the way its firms handle large-scale project finance. Almost two years ago, ten of the world's largest banks signed an agreement to address the social and environmental impacts of the projects they financed (at least, those worth more than $50m). The rules were dubbed “The Equator Principles”, and 29 financial institutions have now adopted them. An article published this year in a Euromoney handbook estimated that such “Equator” banks represented about 75% of the project-finance market in 2003. In its sustainability report for 2004, ABN AMRO reviewed 16 deals that had been subjected to the Equator principles. One had been rejected. Four were approved. The rest were modified to fit in with the principles.

Is it working? Of course, banks are not keen to discuss their businesses in any detail, so there is no real way of knowing. It is easy to be cynical about the principles as little more than “greenwash”. Nevertheless, Mr Forgach explains that when projects are under consideration they have to be screened with a “green check”. He describes this as a series of questions, analyses and consultations on the impact a project will have on biodiversity, the climate and “footprint stuff” (a measure of the consumption of ecological resources).

From the perspective of someone wanting to borrow money, this means that green issues have to be considered from the beginning, and possibly even acted on. So, the proposers of a mining project might have to consider damage to the river and to downstream fisheries of any additional sediment the mine would produce. Borrowers may have to change their plans (as they did in 11 of ABN AMRO's deals last year) so that they are more environmentally friendly, or offset damage by protecting land elsewhere.

In effect, this means that the environment has been brought on to the balance sheet. Furthermore, because insurance companies recognise that the environment can be a huge portion of the risk in a project, there may be a financial incentive for paying to protect it.

Valuation is only ever part of the answer, because not everything is for sale. Mr Forgach says he has calculated that the Panamanians could get far more for their lovely fresh water by shutting down the canal, bottling the water and selling it. Running a canal is a crazy waste of water, he says, but America would not let Panama shut the canal.

Still, many conservationists dislike valuation. Some misunderstand it as an approach that ignores cultural and spiritual values. It does not. It simply converts these values into monetary units that can highlight the cost of a course of action. Of course, it might not be appropriate in some cases for this value to be a factor in making a conservation decision. For example, closing the canal and selling water, or building tower blocks on the site of St Paul's cathedral in London, might be perfectly rational from an economic perspective, but also very unlikely to happen.

The valuation of ecosystem services is not without its difficulties. Nevertheless, the fact that there is a growing consensus about how and where it is appropriate is an important step forward for economists and environmentalists. In 1817, David Ricardo, a pioneering economist, noted that abundance in nature was rarely rewarded: “where she is munificently beneficent she always works gratis.” But if nature pays, who then will pay for nature?

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.


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