Environmental Problems For Sale - Who Bids?

Byron, N., Dwyer, G., and Peterson, D.

Productivity Commission, Melbourne

Key Points

• Clarify the environmental problem and policy objectives.

• Markets can be powerful tools to address environmental problems.

• Understand why markets may be absent - there can be solutions.

• Make policy catalytic - harness the private sector.

• Improve public sector efficiency.

• Establish who should pay for environmental problems.

1 Clarify the 'environmental problem' and policy objectives

We often hear there is an environmental problem. But what precisely is it? What exactly are we trying to fix or prevent? What environmental outcomes do we want? What are the benefits and costs of alternative action? These may seem very simple questions but they are very fundamental for governments designing environmental policy.

Environmental pressures associated with natural resource-based production systems in Australia include: salinisation of land and water; acidification of soil; soil erosion and deterioration of soil structure; spread of weeds; eutrophication of streams and lakes; and loss of biodiversity. Taken together, they are usually seen as systemic - as 'Australia's environmental problem'.

In economic terms, the natural environment has three main (inter-related) roles:

• it provides raw materials for production processes: air water, minerals timber;

• it is a receptacle for wastes generated by businesses and households; and

• it provides amenities and aesthetic values - scenery, wildlife, etc.

The environment differs from other parts of the economy, in that:

• biological resources can be renewable, but if over-harvested they can be wiped out;

• if waste assimilation capacity is over-used, it can be permanently damaged (thus there are serious thresh-holds and discontinuities in their supply); and

• some resources (such as forests and lakes) can provide all three functions.

From an economic perspective, systemic environmental problems are broader than simply the direct costs of the degradation of natural resources. They also include reductions in society's net welfare from inefficient use (including non use) of natural resources. Efficient and effective environmental policy should be based on good science and good economics. Unfortunately, because of the complex and often poorly-understood biophysical relationships involved, an accurate assessment of public and private benefits and costs of any actions, or of inaction, is very difficult. Policy design when there are large information gaps or constraints, is a huge challenge for governments.

If we consider any man-made system, such as a factory, mill or power-station, we know exactly where the inputs go in and the outputs (good and bad) come out; we can measure them, we know how much extra pollution there will be if we use an extra tonne of some input, or if we increase output by some percentage. But for natural systems, we have amazing ignorance about where and when the outflows (borne by air or water) will appear, and what nasty surprises they might contain.

Often, our simple models of environmental systems assume that if we change land-use practices in one place, the environmental consequences will show up nearby, almost immediately. In fact, it may take hundreds of years before the effects appear, and they may appear hundreds of miles away. This also means that often apparent 'ecological crises which demand urgent action' are the result of something that happened decades or centuries before, and either cannot be fixed, or don't need to be fixed, now.

Systemic environmental problems are unlikely to be solved by ad hoc and piecemeal policies that do not address their underlying drivers. While individual case by case on ground works may address localised environmental impacts they will not address the root causes of an underlying, more pervasive, malady.

Complex environmental problems are likely to require a mix of policy tools including: carefully designed regulation; voluntary codes of conduct; suasive approaches, such as public awareness and attitudinal change campaigns; taxes; subsidies; and sometimes, markets. The focus of this paper is on markets - just one aspect of an environmental tool box - how the energy and initiative of the private sector can be harnessed and how governments can be catalytic by ensuring appropriate institutional settings are in place for efficient and effective environmental markets to emerge.

How have governments responded?

Historically, governments have directly provided environmental 'goods' (water catchments, parks and outdoor recreation areas) and regulated private sector activities to curtail environmental 'bads'.

Growing recognition of environmental problems has seen Australia committing large, and increasing, amounts of public resources to the objective of improving the environment particularly through natural resource management. For example, the Murray Darling Basin Council has adopted a program of salinity interception schemes worth $60 million over 7 years, complementing the $1.4 billion National Action Plan for Salinity and Water Quality ( Truss, 2001 ).

But high levels of public expenditure are not necessarily a good indicator that systemic environmental problems are being, or will be, adequately addressed. The mere existence of public benefits from a conservation activity is a necessary but not sufficient condition for that activity being undertaken by the public sector. For example, even if most of the benefits of a particular activity go to others, it still pays someone to undertake the activity if their private gains are greater than the private costs. Government involvement may 'crowd out' private sector initiatives. The key criteria for intervention by governments should be whether or not an improvement in social wellbeing results from that intervention. Any assessment should consider the problems that might arise from government actions as well as the potential benefits.

Recently, various proposals have emerged for leveraging more private sector resources to address environmental problems (e.g. Allen Consulting 2001 ). While the desire to engage the private sector is laudable, care is needed to ensure this is not translated into policy-induced market distortions and perverse incentives that lower net welfare. Well designed and functioning markets for environmental goods and services avoid such problems, since they can:

• harness the initiative and innovative capacity of the private sector;

• alleviate some of the burden on the public sector and enable more remediation to occur; and

• address the underlying drivers of environmental problems.

The role of economics

Economics can provide insights into why environmental problems occur, how they might be solved and indeed whether it is worth solving them. At its broadest level, economics is a framework to help in balancing unlimited wants and scarce resources. The 'environment movement' has done economists a service by highlighting that the environment is a scarce and valuable resource and in order to maximise society's welfare, care is required in using it.

Clearly there are benefits and costs associated with the use and non use of the environment. Importantly, scarcity inevitably results in opportunity costs - the value of the net benefit of available alternatives foregone. We need to remember that environmental resources are not 'free' when they could be put to alternative uses. The problem of opportunity costs is complex and widespread in environmental management. According to Bardsley et al. (2001, p.35) . it is a common thread in the major public policy issues associated with the use and degradation of natural resources:

This is not to say that all market based solutions will necessarily achieve policy objectives - markets may 'fail' to function according to economic ideals. Nevertheless, even imperfect markets for environmental services may yield better net outcomes than no action or a fully regulated approach.

Consequently, a forward-looking approach is needed, one where the expected total benefits and total costs of alternative initiatives are assessed and action occurs where economic benefits exceed the economic costs (including hard-to-value effects like cleaner water and conservation of biodiversity). Environmental managers should use a policy approach that is conducive to weighing the merits of an extra dollar for conservation against an extra dollar for competing social demands - such as for health, education, transport and welfare. Of course society must also balance non-economic considerations and monitor the trade-offs between non-economic objectives and economic objectives.

Environmental choices usually have a time dimension and this has important economic implications for governments considering the benefits and costs of alternative policy options. Since a dollar today is worth more than a dollar tomorrow, how do we choose between options with outcomes in different time periods? How do we 'discount' over long time frames? For example, high discount rates will weight policy choice toward reaping benefits today rather than later, and will also 'bias' decision making towards activities with rather modest costs now, compared with activities with huge costs much later.

There is on-going debate on the choice of discount rates (box 1). Nevertheless it is helpful to separate rudimentary cost-benefit analysis for relatively short horizon environmental projects from the intergenerational equity issues associated with extremely long time horizons. How (or whether) to discount the welfare of future generations and how much capital stock should be passed onto future generations are important questions for governments.

Ecologically Sustainable Development principles suggest the total stock of assets (including natural capital) passed on to future generations should be at least as great as that inherited ( PC 1999, p.8 ). Markets and market principles can be used to help determine the values we place on natural capital, but ensuring a sufficient stock of natural capital for future generations is a problem for society to address more broadly through the democratic process. Economists can aid the decision making by providing information on risks and limitations of any government intervention as well as addressing the absence of markets that make valuing natural assets difficult.

Finally, in assessing benefits and costs of environmental action it is important to consider the human dimension of any policy choices. Where reform is likely to improve the net welfare of the community but also result in significant transitional costs, it is appropriate for governments to consider reducing these adjustment costs and how this might be best achieved.

2 Economic insights into environmental problems

An important insight of economics is that markets can be powerful tools that can be harnessed to achieve better environmental outcomes. The information generated by markets can enable society to improve its well being. Why is this so and what are the limitations of markets associated with natural resources? What can be done when markets do not exist?

To understand these questions it is useful to think of the natural ecosystems as potentially providing both goods and services (see Daily et al. 1997 ). Ecosystem goods are goods that can be harvested from natural ecosystems such as food, fibre, timber and biomass. In contrast, ecosystem services are the functions performed by ecosystems that lead to desirable environmental outcomes, e.g. air and water purification, drought and flood mitigation, and stabilisation of climate.

Well functioning markets enable exchange of goods and services and this is no different for natural resources. Markets for ecosystem goods are easily observed in commodity markets that deliver food and many of our clothing and shelter needs. The information exchanges that occur in the marketplace are critical to the success of markets (see box 2).

While there are markets for many ecosystems goods, there are very few effective markets for ecosystems services ( Daily et al. 1997b ). The lack of markets reduces information the available to decision makers to make appropriate resource use decisions and this can reduce the overall wellbeing of society.

The challenge for environmental managers is understanding why markets may not exist for aspects of the environment and what, if anything, might be done to facilitate them. Broad based and well designed economic instruments should be at the fore of an environmental managers' policy toolkit. In particular, they should be directed to getting the price and value of environmental services right - so that they reflect the true marginal social value of the service. Ideally, the policy objective should be to position environment resources including environmental services as an integral part of the mainstream conventional economy.

Identifying the causes of the environmental problem

The solution of environmental problems lies in understanding clearly their underlying causes. Edwards and Byron (2001) identify three economic factors that commonly explain much of the environmental damage to Australia's natural resource-based economy: lack of knowledge; government policies that have affected incentives faced by landholders; and the absence of markets.

Lack of knowledge

Settlers found the Australia landscape very different from Europe. Soils were dry and infertile and the summers long, hot and dry ( Barr and Cary 1992, p.1 ). Australians have not had long to learn the relationships between the activities of man and the condition of the soil, water, vegetation and fauna (especially given the long lead-times that sometimes occur between human action and nature's response).

New information will continue to be important to address knowledge and attitude shortcomings of both landholders and society more broadly. This will aid their understanding of the Australian landscape and its responses to natural and human induced change. In terms of policy design, this suggests important roles for research and development, education and extension.

There are opportunities here for private natural resource managers. For example, some private conservation businesses are already generating a portion of their income from selling the research skills and management expertise they have developed. It is likely there will be increasing demand for private extension services that advise on conservation management issues.

Government policies

Some policies have made it rational to behave in ways that could damage the environment. For example some agricultural policies (such as tax incentives for land clearing; fertiliser subsidies; irrigator subsidies; product price supports; drought assistance; and pastoral leases conditions) have encouraged intensive and at times environmentally damaging forms of primary production. Similarly, trade protection policies, such as tariffs, have sheltered inefficient manufacturing technologies and industries, usually at high environmental cost. Moreover, other policies have also acted to constrain markets from possibly addressing environmental problems

In terms of agricultural protection, it is also arguable that declining levels of protection has lead some managers to consider alternative landuse systems. Declining farm support has probably increased the conservation focus of some landholders in marginal rangelands - with some seeking to supplement farm income with revenues from conservation activities such as ecotourism related farmstays and native flora production.

Examples also continue to emerge of large properties being bought by conservation initiatives with the sole focus of undertaking conservation activities on the holding - Birds Australia have purchased Gluepot Station in South Australia and Newhaven in Northern Territory; the Australian Bush Heritage Trust have purchased Carnarvon Station in Central Queensland.

Haszler and Hone (2001, p.39) note that the retirement of land is one way of promoting biodiversity conservation in agricultural areas. The effects of land retirement for small and isolated rural communities that have previously relied on pastoralism should be considered. Changing landuse systems can have adjustment implications and this issue needs to be understood by landholders and governments. Nevertheless, the opportunity costs of lost rural production for some rural industries should not be overstated. For example, withdrawing some marginal wool country from production could have positive price effects for the remaining Australian wool producers (see Haszler and Hone 2001 ).

Microeconomic reforms of the last two decades have gone a long way toward addressing many of the price distortions in agricultural commodity markets and manufacturing industries. However, there is still room for improvement in other policy areas, for example water markets, pastoral lease conditions and taxation arrangements.

Absent markets

As noted earlier the absence of markets reduces the information available to resource managers and the community more broadly and can lead to undesirable environmental outcomes (box 3). Economics can help us understand why markets might be absent and how this might be overcome.

Even when the knowledge was available, land managers have sometimes had little financial incentive to consider the effects that their decisions have on others. This applies to decisions on water use that affect irrigation salinity, decisions on tree removal that impact on dryland salinity, decisions affecting the addition of nutrients to ground water and surface water, and decisions on control of weeds and animal pests.

Governments have usually taxed or regulated the actions of those responsible for imposing 'bad' environmental spillovers. Where the source and effect of the spillover are clear such as point source polluters of streams, remediating action is most likely to be successful. In some cases, science is only beginning to emerge to help us understand the biophysical relationships and consequently the causes of some spillovers.

In some cases there has been little incentive for a free market to provide some environmental goods and services even if their provision would enhance overall social wellbeing. Historically, this has been common to goods and services associated with the environment. Governments have traditionally tried to address the 'public good' aspect of conservation through the direct provision of environmental goods and services. For example, in the past national and state parks and reserves were seen as the bastion against biodiversity loss. [1]

Nevertheless, the nexus between public goods and government provision is blurring and this is creating opportunities for private sector conservation initiatives. This is because there is a growing recognition that many aspects of the environment traditionally considered to be public goods can be provided privately. Examples continue to emerge of highly organised private groups and individuals (such as Birds Australia and the Bush Heritage Trust) finding ways to provide what were previously considered public goods.

There are also a multitude of examples of local community groups working with councils and government authorities to provide more local environmental amenities. For example, near Maffra in East Gippsland, the local Landcare group has been working with the local council and catchment management authority to restore a section of the Macalister River to wilderness - bellbirds are beginning to return to what was once known locally as 'Bellbird Corner'.

3 Understanding the absence of markets

In many Australian environmental markets the small number of buyers and sellers and uncertainty over the nature of the service being provided are major hurdles to markets addressing environmental problems. While environmental awareness is growing and more people appear to be willing to pay for environmental services, in many markets the scarcity of buyers is constraining the growth of environmental businesses.

For example, Earth Sanctuaries Limited has noted the lower returns from its more isolated operations such as Scotia Sanctuary in Western New South Wales compared to its smaller more profitable Warrawong Sanctuary in the Adelaide hills. One of the challenges for private conservation initiatives seeking to market their services is educating and convincing the public of the mere existence and benefits of their service.

A related major hurdle is the fact that it is very costly bringing buyers and sellers together to establish a market (see box 4) - the high 'transaction costs' of trying to tap into the latent but dispersed demand of Australian consumers and finding buyers for environmental services.

Many small private conservation businesses struggle to establish markets for their services simply because it is so costly to identify their potential clients and inform them of the product. Even where such costs could be low, other hurdles exist. An interesting example is the Calgar Springs Sanctuary located near Gosford on the Sydney-Newcastle freeway. Despite being on a major tourist route, red tape has prevented any sign on the freeway to inform potential visitors of its existence.

One innovative approach to the transaction cost problem has been to link the marketing and pricing of a good with a related environmental service. For example, Wetland Care Australia has developed a funding model for the restoration of wetlands. Producers of a local branded agricultural product are approached to donate a percentage of the sale price to a wetlands restoration project that can be linked to the product. In return, the producer is able to promote this positive environmental dimension of their product.

This model is working successfully for BRL Hardy Pty Ltd with their Banrock Station range of wines. Sales of these wines have risen with consumers demonstrating a willingness to pay for wetland restoration projects at the Banrock Station winery and other Wetland Care Australia sites.

The marketing strategy has proven so successful for BRL Hardy that they have expanded it to include their European and North American sales (personal communication, Professor Jeff Bennett, Australian National University, 22 February 2002).

Another successful approach (also discussed later in this paper) to the transaction cost problem is auction and tendering. This has been useful where information failures and small numbers of buyers and sellers prevent effective markets from forming. 'Prices' emerge through a structured process of bids rather than the 'invisible hand' of conventional markets. A recent example has been the Victorian Government's 'Bushtender Scheme'.

Addressing complex transaction cost problems can be very resource intensive - particularly in terms of information and capital. In some cases, it seems that a 'critical mass' will be needed for some projects to be established and achieve success (e.g. consortiums of private individuals, groups and businesses).

The role of property rights

A recurring theme of recent Productivity Commission research has been the importance of clear and effective property rights to emerging environmental initiatives. Clear and effective property rights are a foundation of any market or regulatory approach to biodiversity conservation (see box 5).

The emergence of markets for environmental services will be hampered where the rights and responsibilities of the private sector are unclear. If markets for conservation do not function well, there can be a role for governments to establish well-defined and enforceable property rights and thereby facilitate the emergence and operation of efficient markets.

While it is desirable for economic efficiency that rights and responsibilities be more clearly defined, this should only occur to the extent that it is feasible or cost effective to do so. Tightly specified rights can increase transactions costs just as surely as vaguely specified property rights can.

The challenge is to design property rights that are sufficiently defined for markets to form and yet sufficiently flexible to evolve over time in response to changing information and community preferences.

The efficiency with which a society meets the aspirations of its citizens will in the long-run depend largely on the adaptations made to property rights in response to technological developments, newly discovered relationships and community values.

Changes to property rights may occur through the common law or government legislation. Redefinition of property rights needs to be undertaken with care - any changes to property rights can give rise to questions of compensation or assistance.

One approach to aid clarification could be through an appropriate 'duty of care' (see PC 2001b ). A legislated duty of care, in conjunction with voluntary codes of practice, can be more flexible and less prescriptive than many alternative approaches. It could complement other initiatives such as voluntary community action, education and, where appropriate, financial incentives and targeted regulation.

A statutory duty of care has already been introduced by some state jurisdictions - for example see the Queensland Land Act 1994, the South Australian Pastoral Land Management and Conservation Act 1989 and the Victorian Catchment and Land Protection Act 1994 . Nevertheless, it is still largely unclear how such provisions will be applied and how landuse might be monitored or enforced. Further research and public discussion on this issue are needed.

4 Make policy catalytic - harness the private sector

Market based policy instruments can harness the private sector and make government policy catalytic, particularly where the absence of markets is the dominant feature which makes the environment a major policy issue.

By taking actions that reduce transaction costs and improve information:

• the innovation and initiative of the private sector may be tapped unleashing new technologies and investment towards the environment; and

• the resulting markets lower the cost of environmental policy making previously unviable action feasible.

In many cases the actual costs of environmental remediation have been much less than previously estimated because of the capacity of markets to deliver innovative and cost effective solutions.

W hen the US EPA wanted to reduce air pollution, (Nitrous oxide and Sulphur dioxide) control costs were estimated by the industry to be $1500 per tonne. The EPA's (optimistic) estimate was $750 per tonne in 1993. Yet in 1997, permits were trading at just $100 per tonne. The tradable credits system had stimulated all sorts of undreamt of innovations and flexibility.

What can be done to unleash the innovative capacity of the private sector to achieve more desirable environmental outcomes? Some fundamental steps include:

• removing unnecessary legislative and regulatory constraints; and

• creating new markets for ecosystem services.

Remove constraints to potential environmental markets

Once the environmental problem, and its underlying economic and scientific causes are well understood, before considering any other actions, environmental managers should assess whether potential markets are being constrained by unnecessary or inappropriate regulatory frameworks.

For example, a number of institutional arrangements associated with biodiversity conservation - particularly aspects of the frameworks for land tenure, competitive neutrality, native wildlife and taxation - are characterised by extensive and often complex legislation and regulation (see below). These factors can increase the relative costs and risks of private conservation activities compared with those of other viable land uses. This influences investment decisions and may lead to less efficient and effective conservation outcomes.

Some specific examples of constraints to managing for biodiversity are listed below (also see PC 2001a ). While the focus here is largely on Commonwealth and State jurisdictions, others (e.g. Binning and Young, 1999 ) have considered the constraints imposed by inappropriate local government regulation:

• Property rights are not always well specified. For example, property rights for native flora and fauna are not always explicitly, consistently or fully defined in native wildlife legislation, and may vary according to the jurisdiction and any conditions of a licence. The ownership of captive native fauna held under licence in some jurisdictions may be uncertain and some rights appear to be untested, which may limit private conservation initiatives.

• Sometimes legislation unnecessarily prohibits potentially desirable private sector initiatives. For example, only public sector agencies and zoos are allowed to undertake international trade in native fauna - commercial conservation firms are excluded from international trade in native species for profit. However, it is unclear whether such general trade restrictions are effective (for example, in terms of protecting native wildlife from illegal activities) or whether other policy options would improve conservation outcomes at a lower cost.

• At times, legislation and regulation also reduce incentives to develop innovative approaches to improve conservation outcomes. For example, most jurisdictions use extensive licensing systems and a broad range of regulatory controls to control specific pre-conceived end-uses (such as keeping or exhibiting native wildlife) or prescribe a particular approach, or even piece of equipment. This can restrict private sector initiatives unless they are in accordance with a licence or the native wildlife has been declared unprotected or exempt from the provisions.

• Uncertainty regarding the approach or application of legislation and regulations also increases transaction costs and may discourage investment. For example, altering prescribed grazing or stocking levels under existing pastoral lease conditions is usually at the discretion of the relevant minister or pastoral board. The lack of explicit administrative processes or decision criteria can create uncertainty for landholders wishing to undertake conservation activities that require reductions in stocking levels.

• Problems can also occur when legislation and regulation is applied inconsistently. For example, different treatments of donations to environment and heritage organisations affect the relative costs (and therefore attractiveness) of alternative types of donations and may consequently influence the type and amount of 'environmental altruism' undertaken. Amendments to existing gifting provisions in income tax law to address these issues have been proposed ( Howard 2001 ).

• Inconsistencies also exist between the approach and application of legislation and regulation across jurisdictions. For example, significant differences exist between the State-based licensing systems and controls on the keeping and trading of native wildlife. South Australia has a flexible and non-restrictive system where applications can be made to keep any native fauna. New South Wales, Queensland and Western Australia, have more restrictions and controls which appear to be more complex than necessary and may unduly constrain private conservation initiatives.

• These problems may be magnified by other government measures (such as agricultural assistance) and/or tax treatments that encourage other land uses that may adversely impact on biodiversity.For example, concessions that lower the relative operating costs of production and land use may make those businesses relatively more attractive, consequently drawing more resources to them and, potentially, away from biodiversity conservation. Subsidies to fertiliser and irrigation water, and artificially high prices for agricultural crops, have distorted land-use, favouring agriculture where it is not really viable, often accelerating clearance of natural vegetation.

Create markets for ecosystem services

In the last few years there have been considerable efforts to design and establish markets for specific environmental services. Some have been more successful than others - what are the lessons for future policy development?

In general, while the use of market based mechanisms and the creation of new markets offers potential solutions to help deliver desirable biodiversity conservation outcomes, it is unlikely to be suitable as a policy option for addressing all conservation issues. Rather, it is likely that a combination of policy instruments will be required .

Many combinations of market based instruments can be applied to different environmental problems. While care is required to design the right set of instruments for a particular problem, environmental management is full of examples, such as air pollutant markets in the United States, where the mix has gradually evolved over time to address unforeseen outcomes (see Tietenberg 1995 ). This is not a sign of policy failure but rather demonstrates the adaptability of market based instruments when knowledge and technology improve.

A distinction can be made between schemes that use conventional prices to reveal consumers' willingness to pay and producers' willingness to supply, compared with schemes that reveal market information indirectly through structured competitive bidding. The conventional price theory approach (such as those used in cap and trade environmental markets) is more suitable where core market conditions exist, such as enough sufficiently well informed buyers and sellers willing to trade a definable, transferable and excludable commodity.

In contrast, Stoneham et al. (2000) highlight the usefulness of 'game theory' approaches of competitive bidding (such as the Victorian Government's tendering and auctions approach of the Bushtender Scheme) where basic market conditions do not exist and information asymmetries are prevalent.

In terms of property rights, creating markets for environmental services may involve creating proxy commodities. The commodity for exchange must have an inherent value to individuals in the community. The scarcity of the property right is critical and must be enforceable if necessary - without scarcity the value will diminish. Regulation may be necessary to ensure scarcity. For example, the value of carbon credits lie in the restrictions on carbon emissions. [2] A realisable commodity is also central to businesses attracting investment capital for the formation of ecosystem service markets.

Transferable property rights can encourage technology progress - more so than 'command and control' systems ( Millman and Prince 1989 ). This means the pursuit of the environmental objective will be less expensive and more timely. In addition, it is usually easier to establish markets where there are clear point source producers of an environmental commodity ('good' or 'bad'). Schemes that allocate a property right to produce an environmental bad should be designed to ensure concentrations of the bad are not localised in space or time.

Linking property rights to a defined production technology tends to constrain innovation and the development of new lower cost processes. Successful emission schemes have broadly defined the environmental constraint and then allowed producers freedom to meet it as best they can (see Tietenberg 1995 ) i.e. they are outcome-based rather than prescriptive.

Not surprisingly information and technology are critical in the design of market instruments. Science is commonly required to define proxy commodities and verify aspects of the exchange in created markets. High levels of scientific information can be central to the success of schemes where the property right is not easily defined, measurable or verifiable. In the case of markets with offsets, the science to measure and monitor the offset is critical.

This information can be costly and add to transaction costs. However, successful schemes have been designed where scientific information is limited or production technologies are still evolving (see Tietenberg 1995, p. 25 ). For example the feasibility of "Wetlands banking" will depend on the science dealing with the substitutability of the offset areas being traded.

Characteristics of the environment, such as the irreversibility, scientific uncertainty, threshold effects and connectivity associated with biodiversity, attach risks to policy design and implementation. When establishing new markets, a prudent approach to balancing these risks is extensive testing and pilot scale trials. For example, the New South Wales Hunter River Salinity Trading Scheme recently enacted into State legislation started as a pilot scheme in 1995.

Finally, supporting market infrastructure is useful in conventional price markets. In particular a centralised clearing house can improve the efficiency of tradeable schemes. For example, on line trading can facilitate trade in spot and futures markets and trade at short notice. It can also reduce the cost of searching for a buyer and the need for an agency to closely administer the exchange.

5 Improve public sector efficiency

In addition to using markets to allow the private sector to efficiently and effectively deliver environmental goods and services, it is important to examine the performance of public sector provision. Opening up the public environmental sector to greater scrutiny is likely to create opportunities for private conservation entrepreneurs to offer their services in competition.

Private and public sector environmental markets are inextricably bound together and we need to make progress on both fronts simultaneously. Unlike other sectors of the economy where public provision has been prominent (such as utilities and health) there appears to have been limited application of basic competition policy principles to environmental activities ( PC 2001b ).

For example, governments have collectively agreed on the principle that any competitive advantages that government businesses may have over their private counterparts simply by virtue of their government ownership should in general be removed (resulting in what is known as 'competitive neutrality') unless the costs can be shown to exceed the benefits. Despite the apparent generality of this principle, in practice it has had limited application to government conservation businesses.

Similarly, although jurisdictions have reviewed environment related legislation for potentially anticompetitive effects, there appears to have been little change in many areas, such as those related to the conservation of biodiversity. Aspects of pastoral lease arrangements and native wildlife regulatory frameworks may be anticompetitive and overly prescriptive. For example, private sanctuaries have to obtain many licences that are not required by competing public providers and face a broad range of regulatory controls on keeping, use, trade and movement of native wildlife.

The application of other aspects of competition policy could also be considered including the pricing of, and access to, natural assets such as national parks, state forests and reserves.

Further discussion and analysis of these issues is needed.

6 Establish who should pay for environmental problems

One advantage of using markets to address environmental problems is that they are a mechanism to gain funds for environmental action from the private sector. Markets are only one policy tool and others may also be necessary. Other mechanisms will be required to address who should bear the costs of environmental actions.

Establishing appropriate cost sharing frameworks can create incentives for individuals to use resources more efficiently - governments can reduce costs of beneficial private conservation activities and increase the costs to private entities which harm the environment.

Clarifying the rights and responsibilities of the private sector is a fundamental step in determining who should bear the cost of additional conservation on private land. How these rights and responsibilities are assigned is a matter for political judgement based on perceptions of equity or fairness rather than efficiency ( Aretino et al. 2001 ). But at present, when it is unclear who is responsible, very little action is taken by either side.

When the effects of actions by a landholder to address, prevent or reduce environmental damage are confined to his/her own property, it is appropriate for the landholder to pay the costs of addressing the problem, as well as the costs of adapting to it. The case for governments to pay in this situation is weak - examples of situations of this type include some dryland salinity ( Pannell, McFarlane and Ferdowsian 2001 ) and soil acidification.

But where there is a public demand for more conservation than would be provided voluntarily by the private sector alone, an important question arises as to how the additional burden should be shared. If property rights effectively require resource users to maintain an environmental standard, those who fail to achieve this standard are imposing costs on the rest of us. In such situations the 'impacter pays' principle should generally be adopted. This effectively amounts to enforcement of an individual's existing legal responsibilities to protect the public "downstream".

In contrast, if the community demands results well beyond the level required by established property rights, those benefiting from the additional conservation activities (neighbouring property owners, the local or regional community or the broader community, for example) should generally be required to contribute to the cost of undertaking them - the ' beneficiary pays' principle.

The final choice of cost sharing principle and how it is implemented would need to take into account the costs of implementation as well as equity considerations ( Aretino et al..2001 ). For example, in adopting the 'impacter pays' principle, some individuals may seek to avoid paying for conservation, so implementation requires effective monitoring and enforcement. If these costs are too high, it may be simpler for the public to just pay up.

Governments may also choose to pick up more of the tab in the short term to help landowners adjust. Issues surrounding the social consequences of cost sharing arrangements, and the possible need for adjustment assistance, are complex and require examination on a case by case basis, but there are some general basic principles.

Markets structures will ultimately determine the distribution of the costs associated with agriculture-related environmental damage. Even when farmers pay for the environmental costs initially, part of the costs will ultimately be passed on to consumers, domestic and foreign, for those commodities facing imperfectly elastic demand and supply curves. However, for major Australian agricultural commodities other than wool, price is determined totally by overseas supply and demand - no part of extra policy induced environmental costs paid by producers are passed on to consumers.

Edwards and Byron (2001) demonstrate that there is also a broader dimension - if farmers around the world are required to incur extra environmental costs, commodity prices will rise as higher production costs shift the global supply curve upward.

Farmers in those countries where environmental costs are relatively low could be net winners when the market response to the multi-country environmental measures is allowed for. Cassells and Meister (2001) found that New Zealand dairy farmers would lose if they alone were made to bear the costs of effluent controls, but that they would gain if they along with farmers in the other three leading dairy export regions (EU, Australia, and US) all had those costs imposed on them.

Conclusions [3]

This paper has focused on the role markets can play in environmental policy. While they are not a panacea for the environment problem, they are nonetheless a helpful tool for environmental managers. Governments may be an important catalyst bringing the potential of markets for environmental goods and services to the fore.

There are many ways in which markets can be established or market based instruments applied. Our design knowledge is still growing - no doubt there will be successes and failures in the future. Basic market design principles continue to emerge as practitioners focus on addressing poor information and high transactions costs. As environmental science and technology and economics improves so too should the flexibility of the markets we create [4] .

References

Allen Consulting 2001, Repairing the Country: Leveraging Private Investment , Report to the Business Leaders Round Table, Canberra.

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[1] Many ecosystems are poorly represented in (or absent from) the public reserve system and many public conservation areas are not large enough on their own to maintain ecological processes and viable populations of flora and fauna in the long term. With more than 60 per cent of Australia's land area under private management, conservation cannot be adequately addressed without private sector participation. (PC 2001)

[2] Although schemes are generally linked to some regulation, Tietenberg (1995) points out schemes that have been designed to replace rather than overlay existing regulation are the most successful in achieving environmental goals.

[3] This paper was presented to the Getting it Right conference, an initiative of The Government of South Australia, Adelaide, 11-12 March 2002, Productivity Commission, Melbourne.

[4] This paper includes some material presented by Geoff Edwards and Neil Byron to the 4 th AARES Annual Symposium, Public Funding of Environmental Issues, 5 October 2001, Le Meridian at Rialto, Melbourne. It also draws on recent Productivity Commission research related to biodiversity conservation including:

· Creating Markets for Biodiversity: A Case Study of Earth Sanctuaries Ltd

· Constraints on Private Conservation of Biodiversity

· Cost Sharing for Biodiversity Conservation: A Conceptual Framework

· A Duty of Care for the Protection of Biodiversity on Land

· Harnessing Private Sector Conservation of Biodiversity

· Productivity Commission Submission to the Queensland Parks and Wildlife Service

· A Full Repairing lease: Inquiry into Ecologically Sustainable Land Management

These publications are available from the Productivity Commission and may also be downloaded at: http://www.pc.gov.au/publications .