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Using financial incentives and market-based schemes to promote global environmental objectives: some cautionary considerations

By David Friedman - posted Saturday, 15 July 2000

A surprising consensus has emerged among financial theorists, investors, trade economists, regulators and environmental advocates that international financial and market mechanisms should be utilized to promote global environmental objectives. Emissions trading, green funds, investment credits and similar approaches are now seen as essential for protecting human health and critical habitats endangered by world investment.

Such enthusiasm contrasts sharply with the skeptical reaction normally afforded market-based pollution control schemes in domestic contexts. Emissions trading, offsets, conservation banks and the like, it is often asserted, result in "phantom" pollution reductions with little real benefit.

This paper urges that market-based solutions to global environmental concerns be approached with caution. Most significantly, it assumes that markets efficiently and aggressively reallocate whatever chemical constituents, pollution rights or other assets they are designed to exchange. Any health or ecological benefits markets might realize, however, are profoundly dependent on the precision with which their ultimate objectives are defined.


There are good reasons for thinking that these risks are of particular concern as environmental objectives are married with international financial and market regimes. In the international arena, these policy characteristics can generate four potentially adverse consequences:

  1. Imprecise or inaccurate definition of the specific constituents, rights or other "goods" to be traded in markets or fostered though incentives can result in net ecological harm and resource misallocation.
  2. Market-based and fiscal incentive regimes create increasingly vested interests over time that impede future adaptation and flexibility.
  3. Market-based proposals often generate pre-market information that reveals mitigation option marginal costs, a result that makes actual market implementation less desirable.
  4. Structuring international institutions in pursuit of imprecise, contentious objectives can stimulate social conflict and undermine the global financial regime’s legitimacy.

I. Environmental goal definition and interest-group advocacy

The process by which proposed international emissions trading or conservation goals are defined is rarely examined. The most recent analyses suggest that environmental advocates, to an extent generally unmatched by most other interest groups, are sustained by an affluent political base and able to advance objectives subject to fewer serious substantive challenges over time. As their potential opponents’ confidence and effectiveness declines, the risk that imprecisely defined goals will be articulated and pursued correspondingly rises.

There is striking evidence, for instance, that American environmental and related advocacy organizations have adeptly out-maneuvered competing groups and dramatically transformed the tenor and focus of the nation’s politics. From 1963 to 1991 American congressional policy debates, including hearings and legislative committee agendas have shifted focus from matters of economic and material enhancement such as trade, agricultural subsidies, labor policy, and technology development to a "postmaterial" agenda advanced largely by environmental organizations. Rather than consider measures to increase economic opportunities or wealth, Congressional legislative debate profoundly shifted to address the "quality of life" and "postmaterial" issues of concern to the country’s more affluent social classes

Several factors explain these trends. Environmental groups in particular are comprised of, and supported by richer, white, suburban donors who provide them with a stable and generous supply of funds. They are staffed by highly-educated personnel drawn from the same social classes who can afford to make long-term commitments to lobby and curry media support. Most other interest groups seeking space on the national agenda cannot compete with these advantages.


Modern interest groups also increasingly tend to polarize opinion. People with moderate perspectives or who dissent from views advanced by more vocal advocates find that the personal costs of expressing their beliefs are too high. Today, even those oversight entities like the federal Environmental Protection Agency that are charged with rational policy development concede their priorities are determined much more by what the most aggressive activists demand than the risk-based, scientific assessments performed by their own technical experts.

None of this means that environmental concerns are unimportant or inherently illegitimate. An appreciation of how interest group advocacy can generate suboptimal policy goals, however, is critical to the effective design of market-based systems. If program objectives are inaccurately specified, international financial and market mechanisms will almost certainly generate unintended, adverse consequences.

II. Problems with pursuing environmental goals through international market mechanisms

A. Market-based regimes can be more costly and result in greater environmental damage when control objectives are poorly defined

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This is an edited extract of a paper commissioned for the New America Foundation Workshop on the Environmental Dimensions of Global Financial Architecture and presented on July 14, 2000.

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About the Author

David Friedman is Markle Senior Fellow in the New America Foundation.

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