Nascent environmental markets in a time of transition

Environmental markets are an important mechanism to drive investment towards solving some of our most complex environmental challenges. Carbon sequestration and abatement, the allocation of water, and the protection and restoration of biodiversity are all examples of where environmental markets play an important role.

Widescale use of environmental markets is still relatively nascent, despite many having existed for some time (e.g. payment-for-ecosystem services schemes become prevalent in the 1990s). However, this is changing rapidly with increasing levels of interest in environmental markets, particularly voluntary carbon markets, in the last 18 months.

Increasing interest has also led to increased scrutiny, with various market participants and commentators asking whether environmental markets can truly be a mechanism for achieving environmental objectives.

Carbon markets – an example of an environmental market in transition

In Australia, evidence for this can be seen in the dynamic nature of Australia’s voluntary carbon market. In March this year, the Australian Government made several policy announcements on the design and use of the voluntary carbon market. At the same time, market commentators raised questions about the integrity of the market. Looking forward, the recently elected Australian Government has also alluded to a review and potential changes. These types of questions and emerging changes are reflected in other voluntary carbon markets globally.

Increased uncertainty on the future of these markets has been reflected in increased volatility in market prices, further driving uncertainty.

However only six months ago it seemed that supply would never keep up with demand and carbon markets had shown the way for the development of other environmental markets targeting biodiversity, plastic and other important environmental objectives. Now, however, questions are being asked about the design of these markets and whether they can deliver on their promise.

Supporting nascent markets to evolve

It is not unusual for nascent markets and particularly those as complex as environmental markets to undergo growing pains. Markets will invariably evolve over time.

Success now, when the market is new, may look different to success in the future, when the market is more established and mature. In the nascent stages of a market there is a greater risk of losing trust and building and maintaining participation is often a focus. Over time, it is more likely that the focus will be on market efficiency. In recognition of this, the design and use of the market, including targeted intervention, may also evolve over time. For example, temporary policy incentives or complementary investments might be used to support the market as it matures, which may be subsequently removed when the market reaches a certain level of maturity.

For many who have had prior exposure to other the creation of other markets, this form of market evolution is nothing new. For example, the water market in the Southern Murray-Darling Basin has continued to evolve. This experience means there is a significant body of knowledge to draw on to help identify and assess options to continue to evolve the development of environmental markets. The key areas of focus going forward will inevitably continue to include:

• Being clear on the outcomes sought – good environmental market design requires a clear understanding of the motivations and barriers faced by market participants and adequate consideration of risks and perverse outcomes that a market may create. Being clear and targeting specific outcomes is more likely to enable an effective market.
• Good governance underpins market performance – good governance is critical in any market, but particularly in relatively new markets. Good governance includes accountable and transparent decision-making and underpins market integrity and trust. Without these key factors, a market cannot function or grow.
• Recognising opportunities for enhancing return on investment – investments in environmental goods and services, the focus of any environmental market, often provide other important social and economic benefits. For example, carbon farming projects may provide valuable biodiversity or social benefits (or ‘co-benefits’). Recognition of these benefits – whether by the supplier, buyer or both – will enhance the recognised return on investment for any project and encourage market participation.
• Creating an enabling environment – environmental markets do not operate in isolation and their success can be influenced by a range of factors. An important area of focus for environmental markets is a suitable enabling environment for the market, often including the harmonisation of other policy and regulation.
• Accepting a degree of uncertainty – nearly all environmental markets involve a level of estimation established through good science to attribute an action (e.g. revegetation) with its outcome (e.g. a specified level of carbon sequestration). Accepting a degree of uncertainty about this relationship is likely to be necessary. The level of uncertainty that is acceptable may be determined by the minimum viable investment risk that market participants can bear to enable a market to function.

A time of transition – seeing the forest from the trees

Environmental markets will continue to play a role to help deliver environmental objectives. They will continue to drive investment and support the transformation of landscapes, waterways, coasts and oceans. The urgency to ensure they function effectively and achieve their purpose has never been more pressing.

However, designing an environmental market and adapting it in response to changing market conditions is a challenge. As Australia’s voluntary carbon market demonstrates, keeping up with the speed of change can be as daunting a challenge as any other. However, these challenges can be overcome through considered design and review focussed on best enabling the delivery of the benefits that well-functioning environmental markets can offer.