Currencies and the commodification of environmental law.

• Author: Salzman, James

INTRODUCTION

Two major, integrally related trends define U.S. environmental law at the millennium. The first trend is to bring presently unregulated risks under the control of the regulatory system. The second trend ... is toward bigger bubbles--toward broader and broader trading among pollutants and even among various types of risk reduction....(1) Picture a playground where children in business suits trade environmental protection like baseball cards. The front sides bear slick images of endangered species, drops of acid rain, and vanishing habitats. The flip-sides show all the statistics--population remaining, acreage consumed, who benefits from the wetlands, who is harmed by the pollution. And the kids sit huddled round in an excited circle, busily swapping cards. To snag Jamie's prized cattail wetlands, Ben must part with his cherished saltwater marsh.

There are differences, of course, between this imaginary playground and a market in real environmental commodities. A "bad trade" in baseball cards is in the eyes of the beholder and, at worst, damages only a child's ego. When parties trade environmental protection, though, what seems a good trade looking at the pictures may lose its appeal once we take a closer look at the statistics and the effects of the trade on the environment itself.

Over the last decade there has been a sea change in environmental law and policy, marked by growing interest in market-based instruments of environmental protection. In particular, approaches that explicitly commodify environmental impacts by creating markets for their sale are on the rise. These environmental trading markets (ETMs) now operate in a range of regulatory settings where parties exchange credits to emit air pollutants, extract natural resources, and develop habitat.(2) In fact, every major environmental policy review in the last five years has called for even greater use of ETMs.(3) Markets for environmental commodities represent the new wave of environmental protection and, despite critiques both subtle and shrill, they are still building.

ETMs have provided an enormously fertile area for scholarship. Articles have explored the mechanics of trading programs,(4) debated the advantages of trading over command-and-control regulation,(5) and, most recently, assessed the application of ETMs in the international sphere.(6) Within this wealth of literature, however, a basic aspect of trading has largely escaped attention. Perhaps because it is so obvious, there has been scant consideration of the simple question--what is actually being traded?

If one compares trading programs, they all seem to share a basic feature. The CFC, fisheries, and proposed greenhouse gas ETMs, for example, all exchange commodities that appear to be fungible. One molecule of CFC, kilo of halibut, or ton of carbon dioxide seems much the same as another, both in terms of identity and impact. It is trading apples for apples (or pork bellies for pork bellies). Thus ETMs are considered a type of commodity market, where environmental credits go to the highest bidder. And for good reason, since the Chicago Board of Trade now sells rights to emit sulfur dioxide alongside pork bellies, orange juice, and grain futures.(7)

Indeed ETMs must assume fungibility--that the things exchanged are sufficiently similar in ways important to the goals of environmental protection--otherwise there would be no assurance that trading ensured environmental protection. While the precondition of fungibility may seem self-evident, this core assumption turns out to be more problematic than it first appears.

As an example of why fungibility matters, consider wetlands mitigation banking. This policy permits developers, once they have taken steps to avoid and minimize wetland loss, to compensate for wetlands that will be destroyed through development by ensuring the restoration of wetlands in another location.(8) The regulations mandate trades that ensure equivalent value and function between destroyed and restored wetlands. In practice, however, most trades are valued in units of acreage. Within very loose guidelines, trades between productive (though soon to be destroyed) wetlands and restored wetlands are approved on an acre-for-acre basis. More sophisticated banks require ratios, trading development on one acre of productive wetlands for, say, restoring four or five acres of wetlands somewhere else. Counting acres may make for easy accounting, but it is poor policy.

Why? The social value of the habitat is absent from the transaction. The ecosystem services provided by the wetlands--positive externalities such as water purification, groundwater recharge, and flood control--are largely ignored. Opinions may differ over the value of a wetland's scenic vista, but they are in universal accord over the contributions of clean water and flood control to social welfare.(9) Trading acres for acres provides an inadequate measure to capture what is really being traded of significance. To be sure, such a simple metric allows trades, but other important, unaccounted trade-offs are occurring. The program can suffer from a lack of accountability (or, more accurately, a lack of countability).

In fact, upon close inspection, it turns out that most ETMs involve commodities and trades that exhibit a range of fungibilities. Legal trades can range from relatively straightforward kilos of surf clams to trades involving the exchange of different types of habitat (that may provide very different social benefits). To achieve the optimal outcome from ETMs, we need to understand and account much better for the qualities being traded. To do so requires careful consideration of the measure of exchange--the currency--since in the final analysis the currency forms the very basis of the transaction. The trading currency superficially makes the commodities fungible, determining what is being traded and, therefore, protected.

Many of the currencies employed by ETMs present trades of an acre of wetland here for an acre of wetland there, or a ton of emissions here for a ton there, as a basic exchange of apples for apples. In reality, though, this is a misleading description. More times than one might think, we are trading Macintoshes for Granny Smiths, apples for oranges, and, in some cases, apples for Buicks. Put simply, we can end up trading the wrong things.

Within the vast literature on ETMs, important and insightful work has explored the related issues of hot spots and the nature of tradable rights,(10) but none has focused explicitly on the central role that currency selection plays in the structure and effectiveness of ETMs.(11) In this article, we reconceptualize the debate whether ETMs promote environmental protection and social welfare. By exploring efforts to promote nonfungible trading--trading environmental apples for oranges--we undertake a rigorous examination of environmental commodities and the currencies we use to trade them. We argue that nonfungibilities and currencies drive the structure of ETMs, directly influencing their construction, rules of exchange, and provision for public participation. In short, we contend that a more complete understanding of the root issues of commodity and currency provides a previously unlaid and strong foundation to understand better the potential and design of ETMs.

By breaking down the problem of ensuring environmental protection in the face of nonfungibilities, we create an analytical framework that can inform the assessment of any ETM. The structure flows from three distinct stages of an ETM's operation. Currency adequacy involves selection of the currency unit--can the metric capture the significant values exchanged or do some important features remain external to the trades? Part I of the article sets out the theoretical issues underlying a currency's adequacy, examining the technical issue of how trading programs establish what the metric of exchange shall be and why many ETM currencies remain crude, that is, unable to account for important nonfungibilities across space, type, and time.

Exchange adequacy addresses construction of the exchange market--in the face of a currency that fails to capture significant values, how can the market be structured to ensure trades support environmental protection? Part II explores regulators' use of exchange restrictions to compensate for inadequate currencies. We postulate an inverse relationship between currency sophistication and intensity of market constraint. If an ETM relies on a comprehensive currency, there is little need for exchange controls; conversely, and more often the case, crude currencies will result in tightly constrained trading schemes if the market maker desires to restrict environmental externalities. As with currency adequacy, however, equally strong pressures counsel loosening of trading restrictions.

In Parts III and IV we shift our focus to habitat ETMs, where the latent nonfungibilities found in all trading markets are greatly exacerbated. To test our analytic framework empirically, Part III applies the model developed in Parts I and II to a case study of a major habitat ETM--wetlands mitigation banking. As our framework predicts, regulators have responded to the reliance on a crude currency (usually acres) with the imposition of market constraints--limiting the kind of wetlands that can be traded, the locations of the traded wetlands, and the timing of trades. These restrictions on free trade minimize the opportunities for exchanges that might harm the environment, but they also limit the actual number of trades. In the face of pressures to "thicken" the market, regulators have loosened these restrictions, leading to trades that fail to promote environmental protection.

Part IV analyzes review adequacy--the institutional mechanisms for reviewing trades. If, in practice, neither currency nor exchange adequacy will often be achieved, then even trades of nonfungible...