Designing an environmental mitigation banking institution for linking the size of economic activity to environmental capacity.

Author:Saeed, Khalid

While heterodox economics streams have widely recognized the role of institutions in influencing the behavior of an economy, a large part of the writings in institutional economics is devoted to interpreting classical thought on institutions rather than making use of this powerful instrument in designing a policy implementation framework (Neale 1987; Bush 1987). In particular, environmental policy, which should be aimed at creating environmental responsibility institutions that influence the everyday conduct of business, continues to be implemented through command and control and rather arbitrary fiscal instruments, although a few market-based instruments such as tradable pollution permits have been proposed (Cropper and Oates 1992).

Environmental mitigation banking, also sometimes called conservation banking, has recently been suggested as an institutional innovation that allows banking of environmental restorations to offset environmental damage caused by development projects so net change in environmental resources remains zero and strong sustainability criteria are met. (1) Typically, a conservation or mitigation bank is privately or publicly owned land restored for its natural resource values. In exchange for restoring the land, the bank operator is allowed to sell credits to developers who need to satisfy legal requirements for compensating environmental impacts of development projects (California Department of Fish and Game 1995).

Many opinions exist about how the mitigation banking industry should be instituted and regulated, but few of them are based on a clear understanding of how the proposed institutional arrangements and regulatory policies would affect its performance in terms of supporting economic activity, preserving the environment, and minimizing organizational costs and social conflicts. Pricing of environmental credits is an important aspect of the mitigation banking system, and complex engineering methods connecting price to cost have been proposed as pricing criteria. Also, environmental groups have often advocated subsidization of the environmental mitigation activity by the government or other outside agents, without clearly understanding the implications of such subsidies (Marsh et al. 1996). Evidently, there is a need for perfecting design of this new institution before confidence can be placed in its ability to successfully meet the dual goals of maintaining environment and supporting economic activity without a cumbersome and expensive command and control system in place, so it can be applied to a wide range of conservation agendas.

Integrating concepts from economics and system dynamics, I have attempted in this paper to model the role of a mitigation bank operating with a variety of regulatory policies and interventions imposed by an authority. (2) Computer simulation is used to reveal the dynamic behavior of the relationships included in the model. Experiments with my model suggest that a mitigation banking institution established in the market is able to yield both an optimal price for the environmental credits and an appropriate scale for the regulated economic activity without use of engineering methods connecting price to cost of mitigation. These experiments also show that the delays associated with engineering calculations, when they are used to influence price of credits, would restrain economic growth by stifling its multiplier effects, even though they would achieve a balance between the scale of the economic activity and the corresponding environmental resources it affects. Subsidies would indirectly support the economic activity by reducing the price of credits, but for the same budget, direct subsidies support the economic activity more than the market-based subsidies. Connecting credit requirements to environmental conditions introduces instability in all cases in view of the delays and subsequent overcorrection involved in the process but helps to connect the scale of the economic activity to the corresponding environmental capacity when market or cost-based mechanisms for pricing credits are absent. Most important, an environmental mitigation banking system, operating under a variety of appropriately designed institutional arrangements, appears to align economic activity with ecosystem size--a relationship that has been blatantly ignored in orthodox economics (Daly 1991, 1996). The experimental process used in this paper to arrive at an appropriate design for an environmental mitigation banking system is seen in general to be of significant importance to the design of new institutions and for improving the performance of existing ones since it creates a test bed for institutional design.

Institutions as Instigators of Policy in an Economic System

Peter Soderbaum pointed out, "institutionalists have made many theoretical and policy oriented contributions. They have also made suggestions about how inquiry in society can be carried out, about the potential benefits of planning and all. They have written less about specific approaches to decisionmaking, but the conceptual framework of institutional economics is certainly useful to any one who wishes to design more specific approaches" (1987). Michael Radzicki, in a series of writings appearing both in system dynamics and institutional economics literature, has drawn parallels between the qualitative models of how institutions create roles for the agents in an economic system and the formal models created through system dynamics modeling process (1988, 1990, 2003). In my observation, there is also a great similarity between the way an abstract system of roles that process information and return decisions is defined around an articulated problem in system dynamics (Saeed 2003) and how institutional economists define an institution--not as a manifestation of bricks and mortar, but as "a set of socially prescribed patterns of behavior" (Bush 1987), or as "activities of people in situations," which include "1) people doing; 2) the rules including the situations in which they are followed, and 3) the folk views explaining the rules" (Neale 1987). My interpretation is that institutions may be both manifest and latent (Gouldener 1957; Saeed 1998b) and may discharge both a role-sending function and a role-receiving function (Katz and Kahn 1990). While the role-sending function might often be created organically through latent relationships, the role-receiving function is often manifest and open to intervention and amenable to design for creating suitable policy agents in society.

The creation of institutions to act as policy agents is not new. Command and control institutions are widely used in numerous policy contexts and particularly in environmental policy context. Many institutions have also been created to constantly monitor information to create appropriate market interventions. The Federal Reserve Bank is an example of such institutions. I have earlier proposed the creation of a natural resource board to constantly monitor a resource basket with respect to its regeneration rate and to vary a severance tax structure so what is consumed is regenerated (Saeed 1985). Herman Daly (1991) has suggested an innovative set of institutions for the proper functioning of a steady state economy. In all such proposals, institutional norms create policy agents that constantly process information derived from the system state and return decisions to alter this state if it deviates from designated goals.

Figure 1 illustrates the information-processing and decision-making roles of the policy agents operating in a system of role-sending institutions. The decision rules in this system are formed by norms, values, expectations, and sometimes explicit rules emanating over the long term from the role-sending institutions. The decision process is based on access of the agents to information and their manifest or informal contribution to the decisions delivered following those norms and rules. Clearly, this process constitutes a bounded rational rather than an absolute rational decision process as has been pointed out in the seminal work of Herbert Simon (1982). As John Morecroft (1985) and Radzicki (1988) have pointed out, such a bounded rational decision process is also a common construct, both in system dynamics and institutional economics. An important point to note is that the creation of decision rules and actions occurs in feedback loops that involve discerning system state. The former, however, involve a long time constant while the latter a short one.


A system dynamics model constructed as a test bed for institutional design may include both the role-sending functions of the institutions involved in the process and the role-playing functions of the decision agents, depending on the problem of interest. When the causes of an institutional change are to be investigated, the long-term process of changes in rules and norms must be included in the model; however, when the short-term impacts of an institution are to be investigated, these long-term processes need not be modeled since the activities to be addressed by the model constitute the performance of the institution, not the motivation for forming it (Saeed 1992).

Mitigation Banking as an Environmental Responsibility Institution

Mitigation banking banks restored land, not money. Often, it attempts to construct mitigation areas in advance of anticipated impacts caused by future developments. The banks earn mitigation credits by restoring land, while the future developers are required to purchase these credits according to the scale of the impacts they will cause. Thus, the net impact of the development on environment remains zero even though the impact and restoration areas are different. A bank is typically large in area, so it can provide credit trading service for numerous contemplated impacts (NCSU).

Mitigation banking creates a production...

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