Material for this chapter was drawn largely from the report, The Use of Markets To Increase Private Investment in Environmental Stewardship, ERR-64, September 2008.
U.S. farmers and ranchers produce a wide variety of commodities for food, fuel, and fiber in response to market signals. Farms also contain significant amounts of natural resources that can provide a host of environmental services, including cleaner air and water, flood control, and improved wildlife habitat. Environmental services are often valued by society, but because they are a public good—that is, people can obtain them without paying for them—farmers and ranchers may not benefit financially from producing them. As a result, there are almost no "naturally" occurring markets for environmental services.
Markets are driven by individuals and firms striving to maximize their own well-being. Relative prices determined by the interaction of supply and demand satisfy the necessary conditions for maximizing social welfare. The producer considers price information from product markets along with price information from input markets to determine how much to produce and how many inputs to purchase. The consumer participates in various product markets based on prices, income, and personal preferences. If the market functions properly, factors of production move to those uses where they earn the highest return, resources are used most efficiently, and both producers and consumers enjoy maximum benefits from production and consumption.
Prices in a perfectly operating market tell participants how valuable one good or input is relative to another. When a market fails to form, market prices do not exist to guide the allocation of resources. Under these conditions, farmers’ and ranchers’ land-use decisions will be based on the potential return from agricultural commodities alone. If the value that society places on environmental services could be captured by the landowner, he or she would more likely keep a larger portion of his or her land in a natural state, or adopt production practices that provide both commodities and environmental services. The public-goods nature of most environmental services is the primary reason that markets for them do not develop.
Encouraging farmers and ranchers to produce environmental services is one of the goals of conservation programs such as the Conservation Reserve Program (CRP) and Environmental Quality Incentives Program (EQIP). USDA provides a financial incentive to farmers and ranchers for adopting practices that provide water quality, air quality, wildlife habitat, and other environmental services, thus satisfying some of society’s demands. These incentive payments act as a price in a market. However, the incentive payment is not the result of the interaction of supply and demand; most often it is based solely on the cost of adopting a particular conservation practice (known as a cost-share). As such, incentive payment rates do not reflect societal demand for environmental services. In addition, conservation programs are limited by budgets. As a result, much of society’s unexpressed demand for environmental services from agriculture goes unfulfilled.
Despite the public goods nature of environmental services, under certain conditions markets for them might arise. The economic advantages of a market over traditional conservation programs include:
- Prices reflect supply and demand;
- Provision of services not limited by a budget;
- Those who benefit from the environmental service pay; and
- Farmers can benefit financially, as prices received can eclipse cost-share payments.
Development of functioning markets for environmental services often requires direct government involvement. Several types of markets have developed over the years. These markets highlight some of the benefits of markets, as well as the difficulties in creating them. Markets that involve agriculture include:
Water Quality Trading Markets
Water quality trading is one type of emissions market. These markets allow agriculture to supply offsets to regulated firms that are required to reduce their pollutant discharges. This allows pollution reduction goals to be achieved at a lower cost than traditional regulations. Water quality trading markets are defined geographically by watersheds; all demanders and suppliers must be located in the watershed. Over 20 water quality trading programs that include agriculture as a source of offsets have been created by States since 1990. More are under development, particularly in watersheds with chronic nutrient problems.
Farmers produce credits for sale to regulated point sources by changing management practices on their farms to reduce the loss to water of the regulated pollutant. Most trading programs are for nutrients, namely nitrogen or phosphorus. Farmers can produce nutrient credits by reducing application rates, changing crop rotations, changing irrigation practices, changing the timing of applications, planting vegetative buffers, and hauling manure off their farms. Farmers will evaluate all these options to identify the practices that can produce credits at the lowest cost. Farmers are generally believed to be able to produce nutrient abatement at a lower unit cost than point sources are capable of.
Most existing programs have not seen any water quality trades between agriculture and regulated sources. A number of impediments to trading affect the supply of and demand for agricultural credits. One of the most important is uncertainty over the amount of pollution reduction (offsets) that is actually produced by farming practices. Agricultural pollution is not observable as it leaves the field (known as nonpoint pollution, as opposed to point sources that discharge through a pipe), so it cannot be accurately measured. In addition, the amount of pollution reduction that actually reaches the point source (where offsets in a trading program are actually measured) depends on a variety of watershed factors, such as distance and topography. Agricultural pollution is also affected by unpredictable weather events, so the amount of abatement can vary with the weather. In trading markets, uncertainty about the quantity of offsets supplied by agricultural producers reduces demand. Purchasers may be unwilling to enter into a contract with a farmer who cannot guarantee delivery of the agreed-upon quantity of pollution abatement.
Transaction costs can also undermine the development of a water quality trading market. Just locating trading partners can be costly for individual market participants. Because farms are generally widely distributed across a watershed and each may be capable of producing a relatively small number of offsets, the transaction costs for point sources of identifying enough willing trading partners to satisfy their permit needs may discourage them from seeking trades. Providing environmental services is likely to be secondary to a farmer’s primary activity of producing agricultural commodities. It may be too costly for farmers to learn about potential demand for an environmental service, meet participation requirements, develop a business plan, keep the necessary records, and integrate the new business into the traditional farming operation. Farmers may also be reluctant to participate in a market that is created through regulation. They may be fearful of potential onsite inspections by a regulatory agency.
Many of these issues can be dealt with through market design and public-sector support. The use of models to predict offsets generated by agriculture and research on practice effectiveness can help reduce uncertainty. In addition, a guarantee by the regulatory agency that the regulated firm will not be penalized because of unpredictable weather events could alleviate their concerns about purchasing offsets from agriculture. A market clearinghouse can be established so that information on prices and credits being offered and demanded can be easily obtained. An active education program for informing farmers about the benefits of trading could increase their interest in participating. See the report The Use of Markets To Increase Private Investment in Environmental Stewardship, ERR-64, September 2008, for a complete discussion of the steps that can be taken to assist the development of markets.
Greenhouse Gas Markets
Concerns about global climate change have led to various strategies for reducing greenhouse gases (GHG). One policy approach is to create markets for GHG reductions through a cap-and-trade program. One factor in favor of developing an active market is the worldwide potential for such a market. Reducing greenhouse gas emissions or sequestering carbon have the same benefit no matter where they occur, which means a market may have many potential buyers and sellers, a necessary condition for an active market. Similar to agriculture’s role in water quality trading markets, agriculture can be source of low-cost offsets. Nutrient management, manure management, and no-till farming are practices that farmers can use to reduce net GHG emissions.
While a national cap-and-trade program for GHG has not developed, several regional GHG cap-and-trade programs have been started in recent years, These include the Oregon CO2 Standard, the California Global Warming Solutions Act, the Regional Greenhouse Gas Initiative (CT, DE, MD, MA, ME, NH, NJ, NY, RI, and VT), the Western Climate Initiative (CA, NM, OR, WA, AZ, UT, and MT), and the Midwestern Regional Greenhouse Gas Reduction Program (IA, IL, KS, MN, WI, MI, and Manitoba). Firms under program caps generally have the option of meeting requirements by financing allowable offset projects, including afforestation (converting cropland to forest) and the elimination of methane emissions from manure storage through the use of bio-digesters. Many of the issues that affect water quality markets also affect GHG markets.
Wetland Mitigation Banks
Agriculture has traditionally had a profound effect on the supply of wetland services. Wetlands are rich ecosystems that provide a multitude of environmental services, such as biodiversity, recreation, water quality, and air quality. Federal, State, and local governments act on the public’s demand for wetland services by implementing programs and regulations that create and preserve wetlands and restrict wetland losses. Section 404 of the Clean Water Act enables landowners to sell wetland services created through wetland restoration in an offset market.
The Act creates demand by requiring that any loss in wetland services be offset (or mitigated) by a new or improved wetland that offers similar services. Mitigation can occur on-site (where the original wetland was drained), or at a site elsewhere that can provide comparable wetland functions of a quality similar to what was lost. A mitigation bank is a wetland created for the purpose of producing credits that can be sold in the market. Banks may be sited on public or private lands. Over 600 mitigation banks have been approved or are under consideration for approval.
U.S. farmland owners should be in a good position to supply mitigation services. Nearly 60 percent of all counties that have a mitigation bank have agricultural lands that were once wetlands. Wetland restoration tends to be less costly on converted wetland acreage because soil type, topography, and other factors are favorable to wetland development.
However, evidence suggests that agricultural landowners have played a small role so far in mitigation markets, possibly because wetland credits cannot be sold until they are actually created. It may take a number of years for a restored or created wetland to begin producing wetland services commensurate with the services that are being offset. A farmer may not be able to retire profitable cropland under the prospect of no income for a number of years. Instead, farmers may sell land to investors who then create the mitigation bank. The map shows the most likely counties to have a mitigation bank created on agricultural land, based on expected development pressure and availability of suitable agricultural land.
Markets for Wildlife-Related Recreation
Private lands are an important source of hunting, bird watching, and other wildlife-related activities. While wildlife residing on the land is a public good, the right to hunt or observe wildlife on private lands is a private good, controlled by landowners, that can be sold to wildlife enthusiasts willing to pay a fee. Income from such services could be used to protect and enhance wildlife habitat. U.S. farms that received income from all types of farm-related recreation in 2004 (2.5 percent of farms) earned, on average, about $18,000 annually from these activities (see the report, Farm-Based Recreation: A Statistical Profile, ERR-53, December 2007, for details).
Access to private land for hunting activities is one wildlife-related activity that has a high potential. Hunting in the United States is shaped by two factors: (1) wildlife is owned in common by all citizens, and (2) most of the Nation’s wildlife habitat is on private land. Data from the U.S. Fish and Wildlife Services Fishing, Hunting, and Wildlife Associated Recreation survey found that almost 75 percent of hunting days occurred on private land. While some producers market hunting opportunities on their land, most do not. Farm survey data indicate that only 1 to 2.5 percent of farms received income from all types of recreation activities each year from 2000 to 2005. Thus, producers may have substantial opportunities to increase fee-based recreation activities, particularly in counties where demand for hunting appears to be high (see map below).
Selling access to private land for hunting is not as extensive as it could be for several reasons. A fee-based hunting enterprise is not without cost. Setting it up involves the time and expense of advertising, handling contracts, and addressing liability concerns on the farm. Managing a farm for wildlife also involves management activities different from those for producing crops. A farmer must find the "happy medium" between managing a farm for wildlife and for crops.
Another obstacle to greater use of wildlife-related markets may be the asymmetric distribution of costs and benefits. Wildlife does not respect property boundaries, which can limit the incentives for landowners to invest in habitat enhancements because some of the return will accrue to owners of adjacent parcels or even in other States (migratory waterfowl).
One way that a farmer can benefit financially by providing an environmental service is to link the provision of the service to the sale of a private good. Eco-labeling is a way of informing consumers of the methods used to produce the private good and, jointly, the environmental services that are on offer. Consumers who care about environmental services may be willing to pay more for products made in a way that provides those services. Higher prices support environmentally friendly management practices and can entice more producers to adopt such practices.
Starting with the organic label (see the topic on Organic Agriculture for more information) in the 1950s, eco-labels have been used to tout reduced pesticide use, wildlife protection, and other environmental services tied to specific agricultural production systems. Food that has an organic or other eco-label is known as a "credence" good: it cannot be distinguished visually from conventionally produced food, and consumers must rely on labels and other advertising tools for product information.
The success of an eco-label depends on strong, transparent standards that consumers believe are strictly enforced. The organic label is the most prominent eco-label in the United States. It is supported by national standards that are enforced by USDA. USDA requires the producer to use practices that maintain or improve the physical, chemical, and biological condition of the soil and minimize soil erosion. The producer is required to manage crop nutrients and soil fertility through rotations, cover crops, and the application of plant and animal materials and is required to manage plant and animal material to maintain or improve soil organic matter content in a manner that does not contribute to contamination of crops, soil, or water by plant nutrients, pathogenic organisms, heavy metals, or residues of prohibited substances. Benefits include reduced pesticide residues in water and food, reduced nutrient pollution, carbon sequestration, and enhanced biodiversity.
While organic farming in the United States has grown steadily in recent years, only about 0.5 percent of all cropland and pasture were certified organic in 2008. Obstacles include the cost of converting a farm to organic production, access to production and market information, and a lack of publicly funded organic farm advisors and research. In addition, many consumers who value the environmental services produced by organic production methods act as "free riders" and continue to purchase conventionally produced produce. Another potential issue is a proliferation of local and national eco-labels for a variety of environmental services and other causes that may overwhelm consumers. Many of these labels do not come with the standards and certification of the organic label, rendering the label claims suspect. In addition, multiple product labels may make deciding between goods touting different environmental services difficult.