Environmental Economics

This summer’s Lake Erie algae bloom is almost certain to be the worst on record, warn the scientists who study the lake.

via www.dispatch.com

Here is what I said to a group of local environmental professionals about Lake Erie Harmful Algal Blooms last year:

We’ve heard a lot today about solutions for high phosphorous loads in Lake Erie and the resulting harmful algal blooms.  As an environmental economist, I’m told my role in this discussion is to provide a balanced look at the potential costs of reducing phosphorous loadings into Lake Erie, the benefits of those reductions to society, and the burden of the costs of phosphorous reductions. 

Some of you may be wondering, what is an environmental economist? An environmental economist is an economist who applies the science of economics to environmental issues.  I am not an environmentalist.  Don’t get me wrong, I care about the environment.  But I am realistic about the role that incentives, trade-offs, and profits play in finding solutions to environmental issues that lead to sustainable human well-being.   I recognize the reality that the economy and the natural environment are inextricably linked and attempting to separate the study of each creates a situation in which neither is sustainable.  Economic, social and environmental sustainability requires the realization that no single solution exists.

So what then, from my perspective as an environmental economist, is the fundamental issue surrounding harmful algal blooms?  Excess nutrient loads into Lake Erie are the result of misalignment of incentives.  The profit incentives of the on-farm sector fail to fully capture the costs of nutrient application decisions to the non-agricultural sectors.  The cost-savings incentives of industrial and municipal sources of run-off fail to fully capture the downstream costs of urban run-off.  The consume-now incentive of today’s consumers fails to fully capture the cost of today’s decisions on future generations.

None of these statements are judgments on the intent of individual farmers, or municipal decision makers or society today in making decisions that impose excess costs on others.  In fact, in my experience, most people want to do the right thing.  Farmers care about environmental issues.  Municipalities care about water quality.  Today’s generation cares about the future.  Yet when consumption and production decisions are made, reality differs from intent. 

For example, when I drove here this morning, I gave no thought to the cost my car exhaust imposes on others.  I know that my exhaust contributes to increased atmospheric pollution.  I know that by driving I increase the likelihood of health issues for those with breathing issues.  I know that my driving contributes to long-term climate change.  Yet, other than being a genuinely nice person, I have no incentive to incorporate those external costs into my driving decisions.  The price of driving does not fully reflect the external costs.

Prices are the economy’s rationing mechanism.  It is prices that drive economic decisions.  Prices provide signals.  It’s prices that serve as a market’s way of reflecting the value of something.  And if prices fail to fully reflect the current and future costs and benefits of production and consumption, markets will misallocate society’s scarce resources. 

In political and social discussions we hear a lot of talk the need for less government regulation, the need for free markets.  In general I agree with free market advocates.  But in order for a market to do its job of allocating society’s scarce resources today and into the future, that market must capture ALL costs and benefits.  Otherwise a market is not truly a free market.

In the case of the environment, we can think of the problem as one of the failure of markets to properly price the services the environment supplies.  In effect, the environment is treated as a free input in production and consumption.  It is only natural that if something is free we will use more than we would if it is priced at its true value.  If gas were free, I would use a lot more of it.  Because the cost of environmental degradation is not captured in markets, we use more of it than we would otherwise.  It might be tempting then to conclude that markets are the problem.  I agree to a certain extent.  Markets are failing to properly account for costs and benefits.  But markets are also the solution. 

To solve the harmful algal bloom problem, we need to find ways to better capture the external costs of using nitrogen and phosphorous in the markets in which they are used—and then allow the resulting incentives work to solve the problem.  To do so, we can focus on the quantity of phosphorous, or we can focus on the price.  Quantity restrictions are effective if monitored effectively, but effective monitoring is difficult.  Effective quantity restrictions will reflect in market prices.  However, ill-designed quantity restrictions can result in regulatory costs that are higher than needed. 

Regulating prices, on the other hand, allow the users to make decisions that reduce their own costs.  By allowing the freedom to choose how to adapt to higher prices, price-based policies can achieve the same outcomes as quantity restrictions at lower cost. 

However, many of the price-based solutions have a negative reputation:  taxes, subsidies, cap and trade, user fees.  But as an environmental economist, I recognize that solutions that build environmental costs into market decisions allow individuals to make the decisions that are in their own best interest. The result is what’s best for society.

Unfortunately, we are talking about a problem of magnitude that hoping people will do the right thing is not an option.  While voluntary programs are attractive politically, achieving a 40% reduction in Lake Erie phosphorous loadings, if that is indeed the goal, is going to require more than reliance on goodwill.  Real, sustainable, solutions are going to require a recognition that prices need to capture the full social costs of nitrogen and phosphorous use.  Anything short of that will lead right back here next year, hoping the problem solves itself. [emphasis added]

Here's more from the Dispatch article:

Those scientists have recommended cutting the amount of phosphorus that reaches Lake Erie by 40 percent from 2008 levels in order to reduce algae.

To do that, farmers in will have to change the way they operate. Scientists say manure and fertilizers that wash from farm fields are responsible for a large portion of the phosphorus that gets into the lake.

Ohio State and other universities are studying ways farmers can keep phosphorus out of the Lake Erie watershed.

Chris Winslow, interim director at Stone Lab and Ohio Sea Grant, said soil testing could help.

If farmers know how much phosphorus already exists in their soil, he said, they won’t need to add more than the soil needs to grow crops.

The state could also expand wetlands around the rivers and streams that feed Lake Erie. And farmers could install special “two-stage ditches” that would filter phosphorus from runoff before it reaches the watersheds.

So, to answer my own rhetorical title question. 

Nope.