Dr. Matthew Agarwala (Bennett Institute for Public Policy, University of Cambridge), and Dr. Ethan Addicott (Land, Environment, Economics and Policy Institute, University of Exeter)                            CAP0025

Written evidence submitter by Dr. Matthew Agarwala (Bennett Institute for Public Policy, University of Cambridge), and Dr. Ethan Addicott (Land, Environment, Economics and Policy Institute, University of Exeter)

Response to UK Environmental Audit Committee call for evidence:

“The role of natural capital in the green economy.”

We welcome and strongly endorse the EAC’s decision to conduct an inquiry into the role of natural capital in the green economy. This document represents our joint response to the Committee’s associated call for evidence, and draws on insights and expertise from across our respective institutions.

The Terms of Reference demonstrate an interest in the role of private capital in supporting UK nature. There is indeed an important opportunity for the government to provide public money for public goods, and to crowd in private investment. But these opportunities can be rapidly eroded by a lack of credibility and consistency in UK environmental policy.

Dr. Matthew Agarwala:

I write in my capacity as an economist at the Bennett Institute for Public Policy, University of Cambridge and member of The Productivity Institute. I lead the Bennett Institute’s Wealth Economy Project and hold expertise in Inclusive Wealth, natural capital, ecosystem services, green finance, productivity, and the economics of well-being. I have contributed to the inaugural UN Inclusive Wealth Report (2012) and authored the first ever contribution on social capital to the World Bank’s flagship Changing Wealth of Nations report (2021). In 2021, I led the team that created the world’s first climate-smart sovereign credit rating, and in 2022 we published the world’s first biodiversity-adjusted sovereign credit rating. My research has been covered in 250+ media outlets across 40+ countries.

Dr. Ethan Addicott:

I write in my capacity as a lecturer in economics at the University of Exeter Business School and member of the Land, Environment, Economics and Policy (LEEP) Institute. My research deploys applied microeconomics, with identification strategies informed by natural systems, to understand changes in the natural capital asset base and to design and evaluate policies in response to these changes.  My cross-disciplinary work is published in economics, natural science and general interest journals and has been funded through the US Department of Defence, NERC, and AHRC among other organisations.  In 2019, I served as a member of the expert group on national accounting for the High-Level Panel for a Sustainable Ocean Economy and as a co-author for the Blue Paper on National Accounting for the Ocean and Ocean Economy. I currently serve on the Global Expert Panel for the Global Ocean Accounts Partnership.

The UK has enjoyed a world-leading reputation in environmental economics and natural capital research. Landmark contributions with global impact include Blueprint for a Green Economy (Pearce et al 1989), The Stern Review of the Economics of Climate Change (2008), and the Dasgupta Review of the Economics of Biodiversity (2021).

In the past, UK has also shown global leadership in environmental-economic and natural capital policy. The UK can boast that:

• the 2008 Climate Change Act introduced the world’s first legally binding carbon budgets,
• it was the first G20 economy to adopt a legally binding Net Zero target,
• the 2011 natural environment white paper, The Natural Choice: securing the value of nature sought to place natural capital at the heart of the green economy
• the 25-year environment plan demonstrated an attempt to overcome short-termism to protect and restore nature.

But there are also deeply worrying trends towards abandoning, delaying, or watering down environmental policies and regulations, including: nutrient neutrality, toothless regulation of water companies, red tape preventing on-shore wind, and a failed auction for off-shore wind, among others.

In the course of drafting our response, we have learned that the UK Government has decided to break its promise to auto-manufacturers, charge-point installers, electricity companies, mechanics, businesses, housebuilders, construction workers, landlords, renters, and the public to ban sales of new petrol and diesel vehicles by 2030, new gas boilers by 2035, and to improve energy efficiency standards in rented housing. Representing both the supply and demand side of major economic sectors, these groups have invested in developing the skills, patents, supply chains, and production facilities to serve mass markets for EVs, heat pumps, and well-insulated rental accommodation. Such investments were made on the basis of UK Government promises that would have created markets for these goods and services in the near term. Breaking those promises means these investments must wait longer for the returns those markets would have offered. The decision could radically undermine UK government credibility at home and abroad, increase costs to businesses, weaken the case for UK business investment, severely undermine public health, and place additional pressure on NHS services.

We make these comments because in addressing the questions set out by the Committee’s Terms of Reference for this call – which largely focus on the development of private markets for UK nature – the most important considerations are credibility and consistency. As the UK flip-flops on landmark environmental commitments, these are undermined and the scope for private capital in supporting UK nature is severely constrained. Even UK investors who are actively seeking to engage in natural capital markets may look to foreign investment opportunities if the UK’s environmental regulation and commitments cannot be trusted.

Our summary comments are:

1. Combined with, and contingent upon, strong, consistent, and enforced regulation, private markets for natural capital can help support growth and well-being in the UK. A large body of economic research demonstrates that natural capital is fundamental to growth, well-being, and improved environmental-economic outcomes.[1],[2],[3] In the UK, there is strong evidence of the benefits generated by natural capital and the importance of policies that support it.[4],[5],[6]  Financial markets and regulators have expressed substantial interest in developing green finance instruments – and crucially, credible evidence and reporting standards – to help mobilize finance in pursuit of improved outcomes and reduced greenwash. A strong green finance strategy with a clear taxonomy and reliable enforcement can help bring much needed credibility to the world of green finance. This credibility could help inspire confidence in the market and contribute to the mobilization of finance in support of natural capital.
2. Many of the valuable goods and services generated by nature are public goods. The questions set out in the Terms of Reference demonstrate healthy concern over greenwashing, but they also seem to demonstrate a lack of understanding of the public good nature of natural capital. Public goods are non-excludable (meaning the supplier cannot prevent someone from benefitting) and non-rivalrous (meaning one person’s consumption does not prevent another person from also consuming them).

One example of a public good is clean air: a company switching its vehicle fleet from diesel to electric vehicles would improve air quality by reducing tailpipe emissions. The environmental benefit is non-excludable (the company cannot prevent the public from breathing cleaner air), and non-rivalrous (one person’s enjoyment of cleaner air does not preclude another’s). These public good characteristics mean the company cannot effectively charge the beneficiaries of improved air quality. The result is that the company underinvests in improving air quality relative to the social optimum. One policy option to correct this type of market failure is to subsidize EVs, effectively using public money to support the provision of public goods.

3. Some valuable ecosystem processes and services are difficult to observe[7], quantify, or precisely link to sources, making markets an inappropriate tool for ensuring their efficient provision. Markets for biodiversity, ecosystem services, and natural capital rely on the verified and robustly delivered services[8]. However, many valuable processes and services are too costly or difficult to observe, quantify and attribute to sources to allow markets to provide them efficiently. Though the tools and body of evidence will continue to expand the opportunities for markets to address environmental concerns, it would be wholly inefficient to discount the role of public investment in addressing the scope and scale of nature loss in the UK.
4. High transactions costs for environmental goods and services imperil efficient provision via markets. A common form of market failure encountered in environmental economics is known as the ‘missing market’. If there is no market for carbon sequestration, water quality, or biodiversity, entities who might want to supply these services have nowhere to sell them. Those who want to purchase them have nowhere to pay. Governments can help address this market failure by creating new markets, as in the case of an emissions trading scheme or offset programme. Creating markets to direct flows of financial capital to nature can be an effective policy tool. However, even when markets for nature are created, they can still suffer from the same set of market failures that we see elsewhere (e.g. imperfect information, asymmetric market power, etc).

One of the reasons markets for many environmental goods and services fail or do not exist is that there are high costs to negotiating and monitoring the provision of service flows[9]. Geographic distance, for one, may impose a high cost to creating a market. Wildfires hundreds of miles away can reduce air quality in major cities. Linking the downstream effects back to the source can be costly and uncertain. Codifying markets as the solution ignores potential market failures and leakage. Temporal distance can also imperil well-functioning and credible markets. Carbon emitted today impacts generations that do not yet exist, making negotiation across present and future generations through markets a challenge. Beyond these issues, the definition of property rights that enable markets to operate may be impossible (or impractical). Migratory species are a good example. Non-excludable goods and services like clean air cannot be provided only to a select few. And where property rights may be easily established, as in the case of seagrass beds, the value of the resource may be intrinsically tied to its location making spatial arbitrage of natural capital too costly, compared to the fully fungible spatial arbitrage opportunities for financial capital[10]. For cases that lack clear property rights and low transactions costs, market exchange will not deliver efficient outcomes[11].

5. Markets will emerge given certainty and clarity over standards, while stacking should be allowed for efficiency. While regulation to internalise the damage caused by private actors is net-beneficial, it is not costless. Indeed, those regulated actors then need to demonstrate that they are in compliance with the regulations through the financing of ecosystem service delivery elsewhere. Markets – given certainty about the future trajectory of policy – however, are very good at delivering against regulations at low cost. For instance, when water companies were permitted to use catchment-based solutions to meet their water quality obligations, we saw markets emerge to deliver these, and progressively improve to ensure that they were met at least cost. [12] More recently, double-sided markets, with multiple buyers and sellers, have been pioneered and traded in excess of £1m worth of credits to deliver against Nutrient Neutrality and Biodiversity Net Gain legislation.[13],[14] In order to further encourage and facilitate trade, markets need clear standards which set out under what conditions environmental credits can be traded. Moreover, it is clear that in order to deliver these services efficiently, markets must be allowed to stack services. In so doing, they will deliver against obligations with least land take and at lowest cost. On the demand side, this must be matched by ensuring symmetric accounting.
6. Even well-functioning *private* nature markets would undersupply public goods. Markets for natural capital and ecosystem services are essentially attempts to turn public goods into private goods. The purpose of doing so is to enable suppliers of natural capital and ecosystem services to reap the benefits of their provision of public goods, and to encourage consumers to pay for the benefits they receive. For large scale markets, this process is underpinned by effective regulation and enforcement. For instance, the Nutrient Neutrality and (incoming) Biodiversity Net Gain legislation ensures that developments are net-beneficial to the environment. Finally, even the most advanced nature markets are only able to internalise and align incentives across a restricted slice of the benefit flows generated by nature, leaving those unaccounted for external to the establishment of a market equilibrium. This means public money will still be needed for public goods, particularly in the delivering of environmental improvements.
7. The UK may not have a comparative advantage in international nature markets. The UK is one of the most nature-depleted countries on the planet. It has a high population density and competing land uses such as housing, agriculture, and wild ecosystems drive up land prices. These high prices mean that the UK may struggle to offer value for money in international nature markets. Environmental improvement per pound is likely to be far higher in places with lower land prices and more globally important ecosystems (biodiversity hotspots). There are two caveats, relating to a high willingness to pay and the potential for a ‘credibility premium’.

The high willingness to pay for certain types of natural capital (that support outdoor recreation, air quality, etc) in the UK indicates that there is significant potential to improve economic welfare. Similarly, regulated ecosystem services requiring local provision (e.g. nutrients and biodiversity) are highly valued by private buyers.

8. UK markets could attempt to fetch a ‘credibility’ premium if they can demonstrate superior monitoring and verification compared to other jurisdictions. The expected value of a nature credit depends on the credibility (‘Can I, and will regulators and other market participants, recognise this credit?’) and the ecological benefit, minus transaction costs. If these transaction costs include the monitoring and verification, then higher transaction costs could increase credibility, but decrease expected net returns. It may depend on the relative cost of monitoring/verification and the weight markets place on credibility.

In contrast, domestic markets could be extremely beneficial in reducing the search costs involved in finding suitable sites for offsets (relating to biodiversity net gain and nutrient neutrality). Where we can establish cogent property rights, we can make big improvements to internalize externalities and make locally significant changes to nature recovery via private investment; however, in aggregate these markets are insufficient to address the scope and scale of nature recovery for the UK. Moreover, market actors will require policy consistency to minimize costs.

9. The devil is often in the details of the taxonomy. Will substituting treated wood products for concrete in construction count as natural capital investment, and can the sequestered carbon be sold in a market? Does ecosystem maintenance count? If so, how do we achieve additionality? If not, where’s the incentive for conservation? One option is to try to set out a taxonomy that clearly addresses all these issues, but this has not yet been achieved anywhere. Another is to develop and enforce regulation in planning, the water sector, agriculture, and trade. The aforementioned propensities for market failure in the provision of (public and private) environmental goods and services means that private markets can complement – but not replace – good governance. Success requires a combination of both.
10. Markets can struggle to address leakage. Leakage occurs when market conditions or regulations in one jurisdiction induce changes in trade patterns via an offshoring effect. For instance, stricter carbon legislation, agricultural standards (including animal welfare standards) in the UK could lead markets to import associated goods from foreign jurisdictions where regulation is less rigorous. To address this, high standards could be incorporated into trade negotiations and agreements; or be corrected through the use of border taxes to ensure a level playing field. Admittedly, the likely success of this approach does depend on the relative negotiating power of each party.

We hope these comments are considered useful to the committee.

Kindest regards,

September 2023