21 July 2011 by Glen Low

The World’s Greatest Market Failure

Money Trees

By Glen Low and Julie Menter, Blu Skye - In 2006, the Stern Review reported: “climate change is the greatest and widest-ranging market failure ever seen.” Recently, its author Sir Nicholas Stern, former chief economist of the World Bank, re-iterated this sentiment in the MIT Technology Review. In the article, he explains that the failure occurs because “the price we pay for products and services that involve emissions of greenhouse gases does not reflect the costs they cause through damage to the climate.” On the five year anniversary of this historic report, it is time to acknowledge that there is a market failure even bigger than climate change and it is much farther reaching as well: the externalization of the true cost of environmental impacts from products and services.

What this means is that all products and services today are mis-priced because they don’t take the full cost of actually creating and delivering them into account. For example, the price we pay for fossil fuel energy does not include the cost of global warming (not to mention other costs of environmental damage from extracting and burning oil/gas/coal). The price we pay for an ear of corn doesn’t take into account the impacts of excess fertilizer washing downstream to the detriment of fisheries and fishermen (and there are other externalities as well). Conversely, preserving or restoring ecosystems, such as protecting the Amazonian rainforest, has limited or no value in the marketplace.

This failure is referred to as the missing valuation of ecosystem services, meaning that prices fail to reflect the cumulative value that nature provides to human well being. This value includes services such as erosion control, fresh water supply, carbon capture, clean air and pollinat­ing insects to support global agricul­ture.   

This market failure is tremendous.  While greenhouse gas emissions are critical, and will lead to untold impacts if they are not reduced, they are a small subset of all the externalities that the earth’s ecosystems endure.  In a simplified view of the relative sizes, the World Bank reports that the 2010 global carbon market was $142B, with 97% of that value being driven by the EU Emissions Trading Scheme.  Despite ongoing EU ETS issues, Barclays Capital has estimated the global carbon market could be $2T by 2020 if the United States and other countries were engaged.  The estimated value of total ecosystem services is considerably larger.  Research shows the value of ecosystem services ranges from $16 to 54 trillion.  On the low end, this is equivalent to the annual GDP of the United States.  On the high end, it is almost the GDP of the entire global economy. 

So what action is required? A price on carbon is necessary, but not sufficient.  The more expansive set of services that nature provides must be priced into the market also.  Otherwise the economics don’t work.  Economic growth is in tension with the environment because everything is mispriced: this means that by definition we are collectively making poor decisions.  Markets today create financial value in ways that deplete our natural capital because they are optimizing based on the wrong data.  Without a price correction, capitalism will by necessity continue to undermine earth’s long-term health.

Correctly measuring the value that nature provides can create real economic value, not just added cost. For example, it allowed New York City to reduce the cost of getting clean water.  Since 1997, the city’s Land Acquisition Program has invested $541M to protect 116,000 acres of watershed land.   The result?  It has protected the world’s largest unfiltered drinking water supply which provides drinking water for nine million city residents.  The cost of technologically replacing nature’s water filtration service: $10B in filtration plant construction costs alone.  This is a clear example where an ounce of prevention is worth a pound of cure.

A growing number of initiatives are putting a price on nature ranging from the World Bank-led Partnership for Wealth Accounting and the Valuation of Ecosystem Services (WAVES) to the “The Economics of Ecosystems and Biodiversity” (TEEB) research sponsored by the G8 Environment Ministers, which Sir Nicholas Stern himself described as a ‘landmark’ work.  And a growing number of leadership minded companies are realizing that correctly pricing nature can inform smarter financial decisions and lead to real business opportunities.  This is why Dow has chosen to invest $10M with the Nature Conservancy to incorporate the value of ecosystem services into the company’s decision making; specifically starting with at least three of Dow’s manufacturing sites.  Similarly, 14 leading companies chose to road test the World Business Council for Sustainable Development’s Guide to Corporate Ecosystem Valuation.  It is worth noting that these companies are not waiting for a top-down government mandate but instead leading the way to a world where business decisions are aligned with the laws of nature.

Today’s current economic paradigm can no longer be sustained.  The World Wildlife Fund estimates that we are depleting the resources of the planet at an annual rate 50% greater than can be sustained threatening the world’s economic and social development.  If our way of life is to survive, it must change.  We must transform capitalism by making decisions based on the true value of nature.  Sir Nicholas Stern’s words of warning regarding climate change apply perfectly to the valuation of ecosystem services: “the benefits of strong, early action far outweigh the costs”.  The time has come to correct the world’s greatest market failure.


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