Katherine Needham aims to answer this question following her recent  Commentary, Designing markets for biodiversity offsets: Lessons from tradable pollution permits, published in the journal.

At the start of 2018, the UK Government outlined its ambitious 25 Year Environment Plan. The very first action is to embed an ‘environmental net gain’ principle for all future developments, including housing. Reconciling the need to build 300,000 new homes in the UK by the mid-2020s with a goal of creating or restoring 500,000 hectares of wetland, woodland, grassland and coastal habitat requires a new approach. The use of ‘habitat banking’ as part of a market for biodiversity offsets is one such innovative policy tool.

In our paper, we provide an environmental economist’s perspective on the design of markets for biodiversity offsets using key lessons from over 50 years of research into pollution permit markets. We ask: how lessons learnt from pollution trading help to design successful biodiversity offset markets? By ‘successful’ we mean a market which encourages landowners to invest in biodiversity conservation efforts to meet an ecological goal at a lower cost than alternative policies.

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We start by outlining the economic theory of tradable pollution permit markets and how insights from this translate to a market for biodiversity offsets. Such an offset market is simple in theory: firms wishing to develop land would need to hold offset credits, which demonstrate the creation of additional conservation gains to compensate for damages caused by development. These credits would be provided by landowners who invest in restoration or protection actions, which earn them a financial return from the sale of credits. Trading in credits creates opportunities for low-cost, effective conservation actions to be funded, lowering development/conservation trade-offs.

However, turning this idea into reality is complicated. When creating markets, we want to reduce the transaction costs of market participation – the costs for buyers and sellers associated with searching for information, bargaining over what is being exchanged, and transferring the goods. In pollution-permit markets as in biodiversity offset markets, there are also costs associated with monitoring and enforcement to ensure that emissions are being reduced and that a biodiversity offset is being delivered to ensure no net losses across a given spatial area. When transaction costs are high, it is likely that any cost savings will be minimal, since trading does not occur. Throughout our paper, we discuss these transaction costs in relation to four aspects of market design taken from the pollution permit literature and discuss how these would shape a biodiversity offset market.

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In line with ecological literature, we agree that the most crucial aspect of the biodiversity offset market is what to trade or the exchange currency. In pollution permit trading this was a simple choice, such as one tonne of carbon dioxide. However, reducing biodiversity to such a simple exchange mechanism is fraught with challenges.  We argue that offset markets are not the best approach for complex policy goals encompassing multiple elements of biodiversity. Offset markets should only be used where simple targets are involved, such as protecting a certain habitat or species, in the context of a clear regulatory goal such as No Net Loss (or Net Gain).

Related to issue of the choice of exchange currency is the trading ratio, which sets the rate of exchange between offsets at different points in space and time, also known as the multiplier. We recommend using as simple a scheme of trading ratios as is consistent with the environmental objective, to avoid increasing transactions costs. As part of this, we recommend that offset credits are only exchanged when the environmental outcomes (gains) have been certified. This eliminates uncertainty over whether an offset project will deliver biodiversity benefits, and avoids trying to include delivery uncertainty in the trading ratio.

For markets to be successful there needs to be enough potential participants willing to trade. We would advocate creating a regional offset market which has been embedded in a broader landscape plan. This allows for a greater potential number of buyers and sellers but also considers the impacts loss of biodiversity can have on local people.

Critical to the success of a biodiversity offset market is the level of regulatory oversight to ensure compliance, monitoring and enforcement. Where there are not robust structures in place, this will undermine any opportunities to deliver Net Gain through biodiversity offset markets.

We recognise that biodiversity offsetting is controversial. Can it truly deliver ‘No Net Loss of Biodiversity’, or a ‘Net Gain’ in a cost-effective way? We see the greatest benefits for biodiversity offset markets being in situations where strong biodiversity protection measures do not yet exist and where finding a means to reduce perceived ‘biodiversity versus development’ conflicts will be key to convincing reluctant regulators to implement stricter protection measures.

Read the full Commentary, Designing markets for biodiversity offsets: Lessons from tradable pollution permits, in Journal of Applied Ecology.