Guide to resource economics

Introduction

Resource economics can be used to help industry, communities and policy makers to understand the tradeoffs involved in improving natural resource management, and to understand how changes in management and policy can lead to increased efficiencies.

The key ways of using resource economics can be summarised as follows:

1.  Understanding why environmental and production problems might arise, and why there may be groups in society who disagree with the way that resources are allocated and used. Understanding why environmental and production problems occur is a key step in designing solutions.

• Market Failure: Markets don't always work properly to reflect the wide range of impacts that can fall on different groups in society, or to provide incentives for different types of goods and services to be produced.
• Government Failure: Governments don't always operate efficiently, or only reflect the wishes of special interest groups.  In some cases information and planning failures mean that some interests of different groups in society are not registered. This might occur when issues are complex, when there is limited scientific knowledge, and/or when the information held by different groups is not coordinated.

2.  Identifying whether it is worth addressing an environmental or production issue. Solutions are not costless, so a decision framework normally involves not only an assessment of whether it is worth fixing a problem, but also an assessment of the balance to be chosen between bearing the problem and imposing the solution.

• Cost-benefit analysis is a key tool used to identify whether projects or policy changes are worthwhile to society overall. A marginal approach is taken to assessment, where only the potential benefits and costs of a potential change are assessed.
• Application of cost benefit analysis often involves the use of non-market valuation techniques to allow assessment of different environmental and social impacts. These can be grouped into two broad categories of related market and stated preference techniques.
• In many cases there are no non-market valuation estimates available and it might be necessary to use values estimated at one site and apply them in a new or target site. This process is known as benefit transfer and is discussed in detail in a separate section. 
• Production economic modelling is often used to describe how the returns in a productive enterprise change as different input levels are changed. When these models are combined with models of environmental outputs, they are termed bioeconomic modelling. Model outputs are important to predict the tradeoffs involved in changing management actions.
• Other sources of information include the use of case study analyses, and information directly provided by farmers and other experts.
• Other decision frameworks such as the Safe Minimum Standard (SMS) rule or multicriteria analysis (MCA) can also be applied. These are not as comprehensive as CBA, but may be easier to apply and more sensitive to political economy issues.
• An important stage in the assessment is to determine whether there may be impacts (particularly negative ones) on particular groups in society. Impact assessment is used for this purpose

3.  Once a decision has been made to address an issue, a key task is to identify the most efficient ways of meeting the desired outcomes. 

• Cost effectiveness analysis is often employed for this purpose. This involves identifying the different ways of achieving a desired outcome, and the selecting the one that has lowest overall costs to society.
• Some of the alternative policy tools that government might employ include:
  • Improving information flows and persuading people to change behaviour,
  • Setting specific property rights to improve the incentives for people to look after their assets,
  • The use of taxes and incentives to change the direct financial tradeoffs that people might face,
  • The use of regulations to guide behaviour.
• Market based incentives are increasingly being used by government to focus on changing the incentives that resource managers face. These generally refer to the design of incentive mechanisms that help to achieve public policy outcomes.
• Care has to be taken to ensure that interactions between different policy tools do not create perverse outcomes.

Market failure problems

Under ideal conditions, the market mechanism can generate higher levels of wellbeing in society through voluntary exchanges. The general truth of this is demonstrated by the higher levels of economic growth and other social indicators enjoyed by western countries with market exchange systems. However, these mechanisms will not always work well, and there is potential for them to fail. Successful market economies are characterised by institutional and government systems that can address potential areas of market failure.

There are four broad reasons why failure can occur. The first of these is when the market system of voluntary exchange does not work properly for some reason. The reasons include imperfect knowledge, some degree of market power by sellers or buyers, conditions for a natural monopoly to exist, or limitations on the mobility of factors of production.

The second reason why markets may not work properly is when some of the consequences of decisions about resource use don't impact on the decision makers. These unrecognised impacts are called externalities or spillover effects because they are external to the decision process. While externalities can be both positive and negative, it is the negative ones that typically generate market failure issues. Pollution problems, such as when a power station or an airport are located in the middle of residential areas, provide good examples of negative externalities.

The third broad group of reasons relate to the nature of the benefits that occur. Many ‘normal' goods, like an orange, can only be consumed by an individual. However, there are some things, like the signal from a lighthouse that can be consumed simultaneously by a large number of people. These ‘public goods' can also be the source of environmental problems because individuals do not usually want to take responsibility for their use. Where goods are ‘non-rival' (can be consumed by more than one person simultaneously) and ‘non-exclusive' (non-payers can't be excluded from consumption), there is little incentive for private firms to supply the items. This explains why these ‘public goods' such as lighthouses and defence tend to be provided by government.

Government failure problems

There are three broad groups of problems that can be termed as government failure. The first of these are where governments make decisions with inadequate information or do not assess available information with due care. Sometimes governments do not have the right institutional or planning mechanisms to ensure that information gets to the right people. In other cases, the government might fail to collect the right information.

The second group of reasons, known as public choice theory, identifies that the different incentives that people face may not be always in the best interests of society. Bureaucrats might focus on their career opportunities and politicians on being re-elected, rather than serving the interests of wider society.

The third group of reasons relate to processes where the narrow self interests of particular groups in society impose net costs on other groups. This particularly occurs when special interest groups influence the political or bureaucratic process to have decisions made in their interests at the cost to other members of society. This process is known as ‘rent seeking'. Understanding why this can happen can help to identify how to avoid further mistakes.

Cost-benefit analysis

When accountants talk about benefits and costs, they are generally focused on financial flows of actual sums of money. Economists have a much more inclusive view of benefits and costs. A benefit is something that arises from a resource allocation that people approve of, while a cost is a consequence that causes people to disapprove. There are a very large number of impacts arising from most resource allocation issues, including financial costs and benefits, negative environmental impacts (costs), negative social impacts (costs), positive social impacts (benefits), and so on.

The idea behind cost-benefit analysis is to assess the overall outcomes of a project or projected change in environmental assets by adding up all the benefits and all the costs associated with the change. If the net result is positive, then the implication is that the proposed change produces more benefits than costs, and therefore appears worthwhile. To be able to perform a full cost-benefit analysis, there are several very important steps to perform.

• The first of these is to identify all the different outcomes (positive and negative) that might arise from the proposed change. These might include a range of commercial outcomes, environmental impacts, social impacts and other changes that are important.
• The second step is to value these in a common measuring unit so that they can be compared. Money is generally used for this purpose. It is relatively easy to value impacts that have market prices, but specialised techniques are commonly used to value other impacts. It is the economic measures of consumer and producer surpluses associated with each action that needs to be valued.
• The third step is to discount all the impacts back to a common time period, so that the amounts can be summed. This avoids problems arising from costs and benefits occurring in different time periods.
• The fourth step in the process is to add up the benefits and costs so that an estimate of net benefits or costs can be made.
• The fifth step is to perform a sensitivity analysis, particularly for larger projects. This can involve checking what the distribution effects (equity impacts) might be, and how sensitive the outcomes are to different assumptions, such as those about the choice of discount rates.

The advantages of a cost-benefit study is that it attempts to be inclusive in terms of measuring all the outcomes of a proposed action, explicitly values the different impacts and outcomes, and provides a framework where very different outcomes may be assessed against each other. The methodical approach to the assessment of an issue offered in cost benefit analysis helps in the evaluation of issues, and can guard against rent-seeking behaviour by special interest groups.

One of the disadvantages associated with cost-benefit analysis studies is that they can be expensive and time consuming to do properly. As a result, many studies in the past have concentrated on financial costs and benefits, ignoring or setting aside the environmental and social impacts of projects. Another disadvantage is that some project impacts, such as those on recreational, aesthetic, environmental and social factors, are not reflected in markets, and specialised valuation techniques have to be employed to assess them. These can be expensive and time-consuming to perform.

Non Market Valuation

Related market techniques

Related market techniques operate by taking some actual market data on spending by people on goods with environmental or other characteristics, and then isolating out the components of that spending that relates to the characteristic of interest. Because the data is only drawn from actual spending occurrences, where people have actually purchased and used something, these techniques are only capable of estimating direct use and indirect use values. They are not appropriate for estimating non-use values (values that people might hold for something like an endangered species without ever using it).

The main advantages of related market techniques is that they draw on actual transactions that have been made, and thus avoid some of the potential problems of bias that can be associated with the other group of valuation methods, stated preference techniques. There are two main types of related market techniques, being the Travel Cost Method and Hedonic Pricing. A slightly similar field is the use of replacement or averted cost techniques. Here each is described in turn.

Travel cost method
The travel cost method (TCM) is largely used to value the recreation use that people will have for various sites. For example, a National Park might provide a large number of recreational opportunities (hiking, camping, sightseeing) that cannot be directly valued by normal means because people are not directly paying for those benefits. (In contrast, other recreational activities, like going to the movies, can be directly valued from the prices that people pay).

However, people who visit National Parks and similar locations will be incurring a number of incidental costs in their visit. These are mostly tied up with their actual travel expenditure, although some people might also sacrifice working time and other factors to make a visit. By measuring the sacrifices that people make and relating it to the visit rate, analysts can estimate a demand function for the recreation asset, and thus estimate values.

You would expect that the most famous National Parks will not only attract large numbers of visitors, but also visitors who travel large distances to get there. For the recreational areas that are ‘worth seeing', you would expect that people will make larger financial sacrifices. Australians who visit Uluru and Kakadu spend a lot more money than the ones who visit the forest reserve in my neighbourhood. Sites that are popular and attract visitors from large distances will have much higher recreation values than sites which hardly ever have visitors.

There are some difficulties in applying the method. The first major one is apportioning out travel costs where people are visiting more than one site on a trip, while the second major one is deciding whether to include a time factor as a part of trip cost. (If time was a negligible factor in holiday trips, why do people bother to fly?) To help address these issues, the analyst normally collects other information as well as the costs and time taken on travel trips. This might include information such as the purpose of the trip, the prior knowledge held about the site, and the age, sex, and other characteristics of respondents.

There are also some limitations to the travel cost method, aside from its inability to estimate non-use values. It relies on the collection of historical data, and is therefore not necessarily very accurate at predicting recreational values associated with future changes. It also only collects information about actual visitors, and therefore does not assess values from people who enjoy having the opportunity to visit a recreation site, but have not yet made the visit.

Hedonic pricing methods
Hedonic pricing operates by taking sales data for a market such as housing, and identifying statistical differences in prices between houses with different attributes. In some cases, the attributes are geographic and environmental ones, such as impacts of aircraft noise or proximity to parklands areas. In the absence of any other differences between the houses, the property value differences should reflect the value of these characteristics. The collection and analysis of large quantities of data allows the analyst to determine the component of price attached to the various environmental attributes, allowing them to be valued.

Hedonic pricing methods also suffer some weaknesses, apart from being inappropriate to estimate non-use values. Like the Travel Cost Method, they rely on the analysis of transactions carried out in the past, and thus may not be very useful in predicting responses to future changes. They require large amounts of data, both in terms of the number of sales transactions and the details about each property sold. The outcomes are almost always restricted to a particular variation in the environmental attribute (e.g. a certain noise level), making it difficult to extrapolate the data to cover new situations.

Replacement cost and averted cost methods
An alternative to identifying the surrogate value for an item is to identify the cost of replacing or substituting the item or service. For example, the value of water filtration services provided by a forest might be the cost of replacing the service with a mechanical filtration plant. The value of providing clean water could be the averted costs of dealing with the problems of contaminated supplies. There are many cases where the value of an item of infrastructure could be estimated in these ways.

Similar types of approaches are often used in transport fields, where the value of transport infrastructure is often expressed in terms of time saved for general commuters. The time can then be valued at some proportion of the average wage rate to generate an overall value of the improvement.

Stated preference techniques

In stated preference techniques the data is typically collected through some survey format, where people are asked to indicate their preferences between certain hypothetical scenarios. This gives the analyst far more flexibility than can be achieved with related market techniques. Questions can be asked about new potential situations, and the responses are based on peoples' intentions for the future, not on their past actions. As well, the techniques are suitable for the assessment of non-use values as well as a range of use values.

Such flexibility comes at a potential cost. Because these valuation techniques are based on the preferences that people state that they have, rather than on the results of actual behaviour, there is the potential for differences to emerge between stated and actual intentions through the form of various biases. Much of the development work in these stated preference techniques has been focused on the identification and correction of potential biases.

The main stated preference technique that has been in use for more than twenty years is the contingent valuation method (CVM). In more recent times, there has been a new technique developed that is termed choice modelling (CM). These are profiled below.

The contingent valuation method
The contingent valuation method operates by offering people two scenarios, a current status-quo situation and some new proposal. The background to both the status quo and the new proposal is described, together with any costs that might be involved in adopting the new proposal. People are then asked to choose, in some format, which they would prefer. By changing the costs associated with the tradeoff, different proportions choosing between the two options would be expected. This information can then be used to estimate the mean and/or median values where the population will support the tradeoff, and hence, provide a means of valuing the improvement.

For example, a proposal might be to preserve a specific area of bushland that otherwise might be cleared for grazing or mining purposes. A contingent valuation exercise would describe the preservation option, together with the specific cost to the individual, as well as the status quo option (which generally have no additional costs for the individual). Samples of the population are asked whether they would prefer the preservation or status quo option, where the only difference in the questions facing the different samples are the costs involved in the tradeoffs. A statistical analysis of the responses will allow a demand curve to be constructed for the area to be preserved, and from this preservation values can be estimated.

There are a number of guidelines for the construction of successful CVM experiments. There are some difficulties in applying the technique, partly because the successful application will vary according to the case study. This means that the methods used to describe the scenarios, the method of payment chosen (e.g. taxes, donations, price rises) and other factors have to be tailored to the situation of interest. Other problems arise because there is no possibility of verifying results with market-based techniques where non-use values are involved. This makes it difficult to ensure that CVM results are accurate.

Choice modelling
Choice modelling is similar to CVM, but also a bit like hedonic pricing. Instead of just giving people two options to choose from, Choice Modelling involves the selection of a preferred option from more than two. The new options are all similar, but are broken up into the main attributes that make up a possible change. For instance, there might be several options to conserve an area of rainforest, involving different components of area, rare species, views and landscapes, and opportunities to visit. As well, there will be a cost attribute attached to each option. The respondent will pick the combination of these attributes that appeals the most.

By repeating slight variations of this exercise a number of times, and doing it across a number of respondents, a large data set is built about how people tradeoff the attributes involved to make their choices. This can be analysed statistically to identify the tradeoffs between the payment amounts and the changes in the different attributes involved, and hence, derive estimates of value for particular changes.

Bioeconomic modelling

A key task in economics is to link the potential changes in management actions with both changes in enterprise profitability and variations in environmental condition. This can involve the linking of several models for different purposes, a process termed bioeconomic modelling.

Scientists and economists typically use models to make sense of the complexity in the natural world and human systems. Models are a way of predicting the relationships that might exist between important variables. There are a wide range of different approaches from simple mental models to more complex mathematical ones. Sometimes models might seem a little unrealistic, because it is normal to concentrate only on the factors that are important to predict the outcome of interest. This keeps models simple and concentrated, and makes them easier to understand.

Bioeconomic models normally involve at least three key stages. The first stage is a model of the production process. In agricultural applications, this might link rainfall factors and farm inputs with levels of crop or pasture production. Examples are APSIM models for dryland farming, OZCOT models for cotton production, and GRASP models for pasture production.

A second stage is to link these with models of impacts on natural resources or environmental condition. For example, an irrigation model might be combined with models of hydrological flows (IQQM) and sediment movement (SEDNET). Some models such as GRASP combine both the first and second stages, so that the environmental consequences of the production process are part of the model outputs.

The third stage is to predict the economic outputs where the level of inputs and production might be variables. In some cases there is a focus on the variable profit (gross margin) before fixed costs are considered. The resulting models help to understand how changes in management practices flow through to both environmental outputs and economic incentives.

Bioeconomic modelling has become a powerful tool in analysing natural resource management issues such as the operation of fishing stocks, and there are developing applications in agricultural and pastoral systems.

Multicriteria analysis

Multicriteria analysis (MCA) is essentially a process where weights for a number of separate criteria can be combined in a single index. A typical application of MCA would involve experts and community leaders being asked to give scores for a proposal across a number of evaluation categories. The scores are then condensed to a single number using some internal weighting criteria. An example of the steps involved is shown in the table below.

The MCA approach has some benefits in terms of political economy, and achieving the goal of trying to condense a range of complex information into a single index number. The political economy benefits are that it provides a process where both experts and community members can be involved, and can provide feedback mechanisms where participants can see the outcomes they have generated. The consolidation benefits are that the goal of an MCA is to distil a mass of complex information into series of summary index numbers, hence providing a framework where the viewpoints of different stakeholders can be considered and evaluated against each other.

It is the scoring and evaluation steps of the MCA process that on the one hand is most appealing, and on the other, are the source of most weaknesses. The three key process steps of the MCA involve the establishment of some criteria for assessing each of the key alternatives, the setting of some weights to determine what contribution each criteria make to the final summary index, and the actual evaluation of each criteria. The appeal of the technique is that the process for setting the criteria, establishing the weights and then doing the evaluation is intuitively easy to understand. Typically, experts are used to identify the criteria to be used and to assign the weightings, while stakeholders or community members are used to score each criteria and provide the raw data to input into the process.

The key weaknesses of the technique are that it is very open to manipulation in the design stages, and stakeholders or community members typically do not have input into how the weightings are set. This means that there can be some subjectivity in the way that the different criteria are combined to form an index number, and that the intensity of preferences are not always captured very well in the MCA process. The latter weakness limits the usefulness of MCA results, as they can not be transferred into other economic analysis frameworks. The technique is not as well grounded in economic theory as cost-benefit analysis.

Impact assessment techniques

An Economic Impact Assessment is used to identify where policy options may impact on different groups in society, without making any judgement about whether the policy options create net benefits. Policy makers might check that their decisions do not have major negative impacts on groups, or decide between options based on their assessment of the impacts.  From an economics perspective, this approach has a weaker theoretical foundation than cost benefit analysis, but it does have advantages in terms of identifying the different impacts explicitly. It is often used to identify groups that may be disadvantaged so that remedial or compensatory strategies can be developed.  It is popular in the political process, and the conduct of impact assessments, such as an Environmental Impact Assessment, is now mandatory for many major projects.

Both economic and social impact assessment techniques share a common first stage where demographic and other background information about the case study of interest is collected.  This can involve a situational analysis of the local and regional areas affected, a description of the project proposal, and some modelling about employment, population and other factors. A focus of most economic impact assessment studies is to identify the changed income and expenditure flows and employment levels that are associated with a project.

Impact assessment is not always easy to perform because the injection of expenditure into an economy can be expected to generate ‘ripple' effects, where there are subsequent rounds of economic activity. Initial expenditure flows become revenue and income to the people and firms providing labour, goods and services to the project operator. Those people and firms can then spend that revenue and income, creating secondary economic impacts. In this way, an initial injection of expenditure can be multiplied into a larger economic effect on a region.

These impacts can be estimated with varying levels of sophistication.  The choice about the accuracy of the economic impact assessment depends on the need for accuracy of results, the significance of the event under study and the time and resources available for the impact measurement.  There is a range of techniques available for economic impact assessment.  These include (in rough order of accuracy)

• guesses or direct estimates of the direct and indirect impacts,
• simplistic (rough) estimates of such impacts using basic mulitipliers,
• Input-Output analysis,
• more complex models of regional economic activity.

Cost effectiveness analysis

Cost effectiveness analysis is a commonly employed technique. It is often favoured by governments over cost benefit analysis because it leaves many of the harder issues and major decisions firmly within the political process. With cost-effectiveness analysis, the policy maker decides what outcomes are needed, and then asks the economist for advice about the most efficient way of meeting those outcomes. In essence, the task is to assess only the costs of different options to meet a certain outcome. The benefits of achieving the outcome are not quantified.

There are a number of areas where there are potential efficiencies in setting standards through a regulatory process, and then asking about the best ways of meeting those standards. Examples of these approaches are quarantine standards, medical treatments, traffic rules and plant diseases, where certain regulatory standards are set. In these cases, the key analytical task is often to search for appropriate ways of meeting desired outcomes.

Cost effectiveness analysis is particularly useful when the non-market valuation studies for a cost benefit analysis are not available. In this situation, the decisions about what the standard of environmental or social conditions will be can be set in the political process, and then other information about costs and benefits can be used to find the best way of meeting those standards.  In this sense, cost effectiveness analysis is a subset of cost benefit analysis, simply evaluating one set option from a wider pool. Not surprisingly, the steps involved in cost effectiveness analysis are similar to those outlined in cost benefit analysis:

• Identify the relevant costs associated with different options to meet a desired outcome,
• Value the impacts in monetary terms,
• Discount values to a set time period,
• Estimate the net costs of each option, and select most cost-effective one,
• Conduct sensitivity analysis.

Cost effectiveness analysis can also be used to evaluate a number of regulatory and other mechanisms used to achieve desired outcomes, including environmental ones. In these cases, the analysis framework can be used to test if current mechanisms to minimise environmental harms are really that effective. There are a number of regulatory frameworks and government policies that can have perverse outcomes and generate environmental losses. Checking to see if the current mix of regulations, institutions and incentives is the best way of achieving something is an important role for economic analysis.

Market based instruments

Market based instruments (MBIs) refer to the use of market-like mechanisms by government to generate outcomes that governments would otherwise provide. Essentially they refer to options that governments have to create better incentives for people and firms to generate desirable environmental and social outcomes.

There are a number of ways in which market-based instruments can be used to manage natural resources. Taxes, subsidies, market premiums and insurance bonds are types that have been applied in the past. Cap and permit trades, auctions/tenders for covenants or agreements, mitigation banking and transferable development rights are developing forms that have rarely been applied to natural resource management in Australia. Here, these types of market-based instruments are described briefly.

Taxes and subsidies
The negative social consequences of commercial activities can be signalled by the use of taxes. This leaves people with the freedom of choice, but provides a dis‑incentive for use or consumption. Taxes on petrol and cigarettes provide examples of this approach. Subsidies are the flip side, and can be applied where there are positive social consequences of actions. Subsidies and tax exemptions for items like solar hot water systems and rainwater tanks in new housing developments provide examples of this mechanism.

There is developing interest in the use of price-based instruments to deal with pollution and congestion problems. An example of a tax on a pollution item is the proposals for carbon taxes to reduce emissions of greenhouse gases. The key advantages of a carbon tax are that it may be relatively easy to apply to a number of source emissions (e.g. power stations and fuel distributors), and that the market mechanism means that individual consumers will automatically adjust consumption to suit their circumstances and budgets. The actual adjustments that people make will depend on a number of factors, essentially reflecting the responsiveness of supply and demand to changes in price and the time scale involved.

There are several difficulties in applying taxes. Because they are normally imposed by governments at federal or state level, they are usually unsuited for accounting for regional variations. For example, the amount of tax needed to change behaviour may vary between regions depending on wealth, enterprise viability and other factors, but a uniform tax rate may be applied across the state or nationally.

The other major problem with taxes is the amount of detailed knowledge needed by government planners to be able to set levels effectively. Taxes are also difficult to implement because they have negative connotations for a community, while subsidies are limited by constraints on public spending. The combination of these factors means that the use of simplistic taxes and subsidies to address environmental issues is unlikely in the longer term. Instead, other market‑based instruments that provide better feedback about the real costs of making tradeoffs between production and protection options are likely to be pursued.

Auctions and tenders
Auctions and tenders are a way of using competitive processes to generate better returns for public spending. There are two main ways of classifying the use of these mechanisms. The first is where auctions and tenders are used to minimise government expenditure on essentially private items. For example, tenders are routinely called for providing items like mail services and cleaning contracts.

The second case is where auctions and tenders are used to allocate funding for public goods. Many research and grants monies are already allocated through a competitive tendering process. A key focus is where auctions and tenders are used as a way of purchasing environmental services.

For example, tenders might be called to provide a certain area of forest for catchment protection/water quality purposes, or to maintain a rainforest or woodland area for habitat for species protection. The major advantage about allocating funding in this form is that the opportunity costs for landholders to tradeoff production against protection become transparent. When the tendering process is ongoing (e.g. through the annual allocation of funding), variations in those tradeoffs over time become more apparent.

Cap and trade arrangements
Cap and trade mechanisms are some of the better known mechanisms for using market-based incentives to manage natural resources. Pollution permit markets are forms of cap and trade arrangements, where the total amount of pollution that can be created is fixed (capped), and then allocated between market participants. Firms that wish to increase pollution levels (e.g. by building a new factory) can only do so by purchasing pollution permits from elsewhere. The price that is bid for permits provides incentives for other firms to reduce pollution and sell their permits.

Examples of cap and trade programs include a number of programs in the United States to improve air quality, in particular focusing on sulphur dioxide and nitrogen emissions. Emitting firms are given ‘permits to pollute' that are set at a certain cap below current or potential emission levels. Firms wishing to maintain or expand emissions have to purchase permits from other firms, and the resulting market prices provide strong incentives to reduce emissions. High prices mean firms have incentives to reduce emissions so they can avoid purchasing permits, or even be able to sell excess ones.

Baseline and credit
A variation on ‘cap and trade' programs is ‘baseline and credit' programs where a baseline level of environmental conditions is established for a firm, and improvements on this level generate environmental credits. The base is often determined by existing regulations. Firms that can gain environmental credits may be able to sell them to other firms that wish to exceed the baseline, or to ‘bank' them in the event that they exceed their own baseline in some future time period. These schemes are rarely as formalised as the ‘cap and trade' programs, and are better viewed as ways of providing firms with some flexibility in the way that they meet environmental regulations. They represent an improvement on the regulatory approach because they provide firms with incentives to do more than meet the baseline regulatory levels.

Offsets and credits
Various forms of offset and credit schemes exist which provide mechanisms for transferring development opportunities or environmental impacts across locations, time or firms. Some of the most well-known are carbon offset schemes which encourage opportunities for carbon sequestration (e.g. in forestry plantations) to be used as offsets against existing or increased emissions from industrial sources. Because the costs of sequestering carbon in forests are much lower than reducing emissions in industrial practices, there are major opportunities for trade to occur. Other forms of offsets include ‘bubble programs', where a small number of firms or sites have to negotiate to meet an overall target.

Mitigation banking
Mitigation banking describes types of offsets where losses in environmental conditions at a site are offset (mitigated) by protecting or enhancing a proportion of the environmental resource elsewhere. While these forms of offsets became common at particular development sites (e.g. wetlands and mining sites), most interest has focused on the banking concept where protection takes place at one or two central sites. Protecting a number of small sites is often not very efficient compared to protecting the same area in a small number of large sites. A conservation bank is an area of habitat that is managed for natural resource values, and used to mitigate against losses from development in other locations.

Under mitigation banking, development with environmental losses is allowed if the developer ensures that other habitat is preserved in place of the area lost. Usually the habitat to be preserved is similar and located in the same region as the areas lost. Instead of each developer preserving particular areas, specialist groups provide conservation banks and developers pay the groups for the relevant amount of offset. Mitigation banking is often associated with concepts of ‘no net loss' of natural habitat, particularly in relation to urban or industrial developments.

Transferable development rights
Other forms of offsets that have already become established in Australia are transferable development rights. These are often established under planning schemes with the intention of capping overall development (e.g. number of high-rise buildings or areas of vegetation to be conserved). Transferable development rights allow for the actual areas to be developed to be transferred between owners so that some form of flexibility enters through market transactions.