As set out in Section 2.2, markets for forest environmental services have captured the imagination of policy-makers seeking new tools to encourage improved forest management. However, few know how to create or manage markets and there is little empirical evidence indicating how markets impact on welfare and poverty. This report seeks to shed light on these issues through a global review of market creation. To help guide this review, a framework for analysis is developed below, building on lessons from New Institutional Economics and the literature on forest-poverty relationships.
2.4.1 What form do markets take?
Market structures vary between locations and goods. Economists concerned with efficiency have traditionally been preoccupied with the degree of market competition. However, where we are examining markets that are dynamic, involve varied participation and that are embedded in a wider institutional framework, it is important for us to examine an array of features. Seven features are used in this study to distinguish between different market forms: • The commodity. The key ingredient in any market is the commodity that is
being bought and sold.
• Characteristics of participants. Participants include those demanding environmental services, those supplying services and intermediaries involved in facilitating transactions. Participants may include the private sector, the public sector, non-government sector, civil society or a combination.
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• Level of competition. The level of competition determines the extent to which individual market players can influence prices – often referred to as market power. Conventionally we measure competitiveness by the number of players in a market: the fewer the players (e.g. in the case of monopolies and monopsonies), the greater each participant’s market power and the less competitive the market. Competitive markets involve several participants. However, it is critical to distinguish between explicit and effective
competition. Even where markets are highly concentrated, if there is a credible threat of entry by competitors the market may be competitive.
• Payment mechanism. Several options exist for transferring funds from buyers to sellers, including direct negotiation, broker-based markets, auction systems, and exchange-based markets.
• Geographical extent of trading. Trades may be local, national, regional or international depending on the market and its location vis a vispolitical boundaries.
• Level of maturity.Market maturity may be defined in a number of ways. Four useful criteria include: the time period since transactions were first initiated (i.e. the age of the market), the degree of price discovery attained to date, market participation and liquidity, and the level of sophistication in the payment mechanism employed.
• Nested nature. Markets evolve in a context. Not only may markets replace existing institutional arrangements, but they build on institutional arrangements which will influence the form they take. It is important to understand this context and the nature of inter-institutional relationships. These features are not independent and a change in one is likely to be linked to changes in others. For instance, immature markets are likely to have higher levels of public sector participation (reflecting government efforts to promote institutional development), simpler payment mechanisms and lower levels of competition than fully established markets. As competition picks up,
governments are likely to become less interventionist and payment mechanisms more sophisticated.
2.4.2 Why do markets evolve?
As with all institutions, markets evolve in response to changing incentives embodied in the institutional framework. North (1990) highlights two major sources of change: altering individual preferences and changing relative prices and costs. In other words, changing demand- and supply-side factors. In the case of market development for forest environmental services, drivers may be split between those that increase demand and willingness to pay for environmental services; and those that increase investment and supply of these services. Relating this back to public good features (see Section 2.1), increased demand should raise rivalry, while supply side advances should increase excludability. Together these factors move environmental services towards private goods. The key question is, thus, what are the major forces driving changes in willingness to pay and supply? In this study, we attempt to shed light
on underlying drivers for market development in the forest environmental service sector.
2.4.3 How do markets evolve?
Institutional development is, in the main, a slow and iterative process. New institutions evolve out of the old, and this process depends on economic agents recognising the need for change and acting on this knowledge. Imperfect information, uncertainty and limited computation abilities mean it takes time for change to take place. Moreover, because individuals drive institutional change, the path taken will be intimately linked to the existing power structure. As North (1995) puts it:
“Institutions are not necessarily or even usually created to be socially efficient; rather they… are created to serve the interests of those with the bargaining power to create new rules.” (p. 20)
The importance of power relations in determining institutional development helps to explain the slow nature of change. Where it is the powerful that promote the development of a particular arrangement, these individuals have a vested interest in maintaining the status quo. Only where these incentives alter and agents perceive that they may improve their wellbeing through a
modification in institutional arrangements, will change occur.
The source of change, as noted in Section 2.4.2, could be due to a changing cost and price structure (e.g. due to technological change) or changing preferences. For these stimuli to be taken on board, however, organisations must learn. Institutional change depends on the speed and quality of organisation learning. Consequently, welfare-enhancing institutional change depends on incentives for high-quality learning. Competition is likely to be an important ingredient in such an incentive framework.
As already stressed, markets evolve to form part of an array of existing formal and informal institutional arrangements. Different combinations of institutions will produce different market performance. Understanding the nature of institutional interactions, and identifying those combinations that are mutually supportive, as opposed to competitive, is an important part of improving our understanding of the process of market evolution.
While emphasis is placed on the gradual, iterative nature of institutional change, “revolutions” may occur where change cannot be accommodated within the existing structure (North, 1995). This may itself be linked to the emergence of new constituencies of players who are dissatisfied with existing arrangements. However, we cannot assume that a sudden change in formal rules will lead to changes in informal institutions. Informal rules tend to be slower to change and where they contradict formal rules, they may render the latter meaningless. With respect to market development, this point warns us against approaches that focus simply on changing formal rules, e.g. property rights, without any effort to promote change in informal routines/conventions.
The state often plays a central role in orchestrating change. With particular reference to market development in transitional economies, both Fleck (1999) and Nee (1999) highlight the important function of governments in building a constituency of supporters for market development, both inside and outside government. While this process requires time and confidence building, where governments fail reforms may be derailed.
In addition to building political support for market development, it is the responsibility of governments to establish the market infrastructure, e.g. legal, enforcement and judicial institutions (Nee, 1999). These measures are critical for lowering transaction costs and making market exchange attractive. In sum, understanding the process of market development for forest environmental services requires an examination of:
• the stages in market development – changes in formal and informal rules; • institutional nesting – the changing network of complementary and
competitive institutions; and
• stakeholder roles – their incentives for change, the distribution of power and the key proponents.
2.4.4 What do markets mean for welfare?
With market development driven by certain individuals and/or organisations, there can be no presumption that markets will improve wider social welfare. It is critical that impacts are measured. Social cost-benefit analysis offers a tool to guide such calculations.
In undertaking a cost-benefit analysis market arrangements must be set against the next best arrangement for governing the supply of forest environmental services. Often the most realistic alternative will be that currently in use. The estimation of net benefits of market arrangements involves the calculation of the costs and benefits that they will bring forth over time compared to existing institutional arrangements. These costs and benefits are converted into present values using a discount rate and then the difference between the two, or the net present value of markets (NPVm), is calculated. The NPV is expressed
mathematically below.
NPVm = ∑{{(Bet+ Bst+ Bnt) – (Cet+ Cst+ Cnt+ TCt)} / (1 + r)t}
where
Bet, Cetare the economic benefits and costs in year t
Bst, Cstare the social benefits and costs in year t
Bnt, Cntare the environmental benefits and costs in year t
TCtis the transaction cost in year t
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A NPV greater than zero suggests markets will have a beneficial impact on welfare, while a NPV less than zero suggests a project will diminish it. Before a cost-benefit analysis can be undertaken, information needs to be gathered on the costs and benefits associated with the new institutional arrangement. These costs and benefits are normally split into three groups: • Economiccosts and benefits relate to changes in output, income and
employment.
• Socialcosts and benefits include impacts not captured in an economic evaluation, such as impacts on health and education.
• Environmentalcosts and benefits include impacts on natural resource assets and flows.
Where impacts cannot be expressed in financial terms, they should be described quantitatively or qualitatively to ensure they are not overlooked in a final evaluation.
A major set of costs that is often overlooked is the transaction costs associated with the creation and operation of markets. Costs of market creation include, amongst other things, defining property rights, setting up exchange systems, educating market participants, establishing monitoring and enforcement mechanisms and building confidence in the system. Market operation includes costs of information gathering, negotiation, contract formulation, monitoring and enforcement. Ostrom et al(1993) provide the following breakdown of market operational costs:
• Ex-antecosts associated with obtaining relevant information needed to plan, negotiating agreements, making side-payments to gain agreement and communicating.
• Ex-postcosts associated with monitoring performance, sanctioning and governance, re-negotiation when the original contract is unsatisfactory. • Strategic costs associated with shirking, free-riding and corruption. Strategic
costs are associated with both ex-anteand ex-posttransaction costs. Transaction costs are not only financial. Time and other in-kind contributions should be measured and, wherever possible, monetary values of these inputs calculated.
2.4.5 What do markets mean for the poor?
Social cost-benefit analysis helps to determine the aggregate impact of markets on welfare. In this paper we are equally concerned with the distribution of costs and benefits and, in particular, implications for the poor. Focused cost-benefit analysis for the poor will go some way to uncovering how markets affect this group, but should be supplemented with measures of intangible impacts on livelihoods, e.g. increased security or social institution building.
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An asset-based approach helps to focus attention on impacts on assets that underpin livelihood strategies of poor communities. In addition to the five assets highlighted by DFID’s original sustainable livelihood framework (i.e. natural, physical, human, social and financial – see Figure 5, Section 2.3.2), a strong case may be made for evaluating impacts for political capital. Political capital determines peoples’ ability to influence decision-making and is a critical component of individuals’ armoury of assets that underpins wellbeing. Some of the indicators will be qualitative, while others may be quantifiable.
2.4.6 Constraints to market development?
Constraints to market development may be linked to specific biophysical features, characteristics of demand and supply, capacity for implementation, etc. By drawing on lessons from the above, it should be possible to identify key factors that are hindering market creation. Insights should also merge on specific constraints facing poor individuals and groups in accessing markets.