Market Based InstrumentsWhat, why and how…

Andrea La NauzeSenior Economist

Department of Sustainability & Environment

What is a market based instrument (MBI)?

A market based instrument…

• seeks to mimic the attractive properties of a market to achieve an

environmental outcome.

• works by re-aligning incentives to achieve the desired outcome efficiently

and effectively.

• can take a range of forms including:

• Tenders/procurement auctions

• Offsets and permit trading schemes

• Taxes and subsidies

MBIs have been implemented in Victoria for a range of

environmental/natural resource problems

Why market based instruments?

- Information: how much benefit/cost?

- Reveal information on cost and benefit

- Compare across projects/scales

- Efficiency/cost effectiveness: how to get the most

benefit/cost?

- Internalise externalities

- Provide incentives to minimise cost

- Greatest impact for lowest cost

.

Example – revealing information

Q1 Q3Q2 Quantity of environmental

benefits

Cost/price of environmental

benefits

Supply 3

Supply 2 Supply 1

p3

p2

p3

Why market based instruments?

- Heterogeneity

- Exploit differences in costs, benefits & preferences

- Intervention where it is most effective

- Coordination

- Achieve outcomes in presence of thresholds

- Take advantage of potential synergies

- Coordinate joint production of multiple goods and services

Design

A (very) simplified process for environmental market design:

Diagnose1

2

Test

Implement

Monitor & Evaluate

3

4

5

1 Diagnosing the economic and environmental problem

Typical market

failures:

• Public goods

• Externalities

Typical (economic) characteristics:

• Hidden information (cost)

• Hidden actions (moral hazard)

• Heterogeneous costs and benefits

• Lumpy goods

• Synergies

Understand the

characteristics of the

problem, the context and

incentives.

Formulate and clarify

the objective.

Identify specific market failure and

the source of the environmental

problem.

Diagnose

Possible objectives:

• Achieve a target

• Maximise outcomes

• Net gain/no net loss

• Maximise revenue

• Allocate efficiently

2 Designing a market – mechanism design

Design a market to

achieve the objective

Define actions and

obligations associated

with that unit.

Quantify or compare outcomes: define

a ‘benefit’ metric, specify a

good/unit or credit.

Design

Examples

• Tonne of carbon

• Environmental

benefit unit (metric)

• License

Examples

• Management

actions

• Production

methods

• Permitted actions

Examples

• Procurement or

selling auctions

(different formats,

rules)

• Electronic

exchanges/smart

markets

What are the characteristics of the

participants?

How many are there?

What are their objectives/incentives?

Are their different types of participants?

What information do they hold?

What property rights are there?

What type of institution will get the best outcome?

Is the market a once off or ongoing?

For what reasons may trade/participation be restrained?

What information should be provided to participants?

How long should the market run for?

What mechanisms can be built in to reduce the risk of poor

outcomes?

What else might affect the incentives of

participants and the outcome?

Is there a possibility that perverse outcomes will

occur?

Where are there interrelationships with other

policies, markets and institutions?

Questions that inform the design of a market:

3 Testing – experimental economics & field trials

Test the design using experiments and field trials.

Test

Things to test:

• does the institution give

participants the right

incentives?

• are instructions easily

understood?

• is the outcome of the

market efficient?

Economic experiments:

Evaluate theoretical

predictions of economic

behaviour by using

controlled, scientifically

designed tests

The University of Melbourne experimental economics The University of Melbourne experimental economics

laboratorylaboratory

Run the marketOrganise site visits,

provide support to

participants.

Determine eligibility,

compliance/ a target

group and communications.

4 Implementation

Create legal and other

institutional frameworks for

ongoing monitoring, compliance and

regulation.

Implement

Typically:

• Terms &

conditions

• Contracts

• Rules of

exchange/trade

Eligibility can be:

• Geographic

• Sectoral

• Size based

More complex

markets may

require

training/extension.

5 Monitoring & Evaluation

Evaluate the metric,

monitor contracts and

outcomes.

Evaluate the performanceof the institution.

Monitor & Evaluate

Evaluate market

design:

• Was the market

competitive?

• Was the format

appropriate?

• Was their

heterogeneity?

Monitoring contracts:

• Have contracts been

adhered to?

• Have outcomes

been achieved?

Market design for stormwater retrofit

Diagnose1

1. Urban development causes an externality (social environmental cost).

2. Households have low incentives to undertake their own retrofit.

3. Households understand their own costs/preferences for retro-fit.

4. LSC understand costs of streetscape retrofit.

5. Objective: obtain cost effective retrofit for LSC.

Market design for stormwater retrofit

Design2

1. Use an environmental benefit (EB) metric to compare benefits.

2. Estimate costs of streetscape works.

3. Use a (uniform price) auction to reveal household costs/preferences.

4. Allow households to select from various tank/rain garden options.

MK I: Use the cost of streetscape works to formulate a reserve price to ensure

cost-effectiveness.

MK II: Streetscape and households ‘compete’ for funding.

Discriminatory vs Uniform price

EBEB

“My best strategy is to guess the cut-off point and

bid at that level.”“My best strategy is to reveal the true information and if

the price is above my ask, I will even be better off.”

Successful bidders are paid what they asked for Successful bidders are paid the bid of the first

unsuccessful bidder.

Bids submitted

(=True value)

Budget$/EBU

Rent seeking

True value

Bids submitted

and paid

Budget$/EBU

Surplus paid

Market design for stormwater retrofit

Market design for stormwater retrofit

Test3

1. Laboratory experiments tested the uniform price auction.

a. Outcomes were efficient

b. An online tool assisted bidders to make ‘efficient’ selections

Market design for stormwater retrofit

Implement3

$1000

$2000

$3000

0

Bid

0 1 2 3 4 5 6 7 8 9 10

Environmental Benefit (EB)

Uniform price = reserve price

Second phase offer

First phase offer

Over-bidding

Did people understand the format?

Market design for stormwater retrofit

Evaluate4

Stormwater Tender Mk II – results

Design2

Ascending Price Auction

1. Participants are notified of a (low) starting price (per EBU).

2. Expressions of interest are sought at this price.

3. Properties are inspected and EB units verified.

4. Households choose to bid for EB units at this price.

5. If the available supply does not exhaust the budget, bidders are deemed

successful.

6. If there is remaining budget, the price is increased.

7. Participants are notified of the new price.

8. Expressions of interest and bids sought at this price.

9. Steps 5-8 continue until either:

• the budget is exhausted

• a reserve price is reached

• the activity/stopping rule is breached.

Stormwater Tender Mk II – results

EB Supplied from Private and Public Sources

36

81

81

100

115

133

133

133

133

182

353

407

486

495

516

578

0 100 200 300 400 500 600 700 800

1,000

1,500

1,600

2,000

2,250

2,500

3,509

4,346

5,765

Pri

ce

($E

B)

EB

EB Supplied (Private)

EB Supplied (Public)

Implement4

Stormwater Tender Mk II – results

Implement4

Auction results – Mk I vs Mk II

Which auction performed the best?

• Round 1 price = $2839, 131 EB (private)

• Round 2 price = $2500, 134 EB (private)

• EB unit has changed (average impact -45% successful Round 1 EB)

Round 2 more competitive than Round 1?

– Ascending price format: sends signals to participants.

– No regrets strategy/certainty valuable to participants.

Evaluate5

Alternative policy responses

Regulation and rebates

Council works

• Direct public provision

• Requires economies of scale

• May not be cost effective.

• One size fits all: ignores heterogeneity.

• No coordination.

• No cost revelation.

Disadvantages

Design and implementation can be costly upfront:

• Metric design:

- requires both scientific and economic expertise

• Economic design

- specific economic expertise

• Implementation

- comms, stakeholder mgt, field staff and training

- site visits (extension) are expensive but may improve measurement

• Monitoring/enforcement (field staff, contracts)

� Payoff is efficiency

Tips

Benefit side: metrics

• metrics should summarise both outcomes and preferences

• rely on data: site or desktop (collection is costly)

• are about tradeoffs between outcomes

• can be coarse or fine, simple or complex

• poor design can result in zero environmental benefit

Cost side: market design

One size doesn’t fit all!

• Different economic problems warrant different

solutions; as do different environmental problems.

• Types of participants, objectives, existing property

rights, information, regulation, transaction costs will

affect design.

Tips

Pitfalls

Implementation:

• lack of participation � lack of competition

• complexity for participants can be costly (transaction costs)

Competing objectives

• markets can be designed to achieve multiple/competing objectives but:

- can compromise design

- often means compromise on outcomes

Pitfalls

Contracts: securing outcomes

• tradeoffs between incentives (strong contracts) and costs

• weak contracts can compromise outcomes

• monitoring and enforcement is part of contract design

There is plenty of experience and expertise in Victoria:

come talk to us.

Economic Policy Branch

Department of Sustainability & Environment