Hardin, Coase and the Amazon

por The Winners
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Article writer by Eduardo Marson, Businessman, former CEO of Airbus Group Brasil, partner at Global Forest Bond
Artur Villela Ferreira, Researcher at FGV’s Infrastructure and Environmental Solutions Economics Group, partner at Global Forest Bond

Brazil is constantly remembered for its natural resources. Beautiful beaches, rivers that guarantee the largest supply of fresh water in the world and, in particular, some of the most important and diverse biomes, such as the Amazon rainforest.

Having that much natural resources, it was to be expected that nature would be seen as a great provider, the basis for the country´s economic development.

But that is not the case.

Native biomes are seen as an obstacle to economic growth. We classify the land as productive, with crops and cattle, and unproductive, which has “only” forest. Where does this separation come from? 

Obviously, we should not be naive to consider that rural producers are unaware of the importance of ecosystem services provided by native forests. From smallholders in family farming to large agribusiness industries, they understand that the reduction of the forest area has an impact on the climate, rainfall and soil degradation.

They also know that both buyers of agribusiness products and large institutional investors are increasingly demanding regarding the observance of sustainable practices in the value chain.

Why, then, do we continue to treat our biomes as “unproductive”?

The answer may lie in the 1968 article “The Tragedy of the Commons”, published by Garrett Hardin in Science magazine. In the article, Hardin used the creation of sheep in common land in England as a background to study what happens with resources in situations where there is no payment for their use. Imagine a pasture used by ten families and that supports a hundred sheep grazing, ten per family.

If all herders take ten or fewer sheep to graze, there is no problem. The dilemma arises when, for whatever reason, this limit is crossed. Those “smart” guys who took more than ten sheep to graze receive the full marginal benefit of the extra sheep, and the entire population equally shares the costs of pasture degradation, that is, privatized profit and collective loss.

From that point on, a race for resources begins in which everyone is encouraged to take as many sheep as possible next year to make the most of the degrading pasture. Obviously, the result is the system’s failure in the long run.

Currently, we live in a global tragedy of the commons: native biomes, including our beautiful Amazon and Atlantic forests, provide essential services for all mankind, such as carbon capture and storage, contribution to the water cycle, climate regulation, protection of fauna and flora, among several others. Despite this, the owners of these lands, public or private, do not receive payment for these services.

Without a price signal, an incentive is created for them to replace the forests on their land with crops or pasture. Each certainly understands the importance of biomes, but without payment for their preservation, landowners have no incentive to conserve them for the benefit of all.

As with Hardin’s pastors, this situation is not sustainable. Humanity currently consumes 75% more natural resources per year than natural systems are capable of regenerating. This “environmental overdraft”, caused mainly by burning fossil fuels and deforesting biomes, has been used since the early 1970s! Fifty years of operation in the red. And the bill is due.

The issue of managing ecosystem services should be extremely important for Brazil. The country has the largest “environmental surplus” in the world, calculated as the difference between bioproductivity, the ability of our ecosystems to generate resources annually, and ecological footprint, the total resource consumption of productive systems. 

In July 2019, amid fires in the Amazon Forest which made headlines worldwide, Economy Minister Paulo Guedes argued that Brazil should be remunerated for property rights to oxygen produced in the Amazon Forest.

Although the minister has an outdated notion of the Amazon as the “lungs of the world”, Guedes is right on the other hand: the forest generates lots of resources that are used in Brazil and in the World, without any financial compensation.

Solving the problem of overconsumption of resources generated by biomes, such as the Amazon Forest, is not as simple as surrounding pastures for sheep. Despite this, Guedes is correct in putting the definition of property rights as a good first step.

It is necessary to create a spread understanding that forests stores carbon, regulate the climate, contribute to the water cycle, protect biodiversity, among many other services, and that these services have value, so they must be remunerated. 

By allocating landowners with the right to environmental services provided by the maintenance of the biomes on their lands and enabling them to negotiate these rights with resource-consuming industries, it is possible to create incentives to end or even reverse the current situation of growing deforestation .

In 1960, Briton Ronald Coase published “The Problem of Social Cost”, an article that would lead him to win the Nobel Prize in economics three decades later. The article is the basis for the socalled Coase Theorem, which indicates the way to deal with markets where there are externalities – in this case, positive ones – such as forest preservation.

In economics, externalities are the side effects of a decision on those who have not participated in it. There is an externality when there are consequences for third parties that are not taken into account by the decision maker.

Coase argues that it is possible to achieve the best solution for all parties involved, the “optimal allocation of resources”, through voluntary exchanges between economic agents.

For this, in addition to the clear definition of property rights, requirements are that everyone has the same information (low information asymmetry) and that efficient trading instruments (low transaction cost) are used. Any alternative for the remuneration of ecosystem services provided for the preservation of biomes must aim to gather all these characteristics.

The low information asymmetry allows all people and companies to be on the same page regarding the volume of ecosystem services provided by an area of preserved forest. In this way, consumers are able to identify the level of impact of what they consume and what companies are doing to guarantee the replacement of the natural resources they use.

Likewise, an “environmental exchange”, as Minister Guedes suggested, needs financial instruments that enable the efficient trade of rights over environmental services. This is the theoretical background behind the creation of Global Forest Bond, a Brazilian company that developed an innovative methodology for the profitability of ecosystem services.

The methodology is based on the fact that forest conservation is an economic activity, recognized by Brazil´s Statistics Bureau (IBGE), within agricultural activities. In this way, it is possible to use agribusiness financial securities, such as the Rural Product Note (CPR) and the Agribusiness Credit Rights Assignment (CDCA) to trade the rights over ecosystem services.

This ensures that rural landowners, private or public, receive for the services provided by the biomes under their responsibility. Since they are traditional instruments in the financial securities market, forest preservation assets can be traded on stock exchanges, being accessible to all economic agents and guaranteeing a very low transaction cost.

In addition, we have developed an electronic platform that concentrates all the data from the forest inventories that backs the bonds. Thus, it is clear to all parties involved the characteristics of the preserved areas and their contribution in terms of ecosystem services, at the local and global scales.

Blockchain traceability enables companies that purchase these assets to offset their use of resources to print QRCodes in their products, which can be audited by customers and environmental organizations.

Finally, the bonds are issued annually, after one year of preservation has been proven. This ensures that only services already performed are marketed, which is of paramount importance for investors, who do not need to take the risk of nonperformance of the assets.

There is no sale of future services and the risk of preservation in the following years rests entirely with the landowner: if he is not able to maintain the biome on his land, he will not be able to issue new bonds in the following year. In this way, the incentive for future preservation rests on the income that will come from maintaining an untouched forest for another year. With this, we can offer all characteristics necessary for a good market for ecosystem services.

Brazil is the country with the greatest environmental potential in the World. The latest report by the Intergovernmental Panel on Biodiversity and Ecosystem Services (IPBES) estimates the value of Brazilian ecosystem services in US $ 3.6 trillion, more than the country’s entire GDP! Building solutions that allow the best use of those that are perhaps the greatest Brazilian wealth depends on efforts that combine best practices in finance, economics and environmental science.

It is more than urgent for humanity to face the issue of the irrational use of resources, in a pragmatic and technical way, without hiding or running away from the facts. In this scenario, Brazil needs to choose whether to lead the transition to a new economy or just be an observer of history.

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