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The use of markets to increase private investment in environmental 

stewardship. (Economic research report (United States. Dept. of 

Agriculture. Economic Research Service) ; no. 64)

1. Agricultural pollution—Economic aspects—United States.

2. Environmental protection—Economic aspects—United States.

3. Environmental policy—United States.

 I. Ribaudo, Marc.

II. United States. Dept. of Agriculture. Economic Research Service. 

III. Title.

HC110.P55

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Photo credit: Lynn Betts, USDA/NRCS.
United States

Department

of Agriculture

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A Report from the Economic Research Service

Abstract

U.S. farmers and ranchers produce a wide variety of commodities for food, fuel, and fi ber 

in response to market signals. Farms also contain signifi cant amounts of natural resources 

that can provide a host of environmental services, including cleaner air and water, fl ood 

control, and improved wildlife habitat. Environmental services are often valued by 

society, but because they are a public good—that is, people can obtain them without 

paying for them—farmers and ranchers may not benefi t fi nancially from producing them. 

As a result, farmers and ranchers underprovide these services. This report explores the 

use of market mechanisms, such as emissions trading and eco-labels, to increase private 

investment in environmental stewardship. Such investments could complement or even 

replace public investments in traditional conservation programs. The report also defi nes 

roles for government in the creation and function of markets for environmental services. 

Keywords: Eco-labeling, environmental service, emissions trading, market, public good, 

supply and demand, transaction cost

Acknowledgments

This report benefi ted from the insightful comments and information provided by Marca 

Weinberg, Utpal Vasavada, Kitty Smith, Mary Bohman, Pat Sullivan, Scott Swinton, 

Cathy Kling, Virginia Kibler, Jan Lewandrowski, Lorraine Mitchell, and the Natural 

Resources Conservation Service staff. Thanks also to Cynthia Nickerson for her help 

on the maps for the water quality trading case study, to Linda Hatcher for the excellent 

editorial assistance, and to Wynnice Pointer-Napper and Curtia Taylor for the design 

and layout.

Marc Ribaudo, LeRoy Hansen, Daniel Hellerstein, 

and Catherine Greene

The Use of Markets To 

Increase Private Investment in 

Environmental Stewardship

Economic

Research

Report

Number 64

September 2008
ii

The Use of Markets To Increase Private Investment in Environmental Stewardship / ERR-64

Economic Research Service/USDA

Contents

Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

Chapter 1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Chapter 2

Environmental Services From Agriculture . . . . . . . . . . . . . . . . . . . . . . . . 4

 Water Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

 Air Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

 Wildlife . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

 Demand for Environmental Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Chapter 3

Market Basics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

 Markets for Environmental Services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

 Why Do Markets Fail? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Chapter 4

What Can We Learn From Current Markets?. . . . . . . . . . . . . . . . . . . . 14

 Water Quality Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

 Greenhouse Gases and Agriculture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

 Wetlands’ Environmental Services and Agriculture. . . . . . . . . . . . . . . . 30

 Market Incentives for Wildlife . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

 “USDA Organic” and Other Eco-Labels in Agriculture. . . . . . . . . . . . . 44

Chapter 5

Lessons Learned and Potential Roles for Government . . . . . . . . . . . . . 51

 Issue: Performance of Management Practices . . . . . . . . . . . . . . . . . . . . 51

 Issue: Standards and Verifi cation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

 Issue: Cost of Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

 Issue: Bringing Together Buyers and Sellers . . . . . . . . . . . . . . . . . . . . . 55

 Issue: Coordinating Conservation Programs With Markets . . . . . . . . . . 56

 Issue: The Role of Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

 Markets Are Not Always the Answer. . . . . . . . . . . . . . . . . . . . . . . . . . . 58

References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

Appendix

 Predicting the Location of New Mitigation Banks . . . . . . . . . . . . . . . . . 69
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Summary

U.S. farmers and ranchers produce a wide variety of commodities for food, 

fuel, and fi ber in response to market signals. Farms also contain signifi -

cant amounts of natural resources that can provide a host of environmental 

services, including cleaner air and water, fl ood control, and improved wildlife habitat. Environmental services are often valued by society, but because 

they are a public good—that is, people can obtain them without paying for 

them—farmers and ranchers may not benefi t fi nancially from producing 

them. As a result, farmers and ranchers underprovide these services.

What Is the Issue?

Farmers can provide environmental services by adopting conservation or 

production practices that improve the environment. Farmers often produce 

these services unintentionally, however, by maintaining grasslands, wetlands, 

or forests rather than converting them to cropland or by adopting practices 

that increase net returns but also improve environmental performance. 

Although society values these services, because of the services’ public-goods 

nature, farmers usually cannot benefi t fi nancially by intentionally producing 

them. As a result, there are no naturally occurring markets for environmental 

services. If environmental services could be sold like other commodities, 

farmers would likely invest more to maintain wildlife habitat, woodlots, and 

wetlands. The U.S. Department of Agriculture (USDA) has expressed great 

interest in the creation of markets to provide environmental quality and other 

environmental services. Such markets would supplement existing conservation programs and provide an additional source of income for farmers.

What Did the Study Find?

Markets for environmental services may fail to form or function properly for 

several reasons.

• The public-goods nature of most environmental services is the primary 

reason that markets for them do not naturally develop. In addition, environmental services, such as improved water quality and wildlife preservation, are unintended consequences of the primary production activities 

on the farm. These characteristics can limit potential suppliers’ ability to 

benefi t fi nancially from providing environmental services.

• Uncertainty about the quantity and quality of services a farmer can 

produce is a common problem that often hinders market function. 

Environmental services are often diffi cult to observe, such as the nutrientfi ltering capacity of wetlands or the sequestration (storing) of greenhouse 

gases from adopting conservation tillage. Farmers are reluctant to adopt 

management practices if potential returns are uncertain. Uncertain quality 

can also deter potential buyers from purchasing environmental services 

from farms.

• Environmental services are associated with the land and are not transportable to central markets. The costs of bringing buyers and sellers together 

may hinder the development of markets.
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• Government conservation programs and markets for environmental 

services sometimes have common objectives and outcomes and may end 

up competing for the same land, the natural capital in the production of 

environmental services. Such competition could hinder the development 

of markets by driving up costs.

The consequence of these limitations is that markets for environmental 

services are rare. Even though public demand for environmental services is 

strong, farmers are unable to benefi t fi nancially by providing them.

Barriers to market development and function can be overcome in a number 

of ways.

• In some cases, regulation can be used to create a private good, and the 

demand for that good, that is closely related to an environmental service. 

For example, the Federal Government places caps on pollutant discharges 

from regulated fi rms and issues discharge allowances to each fi rm, specifying how much pollution the fi rm can legally discharge. A fi rm may be 

able to discharge more pollution than its original allocation by purchasing 

allowances from other fi rms that have cut their own pollution discharges 

below their own allowances or from unregulated sources of pollution, 

such as agriculture. This transaction is known as a trade. Discharge 

allowances, therefore, have characteristics of a private good. Farmers 

are often able to provide discharge reductions at a lower unit cost than 

industry can and to profi t from the exchange.

• Uncertainty over the performance of agricultural management practices for 

the production of environmental services can be reduced through education and research. USDA and State efforts can play an important role in 

both areas. Research at the Agricultural Research Service, USDA, and 

the Conservation Effects Assessment Project at the Natural Resources 

Conservation Service, USDA, are quantifying the performance of management practices in different settings, and State extension services can 

convey this information to farmers. In addition, validation and certifi cation 

services can bolster consumer confi dence that, when they purchase environmental services, they are getting the service for which they paid. USDA 

has played an important certifi cation role in the organic market.

• Improved market design can reduce the search and bargaining costs of 

bringing buyers and sellers together. Government or other entities can 

play the role of an aggregator or clearinghouse in a market, making it 

easier for geographically dispersed market participants to fi nd each other, 

thereby reducing bargaining costs.

• Coordinating conservation programs and environmental service markets 

can enhance the performance of both. Targeting conservation programs to 

producers who need to meet minimum performance standards to enter a 

market would likely increase the number of farmers willing to participate. 

Identifying program rules that prevent farmers from selling environmental 

services for which they have not received a government payment would 

also increase farmer interest in entering environmental service markets.

Creating markets for environmental services is not always possible or advisable. Transactions costs associated with reducing uncertainty may be greater 
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The Use of Markets To Increase Private Investment in Environmental Stewardship / ERR-64

Economic Research Service/USDA

than the benefi ts of creating a market. The public-goods nature of environmental services may also prevent markets from developing, despite research 

and education. Even though people may be willing to pay for environmental 

services, the ability to acquire these services without paying for them reduces 

the incentive for farmers to provide them. In these cases, regulation or direct 

fi nancial assistance through government programs may be the most costeffective options.

How Was the Study Conducted?

The study used an extensive literature review and fi ve case studies to explore 

important economic issues affecting the development of markets for environmental services. Because working markets for environmental services are 

rare, we used the literature to provide the reasons that markets are not developing and to provide insight into the role government might play in helping 

markets to form and to function.

We present case studies for environmental services for which attempts have 

been made to develop markets. These markets are as follows:

• Water quality trading—Firms with high pollution-control costs purchase 

pollution reductions from another source at lower cost.

• Carbon emissions trading—Same as water quality trading.

• Wetland mitigation—Loss in wetland services is offset by an improved 

wetland with similar services.

• Fee hunting—Hunters pay for access to land in order to hunt.

• Eco-labeling—Labels tout goods made in a way that avoids harming 

the environment.

These case studies provide a more detailed look at the issues surrounding 

markets for environmental services, as well as the steps that were taken to 

overcome market impediments. The fi ndings of the case studies are used 

to identify some specifi c actions governments could take to support the 

creation and function of markets for environmental services. This report 

provides context for the actions USDA has recently taken to support markets 

for environmental services and for the Department’s response to the Food, 

Conservation, and Energy Act of 2008.