B. Market Fragmentation, Background Markets, and
1. Arbitrage
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Temporal nonfungibilities may be neutralized by restricting trades to narrow time periods. Bubbling and offsets require simultaneous trades.90 In more complex schemes, the currency's value can be restricted by issue, compliance, and expiration dates.9 1 In the wetlands program, mitigation is supposed to occur only when the restored habitat is fully functional.92 Sometimes, though, the time window is made more flexible. Under the Clean Air Act's prevention of significant deterioration (PSD) program, the EPA allows trading of contemporaneous emissions, but "contemporaneous" is generously defined as a five-year period.93
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B habitat. The conservation goal for the area is to achieve a balance of the two habitats that favors conservation of type A habitat because of its superior habitat value, and which is relatively consistent throughout the area so as to maintain overall ecological function.94 A trading program, it is thought, will let "the market" most efficiently decide which acres are developed within this hoped-for pattern.
Once this habitat trading market is set in motion, however, it necessarily coexists with the background real estate markets operating within the defined trading area. The real estate market, of course, reflects values relevant to developers and consumers of developed habitat. The trading market, by contrast, is designed to capture values of habitat function, albeit crudely reflected in the acre-based currency. Yet the imposed habitat value exchange rate between type A and B habitats cannot ignore the real estate market's exchange rate between the two types. When the constructed habitat value system is overlaid on the relatively unconstrained real estate market, it is easy to see how "mistakes" in trading valuation can undermine environmental protection values.
Figure 5
For example, the 1:5 trading ratio between type A and type B habitat is intended to reflect the superior habitat function value of type A habitat. But in
94. This last requirement is an important condition. Consistent habitat distribution both provides corridors for species to range throughout the area and may be necessary for species that depend on the two habitat types (e.g., for nesting and feeding).
Dee. 2000]
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real estate Market I, type A habitat is worth only three-and-one-third times as much as type B. In real estate Market I, therefore, a developer could develop 5 acres of type B habitat and mitigate with either five acres of type B habitat at a cost of $15,000, or one acre of type A habitat at a cost of $10,000. Easy decision. Thus, the result of using the 1:5 habitat value exchange rate in the long term could be widespread depletion of type B habitat throughout the trading area and extensive conservation of type A habitat, which may not promote the original conservation goals of the trading program.
Another problem could arise if the trading area is defined too broadly. As depicted in Figure 5, there may be more than one real estate market encompassed within the trading area. Say developers in the trading area believe that type A habitat is undervalued in the real estate market and in fact presents a more profitable development profile than Type B habitat, so that they wish to develop type A habitat and use type B habitat to mitigate. Type B habitat is worth the same in habitat value throughout the trading area, but is worth more in real estate value in Market II than in Market I. As a result, developers in real estate Market II can practice a form of arbitrage by reaching into real estate Market I for cheaper type B conservation acres to compensate for development in Market II, facilitating more development of type A acres in Market II. Once again, we may wind up with a distribution of developed and conserved acres within the larger trading area that is inconsistent with the conservation goals of the trading program.
To an economist, this is simply evidence of market efficiency at work.
Indeed, as the economist would predict, over time the real estate market price of type B habitat will rise if it is demanded for mitigation of type A development, and price disparities in type B acres within the trading area will dampen as demand for the cheap acres increases. That is market efficiency.
But it may not be environmentally acceptable to let that market dynamic play out-by the time the real estate market adjusts, the conservation goals of the trading program may have been irrevocably undermined. Design defects in the constructed market can therefore create externalities that exist independent of the currency design deficiencies.95
Regulators detecting this problem would have a number of solutions. In the arbitrage scenario, for example, the original trading area could be split into several trading areas corresponding to the two real estate markets, thus making arbitrage between real estate markets impossible. Or type B habitat could be divided into several types corresponding to price differential ranges and the exchange rates between the reconstituted habitat types could be altered. For example, if the cheap type B acres were redefined as type C and new exchange rates between it and types B and A habitat were defined, the arbitrage 95. Despite the goal of creating an even distribution of habitat types, market participants have no incentive to abide by that goal and feel no cost when they ignore it. It is external to the transactions.
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opportunity can be foiled. In short, any constructed market defect can be corrected with additional market constructions.9 6 The challenge is in detecting the defect and its externality and designing market-procedure corrections that solve the externality without creating a new one.