ARBITRAGE AND ENVIRONMENTAL ASSETS
When thinking about market-based solutions to resource management, one of the techniques Odd's Creek draws inspiration from is arbitrage.
Arbitrage - In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. [1]
When dealing with real assets, pure arbitrage is almost impossible to execute because the transactions occur at different times or different places. This time lag increases the risk that the price of the second transaction will change, thus decreasing the profit or even resulting in a loss. Nonetheless, the principle of arbitrage can be applied by looking for environmental assets that have different prices in different markets.
This is fascinating because when successful, not only does arbitrage yield a profit, it also effects the convergence of prices in the underlying asset. This price convergence means that more information is included in the valuation of the environmental asset. Let's look at a real example of environmental arbitrage.
REAL ESTATE-STORMWATER arbitrage
Cities around the world experience tension between the pressure for increased development and the negative environmental impacts of that development. Increasing development means building more roads and buildings, which decreases the amount of pervious surface available for absorbing water when it rains. These new impervious surfaces produce stormwater runoff, which has to be properly managed so the city doesn't flood. [2]
Traditional stormwater management involves constructing ponds or basins to hold water and slowly discharge it after the rain passes. This reduces the discharge rate and prevents downstream flooding. However, these ponds occupy land that cannot be used for development. Because land in cities is highly valuable on the real estate market, developers are incentivized to make these ponds as small as possible or remove them entirely. As a consequence, the city may be at risk for increased flooding due to insufficient storage capacity during rain events. The cost of flooding is not born by the developer who increased the risk and is instead passed off to the city's taxpayers.
This is a classic example of a negative externality. [3]
Like most negative externalities, stormwater is typically managed through public policy (taxation, fines, and environmental regulation). But in 2014, the Washington D.C. Department of Energy and Environment (DOEE) took a new approach. Instead of the traditional public policies, they implemented the Stormwater Retention Credit Trading Program (SRC). [4]
With this program, DOEE created a market for buying and selling stormwater credits that can be created by building stormwater storage capacity in excess of the minimum required. The SRC changed the incentive structure for developers by providing a second market by which land can be valued. In arbitrage terms, a single asset could be valued in two different markets, and if those markets priced the asset differently, there is an opportunity for arbitrage.
In terms of price convergence, developers now have a second market by which to compare the value of land, which means that the cost of increased flood risk (represented on the SRC market) is included in the decision on how to develop that land. Beyond new development, an environmental arbitrageur can now continually evaluate land for price differences in the real estate and stormwater markets.
OPPORTUNITIES
Real Estate-Stormwater is just one example of environmental arbitrage that was only made possible by the creation of a stormwater market in Washington D.C. Most opportunities currently rely on newly created markets such as those for carbon credits or PV solar panels. Looking to the future, other markets could be created for water, air, or soil quality.
Odd's Creek is always looking for potential arbitrage opportunities in environmental assets, and if there is an opportunity that doesn't yet exist, we look at the potential to create a second market that would value the asset at a higher price.
References:
[1] Wikipedia - Arbitrage
[2] Wikipedia - Stormwater
[3] Economics Online - Negative Externalities