Economic Insights in Ecological Compensations: Market Analysis With an Empirical Application to the Finnish Economy

Abstract

Biodiversity is decreasing at an alarming rate. Current policies focus on the most valuable species and habitats but cannot stop the degradation occurring in less valuable habitats. One solution is offsetting the loss of biodiversity caused by development projects. The basic idea of biodiversity offsetting is simple: a developer must provide an improvement in biodiversity so that the lost ecological value is compensated for. A banking mechanism for offsetting entails a third party providing offsets for developers to purchase, and thus, an offset market emerges. We develop an equilibrium model to analyse the offset markets and apply the model to the Finnish economy and three selected boreal habitats. We examine how the market depends on trading ratios, the presence of an intermediary and the realization of risks associated with uncertainty. An intermediary can facilitate the market participants meeting each other with minimal transaction costs and safeguard against risks. The results show that the size of the offset markets could potentially be quite considerable and providing offsets could be a profitable business for landowners in Finland. The outcome of the restoration investment and a possible time delay between biodiversity losses and gains impact the trading ratios and thus, have a major impact on the market equilibrium. An intermediary may significantly decrease the costs of compensation for developers, provided that it can provide mature offsets when needed.