News Every Day | 05 December 2021, 10:25

Using sustainable finance theory to save the environment

People usually perceive the finance sector to be the environment’s arch enemy, with its supposed fixation on short-term profits whatever the cost. However, the theories the Goldman Sachses of this world use to make money can also be used to save the environment, if we are open-minded enough to get past the stigma of big finance.

In 2018, University of Queensland ecologist Dr. Hawthorne Baker and his colleagues published a paper proposing a system for conserving marine environments. Global warming is contributing to the gradual disappearance of coral reefs, which could have profoundly negative consequences for all living organisms, including the humans who depend upon oceans for their livelihoods.

One of the options is conservation, but like most good things, we cannot conserve as many coral reefs as we want due to the considerable resource cost. Dr. Baker and his coauthors devise a system for strategically selecting the coral reefs that we should dedicate the most resources to conserving, based on the likelihood that the sustainability efforts will bear fruit.

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Though it may make an environmentalist cringe, coral reefs have features in common with financial assets: their returns are a function of economy-level factors and sector-specific factors. In the case of a coral reef, the list includes rising sea temperatures (economy-level) and local salinity conditions (sector-level); while for stocks the list would include interest rates (economy-level) and industry regulations (sector-level).

In a 1952 paper that would go on to earn him the Nobel prize in economics, Dr. Harry Markowitz proposed a theory of how to choose a financial portfolio to balance the desire to maximize expected returns with the desire to minimize risk. An investor using the model would exploit the fact that while some stocks go up, others systematically tend to go down, and this can be used to dampen the turbulence of financial portfolios.

Dr. Baker and his colleagues applied the same principles to marine environments to help conservationists identify the coral reefs that are best suited for protection, considering the prevailing resource constraints. Though it might seem counterintuitive for a model that enriches people in financial markets to help us live more sustainably, it is but one of many examples of how economics helps societies to flourish.

Complex interventions such as carbon taxes and pollution permits, and simple ones such as transparent garbage bags and smaller plates in all-you-can-eat buffets, all illustrate how we can leverage economic analysis for the protection of the environment. Economists have been at the heart of the genesis of these policies, as well as their rigorous evaluation as they contribute to the evidence-based policy revolution.

People undoubtedly have selfish and destructive tendencies, but as any European resident during the Middle Ages will surely attest, nefarious behavior predated modern economics and capitalism. Moreover, economics and capitalism do not turn people into monsters – the worst crimes against humanity have been frequently committed by staunch anti-capitalists with as much knowledge of economics as Che Guevara wearing a Mao t-shirt.

My late George Mason University colleague Dr. Walter Williams once quipped: “Prior to capitalism, the way people amassed great wealth was by looting, plundering and enslaving their fellow man. Capitalism made it possible to become wealthy by serving your fellow man.”

Somewhat analogously, prior to capitalism, the way people protected the environment was by being too hungry or poor to support a population large enough to threaten the environment. Capitalism makes it possible to devise technologies and market-based interventions that can help us live sustainably without the need for a Malthusian famine to keep our population in check.

The ingenious application of Markowitzian portfolio theory to coral reef conservation by Dr. Baker and his colleagues can clearly be extended to other environmental problems of a similar nature, such as the protection of forests and ice caps.

Getting people to adopt the proposals is a separate problem, however, because policymakers so frequently have other goals. If only there were an academic discipline that could help us analyze incentives.

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