Fair value? Can free markets ever value the environment?

A basic problem with markets that absolutely must be answered if we are to create an environmentally rational economy is that of deciding how to value things. Valuation failures were a key cause of the recent financial crisis, which stemmed at least in part from the policy of allowing companies to claim that their value was whatever the market would currently bear, including any number of imponderable items that had yet to demonstrate any real value, such as future prices, hypothetical values and debatable projections derived from complex financial models. As part of the general indifference to risk exhibited by regulators and accounting authorities during the last decade or so, this so-called ‘mark-to-market’ or ‘fair value’ approach accounting has been a part of US GAAP since the early 1990s and seems to have all but replaced any notion of intrinsic value. And as if all that were not enough, ‘fair value’ accounting was also central to the Enron scandal.

Mark-to-market is obviously important when it came to buying and selling stocks and shares, but it goes far beyond that. The value of company assets that can be offered as collateral is also the basis for loans, derivatives and other direct and indirect funding. So when a bull market lasts for years on end and prices kept going up regardless of any material value of the companies themselves, smart operators are provided with an environment that favours both massive speculation and spectacular frauds. From the point of view of mark-to-market accounting, a bull market amounts to a universal pyramid scheme: whatever the value of an asset or liability today, we can usually assume that it will be worth more tomorrow, so we can borrow today as though we are more wealthy than we really are.

However, when the dislocations and fantasies this situation naturally engenders go too far, the market will be seized by the bears, and the rapid falls in mark-to-market valuations that follow will mean that previous loans, bonds, asset and liability prices, interest rates and pretty much every other number the markets use will start to go the wrong way for everyone – again regardless of the underlying strengths and weaknesses of individual companies. In a bear market, mark-to-market put the pyramid onto its head, and you would be stupid to lend today, as the collateral that guarantees your loans will almost certainly be worth less – maybe a lot less – tomorrow than it is today. In extremis, markets for many items disappear altogether and the financial sector ground to a halt.

The key problem this presents if markets are to be part of the solution of our environmental problems is that the scope, scale and urgency of those problems mean we cannot allow the kind of fragility and flakiness market economies have exhibited to determine how we invest in the environment. Leaving aside the question of speculators actively manipulating environment-related markets (e.g., greenhouse gas cap-and-trade, offsets, and so on – see the final section of this), we cannot accept the risk of being plunged into years of environmental inactivity or retrenchment simply because markets were unable to value these investments appropriately.

But is there any alternative as far as markets are concerned? Is there any definition of value markets can work with that will always reflect the intrinsic social value of taking action to protect the environment? Are there any accounting principles, valuation methods or other general policies, methods or tools that will ensure that environmental investments are not caught up in speculative frenzies and then dumped as unceremoniously as the global financial system was in 2008-9?

Probably not, or at least not ones that are capable of controlling markets without considerable active intervention and constraint – which is to say, undermines their very nature as markets. After all, how are markets to price things other than in money? How am I to judge a given transaction other than in terms of the profit it offers me (which means strictly in terms of money)? And once all value is reduced to money and the only goal is more money, what other valuation method is there apart from what the market says? In other words, regardless of whether valuing assets and companies in terms of their market price is sensible, it represents what market-based investors wanted to know about a stock, because it predicted what they most wanted to know about their ultimate concern, namely profitability.

In short, the markets know the price of everything and the value of nothing. As this is Oscar Wilde’s definition of a cynic, that seems appropriate enough – the attitude of markets (and perhaps business in general) to the environment is cynical at heart, for the only question they are capable of posing is, How do we make money out of this? Not exactly a responsible attitude.

Actually there is a limit to how far this is true. In a market who basic function is to direct investment in the real economy, prices will still be determined by prices, but these prices will be linked to the material consequences of making real investments – in houses, in MP3 players, in clothes, in a million other goods and services. And that of course is what the economy is for – to ensure that society works. True, the answer is still expressed indirectly, in terms of money, prices and profits, but at least the link to real, non-financial value is there.

Or so it should be, in a socially rational economy. But when the central function of markets is perverted into speculation, and the key question is not how to distribute wealth in society but how to make a quick killing by exploiting changes in price.

But is this a real problem, or merely a theoretical stick with which to beat the markets? Unfortunately it is very, very real. For example, by 2008 the average barrel of oil was being traded 27 times before it was actually delivered for use in the real economy. This certainly contributed to the otherwise inexplicable massive price spike of that year, and is hard to account for in terms of buying oil for use in the real economy. Or again, the Tabb Group consultancy has estimated that mroe than 60% of trades in the US stock markets are controlled by automated systems that are designed to take advantage of tiny price difference within miliseconds of their arising – not really an issue for investors in the real economy. More generally, it has been estimated that perhaps 85% of stock exchange activity is speculative, with only a small minority representing genuine investment.

And so on. All in all, the speculators are clearly in charge, and as a number of scandals and exposés have demonstrated, the manipulation of prices is a fundamental of stock markets.

This is perhaps the fundamental problem of using markets to manage the environment: that markets recognise only prices, and no price generated by a pure market can reflect socially rational value (including environmentally rational values) unless forced to do so – which is the very antithesis of a market price. Markets are like severely autistic children: it’s not hard to get through to them – it’s impossible. You can constrain them with regulations and rules, but once the market has taken over control of prices, it is hard to see why just this sort of bubble should not develop.

So can markets play any part in managing the environment? Perhaps in limited ways. But the tendency to break the link with real environmental goals and consequences seems to be intrinsic to any system that measures success strictly in terms of prices and profits. If it doesn’t do that, is it a market? If it does, how can we ever trust it not to undermine every strategy for managing the environment?

More of RJ Robinson at http://richardjrobinson.blogspot.com/

Leave a Reply