Contracts for environmental outcomes: the use of financial contracts in environmental markets

In environmental markets, parties frequently exchange obligations through environmentalcontracts. These contracts imply a distribution of risk between parties. The main focus of ourpaper is to identify contracts that enable risk in environmental markets to be reduced, distributedat least cost, or managed efficiently. The risks that we consider are: moral hazard risk, price risk,exogenous environmental risk, measurement risk and production risk. The first section of ourpaper outlines some of the contracts currently utilised in financial and insurance markets toachieve these objectives. These are: futures and options contracts, spread contracts, weathercontracts and catastrophe bonds. We then provide a snapshot of current applications of thesecontracts both in real markets and in the literature. Finally we discuss some possible applicationsin the environmental sector and indicate how the use of these contracts may alter the waygovernment manages environmental assets and responsibilities. We also suggest a staged processto the introduction of contracts that recognises the current limitations faced by government. Thispaper does not propose new or novel contracts for tackling the problems of risk in exchange.Rather it extends the application of existing contractual arrangements to a new type of problem:environmental markets.