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

In environmental markets, parties frequently exchange obligations through environmental contracts. These contracts imply a distribution of risk between parties. The main focus of our paper is to identify contracts that enable risk in environmental markets to be reduced, distributed at 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 our paper outlines some of the contracts currently utilised in financial and insurance markets to achieve these objectives. These are: futures and options contracts, spread contracts, weather contracts and catastrophe bonds. We then provide a snapshot of current applications of these contracts both in real markets and in the literature. Finally we discuss some possible applications in the environmental sector and indicate how the use of these contracts may alter the way government manages environmental assets and responsibilities. We also suggest a staged process to the introduction of contracts that recognises the current limitations faced by government. This paper 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.