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CHAPTER 13
Making Markets Work
Ceaseless market vigilance— How cheap a future — The myth of
free markets — Skewed markets mean lost capital — Fiddling with
the switches — An ordered arrangement of wastebaskets — “Satisficing” — When regulation fails — Golden carrots — Plain vanilla
motors — Making a market in nega-resources — Alternative annual
report
C H U R C H I L L O N C E R E M A R K E D T H AT D E M O C R A C Y I S T H E W O R S T S Y S T E M O F
government — except for all the rest. The same might be said of the
market economy. Markets are extremely good at what they do, harnessing such potent motives as greed and envy — indeed, Lewis Mumford
said, all the Seven Deadly Sins except sloth. Markets are so successful
that they are often the vehicle for runaway, indiscriminate growth,
including the growth that degrades natural capital.
A common response to the misuse, abuse, or misdirection of market
forces is to call for a retreat from capitalism and a return to heavyhanded regulation. But in addressing these problems, natural capitalism does not aim to discard market economics, nor reject its valid and
important principles or its powerful mechanisms. It does suggest that
we should vigorously employ markets for their proper purpose as a tool
for solving the problems we face, while better understanding markets’
boundaries and limitations.
Democracies require ceaseless political vigilance and informed citizenship to prevent them from being subverted or distorted by those who
wish to turn them to other ends. Markets, too, demand a comparable
degree of responsible citizenship to keep them functioning properly
despite those who would benefit more from having them work improperly. But the success of markets when they do work well is worth the
effort. Their ingenuity, their rapid feedback, and their diverse, dispersed,
resourceful, highly motivated agents give markets unrivaled effectiveness. Many of the excesses of markets can be compensated for by steer-
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ing their immense forces in more creative and constructive directions.
What is required is diligence to understand when and where markets are
dysfunctional or misapplied, and to choose the correct targeted actions
to help them to operate better while retaining their vigor and vitality.
This book has often argued that most of the earth’s capital, which
makes life and economic activity possible, has not been accounted for
by conventional economics. The goal of natural capitalism is to extend
the sound principles of the market to all sources of material value, not
just to those that by accidents of history were first appropriated into the
market system. It also seeks to guarantee that all forms of capital are as
prudently stewarded as money is by the trustees of financial capital.
The notion that much of the remedy for unsustainable market activities is the adoption of sustainable market activities may offend both
those who deny that markets can be unsustainable and those who deny
that markets and profits can be moral. Yet worldwide experience confirms an abundance of market-based tools whose outcomes can be environmentally, economically, and ethically superior. These tools include
institutional innovations that can create new markets in avoided
resource depletion and abated pollution, maximize competition in saving resources, and convert the cost of a sulfur tax or a carbon-trading
price into profits realized from the sale and use of efficient technologies.
Ensuring that markets fulfill their promise also requires us to
remember their true purpose. They allocate scarce resources efficiently
over the short term. That is a critical task, especially as the logic of natural capitalism changes the list of which resources are genuinely scarce.
But the continuity of the human experiment depends on more than
just success in the short term, and efficiently allocating scarce resources
does not embrace everything people want or need to do.
For all their power and vitality, markets are only tools. They make a
good servant but a bad master and a worse religion. They can be used to
accomplish many important tasks, but they can’t do everything, and it’s a
dangerous delusion to begin to believe that they can — especially when
they threaten to replace ethics or politics. America may now be discovering this, and has begun its retreat from the recent flirtation with economic fundamentalism. That theology treats living things as dead,
nature as a nuisance, several billion years’ design experience as casually
discardable, and the future as worthless. (At a percent real discount
rate, nothing is worth much for long, and nobody should have children.)
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The s extolled a selfish attitude that counted only what was
countable, not what really counted. It treated such values as life, liberty,
and the pursuit of happiness as if they could be bought, sold, and
banked at interest. Because neoclassical economics is concerned only
with efficiency, not with equity, it fostered an attitude that treated social
justice as a frill, fairness as passé, and the risks of creating a permanent
underclass as a market opportunity for security guards and gated “communities.” Its obsession with satisfying nonmaterial needs by material
means revealed the basic differences, even contradictions, between the
creation of wealth, the accumulation of money, and the improvement
of human beings.
Economic efficiency is an admirable means only so long as one
remembers it is not an end in itself. Markets are meant to be efficient,
not sufficient; aggressively competitive, not fair. Markets were never
meant to achieve community or integrity, beauty or justice, sustainability or sacredness — and, by themselves, they don’t. To fulfill the wider
purpose of being human, civilizations have invented politics, ethics,
and religion. Only they can reveal worthy goals for the tools of the economic process.
Some market theologians promote a fashionable conceit that governments should have no responsibility for overseeing markets — for
setting the basic rules by which market actors play. Their attitude is,
let’s cut budgets for meat inspection and get government off the backs
of abattoirs, and anyone who loses loved ones to toxic food can simply
sue the offenders. Let’s deregulate financial markets, and self-interested
firms will police themselves. Let straightforward telephone, cable TV,
and airline competition replace obsolete regulatory commissions.
Those seduced by the purity of such theories forget that the austere
brand of market economics taught by academic theorists is only tenuously related to how markets actually work. The latest illustrations of
that principle include the Wild West wreck now looming in Russia,
mad-cow disease, savings and loan fraud, phone scams, and crash-bynight airlines. By the time textbook simplifications get filtered into
political slogans, their relationship to actual market behavior becomes
remote. A dose of empiricism is in order.
THE FREE MARKET AND OTHER FANTASIES
Remember the little section toward the beginning of your first-year
economics textbook where the authors listed the assumptions on which
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the theory of a perfect free market depends? Even as abstract theories
go, those conditions are pretty unreasonable. The main ones are:
01. All participants have perfect information about the future.1
02. There is perfect competition.
03. Prices are absolutely accurate and up-to-date.
04. Price signals completely reflect every cost to society: There are no externalities.
05. There is no monopoly (sole seller).
06. There is no monopsony (sole buyer).
07. No individual transaction can move the market, affecting wider price patterns.
08. No resource is unemployed or underemployed.
09. There’s absolutely nothing that can’t be readily bought and sold (no unmarketed assets) — not even, as science-fiction author Robert Heinlein put it,
“a Senator’s robes with the Senator inside.”
10. Any deal can be done without “friction” (no transaction costs).
11. All deals are instantaneous (no transaction lags).
12. No subsidies or other distortions exist.
13. No barriers to market entry or exit exist.
14. There is no regulation.
15. There is no taxation (or if there is, it does not distort resource allocations in
any way).
16. All investments are completely divisible and fungible — they can be traded
and exchanged in sufficiently uniform and standardized chunks.
17. At the appropriate risk-adjusted interest rate, unlimited capital is available
to everyone.
18. Everyone is motivated solely by maximizing personal “utility,” often mea-
sured by wealth or income.
Obviously the theoretical market of the textbooks is not the sort of
market in which any of us does business. Actually, if there were such a
place, it would be pretty dull. No one could make more than routine
profits, because all the good ideas would already have been had, all the
conceivable opportunities exploited, and all the possible profits
extracted — or, as the economists put it, “arbitraged out.” It’s only
because actual markets are so imperfect that there are exceptional business opportunities left.
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Just how imperfect are the markets in which we all actually live? Let’s
run a quick check on that list of eighteen theoretical requirements:
01. Perfect information about the future? If anyone had it, he or she’d be
barred from elections and stock markets — and probably not given any credence by the rest of us.
02. Competition is so imperfect that exceptional profits are commonly earned
by exploiting either one’s own oligopolistic power or others’ oversights,
omissions, and mistakes.
03. Markets know everything about prices and nothing about costs.
04. Most harm to natural capital isn’t priced, and the best things in life are
priceless.
05. No monopolies? Microsoft, airlines’ fortress hubs, and your managedhealth-care provider come close.
06. No monopsonies? Consider your utility, the Peanut Marketing Board, and
the Federal Aviation Administration.
07. No market-movers? What about Warren Buffet and the Hunt Brothers?
08. Thirty percent of the world’s people have no work or too little work. (Economists justify this by calling them “unemployable” — at least at the wages
they seek.)
09. Most of the natural capital on which all life depends can be destroyed but
neither bought nor sold; many drugs are bought and sold in a pretty effective free market, but doing either can jail you for life.
10. The hassle factor is the main reason that many things worth doing don’t
happen.
11. Does your insurance company always reimburse your medical bills promptly?
Does your credit-card company credit your payments immediately?
12. Worldwide subsidies exceed $1.5 trillion annually — for example, Amer-
ica’s 1872 Mining Act sells mineral-bearing public land for as little as
$2.50 an acre and charges no royalties.
13. It’s hard to start up the next Microsoft, Boeing, or GM — or to get out of
the tobacco business.
14. The world’s regulations, put on a bookshelf, would extend for miles.
15. The Internal Revenue Code exists.
16. You can’t buy a single grape at the supermarket, nor an old-fashioned front
porch in most housing developments.
17. Many people are redlined, must resort to loan sharks, or have no access to
capital at any price.
18. So why does anyone fall in love, do good, or have kids, and why do three-
fifths of Americans attend weekly worship services?
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Actually, the market works even less perfectly than the above counterexamples suggest, for two reasons. First, corporations that benefit from
subsidies, externalizing their costs, avoiding transparency, and monopolizing markets tend to ignore market realities and lobby for making
new rules, or overlooking old ones, that will best achieve their private
benefits. Second, people are far too complex to be perfectly rational
benefit/cost maximizers. They are often irrational, sometimes devious,
and clearly influenced by many things besides price.
For example, suppose you put a group of individuals in hot, muggy
apartments with air conditioners and tell them that both the air conditioners and the electricity are free. What would you expect them to do?
Won’t they just turn it on when they feel hot and set it at a temperature
at which they feel comfortable? That’s what economic theory would
predict; if cooling is a free good, people will use lots of it whenever they
want. But only about to percent of individuals actually behave that
way. Many others don’t turn on the air conditioner at all. Most do run it
occasionally, but in ways that are essentially unrelated to comfort.
Instead, their usage depends largely on six other factors: household
schedules; folk theories about how air conditioners work (many people
think the thermostat is a valve that makes the cold come out faster);
general strategies for dealing with machines; complex belief systems
about health and physiology; noise aversion; and (conversely) wanting
white noise to mask outside sounds that might wake the baby.2
Theoretical constructs are, after all, just models. The map is not
the territory. The economy that can be described in equations is not
the real economy. The world that conforms to eye-poppingly unreal
assumptions about how every economic transaction works is not the
real world. The sorts of economists who lie awake nights wondering
whether what works in practice can possibly work in theory are not the
sorts who should define your business opportunities.
Previous chapters have documented to percent annual
returns on investment in energy efficiency that haven’t yet been captured, as market theory presumes they must already have been. Previous chapters documented improvements in U.S. vehicles, buildings,
factories, and uses of materials, fiber, and water that could probably
save upward of a trillion dollars per year. These efficiency gains are
available and highly profitable but haven’t yet been captured. Chapter
even suggested that waste, in a more broadly defined sense, in the U.S.
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economy could amount to at least one-fourth of the GDP. Such prominent examples of market failure suggest that the standard question of
how to make markets more perfect should be turned around: Are there
ways to address the imperfections in the marketplace that would enable
people to capture the profit potential inherent in those flaws? It’s time
to identify the real-world obstacles to buying resource efficiency, and
determine how to turn each obstacle into a new business opportunity.
The attractive scope for doing this will be illustrated by examples about
energy and occasionally water, but most of the implementation methods
and opportunities described could be extended to saving any kind of
resource.
CAPITAL MISALLOCATION
The lifeblood of textbook capitalism is the flow of capital.3 In theory,
capital flows to the best risk-adjusted returns just as automatically as
water flows downhill. In theory, theory and practice are the same, but in
practice they’re not. In practice, even the major global institutions that
handle most of the world’s large capital flows have significant distortions and imperfections.4 Realistically, most of us can’t attempt to solve
these problems on a global scale, but we can notice and address similar
ones at the level of the firm or community.
Without managerial attention, not much happens. Most managers
pay little attention to such seemingly small line-items as energy (one to
two percent of most industries’ costs). Similarly, most manufacturing
firms choose investments that increase output or market share in preference to those that cut operating costs.5 What both these habits overlook is that saved overheads drop from the top to the bottom line,
where even small cost savings added back to profits can look a lot bigger. When the CEO of a Fortune company heard that one of his
sites had an outstanding energy manager who was saving $. per
square foot per year, he remarked, “That’s nice — it’s a million-squarefoot facility, isn’t it? So he must be adding $. million a year to our bottom line.” In the next breath, he added: “I can’t really get excited about
energy, though — it’s only a few percent of my cost of doing business.”
He had to be shown the arithmetic to realize that achieving similar
results in his -odd million square feet of facilities worldwide could
boost that year’s net earnings by percent. The energy manager was
promoted to spread his practice companywide.
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Once managers do start paying attention, how do they determine
how much energy efficiency is worth buying? Many supposedly sophisticated firms, it turns out, don’t decide very carefully: They make all
routine “small” purchases based on initial cost alone. Thus percent
of the . million electric distribution transformers bought every year,
including the ones placed on utility poles, are bought on the basis of
lowest first cost. Buying the less expensive and less efficient transformers passes up an opportunity to earn an after-tax return on investment
of at least percent a year plus many operational advantages. Nationwide, it also misallocates $ billion a year.6 Every first-year business student knows that the correct way to allocate capital is to compare
investments’ results over the long run, not choose the option that
requires the least initial investment regardless of future return. Every
computer spreadsheet contains net-present-value functions that perform this calculation automatically. Yet most companies don’t buy
energy efficiency using these principles.
Typically, energy-saving devices are chosen by engineers at the firm’s
operating level, using a rule-of-thumb procedure called “simple payback,” which calculates how many years of savings it takes to repay the
investment in better efficiency and start earning clear profits. Fourfifths of the American firms that even think about future savings
(instead of just initial capital cost) use this method. Moreover, they do
so with the expectation of extremely quick paybacks — a median of .
years.7 Most corporate officers are so immersed in discounted-cashflow measures of profitability that they don’t know how to translate
between their own financial language and the engineers’ language of
simple payback.8 They therefore may not realize that a .-year simple
payback is equivalent to a percent real after-tax rate of return per
year, or around six times the cost of additional capital.
Most firms are therefore not purchasing nearly enough efficiency.
They invest every day in ways to increase production or sales that don’t
return anywhere near percent a year after tax; yet they continue to
insist, often unknowingly, that energy efficiency leap this lofty hurdle.
One remedy is to teach the energy engineers how to speak financial language. When the engineer goes to the comptroller and says, “Wow, have
I got a deal for you — a risk-free return of percent after tax!,” he or
she’ll almost certainly get the capital that wouldn’t have been obtained
had the savings been expressed as a .-year payback.
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Many capital-constrained industries use hurdle rates even more
absurd than two years: In some, the energy managers can’t buy equipment that yields anything beyond a six-month payback. Yet at least in
buildings, it’s now possible to obtain capital for energy- or water-saving
investments entirely from outside sources without committing any
capital of one’s own. In , top finance firms joined the U.S. Department of Energy to create the International Performance Measurement
and Verification Protocol,9 which has since been adopted in more than
other countries, including Brazil, China, India, Mexico, Russia, and
Ukraine. This voluntary industry-consensus approach standardizes
streams of energy- and water-cost savings (in buildings and in most
industrial processes) so they can be aggregated and securitized, just as
FHA rules standardize home mortgages. The protocol is creating a
market where loans to finance energy and water savings can be originated as quickly as they can be sold into the new secondary market. For
an individual company, achieving energy savings can therefore be
affordably financed and needn’t compete with other internal investment needs. The protocol’s metering and monitoring procedures will
also help maximize savings and guarantee their longevity by providing
more accurate feedback to building and factory operators.
But the misallocation of capital away from very attractive returns in
energy efficiency has an even larger implication. While most business
owners, just like most Americans in their own homes, typically want to
get their money back from energy-saving investments within a few
years, utilities and other large energy companies have traditionally
been content to recover power-plant investments over the course of
twenty to thirty years — about ten times as long. Our society, therefore, typically requires roughly tenfold higher returns for saving
energy than for producing it.10 Equivalent to a tenfold price distortion,
this practice skews the economy by making us buy far too much
energy and too little efficiency. Until the late eighties, the United States
wasted on uneconomic power plants and their subsidies roughly $
billion a year worth of capital investment, or about twice as much as it
invested annually in all durable-goods manufacturing industries, thus
badly crimping the nation’s competitiveness.
However, in that distortion lurks another business opportunity.
Arbitrageurs make fortunes from spreads of a tenth of a percentage
point. The spread between the discount rates used in buying energy
savings and supply are often hundreds of times larger than that —
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enough to overcome the transaction costs of marketing and delivering
large numbers of individually small savings. Scores of utilities proved
this in well-designed eighties and early-nineties programs that delivered efficiency improvements at a total cost less than the operating costs
of existing thermal power stations.11 The spread in discount rate is also
the basis of the Energy Service Company (ESCO) concept, where entrepreneurs are paid to cut energy bills. They charge nothing up front for
their services but are paid by sharing the measured savings they
achieve. Like the shared-savings landscape-retrofit and water-efficiency
firms mentioned in chapter , skilled ESCOs are flourishing worldwide, although America’s ESCO industry is still in its shakeout phase.
Many federal agencies, though authorized to hire ESCOs, don’t yet do
so because of rigid procurement habits and procedures. This may
change under President Clinton’s July , , order to remove those
blockages, maximize ESCO deals, and — a major incentive — let agencies keep half of their resulting savings.
Individuals have an even harder time allocating capital to energy
efficiency investments than firms do. Few people will pay fifteen to
twenty dollars for an efficient lightbulb when an ordinary one sells for
fifty cents, even though the efficient model, over its thirteenfold-longer
lifetime, will save tens of dollars more in energy bills than its cost and
will keep a ton of CO2 out of the air. But there are ways to jump over
that hurdle. Southern California Edison Company gave away more
than a million compact fluorescent lamps, a meas…
