Water Quality Trading: Science and Policy Challenges

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Water Quality Trading Science and Policy
Challenges
James Shortle Distinguished Professor of
Agricultural Environmental Economics, Penn
State University Director, Environment and
Natural Resources Institute (ENRI)
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Water Quality Trading

• Actively promoted by the U.S. EPA as means for
  controlling nutrients and sediment from
  agriculture and other sources
• Of great interest to state water quality
  authorities
• 70 water quality trading initiatives in at least
  21 states, including Pennsylvania
• The next target of an emerging industry of
  trading entrepreneurs

NOAA
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Overview

• What is water quality trading?
• Why the current interest?
• Challenges in water quality trading
• Characteristics of emerging programs
• Research and policy issues

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What is WQ Trading?

• A market mechanism for allocating capped water
  pollution loads among alternative sources
• Allows sources with higher pollution control
  costs to meet their regulatory obligations by
  purchasing environmentally equivalent (or
  superior) pollution reductions from sources with
  lower costs

USGS
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Reasons for current interest

• EPA Total Maximum Daily Load Rules
• The nonpoint source policy challenge
• Successes of air quality and other environmental
  markets
• Utilized for air pollution control in the U.S.
  since the 1980s (bubbles, banking, etc.) with
  well-documented cost savings
• SO2 trading cost savings have been estimate at as
  much as 1 billion per year over conventional
  controls
• Fisheries management (75 programs
  internationally)
• Water quantity management (US and Chile)
• New frontiers carbon and water quality

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Before the TMDL rule

• Regulatory emphasis on controlling effluents from
  point sources
• National Pollution Discharge Elimination System
  Permits
• Technology-based effluent standards
• Much accomplished but
• Water quality standards unmet
• Nonpoint sources a leading cause of remaining
  problems
• High costs

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After the TMDL rule, states must

• Identify waters that do not meet designated water
  quality standards
• Identify the pollutant(s) causing water quality
  impairment
• Determine with a margin of safety the total
  allowable load
• Allocate the allowable load among point and
  nonpoint sources
• Implement measures to achieve the TMDL

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Why water quality trading for TMDLs?

• Trading is explicitly a mechanism for allocating
  pollution loads among alternative sources
• Trading may offer a mechanism to use regulated
  point sources to purchase needed reductions from
  less regulated agricultural nonpoint sources
• Accumulating evidence that well-designed trading
  programs can achieve environmental goals at lower
  costs than traditional regulatory approaches
• Other possible benefits more rapid achievement
  of goals higher levels of environmental
  protection

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Can trading work for water quality?

• Water quality trading originally proposed in the
  late 1960s as an alternative to inflexible design
  and performance standards
• Water quality trading experiments to date
  (beginning in the 1980s) have not successful
• No or few trades no gains from trading
• Failures to date
• Badly designed markets?
• Necessary conditions for trading not met?
• Trading does not work for water?

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Prerequisites of text book trading

• Discharges must be tradeable
• Substantially controllable
• Measurable
• Existence of gains from trade
• Discharges capped
• Heterogeneous control costs
• Thick markets
• Low transactions costs
• Search, contracting, monitoring and enforcement

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The Water Quality Challenge Nonpoint Sources

• Nonpoint pollution.
• The leading cause of remaining water quality
  problems in the US
• Major target of emerging trading initiatives
• Yet, nonpoint pollution does not fit the text
  book model of a tradable pollutant!

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NPS Emissions

• Cannot be measured routinely and accurately at
  reasonable cost
• There is no tangible nonpoint commodity
• Are stochastic
• Emissions are only partially under control of
  suppliers of NPS pollution reductions
• Cannot be forecast easily and reliably at the
  scale of typical nonpoint source agents
• How should markets with nonpoint sources be
  designed?

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Elements of market design

• Trading rules
• Coordination mechanisms

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Trading rules

• Market type
• Cap-and-trade
• Credit trading
• Commodity definition
• Rules governing commodity exchanges
• Geographic scope
• Environmental equivalence
• Location
• Uncertainty

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Coordination mechanisms

• Bi-lateral negotiations
• Brokers
• Banks
• Clearing houses

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Key Elements of Emerging Programs

• Credit trading
• NPS credits based on predicted temporally
  averaged NPS emissions reductions
• Prediction replaces measurement
• Averaging addresses temporal variability
• trading ratios between point and nonpoint
  sources to address the relative reliability of
  point and nonpoint reductions

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Research and Policy Issues

• Validity/reliability of credit computation
  methods
• Treatment of NPS risk
• Design of coordination mechanisms
• Missing caps
• Policy coordination

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Validity/reliability of credit computation
methods

• Both economic and ecological implications
• Ecological goal achievement
• Cost minimization
• The perfect should not be the enemy of the good,
  but easy numbers arent necessarily good
• Research issues
• How good is good enough?
• Development of low cost credible methods
  protocols (analogous to the phosphorous index)

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Treatment of NPS Risk

• Trade ratios are
• crude at best do not provide incentives to
  reduce risk
• typically perversely specified
• Alternative develop market structures that
  directly address risk
• Reliability-graded credit trading
• Nonpoint performance contracts

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Design of coordination mechanisms

• Little experience with mechanisms for trading
  environmental risks
• Should banks be public or private?
• Rules governing operation of the bank (e.g, who
  has liability for failures?)
• Pricing (auctions, posted prices, bilateral
  negotiations)
• Managing collateral agricultural externalities

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Missing Caps

• Credit-trading vs. cap-and-trade
• Cap-and-trade good
• Credit-trading less so
• Missing cap missing regulatory driver

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Policy Coordination

• Agro-environmental policies, farm-land
  preservation, etc.
• Conflicting incentives
• Multi-media pollution

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Lessons

• Many of the accepted rules for designing water
  quality trading are barriers to success
• Guidelines emerging to help planners
• Real world experience still needed