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                                                                                   1st Quarter 2005 – 20(1)

 The magazine of food, farm, and resource issues                                       A publication of the
                                                                                       American Agricultural
                                                                                       Economics Association
 1st Quarter 2005 • 20(1)

 Crunch Time for Water Quality Trading
 Dennis M. King

         Experience so far with water quality (WQ) trading is proving, once again, that in
 regulation-driven markets the “invisible hand” will not work without the “visible foot” of a
 regulator with the authority and political support to use it. We are definitely not there yet.

Economists have been promoting water quality (WQ)              years of Total Maximum Daily Loads (TMDLs) for
trading for decades. Over the past few years, many             individual water bodies. These are a kind of total
political leaders and upper-level government officials         pollution budget that could be divided among pollution
have been joining them. Money has even started to              dischargers as individual discharge allowances that
flow from Washington to local trading organizations to         could be made tradable. The Clean Water Act of 1972
help make WQ trading work. However, enthusiasm                 required each state to develop and implement TMDLs
about WQ trading is based mostly on conceptual                 by 1979, but they are only now being developed in
arguments about its potential to generate cost savings         most parts of the country. Eventually, TMDLs may
and ideological arguments about the superiority of             provide the market driver that is needed to make WQ
market-based solutions over conventional regulatory            trading work. (See Boyd, 2000.) However, establishing
programs. Experiences with actual WQ trading                   TMDLs will merely be the first of many steps that will
programs have been discouraging. Under current                 all need to be taken quickly if WQ trading is to be
regulatory conditions, there is simply not enough              given a fair chance to succeed. State and local WQ
supply or demand to support WQ trading. The critical           regulators, under increasing pressure to do something
question now is whether the regulatory conditions that         soon about growing WQ problems, are beginning to
are inhibiting trading will change any time soon.              turn to familiar command-and-control methods and
According to a recent EPA-funded review, the number            subsidy programs that often preclude the possibility of
of WQ trading initiatives in the United States during          ever having meaningful WQ trading.
2004 was more than 70 (Breetz et al., 2004), which is               The three questions that even diehard trading
up from around 25 just a few years earlier                     advocates are beginning to ask are: Why are there so
(Environomics, 1999; King & Kuch, 2003) However,               few WQ trading success stories? Why aren’t the point
this recent review, like previous ones, showed that WQ         and nonpoint sources who are supposed to benefit from
trading programs are frozen at an awkward pretrading           WQ trading more supportive? What can be done to
stage of development—plenty of new guidelines,                 improve the situation?
regional trading institutions, and computer simulations             Reviews of regional WQ trading programs reveal
of trading, and even some well-developed WQ trading            the most often cited problems inhibiting regional WQ
software and websites, but very little actual trading          trading, such as inadequate trading institutions, unclear
taking place. Most importantly, point/ nonpoint1               scoring criteria, and high trans-actions costs of
trading involving agriculture—the type that will be            performing trades, are being overcome in most places
needed for WQ trading to have a significant impact in          (King & Kuch, 2003). What is preventing WQ trading
many watersheds and the type of trading that will be           is a simple absence of willing buyers and sellers.
addressed in this article—has not materialized at all.         Under existing regulatory conditions, the supply and
    Advocates of WQ trading are putting their hopes            demand curves in fledgling WQ markets barely exist
on the anticipated establishment over the next few             and certainly don’t cross at any positive price.
                                                               Moreover, those attempting to make regional WQ
1. Point sources discharge pollution from a single place,      work are usually not in positions to change the
such as a pipeline outflow. Nonpoint sources discharge         situation. Tighter federal and/or state limits on
pollution from many places, such as along the edge of a farm   individual dischargers will be required before there
or housing development.                                          1st Quarter 2005 – 20(1)     Choices          71
will be any commodities            Maryland, illustrate why these          trading any time soon in
(rights) to trade in WQ            steps need to take place soon,          Maryland evaporated.
markets;           aggressive      before WQ trading becomes
enforcement of those limits        impossible. More than three             Beyond the ABCs of WQ
will then be needed to bolster     years of work by a partnership          Trading
supply and demand.                 of     state/federal      resource
                                   agencies and stakeholders               In principle, establishing an
New Water Quality Trading          culminated in 2003 with a set           emission trading program is a
Guidance                           of guidelines to support                simple three-step process
                                   watershed-based WQ trading.             involving: (a) establishing
In November 2004, the              At that time, it was generally          an overall cap on pollution
Environmental        Protection    assumed that TMDLs were                 discharges, (b) allocating
Agency (EPA) published a           just around the corner and that         portions of the cap as
Water      Quality     Trading     once trading guidelines were            allowances to individual
Assessment Handbook (EPA,          adopted, trading would take             discharge sources, and (c)
2004) to help regional             place       with      wastewater        allowing each source to meet
organizations establish “the       treatment facilities (point             its allowance by reducing its
necessary conditions for           sources) that have relatively           discharge or by purchasing
successful WQ trading.” This       high discharge treatment costs          credits from other sources that
national guidance is very          purchasing WQ “allowances”              reduce their discharges below
general and focuses on tasks       from agricultural interests             their allowances. As long as
such as developing trading         (nonpoint       sources)      with      there are differences in
institutions, measuring the        relatively     low       discharge      discharge reduction costs,
equivalency of pollution           reduction costs.                        sources with high costs of
discharges, establishing rules         In early 2004, however,             meeting their allowances will
of exchange, setting base-         Maryland’s governor and                 purchase credits from sources
lines, assigning liability, and    state legislature responded to          with low costs, and a market
so on. Most of these tasks         public      pressure       to   do      will be born. This is the
may be necessary for               something about WQ by                   process that established the
successful      WQ      trading.   establishing an innovative              highly       acclaimed       and
However, none of them will         $2.50 per month “flush tax”             apparently successful air
provide the buyers and sellers     on water and sewer users                emission trading programs
that are really needed for WQ      (mostly urban dwellers) to              that helped reduce SO2
trading programs to succeed.       create a fund to subsidize the          emission (acid rain) problems
In fact, managers of the           installation of state-of-the-art        (see Stavins, this issue).
existing regional WQ trading       discharge treatment tech-                   However, the land and
programs that have been            nologies at the state’s                 water use decisions by
failing to produce trades have     wastewater        facilities.    A      nonpoint sources that cause
al-ready completed most of         similar tax was levied on               local water quality problems
the tasks recommended in           households on wells and                 are very different than the
these new EPA guidelines.          septic systems (mostly rural            point source smokestacks that
What are needed beyond what        dwellers) to subsidize the              cause regional air pollution
is outlined in the EPA             planting of agricultural cover          problems.       Most       water
guidance are steps that will       crops and other agricultural            emissions are difficult to
change the incentives and          “best management practices.”            measure, change with the
disincentives facing prospec-      Of course, the flush tax all but        weather,      have      different
tive buyers and sellers in         eliminated       the      expected      impacts depending on where
ways that will make them           demand for WQ credits by                they occur, and are the results
want to trade.                     wastewater facilities; and the          of ever-changing locally made
                                   subsidization of agricultural           and       locally      regulated
Time Pressure                      practices all but eliminated            decisions.      This     is     a
                                   the expected supply of low-             complicated       problem      to
Developments     in     the        cost agricultural WQ credits.           attempt to address with
Chesapeake Bay      region,        With the stroke of the gover-           trading. In fact, two areas of
especially in the State of         nor’s open, prospects for WQ            recent economic research                                  1st Quarter 2005 – 20(1)    Choices           72
suggest that in this type of        costly. As a result, they have         potential buyer’s willingness
situation a great deal of           little incentive to get involved       to pay for a WQ credit is
political      and     regulatory   in allowance trading. Many of          based on that entity’s
reform may be necessary to          them are also aware that               marginal cost of complying
interest anyone in trading.         accepting the notion that              with      nutrient      discharge
     The first area of economic     tradable discharge allowances          restrictions (e.g., dollars per
research           won       two    (i.e., “pollution rights”) can         pound of nutrient discharge
economists—Finn Kydland of          be neatly defined and                  reduction). In-stead, assume
Carnegie Mellon University          assigned to individual entities        that the correct measure of an
and Edward Prescott of              could undermine their long-            entity’s willingness to pay for
Arizona State University—the        term political and legal               a credit is the expected cost of
2004       Nobel      Prize    in   strategies for fending off             not complying with a
economics. Kydland and              regulations. Asserting that            government-imposed             dis-
Prescott (1977) explained           they have a credible basis for         charge restriction. If the
why and how people “game”           earning money by selling WQ            expected       cost     of     not
regulatory programs; that is,       credits now, in other words,           complying is lower than the
why and how they strategize         means that others will have a          cost of complying by
to evade regulations and            credible basis for justifying          purchasing credits, there is no
employ legal and political          future restrictions on their           economic        incentive        to
maneuvering to avoid, delay,        emissions that could result in         purchase credits.
and reduce penalties for            significant long-term costs                Virtually everywhere that
violating regulations they          later.                                 WQ       trading     is     being
cannot avoid. The second                 Based on the above-               attempted,      laws      limiting
involves work in what might         mentioned economic re-                 nutrient      discharges       (on
be called environ-mental            search,     what     is    being       nonpoint sources at least) are
enforcement          economics.”    observed in WQ trading                 weak, rarely enforced, and
This area of research also          programs, in other words, is           involve such low penalties
addresses how people “game”         exactly what should be                 that the expected cost of
regulatory programs, but            expected. In the face of weak,         noncompliance is near zero.
focuses specifically on that        rarely enforced emission               The corresponding willing-
little benefit/cost calculation     discharge restrictions and             ness to pay for nutrient
that each regulated entity          penalties for noncompliance            discharge credits, there-fore,
performs        to    deter-mine    that are small and easily              is also near zero. There is no
whether or not to comply with       avoided, few dischargers are           “natural”        demand          in
a regulation.                       interested in buying WQ                regulation-driven        markets;
     Market-based solutions to      credits. Where there is no             demand always depends on
WQ        problems,       despite   demand for WQ credits, there           what regulations are in place
considerable rhetoric to the        is no incentive for anyone to          and how they are enforced.
contrary, are not substitutes       try to supply credits. This is a           The two 2004 Nobel-
for regulatory solutions; they      fairly simple conclusion, but          winning economists exam-
rely on and complement              it implies that strategies to          ined the deterrent effects of
regulations. It is well known,      improve point/nonpoint WQ              regulations in consider-able
for example, that the acid rain     trading should focus on                detail and pointed out the
trading program succeeded           demand-side and supply-side            impact of what they labeled
because precise individual          issues, rather than the                “time inconsistency prob-
SO2 discharge limits were           institutional and technical            lems” with many regulatory
established and strictly en-        issues that occupy the time of         programs. In case after case
forced with 100% monitoring         most WQ trading experts.               involving financial and real
and severe financial penalties                                             estate       markets,        flood
for violators (see Stavins, this    Demand-Side Issues                     insurance       markets,       and
issue). For now, at least, most                                            environmental       compliance,
nonpoint water pollution            To appreciate what needs to            they showed that people,
dischargers are either un-          be done to stimulate demand,           acting alone and in groups,
regulated or do not expect that     it is useful to abandon the            significantly discounted the
violating regulations will be       standard economist’s operat-           expected cost (penalty) of not
detected or will be very            ing assumption that a                  complying with a regulation if                                  1st Quarter 2005 – 20(1)    Choices              73
they believed that it would not     and to fend off future environ-            Second, farmers know that
be implemented consistently         mental regulations. The main           their discharges are not
over time and could be              problems farmers face here             regulated     as    much      as
influenced later. Kydland and       (although they do not refer to         discharges from most other
Prescott’s work demonstrated        them in these terms) are what          sources because, presumably,
that people tend to believe         in environmental trading               farm discharges are too
that if government yields to        circles have become known as           difficult   to     control    or
one kind of political pressure      baseline/additionality issues.         measure, too dependent on the
to pass laws restricting their          To protect the integrity of        weather, too expensive for
polluting behavior now, they        trading programs, trading              farmers to manage, and so on.
can be expected to yield to         guidelines nearly always               Selling     credits     requires
other political pressure later      prohibit farmers from selling          farmers to provide evidence
that     will    prevent    the     credits for undertaking land           to validate that, in fact, they
enforcement of those laws or        use/land management changes            can reduce their discharges
the imposition of meaningful        that are legally required (e.g.,       and document the results.
penalties.                          by state regulation) or for            Many analysts have addressed
    Their research showed that      which the farmer has already           validation requirements in
the success or failure of           been paid (e.g., green                 terms of their potential to
regulatory systems (market          payments).       Setting     the       increase transaction costs
based or other-wise) depends        baseline for credits in this           associated with completing
overwhelmingly on bottom-           way reduces the ability of             market trades and the
up micro-economic decisions         farmers in most watersheds to          likelihood that these higher
regarding opportunities to          supply low-cost WQ credits.            costs could drive a wedge
game those systems, and far         However, it has other impacts          between buyers and sellers.
less     on    macroeconomic        on farmers as well. It means           However, a more important
governmental decisions about        producing WQ credits by                problem may be that if
how those systems are               implementing        management         farmers show that they can
supposed to work.                   practices that go beyond what          validate the credit-worthiness
    Based on this research, it      they are already required to           of their on-farm activities, it
seems that bolstering the           do will require farmers to             is bound to call into question
demand side of WQ markets           some-how validate that these           whether they should be
will require mustering the          practices do, in fact, reduce          regulated any differently than
political will to establish a       discharge levels.                      other dischargers.
credible system for enforcing       The need to establish a                    There are also other
individual allowances, and          baseline and show addi-                disincentives facing farmers.
imposing            meaningful      tionality poses two problems           The price farmers will accept
penalties for exceeding them.       for     farmers      who     are       for WQ credits reveals their
                                    considering supplying WQ               discharge control costs and
Supply-Side Issues                  credits.                               shows the world that they are
                                        First, it requires that            most certainly lower than the
The gaming model (as                someone       examine       and        discharge control costs of
opposed to the marginal cost        document what farmers are              those buying credits. This
model) also explains what is        already doing to meet their            focuses attention on what
inhibiting the supply side of       legal requirements in order to         many already believe are
regional WQ trading markets.        establish the baseline for             inequities    in     the    way
In watersheds where agricul-        measuring marketable WQ                discharges are regulated and,
tural sources are signify-cant,     credits. Most farmers, for             perhaps,     in     the     way
it is usually assumed that they     obvious reasons, are not               allocations     of     discharge
will be the primary suppliers       interested       in      having        allowances are made to
of WQ credits. However, the         government representatives or          farmers and others. It also
willingness of farmers to           their     agents     examining,        provides evidence that a
supply WQ credits depends in        thinking, and talking about            better long-term cost-saving
critical ways on how it might       the legality of their on-farm          strategy for dealing with WQ
affect their ability to continue    land use/land management               problems might be to tighten
receiving            agricultural   practices or their justification       restrictions on farmers with
subsidies and green payments        for green payments.                    low treatment costs and relax                                  1st Quarter 2005 – 20(1)   Choices            74
them on other dischargers          reform will be needed to               For More Information
who have higher marginal           stimulate supply and demand
treatment costs.                   and make WQ trading work.              Boyd, J. (2000). The new faces of the
    The sources of these                The fact remains, how-               Clean Water Act: A critical
disincentives on the supply        ever, that the regulatory                 review of the EPA’s proposed
side of WQ trading are similar     context that provides the                 TMDL rules (discussion paper 00-
to those on the demand side.       incentives and disincentives              12). Washington, DC: Resources
Weak, vague, and largely           for buyers and sellers to                 for the Future.
unenforced discharge restrict-     participate in regional WQ             Breetz, H.L., et al. (2004). Water
ions inhibit potential suppliers   trading is usually not within             quality trading and offset
                                                                             initiatives in the United States:
from engaging in trading, just     the control of the people who
                                                                             comp-prehensile survey (report
as they inhibit potential          are attempting to make
                                                                             for the EPA). Hanover, NH:
buyers.      However,        the   regional WQ trading work.                 Dartmouth College Rockefeller
strategies that farmers can and    One useful strategy, there-               Center
will use to game market-           fore, is for those people (and         Environmental Protection Agency
based environmental prog-          all the rest of us who want               Office of Water, Wetlands,
rams are intertwined with          WQ trading to have a chance               Oceans, and Watersheds. (2004).
their strategies for gaming        to live up to its potential) to           Water quality trading assessment
other government programs,         work together to influence                handbook: Can water quality
so supply-side problems            state and federal agencies and            trading advance your watershed’s
appear to be more complex.         elected officials who set the             goals? Washington, DC: EPA.
                                   legal and regulatory context              Available on the World Wide
The Immediate Challenge            for WQ trading. Such an                   Web: http://
                                   initiative could focus on the              watershed/trading/handbook/.
Careful observers of emerg-        following five tasks:                  Environomics, Inc. (1999). Summary
ing WQ trading understand          • Make sure the new EPA                   of U.S. effluent trading and offset
that this type of market-based       guidance is followed when               projects. Report prepared for the
solution is not an alternative       establishing a WQ trading               EPA Office of Water,
to WQ regulations. However,          program;                                Washington, DC.
                                   • discourage command-and-              King, D.M., & P.J. Kuch. (2003).
this is still not fully
                                     control regulatory programs              Will nutrient credit trading ever
understood by many political
                                     that inhibit WQ trading;                work? An assessment of supply
leaders and agency heads.                                                    problems, demand problems, and
One immediate challenge,           • encourage binding discharge
                                     restrictions on point and               institutional obstacles. The
therefore, is to convince those                                              Environmental Law Reporter.
                                     nonpoint sources;
who are using the promise of                                                 Washington, DC: Environmental
                                   • encourage meaningful moni-
market-based environmental           toring and enforcement of               Law Institute.
solutions as a justification for     restrictions     with     stiff      King, D.M. (2002). Managing
relaxing regulations that this       penalties; and                           Environmental Trades: Lessons
strategy cannot succeed.           • determine gaming strategies             from Hollywood, Stockholm, and
Another immediate challenge          that point and non-point                Houston. The Environmental Law
is to convince those who are         sources will use to limit               Reporter. Washington, DC:
introducing       new       WQ       regulation and avoid penalties         Environmental Law Institute.
initiatives, such as mandatory       and encourage countervailing         Kydland, F.E., & E.C. Prescott.
engineering or discharge             public policies.                       (1977). Rules rather than
standards, that their decisions       If    these     tasks   are           discretion: The inconsistency of
may make it impossible to          undertaken soon, the potential           optimal plans. Journal of Political
have WQ trading or to realize      of WQ trading might be                   Economy, 85(3), 473-91.
potential cost savings from        realized. If not, WQ trading
WQ trading. At the same            will probably wind up in the
time, it would be useful for       overflowing dustbin of well-           Dennis King is a research professor at
those involved in developing       intentioned economic policies          the University of Maryland Center for
                                                                          Environmental Science and director of
regional WQ trading to             that attracted attention for a
                                                                          King and Associates, Inc., an
perform what might be called       while but never delivered.             environmental economic consulting
a “WQ enforcement audit” in                                               firm.
their region to determine how
much political and regulatory                                 1st Quarter 2005 – 20(1)    Choices            75

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