1 Market Structures for U.S. Water Quality Trading Richard T. Woodward & Ronald A. Kaiser Texas A&M University

2 Pollution trading is on the rise n A national SO 2 market is active n NOx is traded in numerous regional markets n Trading in Greenhouse gases is written into the Kyoto Protocol n EPA report lists 25 Water Quality trading programs in various stages of implementation and development (Environomics 1999)

3 Prominent Water Quality Trading Programs

4 So why all the interest? n Trendy & the economic arguments are convincing n Increasing use of Total Maximum Daily Load (TMDL) regulatory structure n Relative importance of nonpoint polluters -- WQ Trading is seen as a potential carrot since sticks are difficult to impose.

5 Some goals for WQ programs n Ensure that environmental objectives are achieved n Minimize total cost of abatement n Minimize the agency’s costs and legal risks n Minimize participant transaction costs n Minimize initial costs to both the agency and regulated community

6 No single market structure can achieve all of these goals n Market structures in pollution trading Exchanges Bilateral negotiations Clearinghouses Sole-source offsets

7 Exchanges n The prototypical “market” –products are equivalent –prices are observed n WTP of buyers  WTA of holders of the good (net of transaction costs) n No Pareto-improving trades should remain unfulfilled. n Transaction costs are typically quite low

8 Exchanges in Pollution Trading n The SO 2 market n Some NOx markets n Uniformity is achieved: –The good is defined by law to be uniform –Compliance is monitored by the regulatory agency

9 Why Exchanges are difficult in WQ markets n Good is by nature non-uniform –Water flows down hill and changes as it goes n Pollution by nonpoint sources are not easily measured or monitored –All sellers of pollution are not viewed as equivalent –Ongoing relationships between the buyer and the seller are frequently required

10 Bilateral negotiations n Example: the market for used cars These are not ideal markets n Each transaction is negotiated separately n Information, contracting and enforcement costs are quite high

11 Bilateral negotiations in WQ markets n Many programs require a separate contract for each trade n Because of provisions of the Clean Water Act, substantial supervision of each trade is required n Programs with bilateral trading: Dillon Kalamazoo Fox River S. Minn. Beet Sugar Coop. M ichigan’s proposed rules

12 Bilateral Trading: Strengths & Weaknesses n Strengths –Allows for a quite decentralized approach –Risks and responsibilities are born by traders n Weaknesses –Substantial transaction costs –Oversight can be onerous

13 Clearinghouse markets n Like a supermarket selling ground meat –An intermediary purchases many, possibly nonuniform products –Sells them as a uniform product n Both buyers and sellers know exactly where to go

14 An example of a clearinghouse in WQ trading n Tar Pamlico PS/NPS program –Part of the State’s Agricultural Cost Share program –farmers are paid 75% of the cost of implementing BMPs that reduce runoff –Buyers of credits make payments into the fund based on the average cost per unit of reduction (originally $56 per kg, $29 in 1996)

15 Advantages and Disadvantages of Clearinghouses Advantages n Intermediary ensures the quality of credits n Intermediary bears most transaction costs –Low transaction costs for buyer –Low seller Disadvantages n Agency bears all the risk & responsibility n A non-profit intermediary can lead to an inefficient outcome

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17 Sole-source offsets n Alternative to traditional abatement programs but does not involve trading between independent parties n Analogous to firm-level decisions to vertically integrate production processes

18 City of Boulder’s program n Attempts to reduce ammonia through creek restoration n The city’s waste water treatment plant carried out activities independently without trading

19 Sole-source offsets n Advantages –Lower transaction costs (no transactions) –Lower monitoring costs –Can typically be implemented in the context of existing regulations n Disadvantages –Limited potential for cost savings

20 Conclusions n Water quality trading is on the rise n Don’t expect to see a bunch of exchanges developing n In standard markets there are a variety of market structures n Similar diversity will likely be found in WQ markets n Market structure is a choice and must be made carefully