Crunch Time for Water Quality Trading

Advocates of WQ trading are putting their hopes on the anticipated establishment over the next few years of Total Maximum Daily Loads (TMDLs) for individual water bodies. These are a kind of total pollution budget that could be divided among pollution dischargers as individual discharge allowances that could be made tradable. The Clean Water Act of 1972 required each state to develop and implement TMDLs by 1979, but they are only now being developed in most parts of the country. Eventually, TMDLs may provide the market driver that is needed to make WQ trading work. (See Boyd, 2000.) However, establishing TMDLs will merely be the first of many steps that will all need to be taken quickly if WQ trading is to be given a fair chance to succeed. State and local WQ regulators, under increasing pressure to do something soon about growing WQ problems, are beginning to turn to familiar command-and-control methods and subsidy programs that often preclude the possibility of ever having meaningful WQ trading.

The three questions that even diehard trading advocates are beginning to ask are: Why are there so few WQ trading success stories? Why aren't the point and nonpoint sources who are supposed to benefit from WQ trading more supportive? What can be done to improve the situation?

Reviews of regional WQ trading programs reveal the most often cited problems inhibiting regional WQ trading, such as inadequate trading institutions, unclear scoring criteria, and high transactions costs of performing trades, are being overcome in most places (King & Kuch, 2003). What is preventing WQ trading is a simple absence of willing buyers and sellers. Under existing regulatory conditions, the supply and demand curves in fledgling WQ markets barely exist and certainly don't cross at any positive price. Moreover, those attempting to make regional WQ work are usually not in positions to change the situation. Tighter federal and/or state limits on individual dischargers will be required before there will be any commodities (rights) to trade in WQ markets; aggressive enforcement of those limits will then be needed to bolster supply and demand.

New Water Quality Trading Guidance

Time Pressure

In early 2004, however, Maryland's governor and state legislature responded to public pressure to do something about WQ by establishing an innovative $2.50 per month "flush tax" on water and sewer users (mostly urban dwellers) to create a fund to subsidize the installation of state-of-the-art discharge treatment technologies at the state's wastewater facilities. A similar tax was levied on households on wells and septic systems (mostly rural dwellers) to subsidize the planting of agricultural cover crops and other agricultural "best management practices." Of course, the flush tax all but eliminated the expected demand for WQ credits by wastewater facilities; and the subsidization of agricultural practices all but eliminated the expected supply of low-cost agricultural WQ credits. With the stroke of the governor's pen, prospects for WQ trading any time soon in Maryland evaporated.

Beyond the ABCs of WQ Trading

However, the land and water use decisions by nonpoint sources that cause local water quality problems are very different than the point source smokestacks that cause regional air pollution problems. Most water emissions are difficult to measure, change with the weather, have different impacts depending on where they occur, and are the results of ever-changing locally made and locally regulated decisions. This is a complicated problem to attempt to address with trading. In fact, two areas of recent economic research suggest that in this type of situation a great deal of political and regulatory reform may be necessary to interest anyone in trading.

The first area of economic research won two economists — Finn Kydland of Carnegie Mellon University and Edward Prescott of Arizona State University — the 2004 Nobel Prize in economics. Kydland and Prescott (1977) explained why and how people "game" regulatory programs; that is, why and how they strategize to evade regulations and employ legal and political maneuvering to avoid, delay, and reduce penalties for violating regulations they cannot avoid. The second involves work in what might be called "environmental enforcement economics." This area of research also addresses how people "game" regulatory programs, but focuses specifically on that little benefit/cost calculation that each regulated entity performs to determine whether or not to comply with a regulation.

Market-based solutions to WQ problems, despite considerable rhetoric to the contrary, are not substitutes for regulatory solutions; they rely on and complement regulations. It is well known, for example, that the acid rain trading program succeeded because precise individual SO₂ discharge limits were established and strictly enforced with 100% monitoring and severe financial penalties for violators (see Stavins, this issue). For now, at least, most nonpoint water pollution dischargers are either unregulated or do not expect that violating regulations will be detected or will be very costly. As a result, they have little incentive to get involved in allowance trading. Many of them are also aware that accepting the notion that tradable discharge allowances (i.e., "pollution rights") can be neatly defined and assigned to individual entities could undermine their long-term political and legal strategies for fending off regulations. Asserting that they have a credible basis for earning money by selling WQ credits now, in other words, means that others will have a credible basis for justifying future restrictions on their emissions that could result in significant long-term costs later.

Based on the above-mentioned economic research, what is being observed in WQ trading programs, in other words, is exactly what should be expected. In the face of weak, rarely enforced emission discharge restrictions and penalties for noncompliance that are small and easily avoided, few dischargers are interested in buying WQ credits. Where there is no demand for WQ credits, there is no incentive for anyone to try to supply credits. This is a fairly simple conclusion, but it implies that strategies to improve point/nonpoint WQ trading should focus on demand-side and supply-side issues, rather than the institutional and technical issues that occupy the time of most WQ trading experts.

Demand-Side Issues

Virtually everywhere that WQ trading is being attempted, laws limiting nutrient discharges (on nonpoint sources at least) are weak, rarely enforced, and involve such low penalties that the expected cost of noncompliance is near zero. The corresponding willingness to pay for nutrient discharge credits, therefore, is also near zero. There is no "natural" demand in regulation-driven markets; demand always depends on what regulations are in place and how they are enforced.

The two 2004 Nobel-winning economists examined the deterrent effects of regulations in considerable detail and pointed out the impact of what they labeled "time inconsistency problems" with many regulatory programs. In case after case involving financial and real estate markets, flood insurance markets, and environmental compliance, they showed that people, acting alone and in groups, significantly discounted the expected cost (penalty) of not complying with a regulation if they believed that it would not be implemented consistently over time and could be influenced later. Kydland and Prescott's work demonstrated that people tend to believe that if government yields to one kind of political pressure to pass laws restricting their polluting behavior now, they can be expected to yield to other political pressure later that will prevent the enforcement of those laws or the imposition of meaningful penalties.

Their research showed that the success or failure of regulatory systems (market based or otherwise) depends overwhelmingly on bottom-up microeconomic decisions regarding opportunities to game those systems, and far less on macroeconomic governmental decisions about how those systems are supposed to work.

Based on this research, it seems that bolstering the demand side of WQ markets will require mustering the political will to establish a credible system for enforcing individual allowances, and imposing meaningful penalties for exceeding them.

Supply-Side Issues

To protect the integrity of trading programs, trading guidelines nearly always prohibit farmers from selling credits for undertaking land use/land management changes that are legally required (e.g., by state regulation) or for which the farmer has already been paid (e.g., green payments). Setting the baseline for credits in this way reduces the ability of farmers in most watersheds to supply low-cost WQ credits. However, it has other impacts on farmers as well. It means producing WQ credits by implementing management practices that go beyond what they are already required to do will require farmers to somehow validate that these practices do, in fact, reduce discharge levels. The need to establish a baseline and show additionality poses two problems for farmers who are considering supplying WQ credits.

First, it requires that someone examine and document what farmers are already doing to meet their legal requirements in order to establish the baseline for measuring marketable WQ credits. Most farmers, for obvious reasons, are not interested in having government representatives or their agents examining, thinking, and talking about the legality of their on-farm land use/land management practices or their justification for green payments.

Second, farmers know that their discharges are not regulated as much as discharges from most other sources because, presumably, farm discharges are too difficult to control or measure, too dependent on the weather, too expensive for farmers to manage, and so on. Selling credits requires farmers to provide evidence to validate that, in fact, they can reduce their discharges and document the results. Many analysts have addressed validation requirements in terms of their potential to increase transaction costs associated with completing market trades and the likelihood that these higher costs could drive a wedge between buyers and sellers. However, a more important problem may be that if farmers show that they can validate the creditworthiness of their on-farm activities, it is bound to call into question whether they should be regulated any differently than other dischargers.

There are also other disincentives facing farmers. The price farmers will accept for WQ credits reveals their discharge control costs and shows the world that they are most certainly lower than the discharge control costs of those buying credits. This focuses attention on what many already believe are inequities in the way discharges are regulated and, perhaps, in the way allocations of discharge allowances are made to farmers and others. It also provides evidence that a better long-term cost-saving strategy for dealing with WQ problems might be to tighten restrictions on farmers with low treatment costs and relax them on other dischargers who have higher marginal treatment costs.

The sources of these disincentives on the supply side of WQ trading are similar to those on the demand side. Weak, vague, and largely unenforced discharge restrictions inhibit potential suppliers from engaging in trading, just as they inhibit potential buyers. However, the strategies that farmers can and will use to game market-based environmental programs are intertwined with their strategies for gaming other government programs, so supply-side problems appear to be more complex.

The Immediate Challenge

The fact remains, however, that the regulatory context that provides the incentives and disincentives for buyers and sellers to participate in regional WQ trading is usually not within the control of the people who are attempting to make regional WQ trading work. One useful strategy, therefore, is for those people (and all the rest of us who want WQ trading to have a chance to live up to its potential) to work together to influence state and federal agencies and elected officials who set the legal and regulatory context for WQ trading. Such an initiative could focus on the following five tasks:

• Make sure the new EPA guidance is followed when establishing a WQ trading program;
• discourage command-and-control regulatory programs that inhibit WQ trading;
• encourage binding discharge restrictions on point and nonpoint sources;
• encourage meaningful monitoring and enforcement of restrictions with stiff penalties; and
• determine gaming strategies that point and nonpoint sources will use to limit regulation and avoid penalties and encourage countervailing public policies.

Notes

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