Academic journal article Journal of Regional Analysis & Policy

A Simulation of Factors Impeding Water Quality Trading

Academic journal article Journal of Regional Analysis & Policy

A Simulation of Factors Impeding Water Quality Trading

Article excerpt

Abstract. While there is substantial evidence that nonpoint sources have lower nutrient reduction costs than point sources, experience with water quality trading (WQT) reveals a common theme: little or no trading activity. The success of WQT seems, in part, to depend on the structure of the market created to bring buyers and sellers together to transact exchanges. To examine the ways that various market imperfections may affect the performance of a WQT market, a model is constructed which simulates a hypothetical point-nonpoint market. This paper focuses on answering the following question: How can WQT programs be designed in ways that take into account factors that result in non-optimal contracting and what are the implications (if there are any) for determining trading ratios? Here, we find that apart from any implications for environmental risk or political-economic factors, there is an economic welfare justification for high trading ratios in certain situations with limited trading information and/or other barriers to trade. Limited information and other barriers to trade which inhibit the optimal contracting of trades introduces a random element to market participation, creating a risk that high-cost sellers (low-value buyers) will transact to displace low-cost sellers (high-value buyers) who could have traded for greater gain.

1. Introduction

With numerous water quality goals remaining unmet and many millions of dollars being spent on water quality improvement each year in the United States, there is an impetus to increase the economic efficiencies of pollution reduction (Peterson and Smith, 2012). Environmental economists have argued that pollution trading programs are an efficient means of improving environmental quality, as they give firms with the lowest pollution control costs the largest incentive to reduce pollution. Such low-cost firms are able to sell pollution credits to firms with higher control costs. Allowing firms with heterogeneous control costs the opportunity to cooperate displays the potential of reduced costs of pollution abatement. Such freedoms and flexibilities typically do not arise from traditional, uniform regulations.

Following on the highly successful trading programs for air emissions such as sulfur dioxide (NCEE, 2001), many states have recently adopted trading programs to improve water quality. There are at least 47 water quality trading (WQT) programs currently active or under development worldwide, with the overwhelming majority in the United States (Selman et al., 2009). In principle, such programs could be applied to any water-borne pollutant and allow trading among point sources, among nonpoint sources, or between point and nonpoint sources (the latter is known as 'pointnonpoint trading'). Most of the existing programs are designed with point-nonpoint trading to limit nutrient loading: point sources are allowed to meet their (reduced) nutrient emission limits by purchasing water quality credits from agricultural producers in the surrounding watershed. These producers are then obligated to implement a best management practice (BMP) that reduces expected nutrient loading by an amount commensurate with the number of credits sold. A regulatory agency lowering the acceptable limit of nutrient loading by point sources is the common "driver" necessary for the market to function.

From a conceptual standpoint, in a wellfunctioning market with perfect information and zero transaction costs, and where traders' decisions are motivated purely by the economic gain from trading, agents' propensity to trade is perfectly correlated with their relative positions along the demand and supply curves. Heterogeneity in point sources' willingness to pay (WTP) for credits brings about a downward sloping demand curve, where the sources with the highest WTP have the greatest likelihood of trading. Similarly, heterogeneity in nonpoint sources' costs or willingness to accept (WTA) payment for credits generates an upward sloping supply curve, where the sellers with the lowest WTA trade with the highest likelihood. …

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