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Water quality trading
The use of market-based approaches to environmental policy in the U.S. is clearly on the rise. Acid rain is being addressed using tradable permits for sulfur dioxide emission, cities throughout the country allow trading in Nitrogen Oxide, wetland mitigation banks are being widely used, and trading in greenhouse gases is authorized by the Kyoto Protocol on Climate Change.

Cost-Efficient Means for Pollution Reduction

Market-based approaches are also being pursued for the control of water pollution. A market-based approach to pollution control refers to a program in which individual polluters are able to trade among themselves to determine who will pollute less and who will pollute more.

For example, if pollution reduction by source A is more expensive than it would be for source B, then A and B should be able to make a bargain in which A's required reductions are instead achieved by B such that the overall pollution reduction goal is still met. Suppose, for example, that reducing A's phosphorous (P) load by 10 pounds would cost $2,000, while reducing B's P load by the same amount would cost only $1,200.

If A and B are located close to each other, then the same environmental benefit would be achieved regardless of which firm reduces its load. If A is required to reduce its P load by 10 pounds, then paying B (more than $1,200 but less than $2,000) to reduce its load by that amount would be cheaper than implementing the reduction itself. Because the total cost of the environmental improvement is $800 less when implemented by B, such a trade is called cost efficient.

Markets for Water Quality Trading

A market exists when parties exchange goods or services voluntarily. In order for a market to exist, two features must be present. First, the good in question must be scarce so that there is some agent that does not have as much of the good as he or she desires. The second critical feature for the existence of a market is that the rights to the good or service must be transferable. When a good is scarce and transferable, markets tend to develop that allow agents to exchange the good for mutual gain.

In the case of water quality trading, both the scarcity and the transferability must be established through government actions. Without regulation, firms and individuals would be free to pollute at will, and they would feel no need to pay for the right to do so.

Pollution regulations, therefore, create scarcity by limiting the rights of polluters - who would presumably be willing to pay to have the restrictions on their emissions relaxed. The creation of scarcity alone, however, does not create a market, because under standard technology-based controls, environmental improvements by one source cannot be transferred to any other source. The innovation of water quality trading programs is that environmental gains by one source can be transferred to another source that is required to make environmental improvements.

Characteristics of Water Quality Trading Programs

Water quality trading programs differ greatly in terms of who is involved in the trading and the form that such trading takes. The U.S. EPA has identified five main forms of effluent trading and described
them in detail in the Draft Framework (USEPA, 1996a).

Forms of Water Quality Trading

Benefits and Limitations

All forms of market-based pollution reduction yield similar economic, social, and environmental benefits compared to traditional command-and-control regulatory programs. The table below lists some of
those benefits as they apply to water quality trading programs.

benefits of water quality trading

Benefits of Water Quality Trading

It is important to note that very few trading schemes for point and nonpoint source water pollution control have actually resulted in active markets. This lack of trading activity is due to a number of limitations of water quality trading.

For example, the number of trades is influenced by the availability of trading partners and whether or not they discharge the same pollutants. Also, water quality trading is usually best suited for aggregate pollution problems, not pollutants with highly located effects and threshold damages, limiting the applicability to pollutants that have been less regulated historically.

Control of nonpoint sources is difficult because the effectiveness of technologies to reduce their loadings is uncertain and will be determined in part by random factors such as weather. Another limitation stems from the transaction costs required to implement and participate in a trading program; these costs can be quite high and have repeatedly proven to be a barrier to a successful program.

Given these and other barriers, if resources for development, education, and promotion are insufficient, the potential for success will be severely limited. Overcoming the limitations of water quality trading is a major challenge for developers of future programs and would require careful and creative planning and active agency promotion.