Many have argued that water quality trading could become the next large environmental market. However, for the time being, the market is very small and somewhat fractured, with experience in the US and very few other countries. To look at the issues associated with water quality trading in the US–and to draw some lessons learned from experience to date–the Ecosystem Marketplace asked Mark Kieser and "Andrew" Feng Fang, two experts on the subject, to provide us with their views.
Many have argued that water quality trading could become the next large environmental market. However, for the time being, the market is very small and somewhat fractured, with experience in the US and very few other countries. To look at the issues associated with water quality trading in the US–and to draw some lessons learned from experience to date–the Ecosystem Marketplace asked Mark Kieser and "Andrew" Feng Fang, two experts on the subject, to provide us with their views. As the market for carbon takes off in the European Union, many have begun to ask the obvious question: what environmental commodity is next? One answer that is often given to this question is water. Water, say some experts, has all the makings of the next large environmental market. Not only is it essential (i.e., there are willing customers), but it is also being polluted and (in the US at least) there are already reams and reams of legislation dealing with water pollution control. But is this answer correct? Can water every really become a large, tradable, environmental market on the par with carbon? The truth is that, right now, it may simply be too early to tell. After all, there are important scientific questions that are still in dispute (see Seeing the Water for the Trees and Watershed Markets Get a Dose of Myth-Busting Science). Still, in order to truly understand the future potential of water-related environmental markets, it is important to distinguish between two very important types of possible markets: markets for water quantity, and markets that relate to water quality. The former is still very much in its infancy, but the latter has already amassed a wealth of very interesting "lessons-learned", particularly in the US. For this reason, in seeking to understand the possibilities inherent in water-related environmental markets, we believe it is important to take full cognizance of some of the lessons currently being learned on the water quality front in the US. Before doing, this, however, it is useful to look at the broader history of emissions trading in the US.
Water Quality Trading in the U.S.
Emissions trading in the U.S. started with air quality. In the nation's first emissions trading experiment in 1974, the Emission Trading Program allowed limited exchanges of emission reduction credits for five air pollutants: volatile organic compounds, carbon monoxide, sulfur dioxide, particulate matter, and nitrogen oxides. At around the same time that the U.S. began experimenting with air-pollution-related emissions trading, it also began experimenting with similar approaches to controlling water pollution. These experiments started in the early 1980's with the Fox River (Wisconsin) point-point source effluent trading (1981), the effluent bubble for the iron and steel industry (1983), and the Dillon Reservoir (Colorado) point-nonpoint source effluent trading (1984). Although trading activities under these early trading programs were very limited, the potential of trading to substantially reduce abatement costs while still meeting environmental goals prompted U.S. policy makers to re-examine the benefits and feasibility of water quality trading. In 1996, the U.S. EPA (US EPA, 1996) released a draft framework to encourage and facilitate the development of these trading programs. Similarly, at the state level, Michigan developed draft rules in 1999 (finalized in 2002) to guide its water quality trading programs (MDEQ, 2002). More recently, in 2001, the Chesapeake Bay Program published its "nutrient trading" principles and guidelines that were endorsed by all the Bay Program partners including the three Bay states, the District of Columbia, and U.S. EPA (The Chesapeake Bay Program Nutrient Trading Negotiation Team, 2001). Finally, in early 2003, the U.S. EPA released its Water Quality Trading Policy identifying general provisions that they believe are necessary for creating credible watershed-based trading programs (U.S. EPA, 2003). Over a decade in the making, this Policy identifies the purpose, objectives and limitations of these and other trading opportunities. By design, the policy is not prescriptive, but flexible, allowing states, interstate agencies and tribes to develop their own trading programs that meet Clean Water Act (CWA) requirements and localized needs. On the other hand, the Policy does identify restrictions for watershed-based trading, tradable pollutants, baselines for credit generation, general compliance with CWA requirements, and common elements for reliable trading programs (e.g., trading ratios to account for uncertainty and to provide net environmental benefits). Drivers for Water Quality Trading in the U.S. As can be gathered from the above brief overview, point source-nonpoint source and point source-point source water quality trading have seen on-the-ground applications in the U.S. for more than two decades. Two major factors in the mid to late 1990's prompted not only the rapid increase of water quality trading programs in the U.S., but also a fundamental change in the way that water quality trading programs are developed and implemented. The first factor is the highly publicized success of the Acid Rain Program. Many policy makers were convinced that if emissions trading worked for air pollution control, it must have its applications in water pollution control. The second factor is the increasing number of Total Maximum Daily Loads (TMDLs) being developed by states and U.S. EPA as mandated by the CWA. A TMDL is a calculation of the maximum amount of a pollutant that a waterbody can receive and still meet water quality standards. Pollutant loads are allocated in a TMDL amongst sources (Waste Load Allocation [WLA] for point sources and Load Allocation [LA] for nonpoint sources). The established pollutant caps dictate the necessary load reductions. Under the pollutant cap set for the watershed, and with maximum allowable discharges assigned to various sources, the TMDL creates the regulatory foundation for a market where individual sources can trade their surplus allocations. In this, the program closely resembles the Acid Rain trading Program. The annual cost savings that may be achieved through water quality trading as states throughout the U.S. seek to implement some 44,000 TMDLs are potentially significant: the U.S. EPA has projected them to be as high as US $900 million per year. Program Design and Implementation Issues with Water Quality Trading Although the stage is clearly set in the U.S. for water quality trading, not all trading mechanisms are created equally. Former U.S. EPA Assistant Administrator for Water, G. Tracy Mehan III (2003) identified three major challenges for successful water quality trading program development. These include: ensuring that trades create environmentally equivalent pollution reductions; that trading activity avoids hot spots (localized areas with high levels of pollution within a watershed), and; that programs identify and use reliable estimation techniques for calculating nonpoint source pollution reductions. Beyond these issues, minimizing transaction costs and program enforcement to ensure environmental benefits are also critical. The remainder of this paper examines a series of select case studies–essentially water quality trading program examples in the U.S.–that illustrate how these issues are (or are not) being addressed. Some of the prominent watershed-based trading programs are highlighted in Figure 1, and descriptions are summarized in Table 1 [.doc] including relevant program features. Examples of Water Quality Trading In the U.S. Effluent sources are generally divided into two types: point sources (dischargers with defined emission points; e.g., waste water treatment plants) and nonpoint sources (diffuse sources; e.g., agricultural operations and urban runoff). Most point sources are regulated by National Pollutant Discharge Elimination System (NPDES) permits. NPDES permits for municipal and industrial wastewater treatment facilities have been the cornerstone of water pollution control in the U.S. since the passage of the Clean Water Act (CWA) in 1972. On the other hand, nonpoint sources remain largely unregulated. For this reason, the most common forms of water quality trading to date include point source-point source trades, although there have been a few examples of point source-nonpoint source trades. In either case, the underlying mechanics of trading are simple: one source makes a surplus pollutant reduction over and above their current regulatory obligations and sells the surplus to a source needing to meet a pre-determined emission cap or goal. In theory, the greater the difference in marginal abatement cost between two sources, the greater the cost savings and societal benefits through trading. Nonpoint sources (e.g., agriculture) generally have much lower marginal abatement costs for common pollutants such as nutrients and sediment. Consequently, trading between point sources and nonpoint sources should, at least in theory, yield the highest cost savings. There are, however, several legal and technical challenges in establishing point source-nonpoint source trading programs. Figure 1. Select Watersheds in the U.S. with Previous, Developing or On-going Water Quality Trading Programs. Because many nonpoint sources are not legally required to limit their emissions (and therefore do not have permits), the marketable permits approach does not have the essential condition that economists have prescribed, i.e., both the seller and buyer have a limited amount of permit-allowable pollutant discharge over a pre-determined time frame. As such, point sources are almost always the buyer in the market. Nonpoint sources therefore have the market power to influence the price, creating an equity issue. Another consequence of this unequal regulation is that to execute and maintain a trade with a nonpoint source, point sources often use private contracts to hold the nonpoint source accountable for achieving the desired pollutant reductions. Contract negotiation and execution, however, add transaction costs to the trade. Though cost savings with point source-point source trading may not be as high compared to point source-nonpoint source trades, the uniform regulatory condition stipulated by NPDES permits provides an ideal legal framework for point source marketable permits. This permitting system provides a well-tested legal framework for assigning and enforcing pollution control requirements on point sources. By modifying NPDES permit provisions with trading specifications, water quality trading programs that involve point sources can be readily integrated into the current permitting system. In addition, monitoring to quantify load reductions is relatively simple and monitoring requirements are already part of most NPDES permits. This leads to easier government and public supervision, and greater environmental accountability.
Point Source-Point Source Trading: The Long Island Sound Nitrogen Credit Program in Connecticut
One oft-cited example of point source–point source trading is the Long Island Sound Nitrogen Credit Trading Program in the State of Connecticut (refer to Table 1 [.doc] for a summary; see also Long Island Sound Water Quality Program and Information). Connecticut established a 64% nitrogen reduction goal for 79 Publicly Owned Treatment Works (POTWs) in a phased TMDL for nitrogen to remedy hypoxia in Long Island Sound by 2014. A General Watershed Permit allows for point source-point source trading through a state run program. Based on modeling results, the concept of an Equivalent Nitrogen Credit (ENC) was developed to account for different POTW locations and variations in nitrogen delivery efficiency to the Sound. The farther a source is from the Sound, the fewer ENCs it gets for every pound of nitrogen it reduces below its assigned individual limit. The general watershed permit establishes annual nitrogen removal limits, monitoring and reporting protocols, and baselines for credit accounting and trading. Each POTW is required by this general permit to report to the state its monthly flow and concentration data. To prevent hotspots, trading is not allowed for compliance with any local water quality requirements or nitrogen limits set by individual NPDES permit limits. The Long Island Sound Nitrogen Credit Trading Program was authorized by the Connecticut state legislature with a public act in 2001 that provided authorization to the Department of Environmental Protection (CTDEP) to initiate framework development, implementation, enforcement and auditing. This public act guarantees point sources the legal rights to use and sell credits. A unique feature of the program is the establishment of the Nitrogen Credit Advisory Board (NCAB) as program administrator and the credit broker. As the sole nitrogen reduction credit buyer and seller–somewhat like clearing agents on Wall Street–the NCAB has knowledge of each POTW's credit balance, sets the price, clears the credit market, and banks and uses surplus credits according to environmental and economic needs (e.g., sales to new or expanding municipal point sources for offsetting). In this way, the NCAB minimizes credit transaction costs and exerts an overall market control. The NCAB also sets the annual price of an ENCs based on the total physical structure cost of nitrogen reduction projects (capital or capital repayment plus operational) and the total reduction in ENCs resulting from these projects. The first year of trading program operation (2002) collectively produced more than the required nitrogen reduction from the 79 POTWs. Forty-one POTWs were able to reduce beyond their targeted levels to generate nitrogen credits and sold credits to the NCAB. Other plants that could not meet target goals purchased a portion of these credits. Interestingly, there were only 23 POTWs undergoing structural upgrades on or before 2002, suggesting that 18 of the 41 credit-generating sources achieved load reductions by means other than capital investment. The price of an ENC was set at $1.65/ENC lb ($2.64/ENC kg). To clear the market, the state paid $1.44 million to buy excess credits using the state Clean Water Fund. This fund also supports the capital projects undertaken by POTWs. In 2003, 39 sources generated credits and 40 bought them at $2.14/ENC lb (4.72/ENC kg). The state paid $312,000 to clear excess credits. Wetter weather (which decreased the treatment efficiency) and normal increases in capital and operation costs contributed to the increase of credit price (Breetz et al., 2004). Again, with only 25 capital projects in the trading zone, 14 POTWs were able to generate credits without structural upgrades. The design and implementation strategy of the Long Island Sound Nitrogen Credit Trading Program has become a model for other trading programs under development in the U.S. Some of the elements that many consider have made this a success include: using a general permit to include a high number of market participants; the NCAB serving as the broker to simplify transactions for buyers and sellers, and; establishment of a state law to protect participants from uncertainties regarding their property rights vis-a-vis the credits. Though it is still early, cost savings with trading have been projected at $200 million versus the traditional command-and-control strategy without trading (U.S. EPA, 2003). Potential drawbacks of this program are that other non-POTW sources of nitrogen credits are not allowed under the trading legislation. This could prove to be a significant program challenge if nitrogen credits from eligible POTWs are insufficient to meet program demand. In addition, characterizing this program as a market-based trading model for water quality may be overstating the obvious given that the NCAB (i.e., the state) fixes credit prices and is the only seller of credits.
Point Source-Nonpoint Source Trading: The case of the Minnesota River Basin
Despite the practical issues facing trading programs involving nonpoint sources, such programs have emerged in many places because of the tremendous cost-savings potential and the fact that nonpoint sources account for 43% of pollution on all impaired U.S. waterways. The Minnesota River Basin has experienced the highest level of trading activity in the U.S. Although small in scale compared to the Long Island Sound program, trading in the Minnesota River Basin illustrates the potential benefits, as well as the difficulties, inherent in point source-nonpoint source trading. Since 1997, two point sources in the Minnesota River Basin have traded with nonpoint sources for pollution reduction credits under the provisions of NPDES permits to completely offset new pollution loads to the river (Fang, 2003). These two point source-nonpoint source trades were carefully designed for accountability and have been carried out under the close supervision of the Minnesota Pollution Control Agency (MPCA). The point sources and regulators expended extensive and time-intensive efforts in establishing all details of the trades within NPDES permits. The pollutants being traded are essentially nutrients (phosphorus and nitrogen). Nonpoint source controls employed to generate reductions include streambank stabilization, cattle exclusion, wetland restoration, and cover cropping. Trading credit evaluation procedures are detailed in the permit for each of these remedial practices. A unique feature of the Minnesota River trades is the fact that each of the point sources has set up a trust fund devoted to financing its participation in trading and to achieving the required nutrient load reductions. This fund provides financial viability to the program and ensures enough credits will be generated to offset the new loadings. A trust fund board–composed of at least one local watershed manager, one government representative, and one representative of a local water resources organization–is responsible for managing the fund. Both trading projects in the Minnesota River Basin employ a trading ratio greater than or equal to 2:1 (i.e., two units reduced for one unit used in compliance). This ensures equivalence and additionality of load reduction and helps take into account the many uncertainties that exist in converting nonpoint source loads into point source loads. For accountability, every potential trade has to be verified by the MPCA and be held to annual reduction goals outlined in the permit. The permittee is responsible for the construction, installation, operation and maintenance of nonpoint source remedial practices. Furthermore, the MPCA has the right to revoke previously approved tradable credits based on inspection results. Annual reports on the operation and effectiveness of the remedial practices are required. The permittee has the option to meet its total load reduction requirement in several stages with specific and progressive nonpoint source goals. To date, five major trades involving substantial remedial construction work and hundreds of trades involving cover cropping on individual farm fields have taken place in the basin.
Piasa Creek Watershed
An innovative point source-nonpoint source sediment trade is the Piasa Creek Watershed Project in Illinois. The project targets sediment loading reductions in a local watershed and was initiated by the Great Rivers Land Trust (GRLT). GRLT is a private citizens' organization established in 1992 to preserve the scenic and ecologically valuable land along the Alton Lake Heritage Parkway in the St. Louis Metropolitan Region. With the upgrading of its water treatment plant in Alton, Illinois, the Illinois-American Water Company (IL-AWC) was faced with the prospect of building a costly treatment system to handle its treatment of residuals (sediment) that would involve trucking sediment to a treatment lagoon and off-site landfilling. In addition, for both aesthetic and safety reasons, local opposition was strong against the increased truck traffic along a national Scenic Parkway. GRLT proposed point source-nonpoint trading to fully offset the Alton facility's 3,300 tons/year of sediment discharge at a 2:1 trading ratio using upstream nonpoint source sediment reductions such as land acquisition, streambank stabilization and filter strips, etc. The unique feature of the Piasa Creek trading program is the third party broker role assumed by GRLT in engaging landowners, implementing sediment reduction projects, monitoring project performance, and reporting to IL-AWC and Illinois EPA.
Lower Boise River
Another similar program on the Lower Boise River (in Idaho), was used as a model in the U.S. EPA's newly published handbook on assessing if water quality trading can be used in a particular watershed (U.S. EPA, 2004). This program –which has not yet generated any trades due to the delay in a related TMDL approval—employs a phosphorus environmental equivalence factor for loading sources in the basin based on the location of the source in relation to its distance to the mouth of the Boise River. This is similar to the concept of ENC in the Long Island Sound program. The agricultural best management practice (BMP) manual [.doc] developed for the program also establishes a "drainage delivery ratio" to account for transmission losses within a drainage channel, and "a site location factor" to account for transmission losses between cropland and drainage channels. For each eligible agricultural BMP, an uncertainty factor is also applied to account for the uncertainty in the practice's effectiveness resulting from calculating, instead of verifying by monitoring, the actual achieved load reductions. Application of these multiple discounting factors eliminate the need for using a vaguely defined and sometimes controversial "trading ratio" that most other water quality trading programs are employing to account for uncertainties in quantifying water quality benefits of any given agricultural practice. By clearly defining these discounting factors, the need for monitoring actual practices at the field scale is also removed; all of which can significantly lower the transaction costs of the trading program. Another important feature of the Lower Boise River trading program is the incorporation of the TMDL reduction goal (78%) into the program. In calculating the amount of marketable credits resulting from an eligible agricultural practice, 78% of the load reduction will be used to satisfy the TMDL goal first. Remaining load reductions will then go through the discounting process with all four discounting factors before the final value of tradable credits is determined. The Lower Boise River trading program also created a non-profit, the Idaho Clean Water Cooperative (ICWC), to administrate trading and to "enable trading to occur outside of government venues, in a locally controlled, market setting" (ICWC Draft Bylaws, 2000). The creation of the non-profit non-governmental ICWC is one of the several ways that the program helped lessen the farmer's initial discomfort with the trading program.
Grassland Area Farmers
The Grassland Area Farmers Tradable Selenium Loads Program in California (Breetz, et al., 2004) is a widely cited trading program that is considered a success. Although sources of selenium are agricultural land, the unique setting of drainage districts of the San Joaquin Valley rendered this more like a point source-point source trading program with monitoring easily conducted at sumps. The seven participating districts formed a Steering Committee to distribute the overall load cap among the districts. Trading is conducted between districts. There was active trading between 1998 and 2000. However, no trades have occurred since 2000 because of the installation of a drainage recycling project in one district that lowered the overall load to a point that no trade is needed for the seven districts as a whole to keep their collective loading under the cap. However, the group intends to keep trading open as an option for future needs. A unique feature of this program is the significant involvement of a prominent environmental organization, Environmental Defense (formerly known as the Environmental Defense Fund, or EDF), which in contrast to some environmental groups is an advocate of market-based environmental policies and practices.
The Tar-Pamlico Basin trading program is a unique point source-nonpoint source trading program in that the point sources, organized as the Tar-Pamlico Basin Association, pay the state of North Carolina a fixed fee based on how much the association members collectively exceed the overall nutrient limit set for the association. The state then uses the fee collected to undertake agricultural projects aimed at establishing best management practices. There is no direct trading between point sources and nonpoint sources and the state acts as a clearinghouse. Since the inception of the program in 1990, there have been no actual trades because the point sources have been able to consistently keep their discharges below the established limits.
Kalamazoo River Watershed
The Kalamazoo River Watershed trading program has evolved from a pre-TMDL demonstration project (Table 1 [.doc])–funded mostly by the Water Environmental Research Foundation and other private funds–into an EPA-funded Targeted Watershed project under an approved watershed-wide phosphorus TMDL. Developing working trading tools (web-based registry, trading board and credit estimating tools) and engaging landowners in trading are the two main focuses of the current project. These tools and mechanisms are designed to address many of the practical issues of water quality trading that have, in the past, impeded the establishment and operation of effective trading programs: namely high transaction costs, the lack of a recognized marketplace, and enforcement. Tools developed via this program in alignment with Michigan's Trading Rules will be available nationwide through the EPA upon the completion of the project in 2008.
Given that the U.S. has accumulated more than two decades-worth of experience with water quality trading, what lessons can be learned? First, it is interesting to note what water quality trading is not: The U.S. experience suggests that–contrary to common criticicism–water quality trading need not be a "license to pollute," nor does it inevitably lead to the creation of pollution "hotspots," nor is it a rollback of regulations, or an attempt to replace traditional permitting authorities. Water quality trading may not be perfect, but neither is it as full of flaws as critics would have us believe. On the contrary, more than two decades of experimentation and implementation–with over 70 specific cases–of water quality trading programs in the U.S. suggest that water quality trading can achieve environmental goals while reducing costs. Beyond proving that water quality trading can work in many circumstances, the U.S. experience with this approach also provides some lessons whose implications reach far beyond the United States, and far beyond water quality trading. On of the first lessons that we draw from the U.S. experience is that to encourage trading there needs to be clear authority to trade and clear legal protection for using the rights purchased (in the form of water quality credits) to meet established regulatory requirements. The Long Island Sound program uses a state-sanctioned watershed permit to institute a trading program backed by state funds to guarantee trades. The Minnesota River program incorporates point source-nonpoint trading into a legal document, the NPDES permit, to ensure the right of point sources to discharge as long as the permit provisions, including trading, are not violated. Other programs that have successfully traded pollutant reduction credits also have similar measures protecting program participants against legal uncertainties. Second, to generate trades, demand for credits must be created. The Piasa Creek and the Minnesota River trades were created by demand for a 100% offset requirement for point source discharges. The Long Island Sound and the Grassland Area Farmers programs set discharge limits for each participating source, generating demand for credits when water quality limits were exceeded. On the other hand, the Lower Boise River program uses a pending TMDL reduction goal as the baseline and has not seen a single trade because the of TMDL approval delays and no creation of demand. Similarly, the Dillon Reservoir program did not progress beyond several small trades because point sources were able to control loads below established limits. Third, trades are not necessary for trading programs to realize cost savings and achieve environmental goals. Water quality trading offers a flexible solution for point sources to phase in technology upgrades or optimize existing technology to meet more stringent discharge requirements. This flexibility alone is sometimes enough to introduce substantial load reductions and cost savings. For example, the point source association in the Tar-Pamlico River program, faced with collective load limits for phosphorus and nitrogen, was able to maintain discharge levels below the limits despite population growth; mostly via changes in in-plant management practices. Even in the Long Island Sound program, clearly one of the most effective and widely-touted U.S. programs, some of the credit sellers are wastewater treatment plants that have not yet implemented capital improvement projects. Fourth, program design is an essential element for success. The dual goals of any water quality trading program are: first, to achieve the targeted pollutant load reductions, and second, to cost-effectively achieve that reduction. Most of the programs cited here have received wide local support precisely because they were carefully designed to accomplish load reduction goals. However, overly restrictive regulatory controls on trading programs (such as a cumbersome approval process for trades and highly complicated credit quantification methods) will increase the cost of executing trades, diminishing potential cost savings. The current Kalamazoo River project is a comprehensive attempt to address these issues by designing trading tools such as an on-line registry–among others–to strike a balance between ensuring environmental gains and achieving cost savings. Fifth, water quality trading programs –besides introducing cost savings—bring other social benefits to the watershed. Examples of such benefits include: providing for nonpoint sources to undertake pollution control measures (e.g., the Tar-Pamlico River and Piasa Creek programs); and providing a solution to the conflict between economic development and environmental protection (e.g., the Minnesota River program).
The Way Forward
Despite past and current programs, water quality trading has not generated the vibrant national (or even regional) credit market that many had hoped. Nor can it really be compared, in magnitude or effectiveness, to the U.S. Acid Rain Trading Program. The reasons behind this shortfall in expectations are both physical and political. Unlike air pollutants such as SO2, water pollutants are carried by –and have their impact within—specific water bodies (streams, inland impoundments, estuaries). This limits water quality trading geographically to watersheds of various scales. In addition, the mono-directional and linear nature of water pollutant transport and/or dissipation, makes water quality trades (if they are not properly implemented) particularly prone to creating pollution hotspots. One way to avoid this problem is the upstream-only trading condition (where buyers can purchase credits only from upstream sources) that many of the current programs require. Such a requirement, however, further constrains the potential market size and lowers the liquidity of credits generated. These factors work against the creation of the sort of wide-ranging, free-trading, national water quality credit market envisioned by economic theories and exemplified by the Acid Rain Program. On the policy or regulatory side, the uneven regulation and enforcement on different sources of water pollution (i.e., point sources vs. nonpoint sources) also limits the size and potential of water quality credit markets. With the regulatory burden largely falling on point sources–and pollution control mostly being voluntary for nonpoint sources–a fully regulated market can only exist among point sources. This is particularly problematic for broader market development as nonpoint sources are one of the leading causes of water pollution in many U.S. watersheds. Without including nonpoint sources, water quality trading programs will not, in most cases, be environmentally effective. Moreover, nonpoint sources, particularly agriculture, have lower marginal costs of load reduction compared to point sources. In other words, for water quality trading to work as some of us believe it can, it will be necessary to formally engage, incentivize and/or restrict nonpoint sources of water pollution. Uneven regulation and enforcement create uncertainties and increase the risks for regulated buyers; all of which make it more difficult for them to participate in water quality markets. Private contracts go a long way towards solving this problem, but have the potential to substantially increase the transaction costs of trading and thereby depress market activities. To overcome these obstacles, economists (e.g., King, 2005) have suggested that "tighter federal and/or state limits on individual dischargers" and "aggressive enforcement of those limits" will be required. Nevertheless, even without a national market, past and current trading programs studied in this article suggest that water quality trading can and likely will continue to provide a powerful policy tool to solve local problems. In smaller scale trading applications, program design is often more important than the overall regulatory reform economists want to see. In our more-than-ten years of trading policy and program implementation experience, trading has been a "bottom up" process where diverse local stakeholder groups have defined how trading can best serve their needs while explicitly avoiding these long-standing criticisms through local program design. With TMDLs specifying pollutant caps in watersheds, one area of opportunity for further application of trading in the U.S. is for offsetting growth. Growth stresses the capacity of municipal wastewater treatment plants. In addition, federal stormwater regulations have begun to treat sources of stormwater as they do point sources: requiring NPDES permits for stormwater discharges from urbanized areas and most construction sites (see Storm Water Phase III Final Review [.pdf]). Stormwater and wastewater treatment often involve expensive capital investments and high operation and maintenance costs, resulting in high marginal costs of pollutant load reduction. This presents an opportunity for such sources to trade with other nonpoint sources, especially agriculture, where marginal costs of load reduction remain low. Again, such trading markets will be limited in specific watersheds where growth rate is high and agricultural operations account for a substantial portion of the total pollutant load.
Economic theories that have proved successful in air emissions trading programs in the U.S. are being adapted for water quality trading for cost-effective load reductions. Water quality trading is a flexible tool offering a mechanism to achieve additional environment benefits when used in conjunction with traditional command and control approaches. A permitted discharger facing high costs to accommodate new growth or stringent permit restrictions can "trade" for discharge reduction credits with another source having lower costs. A portion of the reductions traded may be explicitly retired, which addresses uncertainty and results in a net reduction of pollutants discharged to the receiving water. Experience suggests that where there is an enforceable requirement for pollutant load reductions associated with high cost solutions, water quality trading can be considered as an option, provided trading is legally recognized by regulatory agencies. Trading does face cost and technical challenges with program design and implementation. Thus, it is necessary to carefully address design issues such as transaction costs, environmental equivalence, hot spots, nonpoint source reduction quantification, and program enforcement for a functioning market. It is clear, however, that the U.S. has developed extensive experience on this issue through a variety of water quality trading projects that have taken place over the last two decades. Lessons learned from these experiences will hopefully lead to new innovation and provide guidance in addressing the most difficult issues related to water quality trading programs. This, we hope, will lead to water quality trading becoming a large and growing environmental market in the U.S. and–why not?–the world. Mark Kieser is Acting Chair of the Environmental Trading Network, a non-profit clearinghouse for market-based environmental program information (www.envtn.org). He is also Senior Scientist and Principal of Kieser & Associates, LLC, an environmental science and engineering consulting firm in Kalamazoo, MI (www.kieser-associates.com). Andrew Fang, is a Ph.D. and Project Scientist with Kieser & Associates.
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