Country Name: United States of America
Author: Erik Ness

After years of planning, Pennsylvania is finally poised to begin water quality trading. The Ecosystem Marketplace checks in with one business eager for the bell to ring.



After a particularly long day last year, Peter and Molly Hughes succumbed to the dangers of being both married and in business together: They took their work home with them. The Hughes and another couple are partners in Red Barn Consulting, an agricultural engineering firm in Lancaster, Pa. that designs modern agriculture facilities such as flushing dairy barns, passive sand separation manure storage systems, and swine finishing barns the size of football fields. They've worked with more than 500 farmers over the last five years, and have 8 employees.

Financing environmental improvements for farmers can be a Byzantine maze of red tape. Red Barn often has to wait for a farmer to get accepted into a federal program such as the Environmental Quality Incentives Program, then wait for the farmer's end of the 80/20 cost-share to materialize.

But that night the Hughes dared to dream: Pennsylvania was developing a nutrient trading system that could radically change their operations. "We really enjoy the business, but we're seeing a lot of regulations and things that are really frustrating to farmers," says Peter Hughes. In their dream world they'd do the same work, but the money would come from the water quality market. "It's pretty exciting to be able to say we can put in manure storage and a new concrete barnyard and have it paid for through nutrient credit trading."

Advocates of nutrient credit trading argue that reducing the overall pollutant load could reverse the environmental damage of excessive nitrogen and phosphorus in our waterways. While removing dissolved nutrients from wastewater is expensive, there is great potential to reduce pollution by changing agricultural practices, which have largely escaped regulatory scrutiny. Many policy makers like the idea of a market trading nutrient credits between agricultural and industrial pollution sources because it addresses the politically sensitive issue of agricultural pollution, while allowing industrial polluters flexibility in choosing the most cost-effective reduction strategies for their business. It's an attractive equation except that, to date, markets built around nutrient trading have been limited in scope and impact. Compared to air quality markets, they simply haven't taken off.

Red Barn nonetheless sensed opportunity. They talked to their customers and began attending the meetings of the Pennsylvania Department of Environmental Protection (DEP) trading group. They initiated a round of back-and-forth accounting exercises, trying to square their calculus with the state's nascent credit certification. In January the company started a separate company, Red Barn Trading, to serve as an aggregator in the new market: They would bundle credits from individual farms and bring them to market. The fledgling company currently has four proposals before the DEP, which says trading could begin any day now.

Market-Makers

Pennsylvania's aggressive water works began when then Governor Tom Ridge signed the Chesapeake 2000 Agreement, pledging to help remove the Bay from the Clean Water Act's list of impaired waters by 2010. The Chesapeake Bay has many interlocking problems, but too much nitrogen and phosphorus is perhaps foremost. In April 2003, EPA assigned tough new nutrient reduction targets to the six Bay watershed states and the District of Columbia. The challenge: double the reduction accomplished in the last 20 years.

In Pennsylvania, 86 percent of nitrogen reaching the Bay comes from nonpoint sources (farms, storm runoff, and construction site erosion) while only about 14 percent comes from point sources like factories and sewage treatment plants. The phosphorus profile is similar, with 78 percent deriving from nonpoint sources and about 22 percent from point sources. These numbers make it abundantly clear that meeting the ambitious Bay goals will require significant engagement from the agricultural sector.

Pennsylvania farmers already have more than 156,000 acres in the federally financed Conservation Reserve Enhancement Program—the largest CREP allocation in the country—but last year the state also tightened regulations on vegetative buffers along streams and manure accounting. The number of highly regulated farms in the state increased six-fold.

Alongside this regulatory tightening, nutrient trading has slowly worked its way to market. When Pennsylvania Governor Ed Rendell made Kathleen McGinty his Secretary of Environmental Protection in 2003, the former adviser to President Clinton and Al Gore quickly staked her commitment to market tools. "Trading can enable us to achieve environmental goals more quickly and affordably than conventional approaches to environmental regulation," she said in her confirmation testimony. "I am very pleased that we now have the ability to harness trading markets in water quality as we have for more than a decade in the air quality arena."

More recently, McGinty called trading "a top priority of the Rendell administration" before a joint committee meeting of the state legislators last September. And she asserted again, that: "Harnessing market forces is an effective way to achieve environmental regulatory goals at less expense than traditional command and control regulations."

McGinty's enthusiasm has been widely noted. "She is a politician, but she is so well-versed in the details you know she's not just pulling a fast one or being a regular politician," says Hughes of Red Barn Trading. The respect is probably mutual since Hughes is precisely the market force that McGinty hopes to harness.

"It has the potential to be extremely large," says Hughes of the imminent market. "That's why we wanted to be out first. We want that brand identity with Red Barn Trading." The state conservation districts will also serve as aggregators under the program, and a handful of other private proposals have also been submitted to the DEP.

"There are not a lot of people who do what we do," says Hughes. "We have access to the farmers, and already have an established relationship. It's not like somebody new coming and selling them windows. It's using our existing clientele to generate those credits."

The big farms, says Hughes, already get it. "They've got a large land base, they probably have tons of different ways the they could generate credits on their farm. Plus, they're regulated already. They're used to having DEP on their farms." An active market could also bring the Amish and Mennonite farmers, who generally refuse government payments, into the water quality business. "Those are really our problem farms in Pennsylvania." The learning curve may be steep at first, but Hughes believes that farmers will quickly climb aboard once the checks start to flow. "All we need to do is get that first one through and the marketing is done."

Silver Bullet?

According to World Resources Institute economist Suzie Greenhalgh, aggregators like Red Barn could play an important role in the Pennsylvania experiment because most potential buyers—developers and municipal wastewater facilities are expected to be first in line–will need more credits than most farmers could provide; contacting 100 different farmers to try and buy their reductions could be a significant barrier. "An aggregator can step in and say I've aggregated 20,000 credits from all these different sources," she explains.

An aggregator may also play an important role in allocating risk and liability—elements not yet finalized in Pennsylvania. An aggregator might purchase 22,000 pounds of reduction, but only sell 20,000 and retain the rest as insurance.

But some experts remain critical. "I don't think the limits to nutrient trading are associated with a lack of aggregators or a lack of spreadsheets or a lack of software or a lack of conferences or a lack of understanding that it would be a good idea if we could do it," says Dennis King, an economist at the University of Maryland's Center for Environmental Science. "It's the lack of supply and demand." King argues that programs such as CREP, where the Federal government funds conservation improvements, hamper market potential by raising the price of potential reductions.

King also says that the cost of verifying the basis for the trades significantly eats into potential profit. But that's where Red Barn's business model looks a little better: calculating nutrient flows is an integral part of their work. "Having an aggregator, especially if they're verifying the basis of the trade, certainly helps," says King. "Whether its a silver bullet or not is another matter."

"Trading isn't going to work unless the environmental community is certain that they're not getting snookered, which they were in the early cases of wetland mitigation trading," says King. And he worries about continuing misconceptions. "I'm getting very concerned that this interest in water quality trading is really either, by design or by people being naive, a diverting tactic. The rhetorical spin around Washington at higher levels is that these trading systems are an alternative to regulations. In fact, the regulations are what's going to drive the trading."

Pennsylvania officials know the challenges, and plan to use existing programs to generate the momentum to get trading started. "We're putting a lot of time and effort into this," says Andrew Zemba, assistant director in the DEP Water Planning Office. "It's a very important element, but what's more important I think is for us as a department to continue to move forward and integrate all of our activities together regarding our Bay goals."

Waiting on Big Brother

"It's like having big brother on your side," says Hughes, who believes the combination of regulatory will and sincere interest in a market approach will bear fruit. "It's amazing the bureaucracy of it—getting everybody on board, getting everybody comfortable," he says. "From my perspective it just seems so simple. We're right there, we could just do it. But then everything goes through a committee and everybody weighs in on it. It's big government working through this process, and big government takes a long time because they look at every angle. As a private business, what we have to do to stay competitive is that you have an idea, you push that forward, and you work the bugs out along the way."

Ultimately, he sees that as one of the benefits of moving water quality out of the realm of federal program and into the market. "If the nutrient credit trading generated money faster, I would think a lot more people would lean towards [the market]. I think it will spread like wildfire. I really do."

"I hope it will," he adds, correcting himself.

But for now, Hughes and his Red Barn Colleagues are stuck waiting for opening day. "We don't know what a credit is worth. I guess we won't know until we take the first ones to the marketplace," he says. "I'm just afraid that if too much time passes the energy and the excitement might lose a little bit of momentum, but we're still seeing this as a major focus of our business."

Erik Ness writes about science and the environment from Madison, Wisconsin.

First published: May 22, 2006

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