Water Trading: The Basics

The Ecosystem Marketplace Team

Water trading has been hailed as the "next carbon", and schemes for valuing and trading both water usage and water "inputs" are proliferating across North and South America, Asia, and Africa. The Ecosystem Marketplace reviews the fundamentals of this promising ecosystem market.

16 April 2008 | In the early 1980s, the de la Motte family realized that cow dung and fertilizers were finding their way into the aquifer that fed the family’s famous (and lucrative) mineral water plant in the town of Vittel, in northeastern France, after upstream farmers had replaced natural, filtering grasslands with corn.

By the end of the decade it had become clear the problem needed an innovative solution – one Vittel’s new owner, Nestle, spent the 1990s hammering out with local farmers. The company purchased 600 acres of sensitive habitat and signed long-term conservation contracts with farmers whose corn and cows had polluted downstream waters.

Nestle now pays these farmers to manage their animal waste, graze their dairy cows the old-fashioned way, and reforest sensitive filtration zones. Though costly, it’s a lot cheaper than the alternative. Competitor Perrier (now also owned by Nestle) once spent more than $260 million on a global recall after benzene made its way into millions of its distinctive green bottles, and its market share has never recovered.


Payments for Ecosystem Services

Vittel’s action, like New York City’s payment to upstate farmers, has become a textbook example of a successful “PES” deal – short for Payments for Ecosystem Services – or, in this case, “payments for watershed services” (PWS). Such schemes, as frequent visitors to this site know, are based on the premise that ecosystems deliver valuable services that most of us take for granted – like filtering water in the above example – but whose value our economy doesn’t normally take into account.

PES schemes try to quantify the economic value of services that an ecosystem provides, and then either entice or mandate those who benefit from the service to pay the people who maintain them.

Unfortunately, for every successful PES scheme, there are scores of failures and near misses, and much debate about what works and what doesn’t. These issues are high on the agenda at the upcoming June Global Katoomba Group Meeting, and over the next two months we’ll be focusing on water-based PES schemes: the history, the theory, the practice, the successes, and the challenges.


Trading Water: Quantity and Quality

The Kyoto Protocol has put the trading of greenhouse gas emissions and offsets on everyone’s radar, but emissions trading actually began decades before the Kyoto Protocol was signed. The US Environmental Protection Agency’s (EPA) Emission Trading Program started in 1974, and allows a limited exchange of emission reduction credits for five air pollutants: volatile organic compounds, carbon monoxide, sulfur dioxide, particulate matter, and nitrogen oxides.

It kicked in at the height of the environmental movement in the United States. The first Earth Day was fresh in everyone’s mind, and the federal Clean Water Act (CWA) and the Endangered Species Act were laying the groundwork for today’s markets in water and biodiversity.


A Wetlands Savings Account

So-called “mitigation banking” covers the quantity of biodiversity and wetlands – which are more than just standing bodies of water. A well-functioning wetland plays a key role in filtering water and thereby “delivering” the ecosystem service of reliable water quality, as well as providing habitat for many plants, insects and animals that are part of the biodiversity of an area. These “services” are difficult to quantify – one reason environmentalists are up in arms over schemes that replace true wetlands with ponds and other bodies of isolated water.

Mitigation banking involves building up reserves of water capital, and is a key response to the CWA’s section 404.

The Act mandates that anyone who plans to dredge a wetland that nurtures other waterbodies try to find a way to avoid its destruction. When this is not possible, the developer must first get a permit through a program administered by the U.S. Army Corps of Engineers and the US EPA. Then, if a permit is granted, the developer must “establish, enhance, restore or preserve” an amount of wetland equal to or greater than what is being dredged – usually in the same watershed.

Mitigation banks are essentially wetlands that have been pro-actively established, enhanced, restored, or preserved – in exceptional circumstances when the land was under significant threat – with the goal of generating credits that can be sold to developers later as offsets. The CWA requires mitigation banks to replace function as well as acreage of jeopardized wetlands, although many complain that the function requirement is often overlooked.


The Drive for Distribution

In addition, you have schemes that cover the distribution of water for drinking and agriculture, and no one has taken this further than the Australians, who’ve turned water into a commodity that is almost as easily-traded as electricity is in other parts of the developed world.

But it’s in the developing world that such schemes could have their greatest impact. Studies show that the poorest usually pay the most for clean drinking water, while many industries simply waste it for free. Trading could put a uniform price on clean, delivered water, thus both reducing industrial waste and enabling delivery to areas that currently have poor access for drinking.


Using Markets to Control Pollution

So-called “nutrient trading” covers the bulk of the quality side – although the boundaries between quantity and quality blur and overlap.

Most watersheds contain two types of polluters – “point” sources and “nonpoint” sources.

Point sources are the ones we hear about the most: industrial enterprises or urban waste treatment plants that directly pollute a watershed from a single pipe or point. Most point sources are regulated by the National Pollutant Discharge Elimination System (NPDES), and have been the cornerstone of water pollution control in the US since the passage of the CWA.

Nonpoint sources, on the other hand, account for a whopping 80% of the nitrogen and phosphorous that ends up in US waters – and most of these are unregulated, for a variety of political, social, economic, and logistical reasons.

These sources include farms, such as those that leached into the de la Motte’s watershed, as well as septic systems and new development whose pollution washes into a watershed over a diffuse area, usually in the form of run-off.

When run-off comes from agriculture, it’s called a “nutrient” – but it’s not the kind of nutrient your mother encourages you to eat with your Wheaties. Instead, these nutrients feed organisms that gobble up oxygen and lead to “dead zones” like those found in Europe’s Black Sea. Such dead zones have been labeled a greater threat to humanity than global warming by the Millennium Ecosystem Assessment, a United Nations-sponsored project that engaged over 1,300 scientists and is easily the most extensive research program to date focusing on ecosystems.

The technology for alleviating the problem of agricultural run-off is readily available. Farms can reduce their run-off by changing the way they till, plant, or fertilize – at a cost of about 1/65 of what factories in the developed world would pay to reduce their levels of pollution emissions, according to one study.

That’s where “nutrient trading” schemes come in. They put the reduction burden on factories and other point sources, but give them a chance to pay nonpoint polluters to reduce their pollution outtakes instead – so-called “point-nonpoint” transactions. In theory, industrial polluters will opt to pay farmers to reduce their pollution emissions along a river when those factories can’t afford to invest in technology to further limit their own discharges.

This is the current holy grail of water quality trading, but most activity remains “point-point” – partly because nonpoint sources are difficult to monitor, but also because it’s difficult to measure results. Also, non-regulated entities such as farms may be afraid of getting involved in voluntary schemes, no matter how lucrative, because they fear it will bring them into what they see as a regulatory boondoggle. In the weeks ahead, we will be addressing solutions on the table for addressing these and other issues.


The Beat Goes On

And there is, indeed, plenty on the table – with water schemes being proposed and implemented across Latin America, Asia, and Africa – as well as the United States, which got started in the early 1980’s with point-point effluent trading on Wisconsin’s Fox River and point-nonpoint trading on Colorado’s Dillon Reservoir.

In 1996, the US EPA formally threw its support behind these trading programs, and several state initiatives have followed suit: Michigan with draft rules for nutrient trading in 1999, followed by the Chesapeake Bay Program in 2001.

The Chesapeake Bay Program, a multi-jurisdictional partnership that is working to restore and protect the Bay and its many resources, encompasses the three Bay states (Maryland, Pennsylvania, and Virginia), the District of Columbia, and the US EPA. But rather than being a unified trading program across the entire watershed, it is more of a hodgepodge of efforts with each state running its own trading scheme.

In early 2003, the US EPA released its Water Quality Trading Policy, identifying general provisions the agency considers necessary for creating credible watershed-based trading programs. Over a decade in the making, this policy identifies the purpose, objectives and limitations of these and other trading opportunities. The EPA has even gone so far as to publish a map of trading programs in the US and a trading toolkit.

The policy is flexible by design, letting states, interstate agencies, and tribes develop their own trading programs that meet CWA requirements and localized needs. Critics, however, say it’s too flexible, failing to identify tradable pollutants and other basic parameters. This leaves the system undefined and fails to generate the kinds of certainty a true market requires.


Drivers for Water Quality Trading in the US

Two major factors in the mid to late 1990’s prompted not only the rapid increase of water quality trading programs in the US, 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, which demonstrated the efficacy of market mechanisms when coupled with proper government enforcement mechanisms. This convinced many policy makers that emissions trading could be applied to water pollution control.

The second factor is the increasing number of so-called “ TMDLs” (Total Maximum Daily Loads) being developed by states and US EPA as mandated by the CWA.

A TMDL is the maximum amount of pollution that a water body can assimilate without violating state water quality standards, and individual states determine the specific TMDLs for specific pollutants in specific bodies of water. TMDLs don’t just cover chemicals, but also things like temperature. In theory, they can act as de-facto caps for emissions in cap-and-trade water schemes, and approaches based on TMDLs and a handful of other tools are already being tested across the United States.

The calculations themselves are complex and the subject of much debate, but the existence of TDMLs identifies the sources and estimates the quantity of pollutants targeted for possible trading. This debate, in part, helps create the driver for a market – for in a well-structured market, the price of a pollutant will be tied to the actual amount of reduction necessary to meet the TMDL, and not to an arbitrary cap.

Water-quality trading can also occur on a “non-TMDL” waterbody (one that is not impaired or one that the government has not gotten around to developing a TMDL for), and trading can occur much sooner because nonpoint sources do not have to meet the TMDL minimum before a trade can occur. This is generally referred to as “pre-TMDL” trading.

This allowance was made because the TMDL minimum threshold may, in many cases, be too high and too expensive for nonpoint sources to meet, and could discourage them from pursuing a trade.

For a trade to occur in a TMDL waterbody, nonpoint sources must first meet their load allocation, then any additional amount of reduction they can accomplish can be sold to offset point source loads.

The TMDL trading unit is the specific pollutant identified in the TMDL. For example, in nitrogen TMDL, the unit is one pound of nitrogen removed from the waterbody; for a temperature TMDL, the unit is one degree of temperature lowered in the waterbody.

Despite the availability of these promising mechanisms, however, demand has been slow to materialize. For these markets to reach their true, enormous potential, awareness must be spread across both the private and public sectors – and to the community at large.

Next Week: Guest authors Mark Kieser and “Andrew” Feng Fang of Kieser & Associates analyze the framework within which water quality trading is evolving in the United States, and offer a round-up of projects underway across the country.

This introductory was compiled from essays submitted to Ecosystem Marketplace over the past two years, and we would like to thank Mark S. Kieser and “Andrew” Feng Fang of Kieser & Associates, Ricardo Bayon of EKO Asset Management Group, Amanda Hawn of New Forests, and regular Ecosystem Marketplace contributors Alice Kenny and Erik Ness.

Steve Zwick is managing editor of Ecosystem Marketplace. He can be reached at [email protected].

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