Market Structures for U.S. Water
Quality Trading
Richard T. Woodward &
Ronald A. Kaiser
Texas A&M University
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Pollution trading is on the rise

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A national SO2 market is active
NOx is traded in numerous regional
markets
Trading in Greenhouse gases is written
into the Kyoto Protocol
EPA report lists 25 Water Quality trading
programs in various stages of
implementation and development
(Environomics 1999)
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Prominent Water Quality Trading
Programs
Project
Fox River, WI
Lake Dillon, CO
Tar Pamlico, NC
Traders
Pollutants
PS/PS
Phosphorus
PS/NPS
PS/PS
PS/PS
PS/NPS
Boulder Creek, CO
PS/NPS
Rahr Malting Co.,
MN
PS/NPS
Under development
Michigan’s
PS/NPS
statewide rules
PS/PS
Phosphorus
Status
Established 1981, no
trades until 1995
Established 1984,
limited trading
Nitrogen &
Established 1989.
Phosphorus
Ammonia,
Established 1990.
nutrients
BOD,
Phosphorus & Established 1997
Nitrogen
Phosphorus
and Nitrogen
Approval anticipated
in early 2001
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So why all the interest?
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Trendy & the economic arguments are
convincing
Increasing use of Total Maximum Daily
Load (TMDL) regulatory structure
Relative importance of nonpoint
polluters -- WQ Trading is seen as a
potential carrot since sticks are difficult
to impose.
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Some goals for WQ programs

Ensure that environmental objectives
are achieved

Minimize total cost of abatement

Minimize the agency’s costs and legal
risks

Minimize participant transaction costs

Minimize initial costs to both the agency
and regulated community
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No single market structure can
achieve all of these goals

Market structures in pollution trading
• Exchanges
• Bilateral negotiations
• Clearinghouses
• Sole-source offsets
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Exchanges

The prototypical “market”
– products are equivalent
– prices are observed

WTP of buyers  WTA of holders of the
good (net of transaction costs)

No Pareto-improving trades should
remain unfulfilled.

Transaction costs are typically quite low
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Exchanges in Pollution Trading

The SO2 market
Some NOx markets

Uniformity is achieved:

– The good is defined by law to be uniform
– Compliance is monitored by the regulatory
agency
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Why Exchanges are difficult in
WQ markets

Good is by nature non-uniform
– Water flows down hill and changes as it
goes

Pollution by nonpoint sources are not
easily measured or monitored
– All sellers of pollution are not viewed as
equivalent
– Ongoing relationships between the buyer
and the seller are frequently required
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Bilateral negotiations
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Example: the market for used cars
These are not ideal markets
Each transaction is negotiated
separately
Information, contracting and
enforcement costs are quite high
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Bilateral negotiations
in WQ markets
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Many programs require a separate
contract for each trade
Because of provisions of the Clean
Water Act, substantial supervision of
each trade is required
Programs with bilateral trading:
• Dillon
• Kalamazoo
• Fox River
• S. Minn. Beet Sugar
Coop.
• M ichigan’s proposed
rules
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Bilateral Trading:
Strengths & Weaknesses

Strengths
– Allows for a quite
decentralized
approach
– Risks and
responsibilities are
born by traders

Weaknesses
– Substantial
transaction costs
– Oversight can be
onerous
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Clearinghouse markets

Like a supermarket selling ground meat
– An intermediary purchases many, possibly
nonuniform products
– Sells them as a uniform product

Both buyers and sellers know exactly
where to go
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An example of a clearinghouse in
WQ trading
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Tar Pamlico PS/NPS program
– Part of the State’s Agricultural Cost Share
program
– farmers are paid 75% of the cost of
implementing BMPs that reduce runoff
– Buyers of credits make payments into the
fund based on the average cost per unit of
reduction (originally $56 per kg, $29 in 1996)
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Advantages and Disadvantages of
Clearinghouses
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Advantages
Intermediary
ensures the quality
of credits
Intermediary bears
most transaction
costs
– Low transaction
costs for buyer
– Low seller
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Disadvantages
Agency bears all the
risk & responsibility
A non-profit
intermediary can
lead to an inefficient
outcome
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Sole-source offsets
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Alternative to traditional abatement
programs but does not involve trading
between independent parties
Analogous to firm-level decisions to
vertically integrate production processes
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City of Boulder’s program
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Attempts to reduce ammonia through
creek restoration
The city’s waste water treatment plant
carried out activities independently
without trading
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Sole-source offsets
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Advantages
– Lower transaction
costs (no
transactions)
– Lower monitoring
costs
– Can typically be
implemented in the
context of existing
regulations
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Disadvantages
– Limited potential for
cost savings
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Conclusions
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Water quality trading is on the rise
Don’t expect to see a bunch of
exchanges developing
In standard markets there are a variety
of market structures
Similar diversity will likely be found in
WQ markets
Market structure is a choice and must
be made carefully
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