Economic and Ecological Rules for Water Quality Trading1

Abstract

Horan, Richard D. and James S. Shortle, 2011. Economic and Ecological Rules for Water Quality Trading. Journal of the American Water Resources Association (JAWRA) 47(1):59-69. DOI: 10.1111/j.1752-1688.2010.00463.x Abstract: Emissions trading in textbook form uses markets to achieve pollution targets cost-efficiently. This result is accomplished in markets that regulators can implement without knowing pollution abatement costs. The theoretical promise of emissions trading, along with real-world success stories from air emissions trading, has led to initiatives to use trading for water pollution control. Yet, trading, particularly when it involves nonpoint sources of pollution, requires significant departures from the textbook concept. This paper explores how features of water quality problems affect the design of markets for water pollution control relative to textbook emissions markets. Three fundamental design tasks that regulators must address for pollution trading to achieve an environmental goal at low cost are examined: (1) defining the point and nonpoint commodities to be traded, (2) defining rules governing commodity exchange, and (3) setting caps on the commodity supplies so as to achieve an environmental target. We show that the way in which these tasks are optimally addressed for water quality markets differs significantly from the textbook model and its real-world analogs. We also show that the fundamental appeal of emissions trading is lost in the case of realistic water quality markets, as market designs that reduce the costs of achieving water quality goals may no longer be implementable without the regulatory authority having information on abatement costs.