Peer Review of the Water Pollution Credits Program

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The Theory and Practice of Pollution Credit Trading in Water Quality ManagementDana L. Hoag and Jennie S. Hughes-PoppDept of Agricultural and Resource EconomicsColorado State UniversityFt. Collins, CO 80523fax (970) 491-2067 phone 491-5549email: [email protected]

A Peer Review byArloe P. Fontenot

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Introduction and Abstract

-The authors, Hoag and Popp, performed a critical review of theory of pollution credit trading and its application to water pollution.

-The Tar-Pamlico Nutrient Trading Program in North Carolina was examined for its application of a water pollution credit program.

-5 programs (pollution credit-trading) exist in the United States, however not a single trade has been made (as of November 1996.)

-Six concepts or factors for a successful pollution credit-trading program were identified:

Transaction costs

Number and Relative Discharge of Participants

Abatement Costs

Enforcement Costs

Trading Ratio

Loading Limits

-These concepts were compared for program implementation; and several factors were highlighted that enhanced or discouraged trades:

-A fixed trading rate tended to eliminate the marginal cost benefits crucial for efficient trading.

-In addition, trading costs were raised by a safety-netted trade ratio of at least 2 to 1 (2:1).

-Finally, allowable emissions may actually increase well above expected emission levels.

-Failure in the trading programs may be due to improper implementation.

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...so how is theory and research put into practice?

-One example relevant to economics (and the industrial community) is…

the case for marketable permits for agricultural pollutants in water

-However the theoretical benefits of marketable permits has not inspired potential traders to make trades where markets have been developed.

-Out of 5 pollution credit-trading programs set up in the US as of Nov. 1996, not one trade has been made in any of the five experimental markets, although, according to the authors, there is some confusion about whether trades have occurred in North Carolina, since no firm has needed to purchase credits.

-These firms have however earned credits through various agreements associated with the establishment of the trading program.

-This failure in North Carolina discouraged any interest in creating a second program nearby due to the perception marketable permits “don’t work”.

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Pollution Credit-Trading BackgroundDefinition.Watershed based (pollutant) trading is allowing one entity to remove or prevent

additional pollutant discharges while allowing another to discharge more than would

otherwise be required. Under the control of an agreement between the two parties

involved, the trade must improve water quality. From an economic perspective,

watershed-based trading is a tool to be used in a watershed whereby all sources contribute

to reducing pollution without any one entity bearing an excessive financial burden. This

shift in responsibility may result in a more equitable, efficient, and cost-effective means

to address water quality problems in a watershed.

(Wisconsin DNR 3rd Progress Report http://www.dnr.state.wi.us/runoff/pt/ptreport2000.pdf)

Tar-Pamlico River Basin Nutrient Trading Program

-The point source dischargers involved are treated as a single unit concerning nutrient loading limits, monitoring, and enforcement.

-Policy typically focuses on point/nonpoint source trading (Letson, 1992; USEPA); however this single unit classification allows for point/point and point/nonpoint source-trading possibilities.

-Non-point sources are considered runoff from fields, etc. Point sources are considered the likes of factories or water treatment plants,etc. (PlanetArk.org 15/1/2003)

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A Review…

Typical “command and control” regulation involves detailed regulation followed up by an ongoing inspection program. In the United States, RCRA, the Resource Conservation and Recovery Act, is a good example of “CAC” regulation.

-The market-based pollution credit-trading regulatory compliance alternative can achieve the same combined level of pollution control as CAC regulation, but permits the burden of pollution control to be shared more efficiently among dischargers.

Another definition states…”pollution credit trading in principle allocates reduction in pollutant loadings across point and nonpoint sources within a watershed using least cost criterion –allowing the point sources (PSs) with high abatement costs to trade pollution credits with non-point sources (NPSs) that have lower costs may reduce the total abatement costs of improving water quality (Malik, Letson, Crutchfield, 1993).”

-Point/nonpoint source trading grants POTWs and industrial point sources the option of bringing agricultural and urban non-point sources under control rather than requiring further controls at point sources.

…..Using the Tar-Pamlico Water Market as model, how do the six factors reviewed influence the success of a marketable permit trading program for water quality?

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6 Factors that influence the success of a Marketable Permit Trading Program for Water Quality

1) Transaction Costs

-Lower costs increase potential for trades, and transaction costs can be reduced by agreements and specialization between polluters and the government.

2) Number and Relative Discharge of Participants

-Allowing both point/point and point/nonpoint source trading increases the potential benefits from trades

*Too many or too few participants can make trading difficult and costly.

*Credit-trading is feasible where there is a small number of large point sources and a fairly small number of large nonpoint sources.

3) Abatement Costs

-Gains are made when marginal abatement costs differ between traders, although the costs of trading are minimized when the marginal costs of control are equalized across all dischargers.

4) Enforcement Costs

-Enforcement costs may be higher for a credit-trading scheme compared to a CAC scheme when neither maximum emissions nor cost parameters are identical across firms.

5) Trading Ratio

-Pollution abatement uncertainty, esp. for non-point polluters, leads to built-in safety factors for trading, which increases the marginal costs of trading and decreases the potential of trading.

6) Loading Limits

-Current pollution loading levels must exceed regulation limits in order to stimulate trades.

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Tar-Pamlico Nutrient Trading ProgramTar-Pamlico River Basin covers an area of 5,401 sq. miles and 2,308 miles of freshwater streams in 16 counties in North Carolina (map following slide). The Basin has been classified as Nutrient Sensitive Waters (NSW).

North Carolina Division of Environmental Management (DEM) developed a special nutrient management plan for the basin, the NSW Implementation Strategy.

-It included a recommendation for a reduction in nitrogen (N) and phosphorus (P) inputs from nonpoint sources, with no increases in N and P levels from point sources.

-Environmentalists and point source dischargers rejected the recommendations due to insufficient

or vague nutrient reduction targets and claimed excessive compliance costs and regulations

imposed on point source polluters (Levitas and Rader, 1993; DEHNR, 1992).

> An alternative plan was developed that contained a provision for nutrient credit trading.

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(courtesy N.C. division of Water Quality)

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Abatement Strategy-The Tar-Pamlico Basin Association, collectively consisting of the DEM, the NC Environmental Defense Fund, the Pamlico-Tar River Foundation, and a coalition of dischargers, all adopted a two-phased plan to achieve nationally determined nutrient reduction goals.

Agreed to develop an estuarine computer model for the basin

>Agreed to conduct engineering evaluations of the wastewater treatment plants

Agreed to implement a nutrient reduction trading program during Phase I (’90-’94)

This model would:

-assess the relative importance of nutrients from point and nonpoint sources.

-track and target “best management practices” (BMPs) for reducing agricultural nonpoint source discharges.

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Nutrient Trading Details for the Plan-A combined reduction goal for 1994 was set at 200,000 kg/yr (180,000 kg/yr total nitrogen, 20,000 kg/yr total phosphorus) based on concentration limits and projected flow for three facilities that planned to expand before 1995.

-The Association’s annual nutrient loading was estimated to reach approximately 625,000 kg/yr by the end of 1994.

-If the Association could not meet the nutrient loading allowance of 425,000 kg/yr, it could purchase nutrient credits through the contribution of funds to the NC Agricultural Cost Share Program (ACSP).

-The ACSP is a voluntary program which provides technical assistance to and pays farmers a percentage of the average cost to implement agricultural BMPs.

-Funds paid by the Association would also supplement state cost-share money already allocated to the Tar-Pamlico

Basin and fund additional personnel for BMP review and identification purposes.

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Number, Relative Damages of Participants and Plan Abatement & Enforcement CostsTar-Pamlico River Basin (1994)

148 active permitted fresh and saltwater dischargers

18 categorized as major dischargers (>0.5 million gallons/day)

The Association

consisted of 12 publicly owned treatment works (POTWs) and 1 industry, collectively displaced 80 percent of the total discharge flow allowed within the river basin (Green, 1993).

Plan Abatement Costs- Phase I total program cost $2.72 million, of which the Association spent $1.13 million for the

computer model, engineering evaluations, ACSP contributions, staff positions, and legal and admin fees (Leyen, 1993).

- The remaining funds are contributed by EPA.

Enforcement Costs- All existing dischargers (Association and non-Association) must meet original DEM nutrient

effluent permit limits if the terms of the agreement are violated.- The DEM may require individual point sources to remove nutrients if a localized water quality

problem arises. The Association receives credit toward its allowable annual nutrient loading if the facility complies; if the project nutrient removal is not met, the DEM may add nutrient levels to the facility discharge permit.

- The Association must then pay for the projected pollution credits incurred, plus a penalty charge of 10%.

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Trading Ratio-The Tar-Pamlico Plan used a 3:1 ratio for cropland BMPs and a 2:1 ratio for confined animal

operations. *Ratios were set at >1:1 since non-point source (NPS) loadings were less predictable, more random, and less reliably controlled over time and space, than point sources (PS).

-These trade ratios accounted for the fees of non-compliance (based on avg. NPS control costs and admin fees)-The Association must pay $56/kg of excess nutrient discharges (whether N or P), into the ACSP.

-All BMP pollution credits have a useful life of 10 years, unless program contracts within the cost-share program provide for a longer period.

-If the Association nutrient reduction goal (200,000 kg) were met entirely through the BMPs, the estimated cost was $11.2 million (200,000 kg * $56/kg = $11.2 million).

-A credit price of $62/yr was imposed on existing non-Association dischargers expanding to 0.5 million gallons/day or greater who wanted to participate in the nutrient reduction trading program.-These dischargers were subject to DEM permit limitations of 2ppm total P, and 4ppm (summer) and 8ppm (winter) total phosphorus.

-New dischargers could not participate in the trade. They must implement non-discharge systems or be subject to permit limits proposed by the DEM (Division of Environmental Management).

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Phase I Achievements and Provisions for Phase II-Engineering evaluations completed in 1991 showed most plants met the phosphorus (P) limit while nitrogen (N) levels

typically exceeded the limits originally proposed (USEPA, 1992b).-Operational and minor capital improvements implemented by the Association reduced discharges below proposed limits

in 1991 and 1992 (Crutchfield, Letson and Malik, 1994). -The end of Phase I (Dec 1994) saw the total nutrient loadings reduced from 670,000 kg to less than 420,000 kg

>5,000 kg less than targeted level or 37% overall reduction in nutrient loadings-The estuary model was also completed during Phase I.

-The model indicated a 45% reduction in 1991 nitrogen (N) load levels would achieve water quality standard targets. Phosphorus (P) limits were constant with 1991 levels.

Phase II-Phase II acknowledged the 45% nitrogen reduction goal and was approved by the EMC, however, uncertainty in the

ability of current BMP and point-source technologies to hit that goal allowed an interim goal of 30% reduction to be set.

-Only 8% of that 30% reduction was allocated to point-sources. Non-point sources were held accountable for the remaining 92%; without knowledge of how this goal was to be accomplished…(a shot in the dark possibly?)

-The NC Environ Def Fund along with others protested the Phase II proposal; citing lack of procedures for non-point sources (predictably) and the conservative interim reduction goal for both type of source discharger.

-The DEM announced a Nutrient Management Plan in Dec 1995, which preserved the 30% reduction goal for the first few years of Phase II; but pending results from an improved estuary model allows for target adjustments in future years.

-The trading rate of $56/kg per excess discharge was also reduced to $29/kg during the Phase II discussions.

…as of Aug 1997 the Environmental Defense Fund has refused to sign Phase II, and although delays continue, the program has continued to work toward a suitable solution for all parties

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Program Assessment-The authors’ research showed the Tar-Pamlico River Basin program revealed some ways the program employed effective organizational schemes to make trades more attractive.

(Pro) >The costs to make trades have been greatly reduced (Number 1 in the list).

How?

-The formation of a point-source polluter Association, representing the small number of polluters with considerable discharges

-The Association can trade as a group with the ACSP, an established program that represents farmers, at

a predetermined rate of $56/kg

-Most of the transaction costs by Members when the Association was established and for the over $1 million paid for Phase I

-Only transaction costs left to Members is the effort and paperwork to purchase credits, at the established price

-The ACSP incurs the costs to implement BMPs; there is no enforcement mechanism to assure they are implemented however

(Pro) >The administrative structure also had notable implications that made trades more attractive.

Such as..

-Point-sources could trade with each other or with non-point sources

-Also, point-source contributors pay for pollution control, while farmers are paid for pollution prevention

-Aside from equity questions, this lowers the transactions costs for farmers and the Association by making it more simple for buyers and sellers to establish trades

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Program Assessment cont’d-There were also substantial deviations from an optimal plan design, as suggested by research.

(Con) > Contrary to point number 3, the program used average cost prices rather than pricing at the margin

(Con) > As suggested by point number 5, the trading ratio was set at 3:1 or 2:1 for some, therefore farmers’ nutrient reductions may have been priced higher than the Association was willing to pay.

-Trades were not made between point source polluters, which cannot be explained by the trading ratio or avg cost pricing

(Con) > Contrary to point 6, the responsibility for future reductions weighs heavily on non-point sources, since the N and P loading limits set by the DEM for the Association allows them to increase their current loadings.

-These two decisions by the DEM may affect the point sources’ willingness to fund non-point source controls

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Administrative Structure-Establishing an appropriate market value for a pollution credit is not unique to nutrient trading programs

-The EPA’s Emission Trading Program is trying to centralize buying, selling interest in the “new cash market”, and by establishing a market for futures contracts and options in SO2 emissions allowances (Rosenzweig and Villarreal, 1993), in order to solve its program’s problems

*Limited geographic size of a typical nutrient trading market combined with differing property rights between buyers and sellers make these trades unrealistic

-Property Rights creates problems of enforcement since Association members are not at risk for noncompliance if BMPs are unsuccessful since they are not involved in their implementation. However individual members of the Association are at risk of more stringent effluent limits, regardless of Association participation and BMP fund contributions.

-Also farmers are not required to reduce pollution levels, so they may show reluctance to accept trades since it could be construed as admission that they are polluters

-It is problematic also that firms are reluctant to transfer any control to outsiders; fearing public scrutiny of their operations.

*This is particularly problematic in the thin market for the Tar-Pamlico (as probably true with other markets also)

-Combining point/point and point/non-point trades results in more cost effective allocation than point/non-point trading alone. In Tar-Pamlico, the greater the number of trading participants, the more opportunities to trade, which lowers the total cost for a given level of abatement.

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Program Pricing and Loading Limits-One important limitation of the Tar-Pamlico Nutrient Trading Program is the $56/kg (later $29/kg) average trading rate for the region, not the marginal rate.

-A second limitation of the cost of the program is the trading ratio, being set at a level >1:1.

*This reduces the cost-effectiveness of non-point source controls and thus discourages trade by point- source dischargers, since each credit becomes more expensive as ration increases.

Phase II Loading Limits for Nitrogen and Phosphorus are 405,256 kg and 69,744 kg for the Association, respectively.

-These figures are roughly 86,000 kg and 15,000 kg higher, respectively, than their 1994 loading levels

- Any point/point source trading activity may be completed at a marginal cost near zero when the nutrient loading allowance is above the actual loading.

*There is no economic incentive nor need to conduct point/point or point/non-point trades until the marginal cost of point-source reductions exceeds the price of a nutrient credit

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Conclusions-Non-point sources have contributed most to federal water pollution control legislation objectives not being met.

-Debate remains on how to impose non-point environmental controls, and who would pay for them.

…one promising method of non-point source control is to use market-forces, such as nutrient credit trading programs.

-Now, over 35 years of research exist on this topic (25 years as of 1996). Only recently has the broader policy community begun to regard market instruments favorably.

…the EPA as recently as 2003 under Administrator Christine Todd Whitman endorsed the water pollution credit program, citing the Agency’s new policy would harness “the power of the market” to reduce water pollution.

-However predictably, environmental groups are skeptical. From the same article release, Bruce Knight of the USDA’s Natural Resources Conservation Service, looks forward to jump-starting a “buffer strips” program, in reference to a program that pays farmers to plant grasses along stream banks to help trap soil, manure, and chemical runoff from fields.

…the Hoag article focusing on the Tar-Pamlico River Basin in North Carolina illustrated that “Putting theory into practice requires compromise between the desire to promote cost-effectiveness and to have an administratively simple, yet politically acceptable program”

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Other Citations and SourcesAbbot, Charles. USEPA backs trading of water pollution credits. PlanetArk.org. January 15, 2003. http://www.planetark.org/avantgo/dailynewsstory.cfm?newsid=19408

Wisconsin Dept of Natural Resources. Trading of Water Pollution Credits, Third Progress Report. September 2000. http://www.dnr.state.wi.us/runoff/pt/ptreport2000.pdf

Tar-Pamlico River Basin map provided by North Carolina Dept of Water Quality http://h2o.enr.state.nc.us/basinwide/whichbasintarpam.htm

Other Useful Links:

Tar-Pamlico River Basin Nutrient Reduction Trading Program Website:

http://www.enr.state.nc.us/DSWC/pages/tar-pamlico.html

Special thanks to Dr. Dana Hoag, Colorado State University, for supplying this article for review.

Dr. Hoag’s website: http://dare.agsci.colostate.edu/csuagecon/people/faculty/hoag/hoag.htm

Thanks

APF 8/7/2008

Peer Review of the Water Pollution Credits Program

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