Volume 3, Issue 1 (January/March 2006)

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In This Issue
Introduction
The Potential for Water Quality Trading in Ohio
What's the Willingness to Pay for Conservation

Introduction

This issue discusses two important topics in water quality in Ohio.  The first article below describes the potential for water quality trading in Ohio. The Ohio EPA is planning to write and implement rules for water quality trading this year.  This means that within several years, a number of pollution trading programs could be in place in different parts of the state.  The article below describes pollution trading, and discusses many of the issues that are likely to arise as Ohio moves down the path towards implementing this policy.

The second article presents the results of an economic analysis of the benefits of implementing conservation practices in the Upper Big Walnut Watershed in Central Ohio. The study was conducted as part of the USDA Conservation Effects Assessment Program, with funding from the Agricultural Research Service of USDA.  The results clearly show that the conservation actions most valued by local residents are those that would increase the proportion of streams meeting water quality standards above the current 40% in the watershed.  These residents would pay up to $34 per acre of farmland per year to help bring streams into alignment with federal water quality standards.  The results of an expert survey suggest that reductions in nutrients and broader use of conservation tillage would provide the most benefits. While there is widespread belief among conservation professionals that conservation pays, these results provide, for the first time in Ohio, quantitative estimates that can be used to help direct the allocation of resources to agricultural nonpoint source pollution control.

The Potential for Water Quality Trading in Ohio
Brent Sohngen (Sohngen.1@osu.edu)
OSU Extension and AED Economics, Ohio State University

The potential for trading water quality credits in Ohio is gaining momentum. After years of effort and hard work, the Miami Conservancy District is moving forward on implementing a trading program in the Great Miami River Basin.  This program involves trades between point sources (i.e., municipal waste water treatment plants), and nonpoint sources such as farmers.  The Ohio Environmental Protection Agency has begun developing rules that will govern future trading programs.  In other areas of the state, such as the Sugar Creek region, individuals are brokering trades between NPDES (National Pollutant Discharge Elimination System) permit holders and upstream sources of nonpoint pollution.  It has been a long time coming, but trading of water quality credits in Ohio is becoming a reality. 

At this point, some readers are probably wondering what trading of pollution credits is all about.  Others may already have formed deeply held opinions.  This article briefly discusses important concepts underlying pollution trading, and it describes how pollution trading concepts may be applied to water quality issues.  Over the next year as Ohio EPA develops rules for a trading program, and as trading programs emerge, a number of important policy issues and questions will arise. This article attempts to highlight some of those issues.

What is Pollution Trading?

Pollution trading was first suggested in the 1960’s by economists considering how society could achieve long-term reductions in pollution without causing an undue burden on the economy.  These economists recognized that if government took the difficult political step of imposing controls (i.e., limiting the right to pollute), we were part of the way down the road to trading.  The next step would be to allow polluters to trade their rights.  With trading, polluters re-allocate the rights to pollute, or in other words, they decide who actually does the pollution abatement.  Those with high costs pollute more (abate less) and those with low costs pollute less (abate more).  Re-allocating rights with trading could save large amounts of money.

Pollution trading recognizes that government has an inherent advantage in establishing overall limits on pollution.  Government should decide, for example, the maximum level of nitrogen or phosphorous or other pollutants in a stream or waterbody.  These overall limits are often called ambient water quality standards.

To meet ambient water quality standards, government has to impose pollution limits on individual firms.  This is complicated because all firms have different costs, and government simply cannot know the costs that individual firms face when reducing their pollution.  Under current regulations, government bases their individual pollution limits for firms on some scientific criteria, followed by lengthy negotiation with firms.  This process leaves some firms with very costly outcomes and some with less costly outcomes. 

With trading, costs are reduced by allowing the firms to trade the rights they have been allocated.  Markets are used to re-distribute rights from low cost firms to high cost firms.  This lowers overall costs.  Pollution trading is nothing more than a system to re-distribute the “who” in pollution abatement. 

What are the Benefits of Pollution Trading?

The most important, and obvious, benefit of trading programs is that they can reduce costs.  A second benefit is that they provide incentives to innovate in pollution abatement technology because individual firms can profit from innovations.  This is under-appreciated in the BMP (Best Management Practice) driven culture that permeates the regulatory and environmental communities.  With traditional, BMP-driven water pollution control, individuals only have incentives to do what government tells them.  They have no incentive to invent new technology, and society has no hope of benefiting from any new technologies developed.  Trading can provide incentives for new technologies to develop.

A final positive aspect of trading is that markets can efficiently and effectively handle risk and uncertainty.  This issue will be discussed more in-depth below, but for now, recognize that markets for most goods traded in the economy have uncertainty in them, and markets are still the best mechanism available to handle large swings in demand, supply, or other factors.   

Has Pollution Trading Worked in the Past?

Pollution trading markets now have been implemented in a number of places.  An excellent source of data and information on environmental markets is the Ecosystem Marketplace website (http://www.ecosystemmarketplace.com/).  An example of pollution trading in the U.S. is the sulfur dioxide market, where permits have been traded since the mid-1990’s.  Wetland mitigation banking is another example of trading in the U.S.  The Europeans and Australians initiated carbon trading programs in early 2005 in anticipation of the Kyoto Protocol limitations or local laws limiting the rights to emit carbon dioxide.  One can argue about the environmental goals set by government in these cases, but trading has worked to meet the goals, and to reduce costs. 

How Would Water Quality Pollution Trading Incorporate Nonpoint Sources?

There is widespread recognition that water pollution trading could occur between regulated, point sources (NPDES permit holders) because these sources are already regulated under the Clean Water Act.  There is debate about whether nonpoint sources, and agriculture in particular, could be included in trading programs.  Because many nonpoint sources currently are not regulated, nonpoint sources could only enter a trading program as an additional supply of credits for the point sources.  Point sources would only be interested in purchasing credits from nonpoint sources if the costs are lower.  For a description of issues related to nonpoint source pollution, please see Leeds et al. (OSU Extension Fact Sheet AEX-465-93).

How would trades between point and nonpoint sources work?  First, regulators would need to introduce flexibility into NPDES permits such that permit holders would be allowed to meet some of their required loading reductions through purchases of reductions accomplished by nonpoint sources.  Second, one would need a way to measure and monitor the reductions provided by the nonpoint sources.  This second issue is where most of the debate about nonpoint source pollution trading has occurred.

Several options have been suggested to address whether reductions in pollution from nonpoint sources who have been contracted to reduce pollution can be "guaranteed."  One option utilized in several trading programs is a trading ratio.  A second option is to base contracts on performance, and to use actual stream measurements when determining effectiveness.  Both of these are discussed below.

Can All Pollution Problems be Addressed with Trading?

Clearly the answer to this is no.  Different problems require different solutions.  For instance, trading can only work if there are large cost differences among firms.  If cost differences are not present, then trading is not all that useful.  Alternatively, if the benefits of reducing pollution are substantial, as with some toxic substances, then bans or other methods are likely to be more efficient. 

How Big Can Water Quality Trading Markets Be?

The basic economic concept is that more individuals involved in trading are better than fewer.  Competitive markets emerge when there are lots of buyers and sellers, so designing markets to promote the largest number of buyers and sellers will lead to more success in a pollution trading market.

However, the size of the market must be tailored to specific conditions within watersheds.  There could be valid ecological reasons in some watersheds to limit trades based on geography (i.e., point sources can only trade with each other if they are both in the same watershed, or point sources can only purchase nonpoint source credits if the nonpoint sources are upstream).  Regulators must be careful when applying these limits though.  If NPDES permits are written too strictly, permit holders will have no economic chance to actually engage in trading.  Similarly, if the standards for agricultural nonpoint sources to enter as suppliers of pollution abatement credits are too strict, none of them may enter the market.  Regulators must be pragmatic here, balancing the need for ecological advancement with the need to contain costs.

How Important is Uncertainty?

Contrary to widely held belief, uncertainty is not a problem for water quality trading.  In order to evaluate the effects of uncertainty, one must be clear on what uncertainty is.  Two types of uncertainty are important: uncertainty related to weather and uncertainty related to performance (Taylor, 2003).

Uncertainty related to weather:  Implementation of farming practices that reduce pollution loads through the application of BMPs do not increase uncertainty, they reduce uncertainty.  Consider what happens on a 1000 acre farming watershed with no BMPs:  Assume that a 2" rain event in 6 hours leads to 2 tons of nitrogen load.  What happens on this watershed in the same rainstorm if the watershed is instead covered with BMPs? If you believe in BMPs, then pollution loads should be lower.  The application of BMPs reduces uncertainty related to weather. 

Uncertainty related to performance:  The real issue with uncertainty lies with performance.  Structures installed on farms have multiple purposes, and landowners will implement BMPs with different levels of enthusiasm and intensity. These factors will influence the performance of the BMPs.  On average, BMPs will perform less than optimally, and consequently will provide less pollution abatement than research studies imply.

This form of uncertainty is problematic, but it can be addressed in several ways.  The most common way to address performance uncertainty is to incorporate trading ratios into the trading program.  Thus, if a point source wants to offset 10 tons of their obligations with credits from nonpoint sources, they may have to purchase the equivalent of 15 tons in order to account for performance uncertainty, implying a trading ratio of 1.5 to 1. 

In practice, trading ratios have been set much higher than this in other trading programs (such as in Michigan and North Carolina), usually on the order of 2, 3, or more to 1.  Regulators must be very cautious setting the trading ratio too high.  Setting the trading ratio too high can reduce the scope for trading by raising costs. 

A different way to address the uncertainty is to use performance-based approaches.  Performance-based approaches would give point sources the option to use a relatively modest trading ratio (1 to 1, or at most 1.5 to 1) as a default, but it would also give them the opportunity to develop measuring and monitoring protocols that prove the reductions they are purchasing. The cost differences (lower costs with lower trading ratio), plus the costs of the monitoring protocols, are likely to be large enough that point sources would go ahead and measure and monitor the reductions they are getting in order to avoid the application of a larger (2 to 1 or 3 to 1) trading ratio. The application of data to the problem would also go a long way towards proving the concept.

How Important is Risk?

There is always risk of catastrophic failure - whether traditional regulations are used or whether trading markets are used.  In the case of water quality, a catastrophic risk would be a spill, or an exceptionally large release of nutrients or chemicals into a waterway.  These risks are not inherently larger with a trading program.  Large spills can lead to fines no matter who the polluter is.  This need not change with pollution trading.  There is no reason why safeguards against spills (i.e. fines and other penalties) cannot be used in combination with a trading program to minimize the possibility of a spill, or in the case of an actual spill, to help pay for the clean up.

What About Hotspots?

Pollution "hotspots" present a challenge for trading programs, but they are not insurmountable.  Hotspots have two dimensions - a spatial dimension and a time dimension.  An example of a spatial hotspot would be when a stream segment below the outfall for a waste water treatment plant has worse water quality than the stream segments above it (or below the hotspot).  A temporal hotspot would occur when a stream has too much of one pollutant during a single season.

Hotspots can be handled with monitoring data, trading ratios, and temporal limits on trades.  Monitoring data should be used to verify the location of a hotspot.  That is, regulators should be free to make allowances for hotspots using trading ratios, or by otherwise limiting the ability of NPDES permit holders to engage in trading.  But these limits should only be imposed if the regulators can verify, with data, that hotspots actually exist.  If a hotspot exists below a particular plant, then regulators may want to limit trading entirely or they may want to impose a fairly strict trading ratio for that plant alone.

Temporal limits would be appropriate if, for instance, phosphorous is found to be causing the non-attainment problem during low flow periods.  If this is truly the case, then regulators can write NPDES permits that make a distinction between high and low flow periods (i.e. winter and summer months), and that allow firms to use nonpoint source pollution credits only during certain months of the year.  There are many opportunities for creatively allowing trading, while at the same time addressing a verifiable pollution problem.

Conclusion: What do We Need to Do to Make Trading Work in Ohio?

Let's face it, the U.S. and Ohio made a lot of progress in water quality between the 1970's and the 1990's, but since the mid-1990's, progress on water quality has stalled.  Many people believe it has stalled because of nonpoint source pollution.  The last "big" idea for pollution abatement was the TMDL process.  That process has given us lots of models, lots of plans, and an incredible demand on voluntary incentive mechanisms, and consequently a large demand on federal farm subsidies.  A trading program will not solve the nonpoint source problem, but it could reduce the costs that point sources will face with new load reductions resulting from TMDLs.  In order to achieve this potential for lower costs, four principles should guide the evolution of a water quality trading program in Ohio:

(1) Be fair and flexible: A fair and flexible trading program is one that provides incentives for point sources to enter the trading programs through their NPDES permits, and for nonpoint sources to enter as suppliers of credits. Regulators can limit the scope for trading in lots of ways, i.e., using high trading ratios, mandating large technological changes regardless of trading.  Obviously, there are valid reasons to restrict trading due to hotspots and other factors, but these restrictions should be carefully applied, with substantial attention paid to actual water quality monitoring data at specific sites.  As conditions permit, regulators should be as flexible as possible in order to encourage trading. 

(2) Keep the trading ratio low: It is widely believed that the trading ratio has to be well above 1 to handle uncertainty.  The important issue related to uncertainty, however, revolves around the performance of BMPs, not uncertainty about weather.  A trading ratio greater than 1 can help alleviate some of this uncertainty, but regulators need to be careful not to set the trading ratio too high.  A high trading ratio raises the costs of trades and reduces the likelihood that trading will occur.  It also holds government to a lower standard than businesses (for example, we don't impose trading ratios on government programs that subsidize BMPs in agriculture).

One solution is to have a modest trading ratio in the range of 1 to 1.5, combined with a monitoring program.  Rather than using the entire value of the trade for installing BMPs, it would be more prudent to take some of the money and spend it on a monitoring program.  Suppose a company wants to abate 10 tons of nitrogen pollution with agricultural BMPs.  A trading ratio of 1.5 to 1 would suggest that they have to buy enough practices to abate 15 tons.  My recommendation would be that instead of purchasing 15 tons, they should purchase 13 tons worth of BMPs, and use the rest of the money for a monitoring program.  Current estimates suggest that abating a ton of nitrogen in a waste water treatment plant would cost around $60,000 (Doering et al., 1999).  This means, in principle, that the waste water treatment plant would pay up to $600,000 for agricultural BMPs.  With the proposed trading ratio, the waste water treatment plant would contribute up to $520,000 to nonpoint source pollution abatement, and $80,000 to a monitoring program.  This could fund a substantial monitoring program. 

(3) Monitor, monitor, monitor: The discussion above highlights the importance of monitoring water quality.  We don't do enough water quality monitoring in Ohio as it is.  We can't do trading without more data on water quality, and in particular, nutrient loads.  In addition to requiring monitoring with trades, the state should allocate more money to conduct monitoring itself.

(4) Keep the goal in mind: Pollution trading is a means to an end.  Regulators generally lack the tools and the legal justification to limit pollution from nonpoint sources, and in particular from agriculture.  They should not expect pollution trading to provide a means to regulate nonpoint sources.  Trading only provides a means to meet an existing target at lower cost.  If we can lower costs, then perhaps we can think about meeting additional, more stringent water quality goals later.

As a case in point, Ohio's proposed rules suggest trading ratios of 3 to 1 when point sources trade with nonpoint sources.  Point sources would get to utilize 1 ton of nonpoint sources offsets for every 1 ton of pollution emitted above their regulated limit.  An additional 1 ton would be utilized for nonpoint source compliance with a TMDL, and 1 ton would be held aside for "uncertainty."  The point source thus pays for 1 ton for themselves, 1 ton for the nonpoint sources, and 1 ton for "uncertainty." 

The goal of allowing point sources to purchase nonpoint source pollution abatement is to lower the costs of abating pollution for the point sources, not to solve the nonpoint source pollution problem.  The additional 1 ton allocated to nonpoint source abatement will increase the trading ratio, and the costs, for no good reason.  If the state wants to regulate nonpoint sources or to subsidize them in other ways to meet their TMDL targets, then the state should try to do that.  But it should not use this innovative tool to try to accomplish something it otherwise cannot.

References

Doering, O.C., F. Diaz-Hermelo, C. Howard, R. Heimlich, F. Hitzhusen, R. Kazmierczak, J. Lee, L. Libby, W. Milon, T. Prato, and M. Ribaudo. 1999.  "Evaluation of the Economic Costs and Benefits of Methods for Reducing Nutrient Loads to the Gulf of Mexico.  Topic 6 Report for the Integrated Assessment on Hypoxia in the Gulf of Mexico."  NOAA Coastal Ocean Program, Decision Analysis Series No. 20. (http://www.nos.noaa.gov/products/pubs_hypox.html#Reports)

Leeds, R., L.C. Brown, and N.L. Watermeier.  "Nonpoint Source Pollution: Water Primer"  OSU Extension Fact Sheet AEX-465-93. (http://ohioline.osu.edu/aex-fact/0465.html)

Taylor, Michael A. 2003.  "Tradable permit markets for the control of point and nonpoint sources of water pollution: technology-based v. collective performance-based approaches."  Ph.D. Thesis.  Interdisciplinary Programs.  Ohio State University. 

Additional Information on Pollution Trading:

Choices Magazine Edition on "Markets for the Environment" http://www.choicesmagazine.org/2005-1/environment/index.htm

Ohio EPA Water Quality Trading Website http://www.epa.state.oh.us/dsw/WQ_trading/index.html

US EPA Water Quality Trading Website http://www.epa.gov/owow/watershed/trading.htm

World Resources Institute: Nutrientnet http://www.nutrientnet.org/

State of Michigan Water Quality Trading Program http://www.michigan.gov/deq/0,1607,7-135-3313_3682_3719---,00.html

Environmental Trading Network http://www.envtn.org/

National Association of Conservation Districts Water Quality Trading Site http://www.nacdnet.org/resources/CITF/WQTintro.htm

What's the Willingness to Pay for Conservation?
Colleen Tennity¹ and Brent Sohngen^2
1 Economist, U.S. Army Corps of Engineers - Baltimore District (Colleen.Tennity@usace.army.mil)
² Dept. of Agr., Env., and Dev. Economics, Ohio State University

In recent years, substantial effort at understanding the potential benefits of agricultural conservation has been undertaken in the Upper Big Walnut Watershed (figure 1) through the Conservation Effects Assessment Program (CEAP), funded by the United States Department of Agriculture (USDA).  Similar monitoring studies are taking place in eleven benchmark watersheds across the country.  As part of the CEAP study in the Upper Big Walnut, we developed a survey to assess the benefits local residents obtain from the implementation of conservation practices.  In April and May of 2005, 1,000 residents in five central Ohio counties (Franklin, Delaware, Knox, Morrow, Licking) were surveyed to determine their attitudes toward conservation programs, and their willingness to pay for new practices that would improve local environmental amenities. 

The average respondents in the survey were fairly typical of residents in the region when compared to Census data (Table 1).  Interestingly, a relatively large proportion of the respondents had some farm work experience, and many had heard of the farm bill.  Over 84% of respondents believe that water quality is an important issue in Ohio, but a smaller proportion believes that water quality is an important issue in the Upper Big Walnut.  They are relatively neutral on whether water quality in recent years has improved in the Upper Big Walnut, although the respondents do appear to believe that additional efforts should be undertaken to improve water quality in the region in the future.  

Table 1: General responses to survey questions.

Respondents were directly asked their willingness to pay, through local taxes, for additional improvements in environmental amenities. The amenities examined included water quality improvements in smaller watersheds and streams, improvements in drinking water taste and quality, and improvements in upland game habitat.  The respondents were willing to pay $2.20 per household in a one time payment for a 20% increase in ground bird populations (i.e., Turkey, Quail, Pheasant, and Ruffed Grouse), $11.08 for a 25% increase in the number of small streams and watersheds that meet Ohio EPA standards for water quality, and $2.80 for a 5% improvement in the taste of water in Columbus.

Across the entire population of 565,535 households, respondents are willing to pay $81,000 per year for 30 years (or a $1.3 million one-time-payment) for a 20% increase in ground bird population, $408,000 per year ($6.3 million one-time-payment)for a 25% increase in the number of streams meeting water quality standards (moving from 40% of streams meeting standards currently to 50%), and $104,000 per year ($1.6 million one-time-payment) for a 5% increase in the quality of drinking water.  Local residents appear to be very interested, and willing to pay, for increases in water quality in smaller streams within the watershed. 

To use these estimates to determine which conservation practices to implement, it is necessary to determine how different practices affect water quality.  In this study, we rely on the results of an expert survey, which asked a group of local experts how different types of conservation practices would improve water quality.  We looked at a range of potential practices, including the implementation of buffer strips, broader application of conservation tillage, and reductions in nutrient management practices.  In all cases, we asked the experts to evaluate the potential effects of a given application of the practices among farms in the watershed.  For instance, we asked how much nutrient loads would decline if 5% of all streams had riparian buffers, or 95% of all farmland was managed with conservation tillage.

When these estimates are aggregated across households and analyzed relative to the benefits that the experts believe agricultural best management practices can provide, the results of the survey indicate fairly substantial regional willingness to pay for local programs that would improve environmental quality (Table 2).  Local residents are least willing to pay to improve ground bird populations, and most willing to pay to improve water quality in smaller streams and watersheds in the upland areas.  The practices that experts believe would provide these benefits most readily are broader application of conservation tillage and reductions in the application of nutrients on farm fields. 

Specifically, residents indicated that they would be willing to fund a local program $3.0 million per year over 30 years to reduce nutrient applications by 50%, and to increase the area farmed with conservation tillage to 95% of all farmland.  There are currently around 565,000 households in the region, so this amounts to $5.40 per household per year for 30 years.  For farmers, this would amount to $34 per acre per year for the approximately 87,000 acres in farmland in the watershed currently.      

Table 2: Annual aggregate willingness to pay into a 30 year local program aimed at improving environmental conditions in the Upper Big Walnut Watershed.

These results provide strong evidence that local residents have important values that are potentially not being met under current policy. Perhaps most surprisingly, the results suggest that less emphasis should be placed on conservation buffers and more emphasis should be placed on reducing nutrients and moving towards conservation tillage.  While buffers are a tangible measure that people can see, the respondents in our sample appear to value water quality more than upland habitat, and the experts we surveyed suggested that conservation buffers would have less effect on nutrients in the watershed.

The results also have important implications for broader policy measures.  Residents value improvements in stream quality: Currently only about 40% of the streams meet federal water quality standards, and residents are willing to pay up to $6.3 million in a one-time-payment to increase this to 50%.  We were very clear in the survey instrument that the streams not meeting standards are smaller streams well upstream from main-stem of the Big Walnut Creek and the Hoover Reservoir.  Regular people seem to have important values that are going un-fulfilled by current public policy that focuses on larger river systems and conservation practices that have limited benefits for smaller streams and rivers. 

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