Achieving Nutrient Water Quality Goals: Bringing Market-Like Principles to Water Quality Management

ACHIEVING NUTRIENT WATER QUALITY GOALS: BRINGINGMARKET-LIKE PRINCIPLES TO WATER QUALITY MANAGEMENT*1

Leonard Shabman and Kurt Stephenson2

ABSTRACT: Market-like trading programs for water quality management begin with enforceable limits on theamount of the pollutant allowed in a watershed. Properly designed market-like trading programs then createincentives for dischargers to reduce nutrient control costs over time by making pollution prevention innovations.However, the structure of the Clean Water Act can be a barrier to establishing market-like trading programs.First, we describe the general features and advantages of market-like trading programs. Then we offer practicalsuggestions for bringing market-like design concepts to nutrient trading programs within the existing legal andregulatory setting.

(KEY TERMS: market-based policy; water quality trading; nutrients; point source; nonpoint source.)

Shabman, Leonard, and Kurt Stephenson, 2007. Achieving Nutrient Water Quality Goals: Bringing Market-LikePrinciples to Water Quality Management. Journal of the American Water Resources Association (JAWRA)43(4):1076-1089. DOI: 10.1111 ⁄ j.1752-1688.2007.00089.x

INTRODUCTION

The benefits of government created markets forwater and air pollution discharge rights, commonlycalled emission or effluent trading, have been recog-nized for 40 years (Dales, 1968). In its idealized form,a limited number of pollutant discharge rights (orauthorizations) are issued. Those holding the rightscan discharge no more than the rights they hold, buthave the incentive to seek out and then to choose thebest effluent control methods for their own circum-stances. In addition, dischargers may exchange pol-lutant discharge rights. In the event of a trade,discharger A can increase the amount of pollutantreleased if discharger B reduces discharges by anequivalent amount. There is no increase in allowed

pollutant discharge, but if discharger A avoids moreexpensive control while discharger B implementsequivalent, but less expensive control, the same envi-ronmental result is achieved at a lower cost. Theresponsibility of the regulatory authority is to assurethat each unit of discharge is accompanied by a rightto make that discharge.

Professed support for market-based policy is nowwidespread. Emission trading programs of varioustypes are a familiar, and in some cases key, elementfor implementing the United States Clean Air Act andglobal climate change policy (Tietenberg, 2006). Fed-eral and state water quality management agencies areincreasingly encouraging ‘‘water quality trading’’ as awater quality management tool, claiming these pro-grams are yet another application of market-basedenvironmental policy (USEPA, 1996, 2003a). However,

1Paper No. J05168 of the Journal of the American Water Resources Association (JAWRA). Received October 13, 2005; accepted December 28,2006. ª 2007 American Water Resources Association. Discussions are open until February 1, 2008.

2Respectively, Residence Scholar, Resources for the Future, and Associate Professor, Department of Agricultural and Applied Economics,Virginia Tech, Blacksburg, Virginia (E-mail ⁄ Stephenson: [email protected]).

*Authors are listed by alphabetical order. No senior authorship is assigned.

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the current statutory structure of the Clean Water Actand the derived regulatory rules make it difficult todesign programs with market-based features(Stephenson et al., 1999; Stephenson and Shabman,2001).

Nonetheless, there has been a proliferation of pro-grams that have been characterized as water qualitytrading (Breetz et al., 2004). Considerable variationexists among these operating and proposed tradingprograms and several efforts have been made to cat-egorize the multitude of experiences (Woodwardet al., 2002; Woodward and Kaiser, 2003). In differen-tiating among programs some authors have notedthat many trading programs lack the basic marketdesign features described above (Stephenson andShabman, 2001; Shabman et al., 2002; Fang et al.,2005; Stephenson et al., 2005).

The objective of this article is to explore ways mar-ket-like properties can be incorporated into nutrienttrading programs under the existing statutory andregulatory confines of the Clean Water Act. Thepaper begins by identifying the basic requirementsfor market-like program design. These designfeatures are contrasted with water quality tradingprograms that are extensions of the existing regula-tory program. The arguments for why more approachmight be preferred as a way to achieve water qualityobjectives are then briefly reviewed. The article con-cludes with an extended discussion of pragmaticrecommendations for how such market principles canbe implemented within the existing confines of theClean Water Act. In some instances, the recommen-dations reflect policies and programs now beingimplemented by state and federal authorities.

The focus on nutrients recognizes that most efflu-ent trading programs seek to control nitrogen andphosphorus discharges. Trading programs are anattractive policy alternative for nutrients becauseextensive conventional regulatory programs have notbeen developed for nutrient discharges. Furthermore,the potential spatial relocation of nutrient dischargeswithin a river that may be a result of trading is lesslikely than other pollutants to cause localized waterquality problems. Higher profile and widely recog-nized examples of nutrient trading programs includethe Connecticut Long Island Sound program (Bennettet al., 2000; Water Environment Research Foundation2000; Connecticut Department of EnvironmentalProtection 2001) and North Carolina’s Neuse andTar-Pamlico programs (Hall and Howett, 1995; NorthCarolina Division of Water Quality 2003a,b). Tradingof nutrients has been documented on the MinnesotaRiver (Fang et al., 2005) and in Idaho (Schary andFisher-Vanden, 2004; Idaho Department of Environ-mental Quality, 2005). Meanwhile, Virginia andPennsylvania are proposing nutrient trading

programs and other states (Maryland and Florida)are actively investigating the option (Blankenship,2005; Maryland Department of the Environment,2005a; Pennsylvania Department of EnvironmentalProtection 2007; Florida Department of Environmen-tal Protection, 2006).

DESIGN REQUIREMENTSFOR MARKET-LIKE TRADING

Trading programs have officially been promoted as acost-effective way to achieve water quality objectivesand provide another policy mechanism to reduce nutri-ent dischargers from nonpoint sources. Cost effective-ness typically refers to the cost savings achieved by a‘‘trade’’ – a low control cost source discharges less efflu-ent in order for a high cost discharge source to dis-charge more. Furthermore, it is often reported thatnonpoint sources (nutrient enriched runoff from unreg-ulated sources such as some agricultural operations)are the ‘‘low cost’’ discharger (Butt and Brown, 2000;Faeth, 2000; Ribaudo et al., 2005). As the presumedlow cost source, nonpoint sources would always be posi-tioned as a ‘‘seller’’ in the program. As many nonpointsources remain outside the federal regulatory scope ofthe Clean Water Act, water quality trading is also des-cribed as a way to provide additional means to encour-age greater effluent reductions from nonpoint sources(Schary and Fisher-Vanden, 2004; USEPA, 2004). Nei-ther predicted cost savings nor attention to nonpointsources is the motivation for a market-based program.

Consider a water quality program in which a regu-lator assembles control cost and effectiveness data forall nutrient sources in the watershed and uses acomputer model to calculate the most cost-effectivecombination of nutrient controls. Then the regulatorissues permits to each source requiring the imple-mentation of controls identified by the cost-effective-ness analysis. For example, the computer modelmight determine that source A faces relatively highnutrient limiting control costs compared with sourceB. So the regulator might allocate controls fromsource A to B, as long as the total amount of thenutrient released to the watershed by all sources islimited to the cap. Meanwhile the total dollars spenton nutrient abatement go down. The regulator alsocould support research into new methods of cost-effective controls at each source and rerun the com-puter model. Based on a new analysis, the regulatorcould reallocate control responsibilities (mandate‘‘trades’’ among sources) to secure the cost-effectivecontrol strategy identified by the computer model.Many quantitative studies calculate cost saving in

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just such a way (Bennett et al., 2000; Faeth, 2000;Horan et al., 2002; Ribaudo et al., 2005). Would sucha program be recognized as a market-based policy?No, yet securing cost-effective controls, as thesedetermined by regulatory authorities, is a frequentjustification for trading.

Also, there is more to a market-like approach thanoffering financial incentives for sources to reduce theirdischarges. Many water quality programs use fundscollected from taxpayers to pay dischargers who agreeto adopt load reducing ‘‘best management practices’’(BMPs). In these programs, dischargers decide whe-ther to accept the payment in return for implementinga government-identified and approved technology orpractice. Offering taxpayer subsidies to install BMPsdoes not equate to a market-like policy. However,securing funds to provide financial subsidies for non-point source controls is a frequently cited justificationfor trading. Offering financial payments to adoptprescribed technologies ⁄ practices does not define amarket, but markets do create financial incentives forsources to lower their effluent discharges.

For these reasons, the design of rules for market-like nutrient trading programs should not be focusedsolely on making trades or on providing financialcompensation to polluters who voluntarily adopt gov-ernment approved control practices. Instead, market-like water quality programs are better distinguishedby two design attributes of any market. First, theremust be ownership of a commodity to be traded(bought and sold). In a market-based system, whatwe will call a cap-and-allowance market (CAM), thiscommodity is called a discharge allowance and a lim-ited number are issued (called a cap) to ensure thatwater quality standards are met. Second, a market-like program would be designed so that dischargershave substantial discretion (within the confines ofrules designed to achieve water quality objectives andlimit third party harm) to decide how pollutionshould be controlled (waste control flexibility) andwhether to buy or sell allowances (exchange flexibil-ity). Often such programs are referred to as ‘‘cap-and-trade’’ programs, but the CAM descriptor focusesattention on the market-like requirements. Forinstance, a ‘‘cap-and-trade’’ emphasizes ‘‘trade’’ butdoes not imply a set of rules necessary to create amarket setting, while ‘‘CAM’’ does (for example, atrade directed by a centralized regulatory agency, asdescribed above, could be described as part of a cap-and-trade program, but would not be ‘‘market-like’’).

Allowances

A market-like policy is organized around thecreation of discharge allowances, and it is these

allowances that are the commodity to be exchanged.Allowances are time-limited permissions to dischargea fixed quantity of a pollutant. For example, anallowance might be defined as the permission torelease one pound of nitrogen during the calendaryear. A discharge source must own allowances to leg-ally release the pollutant into the water. Allowancesmust be accompanied with stipulations and require-ments on the measurement of the total amount ofpollutants discharged and penalties (fines) for failureto hold a number of allowances equal to the amountof pollutant discharged.

Governments issue allowances and the sum of allallowances issued is equal to the total permissibledischarge into a water body or mass load cap. Allow-ances are only created after a water quality standardis established to protect the public’s interest in thewater. The water quality standard is translated intoa total amount of pollutants that can be dischargedwithout causing a standards violation. The waterquality standard does not prohibit the discharge ofall pollutants (zero discharge) because some amountof pollutant may be discharged, while still achievingthe water quality standard.

The total allowable pollutant load is initially allo-cated to broad categories of pollutant sources andthen further allocated to specific sources. For example,the allowable pollutant load first might be dividedamong point and nonpoint sources. The allowablepoint source load might then be divided among indi-vidual industrial plants and wastewater treatmentplants (WWTPs). Allowances are created if these indi-vidual loads then become a legal requirement to limitdischarge. The assignment of limited permissions todischarge should be recognized as the logic behindthe total maximum daily load (TMDL) approach towater quality management (National Research Coun-cil, 2001).

Discharger Discretion

Cap-and-allowance market systems grant discharg-ers decision-making flexibility to determine how thecap will be achieved. A CAM, like any market, willgrant market participants the freedom to decide howto operate their own businesses and households sub-ject to rules that protect others from unintentionalcosts or harm. This decision-making flexibility hastwo dimensions: waste control flexibility andexchange flexibility.

Waste control flexibility means that the dischargerdetermines how nutrients will be controlled. A dis-charger may choose, for example, to alter a produc-tion process, install a new piece of pollution controlequipment, or even reduce production levels as a

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means to keep nutrient discharges below or equal toallowance holdings (Swift, 2001). Such discretion isanalogous to that of a restaurant owner who has dis-cretion to decide what type of ovens to buy, whethersteak will be seared, blackened, broiled, or fried, orwhat type of food to put on the menu. This flexibilityprovides the restaurant owner with the means toeconomize on input costs, streamline production, andrespond to consumer demand. This same type of flexi-bility in a CAM program allows dischargers theopportunity to discover, create, and adopt new andinnovative ways to reduce nutrient loads. The empha-sis on decentralized decision making, however, doesnot imply that decision making is unconstrained ordevoid of government involvement. Returning therestaurant example, health and safety regulations onfood preparation, and maybe even smoking bans, areestablished to provide overall public health andsafety. In a CAM program, government actions set acap that limits total pollutant discharge and suchmatters as the permissible time and location of dis-charge by allowance holders protects the public’sinterest in water quality.

Exchange flexibility means that the permission todischarge can be transferred to different locationsand across time periods through buying and selling(or leasing) allowances. Allowance holders mightdecide to sell or lease allowances to others, retireallowances, or hold allowances for future use (some-times called ‘‘banking’’). The amount of allowancesavailable to sell, lease, retire, or hold increases asallowance owners find ways to reduce their dischar-ges below what is allowed. Buyers of allowancescould be dischargers who are expanding production.Another buyer might be a source that is experien-cing unexpected problems with their control equip-ment and needs to buy allowances to cover theincrease in nutrient loads. Yet another source ofpotential buyers would be new dischargers whoenter a watershed. New sources must buy allow-ances (permissions to discharge) just as they mustsecure land, labor, and equipment in order to oper-ate.

Expanding exchange opportunities and reducingthe costs of exchanging allowances (transaction costs)increases exchange flexibility. Increasing the potentialnumber of buyers and sellers increases the chancesthat market participants can negotiate a mutuallybeneficial trade. Lowering costs of transacting meansmarket participants do not spend considerableamounts of time and money to locate a trading part-ner or gaining regulatory approval for each trade.

Furthermore, exchange flexibility must have spa-tial limits, because water quality effects depend onlocation and timing of nutrient discharges. Forinstance, consider a trading program for an estuary.

A discharger who releases 100 pounds of nutrientsdirectly into the estuary will have a different impacton estuarine oxygen levels than a discharger whoreleases the 100 pounds of nutrients 200 milesupstream. A portion of the 100 pounds releasedupstream will be assimilated or used by natural pro-cesses before ever reaching the estuary. Therefore, aCAM must assure that the exchange of allowances(the commodity) results in ‘‘equivalent’’ water qualityoutcomes in the estuary. A way to maintain exchangeflexibility while still achieving water quality goals isthrough the definition of attenuation or deliveryratios across watershed segments (rather than simplynarrowing the geographic scope of trades). Of course,such measures must also avoid localized water qual-ity problems, sometimes called ‘‘hot spots.’’ The cur-rent interest in nutrient trading programs, however,is in some measure due to the more limited potentialof nutrient trades to create such third party effectscompared with other types of pollutants. Unlike othertypes of pollutants (e.g., toxics), nutrients are, withincertain limits, a beneficial and necessary energysource in the aquatic system. Further, nutrient-rela-ted water quality problems tend to be focused ondownstream endpoints (e.g., reservoirs or estuaries)and potential localized water quality problems (e.g.,ammonia discharge) tend to be addressed outside thetrading program.

Other Forms of Trading

As implemented, nutrient trading programs oftendo not reflect the basic features of a market-like pro-gram. Such programs rely on regulators, rather thandischargers, to choose the best control technology foreach source and to direct the reallocation of alloweddischarges among sources. Such trading programsbegin with the conventional permitting system(Stephenson et al., 1999, 2005; Dunn and Bacon,2005). The Clean Water Act requires that regulatoryauthorities identify technically and economicallyachievable pollutant control technology for categoriesof sources called point sources (Environmental LawInstitute, 1998). Specific performance standards(typically expressed as a concentration limit) are thenestablished based on those technologies. After somenegotiation with each particular discharger, aNational Pollution Discharge Elimination System(NPDES) permit is issued specifying the permissibleconcentration and, in some cases, might includerequirements for using certain technologies (Davies,2001). Also, regulators are expected to periodicallyreview technologies to revise standards downwardover time; called technology forcing or ratchetingdown (Langley, 2001).



Much of the current interest in ‘‘trading’’ is basedon the following situation: unregulated nonpointsources are a significant source of nutrients and strictpoint source permits alone cannot achieve water qual-ity standards (Stephenson and Shabman, 2001).Where water quality objectives cannot be met bypoint source controls, regulators face unpleasantchoices: (1) deny all new point source permit applica-tions unless zero discharge is achieved, effectivelyprohibiting economic growth, (2) create a new set ofpermits and technology requirements for unregulatednonpoint sources, which is a costly, politically conten-tious process, or (3) take no action and let water qual-ity goals be compromised.

To avoid these choices, regulators typically requirethe permitted point source to maximize effluent con-trol technologies used at the facility (Stephenson andShabman, 2001; Stephenson et al., 2005). These lim-its of technology controls typically cannot be trans-ferred or traded away and are established in aNPDES permit. Since the imposition of these strin-gent controls is insufficient to achieve water qualityobjectives, even more stringent effluent limits areimposed (for example zero discharge). Since a zerodischarge limit cannot be technologically achieved bythe point source, the regulator may require the pointsource to finance nutrient reductions at another,typically unregulated, source. Acceptable nonpointsource control practices then are identified by regula-tors and any controls implemented become new condi-tions in the point source’s permit (there is no trade ofpollution control responsibility).

While such extensions of the permitting system areusually called trading, note that regulators, not dis-chargers, are primarily responsible for identifying andapproving effluent control technologies and strategiesfor both point and nonpoint sources. Discharger wastecontrol and exchange flexibility is severely restricted.Payments from the point source are not voluntary nordo the payments result in the point source doing lessthan expensive limits of technology controls. Regula-tors exert primary responsibility to determine whomust trade and what type of additional controls willbe implemented. Whatever the merits, such tradingprograms cannot be described as market-like.

WATER QUALITY ADVANTAGESOF MARKET-LIKE TRADING

The objective of any water quality managementpolicy is to achieve water quality standards. CAMprograms advance the achievement of this fundamen-tal purpose for water quality management, relative to

conventional permitting programs. There are threeadvantages to consider.

Focus on Attainment of Water Quality Standards

To achieve ambient water quality objectives, CAMdesign focuses on establishment of mandatory massload caps for existing and new sources. CAM programsare a constant reminder of the importance of workingtoward a fully capped program. In a fully capped sys-tem, every discharger would be required to hold allow-ances before being allowed to discharge. A fully cappedprogram ensures that actual discharge does not exceedtotal maximum load target (established to achieve awater quality standard). If the total cap (total allow-able discharge) is set to achieve public water qualitystandards, then a fully capped system ensures thatthe desired water quality result will be achieved.

In the CWA context once a TMDL is establishedonly a subset of sources that are regulated by theNPDES permit program are subjected to controlrequirements. So-called nonpoint sources are exemptfrom CWA regulation. If only some discharge sourcesare required to hold allowances, the system is parti-ally capped. In partially capped systems, the numberof issued allowances is some fraction of the totalmaximum load target. Growth in the number of dis-charge sources outside a cap or failure to gain meas-ured and real reductions from uncapped sources willcompromise water quality attainment. A partial capfocuses public and agency management attention onthe significance of the exempted sources and on theeffectiveness of strategies to limit loads from thosesources. The result may be aggressive nonfederalactions (usually at the state level) to cap sources thatare outside the reach of the CWA. Some states havemade this adjustment for some areas (North CarolinaDivision of Water Quality, 2003b).

A CAM program also ensures that economic andpopulation growth does not degrade water qualityover time. Under conventional water quality manage-ment, new or expanding sources are permitted to addnew pollutant loads to the water as long as certaincontrol technologies are implemented. Under CAMprograms, caps are fixed and do not increase when anew source seeks government permission to discharge.In practice, this means a new discharge source willnot be issued new allowances, but must obtain allow-ances from the existing, fixed supply of allowances.

Pollution Prevention

If water quality standards attainment through capsis the goal of CAM programs, discharger discretion



is the means to that goal. This discretion applies tothe opportunity to buy and sell allowances and to theflexibility to choose the waste control method bestsuited to discharger specific circumstances. The resultis the creation of financial incentives for pollutionprevention that are critical to achieving water qualitystandards over time in the face of growth. In a CAMprogram, pollution prevention does not occur whenregulators prescribe additional control requirements.Financial incentives do not come from taxpayerfunded cost-share (subsidy) programs to promoteinstallation of regulator identified control technol-ogies. Instead, it is the opportunity to buy and sellallowances that motivates innovation in pollutionprevention. Dischargers who reduce discharges belowallowance holdings can earn revenue from sale ofallowances. Sources who need to expand and increasedischarges can avoid becoming buyers of allowancesby finding ways to lower discharges per unit of out-put and thus lower costs. Thus, the opportunity totrade creates both seller and buyer incentives to con-tinuously lower pollutant levels.

Paradoxically, the opportunity to trade combinedwith discharger discretion to choose their own controlmethods may actually reduce (at least initially) thenumber of actual trades that occur. Markets withouttrade are a likely initial outcome of a market-likeallowance program and can be evidence of successfulprogram design. Immediately after the implementa-tion of an allowance market, dischargers respond tonew incentives and opportunities by aggressivelyreducing effluent loads below allowance holdings. Inmany cases, unexpected pollutant reductions arefound and pollution control is achieved at a fractionof the anticipated costs. Dischargers often prefer tofind ways to lower their own nutrient loads and costsrather than pay someone else to do it for them. If alldischargers reduce effluent loads below allowanceholdings, the need to trade is limited (Burtraw, 2000;Shabman et al., 2002). Over time, trade may increaseas initial improvements are implemented and newnutrient sources enter a watershed and increaseallowance demand. Thus, a key evaluative criterionfor a market-based program is the ease of makingtrades – not the actual number of trades that occur.

The second form of flexibility, the freedom tochoose the waste control approach, warrants addi-tional comment. In a well-designed CAM, dischargersdiscover pollution prevention opportunities – oppor-tunities that may be quite source specific and thatmay not be initially apparent to either the dischargeror to the regulatory agency. Allowance market designaccepts that those with day-to-day, on-the-groundworking knowledge of production processes thatcause pollution – the dischargers themselves – are inthe best position to develop and apply new ideas and

strategies to prevent pollution. The creation of afinancial return either by not having to buy allow-ances or by freeing up allowances to lease, sell, orbank, encourages dischargers to apply this special-ized knowledge to pollution prevention.

Cap-and-allowance market programs use individ-ual self-interest to serve publicly defined environmen-tal ends. A fixed number of allowances anddischarger freedom to experiment and invest in nutri-ent control strategies fosters both economic growthand achievement of water quality standards. In adynamic economy with a growing population, newnutrient sources are created every year. If new andexpanding discharge sources are to legally dischargenutrients, existing dischargers must reduce dischar-ges to free up allowances for the new sources. Innova-tions for pollution control, creativity, and compliancesparked by allowance markets encourage existingsources to reduce discharges. If economic and popula-tion growth begins to outstrip the pace of nutrientcontrol innovations, allowances will tend to becomemore scarce and more expensive, providing additionalincentives to generate new pollution prevention strat-egies.

Improved Compliance

Noncompliance (discharges in excess of permittedamounts) is a chronic problem in the existing permit-ting system (USGAO, 1996), but a market-like pro-gram can improve compliance in several ways. First,the flexibility to buy or lease allowances means thata discharger who has had a temporary control failureor plant upset can remain in compliance by securingreduced loads from another source. Under the con-ventional permitting system, dischargers who faceunanticipated problems have limited options and apermit violation usually occurs. Also, the ability tobuy allowances from other sources might encouragedischargers to experiment with new pollution controlequipment or processes because they will not run therisk of a permit violation. If tests of a new pollutionprevention strategy fail to produce the expectedresults, dischargers have a fallback compliance mech-anism – buy allowances.

A CAM program also can create incentives for dis-charger self-reporting and self-enforcement. Becauseallowances are limited in number and are a commod-ity that can be bought and sold, they become assetsthat have a financial value. As a result, all discharg-ers have a common interest in protecting the value ofthat asset. If one discharger violates the rules by dis-charging more than allowance holdings, the value ofall other allowances are diminished because the rule-breaker reduces the number of potential customers to



those selling allowances. In a conventional permittingsystem, the noncompliant behavior of one dischargercreates no negative consequences for other discharg-ers. This self-enforcement incentive is no differentthan the self-enforcement that ordinary citizens doevery day against personal property theft. Few citi-zens would stand by silently while witnessing a cartheft. People help police officers enforce against prop-erty theft, not only out of civic duty, but also out offinancial self-interest – detection of a lawbreakertoday may prevent a personal loss of property tomor-row. While markets do not rely exclusively on self-enforcement, broad public support (witnesses, tips,informants, etc.) makes policing against propertytheft and other forms of economic loss less costly andmore effective.

TOWARD MARKET-LIKE TRADING PROGRAMS

Cap-and-allowance market programs must bedesigned within existing statutory and regulatoryconstraints and must take into account the physicalcharacteristics and properties of the pollutant andwater body. This section argues that these practicalimplementation challenges can be addressed and stillfit within the confines of the CWA.

Issue Group Compliance Permits

Under the existing statutory and regulatory pro-grams of the Clean Water Act, the legal permissionto discharge is granted by government through theissuance of individual NPDES permits. However,individual NPDES permits cannot offer the kind ofdischarger flexibility required for a market-like pro-gram (Shabman et al., 2002). For example, pointsources face permitting rules (called anti-backsli-ding) that might prevent a point source from buy-ing allowances in order to increase discharges(diminishing exchange flexibility) (Stephenson et al.,1999; NAPA, 2000; Steinzor, 2003). As implemen-ted, individual NPDES permits have also been criti-cized as being overly prescriptive in instructingsources how effluent discharge must be controlled(Environmental Law Institute, 1998; Davies, 2001).Permits based on technology-based performancestandards may provide strong discharger incentivesto implement specific regulator identified technol-ogies. Individual NPDES permits might also containrequirements to implement and maintain thatparticular technology (diminishing waste controlflexibility).

To achieve the market-like principles describedabove, CAM programs will require alternatives toindividual NPDES permits. Fortunately, a practical,and already tested, permitting strategy, called agroup compliance permit, offers a viable alternative.There are many specific forms that this kind of per-mit can take (USEPA, 2003b). One approach that hasbeen applied for the Neuse River in North Carolinabegins with assignment of individual source limits inNPDES permits as a way to develop a group cap.These NPDES-based limits are then waived and con-verted into allowances as long as the source agrees toparticipate in a discharger association covered by agroup compliance permit. The group permit would bea partial cap on the group of sources in the associ-ation. Allowances that summed to the partial capwould be allocated to the sources in the group.Exchange of allowances (trading) could then occurunder the group permit. Under such an arrangement,dischargers are free to make choices about controlstrategies. Failure to participate in the associationand follow association bylaws would activate thesource’s otherwise dormant individual NPDES permit(North Carolina Division of Water Quality, 2003a).

Under a group compliance permit, individual dis-chargers would not be required to use specific controlpractices, nor are their operational choices con-strained by technology-oriented permit requirements.New and existing sources would not face specific per-formance or technology requirements as a conditionto discharge. Rather, new sources would purchaseallowances from existing sources in the association.Instead of focusing on technology and individualsource control requirements, the permit wouldrequire strong individual monitoring and measure-ment provisions to identify the quantity of pollutantsactually released. The permit would also establishswift and immediate enforcement provisions in theevent that aggregate association discharges exceedthe association cap.

In the program predecessor to the Neuse program,the Tar River (North Carolina) Association, theAssociation members responded to the flexibility ofthe program by aggressively reducing nitrogen dis-charges for a fraction of the original cost estimates(Hall and Howett, 1995). With this flexibility, Associ-ation members initially were able to reduce nutrientloads without expensive capital upgrades by makingoperational changes. The possibility for many of theseinexpensive, but effective, operational changes cameas a surprise to both the regulators and the membersof the Association. Relatively simple and inexpensivenitrogen control strategies remained untapped andunknown until the Association members had the abil-ity and incentive to discover them. During a period ofprolonged economic growth, the Association has not



exceeded the discharge cap once (NCDENR, 2001).Such a compliance record alone is a significantachievement. The establishment of an enforceablecap under a group permit represents a policy withmarket-like flexibility.

One particularly intriguing feature of the groupcompliance permit is the inclusion of fees if the groupdischarge exceeds the group limit. As long as thegroup does not exceed its cap, consistency and compli-ance with water quality goals is achieved withoutrestricting decision-making flexibility. However, ifaggregate point source discharge exceeds the groupcap, the group must make a payment to a fund thatwill secure equivalent load reductions from sourcesoutside the group, usually uncapped nonpointsources.

Direct Regulatory Agency Resources to EffluentControl Performance

Under conventional water quality management pro-grams, substantial agency resources and attention aredevoted to identifying best available control technol-ogies or BMPs at individual sources. Regulatoryprograms are often supplemented by state and federalcost share programs that subsidize the implementa-tion of specific agency approved capital investments.For example, many state programs subsidize theinstallation of biological nutrient control technologiesat wastewater WWTPs (Connecticut Department ofEnvironmental Protection, 2005; Maryland Depart-ment of the Environment, 2005a; Virginia Departmentof Environmental Quality, 2005). Unfortunately,subsidies to install specific technologies or practicescan sharply reduce dischargers’ waste controlflexibility and ability to respond to market-like incen-tives. While the CWA does not require use of specifictechnologies and practices, the emphasis on theindividual source reduction and technology-basedstandards might reinforce such agency tendencies.

Because a CAM program must be oriented aroundthe effluent performance of discharge sources and noton the inputs to achieve that performance, agencyresources must be intensified in three primary areas.First, regulatory staff must develop modeling andmonitoring systems to continually verify the consis-tency of the cap with water quality standards. Sec-ond, regulatory agencies must ensure that adequateprotocols are devised to accurately measure andreport the quantity of nutrients being released. Meas-uring the total quantity of nutrients released requiresboth the measurement of the volume of wastewaterflow and the concentration of nutrients in that flow.When loads come from more diffused sources (morediscussion below) other means to document loads

may also be explored. For example, soil analysis, tar-geted monitoring of flows and concentration, and fieldscale and watershed models may all be employed toestimate loads. Third, enforcement requires monitor-ing for violations (discharges > allowance holdings)and carrying out enforcement actions when ruleshave been violated.

Of course, these very same measurement andenforcement challenges must be met in any crediblewater quality program and all are elements of theCWA. What makes the market-like programs standout is that CAM programs highlight the essentialrequirement of monitoring and enforcement and assuch create the political support for these govern-mental functions. Under a CAM program, regulatorystaff must be less of an engineer working to solvethe dischargers’ pollution control problems and moreof an environmental detective and police officer toprotect the public’s interest in water quality. One ofthe most significant but unrecognized obstacles tothe implementation of market-based trading pro-grams is having regulatory agency staff understand,recognize, and change agency priorities consistentwith these new job responsibilities (Shabman et al.,2002). Such a change does not require a change inthe CWA, but does often require either new agencyresources or a reallocation of agency resources tothese new tasks.

Define the Tradable Commodity as Allowances andNot Credits

In a CAM market the commodity being traded, anallowance, is defined in advance of program imple-mentation by government agencies. Dischargersknow exactly how much they own and how it can beused. Defining the transferable commodity in thisway is entirely consistent with defining total allow-able loads under group compliance permits that havebeen implemented under the CWA (see discussionabove).

An alternative commodity definition for a group ofpoint sources has been termed transferable ‘‘credits’’(Dewees, 2001; Shabman et al., 2002). A credit is cre-ated by the dischargers themselves when total nutri-ent load discharged is less than a governmentestablished ‘‘baseline’’ nutrient load. For example, thegovernment permit might allow a source to discharge100 pounds of nitrogen. If the discharge source relea-ses only 75 pounds, then the discharger created 25credits. While credits and allowances might soundsimilar in concept, credit programs present barriersto achieving exchange flexibility (Shabman et al.,2002). Consider a new and expanding discharger inneed of credits. A prospective buyer cannot know



whether there will be any credits to buy at the end ofthe accounting period because the number of creditsavailable to buyers varies year to year. Under thesecircumstances, an individual source is less likely torely on the purchase of credits as a long-termpollution control strategy because of the uncertainsupply. Similarly, a seller is unlikely to make a long-term investment that would create credits because ofthe uncertainty surrounding the number of potentialbuyers. By creating a certain number of transferablecommodities (allowances) in advance, CAM programsavoid this demand and supply uncertainty.

Strive for Regulatory Certainty

Many pollution control decisions require long-termplanning and investments. Therefore, regulatorsshould be aware how their decisions can diminishincentives to make pollution prevention investments.Dischargers form expectations about how manyallowances they will hold in the future and whatthose allowances will be worth when making opera-tional and investment decisions in pollution preven-tion. Regulatory agencies can create uncertaintyamong market participants if they make unexpectedchanges in the size of the cap (total number of allow-ances issued) or by selectively reducing the allowanceholdings for specific dischargers.

If regulators respond to superior performance bylowering individual nutrient limits or aggregate caps,pollution prevention is penalized, not rewarded (Envi-ronmental Law Institute 1998). This is more than ahypothetical possibility and may even be the result ofa defensible interpretation of the CWA itself. TheCWA contains within it two different goal state-ments for water quality management. The overallgoal is met with the restoration of the ‘‘chemical,physical, and biological integrity of the Nation’swaters’’ [Section 101(a)]. The TMDL program is alsoorganized around attainment of ambient water qual-ity standards in support of this restoration goal(National Research Council, 2001). On the otherhand, the CWA also includes a stated goal to elimin-ate all discharges of pollutants to the nation’s waters– the so-called zero discharge goal (Billings, 2006).Some might interpret the zero discharge goal as adirective for regulators to monitor waste control per-formance and lower effluent permit limits wheneverdischarge levels fall. Such ‘‘ratcheting down’’ logiccan be a disincentive to innovation in pollution pre-vention when applied to individual sources (Stephen-son et al., 1999). Fortunately, such behavior has notbeen interpreted as an agency imperative under theCWA and several nutrient trading programs (theNorth Carolina programs for example) have been

approved and implemented based on achieving anoverall ambient water quality objective.

This said link between the cap and water qualityis itself surrounded by uncertainty. The potentialneed to change the cap based on new informationabout the relationship between cap and water qualityobjectives must be anticipated in CAM programdesign and addressed in ways that do not underminedischarger confidence in the program. This does notimply the cap can never change or be reduced overtime, but changes to the cap must be done in waysthat can be anticipated, and planned for, by marketparticipants.

Be Creative About Nonpoint Sources

Nonpoint sources, including most agriculturaloperations and dispersed urban development, face noCWA legal requirement to limit nutrient discharges.However, in many areas nonpoint sources contributethe majority of the total nutrient load being dis-charged (USEPA, 2002). While not required by theCWA, the states themselves can exercise wide lati-tude on how to manage nonpoint sources. Thus, hownonpoint sources are integrated into a trading pro-gram is largely up to the states.

In setting up a CAM program, state regulatoryagencies might be tempted to accommodate a lack ofCWA authority to limit nonpoint sources by imposingaggregate point source cap at or below levels associ-ated with limits of control technology. Limit-of-tech-nology caps severely truncates point source flexibilityto reallocate loads on the basis of cost as well as rais-ing fairness questions about the allocation of loadbetween categories of sources, especially if the result-ing increment of point source load reduction makeslittle difference in attainment of water quality stand-ards.

The desire to shift control responsibility to pointsources is understandable because nonpoint sourcesare said to pose a special water quality challengepartly because their loads are costly to measure andmonitor (Bartfeld, 1993; Crutchfield et al., 1994;Ribaudo et al., 1999; Shortle and Horan, 2001; Kingand Kuch, 2003). Individual sources tend to be smallin size and each individually discharges a smallamount of total nutrient load. Nutrient loads mayenter the water over a general area and tend to entersporadically during significant rain events. Motiva-ting nonpoint sources to reduce loads and assuringthat such reductions are actually occurring will bepivotal to achieving water quality objectives in manyareas. However, applying the principles of CAMprograms can help address nonpoint source controlchallenges.



Expand the Cap. The most direct way to incor-porate nonpoint sources into a CAM program is tobring the nonpoint sources under a mandatory massload cap. While uncommon, there are examples ofwater quality management programs that haveplaced mandatory mass load limits on nonpointsources (Stephenson et al., 1998). For example, in theSan Joaquin Valley, California, mandatory seleniumcaps were established and loads directly measuredfor six irrigation districts (Austin, 2001). In theNeuse River Basin, North Carolina has developed aset of regulations that cap all sources includingagricultural landowners and urban areas nutrientloads to the river (North Carolina Division of WaterQuality, 2003b).

Many argue, however, that there is little publicenthusiasm for enforcing mandatory limits on cur-rently unregulated nonpoint sources. However, oncepartial caps are put in place and market-like pro-grams are underway, there may be a greater willing-ness to expand the cap to more sources. In fact,incentives might emerge to incrementally incorporatenonpoint sources into a market-like program. Oneexample is to reward a municipality’s WWTP thatfalls under a partial cap for expanding the cap tononpoint sources. The municipality’s WWTP might beinitially assigned allowances under a point sourceload cap. Yet, a variety of other nonpoint sources,such as septic systems or urban runoff, may also existwithin the municipality but face no discharge limits.The municipality could be granted additional allow-ances, and the overall cap could be expanded, if themunicipality agreed to connect houses with septicsystems to the centralized sewer system (Woodward,2003). A strong incentive to take such action wouldexist if reducing urban nonpoint nutrients within itsjurisdiction was less expensive than buying allow-ances from another WWTP.

As a condition for issuing the new allowances andadded management flexibility, the municipality shouldbe required to measure and report the effectiveness ofany nonpoint source implemented. Such documenta-tion would include both the means for quantifyingnutrient reduction effectiveness (documenting per-formance) and providing assurances that reductionsactually occur and are maintained over time. Regula-tory agencies could provide general benchmark meas-urement (quantification) standards or guidelines, butmunicipalities could be allowed to use alternativequantification and verification procedures if such pro-cedures are demonstrated to be at least as reliable asthe benchmark quantification procedures.

Nonpoint Source Credit Trades: TradingBeyond the Cap. If nonpoint sources remain out-side a cap, a point-nonpoint credit trading program

can be established (described further below). Such aprogram differs from a CAM program because one ofthe trading partners (the nonpoint source credit sel-ler) faces no legal requirement to control discharges.Since allowances are not issued to the nonpointsource, the commodity traded will be a ‘‘credit.’’ Asdescribed above, a credit (here for nonpoint sources)is created when documented nutrient reductions arebelow some required baseline level of discharge. Infact, documentation of nonpoint source credits is theprinciple challenge when establishing such a pro-gram.

One approach to credit documentation is to esti-mate, for a given land use, the associated pollutantload before any load reduction action is taken. Thisestablishes the baseline loading and future reductionsin loads from the baseline credits. Credits are calcula-ted by estimating the actual load from the land andsubtracting the baseline from these loads. As a policymatter, some minimum number of conservation prac-tices might be required when establishing a baseline.Of course, this documentation challenge is not uniqueto trading programs – every nonpoint control pro-gram must grapple with this issue. However, market-like programs focus attention on the importance ofdocumentation and control flexibility in nonpointsource management. Through attention to theseissues, market-like trading can provide incentivesand opportunities to improve the conditions necessaryfor effective nonpoint source control programs.

Consider the current documentation approach fornonpoint source controls. Conventional nonpointsource control programs encourage landowners toinstall agency-identified technologies (BMPs). BMPsare typically land use management practices or struc-tures that can be readily observed (e.g., forestedriparian buffers along streams, animal waste storagestructures, winter cover crops, etc.). Average nutrientremoval effectiveness estimates are then assigned tothe BMPs. Too often implementation is not followedup with rigorous monitoring of the technologies useor performance; instead, performance is assumed.Stormwater retention ponds, for example, have beenrequired as urban BMPs for many years, but there isno reporting requirement on a pond’s performance ormaintenance.

In a market-like nonpoint credit trading program,measuring and validating source discharge of totalnutrient loads is absolutely essential and the focalpoint of government agency attention. One way thiscan be achieved is by shifting the responsibility ofidentifying acceptable nutrient control activities fromgovernment agencies to private entities seeking tocreate and sell nonpoint source credits (Stephensonet al., 1998). Credit providers would have the flexibil-ity to provide multiple sources of documentation and



verification of load reduction. Rather than identifyingacceptable BMPs, government agencies are respon-sible for identifying a minimum set of measurementstandards. These standards would provide baselineprotocols for measuring loads and include require-ments for documenting performance over the life ofthe project. With the burden of proof on those cre-ating nonpoint credits to document performance, amarket-like trading program expects nonpoint sourcecredit suppliers to determine how nutrients will bereduced. Credit suppliers are not confined to adoptingfrom a preselected suite of BMPs. Rather, credit sup-pliers will be allowed to determine and experimentwith the most effective ways to reduce nonpointsource loading. Such flexibility might include pre-venting nutrients from entering waters through theapplication of conventional BMPs, induced behavioralchanges (e.g., reducing fertilizer application), or landconversion (crop to forest cover). Given the flexibilityto be creative, credit suppliers might also producenonpoint source credits by removing nutrients afterthe nutrients have entered the water body. Suchcredits might be called nutrient assimilation credits.For example, nutrient assimilation credits would becreated when the increasing biological assimilativecapacity, for example through enhanced oyster aqua-culture (Santopietro et al., 1999; Newell, 2004;Lindahl et al., 2005). Nutrient assimilation creditswould be environmentally equivalent to reductioncredits because increased discharges would be offsetby removal of nutrients by the nutrient assimilationproject (new oyster beds).

An example of some of these features can be foundin a salinity reduction program for the ColoradoRiver. Human activities in the Colorado River basincontribute an estimated 4.5 million tons of salt to theriver. This load is a contributing factor to high ambi-ent salt concentrations and significant economic andecological damages (Trueman, 1998). In 1974,Congress enacted the Colorado River Basin SalinityControl Act to enhance ambient water quality byreducing salt loads to the Colorado River. Initially,the Bureau of Reclamation (Bureau) used a conven-tional cost-share program to reduce salinity loads.The Bureau research identified and assisted in theimplementation of salinity control projects.

In 1994, Congress approved amendments to theSalinity Control Act that granted the Bureau expan-ded authorities to devise, manage, and implementbasin-wide salinity controls. In 1996, the Departmentof Interior released the guidelines to a new competit-ive salinity bid program. The basic premise of theprogram is straightforward. Rather than assume theresponsibility for identifying viable, cost-effective pro-jects, the Bureau issues an annual request for salin-ity control proposals. The Bureau grants financial

awards to those projects that reduce salinity dis-charge at the lowest cost per ton (Trueman, 1998;Adler and Straube, 2000).

A selection committee initially ranks proposals ona cost per ton basis, but then adjusts the final ran-kings both in terms of financial risk and salt removaleffectiveness risk. Financial risk is related to the abilityof the applicant to complete the proposed project.Removal effectiveness risk refers to the possible dif-ferences between quantified (estimated) amounts ofsalinity reductions vs. actual salinity reductions.Applicants can lower both financial and effectivenessrisks and the probability of receiving an award byrefining salinity reduction measurement, providingverification criteria and assurances for long-termmaintenance. For example, applicants that quantifysalinity reductions through direct sampling andquantification of salinity control measures are givenlower effectiveness risks than applicants that relysolely on procedures that quantify salinity controlbased on modeling procedures. Applicants can alsoincrease the attractiveness of their proposal by provi-ding long-term assurances (posting performancebonds or some other type of insurance strategy) thatsalinity controls are financially viable (U.S. Bureau ofReclamation, 2005). In these ways, incentives forimproved accountability and monitoring of nonpointsources are created.

The results are encouraging and demonstrate thepower of market-like designs to stimulate water qual-ity improvements. The application process is highlycompetitive with the number of applicants far exceed-ing the funding opportunities. The cost of salinitycontrol fell well below the expert’s original predic-tions. Under the original cost share program, salinitywas being reduced for an average of $70 per ton. Thetypical project under the competitive bid programreduces salinity for $30 per ton (Trueman, 1998;Adler et al., 2000). By linking awards with riskreduction, program rules also provide new incentivesto improve nonpoint source verification, measure-ment, and monitoring.

Such a program, called a nonpoint source creditresale program, could be adapted for a market-basednutrient trading program. Like the Colorado pro-gram, a nonpoint source credit resale program wouldempower a single government agency to solicit andsecure nonpoint source credits. The credit resale pro-gram would have a designated agency purchase docu-mented nonpoint source reductions and then resellthose credits to capped dischargers that elect to meettheir regulatory obligations through purchase of non-point source credits. For the program to work thegovernment agency would have access to a designa-ted fund for making the purchase. The fund might beinitially capitalized by either private or state funding,



but the program will become self-financing as reve-nues collected from credit sales would be depositedback to the fund and then used to purchase addi-tional credits over time. In this approach, the govern-ment agency acts as an intermediary between pointsource (capped) buyers and nonpoint source sellers(similar to the role played by government agencies inthe North Carolina programs). An additional likelyresult from this approach is that private entrepre-neurs would be likely to invest in identifying creditsfrom urban and agricultural sources and assemblingthose credits for sale to the credit resale agency. It isbeyond the scope of this article to explore possiblereasons why government might serve this function inthe point source-nonpoint source trading context andwhy this might encourage private investment inbecoming credit sellers. The arguments are similar tothose that support such an approach for securingwetlands and stream mitigation credits (Shabmanand Scodari, 2004). As with the Colorado program,the credit resale approach can be designed to empha-size documentation and assurance of outcomes (notpractices) and in so doing create the incentives andflexibility for providers of nonpoint source reductionsto be innovative not only in how they provide credits,but also in how they document that the credits cre-ated are valid reductions in pollutant loads.

CONCLUSION

The growing interest in nutrient trading programsis producing a rapidly growing number of local andregional experiments. Claims of cost effectiveness andnew ways to address nonpoint source discharge oftenaccompany the enthusiasm for these programs. Theinterest ‘‘making trades happen’’ tends to result inefforts to graft trading programs within existingprescriptive (regulator directed) programs. Despitethe implication associated with the label, manytrading programs exhibit few of the characteristicstypically associated with markets.

Advocates of more market-oriented trading pro-grams claim more market-like properties will improveachievement of water quality objectives and facilitatefavorable change in discharger behavior. Manyconventional regulatory and cost share programsimplemented under the Clean Water Act, however,undermine the conditions necessary for the establish-ment of more market-like programs. Consequently,market-like trading programs will require more upfront effort in the design of the program than othertrading programs to overcome these barriers. Despitethe design challenge, practical ways to effectively

implement market-based principles in trading pro-grams exist and can be used within the existing con-fines of the Clean Water Act.

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Documents

Achieving Nutrient Water Quality Goals: Bringing Market-Like Principles to Water Quality Management