Market-Based Alternatives: Key Considerations for Water Quality Trading

By Hannah Mellman

In the U.S., water quality trading continues to gain interest as a viable market-based alternative to control water pollution. To many, the approach is appealing: it creates a cost-effective market for water pollution reductions that can generate greater and ancillary environmental benefits than would be achieved under traditional regulation. Equally significant, water quality trading embraces a holistic approach to watershed management that can collectively engage and address all sources and activities contributing to watershed degradation.

Though water quality trading is not a new concept, the country has yet to see broad adoption and development of robust markets. One key reason for this is that publicly owned treatment works (POTWs), a regulated community and a potentially significant buyer of water quality credits, are hesitant to invest in a market that cannot, for various reasons, guarantee results. So what would POTWs need to see in a water quality trading market to become willing participants and purchase a sizable number of pollution reduction credits?

This is the question the National Association of Clean Water Agencies (NACWA) was asked to answer at a November U.S. Environmental Protection Agency (EPA) Water Quality Trading Forum in Washington, D.C. NACWA represents the interests of more than 300 POTWs and organizations that collectively treat and reclaim the majority of the wastewater generated in the U.S. In the last year, the association has become more engaged in the trading arena, working to provide a utility perspective on the viability of these markets and their ability to achieve more efficient water quality improvements. NACWA's effort signifies the growing recognition that this approach can provide a credible alternative to traditional regulatory approaches.

Need for Market Certainty

Like in any market, buyers need to know they are making a sound investment. They need to know what they are buying and what to expect in return. In the case of POTWs, making a sound investment in a water quality trading program hinges on how certain they are that outside pollution reductions can and will be achieved. This is critical for two reasons. In the short-term, POTWs use purchased reductions to meet their EPA permit requirements, which regulate the amount of pollutants a plant can legally discharge.

However, if a utility invests in water quality credits that turn out to be faulty and misrepresent the actual level of reduction achieved, the utility may find itself out of compliance and subject to hefty fines for each day it goes over its discharge limits. In the long-term, POTWs must budget for the purchase of credits in accordance with a typical planning horizon of 20 to 50 years into the future. To even consider budgeting for 20 years' worth of credits, a utility needs to know it can rely on a long and steady stream of quality reductions to help meet compliance year after year.

The following examines a few key elements of a water quality trading program - both from an design and policy perspective - that POTWs look for when considering the purchase of water pollution reduction credits. While these elements may not alone be enough to increase market certainty, they are critical to building strong, robust water quality trading programs.

Trading Architecture

Unlike point sources where pollution reductions can be monitored with accuracy, the effectiveness of best management practices (BMPs) from a diffuse source, like a farmer's field, is not as easily measured and can result in inexact levels of pollutant loading. Understanding this, POTWs need trade ratios that are technically based and factor in uncertainty to ensure credits are not over- or under-valued. A good trade ratio will also take into account the ancillary environmental benefits realized from implementation of a BMP. Furthermore, the life of a credit should not be artificially constrained by the EPA's five-year permit cycle. Some credits may have a shelf life of 20+ years and should be recognized as such.

Additionally, POTWs depend on robust monitoring and flexible enforcement programs to ensure BMPs remain in place, the value of each credit remains high, and the trade remains viable. Enforcement of these programs needs to be firm but flexible, allowing for some level of adjustment to account for unforeseen events, like extreme weather, which lie outside of participants' control. Where third parties are involved, their services need to be recognized and closely coordinated with the regulatory agencies involved.

Policy Support

In addition to a well-designed market, buyers need to have continued assurance from EPA and state agencies that water quality trading is an approved and supported means to address water quality impairments. It is good to see the EPA continue to stand by its Water Quality Trading Policy, which was released nearly 10 years ago. Yet, as this approach gains more attention, more newcomers are coming to the table who need to hear frequent, vocalized support from the top.

There are two policy issues that are particularly sensitive to POTWs who may be considering buying water pollution reduction credits: Total Maximum Daily Loads (TMDLs) and baseline requirements. A TMDL is the calculation of the maximum amount of a pollutant - for example nitrogen, phosphorus, and sediment - that a waterbody can receive and still safely meet water quality standards. NACWA is adamant that while TMDLs can help facilitate trading, they should not be required for trading to occur.

Around the country, many segments of streams and rivers, lakes, and coastal waterbodies are facing enormous water quality problems but have yet to be fitted with a TMDL. If water quality trading can also make economic and environmental sense in these regions, why limit market formation? The EPA recently expressed its support for the trading of water pollution credits outside of waters subjected to a TMDL, explaining there is no 'one size fits all' approach to water quality trading. This is a positive step and helps to define water quality trading not as a facilitation device but as a bona fide means to improve water quality.

Finally, baseline requirements - the set of mandatory BMPs that must be met before credits can be generated and sold - should be minimal. Setting a rigorous baseline disqualifies the least costly reductions from being offered as offsets. This can make entering the market more expensive, which could limit participation, hamper credit supply, and adversely affect market efficiency. For a utility that needs to depend on a healthy supply of credits for 20+ years, a larger and more affordable pool of credits is more appealing.

Bottom Line

POTWs may be initially motivated to participate in a water quality trading program for financial reasons, but the bottom line is that utilities will only invest in markets that are environmentally sound. It is simply not worth the risk of noncompliance and the sacrifices in water quality gains that could have otherwise been made.

In a functioning water quality trading market, there should be no incentive or advantage for anyone to 'game the system' or manipulate the market for a desired outcome. Buyers and sellers have a symbiotic relationship based on scientific certainty and predictability - factors that market participants must recognize and program administrators and the EPA should take comfort in.

About the Author: Hannah Mellman is Manager of Legislative Affairs at the National Association of Clean Water Agencies. For more information on NACWA's water quality trading efforts, please contact Mellman at [email protected].