Accounting for Transaction Costs in Point/Nonpoint Water Quality Trading Programs in the Chesapeake Bay Watershed.

Relevance

Water quality in the Chesapeake Bay is below levels required to sustain desired levels of fisheries, recreation, and other ecosystem services.  Since the creation of the Chesapeake Bay Program in the early 1980’s, voluntary-based approaches by watershed states have failed to measurably improve the Bay’s water quality.  In response, the U.S. Environmental Protection agency has established a Total Maximum Daily Load (TMDL) for the Bay.  The TMDL sets pollution reduction targets for the watershed states.  State Watershed Implementation Plans, which detail how the Bay states will meet their pollution allocations, all include the development of point/nonpoint water quality trading programs which will allow regulated point sources to offset discharges from future growth with reductions in unregulated nonpoint sources, primarily agriculture. 

Point/nonpoint trading has not been very successful to date, at least in terms of the participation of potential traders and the number of trades between regulated sources and farms (Breetz et al., 2004).  Much has been written about various issues related to point/nonpoint trading, including uncertainty, trading ratios, and validation issues (King, 2005; King and Kuch, 2003; Woodward and Kaiser, 2002; Ribaudo and Nickerson, 2009).  One issue that is frequently mentioned is high transaction costs.  Successful emissions trading programs, such as the SOx and NOx air quality programs, have been characterized by low transactions costs, largely because they involved only easily-measurable point sources.  While “high” transaction costs have been a common characterization of a water quality trading program, estimates of the true nature of these costs are lacking.  A more exact knowledge of these costs is important because high transaction costs can affect the optimal choice and design of policy instruments such as trading, affecting economic efficiency and reducing the overall benefits (Stavins, 1995; McCann et al., 2005). 

A full accounting of transaction costs would include ex ante and ex post program activities such as research, enactment or litigation, design, support and administration, contracting, monitoring and detection, and prosecution and enforcement (McCann et al., 2005).  Knowledge of these costs would provide an assessment of whether transaction costs are truly a threat to a successful trading program, and to identify actions that might be taken to reduce these costs. 

Methodology

We will lay out the steps necessary to create, design, implement, and enforce a water quality trading program after the enabling legislation has been enacted.  The water quality trading policies for each of the Bay states will be reviewed to identify how each step is to be conducted, and who is responsible for conducting it.  These steps will be compared with those of existing programs, as reported in the literature and in various program reports and websites.  Activities that have already been completed in the development of the TMDL will be noted, as well as steps that appear to be missing from state programs. 

Costs will be estimated with data from the literature, and from personal conversations with state agencies responsible for carrying out the program.  The final result will be an estimate of annual transaction costs for a program in the Bay watershed as well as the incidence of those costs. 

Preliminary Findings and Discussion

The development and implementation of a trading program can be broken up into 5 major steps:  (1) establish regulations; (2) distribute tradable allowances; (3) establish trading rules; (4) implement trades; (5) post-trade activities.  Each of these steps contains a number of activities that entail administrative and resource costs, borne by the administering agency or market participants.   The development of the Chesapeake Bay TMDL by EPA provides a discharge cap, source contributions, and modeling capability the states can use to build their own trading programs.  These are costs already borne by the Federal government.  Some of the costs that will be borne by the states include:  developing appropriate trading ratios; developing and operating a  “marketplace” for bringing buyers and sellers together; tracking credits sold (registry); verifying the baseline of each farm; developing tools for calculating nonpoint source offsets; verifying implementation of BMPs; monitoring water quality; and enforcing program compliance. Transaction costs that will be borne by market participants include: the cost of calculating credits for different management measures (nonpoint sources); cost of finding trading partners; cost of negotiating trades; and recordkeeping.