Incentive-based solutions to agricultural environmental problems: recent developments in theory and practice

Journal of Agricultural and Applied Economics, 32,2(August 2000):221-234© 2000 Southern Agricultural Economics Association

Incentive-Based Solutions to AgriculturalEnvironmental Problems: RecentDevelopments in Theory and Practice

Alan Randall and Michael A. Taylor

ABSTRACT

Theory predicts that incentive-based regulatory instruments reduce compliance costs byencouraging efficient resource allocation and innovation in environmental technology. Costreductions from pollution permit trading often have exceeded expectations, but the devilis in the details: the rules matter. In recent years, IB instruments of many kinds, frompermit trading to various informal voluntary agreements, have been introduced in manycountries. Point-nonpoint trading programs have been established in the U.S., but recordedtrades have been rare. We speculate about prospects for performance-based monitoring ofagricultural nonpoint pollution which, we believe, would encourage trading to the benefitof farmers and society.

In recent years, incentive-based (IB) ap-proaches to environmental regulation havefound increasing application. The basic idea-that IB regulatory instruments provide a levelof flexibility that is absent in traditional com-mand-and-control (CAC) approaches andthereby reduce compliance costs by encour-aging efficient resource allocation and inno-vation in environmental technology-can befound in the economic literature since Pigou'sproposal to tax externalities and Crocker's pol-lution-permit trading proposal. Implementa-tion of IB policies proceeded slowly at first:pollution charges have been imposed in cer-tain particular instances in Europe since the1960s, and the US mounted some initial foraysinto pollution trading in the early 1980s. More

The authors are, respectively, professor and chair andgraduate research associate in the Department of Ag-ricultural, Environmental, and Developmental Eco-nomics at The Ohio State University.

The authors are grateful for research support fromthe National Research initiative, and for detailed com-ments from Richard T. Woodward.

recently, however, more countries have adopt-ed IB instruments and the array of environ-mental problems to which the instruments arebeing applied has been expanding rapidly.

We plan to conclude this article with somerather specific suggestions concerning point-nonpoint pollution permit trading. Along theway we will touch on the conceptual founda-tions of IB approaches and provide some ev-idence of their increasing application in thepolicy arena and their effectiveness. Most ofthe early applications have been to industrialand municipal point sources. Nevertheless, wewill be alert to developments in the agricul-tural sector, which has been relatively slow toembrace IB approaches.

Incentive-based approaches encompass awide variety of policy instruments that havein common the intent to reward, rather thanmandate, environment-enhancing behavior.Here, we abandon all hope of comprehensive-ness, ignoring entirely the rich tradition of Pi-govian taxes to concentrate on voluntaryagreements and trading mechanisms. Within

Journal of Agricultural and Applied Economics, August 2000

even this narrowed scope we will be less com-prehensive and more eclectic and anecdotalthan might be desirable.

Background

A Perspective on Market Failure

Economists have traditionally diagnosed en-vironmental problems as market failures: thefailure of markets to transmit appropriate in-centives and thereby achieve efficiency. Con-ventional solutions call unambiguously forgovernment action to tax or regulate external-ities and to raise revenue for public projectsto provide public goods.

The "market failure, government fix" di-agnosis and prescription have fallen underconcerted attack from individualists arguingthat allocative inefficiencies are caused mostlyby incomplete property rights-and thereforeprivatization is the appropriate policy re-sponse-and asking what policy implicationscould possibly arise from market failure whenthe failures of government are even more per-vasive.

Mercifully, we are no longer asked tochoose between these two paradigms, withtheir mutually antagonistic diagnoses and pre-scriptions. There is an important class of prob-lems, called isolation paradoxes, where insis-tence on individual action or none at all canleave everyone isolated and ineffective, andthe search for arrangements that make coor-dinated action beneficial to all concerned maybe rewarding. Abstract theory (from game the-ory, political science, and economics) andemerging experience have broken down theold simplistic dichotomy of government vs.market solutions. The isolation paradox con-cept suggests openness to solutions that in-voke a variety of institutional forms. Theseinclude private enterprises, voluntary associa-tions, and government ranging from the mostlocal level to the national scale and beyond(Randall 1999). Given the centrality of infor-mation and coordination, the array of feasibleinstitutions is continually shifting as informa-tion, communication, and exclusion technolo-gies develop. For particular problems, the ap-

propriate institutions will be consistent withthe dimensions and scale of the problem itselfand with the prevailing technologies and po-litical realities. Flexibility is the key in bothinstitutional forms and the incentives those in-stitutions transmit.

Isolation paradoxes abound in agriculture.Agricultural nonpoint sources are now theleading cause of water pollution in most areasof the United States (Davies and Mazurek) andcan therefore expect to come under increasingregulatory scrutiny. However, the difficulty ofmonitoring nonpoint sources has thus far pre-cluded the public from enjoying the benefitsof adequate controls and farmers from profit-ing from gainful permit trades. Another ex-ample is biodiversity and habitat protection,where fragmentation of land into private par-cels and failure to devise incentives for co-operation among landowners have denied thepublic adequate provision for biodiversity andfarmers the opportunity to profit from the po-tential value of their land as habitat. Eclecti-cism in institutional innovation will be essen-tial to progress in resolving many of the mostpersistent environmental problems of agricul-ture.

Pollution Permit Trading

Economists have long argued for policy in-struments that take maximum advantage ofvoluntary exchange with its efficiency and Pa-reto-safety properties. Political scientists fre-quently make similar arguments, albeit inmore accessible terminology, when they callfor win-win solutions. Trading mechanismsare being implemented in air and water pol-lution control, wetlands and shoreline mitiga-tion, land swaps to meet habitat protection andsimilar objectives, and resources-for-resourcescompensation provisions for natural resourcedamages (e.g., the Superfund law and the OilPollution Act).

Economic Theory. Economists since

Crocker and Dales have argued, on efficiencygrounds, for establishing markets in rights topollute. Most pollution market proposals callfor tradable pollution reduction credits (usu-ally called permits), which establish property

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Randall and Taylor: Incentive-Based Solutions to Agricultural Environmental Problems

rights (in terms of allowable discharges) with-in a public goods setting. Efficiency would beserved, as low-cost abaters reduced their dis-charges and permits were reallocated to theirhighest valued uses through market exchange,and innovation in cost-efficient abatementtechnology would be encouraged. Variousforms of property rights have been incorpo-rated within tradable permit systems suggestedin the literature (Montgomery; Krupnick, etal.; McGartland and Oates; Tietenberg;McGartland). Empirical simulations haveshown that regulatory costs under CAC poli-cies may be several times those of incentive-based policies (Atkinson and Lewis; Roach, etal.; Hahn and Noll; Seskin, et al.). The costsavings claimed for IB approaches, such astradable permit markets, derive from their ca-pacity to take advantage of differences in thecost of pollution abatement across firms andto provide incentives for innovation in pollu-tion abatement.

First Steps: Air and Water Control in theUS. Economists' proposals for pollution trad-ing were roundly criticized by environmental-ists and largely ignored by governmentthroughout the 1960s and '70s. The US EPAtook its first steps toward pollution trading in1980-introducing offsets, banks, and bub-bles, initially for point sources of air pollution.In the early 1990s, trading in sulfur oxides(SOx) permits was introduced on the ChicagoBoard of Trade. Economists were surprisedthat trading was less active and the price ofpermits was lower than they had predicted(Joskow, Schmalensee, and Bailey). A plau-sible explanation is that the switch from CACregulation to permit trading is actually a two-step process: first, the switch from regulationof control technology to performance stan-dards that allow the firm to choose its abate-ment technology and, then, the introduction oftrading (Burtraw). It is likely that the first stepgenerates major savings in abatement costs, al-lowing firms to delay purchasing permits.Subsequent experience has been consistentwith that conjecture, in that the volume oftrades has increased over time, but the priceof permits remains lower than was predictedex ante.

Expanding the Scope of IB Instruments

The United States. In the US, the current trendis to encourage adoption of trading and relatedIB instruments, instead of traditional CAC ap-proaches, to address a broad range of environ-mental problems (Keohane, et al.). Watershed-based trading involves the exchange of waterquality or other ecological improvements be-tween individuals responding to private mar-ket incentives (USEPA). Trading institutions,in forms ranging from tradable permit marketsto wetlands mitigation, have increasingly beenused for protection of water quality (USEPA;Netusil and Braden; Keohane, et al.; Stavinsand Whitehead). Public trustees pressingclaims for compensation for natural resourceinjury are now less inclined to assess the com-pensating monetary payment, seeking insteadto determine the compensating scale of re-source restoration (Randall 1997).

IB Instruments in Other Countries. Themove to more flexible regulations is not lim-ited to the United States. The role of IB reg-ulations has grown in prominence throughoutthe world, as has the diversity of the policyinstruments. Traditionally, tradable permitswere seen as a uniquely American preoccu-pation; in Europe and much of the world, se-rious consideration of IB instruments was lim-ited to environmental taxes. This is changing,as Australia, Canada, and Mexico all currentlyoperate tradable permit systems for some par-ticular environmental problems, and Denmark,Poland, the Netherlands, Norway and the U.K.are considering their introduction for the firsttime (OECD).

Perhaps the most important shift in envi-ronmental regulation in Western Europe hasbeen centered on the use of voluntary agree-ments. Voluntary agreements, negotiatedagreements in particular, have become a verypopular policy tool since the early 1980s. Ne-gotiated agreements are contracts that are cre-ated between regulatory authorities and theregulated firm or industry. Unlike traditionalunilateral regulation, both the regulated andregulator contribute to policy formulation.This type of solution is being applied to a wide

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Table 1. Diversity of Environmental IssuesCovered by Voluntary Agreements

Agri- Totalculture Energy Industry VA's

Austria / 20Belgium / 6Denmark / / / 16Finland / 2France V/ / 8Germany / /' 93Greece / ' 72Ireland / 1Italy ' 11Luxembourg / 5Netherlands / / J' 107Portugal / v 10Spain , 6Sweden / / / 11United Kingdom / 9

EU Total , 305

Source: EEA, 1997.

variety of environmental issues, including ag-riculture (Table 1).

The term voluntary agreement covers awide range of agreements ranging from vol-untary 'codes of conduct' to legally bindingagreements. In general, they include all com-mitments undertaken by firms and sector as-sociations, which are the result of negotiationswith public authorities and/or explicitly rec-ognized by the authorities (EEA). The termvoluntary agreement can be misleading as itcan also be applied to agreements reached un-der coercion in the form of future legislativethreats (Segerson and Miceli).

In Eastern Europe, introduction of pollu-tion trading is impeded by the larger challengeof (re)introducing markets in general and es-tablishing a structure of property rights to sup-port them. Nevertheless, the first Polish ex-periment with transferable permits for volatileorganic compounds in Chorz6w, while requir-ing complicated and painstaking legal maneu-vers, proved very successful in bringing visi-ble improvements more rapidly and at a lowercost than those attainable through traditionalinstruments (OECD). However, wider repli-cation cannot be contemplated without majorchanges in laws.

In Australia, there has been a shift towardmarket institutions for handling things previ-ously mediated by rigid bureaucracy; one ex-ample is the emergence of water markets. Thischange in thinking has influenced environ-mental policy. Trading in salinity reductioncredits in the Hunter River (where the coalindustry discharges saline water) was intro-duced on a pilot basis in 1995 and continues(SSC). In the Hawkesbury-Nepean river sys-tem (a highly productive agricultural regionexperiencing urbanization pressures from thegrowth of the Sydney metropolitan area), highnutrient loads have been attacked by issuing abubble license involving the major sewagedischargers (EA).

Some Stylized Facts about the Performanceof IB Instruments

Compliance Cost Savings: a Clear Benefit.Pollution trading programs have typically ex-ceeded expectations, in that total dischargelimits are attained with cost-savings greaterthan predicted at the outset. A plausible ex-planation is that moving to a tradable permitmarket involves two steps: a switch to perfor-mance standards and the introduction of trad-ing. The switch to performance standards pro-vides private incentives-absent under CACregulations-to find cost-efficient abatementmethods, generating cost savings in additionto those afforded by trading of permits.

"Innovation Offsets"? Porter and van derLinde suggest that in a dynamic setting prop-erly designed environmental policies can trig-ger innovations that offset the increase in com-pliance costs, partially, completely, or evenmore than completely. Their claim is that ex-plicit environmental improvement policies canreduce the uncertainty that investments ad-dressing pollution abatement will be valuableand motivate innovation and progress (similarto the creative force of the market). Innova-tions can be developed and implemented todecrease environmental impacts while simul-taneously improving the product and/or the re-lated production process leading to these "in-novation offsets" (Porter and van der Linde).The proper policy instruments for achieving

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such offsets emphasize the use of private in-centives, by leaving the approach to innova-tion in the hands of the producer (Porter andvan der Linde). The "Porter hypothesis" hasattracted critics who deny its plausibility,claiming that while offsets are theoreticallypossible, they are likely to be rare or small inpractice.

For "end-of-the-pipe" pollution controls,offsetting productivity gains or cost savingsseem unlikely. However, a plausible theoreti-cal case can be made for offsets in the casewhere pollution controls can be integrated intoproduction processes. Dixit and Pindyck arguethat due to uncertainties of various kinds firmstend to replace productive assets less frequent-ly than seems economically optimal. Produc-tive assets typically are replaced with techno-logically enhanced assets, and uncertaintyabout the nature of technological enhance-ments to be introduced in "next year's model"may induce delays in asset replacement. Theneed to meet an environmental performancestandard may induce investment in a new andtechnologically enhanced integrated produc-tion and pollution control system so that effi-ciency gains in production offset all or part ofthe pollution control costs. Purvis, et al.showed that certain livestock waste controlpractices offer advantages for both productiv-ity-augmentation and pollution abatement.

The Problem of Uncertainty. A commonimpediment to all trading programs is uncer-tainty of various kinds (Carlson and Sholtz;USGAO; Purvis, et al.). Trading will be in-hibited by market participants' uncertaintyabout future total discharge limits, enforce-ment of existing policies, and the cost and ef-fectiveness of control technologies. As we willsee below, uncertainty may afflict the regula-tory community, too. For example, regulatorsmotivated to meet environmental performancegoals may hedge against uncertain perfor-mance of control technologies by specifyinghigh trading-ratios (t-ratios), which provide anenvironmental safety margin but impedetrades and limit the effectiveness of tradingprograms.

Wetlands Mitigation

The preservation of wetlands has gained at-tention in recent years as the acreage of naturalwetlands has declined. There are essentiallytwo types of wetland policies in the US. TheWetland Reserve Program represents the tra-ditional approach: a federal incentive systemthat pays farmers to preserve and enhancewetlands. Section 404 of the Clean Water Actintroduces a regulatory approach, mandating"no net loss" of remaining natural wetlands.However, Section 404 contains an interestingprovision that allows individuals who wish todrain wetlands in one location to mitigate theloss by enhancing wetlands elsewhere.

Land developers must apply for a permit toalter any existing wetland. The regulator eval-uates the physical qualities of the wetland anddetermines whether the applicant must mini-mize the impact of development or offset orminimize negative impacts on wetlands. On-site offsets include setbacks and filter stripsdesigned to minimize degradation of the di-rectly impacted wetlands. However, it can of-ten be more effective to permit offsets to beimplemented offsite. The developer pays tocreate new wetlands or improve an existingoffsite wetland. The regulatory goal is to re-quire that loss of impacted wetlands be offsetby addition or enhancement of wetlands ofhigher ecological quality within the same hy-drological and ecological region.

The effectiveness of constructed wetlandsis uncertain, and some observers claim thatconstructed wetlands typically are inferior tonatural wetlands. To compensate, a mitigationratio is imposed by the regulator (i.e., EPA andthe Army Corps of Engineers), requiring morethan one acre of constructed wetlands to offsetthe loss of a single acre of existing wetlands.The most common mitigation ratio is 1.5:1 inOhio, but ratios of 3:1 or more have been im-posed for high quality and/or particularly sen-sitive wetlands. However, this ratio can beeven greater if the impacted wetlands are of ahigher quality. The mitigation ratio is deter-mined on a case-by-case basis during the per-mit process.

Wetlands exhibit economies of scale and

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scope, in that larger wetlands tend to supportmore diverse and productive ecosystems thansmall ones. Provision of larger and better wet-lands is a classic isolation paradox such asthose affecting many ecosystem issues: formany kinds of ecosystems, protection of bio-diversity requires large areas of contiguoushabitat. This is feasible only if considerablenumbers of independent landowners can beencouraged to cooperate with each other and,often, to cooperate with public land agencies.Private mitigation banking creates incentivesfor such cooperation.

Wetlands Mitigation Banks. Mitigationbanks are large constructed wetlands createdfor the sole purpose of providing future offsetsfor wetland loss due to conversion. The bankersells acreage in the constructed wetland to de-velopers and others who are required to offsetwetlands conversion in the same ecologicaland hydrological region. Twenty states haveestablished mitigation banking policies. Somelocal communities, such as Eugene, Oregon,have established local mitigation banking pol-icies as well. Nationwide, mitigation costsvary from $7500 to $60,000 per acre, and asof January 1997, over 200 wetland mitigationbanks, mostly nonprofit, were in operation orunder development in the United States, withat least one in each state (Environmental LawInstitute, 1998). Forty for-profit mitigationbanks have been approved and another 75have been submitted for approval (Environ-mental Law Institute). Florida has 18 mitiga-tion banks with more than 20,000 acres ofwetlands, and mitigation banking constitutes a$750-million industry in the state (Environ-mental Law Institute).

The Ohio Wetlands Foundation is a non-profit organization that creates constructedwetlands banks and sells acreage to land de-velopers for offsetting purposes. Since 1993,the Foundation has sold out three separatebanks ranging in size from 33 acres to 330acres (Sutliff). Mitigation banking allows mar-ginal wetlands to be put to more valuable uses,while maintaining, and in some cases increas-ing, the total amount of high-quality wetlands.

Toward Performance Standards. The eco-logical functions of a wetland involve com-

plex ecological interactions that are difficult tomeasure and monitor and, especially for con-structed wetlands, are subject to uncertain timepaths. Standards for environmental perfor-mance are difficult to implement, so design(i.e., technology) standards have been thenorm. The agency approves the plans for con-structed wetlands and will set measurable im-plementation goals that are fairly good predic-tors of ecological function. Nevertheless,mitigation banking is arguably impeded by thewidespread use of relatively high mitigationratios, while environmental performance ofconstructed wetlands has been spotty enoughto generate skepticism among environmental-ists (Marsh et al.).

The Army Corps of Engineers has pro-posed and is the process of requiring all na-tionwide permits to be based on the use of thehydrogeomorphic (HGM) approach to assess-ment of wetland functions (Federal Register).HGM works in three stages: first, wetlands areclassified on the basis of their differences infunctioning (landscape setting, water source,hydrodynamics); then the functions that eachclass of wetlands performs are defined; and,finally, references are used to establish therange of functioning of the wetland. This pro-posal is intended to move wetlands mitigationcloser to accomplishing in-kind replacementof lost wetlands. Thus, the HGM approachrepresents a shift toward performance stan-dards for wetlands mitigation, as regulatoryagencies respond to public anxiety about theperformance of constructed wetlands.

Point-Nonpoint Pollution Trading

Agricultural nonpoint sources are currently theleading cause of water pollution in most areasof the United States (Davies and Mazurek).Yet they have avoided intense regulatory scru-tiny until fairly recently, due perhaps to thelong-standing tradition of using subsidies rath-er than regulatory pressure to influence theperformance of agriculture and the claim thatregulation is impractical in that it is inherentlydifficult to identify individual contributions tononpoint pollution loads. The result is that ag-ricultural nonpoint sources have been ad-

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dressed mostly by specifying best manage-ment practices (BMPs)-if used as standards,BMPs are technology standards-which areencouraged mostly by subsidies of variouskinds.

In recent years, however, the US EPA hasencouraged point-nonpoint pollution tradingprograms in which farmers implementingBMPs would earn pollution reduction creditsto be sold to point-source polluters. EPA lists13 existing point/nonpoint trading programs,and a similar number are under developmentor consideration. Agricultural sources of pol-lution are included in the majority of thesetrading markets. Programs are set up at thecatchment or sub-catchment level. Several lev-els of government are involved, as are point-source polluters, who may be private or publicorganizations, and nonpoint-source polluters.These trading programs simultaneously intro-duced a number of innovations in pollutioncontrol policy: (1) point sources of pollutionwere switched from command-and-controltechnology standards to performance stan-dards, (2) economic incentives were intro-duced via permit trading opportunities, and (3)point sources in need of credits contract withnonpoint polluters collectively. Of these in-novations, the first two are classic IB instru-ments, while the third solves the isolation par-adox by providing benefits (i.e., income fromthe sale of abatement credits) to all membersof the group whenever a group target isachieved.

Here we describe briefly the situation andperformance to date for three trading programsthat represent the existing range from formalmarkets to informal voluntary agreements.

Tar-Pamlico River Basin, North Carolina

High nitrogen and phosphorous levels withinthe Tar-Pamlico river basin led to eutrophica-tion and fish kills. To deal with the problems,a permit trading system was created to reducenitrogen and phosphorous loadings at lowcost. The participants in the trading marketsconsisted of 13 point sources (12 water treat-ment works and one private firm) and numer-ous nonpoint sources within the watershed

(primarily cropland and livestock). The pointsources organized themselves into a singlegroup, referred to as the Association. The As-sociation placed all individual point sourcesunder a single "bubble." If the total loadingsattributable to the Association exceed the al-lowable nutrient load, then members are re-quired to purchase offsetting nonpoint sourceabatement.

Permit prices are not established by text-book market equilibrium. Based on a comput-er simulation of potential trades, the price ofa tradable permit was set for the market at aweighted average of $29 per kg of nitrogen/per year (Gannon). Credits are good for 10years. The regulator sets the trading ratio at 3:1 for crop agriculture and 2:1 for livestock,based on estimations of best managementpractice performance and expected costs (USEPA). The North Carolina Department of Soiland Water Conservation arranges "trades"through the North Carolina agricultural cost-share program. Should the Association violateits aggregate standard, it is required to depositfunds into the existing cost-share program.These funds are earmarked for programs in theTar-Pamlico Basin and are used to enroll moreland in the cost-share program.

The Association is required to maintain aminimum $500,000 annual reserve in the Ag-ricultural Cost Share Program; to date this hasgrown to $1,031,000. This ensures the avail-ability of funds for the implementation of anypotentially required trades. Since the Associ-ation is not involved in the implementation oftrades it does not carry the responsibility ofensuring compliance by the nonpoint sourcetrading partner (Gannon). Instead, the State,through Soil and Water Conservation Districtofficials, bears the cost of inspection and en-forcement of compliance. This arrangement isthought to relieve the point sources of bearingexcessive risk through trading.

In summary, while the US EPA is pleasedto promote these arrangements as point-non-point pollution trading, they are in fact a ratherrigid kind of trading and the regulator's roleis more prominent than the term trading or-dinarily suggests.

To date, no mandatory trades have oc-

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curred between point and nonpoint sourceswithin the Tar-Pamlico market. However, theAssociation has purchased some nonpoint-source credits to offset potential future needs.In addition, point-source trading within theAssociation bubble is reported to be very ac-tive. During Phase I of the market's formation,each point source was required to perform anengineering analysis of its management andoperation practices for pollution abatement(Hall and Howett). As a result of these anal-yses, many new low-cost methods of pollutionabatement were implemented. In response tothe flexibility derived from the switch to a per-formance standard the point sources were ableto abate nitrogen and phosphorous dischargedirectly, and trading was not required. Asso-ciation members still remain well below theirallowances. Therefore, trades are not antici-pated for a few years (Gannon).

Laguna Del Santa Rosa

Laguna de Santa Rosa, California, is the siteof an informal trading arrangement. The Cityof Santa Rosa faced difficulties in meeting wa-ter quality standards during the summermonths. Instead of increased abatement ef-forts, the city shipped treated wastewater toarea golf courses as well as dairies and farmsfor application to pasture and some food crops(Smith). No overall trading mechanism existsand trades are not reflected within the City ofSanta Rosa's NPDES, but they are accountedfor within the Total Maximum Daily Load(Smith). The city initially paid dairies to takethe water, but payments are no longer made dueto the desirability of the nutrient content (USEPA). Local governments enforce noncompli-ance problems against the farmer or rancherwho applies the wastewater to fields (Smith).

Boulder Creek, Colorado

Within a 15.5-mile segment of Boulder Creek,a trading program was established to reduceammonia levels contributed by point-sourcewastewater treatment plants and nonpoint ag-ricultural sources. High water temperature andpH were identified as the primary causes of

increased ammonia levels, which were linkedto the physical degradation of the creek's ri-parian zone. Reducing the ammonia levels re-quired cooperation of both point sources andnonpoint sources. Various forms of direct non-point-source abatement offsets were madeavailable to the point source (the City of Boul-der's Public Works Department) to meet am-monia reduction levels. Point sources have theoption of reducing ammonia discharge directlyor of increasing stream capacity for ammoniaby funding projects which will return the creekto its original flow (i.e., removal of structuraldiversions), and/or projects which reduce non-point-source impacts (i.e., paying farmers tofence livestock out of the riparian zone) (USEPA). The point source has upgraded its plantto meet current regulatory standards, and hasopted to adopt these unconventional pollutionoffsets in anticipation of future abatementneeds.

Improving the Prospects for Point-NonpointPermit Trading: Theory and Hypotheses

The experience of the Tar-Pamlico River Basintrading program, in that no trades have yetbeen recorded, suggests that the potential ben-efits of point-nonpoint permit trading have yetto be achieved in full. One possible explana-tion is the stylized fact, discussed above, thatefficiency gains from the switch to perfor-mance standards for point sources have re-duced the demand for permits. Before we ac-cept this explanation too complacently, weshould entertain a second possibility: tradingmarkets that have been introduced are too re-strictive and too many bureaucratic controlsremain so that permit exchange is impeded bymarket design.

While there is a considerable literature ad-dressing permit market design, relatively littleof it deals with extending permit markets toinclude nonpoint sources. It is often arguedthat including nonpoint source pollution with-in a permit trading market is difficult becausemonitoring individual contributions can beprohibitively costly, loadings are in large partdriven by random weather events, and uncer-tainty exists regarding the effectiveness of pol-

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lution abatement controls (Tomasi, et al.).Since nonpoint source discharges are difficultto observe at the individual level, existingtrading programs have resorted to monitoringabatement technology (e.g., best managementpractices) rather than performance. As a result,trade within the point-nonpoint source permitmarket involves heterogeneous goods (point-source discharges and nonpoint-source bestmanagement practices).

Trading ratios have been introduced to al-low for the exchange of heterogeneous goodswithin a tradable permit market (Mendelsohn;Hahn). The trading ratio specifies the numberof units of nonpoint pollution reduction, esti-mated by modeling the effectiveness of thechosen best management practice (BMP) thatmust be exchanged for a single unit of point-source pollution. The optimal trading ratio de-pends on the relative costs of enforcing pointand nonpoint source abatement as well as theuncertainty associated with nonpoint loadings(Malik et al.). This uncertainty has two sourc-es. The first derives from the weather drivennature of nonpoint source pollution. The sec-ond is that there is considerable uncertaintyregarding the effectiveness of nonpoint sourcepollution abatement controls. A t-ratio greaterthan one provides a safety margin for the en-vironment. With more than one unit of (esti-mated) nonpoint source reduction credit re-quired, deviations from the expectedabatement performance of the BMPs are lesslikely to result in violations of the regulatorystandards. To ensure that regulatory goals aremet, the t-ratio tends be set cautiously high,but high t-ratios impede trading, thus under-mining the raison d'etre for permit trading.

An alternative to monitoring technology(e.g., BMPs) is to monitor the nonpoint sourc-es on the basis of performance. Removing theregulator's uncertainty about the effectivenessof the nonpoint source abatement technologieswould, in concept, allow reduction of the t-ratio and generate an increase in the frequencyof trades. If it is conceded that monitoring in-dividual nonpoint sources on the basis of per-formance is technically difficult, and thus like-ly to be prohibitively expensive, arrangementsbased on collective monitoring at the catch-

ment level might be considered. Monitoringpollution loads leaving the catchment is a sim-ple process; the difficulty is to provide theright incentives to individual farmers withinthe catchment. Griffin and Bromley have sug-gested the use of estimated individual non-point discharges, derived from the monitoringof total loadings in the catchment determinedthrough a biophysical model relating inputs toloadings and ambient water quality standards.Segerson (1990) has suggested liability bond-ing. The game theory literature offers "scape-goat" and "massacre" solutions (Rasmussen),variations on the theme that all firms willmake appropriate abatement effort if collectiveperformance is monitored and randomly cho-sen individuals punished in the event the col-lective target is not met; schemes for punish-ing all members of a group for shortfalls incollective performance thus avoiding the ar-bitrariness of "scapegoat" and "massacre"while providing second-best incentives (Se-gerson, 1988) and tournaments (Govindasa-may, Herriges, and Shogren) that reward firmsfor contributions to attainment of abatementtargets.

Further research is required to refine meth-ods for enforcing performance standards viacollective monitoring of nonpoint sources.There are two key requirements for an ac-ceptable collective monitoring and enforce-ment mechanism. The first is that it transmitsto group members clear and readily compre-hensible incentives that are consistent withgroup goals; in effect, incentive-compatibilityand simplicity (which may come into conflict)are valued. The second requirement is thatpenalties and rewards imposed on individualsdo not violate ordinary notions of fairness. Pe-nalizing all members for a group shortfall maybe considered unfair to those group memberswho did not shirk. The point-nonpoint tradingprograms introduced thus far have relativelylittle exposure to this problem because theyinvolve rewarding farmers for pollution reduc-tions rather than punishing them for exceedingregulated levels. Society seems to treat denialof a deserved reward as much less serious, inthe moral sense, than imposition of an unde-served penalty: bonuses for team success are

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a staple of contemporary management. Thosewho believe that the "polluter pays" principleshould be extended to agriculture must, how-ever, deal with the more difficult issue of spec-ifying justifiable penalty structures for mem-bers of groups that collectively violateperformance standards.

Performance monitoring, if successful,would reduce the role of technological uncer-tainty, thus allowing reduction of the optimalt-ratio. Malik, et al. have examined the opti-mal t-ratio in a static setting, and Letson em-phasized that if technological uncertainty istoo large it can eliminate the incentive forpoint sources to enter into trading agreements.However, regulatory schemes that managetechnology are inherently static, whereas mostwater-pollution problems exist in a dynamicworld, with technology that is constantlychanging. It is important to assess how the lev-el of trading will adjust and adapt to changesin the ability of regulators to monitor BMPeffectiveness in reducing effluents and the re-lationship between nonpoint effluent reductionand ambient water quality.

Our central hypotheses are that adoptingperformance standards rather than technologystandards in point-nonpoint trading programswill reduce the costs of pollution abatementwithin a watershed, and that with performancestandards the t-ratio may be adjusted over timeas innovation improves the technology avail-able for reducing nonpoint source pollution.The efficiency of permit markets requires min-imum t-ratios consistent with prudent environ-mental regulation. These hypothesized gainswould result from allowing nonpoint sourcepolluters in trading markets to determine theoptimal technology, rather than having a cau-tious regulator choose the technology andhedge against uncertain performance by im-posing a high t-ratio.

A performance-based system would focuson monitoring overall pollution levels and itwould establish individual incentives amongnonpoint sources through the use of some col-lective enforcement mechanism. Point sourceswould be able to purchase a given level ofnonpoint source pollution reduction and thenonpoint sources would have their choice of

mechanisms to reduce their pollution discharg-es. Uncertainty as to the effectiveness of on-farm abatement technology is borne by thefarmers (who are best able to handle it), al-lowing greater efficiency in the permit marketas regulators and point source polluters enjoya higher level of certainty. All parties wouldgain from the increased efficiency of permitmarkets. Nevertheless, some uncertainty re-mains because neither polluters nor the regu-lators know the exact relationship betweennonpoint source reductions and ambient waterquality.

A natural question that arises in a perfor-mance-based system is the choice of enforce-ment mechanisms. An objective of our on-go-ing research is to survey the literature, assessthe different mechanisms suggested, and de-velop and assess new or modified mecha-nisms. The choice of enforcement mechanismhas important implications for the feasibilityof a performance-based system due to uncer-tainty about the effectiveness of nonpointsource pollution reductions and risk aversionof permit market participants and the regula-tor. High levels of risk aversion and high un-certainty reduce the scope for trade and hencethe efficiency and welfare gains from permittrading.

Conclusions

Our comments have addressed three majorthemes: (1) recognition that solutions to agri-cultural environmental problems will take avariety of institutional forms, (2) the expand-ing role of incentive-based policies includingvoluntary agreements and pollution tradingprograms of various kinds in many countriesand applied to many kinds of environmentalproblems, and (3) the prospective gains thatattend implementation of trading programsbased on performance standards rather thantechnology standards.

Creativity and Eclecticism in BuildingTrading Institutions

Trading programs allow, in principle, for theinclusion of a wide range of trading partners

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including point sources, nonpoint sources, lo-cal governments, and federal agencies. Asseen in the examples above, trading regimesdo not necessarily have to be developed in thetraditional sense discussed by economists or aspioneered under Title IV of the Clean Air ActAmendments of 1990. Opportunities for trad-ing can be created at many different levels andscales. For example, point sources may tradewith other point sources or with nonpointsources, nonpoint sources may trade with non-point sources, or government agencies maytrade with other government agencies. Tradingmay be formal or informal, and enforcementof agreements made may be rigid or to someextent negotiable.

Despite this diversity of institutional formsfor trading, some principles for success can beidentified. Two in particular deserve specialattention: a long-term and broadly inclusiveprocess and markets scaled appropriately forthe problem at hand.

A Long-term Process Involving All of theLegitimate Interests. Trading mechanismsbring together all of the stakeholders with theregulatory agency. The process of establishinga trading system identifies all relevant sourcesof environmental degradation, identifies thepotential trading parties, and creates avenuesof communication. The commitment of gov-ernment minimizes institutional uncertainty,and the promise of gains from trade providesthe glue that keeps participants in the game.

Problem-scale Trading Markets. Environ-mental performance typically has a strong re-gional dimension: there are good reasons whyambient pollution targets are defined at thecatchment level and compensating wetlandsmust be located with due respect to aquifersand ecological boundaries. The geographicalboundaries of wetlands mitigation bankingdistricts and pollution permit trading marketsshould respect these considerations, as well asthe need to be large enough to avoid "thinmarkets" yet small enough for administrativeefficiency.

Wetlands can be mitigated on-site or inlarger mitigation banks many miles from theconversion area. Wetlands mitigation dependsupon evaluations of wetland quality and the

probable success of habitat creation. Loss of awetland that is non-unique may be offset withcontributions to an offsite mitigation bank pro-viding greater habitat than the original acre-age, while unique or highly critical wetlandsmay require on-site mitigation to prevent se-rious local habitat loss.

Many factors play into the determination ofappropriate scale and distance in water pollu-tion trading schemes. But the immutable factthat water tends to flow downhill provides anenduring organizing principle: trading marketsshould be delimited by hydrological bound-aries such as catchments and watersheds.

Performance-based Trading Prospects forAgriculture

Regulatory institutions that provide private in-centives hold the potential for improving theenvironmental performance of agriculture."No net loss" provisions and mitigation bank-ing hold the promise of maintaining and en-hancing wetlands with minimal disruption tothe land economy. Rather than the traditionalpublic provision of cost-share assistance, in-novative point-nonpoint pollution trading pro-grams provide private incentives for pollutionabatement on farms. The institutions for pol-lution trading can vary greatly: from informalto formal, from technology to performancebased, and from market-clearing to adminis-tered-price trading. This variety in trading pro-grams demonstrates creative institutional ad-aptation to the circumstances at hand.Nevertheless, we are convinced there are con-siderable gains to be had from further refine-ment of some of these trading programs.

Wetlands mitigation works in the north-western two-thirds of Ohio, which is naturallya vast wooded wetland, and supports agricul-tural and urban development only with the aidof extensive artificial drainage. For most of theUS, however, wetlands mitigation has hadmixed success, and failed mitigation projectsoccur often enough to cast a shadow on thewhole process. Regulators are currently movingtoward performance-based mitigation bankingby introducing a hydrogeomorphic approach.

Although existing cost-share programs can

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change farmer practices, reducing agriculturalpollution, they rely heavily on subsidizing ap-proved technologies. The point-nonpoint pol-lution trading programs that have been intro-duced thus far have also applied a technologystandards approach on the nonpoint side of themarket. One distinguishing feature of manytradable pollution permit programs applied topoint sources is that they require regulatoryagencies to monitor performance rather thanthe installation of abatement technology.

Performance standards shift the burden ofuncertainty from regulators to polluters whohave access to information of various kindsthat is unavailable to the regulator. Under thecurrent regime, where cost-share incentivesare based on technological inputs, the regula-tors face all of the uncertainty about perfor-mance of BMPs. Under a performance-basedtrading system, however, the parties involvedin the trade would be held liable for non-com-pliance with water quality standards, placingthe burden of uncertainty on the parties bestable to adapt to it.

Under current technology-based point-non-point trading arrangements, regulators imposetrading ratios to provide a measure of assur-ance that environmental targets are met viapollution trading. Yet high t-ratios, which re-duce potential gains from trade, can provideserious impediments to the success of tradingprograms. A switch to performance-basedtrading seems warranted, but runs counter totraditional insistence that that nonpoint pollu-tion cannot be monitored at the source. Theday is not far away, technological optimiststell us, when effective and inexpensive spy-in-the-sky monitoring technology will render thisobjection moot. Alternatively, collective en-forcement at the (sub)-catchment level wouldpermit introduction of performance-basedpoint-nonpoint pollution trading today. Theopportunity for considerably enhanced gainsfrom trade may be sufficient to induce farmersto accept collective enforcement of tradingcommitments.

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