Water Quality Trading Market Structures

Transcription

1 Fox P Trade Program January 2015 Prepared by: Bryan Comer, Fellow, Great Lakes Commission Water Quality Trading Market Structures Introduction This document describes four water quality trading (WQT) market structures: bilateral negotiations; clearinghouses; exchanges; and auction platforms. We also discuss sole-source offsets, an approach that does not incorporate WQT but has been used as an alternative water quality permit compliance tool in some cases. The market structure names (bilateral negotiations, clearinghouses, etc.) are not used consistently in the literature on WQT. For example, if two WQT programs claim to use the same market structure, the roles of each program participant (e.g., Buyer,, broker, verifier, etc.) may be very different. Thus, one should focus on the roles of the participants rather than the market structure name when evaluating the suitability of a market structure for the Lower Fox River Watershed (LFRW). The Appendix contains a table summarizing the characteristics of the WQT market structures as well as diagrams that illustrate each structure. Market Structures Four WQT market structures presented: bilateral negotiations, clearinghouses, exchanges, and auction platforms. Sole-source offsets are also discussed. The characteristics, challenges, solutions, and potential applicability in the LFRW are discussed for each market structure. Keep in mind that these market structures are not set in stone and they can be modified to suit the needs of WQT participants in the LFRW. Bilateral Negotiations Bilateral negotiations are one-to-one negotiations between Buyers and s (or their agents). Sometimes these negotiations are brokered by a third-party intermediary (e.g., a broker). The credit price is arrived at through bargaining: think of it like the used car market. Bilateral negotiations are often used in WQT markets because of the non-uniform characteristics of water pollution credits and the need to ensure compliance with the CWA. Wisconsin s Red Cedar River Nutrient Trading Pilot Program 1 is an example of an environmental market that uses a brokered bilateral negotiation structure. Additionally, the Freshwater Trust and Willamette Partnership are teaming to advance WQT projects that incorporate bilateral negotiations in the Pacific Northwest. 2 1 See pp. A115-A118: 2 For more information, see the Freshwater Trust s Water Quality Trading section here: and Willamette Partnerships regional recommendations on water quality trading for the Pacific Northwest here: 1

2 Characteristics: Non-uniform goods o A credit from one is not viewed as equivalent to one from any other source. Restricted information flow o Buyers and s may not know the quantity of credits produced, available on the market, and sold. o Buyers may not know the willingness to accept of s, and s may not know the willingness to pay of Buyers. Prices are negotiated o Buyers and s (or their agents) negotiate the price of a credit, compared to markets where prices are set by other forces (e.g., exchanges or auction platforms). One-to-one negotiations o Buyers and s (or their agents) negotiate the price, terms, and conditions of the trade with or without the use of an intermediary. High transaction costs o Buyers and s must expend time and resources negotiating the price, terms, and conditions of the trade. o Buyers and s must expend time and resources meeting the terms and conditions of the trade over time. Liability rests with the trade partners and perhaps a third-party intermediary o In point source to nonpoint source (PS-NPS) trades, regulatory compliance liability rests with the PS permittee (i.e., the Buyer) under the CWA. However, liability for ensuring credit quality rests with the trade partners. The liable partner(s) are specified in the contract. Typically the is liable. In a brokered bilateral negotiation, some credit quality liability may rest with the broker. Challenges: High transaction costs Substantial third-party (e.g., WDNR) oversight to ensure compliance with WQT rules. Solutions: Standardize the negotiation process (e.g., standardized forms and negotiation timeline). Prospective Application in the LFRW: Bilateral negotiations may work in the LFRW because they can more readily ensure compliance with Wisconsin s WQT requirements and are well-suited to thin markets. The LFRW is presently a thin market primarily due to limited credit supply as highlighted in the Fox P Trade Feasibility Assessment and the general newness of trading in the area. However, the high transaction costs associated with this approach were blamed for the failure of the PS-PS Fox River WQT program which despite being established in 1981 did not register a trade until 1995; this market is now defunct. It may be possible to use a bilateral negotiation platform but have those negotiations brokered by a third party intermediary (e.g., the Great Lakes Commission, the County LCDs, or another entity). As third parties gain experience in brokering trades and institute standard forms and processes, and stakeholder confidence in brokers increases, transaction costs for Buyers and s may be reduced. 2

3 Clearinghouses With a clearinghouse, Buyers and s work through an intermediary that purchases pollution credits from s and sells them to Buyers at a uniform price. Unlike bilateral negotiations, there is no contract between Buyers and s; rather, each contracts directly with the clearinghouse to buy or sell credits. Think of it like a supermarket that purchases various qualities of beef at different prices, converts it to ground beef, and sells it at a uniform quality and price. The clearinghouse can also be thought of as a bank that purchases and holds credits that can be sold to Buyers at a later date. The Southern Minnesota Beet Sugar Cooperative Permit Program 3 uses a clearinghouse structure and has successfully completed P trades. Characteristics: Non-uniform inputs; uniform outputs o The intermediary collects non-uniform WQT credits from many s and converts them to a uniform quality and price. Intermediary ensures the quality of credits o The intermediary must ensure that credits will achieve the advertised pollution reductions to enable PSs to achieve regulatory compliance (e.g., a one-pound P credit must reduce P runoff into surface waters by at least one-pound). Prices are set by intermediary o The intermediary sets the credit price at a level to cover the cost of purchasing the credit from the NPS and the cost of administering the market. s sell to intermediary; intermediary sells to Buyers o One-to-one interactions between Buyers and s are unnecessary. Low transaction costs for Buyers and s; higher transaction costs for intermediary (could be factored into the cost of credits) o Limited interaction between Buyers and s reduces their transaction costs, and the intermediary incurs the costs of transferring credits. Liability for credit quality rests with the intermediary o While the PS Buyer remains liable for permit compliance, the clearinghouse assumes liability for ensuring credit quality. Challenges: Liability and risk rest with the intermediary. Pollution discharges must be sufficiently uniform. Solutions: Establish a credit certification process. Use trade ratios to ensure that water quality improvements occur. Only allow trades within the same subwatershed to achieve sufficient uniformity. 3 See pp. A47-A57: 14.pdf 3

4 Prospective Application in the LFRW: Clearinghouses may eventually work in the LFRW if the market becomes thick enough. However, the LFRW appears at present to be thin with undeveloped and uncertain number of credits for sale and uncertain interest in buying credits, despite great potential on the demand side. Success of this market structure may also hinge on a well-known entity (e.g., DNR or a third-party) agreeing to serve the clearinghouse function. Exchanges An exchange is the classic market type. Think of it like the New York Stock Exchange: Buyers and s meet in a public forum where prices are observed and uniform goods are traded; at any given time, there is a unique market-clearing price set by external market forces. Exchanges have been used in other pollution trading markets in the U.S., including the SO 2 market. In addition, exchange markets for WQT have been established in the U.S., including the Pennsylvania Nutrient Credit Trading Program 4 and Maryland s Nutrient Trading Program. 5 Both programs are focused on the Chesapeake Bay watershed. Characteristics: Uniform goods o A credit from one is viewed as equivalent to one from any other source. Open information flow o Buyers and s know the quantity of credits produced, available on the market, and sold. o Buyers and s know the market price of a credit at any given time. Prices are observed o At any given time, there is a unique market-clearing price. Fluid transactions between Buyers and s o No need for an intermediary, so transactions can occur quickly. Low transaction costs o Uniform goods enable confidence in credit quality, eliminating the need for long and costly reporting and approval processes. Liability for individual trades may be at least partly assumed by the credit exchange entity o While in PS-NPS trades, regulatory compliance liability rests with the PS under the CWA, the credit exchange entity may be responsible for ensuring the quality of credits offered on the exchange. Challenges: Non-uniform goods o Water pollution from two different sources may have different impacts, especially if sources discharge into different water bodies. o Separate markets must exist for separate watersheds. 4 More information at: Additionally, PA s online trading marketplace, NutrientNet is available at: 5 More information at: 4

5 o A Buyer s willingness to pay for pollution reductions will depend on the relative location of the credit generator. Reducing pollution upstream will improve water quality downstream, reducing the cost of treating intake water that point sources use. Solutions: Non-uniformity may be overcome by applying and manipulating trade ratios to equate the marginal damages from two sources. Prospective Application in LFRW: An exchange market could be difficult to establish in the LFRW because this structure requires thick markets (i.e., many credits available for sale and many interested Buyers). Also, it may be difficult to overcome non-uniformity if the market is thin (few credits available and/or few interested Buyers). Further, the CWA requires agencies to monitor the distribution of pollution within a watershed and does not authorize any program that might lead to a reduction in water quality; this may preclude an exchange market. Auction Platforms Auction platforms include typical auction pricing and reverse auction pricing. In typical auction pricing a Buyer bids on a water quality credit and the Buyer willing to pay the most for a credit typically wins. In reverse auction pricing, the bids to sell a water quality credit to a Buyer and the willing to accept the lowest price typically wins. However, the rules of the auction could allow for other outcomes. For instance, in typical auction pricing, the could consider all bids and choose the Buyer they wish to sell to, even if that Buyer was not the highest bidder. Also, the may be allowed to set a reserve price that disallows the sale of credits below that price. For example, if the set a $50 reserve price but the highest bid was only $45, the credit would not be sold. Alternatively, the auctioneer could refuse to accept bids below a particular starting price. Auction platforms rely on brokered trades, but Buyers and s bid on, or offer, credits independently. The Electric Power Research Institute s Ohio River Basin Water Quality Trading Project 6 uses an auction platform. Characteristics: Uniform or non-uniform goods o In WQT markets, credits will likely be non-uniform because a credit from one may not be viewed as equivalent to one from any other source; this will affect the value of the credit. However, auction platforms do not require goods to be uniform or non-uniform; either is acceptable. Prices are influenced by supply and demand o The price of a credit will be influenced by how many credits are on the market at any one time and the demand for those credits. Limited Buyer- interaction o are transferred from the to the Buyer through the auction platform, but no one-to-one contracts between PS and NPS are necessary. 6 More information at: 5

6 Low transaction costs for Buyers and s; higher transaction costs for intermediary o Limited interaction between Buyers and s reduces their transaction costs, and the intermediary incurs the costs of transferring credits. Liability for individual trades may be at least partly assumed by the intermediary o While in PS-NPS trades, regulatory compliance liability rests with the PS under the CWA, the intermediary may be responsible for ensuring the quality of credits offered on the auction platform. Else, the may be required to ensure credit quality. Challenges: Works best in a thick market. Reverse auctions may fail to reflect actual costs of conservation practices and other credit-generating activities as the s compete with one another to offer Buyers the lowest credit price. This can undermine the market as credit generators may not be fairly compensated for their costs incurred. Questions about who is liable for trades. Solutions: Disallow reverse auctions. Prospective Application in the LFRW: Auction platforms may be used in the LFRW, but this approach may require many Buyers and s to have a robust market. Sole-source Offsets Sole-source offsets are not WQT. With sole-source offsets, the regulatory agency allows point sources or nonpoint sources to increase pollution discharges at one location by reducing pollution through nonstandard means at another location in order to achieve regulatory compliance. For example, the City of Boulder, CO was given credit for ammonia pollution reductions by restoring riparian areas along the creek to which they discharged. Characteristics: No trading o Sole-source offsets are not WQT. No transaction costs o Because no trading occurs, no transaction costs are incurred. Liability rests with the permittee o Under the CWA, the permittee remains responsible for regulatory compliance. Challenges: Does not create a market. Limited opportunity for cost-savings to the polluter. No incentive for NPS to reduce discharges. 6

7 Solutions: Allow sole-source offsets in conjunction with WQT as a means of regulatory compliance. Prospective Application in the LFRW: Sole-source offsets may be used by the DNR on a case-by-case basis, but is contrary to the goal of establishing a robust and sustainable WQT market and therefore will not be considered for the LFRW. References Branosky, E., Jones, C., and Selman, M Comparison tables of state nutrient trading programs in the Chesapeake Bay watershed. WRI Fact Sheet. Available at: ent_trading_programs.pdf Selman, M., Greenhalgh, S., Branosky, E., Jones, C., and Guiling, J Water quality trading programs: An international overview. WRI Issue Brief. Available at: Willamette Partnership A how-to reference for building point-nonpoint water quality trading programs: Overview (Part 1 of 3). Available at: Wisconsin DNR A water quality trading how to manual. Available at: Wisconsin DNR Guidance for implementing water quality trading in WPDES permits. Available at: Woodward, R.T. Water quality trading in the U.S. Presentation to Purdue University s Discovery Park. Available at: Woodward, R.T., and Kaiser, R.A. Market structures for U.S. water quality trading. Review of Agrcultural Economics 24(2): Available at: 7

8 Appendix: Summary Table and WQT Market Structure Diagrams Table A1: Summary WQT market structure characteristics and their potential application in a Lower Fox River Watershed WQT program. Structure Bilateral Negotiations (unbrokered) Uniform Goods Pricing Transaction Costs No Negotiated High None Intermediary Credit Quality Liability Holder* Potential for LFRW WQT Low (high trans. costs) Bilateral Negotiations (brokered) No Negotiated Medium Broker and perhaps Broker Medium (lower trans. costs) Clearinghouse Yes Set by clearinghouse Depends Clearinghouse Clearinghouse Exchange Auction Yes Yes or No; either is acceptable Set by external market forces of supply and demand Highest bidder wins Low Auction Low Exchange Exchange and/or *Refers to liability for credit quality; not regulatory compliance liability, which rests with permittee (i.e., the Buyer). Auction and/or Low (thin market) Low (thin market) Low (thin market) A-1

9 Bilateral Negotiations (unbrokered) Buyer Bilateral Negotiations (brokered) Broker s Agent Buyer s Agent Buyer A-2

10 Clearinghouse Clearinghouse Buyer Exchange Exchange Buyer A-3

11 Auction Auction Bids Bidders Buyer (High Bidder) A-4