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Preliminary Preview for a

Geographic and Monitoring Program Project: A Review of Point
Source--Nonpoint Source Effluent Trading/Offset Systems in Watersheds

By Alexander Wood and Richard Bernknopf

#### 

#### **Open-File Report 03-79**

**2003**

U.S. Department of the Interior

U.S. Geological Survey

# Table of Contents

Abstract 3

Notation 4

Review of Project Description 5

Introduction 6

Literature Review 7

> I. History of Trading and Offsets

-   Environmental Trading 8

-   Water Quality Trading 9

> II\. Significant Concepts and Issues

-   Environmental Concerns: Natural Variability of Nonpoint Source Loads
    11

-   Uncertainty Analysis 11

-   Economic Considerations 13

-   Legal Implications 15

> III\. Empirical Evidence: Case Studies of Trading/Offset Programs in
> the United
>
> States

-   Lake Dillon, Colorado 16

-   Tar-Pamlico River Basin, North Carolina 17

-   Clear Creek, Colorado 18

> IV\. Discussion 19
>
> V. Optimal Conditions for Water Quality Trading 20
>
> Conclusion 22
>
> References 23

## ABSTRACT

Watershed-based trading and offset systems are being developed to
improve policy- maker's and regulator's ability to assess nonpoint
source impacts in watersheds and to evaluate the efficacy of using
market-incentive programs for preserving environmental quality. An
overview of the history of successful and failed trading programs
throughout the United States suggests that certain political, economic,
and scientific conditions within a temporal and spatial setting help
meet water quality standards. The current lack of spontaneous trading
among dischargers does not mean that a marketable permit trading system
is an inherently inefficient regulatory approach. Rather, its infrequent
use is the result of institutional and informational barriers. Improving
and refining the earth science information and technologies may help
determine whether trading is a suitable policy for improving water
quality. However, it is debatable whether or not environmental
information is the limiting factor. This paper reviews additional
factors affecting the potential for instituting a trading policy.

The motivation for investigating and reviewing the history of offsets
and trading was inspired by a project in the preliminary stages being
developed by U.S. Geological Survey Western Geographic Science Center
and the Environmental Protection Agency Region IX. An offset feasibility
study will be an integrated, map-based approach that incorporates
environmental, economic, and statistical information to investigate the
potential for using offsets to meet mercury Total Maximum Daily Loads in
the Sacramento River watershed. A regional water quality offset program
is being studied that may help known point sources reduce mercury
loading more cost effectively by the remediation of abandoned mines or
other diffuse sources as opposed to more costly treatment at their own
sites. An efficient offset program requires both a scientific basis and
methods to translate that science into a regulatory decision framework.

# Notation

ACSP: North Carolina Agricultural Cost Share Program

BMP: Best management practices

CERCLA: Comprehensive Environmental Response, Compensation, and
Liability Act

CWA: Clean Water Act

CZARA: Coastal Zone Act Reauthorization Amendments

EMC: Estimated Mean Concentrations

EPA: Environmental Protection Agency

ETP: Effluent Trading Program

MNA: Monitored Natural Attenuation

NC DEM: North Carolina Division of Environmental Management

NCPDI: National Coastal Pollutant Discharge Inventory

NPDES: National Pollutant Discharge Elimination System

NPS: Nonpoint source

NRI: National Resources Inventory

NSW: Nutrient-sensitive waters

POTW: Publicly owned treatment works (wastewater treatment facilities)

PS: Point sources

SRSCD: Sacramento Regional Sanitation County District

SRWTP: Sacramento Regional Wastewater Treatment Plant

TBEL: Technology-Based Effluent Limitations

TMDL: Total Maximum Daily Loads

TPA: Tar-Pamlico Association

WQBEL: Water Quality-Based Effluent Limit

# Review of Project Description

Over the past couple of centuries, mercury (Hg) from mining activities
has been transported with sediments downstream (nonpoint contamination)
into the Sacramento Estuary, where it is believed to have contributed to
elevated concentrations in fish, resulting in consumption advisories.
Most of the mercury lost to the environment in this area was from
placer-gold mines, which used mercury to extract gold through hydraulic,
drift, and dredging methods (Alpers and Hunerlach, 2000). Large
quantities of placer gold originating from large gravel deposits within
the Sierra Nevada gold belt provided the basis for large-scale mining in
California in the mid 1800s until the 1890s (fig. 1).

![](media/image2.png){width="1.8395833333333333in"
height="1.3680555555555556in"}

> **Figure 1.** Mercury production from mines in the Coast Ranges of
> California, 1850-1917 (Bradley, 1918). (Provided by Alpers and
> Hunerlach, 2000).

Mercury is widely recognized as a serious environmental contaminant. Of
particular environmental concern is the presence of methyl mercury
(MeHg), an organometallic form of mercury that is a potent neurotoxin to
humans through fish consumption. The Environmental Protection Agency
(EPA) Region IX is developing total maximum daily loads (TMDL) for
methyl mercury in various water bodies, among other criteria and
standards for water quality, using EPA's new human health fish-tissue
residue criterion.

The successful reduction of mercury loadings from nonpoint sources (NPS)
will alleviate the need for stricter point source controls. Examples of
point source (PS) controls are wastewater treatment plants, chloralkali
plants, and industrial facilities. NPS controls are gold and mercury
mines, erosion control activities, and mercury reduction programs, such
as mercury recycling. PS reductions have already been made, and
controlling additional PSs is difficult, expensive, and unlikely to
significantly reduce mercury loading in the basin.

\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_

Any use of trade, product, or firm names is for descriptive purposes
only and does not imply endorsement by the U.S. Government. The U.S.
Geological Survey (USGS)

Western Geographic Science Center, with support from EPA Region IX, will
research the feasibility of using an alternative incentive-based policy
(offset policy) to meet water quality standards. In an offset system,
water quality can be improved when one party (PS) can maintain or
increase its own loadings by reducing pollution from another location
that may or may not have an owner (for example, abandoned mine). Thus,
the discharger can accumulate pollution reduction credits that can be
used to offset its own loadings. An integrative environmental, economic,
and statistical map-based management approach has been proposed to
investigate the potential for using offsets to meet mercury standards.
This project is being supported by the USGS Geographic Analysis and
Monitoring Program (GAM) in pursuit of its goal of developing "GIS-based
decision support tools that integrate earth science information and
economics in order to model complex human and natural systems to
specific environmental or risk issues" (Acevedo and others, 2002).

The project will develop a highly focused, integrated study that
incorporates various environmental elements to assess whether using
offsets is technically (environmentally) and economically feasible as a
management strategy for reaching water quality standards for mercury,
using the Sacramento Basin (or subbasins) as a pilot case. This project
provides an opportunity to ask an important question: can water quality
be improved using a risk-based regional offset program? The hypothesis
is that the nonpoint control option will turn out to be favorable and
will reduce the need to pursue costly PS controls. A literature review
will focus on this question and other principles of trading and offsets
in making water quality policy decisions.

# Introduction

During recent decades, considerable progress has been made in reducing
PS pollution. However, the Nation's water quality has not improved
proportionately with these PS reductions (Letson, 1992). Regulators have
shifted their emphasis accordingly to NPS-related impairments, such as
sedimentation, agriculturally driven nutrient enrichment, and toxic
contamination of fish tissue and sediments (Letson and Crutchfield,
1993). NPS pollution, which is now the most common source of pollution,
is transported by runoff from rainfall or snowmelt moving over and
through the ground and deposited into sediment, soils, and various water
bodies, endangering human health and the environment.

An NPS, technically and legally, is defined to mean any source of water
pollution that does not meet the legal definition of "point source" in
section 502(14) of the Clean Water Act (CWA). According to the CWA, the
term "point source" is defined as any "discernible, confined and
discrete conveyance, including but not limited to any pipe, ditch, or
channel" (CWA §502(14); see also 33 U.S.C. §1362(7); 40 C.F.R. §122.2).
Agricultural stormwater discharges and return flows from irrigated
agriculture are not included in this definition.

Although diffuse runoff is generally treated as NPS pollution, runoff
that enters and is discharged from conveyances such as those described
above is treated as PS discharge and hence is subject to the permit
requirements of the CWA (Hoag and Hughes-Popp, 1997). In contrast, NPSs
are not subject to Federal permit requirements. The distinction between
NPSs and diffuse PSs is sometimes unclear. Although NPS pollution is
defined as being diffuse, knowing the general location of these NPSs,
such as agricultural fields, urban development areas, mines, and land
disposal sites, makes it possible to treat an NPS as a PS conceptually,
thereby allowing remediation to take place at the site of contamination.

PS pollution has been controlled through the application of
technology-based requirements administered by States using the National
Pollutant Discharge Elimination System (NPDES) permit program. Almost 87
percent of the major municipalities and 93 percent of major industrial
facilities were in compliance with NPDES permits by 1990 (EPA, 2002).
Despite these accomplishments, water quality problems persist as a
result of NPS pollution. The natural variability of NPS pollution, as
well as political aspects and legal issues, has made identifying and
locating sources problematical, thereby hindering the development of
efficient and capable regulatory approaches. There has been a growing
interest among private industries and regulatory agencies in using
market-based incentives, particularly trading programs, for NPS
mitigation to improve water quality in numerous watersheds and produce
cost savings.

This report will explore the ability of trading/offset programs to
resolve NPS problems in watersheds. It will explore the issues that
constrain and support possible trading programs. It contains a
literature review of these issues and examines associated concerns and
questions. Empirical illustrations from both successful and failed
incentive programs will help answer some of these questions. This
information could be used to develop guidelines for future decisions
about whether permit trading is an appropriate regulatory instrument.

# Literature Review

The relevant literature for this project can be divided into four main
categories:

-   History of Trading and Offsets

-   Significant Concepts and Issues: Scientific, Economic, and Legal
    Implications

-   Empirical Evidence: Case Studies of Trading/Offset Programs in the
    United States

-   Optimal Conditions for Water Quality Trading

We outline the state of research in each of the above categories and
define the important research concepts from each of them. For this
paper, we focus on those aspects of the literature that are most
critical.

# I. History of Trading and Offsets

#### Environmental Trading

Trading/offset programs rely on financial incentives and decisionmaking
flexibility to reduce control costs. A trading program allows
dischargers to transfer discharge control responsibility in common units
of exchange---a tradable commodity, such as units of air or water
without violating the overall emission standard or limit. In theory,
efficiency is achieved since the utility has the flexibility to either
use the least cost abatement techniques or purchase additional permits
if others can reduce emissions more cheaply (Stephenson and others,
1998). After meeting technology-based effluent limitations (TBEL) as
part of the TMDL, PSs are allowed to gain credit for any further
reductions (Wilson, 2001). Trading programs would allow the TMDL to be
met at an overall lower cost. However, the success of a trading program
depends on the type of contaminant, contaminant transport, ability to
assume mixing, physical and chemical characteristics, and media. In
addition, the potential for a cost-effective trading policy depends on
whether or not the transaction costs of administering and monitoring the
policy surpass the cost savings of implementing such a program
(Ortolano, 1997). This literature review will expand on these
environmental, economic, and legal concerns affecting trading policies.

Offsets and trading will be used interchangeably in this analysis,
although they are not the same theoretically. The State Water Resources
Control Board of California differentiates between each of them:

"Pollutant trading refers to an exchange of either permitted discharge
levels or required abatement levels between two or more dischargers,
either in a formal 'commodities' market or banking system, or a less
structured exchange; offsets generally refer to unilateral abatement
efforts by a discharger to remove a certain amount of pollutant
discharge from existing sources to compensate for the discharger's own
discharge." (Wilson, 2001)

Emissions trading programs (ETP) were first used to provide greater
flexibility for emission sources to meet air quality standards. The
first practical application of an ETP concerned the problem of sulfur
dioxide emissions from coal-fired power plants. Sulfur dioxide emissions
and the resulting acid rain have had negative impacts on vegetation
throughout the Eastern United States and Canada. Established under the
1990 Clean Air Act, the Acid Rain Program is the most widely known and
successful trading program. Although cost savings have been difficult to
measure because of the proprietary nature of industrial pollution
control-cost data, this program was expected to save more than \$2
billion a year in compliance costs within the next decade compared with
the cost of preexisting regulations (Jarvie and Soloman, 1998).

One of the potential problems with this program was its national
structure. Sulfur dioxide is a regional pollutant, meaning that its
effects may be felt hundreds of miles away from the source, but not
thousands (Cramton, 2000). Therefore, reductions in one area may mean
fewer reductions in others and cause "hot spots" (high concentration of
pollution in a defined area). The alternative was to reduce trading
flexibility by setting up regional caps that would prevent hot spots.
This regional approach appears to have been effective, because no hot
spots have been detected (Cramton, 2000). This is an example of how the
types of contaminant and the media have a role in the development and
success of a trading program.

#### Water Quality Trading 

Since the early 1980s, the EPA has been planning new and innovative
schemes to manage and reduce NPS pollution, including trading programs.
The Water Quality Act of 1987 required States to assess NPS pollution
and develop plans for managing it. In 1990, the Coastal Zone Act
Reauthorization Amendments (CZARA), required coastal States to develop
NPS programs that could include land use management and agricultural
best management practices (BMP) that reduce loadings (16 U.S.C. §§ 1455
(d)(16), 1455b) (Ribaudo and others, 1999).

The EPA issued a broader Policy Statement on Effluent Trading in
Watersheds (1996) and more recently a proposed water quality trading
policy (2002) establishing a more clearly defined role for water
regulation. The EPA supports and encourages water quality trading
programs for many purposes: reducing the cost of compliance with water
quality-based requirements, offsetting growth, achieving early
reductions and progress toward water quality standards pending the
development of such standards, and establishing economic incentives for
voluntary reductions (EPA, 2002). Under EPA's proposed policy, to create
pollution credits to trade or offset, PSs must reduce pollution levels
beyond the level of the most stringent technology requirements.

EPA's proposed rules for the implementation of the (TMDL) program (1998)
will have important implications for water quality trading. As the
proposed rules explain, "the TMDL specifies the amount of a particular
pollutant that may be present in a water body, allocates allowable
pollutant loads among sources, and provides the basis for attaining or
maintaining water quality standards" (EPA, 1998). TMDL implies that PS
and NPS contributors must share the responsibility for meeting target
levels. The question then becomes what is the best policy to meet these
standards; for example, discharge standards, discharge fees, or tradable
permits (Ortolano, 1997). Previous environmental regulatory policy
focused on controlling the output of pollutants from each source
separately without focusing on the final overall quality within the
watershed or on different control costs (Boyd, 2000). Individual permits
were issued without taking a holistic overview of a watershed.
Currently, policymakers and regulators are focusing more on
environmental and economic objectives while giving flexibility to
dischargers to find ways to achieve public goals.

Although these rules will have significant implications for PSs, the
impact on NPS pollution control will be most important. Since the focus
has turned to NPS pollution, and ambient monitoring will find a large
number of nonpoint polluted water bodies, "TMDL's will change the
politics, economics, and implementation of water quality regulation"
(Boyd, 2000). Policymakers and regulators will need to become more
flexible in allocating loads, as well as in devising methods to meet
water quality standards as financial constraints limit opportunities for
contaminant reduction.

Load allocations (the amount of total pollution allowed set by the
States under a TMDL) for NPSs are not directly enforceable under the CWA
but, according to the proposed rule (EPA, 1998) in 1998, are enforceable
only by State laws and regulations. This proposed rule was promulgated
in 2000 into law; however, Congress prohibited funding for the
implementation (EPA, 2001). This law will be withdrawn in April 2003,
but there will be a proposal for a similar rule (Matt Mitchell, oral
commun., 2002). However, regulatory requirements still prevent the EPA
from implementing any nonpoint regulations explicitly.

Watershed-based trading may provide a tool for sources to meet the
stringent limits expected to result from TMDL development. These
analyses supporting TMDL development estimate NPS and PS contributions
to each watershed through data collection, expert judgment, and water
quality modeling (Borsuk and others, 2002). After a TMDL identifies
contributions from each source, the total amount of pollution that can
be discharged to the water body is set, and allowable discharges are
allocated to individual pollution sources. Figure 2 illustrates a simple
schematic of the implications of PS and NPS contributions to water
quality degradation and the impacts of trading/offsets.

  -------------------- ------------------------ ---------------------------
  **Type of Source**   **NPS**                  **PS**

  Status               Diffuse and large water  Easier to identify (end of
                       contributor to water     pipe)
                       quality degradation      

  Solutions/Remedies   BMPs, source reduction,  Technological/capital
                       recycling                investments

  Problems with        Difficult to enforce and Costly
  remedies             to clean-up/control      

  Trading/offsets      NPS Pollution is         Reduction in costs
                       addressed                
  -------------------- ------------------------ ---------------------------

**Figure 2.** Impaired water quality.

Trading/offset systems are founded on the idea that it may be more
economically efficient to have high-cost polluters pay low-cost
polluters to reduce pollution further, providing more pollution
reduction at a lower total cost. In other words, if it costs one entity
much more than another entity to reduce the same amount of pollution,
then these two entities can trade pollution credits. However, this
approach has been limited because of the natural variability and
uncertain monitoring of NPSs, as well as other issues, such as
liability, lack of clear water quality standards, and lack of
consistency in regulatory methods (Stephenson and others, 1998). The
next sections will review some of these limitations.

# II. Significant Concepts and Issues

#### Environmental Concerns: Natural Variability of Nonpoint Source Loads

The physical nature of NPS pollution has confounded attempts to regulate
and control its occurrence (along with a lack of legal and/or regulatory
authority). Problems include its sporadic and diffuse nature, a lack of
monitoring capability, and the difficulty of assigning responsibility
for the NPS pollution. It is generally not possible to observe or too
expensive to identify the amount of discharge of any \[individual\]
suspected polluter at all times or to infer NPS levels from observable
ambient pollutant levels. Although predictive models exist, there are
large areas of uncertainty about the fate and transport of target
pollutants (Letson and others, 1993). With respect to water quality,
emissions of several polluters contribute to the ambient levels, and
only combined effects are observable (Sergerson, 1988). Therefore, it is
difficult to monitor and regulate NPSs. In addition, NPSs have estimated
loads that are neither completely known nor constant with the seasons
(Jarvie and Soloman, 1998).

Efficient environmental policy for NPS pollution has been constrained as
a result of the natural variability associated with weather conditions
and episodic events, such as wind, rainfall, and temperature
(Xepapadeas, 1992). Weather and climate strengthen the uncertainty of
estimating the contaminant load and concentration. For instance, during
a severe and prolonged storm, the erosion capacity increases, producing
greater runoff and more contaminant discharge into the receiving waters.
NPS loadings generally increase during rainy seasons and decrease during
dry seasons. However, the effects of discharge on a water body depend
not only on the total quantity of the effluent released but also on the
assimilative capacity of the receiving water body (Stephenson and
others, 1998).

Since rain also dilutes NPS runoff, the short-term effects of NPSs may
be mitigated to some extent, thereby reducing the chance of violating
the water quality standards, although there are other factors that
determine the final outcome, such as slope, topography, hydrogeology,
and so on (Jarvie and Soloman, 1998). Nonetheless, it is unclear that
increased NPS loads caused by above-normal rainfall will significantly
affect ambient water quality. These environmental processes are very
site specific, thereby inhibiting efficient regulatory requirements
(Stephenson and others, 1998).

#### Uncertainty Analysis

The physical realities of NPS pollution described above imply that there
will be a range of possible loading or concentration levels associated
with any given remediation practice or discharge level at any given
time. Current monitoring technologies can't measure NPS emissions at a
reasonable cost because they are diffuse (Ribaudo and others, 1999).
However, through multiple sampling trials, one could estimate the range
or probability of loading and concentration. The objective of a PS-NPS
trading/offset policy would be to increase the probability that
concentration levels of the targeted pollutant will fall below the water
quality standard (Stephenson and others, 1998).

The risk of exceedance is the probability that the amount of targeted
contaminant, say total mercury loading, discharged into the system will
exceed the target (allowable) value set by the EPA or Regional Water
Quality Control Board (Jack Schuenemeyer, written commun., 2000). That
risk is a function of the uncertainty associated with the loading of
mercury in any given time at the NPSs. Reducing the uncertainty of
mercury loading at one or more of the NPSs can reduce this risk to the
system. The following hypothetical situation illustrates the impact of
uncertainty in controlling NPSs and how and why PSs make remediation
decisions.

The goal of a PS is to comply with existing laws and regulations in a
cost-effective manner. Suppose a PS is required to remediate Z volume of
mercury and assume that the choices available to a PS at a certain time
are to reduce total mercury loading at the point of discharge or to
select an offset; that is, reduce pollution from one or more NPSs. The
PS can choose among X number of NPSs. Each "what-if scenario" has an
estimated mean and variance of mercury loading reduction and remediation
cost. Note that the probability distributions can be estimated from
data, expert judgments, or a probabilistic water quality model. Suppose
a PS is required to remediate Z volume of mercury by cleaning up one or
more of the X NPSs. To simplify matters, suppose there are three NPSs
and a PS has to decide which one to offset. The following example
provides data on three NPSs. An offset reduction requirement is
estimated using the applicable regulatory standard. A percentage
reduction is the percentage of contaminant the PS has to reduce.
Consider the following specific example. The publicly owned treatment
works (POTW) must offset 20 kg (or 20 percent of its total loading) of a
contaminant to meet the requirement. Each NPS has a mean and a variance
of how much contaminant can be reduced. The POTW has to decide which one
to offset.

  ------------------ ------------------------- ---------------------------
  Offset Reduction                             
  Requirement = 20                             
  kg (the amount of                            
  pollution that                               
  must be reduced)                             

  **NPS \#**         **Mean (kg)**             **90% Confidence Interval
                                               (kg)**

  1                  22                        (17-27)

  2                  18                        (15-21)

  3                  25                        (15-35)
  ------------------ ------------------------- ---------------------------

**Figure 3.** Hypothetical example of remediation decisions.

In the proposed study, the data would come from existing field
collection, water quality modeling, expert judgment, and historical
discharge, or from new data collections. Although there is a reasonable
chance that any of the NPSs could meet the PS's needs, other factors
must be considered before a decision can be made. Suppose that the PS
chose site 1 with the mean of 22 and a 90 percent confidence interval
from 17 to 27. If we assume that these statistics are based on a
representative sample (an average over all seasons and times), then one
could estimate the probability distributions for the volume of mercury
at NPS site 1. The reduction requirement is set at 20; thus, site 1
satisfies the cleanup requirement. At site 1, the sampling distribution
of mean values is centered at 22, so undertaking this remediation
project will meet and surpass the percentage reduction requirement.
Although this example uses a normal distribution, other distributions
could be tested. The risk, the probability of noncompliance, is the area
to the left of 20 in figure 4 (indicated by a double-headed arrow). If
this risk is perceived as too great, the PS might choose another site or
invest resources in data collection.

![](media/image3.wmf){width="5.504861111111111in"
height="2.359722222222222in"}

> **Figure 4.** Total mercury loading distribution.

Remediation decisions made by PSs are quite complex. Uncertainties of
remediation decisions include remediation costs at each site, the
benefit to the PS if its cleanup/remediation exceeds the target value,
whether there is a forward (banked) credit if a PS exceeds its reduction
requirement, and potential penalties for noncompliance. Also, PSs will
need to decide whether to collect more data or install new controls at
their current facilities. The PS must account not only for the
scientific uncertainties but also for legal and economic uncertainties.

#### Economic Considerations

It is often difficult to compute the economic and environmental damage
caused by NPS pollution (Ribaudo and others, 1999). These damages may
include fish kills, an increase in eutrophication, and a reduction in
opportunities for recreational activities, depending on the designated
beneficial use of the water body. Instead, dischargers can evaluate
their policies on the basis of their ability to achieve specific
environmental goals at the least cost, given the policy instruments
available to a resource management agency, along with other political,
legal, or information constraints that may exist. Such an outcome is
referred to as "second best" (Lawrence Goulder, oral commun., 1999).
"Second best" applies when, for one reason or another, regulators are
unable to use the optimal regulatory instrument and so must do the best
they can with restricted opportunities. Frequently, damages are not
proportional to known discharges and exhibit nonlinear behavior;
therefore, controlling discharges will most likely be a second-best
strategy (Braden and others, 1989). The success of a trading system will
depend on whether or not certain economic conditions are in place:
differences in marginal abatement costs (the costs for each additional
unit of contaminant reduction), the trading ratios (amount of NPS
pollution reduced to receive a unit of PS pollution-reduction credit),
transaction costs (the costs of negotiation and bargaining between
sources), monitoring costs, and the number and size of participants.

The economic appeal of PS-NPS trading/offsets depends on the differences
between unit/marginal costs of pollutant reduction for different PSs
compared with such costs for NPSs. Although the volume of trades is
important, efficiency will be greatest when the trading results in the
marginal costs of abatement (that is, of avoiding a given amount of
damage) being equal after transactions between the entities (Baumol and
Oates, 1994). Differences in marginal costs arise when NPSs can
implement cheaper methods to reduce loadings while PSs need to install
more expensive technologies to achieve the same reduction in loadings.
Equalization of marginal costs can come about with minimal trades if
there is little deviation in marginal abatement costs at the initial
allocation of permits.

NPS reduction is often cheaper on a per-unit basis (compared with PS
control) because PSs often require expensive technological methods to
control further discharge, but NPSs often rely on cheaper nonstructural
BMPs to reduce pollutant loading. The development of BMPs is "based on
the practical experience of land managers and improvements in the
scientific and technical understanding of the relationship between land
management practices and environmental impacts" (Boyd, 2000). Examples
include installing riparian buffer strips, building adequate fencing to
keep livestock from directly soiling surface water, and placing sheds
over manure piles to minimize runoff (Boyd, 2000). However, BMPs
sometimes never achieve what they are intended to do (Randall and
Taylor, 2000). Because of the uncertainty of BMPs, regulators institute
a trading ratio.

The natural variability of NPS pollution, the assimilative capacity of a
water body, and the uncertain efficacy of BMP's and other strategies
prompt regulators to establish a trading ratio. To obtain water quality
goals, PSs generally must sponsor a larger reduction through the NPS
because of the uncertainty of the volume of NPSs (Crutchfield and
others, 1994). Trading ratios, most likely set by States, are used to
overcome this uncertainty. These ratios define how many units (volume)
of NPS pollutant reduction are equivalent to one unit of PS loading
reduction. For instance, at a trade ratio of 2:1, point sources reducing
2 pounds of NPS nitrogen loadings would receive credit for 1 pound. This
extra reduction represents a response to an attempt to compensate for
the uncertainty about the relative effectiveness of PS and NPS controls
(EPA, 1996). Although this helps ensure that expected water quality
improvements actually occur, potential side effects may include
increasing marginal costs of trades and decreasing trading potential
(Hoag and Hughes-Popp, 1997).

Transaction costs are another important economic issue in assessing the
usefulness of a PS-NPS trading scheme. Identifying potential trading
partners, negotiating a trade, monitoring the water quality, and using
government or private administration all contribute to transaction
costs. The administration costs serve as an important determinant of
trading potential: determining the type of pollutant to be traded; the
structure of trading (through actual parties, watershed organization,
EPA); the units of trade; directionality (must buyers always be
downstream of source that reduces its pollutants?); size of trading
area; trading ratio; monitoring requirements; enforcement costs; and
verification of credits (EPA, 1996). Additionally, PSs and other
stakeholders may have to incur lobbying costs to convince NPSs, which
are not regulated currently, to create trading opportunities. The number
and size of trading participants will also affect trading potential. For
trading to be practical, a few PSs of significant size should exist. If
there are too many participants, costs to locate available sources for
trading, negotiation costs, and administration costs to run the program
will all increase and reduce trading potential. Transaction costs will
exceed the potential for control cost savings if a watershed contains
numerous PSs requiring costly bargaining and negotiation time.

For PS-NPS trading to contribute to overall water quality improvement
and increased cost savings, both types of sources must contribute
significantly to total pollutant loadings (Ribaudo and others, 1999).
For instance, if NPS contributions are relatively large in relation to
PS contributions, then most likely PSs will not be able to afford the
purchase of enough NPS permits to meet their required reductions and
make any improvements in water quality. If NPSs contribute 99 percent of
the loadings, implementing an incentive-based program may not help
dischargers because requirements imposed on PSs will not be sufficient
to meet water quality standards through offsets. There may be an
improvement in water quality, but the focus of using an offset program
is to help dischargers meet their regulatory requirements.

The logistics of a watershed network (for example, the number of each
source contributing to the watershed, the contribution of each, the size
of the trading area, enforcement and monitoring costs, differences in
marginal costs) ultimately determine the potential of a PS-NPS
trading/offset program as a suitable water quality policy. In addition
to the environmental and economic uncertainties, legal and political
motivations play a large role on deciding whether water quality trading
is a feasible policy.

#### Legal Implications

Before any type of water quality incentive-based programs can be
implemented, legal authority for these programs to supplement water
quality regulation needs to be established. Legal issues that arise
include antibacksliding rules from the Clean Water Act, the extent to
which regulations authorize new or renewed permits, and potential
liability postremediation (Wilson, 2001). Initially, provisions must be
consistent with the CWA, including the following: requiring sources and
activities to obtain a Federal permit before being allowed to
participate in a trading program; developing baselines for trading
derived from water quality standards; not accepting any use of pollutant
reduction credits or allowances that would cause a localized impairment;
requiring that NPDES permits describe how baselines and conditions or
limits for trading will meet water quality standards, and so on (EPA,
2002). In addition, under section 402(b) of the CWA, all NPDES permits
issued by States require each PS to be subject to applicable TBELs as a
floor, with the possibility of using offsets to make further progress
toward water quality goals (Wilson, 2001).

An offset program must do more than substitute one contributing source
for another because Federal law prohibits new discharges from
contributing to violations of water quality standards. The
antibacksliding rule draws on this distinction between new and existing
sources by not allowing, unless certain exceptions are met, permits to
be renewed or modified "to contain effluent limitations which are less
stringent than the comparable effluent limitations in the previous
permit except in compliance with section 1313(d)(4) of this title" (CWA
33 U.S.C. ζ 1342 (o)). The application of antibacksliding rules could
have significant consequences in terms of permissibility of offsets
since, in theory, offsets provide dischargers with flexibility in lieu
of the application of an otherwise stringent effluent limitation.

An essential legal implication of water quality trading is the potential
for contingent liability suits. There is a potential for liability
lawsuits when unilateral remediation action at a particular site is
committed for an offset and contamination resurfaces in the future.
Under the current CWA, a "Good Samaritan" that wants to clean up a site
is not protected from liability if more discharges occur after the
cleanup work is completed. These liabilities become an overwhelming
disincentive to voluntary remedial activities for resolving the serious
problems associated with abandoned and inactive mines. As a result, the
potential legal costs, as well as further remediation costs, will
prevent most remediation from taking place. If a "Good Samaritan"
liability law were formulated to reduce potential contingent
liabilities, dischargers might be more willing to risk adopting an
"abandoned" offset site.

# III. Empirical Evidence: Case Studies of Trading/Offset Programs in the United States

*A. Lake Dillon, Colorado*

Dillon Reservoir, located 70 miles west of Denver, Colo., was the first
PS-NPS trading program in the Nation and is still ongoing (Stephenson
and others, 1998). Studies determined in the early 1980s that excessive
phosphorous (P) discharge was accelerating algae growth, which was
causing eutrophication[^1] problems, particularly low dissolved oxygen
levels in the reservoir (Stephenson and others, 1998). Estimations
derived from data collection and modeling indicate that about one-half
of the anthropogenic P loads entering the reservoir were contributed by
PSs, mainly from four POTWs, and half were from NPSs, primarily
individual septic systems and urban runoff.

In 1984, using population projections, the State of Colorado estimated
that the health of the lake would require a reduction in the quantity of
P coming from the four major POTWs. Rather than having to upgrade their
own facilities, the POTWs were offered the option of implementing
controls for existing urban NPSs. Cost studies showed that POTWs could
achieve the same overall reductions in P for half the cost if they
concentrated on NPSs rather than solely on their own emissions (Jarvie
and Soloman, 1998). The EPA approved a trade ratio of 2:1 so that there
would be enough P reduction in the basin to allow for growth of the
POTWs and new NPSs based on estimated population growth.

An example of how credits are created involved the community of Frisco.
In 1985, the Frisco Sanitation District (a POTW) decided to address NPS
storm-water runoff of P into the lake. The district built storm-water
control structures to guide the surface runoff back underground.
Approximately 50-70 percent of the P was removed as the water filtered
through the pipes (Jarvie and Soloman, 1998). The number of credits
gained from this project was set equal to the amount of P removed,
determined by monitoring the flow and concentration of incoming and
outgoing water. This is an example of a direct measurement of NPS
effluent discharge. The Frisco District was offered P credits for its
NPS reduction by the Colorado Water Control Commission. Frisco only
needed a small portion of P allocated to it annually and donated its
surplus credits to offset increased P discharge associated with the
construction of a new town golf course (Jarvie and Soloman, 1998). The
credits in this trade were not actually bought or sold, but the process
worked to the benefit of both parties. In this instance, trading allowed
further development while still improving lake quality.

The Dillon Reservoir example demonstrated that the direct measurement of
NPS load is not impossible. Although NPS pollution is defined as being
diffuse, knowing the relative location of these NPSs makes it possible
to treat an NPS as a PS and measure it with more confidence. In
addition, trading does not necessarily need a tangible cash transaction
for cost savings to occur. As of November 1999, 2 trades have occurred
and more than 10 NPS projects have generated credits that have been
banked but not yet used or sold (Sohngen, 1998).

*B. Tar-Pamlico River Basin**,** North Carolina*

Excessive nutrient loading in the Tar-Pamlico Estuary in recent years
has caused low dissolved oxygen levels, sporadic fish kills, and other
water quality problems. Nitrogen (N) and P, the main culprits, came from
agricultural NPSs (livestock and crop production) and wastewater
treatment plants (Jarvie and Soloman, 1998). In 1989, as a result of
severe eutrophication problems in the basin, the North Carolina Division
of Environmental Management (DEM) Commission classified the basin as
nutrient-sensitive waters (NSW). Under this classification, the DEM was
required to implement a strategy to reduce PS and NPS loads of N and P.
Cost studies showed that upgrading these POTWs to meet new discharge
limits would cost the dischargers as much as \$100 million (Jarvie and
Soloman, 1998). Because of these large costs, 12 POTWs and 1 industrial
firm voluntarily formed the Tar-Pamlico Association (TPA) to meet an
overall nutrient cap. The association estimated that reducing one unit
of NPS pollution would cost about 10 percent of the price of reducing
one unit of PS pollution, or about \$11 million (Jarvie and Soloman,
1998). The State of North Carolina and the TPA agreed to a plan for
setting a basinwide reduction goal.

TPA members are jointly responsible for meeting the total nutrient
loading allowance (cap). If the TPA exceeds this cap, it agrees to pay a
\$56/kg fee ("buying nutrient credits") for every excess kilogram (Hoag
and Hughes-Popp, 1997). This fee accounts for a 3:1 trading ratio for
cropland BMPs or a 2:1 ratio for confined animal operations and is based
on average control costs and administrative fees. These funds go to a
voluntary program called the North Carolina Agricultural Cost Share
Program (ACSP), which provides technical assistance and pays farmers a
percentage of the average cost to implement nutrient-reducing BMPs (Hoag
and Hughes-Popp, 1997). Therefore, in this trading scheme, farms -the
NPSs- are not direct participants in the "trading" of the credits. The
ACSP, a representative entity of the farmers, acts as a mediator in this
trading system. In addition, changes in nutrient discharge resulting
from these BMPs are not measured directly. Credits for implementing
these measures are given on the basis of average levels of pollution
documented in prior research (Stephenson and others, 1998).

In the initial stages of the project, dischargers could trade reduction
credits with other PSs or pay to implement BMPs at NPSs at a 3:1 ratio
(Jarvie and Soloman, 1998). Annual reduction goals were met successfully
and even exceeded in this first phase. It was estimated that the
association avoided nearly 75-90 percent of the estimated cost of using
standard industrial nutrient reduction technologies (Jarvie and Soloman,
1998). Through the application of various agricultural BMPs, the
requirement for much more costly advanced wastewater treatment
technologies was avoided. Moreover, in this case almost 80 percent of
the nutrient pollution in the river was from NPSs sources (Jarvie and
Soloman, 1998).

The TPA has not exceeded the maximum allowable nutrient loading yet, and
therefore there has not been an actual PS-NPS trade. Most of the
reductions were met through the initial cheap reduction opportunities
from PS facilities and monetary contributions to a BMP fund. There is a
growing sum of banked BMP credits. Additional program benefits include
funding for additional collection of nutrient effluent data and the
development of an estuarine model for the basin.

*C. Clear Creek, Colorado*

In the mid-1990s, the National Forum on Nonpoint Source Pollution began
the Orphan Sites Feasibility Study to identify and display innovative,
nonregulatory approaches to nonpoint pollution (U.S. Water News Online,
1998). An "orphan site" can be defined as a contaminated site that
cannot be regulated under current laws, has no identifiable, responsible
entity that can be located, and has no means to address the problem. The
purpose of this study was to discover new approaches of market-based
incentives to achieve water quality standards not otherwise attainable
under existing regulatory programs. This offset program would allow any
interested discharger to "adopt" and clean up an unregulated orphan
source of pollution in exchange for discharge credits. The Clear Creek
watershed, nearly 500 square miles in the Front Range west of Denver,
Colo., served as the model watershed for this study (Holm, 2001). This
area, containing more than 1,300 orphan mine sites, is contaminated by
numerous heavy metals in the water caused by runoff and drainage
(Environomics, 1999).

Although the previous two case studies were successful in implementing a
trading/offset program, various barriers prevented this program from
moving beyond its conceptual stages in this case. For instance, as a
result of the "Good Samaritan" liability issue, dischargers weren't
willing to risk adopting an orphan site because they could be held
liable for further contamination (Carl Norbeck, written commun., 2001).
Under the current Clean Water Act, a "Good Samaritan" that wants to
clean up a site is not protected from liability if more discharges occur
after the cleanup work is completed. Carl Norbeck, from the Colorado
Water Quality Control Division, explained that dischargers were shielded
from liability lawsuits by Federal and State agencies but not from
citizen suits. In addition, he said that the amount of time spent by the
Steering Committee was astronomical, with very little payoff. Other
barriers included soliciting participants (unsuccessful development of a
liability relief tool), evaluating the merits of the cleanup, evaluating
the merits of the desired benefit, and spending far too much time to
gain acceptability.

# IV. Discussion

These case studies highlight some of the challenges and benefits of
trading programs. First, trading programs can be used to help
nonattainment areas reach water quality standards more cost effectively.
In some cases, the complete removal of a POTW would not have achieved as
much water quality improvement, even if it were possible or practical. A
program where PSs and NPSs cooperate with each other to reduce
discharges for the least cost may save money, as well as meet water
quality standards. These programs have the potential to limit top-down
Government control and to encourage and institutionalize cooperation and
discourse between interested parties (Woodward, 2002).

The cost-effectiveness of a trading program can be affected by
additional transaction and program administration costs. In the
Tar-Pamlico case, costs were greatly reduced by the formation of a PS
association-trading group with another established entity, the ASCP,
representing the farmers. Most of the transaction costs dissipated as
the association became established. The only remaining transaction costs
were to the firms for the effort and paperwork needed to buy the credits
and to the farmer for implementing the BMPs (Stephenson and others,
1998). Since PSs pay for reductions elsewhere and farmers are paid for
pollution prevention, transaction costs are reduced for the farmers and
the association by making it easier for buyers and sellers to establish
trades. These economic incentives will increase the likelihood of
trading.

There are some attributes of these programs that limit
cost-effectiveness. For instance, although the Tar-Pamlico program
reduced transaction costs, the program was administered using average
costs rather than marginal costs, thus eliminating some of the marginal
benefits that could be achieved in a more efficient market. Also, both
programs incorporated a fixed trading ratio. Although these ratios are
used to reduce the monitoring and causal uncertainties associated with
NPS loadings and provide a "margin of safety," the additional reduction
of pollutants may outweigh the potential cost savings of meeting the
established water quality standard.

Regulators use trading ratios to account for these uncertainties;
however, in effect this produces greater costs in administering an
offset policy. One solution would be to replace the fixed rate (ratio)
with a variable rate based on random episodic events. For instance, a
higher ratio could be used when there are higher probabilities that
damage will occur, such as during high-precipitation seasons with more
runoff. In addition, better monitoring technologies and information in
the future could create less stringent trading ratios.

# V. Optimal Conditions for Water Quality Trading 

The previous section highlighted some of the specific conditions that
would support and prevent implementation of a successful trading
program. The following is a general description from the literature of
recommendations for creating the best conditions to implement trading
programs:

-   *Responsibility*: The total amount of pollution discharge allowed,
    as well as the property rights and responsibility for all
    participants, needs to be defined clearly when the program is
    established.

-   *Legal Authority*: Clear legal authority for trading must be
    established by the States and Federal Government through
    legislation, rulemaking, and incorporating provisions for trading
    through NPDES permits (EPA, 2002).

-   *Delineated Watershed*: The geographic area, in which trades will
    take place, whether it is an entire watershed or small segments
    within a watershed, must be specified (Kerns and Stephenson, 1996).
    Provisions must be made to prevent potential "hot spots" or
    localized water quality problems.

-   *Marginal Costs*: A necessary condition for any type of
    environmental trading program to work is that the marginal costs of
    abatement (the additional cost of eliminating discharge in
    controlling an additional unit of contaminant) must be different
    among a sufficient number of dischargers (Baumol and Oates, 1994). A
    trading program is only more cost-effective than the status quo
    policy if it can achieve the same environmental standard at a lower
    cost or a better standard at the same cost. Trading is effective
    under these terms because firms with high marginal costs of
    abatement can compensate those with lower costs.

-   *Proper Regulation*: Mechanisms (monitoring, statistical models, and
    so on) are needed for determining compliance and ensuring
    enforcement. BMPs represent the analog to end-of-pipe controls on
    PSs (Boyd, 2000) and need to be monitored for effectiveness. The PSs
    need to be accountable for making the investment in NPS reduction.

-   *PS and NPS Contribution*: Both PS and NPS loads must be significant
    and contribute a substantial share of the emissions/pollutants for
    trades to be cost-effective. If either PSs or NPSs contribute
    substantially more pollution relative to the other (for example, one
    source contributes more than 80 percent of the loading), a trading
    program may not be able to achieve water quality or cost-saving
    goals. A trading program, however, could still produce improvements
    in water quality even if short of meeting the standard; this isn't
    an aspect that should be overlooked. In addition, a trading program
    will not work if participant sources are too small or too few.

-   *Transaction Costs:* Methods to reduce transaction costs must be
    identified and implemented. These costs include those of identifying
    potential trading partners, of negotiating a trade, and of having
    government and/or private administration (the costs of information
    collection, of time, and of communication). These costs could negate
    the potential cost savings from making trades between sources that
    have different marginal costs. One solution to reducing transaction
    costs is "piggybacking," or the act of PSs expanding NPS pollution
    control projects that are already being implemented. (EPA, 1996).

-   *Information exchange*: Stakeholders need to share information about
    existing or planned projects with PSs that can then contribute
    additional funding to expand a project's scope. The costs to PSs
    that are associated with trade identification, evaluation,
    implementation, and monitoring are thereby reduced. A private or
    public information exchange system could help provide technical
    information to the trading participants to further reduce
    transaction costs.

-   *Stakeholder involvement:* The general public needs to be involved
    in the decision process. If the public is included, its concerns can
    be considered and possibly incorporated into the trading program
    rather than being dealt with later through costly lawsuits. Public
    inclusion can provide understanding and confidence in the process
    that will make the issuing of regulatory permits easier and quicker
    by reducing time for planning and administration iterations. Public
    participation can in effect help a trading program become
    cost-effective.

-   *Program Evaluations:* Environmental and economic effectiveness
    should be assessed periodically to ensure that localized violations
    of water quality do not occur.

# Conclusion

This report reviews a general perspective on the suitability of a PS-NPS
trading program. The objective was not to make a case that trading
should be implemented but rather to review the conditions under which
trading could be implemented. The current regulatory strategy is to
focus on the ambient level of pollutants; however, the challenge is to
infer how the actions of specific NPSs are affecting them.
Alternatively, we can assess this uncertainty through statistical and
economic means to provide appropriate regulatory approaches.

The lack of spontaneous trading among dischargers does not mean that a
marketable permit trading system is an inherently inefficient regulatory
approach; rather, its infrequent use is the result of institutional and
informational barriers (Crutchfield and others, 1994). The idea and the
institutional (administrative) and legal structures to support it are
fundamentally quite new and untested. The outlook for a PS-NPS trading
scheme is quite positive if these problems can be resolved. According to
the literature reviewed, the potential for trading can be improved
through technical advances, better monitoring, institutional upgrades,
and better earth science information. Better defining the relationship
between changes in land use and management practices and effluent
discharges can reduce the uncertainty in measuring and monitoring NPS
pollution. Ultimately, a compromise is needed between saving on costs
and having an administratively simple, politically acceptable program.
The literature review and issues discussed will be useful when
evaluating the feasibility of offsets for meeting mercury TMDLs
currently being developed by the USGS Western Geographic Science Center.

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[^1]: Eutrophication occurs when organic matter increases in an aquatic
    environment or in the ecosystems of lakes, reservoirs, and streams
    and causes hypoxic, low dissolved oxygen levels; conditions when
    decaying organic matter on the bottom depletes oxygen and
    replenishment is blocked by stratification. The fluxes of organic
    matter to the bottom are fueled by nutrients carried by river flow
    or from upwelling that stimulates the growth of phytoplankton algae.
    (Source: http://www.nos.noaa.gov/pdflibrary/hypox_iafigs.pdf)