WATER QUALITY TRADING IN THE PRESENCE OF ABATEMENT‐COST SHARING

1. INTRODUCTION The efficacy of incentives contracts for resolving asymmetric information problems is by now well understood. Generally speaking, the principal (or regulator) pays the agent(s) an informational rent in order to procure a desired (typically ex ante) outcome (Laffont and Tirole 1993). In the case of multilateral contracting, for example, a single regulator contracting with two or more agents, the procurement problem extends beyond controlling a single agent's decision problem to designing a game that accounts for the agents' interactions with each other (Bolton and Dewatripont 2005). (1) The problem also extends to symmetric (or common) uncertainty regarding nature and the absence of a unique dominant strategy equilibrium. This paper considers a multilateral contracting problem where (1) the agents have hidden information about their respective production costs, (2) the regulator is endowed with the authority to subsidize the agents' costs, and (3) the agents trade their product in a quantity-constrained market. (2) A good example of this type of game is the idealized control of nonpoint-source (NPS) water pollution in the United States through water quality trading (WQT) in the presence of existing NPS abatement-cost subsidies. We say "idealized" because to date, few successful WQT markets have been established in the United States for watersheds that include predominantly NPSs (Breetz et al. 2004; Environomics 1999; Hoag and Hughes-Popp 1997; King and Kuch 2003; King 2005; Ribaudo 2001). Therefore, to promote WQT among NPSs, it may be that policy instruments such as abatement-cost subsidization need to be used in a complementary fashion with--rather than as substitutes for--WQT. Since the passage of the 1972 and 1977 Federal Water Pollution Control Act Amendments (the Clean Water Act), approximately 34,000 of the United States's water bodies have either remained or become non-compliant with the amendments' standards for drinking water, contact recreation, or aquatic life support (U.S. Environmental Protection Agency [EPA] 2005). The main factor contributing to this noncompliance is "loading" of nutrient- and pesticide-based pollutants from agricultural NPSs, for example, crop and feedlot operations, through natural runoff and leaching processes (EPA 2011b; Freeman 2002). Control of NPS loadings, particularly in agricultural-based watersheds, is therefore a crucial determinant of whether compliance with the Clean Water Act will ultimately be achieved on a broad scale nationwide. WQT is premised on the notion that sources within a given watershed (both point and non-point) face different abatement-cost structures. Assuming these cost differences are divergent enough, and that a given source's abatement level can be estimated with a reasonable amount of certainty, the overall control costs of meeting a given watershed-wide pollution standard can be minimized if sources facing low control costs effectively abate at levels in excess of their respective, required (or regulated) abatement levels and then sell their excess abatement "credits" to high-cost sources in a formal WQT market. To date, however, the involvement of NPSs in WQT has been virtually nonexistent in the United States, even in spite of the potential for the National Resource Conservation Service's (NRCS's) existing best management practice (BMP) subsidy program, known as the Environmental Quality Incentives Program (EQIP), to stimulate an interest in trading by effectively reducing NPS abatement costs and thus engendering cost divergence between NPSs and point sources in a given watershed. (3) This paper characterizes one possible solution to the lack of NPS involvement in WQT in the United States by examining how a regulator might ideally subsidize BMPs. As demonstrated in Sections II and III, our characterization is ideal in the sense that it (1) assumes WQT and abatement-cost subsidization can be used as complementary policy instruments, (2) requires enough information about individual NPS abatement costs within a given watershed to estimate continuous marginal cost functions, and (3) similarly requires enough information about the watershed's topography, soil types, and hydrology to estimate NPS loadings and delivery ratios (or transfer coefficients). …