Review Paper — Economics and Policy of Point-Nonpoint Source Water Pollution Trading Programs

Pollution permit trading is of interest due to its potential to meet pollution control targets at minimum cost without market designers knowing polluters’ abatement costs. This potential has been substantially realized in applications to air emissions but, with a very few exceptions, not to water quality protection. Yet substantial interest in water quality trading remains. We explore the economic literature on water quality trading, focusing on class of trades generating the most interest: trades between point sources and agricultural nonpoint sources, or PS-NPS trading. We describe how NPS pollution processes and institutional environments create unique market design challenges, prompting the development of a specialized literature. The principal challenges stem from NPS emissions being unobservable and stochastic, preventing actual NPS emissions from serving the traditional role of a quantifiable, tradeable property right. Additionally, PS-NPS trading programs generally operate in complex institutional environments that limit the ability to regulate agricultural sources and also include pre-existing environmental policies. We describe that, while the integration of PS and NPS control efforts under PS-NPS markets has the potential to improve the overall efficiency of pollution control, good market design is key to realizing these gains. Well-designed markets will incentivize trades so that cost-reducing abatement reallocations do occur, with these trades either reducing or not substantially increasing environmental risks brought about by NPS uncertainties.