United States
Environmental Protection Agency


   Can Water Quality Trading Advance
      Your Watershed's GoalsP

 Please note that the EPA statutes and regulations described in
    this document contain legally binding requirements. The
recommendations provided in this document do not substitute for
 those statutes or regulations, nor is this document a regulation.
   This guide is strictly voluntary and does not impose legally-
binding requirements on EPA, states, local or tribal governments,
   or members of the public, and may not apply to a particular
     situation based upon the circumstances. Although EPA
  recommends the approaches outlined in this document, state
  and local decision makers are free to adopt approaches that
    differ from this guide.  Interested parties are free to raise
  questions about the appropriateness of the application of this
    guide.  Any EPA decisions regarding a particular matter
  addressed in this guide will be made based on the applicable
                  statutes and regulations.
                      November 2004
            U.S Environmental Protection Agency
                  Office of Water (4503T)
               1200 Pennsylvania Avenue, NW
                  Washington, D.C. 20460
    Additional copies of this document may be ordered from:

     National Service Center for Environmental Publications
                  Phone: 1-800-490-9198

United States
Environmental Protection
 Prepared under EPA
Contract 68-W-02-048
         Can Water Quality Trading Advance
              Your Watershed's GoalsP
                     November 2004

Contributions to this handbook by the following
     individuals are greatly appreciated:

               Brewster Boyd
             Katharine Dowell
             Rob Greenwood
                Lynda Hall
                Barry Korb
             Matthew Mitchell
               Todd Roufs
               Claire Schary

Water quality trading has gained increasing attention as an innovative approach for achieving
water quality goals at lower cost.  Where it is the appropriate tool, water quality trading (WQT) is
a powerful and effective market-based approach to cleaner water. As an innovation unfamiliar to
many watershed managers and stakeholders, however, questions about trading often arise such

       What is water quality trading?
       How does it work?
       How do you know when and where trading is the right tool?
       Will water quality trading work in my watershed?

This handbook is  intended to help you answer the  third  and fourth questions, providing an
analytical framework to assess the  conditions and water quality problem(s) in  a watershed and
determine whether WQT could  be  effectively used to meet the water quality standards. The
framework is illustrated through the  use of example trades in a hypothetical river basin which will
familiarize the reader with the  requisites and potential benefits of specific trading scenarios.  For
this reason the handbook is useful reading for anyone who wants to learn more about WQT and
the  essential functions that a WQT market should deliver.  For a basic introduction to WQT check
EPA's website at www.epa.gov/owow/watershed/trading.html.

Once the assessment  outlined  in  the  handbook is complete, you will be well  positioned to
determine whether WQT is viable in your watershed.  If watershed circumstances are favorable
for WQT, the assessment will  provide you with an understanding of the pollutant reductions that
may (and may not) be traded, the potential trading  parties, possible financial  benefits, and the
range of interested stakeholders.   With this  information, you will be ready to approach other
relevant parties and engage state and local clean water authorities to commence WQT program
design and implementation.

While embarking on a WQT program or any new management approach is not an easy task,  it
can be well worth the effort in the right circumstances. I anticipate that this handbook will help
more watershed stakeholders understand WQT  and its potential uses and benefits as well as
those situations where other management approaches may be a better fit. Finally,  I would like to
acknowledge the EPA staff who worked to develop this document, especially those from  Region
10 who published in July 2003 the precursor to this national handbook.
Diane C. Regas, Director
Office of Wetlands, Oceans and Watersheds
U.S. Environmental Protection Agency
                           Water Quality Trading Assessment Handbook

Note: The information in this handbook focuses on conducting an analysis to determine whether
watershed scale trading is likely to be viable in a particular watershed once environmental and
economic factors are considered.  The handbook material assumes some  familiarity with water
quality trading and the mechanisms by which trading is implemented.

Those seeking  a basic introduction to water quality trading are encouraged to check the EPA
website  www.epa.gov/owow/watershed/trading.htm  including the  Frequently Asked Questions
and 2003 Water Quality Trading Policy.  Examples  of trading projects can  also be found at the
                           Water Quality Trading

I.   Introduction	1

II.   Pollutant Suitability	5
    Purpose	5
    Approach	5
    The Six Step Pollutant Suitability Analysis	6
     STEP ONE:  Create a Watershed Loadings Profile	7
     STEP TWO:  Identify Type/Form of Pollutant Discharged by Sources	12
     STEP THREE: Assess Water Quality Equivalence of Pollutant Reductions
     at Different Discharge Points	15
     STEP FOUR: Determine the Potential for Aligning the Timing of Load
     Reductions and Regulatory Timeframes Among Dischargers	19
     STEP FIVE:  Determine if the Supply of and Demand for Pollutant
     Reduction Credits Is Reasonably Aligned Within the  Watershed	22
     STEP SIX: Review the Results of Steps One Through Five to Complete the Pollutant
     Suitability Determination	24

III.  Financial Attractiveness	27
    Purpose	27
    Approach	27
    What Makes Water Quality Trading Financially Attractive?	28
     STAGE 1: Calculating Incremental Cost of Control for One or More Key Point Sources ....29
     STAGE 2: Examine Other Data	36
     STAGE 3: Analyze the Results	38

IV.  Market Infrastructure	49
    Purpose	49
    Approach	49
    Considerations: Market Sizing	50
    What Is Driving the Market?	51
    What Are the Essential Functions of a Water Quality Trading Market?	52
     1. Assuring Compliance with Clean Water Act and State/Local Requirements	52
     2. Defining and Executing the Trading  Process	53
     3. Defining Marketable Reductions	54
     4. Ensuring Water Quality Equivalence of Trades and Avoiding Hotspots	55
     5. Communicating Among Buyers and  Sellers	55
     6. Tracking Trades	56
     7. Managing Transaction Risk Among  Parties to a Trade	57
     8. Providing Information to the Public	57
    Current Market Models	58
     A Private, Non-profit Co-operative Facilitating Pre-Approved, "Dynamic" Trading	59
     A Public Authority Banking and Managing Phosphorus Credits with
     Case-By-Case Approval of Credit Use	63
     A State-Managed Nitrogen Credit Exchange	67
    Summary	72

V.  Stakeholder Readiness	73
    Purpose	73
    Approach	73
     Identifying Potential Participants	74
     Engaging Essential Participants	77
     Positive Features of Water Quality Trading	77
     Frequently Raised Issues About Trading	78
     Stakeholder Participation in Market Infrastructure	80
    Conclusion	82

Glossary	83

Appendix A	85
    Water Quality Trading Suitability Profile for Phosphorus	85
     Trading Suitability Overview	85
     Key Trading Points	85
Appendix B	89
    Water Quality Trading Suitability Profile for Nitrogen	89
     Trading Suitability Overview	89
     Key Trading Points	90

Appendix C	95
    Water Quality Trading Suitability Profile for Temperature	95
     Trading Suitability Overview	95
     Key Trading Points	96

Appendix D	101
    Water Quality Trading Suitability Profile for Sediments	101
     Trading Suitability Overview	101
     Key Trading Points	102

Appendix E	105
    Capital Cost Annualization Factors	105

Appendix F	107
    Participant Pollutant Management Options Characterization	107

References	109
                           Water Quality Trading
                                      Table of Contents

Water quality trading can be a cost-effective, environmentally sound local solution to improving
water quality.   Generally, water quality trading (WQT) involves a party  facing relatively high
pollutant reduction costs  compensating another party to achieve less costly pollutant reduction
with the same or greater water quality benefit. Water quality trading can be a useful tool for water
quality enhancement in the right circumstances, and some  dischargers will welcome the flexibility
it can provide.

The  United  States  Environmental Protection Agency (EPA) has supported the concept and
implementation of water quality trading for several years. Activities have included the preparation
of the "Draft Framework for Watershed-Based Trading" issued in 1996 and financial support to a
number of watershed-based trading efforts including  those on the Tar-Pamlico River in North
Carolina, in  Long Island Sound and the Chesapeake Bay, and  in the Lower Boise and Snake
Rivers in Idaho.  Several water quality trading markets are currently operating, with others under
development.   Most of these markets  are  focused  on  either  phosphorus or nitrogen-based
trading,  though increasing interest has emerged for trading sediment runoff, biological oxygen
demand, and temperature.

Experience to date with water quality trading indicates  a number of economic, environmental, and
social benefits.  Economic benefits can include:  allowing  dischargers to  take  advantage of
economies of  scale  and  treatment efficiencies  that vary  from source to  source;  reducing  the
overall costs of achieving water quality objectives in  a watershed; and  providing  the means to
manage growth while protecting the environment. Environmental benefits can include: achieving
water quality objectives more quickly;  encouraging  further adoption of pollutant prevention and
innovative technologies; engaging more nonpoint sources  in solving water quality problems; and
providing collateral benefits such as improved habitat and ecosystem  protection.  From a social
standpoint, trading efforts have helped foster productive dialog among watershed stakeholders
and  helped create  incentives  for water quality improvement activity  from a  full  range  of

In January 2003, EPA took a major step to advance water quality trading with the issuance of its
Water Quality  Trading Policy.  The policy further enables  and supports the adoption of market-
based programs for improving  water quality.  The policy acknowledges that  the progress made
towards restoring and maintaining the  chemical, physical,  and biological integrity of the nation's
waters under the 1972 Clean Water Act (CWA)  and its National  Pollutant Discharge Elimination
System  (NPDES) permits has been incomplete.1  When  the policy was issued,  40 percent of
rivers, 45 percent of streams,  and 50 percent of lakes that had been assessed in the United
States failed to support their designated uses.2  Faced with these challenges, stakeholders are
seeking innovative, supplementary ways to achieve federal, state, tribal, and local water quality
goals.  EPA's policy specifically endorses the use of "water quality trading" for certain pollutants
where it can help achieve Clean Water Act goals.
1 Water Quality Trading Policy (EPA, January 2003)
2 Ibid.

This Handbook provides a means for assessing your watershed's potential to take advantage of
this innovative water quality approach.  The Handbook assesses the likely viability of watershed-
scale trading conducted in the context of a Total Maximum Daily Load  (TMDL) or equivalent
framework. The analytical approach  assumes  that  a TMDL  has been completed  and  will
contribute valuable  data on pollutant loadings, the overall pollutant 'cap' or bounding  limit on
trading activity, and  watershed conditions. TMDLs and  similar frameworks function as "pollutant
budgets" for waterways, estimating the total pollutant load that a specific watershed or segment
can  assimilate without  exceeding  water  quality standards.  Water quality  standards  are
established by states at levels that protect the designated use(s) of each water body such as
recreation, fishery, or source of drinking water.

Once established, the TMDL total allowable load is allocated across point sources and nonpoint
sources located in the watershed.  Point source facilities that have NPDES permits may receive
more stringent discharge limits based on a TMDL.  This  can provide the impetus or "driver" for
trading, as sources seek lower cost,  environmentally equivalent pollutant reductions. TMDLs are
the leading, albeit not the only, market drivers for water quality trading markets today.  (It should
be noted that the original TMDL allocation scheme may  influence the degree to which trading can
effectively reduce TMDL implementation costs.)  In some cases, pollutant load reductions made
before a TMDL was  established have been incorporated into a trading marketplace; however, this
Handbook does not address pre-TMDL trading.

To  conduct the WQT assessment outlined in the handbook, key watershed stakeholders and
clean water authorities will need to be engaged. You may also want to consult with specialists in
areas such  as finance or  agricultural  best management practices. The handbook helps you
identify what you need to know, with whom you might consult, and where to find the information
needed to determine whether WQT is right for your watershed. A similar analytical approach has
been used to conduct  screening level  WQT assessments  of several watersheds  with limited
expertise and resources,  taking between one  to  three months to complete. The size and
complexity of your watershed, along with availability of data, will be key factors in how readily you
can conduct a WQT  assessment.

Even if this assessment ultimately indicates that your watershed has limited or no potential for
watershed scale trading, other trading  opportunities may exist.  Markets,  in and of themselves,
can often create opportunities not easily recognized in advance analysis. While the approach in
this  Handbook attempts to screen  for appropriate  watershed  scale markets, the potential for
unexpected benefits in any market argues for, at  minimum, not precluding trading as an option in
your watershed. Moreover, smaller scale trading may  apply in your area.  Options include site
specific offsets (where an individual NPDES permit holder arranges for equivalent control  from an
alternative discharge source)  and intra-plant trades (where an individual NPDES permit holder
trades between its own discharge points).

The viability of trading  in the TMDL context depends on conditions discussed in EPA's Water
Quality Trading Policy, among others. These include: a  market structured within the current  CWA
regulatory framework; voluntary participation and public input; a suitable pollutant; and sufficient
differences in control costs among sources. Experience with trading programs to date provides
insight into the opportunities and challenges trading may present in your watershed.  Success in
watershed scale trading markets will be influenced by several factors, including the:
                           Water Quality Trading          Handbook

        pollutant to be reduced and the physical characteristics of the watershed;
        cost of pollutant control for individual dischargers;
        mechanisms used to facilitate trading; and
        ability and willingness of stakeholders to embrace and participate in trading.

This Handbook will help you assess the environmental, economic, and technical factors that will
influence the ability to  create and sustain a water quality trading market. The purpose of this
Handbook  is  to  help  assess if  water  quality trading is worth  pursuing  in  your  watershed.
Developing a trading program can be an ambitious undertaking with few  short cuts to the  work
that needs  to be done. Water quality trading also has many connections to other programs and
processes,  such as TMDLs and NPDES permits,  likely requiring time and resource commitments
from people in those areas.  Thus, before embarking on the effort to develop a watershed scale
trading program it is helpful to assess whether threshold conditions for trading exist.

During the  assessment, you will focus on each of the individual factors that make trading viable.
As you examine these factors, you  will organize information  into a  comprehensive view of
relevant local  conditions. You will need to obtain  some information from other stakeholders in
your watershed.   Your  efforts will  be simpler if  most  stakeholders  understand  a common
terminology.  This Handbook will  help provide  that common  terminology,  giving  you  a
methodology for organizing critical information into a logical, easy-to-follow  format.

The  first chapter of the  Handbook—Pollutant Suitability—addresses  whether  a  "common" or
"tradeable"  commodity exists that is  important to helping meet  water quality  goals.  Certain
pollutants and watershed conditions are more suitable for trading than  others.  Pilot projects
around  the country have  demonstrated that nutrients  can  be  successfully traded.   Less
information  is available about trading other  pollutants. After  reading  the  Pollutant Suitability
chapter and examining the  pollutant characteristics and watershed conditions, you will be better
able to decide whether to pursue trading.

The second chapter—Financial  Attractiveness—addresses how  to evaluate the economics of a
water quality trading  market through consideration  of the financial viability of potential individual
and  aggregate  trades.   The  financial attractiveness of trading  depends  on whether the
incremental costs of trading  are  less than the incremental costs of control options otherwise
available to an individual. Incremental cost  (essentially a hybrid of marginal and  average cost) is
the average cost of  control for the  increment  of  reduction   required  to meet  compliance
obligations.  Incremental cost represents a good approximation of the upper-bound of a source's
willingness  to  pay others within  the watershed  to alter their discharging behavior. For trading to
be financially  attractive,  the  difference  in  incremental costs  between  dischargers  must,  at  a
minimum, be sufficient to cover trade transaction costs and offset any sense that trading partners
may have of increased  risk of noncompliance.  Assessing the incremental cost ranges associated
with specific transactions provides information on whether trading—in practice—will be financially
attractive to potential market participants.  After reading the Financial Attractiveness chapter,
exploring the example  provided, and employing the tools/methodologies discussed,  you will be
able to make a more  informed decision about whether to pursue trading.

The Market Infrastructure chapter will help you  determine whether the market framework needed
to facilitate  trading can be built.  The analysis  will not provide a specific blueprint for creating  a
market, but will highlight likely market functions and challenges,  and identify ways in which your
watershed  can  benefit from  lessons  learned  in  other  markets.  After reading the  Market
                            Water Quality Trading          Handbook

Infrastructure chapter, exploring the examples provided, and reflecting on the lessons from the
rest of the Handbook, you will better understand the watershed's unique market infrastructure
needs and possible market mechanisms suited for the watershed.

Finally,  the  Stakeholder Readiness  chapter  addresses the level of stakeholder interest and
support needed to  pursue water quality trading.   In  addition  to working  with  environmental
agencies, if you decide to pursue trading, you will need to work with other potential participants
and stakeholders in the watershed.  Stakeholders may need to be  persuaded that time  spent
exploring  trading  opportunities will lead  to worthwhile  alternative approaches. Parties with the
greatest potential to supply  and/or  use pollutant reductions  are  necessary participants.   In
addition  there  should  be  engagement  with  and  opportunities for  input  by non-discharging
stakeholders  including  citizen's groups.  After reading  this chapter,  you should  have a  better
understanding of how to  identify and engage other stakeholders.

The Handbook offers common themes that are important to your assessment  and market creation
efforts.  Among these is the  recognition that  the potential benefits of water quality trading are
accompanied  by  a  variety of real or perceived transaction risks for participants and market
development costs.  Potential trade participants  will face the possibility that, despite their hard
work,  the market they desire will  not emerge.  After  a market emerges and trading begins,
transaction costs will be associated with  information gathering, trade execution, and compliance
efforts.    While  all  water quality  management  approaches  have  associated  costs,  the
attractiveness of water  quality trading markets will be affected  by these cost and  uncertainty
factors.  Lessons learned from other markets as discussed in this Handbook will help you assess
whether costs and risk can be managed  in your watershed to support a viable market that  reaps
the cost-effectiveness and environmental benefits of water quality trading.
                            Water Quality Trading           Handbook


This chapter is intended to help you assess your watershed and associated pollutants for water
quality trading  potential. The first step is to review the pollutant characteristics and the watershed
conditions. Certain pollutants and watershed conditions are more suitable for trading than others.

This chapter considers:

    o  What factors determine a pollutant's  suitability for water quality  trading in  a  particular
       Do the watershed conditions and pollutant characteristics warrant consideration of water
       quality trading in the watershed?

Pilot projects  have demonstrated that nutrients such as  phosphorus  and nitrogen can  be
successfully traded,  i.e.,  cost-effective trades can  reduce overall  pollutant loadings without
creating locally high pollutant concentrations.   Less information is available about trading other
pollutants, although pilot projects have explored reducing sediment loadings, temperature, and
selenium through trading.  The  2003  EPA Water Quality  Trading  Policy specifically supports
nutrient (e.g., total phosphorus and total nitrogen) and sediment trading.  The policy indicates that
other pollutants, such as  metals, will  require more  scrutiny to  ensure  that trading  can lead to
meeting  water quality standards.  The trading  of persistent  bioaccumulative  toxics is  not
encouraged and would be supported by EPA  only under  limited conditions  as part  of a pilot
project. While  this Handbook cannot  provide a clear "yes" or "no" answer in  terms of pollutant
suitability for trading, this chapter should help you determine whether to continue  consideration of
trading based on pollutant and watershed characteristics.

This chapter discusses conditions needed for a  pollutant to serve  as a  commodity that can be
bought  and sold in  a trading  framework established to  meet  water quality goals.  Common
commodities, like wheat, can be traded easily because buyers and sellers understand and can
clearly  compare  the  characteristics of the  product.   For example, with  wheat, all  market
participants have a common understanding of the meaning of a bushel of hard, red winter wheat.
For water quality trading opportunities to exist,  dischargers in a watershed  should establish a
common understanding of the commodity that  is to be  bought and sold.   Establishing  and
adhering to this definition is essential to the integrity and success of a trading program.

The chapter then suggests a process for analyzing the suitability of trading a particular pollutant
in a particular watershed. To enrich your understanding of the conditions that enable trading, the
Handbook employs a hypothetical watershed to illustrate key points and highlight potential trading

What is needed in a given watershed for a pollutant to serve as a
"tradeable commodity" that dischargers can buy and  sell?

A  condition  for water quality trading is  identification  of a pollutant  commodity that  can be
sufficiently controlled,  measured, and traded by  sources (possibly  including  both  point and
nonpoint sources) in the watershed or targeted market area.   The four key trading suitability
factors—Type/Form, Impact, Time, and Quantity—are related to inherent pollutant characteristics,
watershed conditions, and the compliance regime.

        Type/Form: Potential trading partners should not trade "apples and oranges." Generally
        a single pollutant should be identified in a common form.  For example, dischargers could
       trade total phosphorus but might not be able to trade soluble for non-soluble forms of
        phosphorus.   In some  cases, different pollutant types  (e.g., total  phosphorus and
       dissolved oxygen) can be traded using a  defined translation  ratio based on the quantities
        of each that have an equivalent overall effect on  water quality.
       Impact:  There should be an ability to establish water quality equivalence between the
        location where a pollutant  reduction  is made and the location where  that reduction is
        purchased  or  used.  This  ensures  that the water quality impact of trading will be
        equivalent to, or better than, the pollutant  reductions that would have  occurred without
       trading. In addition to ensuring that overall pollutant reduction impacts are  equivalent,
       trades  must not create locally high loadings of pollutants or "hotspots."
        Timing:  Participants should consider and work to align two time dimensions to support a
       trade.  First, purchased reductions should be produced during the same time period that
        a buyer was required to produce  them (e.g.,  during the permit compliance reporting
        period  or during the same  season  when the permit limit was applicable). Second, the
       schedule for achieving pollutant reduction targets should align among trading partners.
        Quantity: Overall supply and demand should be reasonably aligned.  The total amount
        and  increments of excess  pollutant  reductions ("credits") available should  reasonably
        align with the needs of potential purchasers of credits.

For water quality trades to occur,  potential trading partners need to align all four suitability factors.
The Six Step  Pollutant Suitability Analysis
This section will help you examine the four trading suitability factors.  The analysis assumes that
a TMDL has been developed for the watershed and relevant pollutant.  For each factor—Type,
Impact,  Timing, and  Quantity—this  section provides  additional  background information  and
examples in the form of six steps. Each step involves a series of questions to evaluate whether
potential trading partners will be able to establish a tradeable commodity.  To help answer the
questions, the  inherent characteristics of a  number of common pollutants  are  provided.
Appendices A, B, C, and D contain this information. Stakeholders should also consider TMDLs,

TMDL  implementation  plans,  watershed  plans,  NPDES permit  language,  and  other local
assessments and requirements to evaluate specific sources or conditions in your watershed.
The purpose of this step is to characterize the pollutant(s) to be reduced (e.g., as identified in a
TMDL)  in the watershed or defined trading area.  You will use this information  in later steps to
evaluate suitability and, in  the next chapter, the financial  attractiveness of trading.  During this
step, it  will be important to understand the type/form,  location, and quantity of pollutant(s) to  be
reduced from point and nonpoint sources.

One way to display this information is to use a simple  chart, as in Figure 2.1.  You will complete
only certain columns during this step; in subsequent steps you will gather more information to fill
in additional  columns. The example that follows uses this  same format to create a profile for the
sources in a  hypothetical watershed.
                        2.1:           for         a
Name of
Drain, or
Source #1
Source #2
Diversion #1
Return #1
Source #3
River Mile

Form of Pollutant
As Allocated in As
the TMDL Discharged

Discharge Control
(e.g., seasonal, Obligation
cyclical, etc.) (Regulatory)

Current Target Reduction
Load Load Needed
(Ibs./day) (Ibs./day) (Ibs./day)

The Current Load is the  amount of pollutant discharged at the time of the trading suitability
analysis3.  The Target Load is the amount of pollutant loadings  allocated to  each source in the
TMDL.   For point sources, the Target Load will be  reflected as a  wasteload allocation  later
translated into an  NPDES  permit limit.  For nonpoint sources, the Target Load will be reflected as
a load allocation that can later be translated  (e.g., in a watershed plan) into a set of management
practices to achieve the  load allocation. The nonpoint Target Load is  a non-regulatory allocation
 Most TMDLs use Current Load to determine needed reductions.  However, some TMDLs use a Baseline Load, distinct
from the current load and tied to a specific year to allow for pre-TMDL credits. In these cases, some pre-TMDL pollutant
reductions may qualify as tradeable credits. In other circumstances, older pollutant reductions may not be creditable in
the trading framework. Excluding "old" reductions may discourage some trading, but doing so may be critical to ensure an
environmentally sound marketplace. While such practice may be appropriate in  some cases, this Handbook does  not
address pre-TMDL credits.

that would have to be achieved and surpassed  in order to create surplus reductions (credits).
The Total Reduction Needed is the difference between the Current Load and the Target Load.

You may  be able to find sufficient information to complete the chart in the text of a TMDL, in a
TMDL  implementation plan, watershed plan, or from other sources in the local watershed.  For
example,  information about  quantities  discharged by  point sources  is contained in TMDL
analyses and in the relevant NPDES permits (permit numbers are often listed in the TMDL). The
TMDL will typically describe current discharges (or "loads") and the specified wasteload allocation
for each  point  source based  on a calculation of what is required to meet desired instream
concentrations  and achieve water quality standards.   Additional guidance  is provided in  the
following chapter (Financial Attractiveness) about calculating quantities associated with projected
future growth. For  nonpoint sources, TMDLs generally do not provide data about each individual
source, but estimate  quantities  from selected  land  uses or areas,  inflows,  or tributaries.
Additional information about agricultural practices in each area will  be needed to estimate current
loads from individual sources.  State agricultural agencies and extension  agents will often have
helpful information and access to tools for estimating loadings and potential reductions from
management practices.

This  profile offers a coarse initial screen for water quality trading viability. For example, if there
are no  major point sources in the watershed that are required to  reduce pollutant loads, or if only
a small number of widely dispersed sources produce small quantities of the pollutant of concern,
trading may not be viable.  On the other hand, a watershed that includes a  point source with large
reduction obligations and many other closely clustered sources of the same pollutant may present
opportunities for water quality improvements at lower cost through trading.

The questions below will help create a profile of pollutants being discharged into the watershed.
It is important to gather as much of this information as possible  because you will  need it in later
steps to evaluate suitability more specifically with regard to pollutant type/form, impact, time, and

For the selected sources of the pollutant in the watershed:

       What is the geographic location of the discharge (e.g., river mile)?
       What form of the pollutant is discharged (and/or controlled)  by the source?
       What quantity of the pollutant does the source discharge?  If possible, this should include
       current loads and allocated loads from the TMDL, along with any seasonal or other cyclic
       load variability considerations.
                            Water Quality Trading Assessment Handbook

   Overview of Happy River Basin
To demonstrate how you will use the  information gathered to assess trading opportunities,  a
hypothetical watershed, the Happy River Basin, is presented below.

A TMDL for phosphorus has recently been completed for the  main  stem of the Happy River,
providing wasteload allocations  for the permitted point  sources and load allocations  for the
nonpoint sources and tributaries.  The TMDL indicates that the  primary area of concern  is Lake
Content where nuisance aquatic growth and  dissolved  oxygen (DO)  sags result from  nutrient
enriched water slowing and warming.  Nine sources of phosphorus contribute loads to the  basin.

•»   Herb's Farm, a family-owned farm growing a range of crops, is located on  an irrigation
    district controlled return flow.  The farm is  a  nonpoint source agricultural entity that does not
    have federal Clean Water Act regulatory  requirements. However, Herb's  Farm is the only
    source discharging directly into the  irrigation return flow, which  is  assigned a load allocation
    under the  Happy  River TMDL.  While  point sources  will all measure their  phosphorus
    discharge,  Herb's Farm, as a nonpoint source, will have the option of either calculating the
    phosphorus run-off or measuring it where possible and economically feasible.  This would
    enable  Herb's Farm to voluntarily participate in  a trading  market  that might emerge. The
    return flow enters the Happy River at RM (river mile) 570.
•»   Pleasantville POTW (publicly owned treatment works), a municipal wastewater treatment
    plant owned and operated by the City of Pleasantville, discharges  at RM 567. The POTW is
    required to meet a more stringent NPDES  permit limit based on a wasteload allocation in the
-»   Acme Inc., a food processing facility, is located  four miles  up Nirvana Creek, a tributary to
    the  Happy  River  in  an industrial  corridor  cluster.   Production Company,  a microchip
    manufacturing facility, is located on just  the opposite side of Nirvana Creek from Acme.
    Widgets Inc., a widget factory,  is located  next to  Production Company  and  across from
    Acme.  The creek currently meets water quality standards; therefore, these three dischargers
    have not received TMDL wasteload  allocations.  However, the Happy River TMDL provides a
    load  allocation  identifying a  reduction in the phosphorus loads entering Happy River from
    Nirvana Creek. These sources are expected, as part of the TMDL implementation  plan, to
    receive modifications to their NPDES permits to further limit phosphorus discharge. The
    creek's confluence with the Happy River is  at RM  547.
•»   Hopeville POTW,  a municipal wastewater treatment  plant, owned and operated by the City
    of Hopeville, discharges at RM 546. Hopeville is required to meet a more  stringent NPDES
    permit limit based on a wasteload allocation in the TMDL.
•»   AAA Corp., a sugar mill owned and operated by a multinational corporation, discharges at a
    location three miles up Lucky Creek,  a tributary  to Happy River.   AAA Corp. is required to
    meet a more stringent NPDES permit limit  based on a wasteload allocation in the Lucky
    Creek TMDL which was finalized two years ago.  Lucky Creek enters the Happy River at RM
    544 and has been given a load  allocation at its confluence with the  main stem under the
    Happy River TMDL.
•»   Chem Company is a chemical  manufacturing plant and a  major discharger of phosphorus
    with  its discharge located downstream of  Hopeville  at RM 541.  Chem has received  a
    wasteload allocation under the Happy River TMDL.
•»   Easyville Dam, owned by Hydro Power Company, is located downstream, at the end  of Lake
    Content, a fifty-mile long reservoir, which is  the pool  behind Easyville  Dam.  The dam does
    not produce phosphorus; however,  the power company, under the Happy  River TMDL, has
                           Water Quality Trading Assessment Handbook

    received  a  dissolved  oxygen  (DO)  load  allocation.   This load  allocation  reflects  the
    modification  of hydrological conditions by the dam, which contributes to DO related violations
    of water quality standards. The dam does not hold an NPDES permit. Its load allocation will
    be addressed in the context of a state-issued permit.  The Dam sits at RM 535.
->  Laughing Larry's Trout Farm, a privately owned aquaculture facility, is located at River Mile
    530, below the Easyville Dam.  Because the Happy River TMDL did not extend beyond
    Easyville Dam, Laughing Larry's has not received an allocation under the TMDL.

Note: Lake Content represents a typical set of physical characteristics that can lead to a pollutant
sink and water quality concerns.  Other physical features which have similar slow moving water
conditions and/or open  area exposed to warming may have similar water quality problems.  While
lakes,  reservoirs,  and  large  eddies are the primary areas  of concern in  freshwater,  inland
watersheds, bays, or estuaries can exhibit similar characteristics in coastal areas.
  Figure 2.2:  Watershed Loadings Profile with Location, Pollutant Form, and Quantity Information
Name of Discharge Source, Diversion, Agricultural
Drain, or Tributary
Herb's Farm**
Pleasantville POTW
Acme Inc. (Nirvana Creek Confluence)
Production Company (Nirvana Creek Confluence)
Widgets Inc. (Nirvana Creek Confluence)
Hopeville POTW
AAA Corp. (Lucky Creek Confluence)
Chem Company
Laughing Larry's Trout Farm
River Mile
Form of Pollutant
As Allocated in the
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Current Target Reduction
Load* Load* Needed*
(Ibs./day) (Ibs./day) (Ibs./day)
753 527 226
791 633 158
547 410 137
419 415 4
237 215 22
62 50 12
195 166 29
1645 493 1152
*Note: Nirvana Creek and Lucky Creek have received allocations at their confluence with the Happy River. The Current
and Target Loads displayed are for the actual point of discharge to the tributary and are derived from the discharges' water
quality impact at the confluence with the Happy River.
"Note: Herb's Target Load is not a federal regulatory obligation, but a voluntary target derived from the TMDL load
allocation through the TMDL Implementation Plan. As a nonpoint source, Herb's Current load could be either estimated or
measured depending on physical conditions of the site and available data.
                            Water Quality Trading Assessment Handbook

      Figure 2.3:  Schematic Map of Happy River Basin
        Happy River
                                 Agriculture Return (25%)
                                             Diversion (75%
                                                       / .
                                     Hopeville POTW  /  f
    Chem Company
         Easyville Dam
                            Laughing Larry's Trout Farm
           Water Quality Trading Assessment Handbook

The purpose  of Step Two is to help evaluate whether sources are discharging the same type
and/or form of pollutant.  Type/form is the first of the four factors that must be aligned among
dischargers for trading to be viable. Sources must first determine that there is a common type of
pollutant to be traded (e.g., phosphorus, sediments, or temperature). Types of pollutants may or
may not be sufficiently correlated to allow trading. Even if sources are discharging the same type
of pollutant, the  form of  pollutant  as discharged may differ from source to source.  Current
practice requires  that water  quality trading  systems  use an  identified  controllable  pollutant
common to all potential market participants.  This establishes a "common  currency" with which
market participants can evaluate potential trades and enables evaluation of relative water quality
impact of trades.

A.  Determine  if  sources  are discharging  the  same  type/form  of pollutant  as
    identified by the TMDL.

Using the  information developed in Step One, identify the type of pollutant addressed  in the
TMDL, and the various forms discharged by sources.  In some cases a common type of pollutant
will be present in more than one form.   For example, phosphorus loading is often allocated in
TMDLs because  excessive phosphorus  concentrations encourage nuisance aquatic growth  and
reduced dissolved oxygen levels. Often, TMDLs provide allocations for total phosphorus. Total
phosphorus is comprised  of both soluble and non-soluble forms and most sources discharge a
combination of these forms.  As trading opportunities are considered in a  watershed,  it will be
important to understand the actual forms of the pollutant being discharged by sources  to assure
that trades  represent  an equivalent  impact on  water quality.    For example, if  individual
dischargers have load characteristics that vary widely (e.g., one  primarily discharges soluble
phosphorus while another primarily discharges non-soluble sediment-attached phosphorus) then
a trade between the two may or may not have an equivalent impact on water quality depending
on watershed conditions and where the  pollutant  loadings exert an impact. The  following
questions  are intended to help assess whether a  pollutant can  be  treated  as  a  "tradeable
commodity" based on commonality of the form of the pollutant being discharged.

        What is the type and form of pollutant addressed in the TMDL? Does the TMDL provide
        allocations for more than one form of the pollutant?
        Do sources discharge the same form of the pollutant? If not, what form is discharged?
        What are the  impacts of concern for this pollutant and do  impacts vary based on the
        different forms (if any) discharged?
        If impacts vary based on form, would local watershed conditions be likely to exacerbate
        or mitigate the effects  of different pollutant forms?

In answering  these questions,  if you find  that 1)  the TMDL provides  allocations for a  single
pollutant form; and  2) sources  in  a watershed discharge  and measure that same form, or 3)
sources discharge different forms but watershed conditions mitigate the potential for differential

impacts from the two forms (i.e., the impacts of concern do not vary significantly based on form),
you are in a strong position to continue the trading analysis.  If this is the case, proceed to Step
Three, to evaluate the potential for establishing  water quality equivalence among  pollutant
reductions.  If this is not the case, use the set of questions below to consider whether you can
establish translation ratios between different pollutant types or forms.

B.  Determine if there  are opportunities  to  trade between different  forms of the
    same pollutant, or between different types of pollutants.

This section considers circumstances in which  different forms or types of a pollutant might be
involved in a water quality trade. For example, if  the TMDL provides allocations for different forms
(e.g., chemical  compounds) of the same pollutant, you  would need to assess the potential for
establishing  a translation between them.   In some instances, such a translation can  make  it
possible to trade more than one form of pollutant by defining the ratio at which the two forms may
be  exchanged  with  an equivalent effect on water quality.  Without a reliable,  scientifically
defensible translation basis, in certain cases it  may be  impossible  to trade different forms of  a

In some cases, trading can  even occur between  two  different types of  pollutants if there is
sufficient information to establish translation ratios that describe  how they interrelate.  For
example, reductions in upstream nutrient levels can improve downstream dissolved oxygen levels
or biochemical  oxygen demand.   The 2003 EPA Water Quality Trading Policy supports cross-
pollutant trading for oxygen-related pollutants when reliable translation ratios can be established.

The following questions should be answered if  you  are  considering a translation ratio  for more
than one form of the same pollutant, or  for  two different types of pollutants.  Establishing
translation ratios  requires  adequate  data  and analysis, consistent with the TMDL,  about how
pollutants behave under specific watershed conditions.  If it appears  that the data  or analysis
cannot be developed, cross-pollutant trading opportunities will be foreclosed.

        If different forms are being discharged, is there sufficient information to establish  a
       translation basis between those different forms of the pollutant?
        Is the pollutant measured/regulated directly or by using an  indicator of its indirect effects
       on  water quality?   Has  a  basis  for translating  load  limits  to  indirect  effects  been
        Is there an established causal relationship  between this pollutant and others?  Has  a
       translation factor been established between the two pollutants that could apply in this
•* Pollutant Type/Form:  Exploring Potential Trading Opportunities

The  hypothetical  TMDL  and  associated  implementation  plan  provides  total  phosphorus
allocations for dischargers located on the  main stem of the Happy River.  Lucky Creek, where
AAA Corp. discharges, has a phosphorus  TMDL in place  and AAA is subject to a WLA for total
phosphorus.  Figure 2.4 lists the  various forms of phosphorus as discharged by each of these
facilities. The following examples of potential trades illustrate how pollutant form and type play a
role in assessing the viability of trading in a watershed.
                            Water Quality Trading    •* •   ent Handbook

Pleasantville  and  Hopeville  POTWs.  The wastewater  discharges  from Pleasantville  and
Hopeville  contain a  similar  combination  of both  soluble and non-soluble, attached forms of
phosphorus. Because the discharges will be measured using the same form of phosphorus (total
phosphorus) and the actual forms discharged are also very similar, trading opportunities between
these two  sources can exist.

Herb's Farm and Pleasantville. Herb's Farm is the only farm located  on the  irrigation district
drain  flowing into the Happy River at RM 570.  Although the phosphorus entering the river
through this agricultural  drain is likely to be primarily the non-soluble, sediment-attached form,
total phosphorus will be  the form measured to monitor attainment of the  TMDL allocations.  The
discharge  from Pleasantville, which contains a different combination of actual phosphorus forms
than the Herb Farm  drain, will also be measured and reported in units of total phosphorus. Under
certain circumstances this type of trade might raise concerns (particularly for a localized  impact)
because these sources are discharging significantly different  phosphorus  forms.  However, in this
watershed and as  indicated by the TMDL, the primary  area  of water quality concern  is Lake
Content. Over the  mid-to-long term, both  forms of phosphorus will  play  an equivalent role in
nuisance aquatic growth conditions and attendant dissolved oxygen impacts in the lake. Because
of local hydrological conditions in Happy River, specifically cold, swiftly flowing water, there is not
a water quality concern  at or near Pleasantville's discharge point. Therefore additional  soluble
discharge  from Pleasantville will not affect Lake Content or  the intervening river segment more
than the non-soluble form. Thus, trading opportunities between these two  sources can exist.

Hopeville  POTW and Easyville Dam.  Easyville Dam has a  load allocation for dissolved  oxygen
(DO), not  for total  phosphorus (TP).  Phosphorus loading in  the Happy River above the dam
contributes to nuisance  aquatic growth in the  reservoir, which is the  major cause of DO related
water quality  standards violations.   Hopeville POTW  has  a  wasteload  allocation for total
phosphorus.   The  operators of the dam  have expressed  interest  in  substituting upriver TP
reductions for  more direct DO enhancement efforts in  the reservoir (e.g., direct oxygenation) to
meet its allocation.  A clear causal relationship does exist between phosphorus loading and DO
levels, and the TMDL modeling provides a basis for developing a translation ratio to support TP to
DO trading.  If a reliable translation ratio can be established between  the two pollutant types  and
the  two sources, trading opportunities between these two sources can exist. In the absence of
such a translation ratio,  however, Easyville Dam would lack the basis for trading in the Happy
River Basin market.
                           Water Quality Trading Assessment Handbook

                       2,4, Chart of                     Form As
Name of Discharge Source, Diversion, Agricultural Drain, or
Herb's Farm
Pleasantville POTW
Acme Inc. (Nirvana Creek Confluence)
Production Company (Nirvana Creek Confluence)
Widgets Inc. (Nirvana Creek Confluence)
Hopeville POTW
AAA Corp. (Lucky Creek Confluence)
Chem Company
Laughing Larry's Trout Farm
River Mile
Form of Pollutant
As Allocated in the
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
As Discharged
                                   Step 3
The purpose of Step Three is to evaluate the location of potentially tradeable load reductions and
relevant receiving water conditions to determine whether the water quality impact from traded
load reductions is equivalent to reductions that would have been made in the absence of trading.
Water quality impact is the second of the four factors that must be aligned for trading to be viable.
Your  Step  One watershed loadings profile will  give you the  location  of the pollutant loadings.
Participants should be able to establish that the trade would  result  in the same (or better)
environmental improvement in the receiving water if pollutant loadings are reduced in the seller's
discharge rather than in the buyer's.

Two  related   factors  influence  water  quality  equivalence.    First,  the  fate  and  transport
characteristics of a pollutant (e.g.,  how it  behaves in  a river  system) should be considered.
Second,  the  unique  conditions  of the watershed  should  be evaluated.   The  pollutant's
concentration  or presence and  its effects  on water quality may vary greatly as  it moves from
upstream to downstream.  For example, the effects of a pound of phosphorus discharged into a
river can greatly diminish as it travels down  a  river through uptake by aquatic plants, settling out,
and/or water diversion for agricultural or other  uses. This can diminish the environmental value of
a purchased pollutant reduction  as it travels downstream. Purchasers therefore may be required
to buy more total loading  reduction  from other sources than would have  been required at their
own discharge point.

Most trading systems  use  pollutant "equivalence ratios" or similar mechanisms to establish water
quality equivalence  relationships.  In these systems each source or trade transaction is assigned
a ratio to account for the effects  of distance, attenuation, withdrawals, and hydrology between the

seller's and buyer's discharge points or other areas of interest such as a zone of low dissolved
oxygen. The model used to develop the TMDL may be able to provide equivalence information.
In all cases, the equivalence  model and data used should be consistent and/or compatible with
any  model and assumptions used in developing the TMDL.  Where possible,  equivalence ratios
should incorporate monitoring data to help characterize the relationship between sources.

In general, the greater the geographic distance between discharge points, the greater the chance
of pollutant uptake and settlement, and  complex intervening hydrology in the waters between
those  points.  It will generally be more straightforward to establish water quality  equivalence
between sources in close geographic proximity. More distant sources will require more complex
models to capture the  dynamic relationships.  In some cases, the  influence of diversions and
tributaries may be too great to establish reliable impact relationships.
How Ratios Are Used to Establish Water Quality Equivalence

Most trading systems  use equivalence ratios or similar mechanisms to adjust for  fate and transport
characteristics of pollutants and variable watershed conditions.  In these systems each source or trade
transaction is assigned a ratio to account for the effects of uptake, diversions, and other factors on the
pollutant between the seller and buyer's discharge points, or  other points of environmental concern. Ratios
are often based on a source's location along the river, tributary, or agricultural drain  in relation to  other
market participants or a designated instream monitoring area.  They can also be based on other site location
factors that reflect the potential for further diversion and reuse of water below the point of discharge.  Other
site location factors for nonpoint sources include soil type and permeability, slope, vegetation, amount of
rainfall, etc.   Some demonstration programs use separate ratios to account for river location and other site
location factors.  Others use a composite ratio that accounts for all factors.

The example of phosphorus  helps illustrate why  equivalence ratios are needed.  A pound of phosphorus
discharged upstream may not arrive as a pound of phosphorus at a given point downstream. Some may be
diverted as water is withdrawn for agricultural use or other water supply needs. Phosphorus can also drop
out of the water column and be deposited as sediment, transmitted to groundwater through infiltration, or
taken up by plants along  the way.  The ratio reflects the best estimate  of the water quality effect of a
reduction. For example, a 3:1 ratio indicates that for every three pounds of phosphorus reduced by a
discharger, a one pound reduction will be achieved at the critical downstream monitoring point,  e.g., area of
low DO.
Appendices  A,  B,  C,  and D  of  this  Handbook  provide  information  about the  inherent
characteristics of selected pollutants that are relevant to how they may  behave  in receiving
waters.  You will also  need to  collect  information  about relevant conditions  in your  specific
watershed, such as the locations and volumes of major inflows and outflows. If necessary data or
reliable models are lacking, or pollutant fate  and transport characteristics are very complex,
uncertain, or unknown, it may be difficult to establish reliable trading  ratios.
                             Water Quality Trading Assessment Handbook

Avoiding Localized Impacts or "Hotspots"

Some potential trades that could result in a general water quality improvement in a broad area may also
result in  acute  or chronic  localized impacts.   Trades that create  "hot  spots"—localized  areas  with
unacceptably high levels of pollutants—must be avoided. The following factors should be considered.

Characteristics of the Pollutant
    Each pollutant poses different risks to local water quality; trading may have to be avoided for pollutants
    that exert acute effects.
Watershed Conditions
    Areas that  have  no additional assimilative capacity for the relevant pollutant may show  localized
    impacts if loads are increased.
    Areas with low flows and/or a high  capacity for retentiveness  will be more likely to show  localized
    The presence of other pollutants will affect the potential for localized impacts.
Type of Trade
    Downstream trades (i.e., a source compensates a source downstream to overcontrol its discharge)
    have greater potential for localized impacts  because if the buyer's discharge  exceeds its TMDL
    allocation, loads in the stream segment between the sources may become unacceptably high.
    Upstream trades (i.e., a source compensates a source upstream to overcontrol its discharge) present
    lower potential for local  impacts because  overcontrol  by the upstream discharger will  result  in
    improvements to  water quality beyond those  specified in the  TMDL in  the  segment between the
Use of Modeling and Assessment
    Monitoring, modeling, and assessment approaches used to support trading should be able to identify
    the potential for localized impacts so that they can be avoided through program design.

Various approaches exist to avoid unacceptable localized impacts.  One is to use permit limitations to cap
the number of credits  used in an area susceptible to localized impacts. By limiting the amount of credits
used, you can avoid transferring loadings to sensitive parts of the watershed.  Other approaches include
limiting the  direction of trades, e.g., upstream versus downstream, and imposing discharger-specific limits
for pollutant(s) that could cause localized concerns.  Chapter IV contains more information on mechanisms
being used by trading programs to avoid localized impacts.
Answering the following questions will help you assess the potential water quality equivalence
between discharges. Information to help answer these questions can be found in the Watershed
Loadings Profile developed in Step One, in Appendices A, B, C, and D and in relevant TMDLs.

        Where are the discharges of the relevant pollutant?
        Where are the major hydrologic inflows and outflows?
        What are the general fate and transport characteristics of the pollutant?
        How do  river conditions, such as flow  rate and  temperature,  affect the  behavior and
        impact of the pollutants?
        Is there a potential for localized impacts? Under what conditions?
        What options need to be  considered  for establishing  water quality equivalencies for
        different areas of the river?

Water quality trading is one of several tools  available to implement TMDLs.  Trading  requires
understanding the effect of pollutant reductions by sources at different points in the watershed.
Trades that result in localized impacts and fail to meet water quality standards are not acceptable.
                             Water Quality Trading Assessment Handbook

It is possible to use predictive models to  estimate the water quality equivalence of different
discharges, but water quality monitoring will be an essential element in any trading program to
ensure that water quality goals are achieved.
•* Water Quality Equivalence: Exploring Potential Trading Opportunities Between

Appendix A provides information on the general fate and transport characteristics of phosphorus.
With that information in mind, you  are ready to take a closer look at the specific conditions in the
Happy River Basin watershed  to  assess the potential water quality equivalence and trading
opportunities among dischargers.

The following examples of potential trades illustrate how water quality equivalence can play a role
in assessing the viability of trading. You may want to refer to Figure 2.3.

Herb's Farm and Pleasantville
Herb's Farm is the only identifiable source located on an agricultural drain that empties into the
Happy River  at  RM 570.   The  Pleasantville  POTW discharges  nearby,  only  three  miles
downstream. Because of swift flowing water, no other intervening diversions or returns, and little
plant  life between the two  sources, the equivalence ratio  between  the two dischargers is 1:1.
(Trades involving other sources will require calculation of separate ratios.)  Because of the  low
equivalence ratio between Herb's  Farm and Pleasantville, opportunities for water quality trading
among these two dischargers are likely.

Acme Inc., Production Company, and Widgets Inc.
The industrial cluster of Acme, Production Company,  and Widgets  has discharge outflows  within
a one mile distance of each other.  Because of their close proximity,  the  equivalence ratio
between the three dischargers is 1:1.  (Trades involving other sources will require  calculation of
separate ratios.)  Because of the low equivalence ratio within the industrial cluster, opportunities
for water quality trading between these three dischargers are likely.

Pleasantville and Hopeville
The Hopeville  POTW is located 21 miles from the Pleasantville POTW. Between Hopeville and
Pleasantville is one major agricultural diversion, which diverts 75 percent of the river's flow. The
diversion takes with it  much of Pleasantville's phosphorous  discharge resulting in a  5:1 ratio
between Pleasantville and Hopeville. (This diverted load is assumed to not return  to the Happy

There are two  potential options for trading between the wastewater dischargers. One option is an
"upstream trade," in which Pleasantville undertakes phosphorus reductions beyond  its wasteload
allocation to create reduction credits.  In this case, Hopeville could purchase reduction credits
from Pleasantville.  However, because of the  5:1 ratio, Hopeville  would need to purchase five
pounds of reductions  at  Pleasantville to achieve  an equivalent  reduction  of one  pound  of
phosphorus at Hopeville's discharge point.  (This  may or may not be  cost effective for Hopeville.)
Pleasantville would then reduce its phosphorus discharges beyond its wasteload allocation, and
water quality in the 21 mile segment would be improved beyond that specified by the TMDL.

Another option  is a "downstream trade," in which Hopeville reduces its phosphorus  discharge
beyond its TMDL allocations and Pleasantville purchases reduction credits from Hopeville. In this
example, Pleasantville would not directly reduce its discharge and there would be no phosphorus
reduction in the 21 mile segment between the two dischargers. A downstream trade such as this
would satisfy the TMDL only if the water quality impairment addressed by the TMDL occurs in the
river segment below  Hopeville  and  not between  Pleasantville  and Hopeville.   In this case,
Pleasantville's TMDL wasteload allocation was established  to reduce  its  contributions  to
impairments below Hopeville. Except in  similar circumstances,  a downstream  trade in impaired
waters could cause unacceptable localized impacts between dischargers.

Hopeville and Laughing Larry's Trout Farm
Laughing  Larry's  Trout  Farm  is  located downstream  of Lake Content, the  reservoir behind
Easyville Dam.  A reliable location ratio has not been established for the trout farm that would
allow it to trade with any dischargers located  upstream.  The complexity of the river ecosystem
increases significantly in this area of the Basin as  water  flows through the reservoir.  (This
complexity also results in setting the lower boundary of the Happy  River Basin TMDL at Lake
Content.)  The slower moving water promotes aquatic plant growth and higher retentiveness of
phosphorus in this area.  The fate and transport characteristics of phosphorus and the complexity
of the watershed conditions make it difficult to  predict how phosphorus reductions above the dam
will affect water quality  at  locations below the dam.  This  high level of uncertainty will  likely
prevent development of a ratio that would  allow Laughing  Larry's to trade in the Happy River

Note: The complex flow characteristics caused by the  Easyville Dam could also  be representative
of bays or estuaries, where similar flow or hydrological conditions may exist.  In  general, pollutant
sources that are difficult to  hydrologically relate to other sources, or  to the  area of water quality
concern, will not be able to trade to address that impairment.
                                     :i;/7.v    "\x Step 4    •.•  :-;•-,-:;•"„    <•; _  ->,;.;,c
                                     '','••>',::  ,^~;,;v  Timing    /'' • '-:-~.\ V1:._  ,-••-•'  '"• •:;••• r;
Timing is the third factor that must be  in alignment for trading to be viable.  In Step Two, you
considered the variability  among discharges in terms  of the forms of a pollutant or types of
pollutants.  In Step Three, you considered the variability of geographic locations in the watershed.
In this step, you will consider how discharges from different sources vary across time and  the
implications of this variability for the viability of trading.  Three timing  dimensions should be
considered; if all three can be aligned, trading may be viable.

Load variability:  A discharger's load is  likely to vary over time.  You will need to identify only
major load variations that occur over the  course of the  year, not minor fluctuations.  Much load
variability  is  seasonal.   For example,  some  POTWs reduce discharges  substantially  by
substituting land application during summer months. Some agricultural nonpoint sources have

significant reductions of nutrient loadings during the winter months. One important consideration
is whether the allocations in the TMDL are seasonal or annual. Potential trading partners need to
meet TMDL timing considerations and link up with other sources with similar discharge timing.
Because of the effects of temperature and sunlight, for example, winter nutrient loadings have
very different environmental impacts from summer loadings.  In addition, some areas, estuaries in
particular, are more apt to have annual load limits than seasonal limits.

Compliance determination variability:  Because of the different considerations in  establishing
appropriate  NPDES  permit  limits,  temporal specifications  for discharge  monitoring  and
compliance determinations vary among dischargers (e.g., some have monthly limits,  others have
daily limits, and some have both).  To be viable, a trade must be consistent with the time periods
that are used to determine compliance with permit limitations. For example, a point source with a
permit that  requires compliance with  monthly average limitations will be able to trade only with a
discharger who can demonstrate monthly reductions.

Compliance deadline variability: For a viable trade, dischargers' compliance deadlines should
be reasonably  aligned. For example, a potential purchaser may need to  meet pollutant reduction
requirements in 24 months.  It may take twelve months to fund,  install, and fully implement the
pollutant control technology  needed to meet  those requirements. Such  a  potential purchaser
cannot wait 18 months while a potential  reduction  provider verifies its own  obligations, selects its
mitigation option, and calculates any surplus reductions available for purchase. In some cases,
potential market participants may have different compliance deadlines because they are located
in nearby tributaries with  different TMDL  implementation schedules.

Much of the information required  to assess time dimension variability  should be found in the
TMDL and NPDES permit language specific to  each watershed and source. Appendices A, B, C,
and D give an overview of timing considerations typical for each pollutant.

Answering the following  questions will help determine the potential alignment of schedules in
terms of load variability, metrics for  pollutant limits, and  deadlines for compliance or achieving
NPS reductions. If participants are able to reasonably align all three dimensions of time, trading
may be viable.  It is not necessary  for all point sources in the watershed to align  compliance
schedules;  however,  a sufficient number should  be aligned to support one or more  beneficial

        Timing for Load Reductions (compliance determination variability)
        >   Does the TMDL establish seasonal allocations or year-round  reductions?
        >   What units of time are used to define and  monitor compliance with relevant permit
        >   What time period is anticipated for non-permitted sources (e.g., nonpoint sources) to
           achieve and  measure load reductions? (Seasonally, annually?)
        >   Do any sources have significant seasonal or other cyclical load variability?
        Timing for Overall Implementation (compliance deadline variability)
        >   Has a  TMDL  implementation schedule been established?   If so, do  compliance
           schedules among major dischargers reasonably match up?
        >   Are there other compliance deadlines (e.g., pending renewal of NPDES  permit) that
           should be considered?
                           Water Quality Trading          Handbook

-> Timing: Exploring Trading Opportunities Among Dischargers

Trading is most likely to occur when all three aspects of timing can be aligned among potential
trading  partners. The following examples  illustrate issues relating  to  (1) aligned  timing,  (2)
seasonal load  variability, (3) compliance  determination  variability, and  (4) compliance deadline

Acme Inc., Production Company, and Widgets Inc. (aligned timing)
Acme,  Production Company, and  Widgets must participate  in meeting the load  allocation  for
Nirvana Creek. The Happy River Basin  TMDL implementation plan requires Nirvana Creek to
meet its load allocation by 2007, and the three companies expect to receive modifications to their
NPDES permits to  limit phosphorus discharge.  Therefore, all three facilities are subject to  the
same compliance timing. In addition, all three are NPDES permit holders with similar, consistent
loading  throughout the year.   The alignment of both  their  permit and their discharge timing
strongly support trading opportunities.

Pleasantville and Herb's Farm (seasonal load variability)
Pleasantville's  POTW  operates  year-round, with  some  minor variation in the  amount  of
phosphorus in  its discharge. Herb's Farm contributes to phosphorus loading in the  river primarily
during  the growing season.  In the winter when farmland is frozen  over, the farm  contributes
much lower loadings of phosphorus.

If the TMDL identified year-round  load reductions to meet Pleasantville's  wasteload  allocation,
Herb's  Farm would  be unlikely to produce sufficient reductions for the entire relevant time period.
However,  the  Happy River phosphorus TMDL is  typical  of other  phosphorus TMDLs and
establishes only seasonal  allocations which  are  applicable between April and September.
Therefore, opportunities for trading  between these two dischargers can exist.

Hopeville and  Pleasantville (aligned compliance determination)
In  this  example, both Hopeville and Pleasantville are regulated by NPDES permits  with limits
expressed in similar temporal terms (e.g., monthly averages).  These closely matched limits help
support water quality trading opportunities between the utilities.

AAA Corp. (compliance deadline variability)
AAA is located on  Lucky  Creek,  a tributary to the Happy  River.   Lucky Creek has its own
separate TMDL and implementation plan.  AAA was given a wasteload allocation under the Lucky
Creek TMDL.  The  Lucky  Creek and Happy River  TMDL implementation plans have different
compliance deadlines, so there is a potential timing misalignment.  If the TMDL for Lucky Creek
had not yet been completed, AAA might not be motivated to participate in the trading market with
Happy  River dischargers. However, because the Lucky Creek TMDL has been completed, AAA
currently has sufficient knowledge about its requirements. With this knowledge, they may be able
to align the timing of their compliance efforts to participate in trading.
                           Water Quality Trading Assessment Handbook

The watershed loadings profile developed in Step One should include quantities or estimates of
the relevant pollutant discharged by representative sources in the watershed. In this Step, that
information will be analyzed to determine whether supply and demand are reasonably aligned.
For trading to be  viable, the quantity of pollutant reductions that can be supplied must meet or
exceed the quantity of reductions needed to ensure compliance.

Demand  for pollutant reductions is driven by current and future loads (what dischargers  are
currently  discharging or expect to discharge in the future), as compared to target loads identified
in the TMDL. For individual nonpoint sources, these quantities are not normally specified  in the
TMDL and so will  need to be estimated using aggregated nonpoint discharge data from the TMDL
along with  other  information,  such as data developed  by state agricultural agencies and  soil
conservation districts.  The TMDL will provide information  about current and target loads from
inflows and tributaries.   Methodologies  for calculating  current and  target loads  for individual
nonpoint  sources  along  each  inflow and tributary may differ from watershed to watershed and
from state to state. These calculations may have a high degree of uncertainty, but can produce a
valuable rough understanding of the supply and demand dynamics in the watershed.

Supply is dictated by a source's ability to "overcontrol," or reduce its pollutant loadings below the
target load specified by the TMDL (or other appropriate baseline for nonpoint sources).  The
surplus reductions achieved beyond TMDL expectations represent the stock of potential pollutant
reduction credits  available for exchange  with  other parties.   The increments,  or range,  of
reductions demanded and supplied will determine whether a match is possible.  The quantity of
reductions  that may be supplied  is  determined  by the  efficacy  of control techniques and
management methods  available to sources.   These  techniques and methods  include altering
industrial production levels or  land  management  practices, substituting  inputs such as raw
materials and agricultural chemicals, or investing  in  new control technology.

In the next chapter, the  financial feasibility of various  control options is examined as a factor in
projecting supply and demand.  At this stage, answering the following questions will help develop
an initial  understanding of the  supply and demand dynamics in the watershed.  If it appears that
the supply of pollutant reductions can reasonably meet the demand, then trading may be a viable
tool to address water quality  problems.   Although the example does  so, you do not need to
estimate  supply and demand  for each discharger in the watershed in order to gauge whether
overall supply and demand could reasonably align.  You will need to estimate demand from likely
credit buyers in the watershed  (i.e., large  point sources) and a sufficient number of potential credit
sellers to determine whether supply and demand  can meet.

       For each relevant discharger, what are the current/future loads compared to target loads?
       For each source, what is the capacity to provide reductions beyond  the TMDL allocations
       (i.e., do they have the technical capacity to generate pollutant reduction credits)?

•* Supply and Demand: Exploring Trading Opportunities Among Dischargers

It is often difficult to project the balance of supply and demand for pollutant reductions.  In the
Happy River Basin example you have a general idea of the total amount of reductions needed by
all sources to meet TMDL allocations.  In the next chapter on Financial Attractiveness, the
Handbook will examine  how differing  costs of control options may make some sources likely
buyers and others likely sellers.  But even at this stage, some  early supply and demand patterns
begin to emerge.

The following examples illustrate how supply and demand plays a role in assessing the viability of

Herb's Farm and Hopeville (supply and demand in balance)
Under current conditions, Hopeville has  projected that  it will  need to reduce  phosphorus
discharges by 12 pounds per day to meet its Target Load.  (See Figure 2.2, Watershed Loadings
Profile, with total reductions needed  by Happy River dischargers.)  Hopeville may  consider
purchasing  reduction credits from Herb's Farm rather than  investing in  control technology that is
projected to  produce  considerably greater pollutant  reductions  than  it needs.  Herb's  Farm
expects to install management practices with potential to create reductions that would satisfy the
load  allocation and generate sufficient excess reductions to meet Hopeville's  needs even after
application of location  ratios.  Other dischargers in the Basin  also have potential to generate a
sufficient supply of reduction credits to meet Hopeville's demand.

Acme Inc., Production Company, and Widgets Inc. (supply  likely to meet demand)
The TMDL implementation plan assigns load targets to each facility. Acme needs to reduce 137
Ibs./day,  Production Company  projects 4 Ibs./day reduction,  and  Widgets needs to reduce 22
Ibs./day.  All of the facilities are investigating  control technologies that have the potential  for
overcontrol beyond their needed reduction.  Acme projects it would be  able to supply Production
Company and Widgets with the necessary pollutant reduction credits.  And  Production Company
projects that  with its  control technology, they would be able supply Widgets with  the  needed
credits for 22 Ibs./day reductions. Thus it appears that supply and demand can be aligned among
these three companies.

Chem Company (demand outstrips supply)
Chem Industries,  located at River Mile 541, is  a major discharger of phosphorus.   To meet its
TMDL wasteload allocation, Chem will need to  reduce its discharge by 1151 Ibs./day.  Chem is
considering an on-site  option that will meet  its allocation, a  one-size-fits-all control technology.  It
is also considering purchasing reductions from other dischargers in the Basin. Because of limited
technology control options Chem cannot opt to use a less effective, less costly onsite control and
purchase reductions from other dischargers.   Chem must choose trading or on-site  control.
(Note: in practice, 'blended' control strategies comprised of onsite controls and purchasing credits
will often be an option). As Chem considers purchasing reductions from other dischargers, it will
need  to project whether the potential supply of pollutant reduction credits will meet  its demand,
i.e., enable it to fully meet its permit limit based on the TMDL wasteload allocation. Using Figure
2.2, Watershed Loadings Profile, you can calculate that Chem needs five times more reduction
than  any other source; it will be almost impossible for the remaining dischargers in the Basin to
                           Water Quality Trading Assessment Handbook

create a sufficient supply of reduction  credits  to meet Chem's demand.  Chem can see that
trading will not be an option for its compliance plan because the supply of reductions is unlikely to
meet its demand.
                                                                   - •
                                                                          ^  Step 6
                                                                         Jy Results
Before moving  on to the next chapter, review the outcome  of the suitability analysis in the five
steps above.  For trading potential to be high, all four suitability factors will need to align for at
least two market  participants.  Water quality trading will be possible if all four pollutant suitability
factors show medium to high  potential for alignment.  If any one of the four pollutant suitability
factors  (i.e.,  type/form, location, timing, and quantity) show low  potential  for alignment, the
pollutant is probably not suitable for water quality trading in this watershed.  The user may wish to
consider whether other pollutants discharged by sources in the watershed may have potential
trading opportunities.
          Figure 2.5, Complete Watershed Loadings Profile with all pertinent information
Name of Discharge Source, Diversion, Agricultural
Drain, or Tributary
Herb's Farm**
Pleasantville POTW
Acme Inc. (Nirvana Creek Confluence)
Production Company (Nirvana Creek Confluence)
Widgets Inc. (Nirvana Creek Confluence)
Hopeville POTW
AAA Corp. (Lucky Creek Confluence)
Chem Company
Laughing Larry's Trout Farm
River Mile
Form of Pollutant
As Allocated in the
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
As Discharged
cyclical, etc.)
Yea -Round
Yea -Round
Yea -Round
Yea -Round
Yea -Round
Yea -Round
Yea -Round

I otal
Cu rre nt Ta rget R ed uctio n
Load* Load* Needed*
(Ibs./day) (Ibs./day) (Ibs./day)
753 527 226
791 633 158
547 410 137
419 415 4
237 215 22
62 50 12
195 166 29
1645 493 1151
*Note: Nirvana Creek and Lucky Creek have received allocations at their confluene with Happy River. The Current and Target Loads displayed are for the actual point of
discharge to the tributary and are derived from the discharges' water quality impact at the confluence with Happy River.
**Note: As a nonpoint source. Herb's Farm has the option of calculatina or measurina (where possible) the Current Load.
   Outcome of Six Step Suitability Analysis
Of the nine Happy River Basin sources identified  at the beginning of the Six Step Suitability
analysis, seven appear to reasonably meet the suitability factors; while two appear to be unlikely
trading participants because they cannot match a key trading suitability factor with other sources.

Laughing  Larry's is located downstream of the Easyville Dam.  Its  location  involves complex
factors that prevent definition of a reliable relationship with other dischargers to  ensure equivalent
water quality improvements. (Trading Suitability Factor: Water quality equivalence)

Chem  Company  will  require more pollutant reductions  than would  likely be  generated from
sources in the basin when probable trading ratios are taken into consideration.  To meet Chem's
demand for credits, including trading  ratios, a  majority of sources would have to reduce their
loadings to zero.  Thus, Chem's demand outstrips  potential supply.   (Trading Suitability Factor:

In the next chapter, the remaining seven sources will be further examined to assess if trading will
be financially attractive for dischargers in the Happy River Basin.
                            Water Quality Trading Assessment Handbook

Water Quality Trading Assessment Handbook


Financial attractiveness is the second  major consideration in assessing water quality trading
potential in your watershed.  This chapter reviews the financial relationships affecting the viability
of trading.   The  potential economic gains associated with  trading are  influenced by factors
specific to  the  watershed as well as factors external  to the watershed.  Because the relevant
financial relationships are  often nuanced and dynamic,  this section can offer only the foundation
needed to begin examining current financial relationships in the watershed and their sensitivity to
different assumptions. This chapter will help answer the following questions:

        What makes water quality trading financially attractive?
        How can I measure financial attractiveness?
        Where can I find the data?
        What could the analysis mean for my watershed?

In analyzing financial attractiveness it is not necessary to estimate costs for all possible trades in
a watershed. This chapter discusses how to identify "Alpha Trades," those trades with sufficient
economic return to be viable even after water quality ratios are applied. Analyzing these trades
should  provide a good  indication of trading viability in your  watershed;  if the watershed can
support several Alpha Trades, trading  is  likely to be  financially viable. Although this  chapter
discusses  detailed  calculations,  a typical analysis will produce  'ballpark' estimates.   These
estimates should enable you to locate an individual trade's position along a relative continuum of
financial attractiveness from "high" to  "low." After reading this chapter, considering the examples
provided, and employing  the methodologies discussed (or other appropriate approaches), the
watershed  participant should  be able to  screen  out unlikely trading  scenarios  and make an
informed decision as to whether further pursuit of water quality trading is warranted.

This chapter reviews the primary drivers of financial attractiveness and describes the three stages
for  conducting an  analysis to assess those drivers in a specific situation. First, the Handbook
suggests investigating key point sources for which the necessary data are relatively accessible.
The investigation includes building a basic model assessing the sources' current and future costs
for  controlling  the  relevant  pollutant(s).    With  this  basic understanding  of the  financial
considerations for a few key sources, the reader is encouraged to compile data for other sources
in the watershed.   Data collection strategies and  data formatting are considered.  Finally, this
chapter describes  factors  such as  trading ratios  that  influence the  strength  of  financial
attractiveness and  how to incorporate them into an analysis.

              Stage 1:     \   \       Stage 2:        \   \       Stage 3:
        Estimate Key        j    j     Examine         j    j   Analyze the
       Point Source Costs /   /     Other Data       /   /      Results
Certain types of trades will present themselves as relatively straightforward, easy to execute, and
financially beneficial to all parties.  Other potential trades will be more difficult and may not result
in cost savings. For example, two point sources of phosphorus, located a quarter-mile apart, and
facing large differences in their control costs likely will uncover a compelling case for trading. On
the other hand, two  sources at opposite ends of a  complex watershed,  attempting to control
temperature,  and sharing only moderately different control costs are unlikely to obtain  any
advantages from trading. The ability to differentiate scenarios systematically will help watershed
participants use trading wisely as a tool to improve water quality at lower cost. Throughout this
chapter, the Happy River Basin example will be  used to illustrate the analytical process.

The economic models, financial models, and analysis techniques provided in this chapter are, by
design, very basic. They will help you screen your watershed for financial attractiveness at a very
general  level  and  provide you with the basic ability to gauge whether you have low, medium, or
high financial  opportunities for trading.  Pilot projects have indicated that conducting more precise
and in-depth analysis will typically involve a substantially increased level of effort and will quickly
move outside the  realm  of readily available data.  The tools provided  in this chapter  have  been
well tested, do not require sophisticated economic modeling skills to implement, and are sufficient
for basic screening purposes. More precise analysis will typically require in-depth interaction with
individual discharge  sources and  may  encounter  issues  related  to  proprietary  business
information.   As a result, this more  in-depth work will often be  best conducted by  individual
sources in the context of specific trade negotiation activities.
What Makes Water Quality Trading Financially Attractive?

The  financial attractiveness  of water  quality trading  is created by differences in  the  pollutant
control costs faced by individual dischargers.  These differences may make it possible to improve
water quality  at lower cost overall by allowing pollutant dischargers facing high control costs to
pay dischargers with lower cost control options to "overcontrol" their discharges. "Overcontrol" as
used  here means  reducing  a  pollutant discharge  below  the target load specified  by the
watershed's market driver (typically a TMDL). The amount of pollutant control beyond obligations
represents the stock of potential surplus reductions available for exchange with other parties. In
water quality trading, pollutant overcontrol creates a  "product" with  buyers  and sellers in  a
potentially competitive market that can encourage  innovation  and efficiency untapped by a more
traditional approach.

To assess trading viability, a common measure is needed to assess the costs each discharger
will face to comply with its requirements. Chapter One explained the need to identify a tradeable
commodity.  Moving on to calculate the cost of producing the commodity in the form of surplus
pollutant reductions will show whether the relative cost efficiency  of some dischargers' control
options can lead to economically efficient trades.
                           Water Quality Trading Assessment Handbook

Some pilot projects have used "incremental cost of control" as the common measure. Incremental
cost of control is calculated as the average cost of control for the increment of reduction required
for an individual source to achieve the  Target Load.  For example, if a discharger needs a 5
Ibs./day reduction to comply with  its permit, but the only reasonably available technology costs
$10 million and produces a 20 Ibs./day reduction, traditional average cost would divide costs by
20 Ibs./day, but incremental analysis divides the costs by 5 Ibs./day.  Importantly, in this example,
the incremental cost analysis suggests a unit cost four times higher than average cost.
            Stage 1:
        Estimate Key
       Point Source Costs
The first step to assess financial attractiveness is to calculate the incremental cost of control for
one or  more key dischargers.   The first sources  analyzed should be point sources that are
obligated to make significant pollutant reductions thus providing an impetus for trading activity.
These could be sources that are likely to be large buyers or sellers of pollutant reduction credits,
i.e., those that have a significant discharge and/or will need  a substantial level of control to meet
the wasteload allocation. The following data are needed to calculate incremental cost of control:

        The source's current load;
        The source's TMDL (or equivalent) target load;
        The source's  projected  load  on  its required  compliance  date if  no  controls are
        The source's projected future load (considering anticipated growth and other  relevant
        Annualized cost of the control option(s) including capital investment and annual operating
        and maintenance (O&M) costs; and
        Expected reductions achieved by the control option.

Calculating the incremental cost then involves the following tasks.

Task 1: Calculate Required Reductions

A facility's future discharge will be influenced by any changes in demand for the facility's primary
services or products (e.g.,  municipal sewage treatment,  industrial production,  or agricultural
production). For a publicly owned wastewater treatment plant, discharge will likely vary as local
population  increases and/or the number and activity level of industrial users changes. Industrial
sources may discharge more as production rises.  An increase (or decrease) in discharge and
resulting reductions  needed to  maintain compliance will affect needed reductions, incremental
cost of control and, potentially, the financial attractiveness of trading in the watershed.

The  reductions needed  to comply equal  the discharger's target  pollutant wasteload minus its
current  loads  and  any  expected  future  loading  increases.  Both  the projected  load  at  the
compliance date and the projected long-term future load should be calculated. Compliance dates
and  capital budgeting interact with projected changes in future demand to influence discharge
control choices; therefore,  multiple timeframes may require examination.  Currently,  NPDES
permits implement TMDLs for point sources and typically give sources three to five years to meet
their permit  limits.  This  normally gives dischargers a window of opportunity to evaluate their
options, select the best  alternative, and implement it.  In the Happy River Basin  example,  the
NPDES permit holders have five years to comply.

Water  pollutant control  technology  often  represents  a significant,  fixed,  long-term  capital
investment.  If a discharge increases beyond the existing control technology's ability to maintain
compliance during its useful life,  new investments may be required  in the future.  Sources
therefore need to examine the implications of their available options over an extended period.

In the  example,  the point sources project discharge  volumes  in five  years  for  compliance
requirements and in ten years  for capital budgeting needs.  Future discharge levels can  be
difficult to estimate.  For the purposes of analysis, it may be best to create several scenarios with
different  levels of anticipated growth.   Past  pilot projects  have  used a  system  of  "High,"
"Moderate," and "Low" growth trends.  Current pollutant loadings may be estimated to increase at
a constant rate over a specified period to estimate future loads and future required reductions.
•* Hopeville's Required Pollutant Reductions

Projecting Hopeville's Required Reductions
The Hopeville POTW currently discharges, on average, 4.1 million gallons of wastewater per day.
Routine sampling results show that the total phosphorus (TP) concentration in the effluent is 2.99
milligrams/liter.  Converting gallons into liters and milligrams into pounds, the POTWs current TP
load is 62 Ibs./day4. POTW managers believe their system could face demand increases between
1 percent and  8 percent, on  average,  over  10 years.  Hopeville believes  that a  reasonable
assumption is that moderate population and industrial growth will increase  its TP load 3 percent
annually over the next five  years to  72 Ibs./day.  The  TMDL assigns Hopeville a wasteload
allocation,  or  Target Load, of 50  Ibs./day  and this  becomes  an  enforceable compliance
requirement in its permit. Figure 3.1 summarizes needed reductions at today's current discharge,
five years from  now at the time  permit compliance is  required, and  ten years  in the future
assuming 1 percent, 3 percent, and 8 percent annual growth.

As shown in the  table, Hopeville needs to consider a wide range of potential pollutant reductions
to meet its permit obligations under different growth scenarios.  At current discharge levels, the
POTW needs to reduce TP discharge by 12  Ibs./day.   Five  years  from  now, when  failing to
comply has real  economic consequences, Hopeville will need to have reduced its TP discharge
by between 16 and 42  Ibs./day, depending on demand for its services.  Looking further into the
future, Hopeville will need to generate between 19 and 84 Ibs./day of TP reductions to remain in
compliance. For the purposes  of examining financial attractiveness, Hopeville chooses to focus
on reductions needed in five years for compliance and assumes that  it will  experience moderate
411b = 453592.37 milligrams and 1 gallon = 3.79 liters
                           Water Quality Trading Assessment Handbook

growth.  Therefore, the assumption is that Hopeville will be generating 72 Ibs./day of TP and will
have to reduce that discharge by 22 Ibs./day in five years.
                        Figure 3.1, Hopeville POTW Load Projections
Hopeville POTW Load Projections
Current Reduction
Load Annual TP Load Target Load Needed
(Ibs./day) Growth (Ibs./day) (Ibs./day) (Ibs./day)
Current Baseline
0% 62
5 years (Compliance Date)
1 .0% 66
3.0% 72
8.0% 92
10 years (Capital Budgeting)
1 .0% 69
3.0% 83
8.0% 134
Task 2: Examine Control Technology Options

The next task is to examine available technologies' ability to control the pollutant discharge and
the associated costs.  Multiple technologies and mitigation approaches may be available to each
source to address water quality impairments. While the cost and efficacy of control options vary,
more control generally means greater cost.  Moreover, current control technology often achieves
reductions by removing pollutants in large increments. Some control technologies will, therefore,
produce the needed reduction increment and a significant additional increment for little or no
additional cost.  As  control needs increase past the technology's ability to control the pollutant,
the facility may need to invest in more control, often by taking the next "technology step."
•* Hopeville's Control Technology Options

Hopeville's wastewater treatment engineers have identified three technologies that could reduce
phosphorus discharge from their POTW and offer a range of control.

 ;   Step 1: Advanced Primary Treatment (APT) is capable of removing 16 Ibs./day.
 :   Step 2: After an investment in APT, the next "step" is Biological Nutrient Removal (BNR)
    which would remove an additional 22 Ibs./day.
•*   Step 3:  Finally,  additional  aeration basins  and secondary  clarifiers would  eliminate an
    additional 30 Ibs./day for a total phosphorus removal of 68 Ibs./day.
                                Quality Trading

Task 3: Calculate Incremental Reductions Needed for Compliance

When a technology step (or combination of steps) fails  to generate, at a minimum, the total
reduction needed, a source may be forced to consider investment in an additional technology
step, even though this would produce more reductions than are needed. To evaluate its options,
Hopeville generated the following table for its 5-year projection.
                       Figure 3.2, Hopeville's POTW 5-Year Projection
                                Hopeville POTW 5-Year Projection
Low Growth Scenario

TP Load
Potential Surplus
Available to Market
1.0% 66 50 16
Stepl APT 16 16 0 0
Step 2 BNR 22 38 0 22
StepS Clarifiers 30 68 0 50
Moderate Growth Scenario

TP Load
Potential Surplus
Available to Market
3.0% 72 50 22
Stepl APT 16 16 6 0
Step 2 BNR 22 38 0 16
Step 3 Clarifiers 30 68 0 46
High Growth Scenario

TP Load
Potential Surplus
Available to Market
8.0% 92 50 42
Stepl APT 16 16 26 0
Step 2 BNR 22 38 4 0
StepS Clarifiers 30 68 0 26
   Hopeville's Incremental Reductions Needed for Compliance
Under low growth assumptions, Hopeville faces a reduction need of 16 Ibs./day.  As the table
demonstrates, APT generates 16 Ibs./day of reductions, the exact amount of reductions identified
by the TMDL.  If the POTW implemented this control technology, compliance would be reached
and there would  be  no incremental reductions needed.   However, under moderate growth
estimates, the  TMDL would  specify Hopeville to reduce  its  discharge by 22 Ibs./day.  The
difference between the reductions achieved with APT (16 Ibs./day) and the  total  reductions
needed  (22  Ibs./day ) would equal 6 Ibs./day.  These represent  the incremental  reductions
needed for compliance.  Similarly, under high growth assumptions, implementing APT and BNR
                          Water Quality Trading Assessment Handbook

would generate 38 Ibs./day of reductions, while Hopeville would need to reduce its TP discharge
by 42 Ibs./day.  Under these assumptions, the POTW would fall short of compliance and need 4
Ibs./day of incremental reductions. If Hopeville implements the third technology step beyond APT
and BNR, the facility would not require any incremental reductions, even  under the  high growth
scenario, and would in fact have surplus reductions to sell.
Task 4: Calculating Annualized Control Costs

To estimate the anticipated annualized cost of each control option, you will need to  total the
annualized capital cost and the annual O&M cost.

        Annualized  capital  cost is the total cost (including associated finance charges) incurred
        for installing a control option divided by the control option's useful life.
        Annual O&M cost should include but not be  limited to monitoring, inspection, permitting
        fees, waste disposal charges, repair, replacement parts, and administration.

The following worksheet describes the calculations5:
                  Calculation of Annualized Control Costs
       Cost of Installing Control Option                       	(1)
       Time Period of Financing (Expressed as years)         	(n)
       Interest Rate for Financing (Expressed as a decimal)   	(i)
       Annualization Factor*                                	(2)
       Annualized Capital Cost [Calculate (1)x(2)]             	(3)
       Annual Cost of Operation & Maintenance**             	(4)

       Total Annual Cost of Control [(3)+(4)]                	
       * Appendix E contains the Annualization Factor for a range of interest rates
       and time periods.

         For recurring costs that occur less frequently than once a year, pro rate
       the cost over the relevant numbers of years (e.g., for pumps replaced once
       every three years, include one-third of the cost in each year).	
The  appropriate interest rate  will  depend  on the facility's ability to access financing.   Public
treatment works may have access to  grants and revolving funds designated for water  quality
infrastructure improvements.  Currently, the EPA and state funded Clean Water State Revolving
Fund issues loans at rates between 0 percent and market rates, with an average of approximately
5 As previously mentioned, the models and tools in this chapter provide you with general screening capabilities.  In certain
cases, an investment made in control technologies may be phased in over several years.  This potentially affects your
annualized cost calculation.  When analyzing a phased investment, the precision of your analysis will increase by
appropriately modeling each phase of the project and summing the individual results.
                            Water Quality Trading Assessment Handbook

2.5 percent. In some circumstances, certain private entities are also eligible for loans from these
below market funds. Borrowers from the capital markets face interest rates of approximately 6
percent (at the time of publication). Nonpoint sources may also have potential to  reduce the cost
of control through cost-share programs from the Natural Resources Conservation Service, local
soil conservation districts, or other local and federal agencies.
•* Hopeville's Annualized Control Cost

Hopeville is analyzing its Step 1 control costs based  on installing  APT.  The equipment costs
$332,468 to install (1) and will be financed through a municipal bond backed by Hopeville's water
and sewer fees over a 10-year period (n).  Similar bonds issued by comparable municipalities pay
4.5 percent (i).  The Annualization Factor for a 10 year financing period at 4.5 percent is .1264 (2)
(see Appendix E  for Capital Cost Annualization Factors); therefore the  annualized Capital Cost
equals ($332,468) multiplied by (0.1264) or $42,024 per year (3).  The O&M costs for this option
are estimated to total $14,008 (4) annually. Therefore it will cost the POTW$56,032 each year to
control their discharge and maintain compliance by investing in APT.
Task 5: Calculate Incremental Control Cost

The final task is to evaluate the unit cost of pollutant control for each source. While traditional
economic models often evaluate marginal or average cost,  in the case of assessing trading
viability, incremental  cost  represents a better approximation of the upper-bound of a source's
willingness to pay others for pollutant reduction credits. As discussed later in the chapter, other
measures may be useful when assessing the price a source may be willing to accept for credits it
has to sell. As Figure 3.3 illustrates, using  average costs undervalues the true cost of meeting the
incremental reductions because it treats  each additional  pound of reduction as a discrete unit
rather than treating the entire control option as the step function it is.

It should also be noted  that each control  step, once implemented, is a "sunk" cost.  If a source
had previously installed control technology,  those funds are already committed  and do  not
influence the next step decision for pollutant control. For example, if a source implements step 1
control technology and  is  now  looking toward a step 2 option, the incremental cost of control
considers only the cost of the second step of control technology; the previous step cost is "sunk"
and is no longer part of the decision making analysis.

To calculate incremental control cost for each step of pollutant control, divide annualized costs by
the incremental reductions  needed for compliance. This should be done for each relevant time
period (e.g., 5 years and 10  years) under each growth scenario.  Hopeville analyzed its three
options for the POTWand produced the following table for  its five-year projection.

The above analysis would  be repeated for the key point sources, i.e., those likely to be large
credit buyers or sellers, in the watershed.
                            Water Quality Trading    -v   ent

                 Figure 3.3, Hopeville's POTW 5-Year Projection Including Costs

Step 2
Step 3
Low Growth Scenario
TP Load





Needed for
Control Increment
Capital/OSM Incurred
($ annualized)

Control Cost

Average Control
Cost ($/lb./day)


Step 2
Step 3
Medium Growth Scenario
TP Load





Needed for
Control Increment
Capital/OSM Incurred

Control Cost

Average Control
Cost ($/lb./day)


Step 1
Step 2
Step 3
High Growth Scenario
TP Load





Needed for
Control Increment
Capital/OSM Incurred

Control Cost

Average Control
Cost ($/lb./day)

Note: Incremental control cost = annualized cost ($/yr) •*• incremental reduction needed (Ibs./day)
•*• 365 (days/yr).
   Hopeville's Incremental Control Cost
As noted  earlier, Hopeville's "Step  1" control option generates the exact number of reductions
needed for compliance under low growth assumptions.  Therefore, the  incremental control cost
for Step 1 is  equal  to $56,032 (the annualized  cost) divided  by 16 Ibs./day  (the incremental
reduction  needed for compliance  with  no additional  control)  or $9.59/lb./day.6   If the  city
experiences medium growth  over the next  five years, Step 1 will fall 6  Ibs./day short and force
Hopeville to implement both Step 1  and Step 2. The incremental control cost for Step 2 is equal
to $219,022 divided  by 6 Ibs./day (the  incremental reduction  needed for compliance after using
Step 1  control)  or $100.01/lb./day.   However,  Step 1  and Step 2 together would  not produce
compliance  under a  high  growth  scenario.   Consequently,  in  the high growth scenario,  the
incremental control cost would  be  $339,450 divided by 4 Ibs./day (the  incremental reduction
needed for compliance after using Steps 1 and 2 controls) or $232.50/lb./day.
6 Most trading projects have chosen to denominate their costs in dollars/pound/day.  Accordingly, the table divides the
annualized control cost by 16 Ibs. and 365 days. $56,032/16 lbs./365=$9.59.
                            Water Quality Trading

                            • ier
                                         Stage 2:
                                       Other Data
As already discussed,  the goal of water quality trading is to take advantage of differences in
incremental control costs among sources in a watershed by allowing facilities facing higher costs
to compensate those who can produce reductions at lower cost, thereby producing the same (or
more) environmental benefit with  less overall cost to society.  To assess whether more cost-
effective pollutant reductions can be achieved through trading it is not necessary to analyze costs
for every source in the watershed.  It is important to analyze costs for key point sources and,
where  nonpoint  sources reductions  are desirable, for a selected group of typical  nonpoint
sources.   Analyzing  incremental  costs  for selected sources in  a watershed  is an  important
preliminary segmentation of the market into high cost pollutant reducers (likely credit buyers) and
low cost pollutant reducers (likely  credit sellers).  At this time, the main focus of analysis should
be to characterize the size of the incremental control cost differences present in your watershed.
The  differences  in incremental  control costs  may be mitigated by  other financial and market
factors that are discussed in Stage 3. At this time, you are  concerned  only with  identifying  the
range of cost differences present based on  different growth assumptions.

Compiling  Information from Other Sources

The  potential advantages of trading may motivate a variety of actors, both public and private, to
investigate trading opportunities  in the  watershed.  Analyzing trading  potential therefore may
involve compiling information from many sources, including  farms, POTWs, and publicly traded
corporations. These potential market participants may  have  different motivations for discussing
water quality trading.  In addition, incentives to share information with outsiders, like regulators or
environmental groups,  may vary.  Engendering trust and being creative may help in acquiring
needed data.  (For example, Appendix F is a sample data sheet distributed to pollutant sources
participating  in a pilot project. This information was then compiled into spreadsheets used for a
market assessment.) Trust building and  stakeholder engagement is discussed further in Chapter

Public Point Sources

Ability to gather the  needed control  cost  information  for POTWs or other public point source
dischargers  is likely  enhanced by public disclosure and  information laws.  Citizens are  often
entitled to obtain a wealth of information including planning documents and discharge data. Often,
public facilities have required  planning  cycles  for projecting future demands  for service and
preparing  to  cost-effectively manage community  infrastructure  needs.  In  addition, working
directly with the  POTW to  obtain the  pertinent information may  help develop  relationships
beneficial to future trading efforts.

Private Point and Nonpoint Sources

Soliciting information from private sources is more challenging. Creating a water quality trading
market is an  unconventional approach to improving water quality that explicitly depends on the
potential benefits of trading in a given watershed.  In conventional markets, cooperation evolves
during the exchange of goods and services when buyers  indicate their willingness to pay and
sellers exhibit their willingness to accept.   Consequently,  in a traditional market, information
sharing  is  usually  limited  to  negotiating  a  specific transaction.   Analyzing the  financial
attractiveness of watershed scale trading requires sharing information prior to negotiating trades.
The desired information includes potential reduction costs,  which could give competitors  clues
about a facility's future strategic plans.  Wide  dissemination of this information could reduce
competitive advantages currently enjoyed  by the local facility. In addition, detailed information on
cost,  market supply,  and  market demand  for pollutant reductions may allow other market
participants to capture larger shares of trade benefits.  Therefore, both the information required to
develop the watershed trading financial analysis and the results of that analysis may be  perceived
as potentially leading to financial losses. Private entities  may be understandably reluctant to
provide  information considered business sensitive, but the potential benefits of participating  in the
trading market may provide an incentive for information sharing.

Nonpoint Source Cost and Pollutant Reduction Information

In many cases, nonpoint sources have access to information resources pertinent to their likely
costs.   If they  are  unwilling or  unable to share the  information, nonpoint cost and  pollutant
reduction information will  likely have to be pieced together from a  variety of sources.  Some
trading  pilot  projects,  like  Tar-Pamlico in  North  Carolina, have  completed cost studies and
published them on the Internet. Other information sources include state agricultural agencies, the
U.S. Department of Agriculture's Natural Resource Conservation  Service, Agricultural  Research
Service, and cooperative extension programs.

Putting the Information Together

As more dischargers are included in an analysis, complexity increases. The key to organizing the
information is to ensure an "apples to apples" comparison.  As discussed in the previous chapter,
annual and seasonal TMDL allocations are often implemented through NPDES permit  limits with
daily,  weekly, or monthly compliance metrics.  In the example,  the pollutant is  measured  in
pounds  per day. Although translating between any two metrics is possible, you should verify that
the analysis employs a common numerator and denominator for all  sources.  The format used
below to analyze incremental cost of control  in the  example has  been used  in pilot trading
programs. It is always wise, however, to tailor the format for the analysis according to the needs
and skills of watershed participants.
                            Water Quality Trading          Handbook

   A Financial Snapshot of Sources in the Happy River Watershed
Combining the Needed Data
Hopeville and its fellow sources exchanged the needed  information and produced the following
spreadsheet, cataloging  incremental control cost in five years under a moderate growth scenario
for each source. Sources are listed from upriver to downriver and all possible technology steps
for each source are listed.
                   Figure 3.4, Happy River Watershed Combined Analysis

Medium Growth
5 Year Projection
Phosphorus Target Redu
Annual Load Load Nee
Facility Growth (Ibs./day) (Ibs./day) (Ibs./
Herb's Farm 3.0% 873 527
Step 1
Step 2
Incremental Total Incremental Increment
;tion Reduction Reduction Reduction Capital/O&M
Jed Achieved Achieved Needed Incurred
Jay) (Ibs./day) (Ibs./day) (Ibs./day) ($ annualized)
91 91 255 $49,823
623 714 0 $464,014
Control Cost

Pleasantville 3.0% 917 633 284
Stepf 662 662 0 $2,071,893
Step 2 107 769 0 $5,222,364

Acme Inc. 5.0% 698 410 28
8 506 506 0 $6,301,466

Production Company 5.0% 535 415 120
Step 1 46 46 74 $249,499
Step 2 485 531 0 $985,312

Widgets Inc. 5.0% 302 215 87 287 287 0 $1,552,455

Hopeville 3.0% 72 50 22
Step 1 16166 $56,032
Step 2 22 38 0 $219,022
Step 3 30 68 0 $339,450

AAACorp. 7.0% 274 166 108 163 163 0 $589,966

                                     Other Data
  Stage 3:
Analyze the

Task 1:  Identify Potentially Viable Trades

The format used to compile incremental control cost information in Figure 3.4 allows watershed
participants to analyze a one-to-one pollutant reduction purchasing relationship.  The next step is
to identify potentially viable trades.  As demonstrated in the 5-Year Medium  Growth Projection,
the approximate incremental control costs ($/lb.), in descending order, are:

       Hopeville:  $100
       Acme Inc.: $60
       Widgets Inc.: $49
       Production Company: $36
       Pleasantville: $20
       AAACorp.: $15
       Herb's Farm: $5

Because trading allows facilities facing higher reduction costs to compensate those with  lower
reduction costs, sources theoretically would consider trading with any source  below them on the

An important distinction  should be made between evaluating potentially  viable trades and
estimating the price or economic benefits of trades.  The analysis to this point has focused on the
incremental  control cost, which represents the  maximum willingness-to-pay from the buyer's
perspective.  Using this measure is  appropriate when evaluating a watershed for trading potential;
it is not, however, the only perspective.  Once you have identified potentially viable trades, you
may be interested in other measures from the  seller's perspective. Calculations such as average
cost or marginal cost may provide a more realistic indication of the price a credit seller is willing to

For example, a source might choose to use trading as a profit maximizing endeavor, pricing
credits at the maximum that any watershed buyer would be  willing to pay. On the other  hand,
another source might sell  credits at  a price that recovers just some of the cost of generating  them.
The range of possible prices could include anything in between these two extremes.

The implication  of considering the seller's perspective is that the incentive to trade may be even
greater than when only the buyer's incremental cost is considered.  If a seller is willing to price
credits below their incremental control  cost,  the lower price will be even  more attractive to
potential  buyers than the  analysis initially suggested.  For example, if Production Company were
willing to price their credits at $30/lb.  to offset at least some of their control cost of $36.44/lb.,
Acme and Widgets have an even greater financial incentive to trade.

Task 2:  Detailed Analysis

Although the Preliminary Analysis may identify potential trades, assessing financial attractiveness
on this basis alone  requires making several assumptions. (The previous chapter discussed how
unlikely some of these assumptions may be.) For example, one would have to assume that:

       The effectiveness of the control technology selected is not variable;
       Reductions in all locations in the watershed are environmentally equivalent;
                            Water Quality Trading Assessment Handbook

        Transaction costs are zero;
        Reductions are certain to occur; and
        The timing of all reductions will coincide with compliance mandates.

The financial attractiveness of a trade may decline as these and  other complicating factors are
included in the  analysis.  An organized  analysis  is  useful  to add  the  relevant additional
considerations  as  an  overlay  to  the  preliminary  financial   analysis.    These  additional
considerations (discounts, ratios, transaction costs, and  risk) are best investigated in ascending
order of complexity. As each consideration is added to the analysis, stakeholders  can  decide
whether further effort to create a trading  market is warranted.  If the incremental cost differences
become very small, thereby substantially reducing financial attractiveness, watershed participants
may decide that trading  is not viable. If a  reasonable  level of financial attractiveness remains,
additional factors can be  considered.

Incremental Control Cost Adjusted by Uncertainty Discount

Two types  of pollutant  reductions have been  identified  in pilot  projects  and the  literature—
measured  reductions and calculated reductions.   Certain control technologies result in easily
measured  water quality  improvements; ongoing  monitoring  effectively quantifies  the  actual
reductions  achieved.  In  some cases, however, measuring a control option's impact on pollutant
loading is either impractical or very costly. Reductions for these control options may be estimated
based  on   models,  scientific  tools,  or performance  data.  Loading   reductions  from  Best
Management Practices (BMPs) used by nonpoint sources are most likely to be calculated.

BMPs perform differently based on a variety of site specific factors that may not be accounted for
in existing data or models, introducing the chance for variable and unpredictable results.  In pilot
projects, the relatively variable  and  unpredictable performance of nonpoint source BMPs  has
been  handled by discounting the estimated reductions available for trade.  The  uncertainty
discount is intended to ensure that errors in BMP performance estimates will not jeopardize the
water quality equivalence of trades involving these  pollutant control actions.  The  size of the
discount will likely be driven by local conditions with input from stakeholders.  To measure the
uncertainty discount's effect on the financial attractiveness of individual trades, you will need to
recalculate the source's incremental cost of control using  the discounted reductions.
-> Discounting Credits for Uncertainty

Herb's Farm and Pleasantville
Herb's Farm can use its Step 1 and 2 control options—sediment ponds and constructed wetlands
that  are  maintained to treat  phosphorus—to control discharges from its fields and trade the
overcontrol to Pleasantville. Available data show that, on average, these treatment options could
reduce phosphorus loadings  from  the farm  by about 620 Ibs./day.   At  an annualized cost of
$464,014 the incremental control cost for Step 2 is approximately $5/lb./day7.
7 The cost per pound per day is based on the same incremental costs analysis performed for Hopeville. As per Figure
3.4, Herb's Farm Step 1 reduces discharge by 91 Ibs./day. The farm would need an additional increment of 255 Ibs./day
to meet the TMDL allocation, thus enabling reductions beyond this level to qualify as credits. As such, to calculate the
incremental control cost, the annualized cost for Step 2 ($464,014) must be divided by 255 Ibs. by 365 days.
                            Water Quality Trading   -v  ent

However,  reductions by Herb's Farm are likely to vary based on its unique  (and  sometimes
unknown)  characteristics.  It would be impractical to measure the actual  phosphorus reduction
achieved on  a daily basis.  An  alternative is  to apply an  uncertainty discount  factor to  the
projected reductions achieved. A  50 percent uncertainty discount would mean, in effect, that the
farm must produce  2 pounds of pollutant reductions for  every  1  pound it wishes to  sell.
Consequently, from Pleasantville's perspective, the total cost of achieving its needed increment of
control through trading with Herb's Farm will increase because it will need to purchase twice the
number of credits to  achieve  the needed pollutant reduction.  The price per pound of reduction
increases from $5 to $10.  This erodes somewhat the financial attractiveness of a trade between
Herb's Farm and Pleasantville but is still only half as costly for Pleasantville as installing controls
onsite. Also keep  in  mind that Herb's  Farm may be willing to sell credits for less  than  the
incremental control cost (e.g., possibly at average cost or below),  depending on the return on
investment the owner hopes to achieve.  At the same time, the market may support a significantly
higher price depending on  the buyer's willingness to pay.
Incremental Control Cost Adjusted by Water Quality Equivalence Ratios

The  water quality impact  of  a pollutant discharge varies  depending  on  its  location  in  the
watershed.  As discussed in the previous chapter on Pollutant Suitability,  a  discharge's  impact
depends on the pollutant's fate and transport as well as hydrologic conditions in the watershed.
In general, when trading occurs over large areas,  water quality equivalence ratios should be
established to ensure that pollutant reductions traded in any part of the watershed  will have an
equivalent impact on  water quality.  Ratios can be distributed within a market to find the least cost
pathway to achieving the reduction goal.

Pilot projects have used different water quality equivalence ratio methodologies ranging from the
simple to highly complex.  Some have used a simple fixed ratio (i.e., 2:1) for all trades.  Others
have  created an index system based  on  a  mass balance model that  accounts for  inputs,
withdrawals,  and  groundwater infiltration.   In these systems, a compliance point downstream is
used to index the fate and transport of the pollutant from upstream sources.  Dividing Source A's
index by Source B's  index determines the ratio of reductions Source A would have to  buy from
Source B.

Because these ratios can compare water quality equivalence only between two sources at  a time,
it is difficult to present a comprehensive analysis of their effects on the financial attractiveness of
trading for the whole watershed in  a single spreadsheet.  Watersheds with  a large number of
sources  can be  extremely complex.   Ten potential trading sources would involve  54 trade
permutations, many of which are not likely to prove viable.  The goal of your analysis  should be to
identify "Alpha Trades," those with potentially significant financial gains, and therefore  strong
financial attractiveness, even after water quality equivalence ratios are applied.

Potential Alpha Trades that may merit analysis in the Happy River Watershed are:
                            Water Quality Trading Assessment Handbook

        Hopeville compensates Pleasantville
        to overcontrol;
        Hopeville compensates Herb's Farm
        to overcontrol;
        Acme Inc. compensates Production
        Company to overcontrol;
        Widgets Inc. compensates
        Production Company to overcontrol;
        Pleasantville compensates Herb's
        Farm to overcontrol; and
        Pleasantville compensates
        Production Company to overcontrol.

Water quality  equivalence ratios can have a
profound  effect on financial  attractiveness.
As  the  ratio  between  buyer  and  seller
increases,   the   amount   of   purchased
reductions necessary to maintain  compliance
increases,  driving  the  cost  per  unit  of
purchased reduction higher.  Conversely, as
the ratio  between buyer  and  seller  gets
smaller, cost per unit of purchased reduction
falls.    As  illustrated  in  the  Alpha Trade
analysis below,  two  potential trades  that
initially  appeared robust have  no  or modest
value after application of equivalences ratios.
However,  four other potential  trades,  remain
viable.  Based on this analysis  there does
appear  to be trading  potential in the Happy
proceed to begin thinking about market design.
     •, Company
                          Pleasantville POTW
            Widgets Inc.
         ACME Inc.
                           Hopeville POTW
                    AAA Corp.
        Chem Company
                      Laughing Larry's Trout Farm
River Basin,  and watershed participants could
   Alpha Trade Analysis
Hopeville Compensates Pleasantville
Hopeville faces incremental control costs of $100/lb.  Pleasantville's incremental control cost is
$20/lb., while its average control cost is about $9/lb., creating a substantial control cost difference
of between $80/lb. and $91/lb.  Financial attractiveness appears high  assuming the reductions
have an equivalent effect  on water quality.  However, as  a mass balance  model indicates, the
distance  between the two  sources and an  intervening river diversion  between create a water
quality equivalence ratio of 5:1. Therefore, Hopeville must  purchase 5 pounds of reductions  from
Pleasantville  for every 1 pound of its own required reduction.  This significantly erodes the cost
differential  between  the  parties  and  may,  depending  on Pleasantville's  pricing  strategy,
completely erode the financial attractiveness  of trading between these two parties.

Hopeville Compensates Herb's Farm
Herb's Farm has an  incremental control cost of $5/lb.,  creating an incremental  control cost
difference between Hopeville and the farm of $95/lb. However, the river diversion creates a water
quality equivalence  ratio  of 5:1  between the POTW and  the farm.  Therefore, Hopeville must
purchase  5  pounds of reductions from Herb's Farm  for every  1  pound of its own required
reduction. In addition,  remember that Herb's Farm has a 50 percent uncertainty discount.  In this
case, the unit cost to Hopeville of a one pound reduction purchased from the farm, depending on
Herb's pricing strategy, could increase from $5 to  $50 ($5  x 5 x 2).  The difference between
Hopeville's cost of controlling  one  pound  of phosphorus  or purchasing  the water  quality
equivalent from the farm is  $50/lb. ($100 -  $50).  This appears to remain  a highly attractive
potential trade.

Acme Inc., and Widgets Inc. Compensate Production Company
As explored earlier,  largely due  to the proximity of the three companies  in the industrial cluster,
their water quality equivalence ratio to one  another is  1:1.  In  this situation, evaluating trading
scenarios is simply a case of comparing the incremental cost of control for each of the facilities.
As it turns out, Acme is  a 40 year old facility, and control technology would be very costly to
install. Acme faces a $60/lb.  incremental control cost.  The Widgets facility already has relatively
advanced control technology; its next step of control will also be quite expensive, approximately
$49/lb.   Production Company,  however,  is  a  new facility with only basic  control  technology
allowing it to improve at a significantly lower incremental control cost, $36/lb., and average cost of
about $6/lb.   Within  the industrial cluster, the Production  Company has the lowest cost of
pollutant  control and has the  potential to overcontrol significantly and create tradeable reductions
(411   Ibs./day). The difference  between Acme's  unit control cost and  Production  Company's
control cost is, at least, $24/lb.  ($60 - $36).  The difference between Widgets' unit control cost
and Production Company's control cost is at least $13/lb.  ($49  - $36). Both Acme and Widgets
have  a significant  financial  incentive  to purchase  reductions from  Production Company, and
Production Company  may have an opportunity to sell  credits at a price substantially above  its
cost of control.

Pleasantville Compensates Herb's Farm
Pleasantville's downstream proximity to Herb's Farm means every pound of phosphorus the farm
can remove from the river achieves similar environmental benefits than if Pleasantville had made
the pollutant reductions  itself; they have  a  1:1 equivalence ratio.  However, as noted before,
Herb's Farm has an uncertainty discount of 50 percent,  meaning Pleasantville would have to
purchase 2 pounds for every pound of reduction it needs. Therefore, the cost to Pleasantville per
pound of equivalent reduction purchased  (using Herb's incremental control cost) from the farm
would be about $10/lb. ($5x2); half the cost of its own $20/lb. incremental cost of control.

Pleasantville Compensates Production Company
Pleasantville's incremental cost of control to achieve  the necessary reduction is $20/lb., and
Production Company's incremental cost of control for the necessary reduction  is $36/lb.  Initially it
appears that Pleasantville would not  have an incentive to compensate Production Company to
overcontrol.   However, water quality  equivalence ratios in downstream  trades can reverse the
relationship between higher  and lower incremental  control cost sources.  In  the context of this
example, assume Lake  Content is the relevant monitoring  point.  To establish a trading ratio
between  Pleasantville  and Production  Company, both sources use their ratio to the  compliance
point  (Lake Content).  Production Company's ratio to  Lake  Content from the confluence of its
tributary and the mainstem is 2:1;  every 2 pounds of reduction at Production Company results in
                           Water Quality Trading Assessment Handbook

1 pound reduction at Lake Content.  The large diversion downstream of Pleasantville means only
a portion of the discharge from its facilities remain in the mainstem of the river and arrive at Lake
Content.  Pleasantville has a ratio of 6:1; every 6 pounds of reduction at Pleasantville results in 1
pound reduction at Lake Content.  The relationship between these two  ratios  (6:1 - to  - 2:1)
establishes a water quality equivalence ratio of 3:1  between these facilities.   In this case,  for
every 3 pounds of targeted reductions, Pleasantville would need to buy 1 pound of reduction from
Production Company (or 1/3 Ib. for every 1 Ib.).  Using Production Company's $36/lb. incremental
control cost, the cost to Pleasantville could be $12/lb. (1/3  x $36).  Depending on Production
Company's pricing strategy, Pleasantville may or may not be  able to purchase reductions for less
than its own $20/lb. control cost.
Transaction Costs

Transaction costs influence the financial attractiveness of a trade. Transaction costs represent all
the resources  needed  to  implement the  trade, including  information gathering,  negotiation,
execution,  and monitoring.   For a trade to be developed, at least  one party must  expend
resources  (usually  time  and   effort)  assessing  the  potential  viability of  the  trade  and
communicating findings to the other party.  To achieve the necessary "meeting of the  minds,"
discussions with the other  party and additional key stakeholders (i.e.,  regulatory agencies and
local interest groups) must be undertaken. These negotiations may involve staff  time, travel
expenses,  and  legal fees.  Costs are  later  incurred  in  monitoring  compliance with  trade
agreements and maintaining communications with stakeholders.

Transaction costs should be considered in your financial attractiveness analysis.  While traditional
regulatory approaches to water quality have relatively predictable transaction costs, transaction
costs for trading can be  highly variable.  Depending on such factors as the volume of trading, the
program infrastructure  used to  facilitate  trading, and the  number and  types of  participants
involved, transaction  costs  can  be minimal or can be  large enough to diminish the financial
attractiveness of trading.   Regulatory agencies will have significant influence on the  relevant
variables, and  are  therefore key controllers of transaction costs.   Trading  system designers
should be attentive to the transaction costs they design into each trading arrangement. Failure to
adequately  control transaction costs can  diminish  or even eliminate the potential benefits of
trading. Various market mechanisms  can help manage transaction costs, such as watershed
permits and nonpoint source banks.  Chapter IV discusses market infrastructure in greater detail.

Several common tools  can be  used  to estimate transaction costs.   For example, Full  Time
Equivalents (FTEs) can be  used to represent the salary and personnel overhead expenses of
employees typically performing functions related to the trading market.  In  addition to assessing
and negotiating a trade,  employees will need to  meet monitoring and reporting obligations related
to the trade. All these transaction costs of trading,  along  with the annualized capital and  O&M
cost for each control technology  step, increase  incremental control cost. To the extent that you
are able to include these in your annualized costs, the precision  of your incremental control  costs
estimates will increase.
                            Water Quality Trading Assessment Handbook

Market and Trade Risk

Risk is the final factor to consider in assessing the financial attractiveness of a trade.  The first
consideration is that efforts to create a trading system may or may not result in  an approved
trade.  As already discussed, designing a water quality trading program can be  complex and
involve substantial costs. During initial design and negotiation, watershed participants are likely to
reassess the chances of success continuously and will discount  the value of a potential trade
accordingly. For a trade to  be viable, potential participants must believe that the financial benefits
of the trade will be  large enough  to  justify  bearing  the  market risk.  The timeliness and
predictability of the decision processes prior to the first trade are therefore key leverage points to
mitigate market risk and  facilitate trading.

The other dimension of risk is trade risk.  In a water quality trading market, one party must rely on
another party(s) to fulfill its  obligations.  Agreed  upon terms  of a trade may or may not be
performed  by the parties.   If agreed upon  reductions are  not achieved  and NPDES  permit
requirements are thereby violated, the purchaser of those reductions may face legal enforcement
and  monetary penalties.   In the context of water  quality trading, trade risk represents the
expected  cost of non-compliance and the perceived  probability that such non-compliance will
occur.  Currently  no entity  provides third-party  insurance policies for water quality trading.  As
long as they must self-insure, watershed participants will value trade risk subjectively and mitigate
for it by  discounting the price paid  for available reductions.

The  subjective valuation of trade risk limits your  ability to  estimate the trade  risk markdowns
watershed  participants are  likely  to  demand when negotiating a trade.  At this  point in your
analysis, it may prove beneficial  to discuss trade  risk and the associated discounts with other
watershed participants.  Risk markdowns may be considerable in light of the large noncompliance
penalties authorized by the  Clean  Water Act and the uncertainties surrounding trade risk.

As you  begin to examine trading  risk and transaction  costs, you  may wish to review the likely
incremental cost differences between parties after uncertainty discounts and  location ratios are
considered.  If a  substantial difference  remains,  it is likely that risk and transaction costs will
erode only a portion of the  remaining financial attractiveness of a trade.  If uncertainty discounts
and location ratios have already significantly eroded the difference in incremental control costs,
the remaining financial attractiveness may well be entirely consumed by transaction costs, market
risk, and the buyer's trade risk markdown.

Implications of Transaction Costs, Risk, and Market Design

Transaction costs and risk can be mitigated to some extent through thoughtful market design.
Chapter IV more fully describes  the building blocks and key functions of a  market and offers
suggestions on  how to tailor a market to  its  watershed's unique  characteristics.   Many
stakeholders  may be  involved, each with  different needs. A highly constructive stakeholder will
focus on designing a  market that  ensures accountability and equivalent (or better) water quality
results while reducing market risk and lowering transaction  costs.  Transaction costs are largely
associated with  collecting  and  communicating  information  and  obtaining agreements  and
regulatory  approvals.   To the extent  that  trading  arrangements  are  transparent  and
straightforward to execute, costs  and risks associated with communication  and understanding
can  be reduced.   Similarly, transparency  and  the  free  flow  of information  create  stable
                            Water Quality Trading          Handbook

expectations and outcomes for market participants. With fewer lurking "unknowns", participants
will feel less vulnerable in the marketplace and their required risk discount may shrink.

Other Important Factors

As you  can  see, the financial attractiveness of water quality trading may  be highly influenced by
the considerations already addressed. Other factors  may  arise in your watershed based on its
unique characteristics.  The following are just two examples  of watershed-specific considerations.

Market Size

Because pollutant control technologies often produce reductions in  large blocks, the water quality
trading marketplace may be "lumpy." Depending on how much reduction a potential buyer needs
relative to what technology can deliver, this can limit or enhance financial attractiveness.  If a
discharger needs one pound  per day of reductions to comply, but its only available onsite control
technology is very expensive and will produce reductions well  in excess of one pound per day,
then that discharger's willingness to pay  another party for that  one pound of reduction could be
very strong.  On the other hand, if the same discharger needs 200  Ibs./day, they will only be
willing to purchase  reductions if the entire 200 pound reduction is reliably available. If that  200
pound reduction is  available  only from diffuse sources  with small  individual surplus reductions,
the associated transaction costs and trade risks may be so significant that trading is not viable.

Missing the Market

The  ratio of fixed (capital) to variable (e.g., operations and maintenance) costs associated with
control options, combined with the timing of pollutant reduction demand and supply, will affect the
financial attractiveness of a trade.  If the discharger's  control option involves relatively high fixed
costs, the incremental costs of control will differ dramatically  before and  after investment in  that
control option. Before investment, a potential reduction  purchaser will calculate the incremental
cost of control as the combination of the amortized fixed and the annual variable costs of control.
Once the discharger invests in high fixed-cost controls,  those fixed costs are "sunk," and he will
calculate the incremental cost of control based only on his annual variable costs.  As a result, any
trades that  were financially  attractive before  the investment will have a greatly  diminished
incremental  cost differential after the investment and may actually  represent a  negative financial

It is especially important to consider the fixed/variable cost  profile in cases where supply will lag
behind demand.  In such  situations, the  potential purchaser of pollutant reductions will need to
comply (i.e., meet demand) by creating  its own  reductions, at least  initially.  If this discharger
needs a high fixed cost  control strategy to create  these reductions, the financial attractiveness of
any  potential future trade will be altered, probably diminished.  In effect, the  parties will have
missed the market unless  potential suppliers of pollutant reductions have low incremental control
costs that can  compete with the discharger's lowered  incremental control costs after its large
fixed cost investment.  In some cases, a discharger can use a high variable cost control strategy
to create the reductions needed initially without incurring large fixed  costs.  In such cases, the
discharger may still find it financially attractive to purchase reductions from another party in order
to avoid continued implementation of its short-term, variable-cost control strategy (or in order to
create additional margins for growth).
                            Water Quality Trading          Handbook

Alternative Scenarios

In light of the  various  factors influencing financial attractiveness and market participation,  a
watershed participant would be wise to assess the financial outcomes of trading under alternative
assumptions.  This is  especially important  relative to the two factors that are likely to exhibit
variability due to quantification difficulties and/or subjectivity—transaction  costs  and perceived
risk.  Spreadsheet programs allow for  easy scenario playing,  including:  removing individual
participants from the market; changing water quality equivalence  ratios; or projecting alternative
TMDL allocation. Examining alternative scenarios may reveal, for example, that  a large source
unable to garner all reductions it needs from other watershed participants may decide to invest in
controls  and thereby eliminate almost all  of  the demand in the watershed,  rendering  trading
unlikely due to insignificant remaining demand. You may discover other factors that could erode
control cost differences beyond the level at which trading remains financially attractive.

On the other hand, if after accounting for credit discounts and initial consideration of transaction
costs there remain multiple buyers and  sellers  with  robust cost differences,  you can be fairly
confident that your watershed has met the  threshold conditions for trading. The understanding
gained from the  analysis undertaken so far will inform your consideration of market infrastructure
and how different program designs might work in  your watershed.
                            Water Quality Trading          Handbook

Water Quality Trading Assessment Handbook


The  previous chapters of this Handbook addressed the viability of trading  based on pollutant
suitability, watershed  and discharger  characteristics, and  the  financial attractiveness  of likely
trades.  This chapter  considers the infrastructure required  to enable trading.  This chapter will
help answer the following questions:

       What functions must a water quality trading market perform?
       Why is each function important to the success of water quality trading?
       What mechanisms have been  used to perform these functions in demonstration trading
       What are  the  considerations in selecting appropriate mechanisms and integrating them
       into a market?

After reading this  chapter, considering the examples provided, and reflecting on what you have
learned in the previous  chapters,  you will better understand  the watershed's unique  market
infrastructure needs, market mechanisms best suited  for the watershed, and the commitment that
may be needed to create a market.  This  Handbook does not provide a specific blueprint  for
creating a market, but does highlight features of different market  designs that you will want to
consider as you proceed. With this information you will be  better able to tailor a market to your
watershed's  unique needs.

All viable markets, whether trading water pollutant reductions or widgets, must efficiently create
benefits for its participants.  "Markets" are social constructs facilitating interactions among parties
interested in exchanging goods or services.  Research indicates that successful markets evolve
to reduce costs associated with:

        identifying others willing to purchase or supply goods or services;
        comparing the goods or services offered by other parties;
        negotiating the terms of an exchange of goods and services; and
        enforcing the terms of the exchange.

A market is more likely to be successful if it has rules, procedures, and  norms allowing parties to
participate at a cost acceptable to everyone involved. Viable water quality trading (WQT) markets
are no  different from conventional  markets  in this  regard.   However, WQT  markets are
unconventional in the sense that they  exchange goods (pollutant loading reductions) that are
created  primarily by  (i.e.,  have value  because of) regulatory obligations by at  least  some
participants. As  such, WQT  markets  may require different and/or  additional infrastructure to
ensure  practical  enforceability, water quality equivalence, avoidance of localized impacts, and
sufficient progress towards water quality goals.   In WQT the "products" exchanged  have an

essential purpose in meeting CWA goals that serve the public good. The challenge is to design a
market that  meets these essential needs in a way that is cost-efficient and minimizes program

Market development and transaction costs, as well as risks associated with various uncertainties,
play an ongoing role in encouraging or suppressing market activity.  These considerations, which
collectively represent  the degree of "friction" individual transactions face in the marketplace,
should remain central  to all infrastructure design decisions. Failure to manage  market friction
effectively will substantially constrain and may entirely stifle otherwise environmentally equivalent
and financially attractive trades.

As discussed in the previous chapter, potential WQT market participants may be challenged by a
variety of market development costs, including those associated with  analyzing the viability of
trading in the watershed, developing and selecting options for market infrastructure, convening
interested parties to discuss trading  perspectives and options, and creating the  infrastructure.
Market development uncertainty—the risk that a market may not emerge—compounds these

In addition to market development costs, transaction costs include information gathering, trade
execution, and  any additional  monitoring undertaken as part  of  the trading  program. These
transaction costs will be driven largely by the procedures, trade execution  methods, and tracking
infrastructure established in the watershed.   Transaction uncertainty due, for example, to an
unclear basis or time-frame for regulatory approvals will compound these costs.  A market that
needs trade-by-trade  regulatory approval, for example,  will be relatively costly  and uncertain.
There will be a  constant risk  that any particular trade  will not materialize or will  not receive
regulatory approval in  time to  satisfy  a source's capital budgeting and/or compliance deadline

WQT markets are  intended to  meet water quality goals at a lower societal cost.  The choice of
trading program  infrastructure  will substantially  impact the costs associated with implementing
trading.  High market  development  costs  and uncertainty  combined  with   high  transaction
costs/uncertainty  produce substantial overall market  "friction."  High  market friction will  limit
activity to only very, very financially attractive trades. Therefore, the infrastructure designer's goal
is to create  the smoothest transaction path consistent with regulatory  requirements and water
quality improvement goals.

This chapter of the Handbook suggests ways to manage  market and  regulatory imperatives to
encourage efficiency and increase the likelihood that trading will occur.  To this end, three WQT
models will be discussed based on how each model performs particular functions.  Building on
the  information and analysis you developed  in the previous chapters, this additional information
will  help you design an appropriate market infrastructure to perform the essential functions in your
watershed. No particular approach is  prescribed, but this  chapter  offers  options and criteria to
evaluate  them.
Considerations:  Market Sizing

This section is  intended to help you  find ways to  substantially reduce  market friction  by
appropriately sizing market infrastructure to your watershed's unique trading characteristics. The
                            Water Quality Trading          Handbook

chapters on Pollutant Suitability and Financial Attractiveness are intended to help you develop a
solid understanding of where your watershed might be positioned along the water quality trading
spectrum.  At one end of the spectrum  is a watershed with a  single viable trade between two
point sources who  will experience modest financial  benefits and  are expected to  sustain the
trading relationship  for the foreseeable future.  At the other end of the spectrum is a watershed
with a  potentially large number of viable trades among both  point and nonpoint sources.  This
potentially large  number of trades would involve numerous transactions among diverse  parties,
potentially saving millions of dollars.

For the watershed with only one viable trade, an overly large market infrastructure consisting of a
web-based trading platform linked to state agency permit databases would  be unnecessary and
so expensive that,  if it were required, would likely make the trade unattractive.  On the  other
hand,  if  participants in  the large, dynamic market didn't have sufficient market access and
infrastructure support and  were required  to manually  record  trades and  revise  their NPDES
permits to reflect each individual trade, the costs and uncertainty in the market would diminish or
eliminate the value of trading to many if not all of them.  In practice, the geographic size and
number of point  sources  in a watershed will be a  strong consideration to determine the market
infrastructure.  The following information  and  examples illustrate  ways to tailor your market
infrastructure and associated  "overhead" costs  to the potential  size  of the  market  in  your
What Is Driving the Market?

All markets evolve to  help fulfill the demands of consumers.  Consumers provide producers an
opportunity to earn a  profit for altering their behavior and attending to the market's constantly
changing demands for goods and services.  Until a consumer decides they "need" a soda, and is
willing to pay someone to produce it, there is no market for sodas.

Total Maximum Daily Loads (TMDLs) are the leading  market drivers for WQT markets today
because they typically create  the  "need" to  alter  behavior  by identifying pollutant reductions
needed to  meet water  quality  standards.  TMDLs  and  similar frameworks  are sometimes
described as "budgets" for the introduction of pollutants into watersheds.  Scientific  studies
estimate the pollutant loading that a specific watershed or segment can assimilate  without
exceeding the water quality standards enacted to protect the watershed's designated  beneficial
use(s).   This "pollutant  budget"  is then allocated  across  point sources through wasteload
allocations and nonpoint sources through  load allocations and incorporates a federally mandated
"margin of safety." TMDL wasteload allocations for point sources are reflected in NPDES permit
limits that often will require greater levels of pollutant control.  For nonpoint sources, the TMDL
load allocation  is not translated into  a  binding requirement. However, WQT  can provide an
incentive for nonpoint  sources to reduce their pollutant loadings by providing financial incentives
(i.e., ability to sell pollutant reduction credits) for controlling pollutant loadings beyond the TMDL
load allocation.

EPA's  2003  Water Quality Trading  Policy supports  trading to meet TMDLs (or similar analytical
framework)  for  certain  pollutants. The  policy  also supports  pre-TMDL trading  in  certain
circumstances and trading to maintain existing high water quality.  This chapter assumes that
                           Water Quality Trading          Handbook

your watershed has a  TMDL,  or similar framework, driving your interest  in creating a WQT
What Are the Essential Functions of a Water Quality Trading

Based on a review of the academic literature and the water quality trading projects conducted to
date, a WQT market has at least  eight essential functions. Various mechanisms can perform
these functions.   Market mechanisms  are  limited  only  by  participants'  creativity, regulatory
imperatives, and the characteristics of the watershed.  In some cases, specific mechanisms may
perform more than one function, potentially increasing market efficiency.  It is important to note
that these market functions do not cover all essential activities involved  in implementation of
trading such as soliciting public input,  crafting NPDES permits that incorporate trading,  and
assessing  progress  towards  water quality standards as  would be done with any watershed
management approach. The functions do encompass essential functions central to market-based
approaches for water quality management.

The eight essential functions are:

1.  Assuring compliance with the Clean Water Act and relevant state and local requirements;
2.  Defining and executing the trading process;
3.  Defining marketable reductions;
4.  Ensuring water quality equivalence of trades and avoiding hotspots;
5.  Communicating among buyers and sellers;
6.  Tracking trades;
7.  Managing risk among parties to trades; and
8.  Providing information to the public and other stakeholders.

The following discussions review briefly why these functions may be necessary for conventional
markets and why they are essential for WQT.  How well a mechanism may perform its function is
discussed in light of market friction.
Conventional Market  Function—In some conventional  markets,  buyers  and  sellers  have
regulatory obligations to entities outside the transaction. These obligations derive from a variety
of public policy goals including protecting the parties directly involved in the trade and/or those
with an indirect interest in the transaction's outcome. For example, the Securities and Exchange
Commission  requires publicly traded  companies to  conduct third-party audits  of financial
statements and report specific information annually to the public. This reduces the opportunity to
commit fraud and lowers investors' market risk.

Regulatory Obligations in WQT Markets—WQT processes must  involve various watershed
participants, including important non-discharging stakeholders like regulatory agencies. EPA's

Water Quality Trading Policy states that trading programs must be developed in the context of
regulatory  and  enforcement mechanisms, which  predominantly  rely  on  NPDES discharge
permits.  Thus, the market, federal, state and local regulations, and the agencies responsible for
their enforcement are closely  connected.   EPA's Water Quality Trading Policy says  that
"mechanisms for determining and ensuring compliance are essential for all trades  and trading
programs... States and tribes should establish clear, enforceable mechanisms consistent  with
NPDES regulations that ensure legal accountability for the  generation of (pollutant reductions)
that are traded."  The appropriate regulatory agency(s) therefore will need a process to authorize,
evaluate, permit, verify, and evaluate trading programs or even individual trades.  Demonstration
projects have performed this function in a variety of ways.

A  good  regulatory  compliance assurance mechanism minimizes the  transaction costs  and
transaction uncertainties associated with any potential  trade by achieving consistent approval
decisions—in both outcome and timing—based on the data needed to ensure achievement of the
required  pollutant reductions, water quality equivalence, and  avoidance of hotspots. A poor
mechanism increases transaction costs and transaction  uncertainty by sending incorrect signals
to  the market regarding what is expected of participants and then inconsistently processing the
provided information.
2.       . • . -  - '."• '  .'   «          fll'1" f . <
Conventional Market Function — Each conventional market has its own unique trading process.
The types of trading processes depend on the types of products and participants involved.  For
example, in a simple retail exchange at the local convenience store, a customer chooses a loaf of
bread based on personal taste and  posted prices, pays the proprietor at the cash  register,  and
leaves the store free to eat the bread or feed it to the pigeons. A more complex trading process
occurs when a party seeks to purchase  goods and services for construction of a new skyscraper.
This process may involve a request for proposals, bidding by several interested firms, financing
the project,  selecting  a general  contractor,  purchasing  materials, arranging for all necessary
permits  and inspections,  overseeing and  inspecting physical construction, and agreeing on the
level of completion. Friction in conventional markets can be minimized if participants have a solid
understanding of the  steps involved  in  a transaction,  the order  in which  they  need to  be
completed, and each step's likely  cost.

The Trade Process in WQT Markets — EPA's Water Quality Trading  Policy supports trading
under different conditions (i.e., both within the context of a TMDL and prior to its approval.)  The
policy does not prescribe specific processes that each market must employ to complete a trade.
Each WQT market may develop its own  trading process.

The "Trading Process" includes the  steps all parties must take to complete a  proposed trading
transaction that ensures full CWA practical enforceability and fully supports TMDL requirements.
These steps could include, but are not limited to:

        Negotiating a transaction;
       Accounting for water quality equivalence and avoiding hotspots;
        Completing and conveying appropriate paperwork;
        Reviewing and  approving trades;
        Installing control technologies or adopting  pollutant management methods;

       Monitoring and verifying reductions;
       Reporting to appropriate regulatory agencies and stakeholders;
       Auditing reported information against regulatory obligations; and
       Taking enforcement actions, if necessary.

A good trading  process covers these  steps in the appropriate order while minimizing uncertainty
and costs associated with the trading  transaction.  A poor mechanism is incomplete and adds to
uncertainty and costs associated with the transaction so  that trading is potentially suppressed.
This can happen  if the steps don't generate enough momentum towards trade completion. In
addition,  redundancies in the process  (i.e., steps that are revisited without adding sufficient value)
add to transaction costs and will erode the value of trading.

Some states considering trading and/or with demonstration projects underway have developed
documents that describe the process the state will  use to formally recognize water quality trades.
These documents usually do not prescribe  exacting protocols for  individual trades,  but provide
general  guidelines.  Care should be  taken to review your state's  document (if it has one) and
design the  market consistent with its guidelines and in consultation with appropriate state

Conventional Market Function—In conventional markets, a "marketable" product or service is
anything that  one individual is willing  to  compensate another individual to produce.   The
marketability of a product or service may be influenced by personal need, taste, and economic
conditions. For example, a person may need shelter, may prefer to live in a townhouse, and  may
find it financially advantageous to pay someone to build the house rather than foregoing salaried
employment to  build it alone.  A product  may be marketable to one  person but not another.  For
example, a second person  may share the  need for shelter but prefer to live in an  apartment.
Such a person may have no interest in  purchasing a townhouse.

Marketable Products in WQT Markets—In WQT markets, "overcontrol" of pollutant  loadings is
the marketable  product.  The product is produced when the  reduction of pollutant loadings goes
beyond  a source's regulatory obligation  or  a nonpoint source's TMDL load allocation (or other
baseline). A WQT market must do two things to create a marketable product. First,  the market
must identify the relevant pollutant reduction expectations; overcontrol cannot exist until a TMDL
or other framework  sets  the reduction  expectations.  Second,  the  market must transform
overcontrol into a marketable product by  allowing that behavior to acquire value.  Value  is
acquired when a  regulatory framework  allows  one source to offset  its  discharge reduction
obligations with overcontrol by  other sources.  As described in  the Financial Attractiveness
chapter of this Handbook,  the value  of overcontrol is highly dependent  upon differences  in
incremental control costs. Minor control cost differences will create little, if any, value  even if the
regulatory framework allows offsets.
                           Water Quality Trading Assessment Handbook

Conventional Market Function—Some market mechanisms allow consumers to compare the
characteristics and quality of products targeting similar needs.   For example, over the counter
drug packaging must inform consumers of the drug's chemical contents—including the relative
amount of active ingredients.   This  allows consumers to compare the likely effectiveness of
various painkillers and cold remedies so they can select the product that best meets their needs.

Equivalence in  WQT Markets—As emphasized earlier, trading requires that the impact  of the
purchased  pollutant reduction is (at least) equivalent to the reduction that would have occurred
without trading.  Market participants and regulatory agencies must  be able to evaluate the water
quality equivalence of reducing  pollutants at the points of credit creation and use.  For example,
hydrologic conditions in the stream between the two trading points must be evaluated because
they can have a profound impact on water quality equivalence.

Demonstration WQT projects have used various mechanisms to perform the essential market
function of facilitating water quality equivalence assessments.  One  important consideration is the
higher cost of developing an accurate  model versus setting ratios based on a rule of thumb (i.e., 3
to 1).  Although establishing ratios based on accurate modeling and  a wealth of ambient data may
be the most precise approach, a WQT program may not be viable unless less costly approaches
can be found. The potential participants may  be willing to make a  tradeoff in such a  case.  For
example, a rule  of thumb ratio  that is less expensive to develop can  be set at a high level to
provide a  margin of safety with  each  trade, even though this might drive up the cost  per unit of
needed reductions.  A good mechanism will ensure  equivalence while keeping the total cost of a
specific trade (i.e., costs to develop the ratio and the cost of needed equivalent reductions) to a
minimum.  A poor mechanism will fail to control total  costs.

Various approaches  exist for avoiding  localized hotspots including: retaining  individual (non-
tradeable) permit limits on pollutant forms that  can exert an acute effect, e.g., ammonia nitrogen;
limiting the portion of a facility's discharge limit that  may be met through the purchase of credits;
and not permitting trades beyond a certain size. State  regulatory  agencies will have a primary
voice  in how water quality equivalence is established and localized impacts avoided.
Conventional Market Function—All conventional markets are communication systems.  They
provide participants with information on product availability, variety, quality, quantity, and price.
This information is used to:

        Identify parties willing to produce or consume goods;
        Compare the merits of similar offers; and
        Negotiate mutually beneficial terms of exchange.

Without a means to acquire the needed information,  potential  market participants would  be
unable to benefit from each other's ability and willingness to produce goods and services.

Communication's Unique Role in WQT Markets—A WQT market gives dischargers who face
pollutant control costs a forum for communicating with other sources to identify environmentally
equivalent excess reductions that can be attained at a lower cost. Because pollutant suitability
and financial attractiveness are specific to the pollutant's chemical properties, the watershed's
physical  characteristics, and the relevant economic conditions, WQT markets must facilitate
sharing information regarding a relatively  complex product—a  certain type/form  of pollutant
reduction, at a specific time and place, for a predetermined duration, in a particular quantity, for a
certain cost.

A good WQT market allows parties to learn what quantity of excess reductions are being offered
and demanded, when they can/will be delivered, their duration, their likely impact on water quality
at all relevant points, and how much they will potentially cost to acquire. A WQT market is more
likely to succeed if it allows participants to efficiently survey the details of all potential offers to buy
or sell overcontrol  and identify those most  beneficial to their unique needs.   It is  less likely to
succeed  if it fails to disseminate the pertinent information and/or requires participants to expend
an inordinate amount of time, energy, and money to do so.
,1;.    ':.-cki'.,  .:  .  ,35

Conventional Market Function—Most conventional  markets track transactions.  How much
information is gathered, who stores it, and its future use depend on the types of transactions and
the purposes for tracking. For example, when an individual purchases a loaf of bread at the local
convenience store, the store may track the amount paid, when the transaction was completed,
and what was purchased. This information may be saved by the register or transmitted to a large
database for all transactions completed in the region.  The information may be used to justify
keeping that store  open until 2 a.m., to document sales tax collection, or to manage  inventory.
The customer receives a receipt that can help reconcile their budget, obtain reimbursement from
housemates, or enable a return of damaged goods.

Why  Trades Need to be  Tracked in  WQT Markets—Tracking trades  in a WQT  market is
necessary to ensure that pollutant reductions credited to a source are actually made, all relevant
discounts are applied to credits, trades are not double counted (i.e., one source does not sell the
same reductions to more than one buyer)  and to provide  a clear audit trail for compliance
assurance purposes. Crucial pieces of information a water quality trade tracking mechanism must
include are amount of excess reduction and  chain of custody.  In this context, chain of custody
refers to the possession of the  right to use the pollutant reduction for regulatory compliance
purposes. Keeping track of this information is essential to ensuring that the goal of the TMDL,
meeting  water quality  standards,  is  being advanced  and  that  practical  enforceability  is
maintained.   In addition, this  information  makes  the creation  and  ownership  of  individual
reductions clear and traceable in the context of determining if sources are complying with NPDES
or other relevant permits.

A good trade tracking mechanism minimizes market friction by keeping transaction costs for chain
of custody low, while providing regulators with easy and prompt access to  appropriate levels of
transaction detail. Transaction costs can be kept low by setting clear and consistent expectations
for what information is required and limiting the administrative burden on trading partners.  Sizing
the tracking  system to the  market will also help limit transaction costs.  A poor  trade tracking
mechanism will drive up the cost of administering individual trades to the point where it erodes
                                Quality Trading Assessment Handbook

the value of trading.  It may require trading partners or regulatory agencies to perform non- value-
added administrative tasks (e.g., reconstructing  market activity  from inconsistent transaction
                               -.     ,,-  .

Conventional Market Function—During the exchange  of goods  or services, a chance always
exists that the specific terms or the intent of a negotiated deal will not be fulfilled.  Conventional
markets  allow parties to  identify this  transaction risk,  assign the burden  of  the  risk to the
appropriate party, and provide the opportunity for recourse if it  is needed.  Escrow deposits and
performance bonds are examples of such risk mitigation mechanisms.

Managing Transaction Risk in WQT Markets—WQT markets involve three facets of transaction

       The risk that regulators will find  that the discharge reductions negotiated  under the
       agreement do not conform to  market rules;
       The risk that the specific discharge reductions  negotiated under the agreement (for a
       pollutant type/form,  at a specific time,  for  a predetermined duration, in  a particular
       quantity) will  not be produced; and
       The risk that  reductions will fail to have the intended impact on water quality.

The chapter on  Financial  Attractiveness explained the detrimental effects transaction  risk can
have on trading.  Insufficiently  managed risk will induce participants to steeply discount the price
they are  willing to  pay for discharge  overcontrol.  This erodes the financial benefits associated
with trading and can potentially suppress market activity.

Risk management  transaction  costs (identifying and assigning risk) increase  when remedies for
non performance  of discharge reduction obligations  are less  certain. A good  mechanism  for
managing transaction risk identifies and assigns the  three types of transaction  risks  to specific
parties, and sets reasonable expectations  about how failure to  fulfill terms of the agreement will
be handled, including the size of the remedy.  As always, good mechanisms minimize transaction
costs.  A poor mechanism will create high transaction  costs  and fail to account  for all three
transaction risks, assign the risk to an inappropriate  party, and/or create ambiguity over how a
transaction "gone bad" will be handled.
Conventional Market Function—Some conventional markets recognize that commercial activity
can directly or indirectly affect parties other than the traders.  For example, the Securities and
Exchange Commission requires corporate officers to notify the public when they purchase or sell
stock in the companies they manage.  Public dissemination of this information provides investors
and securities regulators with information relevant to investment decisions and public policy.

Public Information  in  WQT Markets—The CWA  and federal, state, and  local water quality
regulations require provision of opportunities for public participation, including public notice and

opportunity for comment.  WQT markets must therefore perform this essential function.  WQT
viability often depends on the  public participation  process to generate understanding and trust
among watershed participants.  Failure to do so could  influence stakeholders to  challenge the
market system  or specific trades, potentially introducing uncertainty  and eroding the value of

EPA's  Water Quality  Trading  Policy supports, "public  participation at the earliest stages and
throughout  the  development   of  water  quality  trading  programs to  strengthen program
effectiveness and credibility." Both early and on-going public participation are important to market
development.  Easy and timely public access to  transaction information  may increase  market
efficiency. Improving water quality takes sustained effort. An uninformed public may lose interest
in a trading program, threatening its long-term viability. Informed watershed participants are more
likely to discover and/or support  new forms  of trading.  Some trading  markets  may produce
trading opportunities that do not conform to the market design's original vision of trading, but do
provide real water  quality and economic benefits.   Such opportunities  evolve  as  watershed
participants learn more about each other's needs and the needs of the watershed's  ecosystem.

A good public  information mechanism  is transparent, easy  to engage, and  available to  all
interested parties while controlling transaction costs.   The  EPA Water Quality Trading  Policy
encourages electronic publication of information on:

       Boundaries  of the watershed and trading areas;
       Discharge sources involved;
       Quantity of credits generated and used; and
       Market prices where available.

Other information may be important to participants in your watershed.  The value of satisfying all
interests will need to be balanced with the cost of  collecting, managing, and distributing data. A
poor public information mechanism will be resource intensive for both the information distributors
and its consumers.  As watershed participants must work harder to get information, their level of
trust may diminish, threatening the market's stability.
Current Market Models

The  remaining  market infrastructure discussion  focuses  on three market models that are in
various stages of implementation in the United States. Each of these market models responds to
the unique needs of its watershed  and  market participants while handling the essential WQT
market functions discussed  above.  Each market model is discussed  in terms  of the basic
premise underlying the market, important mechanisms used to support the system, and how the
model performs certain WQT market functions.  These models  illustrate significantly  different
approaches.  The examples run from a  predominantly urban and point source focused estuary
(Connecticut) to a strong agricultural and  nonpoint source influenced river (Idaho). The examples
provided  are ones that have been established with varying degrees of success.  After reviewing
them, you will have a better understanding  of approaches potentially suitable for your watershed.
However, note  that any market  will  be tailored to local conditions; other  models not mentioned
here may have aspects that are more suitable for your watershed.
                           Water Quality Trading          Handbook

In 1998, the Lower Boise River Water Quality Trading Pilot Project undertook design of a WQT
system for approximately 64 miles of river from Lucky Peak Dam to the mouth of the Boise River.
Market participants agreed  they  could make trading more robust, flexible, and cost-effective by
focusing  on minimizing  market friction.  Participants identified design principles they felt were
crucial to a viable market in  their watershed, including the following:

       Avoid trade-by-trade changes to the TMDL;
       Avoid trade-by-trade changes to NPDES permits; and
       Acquire advance agency approval for specified trading to minimize trade-by-trade review.

To support these  three design  principles,  watershed participants  and regulatory stakeholders
worked together to design clear  guidelines  and requirements for trades that would preclude the
need for trade-by-trade review of most transactions.  Public notice, review, comment, and agency
approval  of these trading guidelines and requirements were pivotal to this approach and created
a model for dynamic trading.  The  key element of the Lower Boise  market that allows market
participants to trade in this fashion is the pre-approval of trade transactions through the issuance
of a single new or modified NPDES permit enabling trading.8

The  Idaho Clean  Water Cooperative, a  private, nonprofit association  of  various  watershed
participants, is charged with  the day-to-day management of trading  in the Lower Boise  River.
The Co-op will rely on language  in the TMDL, language  in NPDES  permits, and a State Trading
Document establishing the  ground rules for creating and verifying trade transactions to facilitate
trading.  The Co-op will be responsible for helping connect buyers and sellers, developing  and
maintaining a trade tracking database, and  preparing monthly watershed-wide trade summaries.
The Cooperative will provide an important link among trading  parties, the environmental agencies
ensuring  Clean  Water  Act compliance,  and  the public.  By maintaining  the  trade tracking
database  and regularly disseminating transaction details, the association will  also ensure  that
timely information about trades is available to the public and the environmental agencies. As a
non-governmental  organization,  the Cooperative will be  dedicated  to  supporting the trading
system as agreed to by its members and in accordance with established rules.

Water Quality Market Functions in the Lower Boise River

Defining  marketable  reductions—The  Lower  Boise  market  uses a  common definition of
overcontrol (control below  a source's TMDL defined  allocation) to classify the reductions  that
sources  may  sell.  To enable nonpoint source  market  participation,  market stakeholders
(including state and federal regulators as well as agricultural and technical assistance agencies)
created  a list of Best  Management Practices and  construction  management, monitoring,  and
verification protocols that pre-qualify resulting  reductions for  sale.  The BMP  List provides the
basis for the straight-forward  verification of the nonpoint  source generated reductions.  This was
done to eliminate the need  for an intermediary in any transaction and create the opportunity for
8 As of the publication of this document, trading in the Lower Boise market has not been initiated for reasons unrelated to
the market design issues discussed here. Several steps and mechanisms have been created to enable trading, including
the creation of the Idaho Clean Water Co-operative, reporting  forms, model NPDES permit language, model TMDL
language, and the State Trading Document.

direct  participation  of nonpoint sources  in  dynamic  trading.    Nonpoint sources  that  can
demonstrate they follow  the  appropriate protocols  have reductions  recognized  as valid  and

Communicating among  buyers and sellers—Although the Co-op is charged with connecting
buyers and sellers, the mechanisms used to fulfill that role are currently undefined. As the market
manager, to which all sources must report certain information if they choose to trade, the Co-op is
uniquely situated to act as a "broker". This may entail providing an electronic or physical  bulletin
board of bids and offers for reductions or may evolve into a more formal matchmaking role where
the Co-op introduces sources with reduction  needs to dischargers capable of addressing them.
Both methods can help participants  identify  trades that may  meet their needs.  The costs of
communication in the Lower Boise will be borne by both the Co-op and market participants.

Ensuring water quality  equivalence and avoiding hotspots—One factor that  is particularly
important to address in dynamic, pre-approved trading is the potential for adverse environment
impact resulting  from  individual trades.  To lower the total cost of developing  a  ratio and the
needed equivalent reductions, the Lower Boise market will  rely on the water quality model
developed  for formulating the TMDL.   This  model provided each major discharger with  an
individual index, allowing a source to relate their discharge's effect on water quality to discharges
by other sources. Use of an existing model keeps development costs to a minimum.  In addition,
this model ensures  that trading ratios used  are consistent with the TMDL.  Relative to ratios
based on a rule of thumb  set artificially high to ensure equivalence, this minimizes the number of
reductions a source  must purchase. To preclude localized impacts, modified NPDES permits will
include caps limiting the downstream  trading capacity of  individual sources.  This will ensure that
individual trades do not produce discharges  in excess  of the local assimilative capacity of the
river segment between trading sources.

Assuring compliance with the CWA and regulations in the Lower Boise—In  this market, the
pertinent TMDLs will contain initial phosphorus wasteload allocations  (WLAs) for  point sources
and a provision for trade-dependent WLA variability. Sources will then receive a new or modified
NPDES permit incorporating their WLA as a limit and, if desired, a provision enabling a trade-
dependent variable  limit.   In  all  point-source to  point-source trades,  the  enabling  provision
automatically adjusts the  buyer's NPDES discharge limit up and the seller's NPDES discharge
limit down,  based on the volume of reductions traded and their water quality equivalence ratio.  If
a source exceeds its  adjusted discharge limit during a  reporting period,  it is in violation of the
CWA and potentially subject to regulatory enforcement.

In nonpoint source to  point source trades, the enabling provision gives the point source a credit
that can be applied  against the point source's  NPDES permit limit during that reporting  period.
The credit  is based  on the amount  of environmentally equivalent reductions that have  been
traded  from the nonpoint  source(s) to the point source.   A point source violates the CWA if its
actual discharge, adjusted for all reduction credits acquired through trading during that  period,
exceeds  its discharge limit.  In this  market, EPA  or the  Idaho Department of Environmental
Quality (DEQ) may invalidate credits established by the nonpoint source reductions if they fail to
meet BMP  protocols and  retain full authority to enforce the corresponding point source's effluent
limit without applying the invalid credits.

Point sources  involved in a trade will use modified Discharge Monitoring Reports (DMRs) to
report to the EPA.  Along with the modified DMR, each  source will submit an individual Monthly
                           Water Quality Trading          Handbook

Trade Report created by the Co-op.  DMRs and Trade Reports include actual discharge, point
source trades lowering or increasing their discharge limit, and nonpoint source credits reducing
their recognized loadings. This information will be used by EPA to assure CWA compliance.

Defining and  executing the  trading  process—The Lower Boise  stakeholders developed  a
trading framework clearly defining the  roles and  responsibilities of all parties involved in  a
transaction (the buyer, the seller, the Co-op, and the regulatory agencies) and the steps needed
to "complete" a transaction.  Two steps common to water quality trades are handled automatically
by certain mechanisms: 1) accounting for water quality equivalence and avoiding hotspots; and 2)
reviewing and approving trades.

The  framework allows market  participants  to  negotiate trades on their own and provides clear
guidelines for paperwork submission,  control technology or  process installation, and reporting
protocols. Reduction monitoring and/or verification  is generally assigned to point sources, while
the Co-op,  Idaho  DEQ, and  EPA will  work together to audit trades and  assure regulatory
compliance. EPA will be responsible for regulatory enforcement actions.

With pre-approved  trading, mechanisms are incorporated  upfrontto ensure that each trade  meets
water quality requirements. The Lower Boise market uses two mechanisms to prevent the need
for trade-by-trade review without increasing the chance  for adverse environmental  effects: the
use of known, published ratios for any given trade which  lowers transaction costs by eliminating
the need to negotiate ratios for each trade;  and a pre-qualified set of BMPs which provides
participants  a  clear  understanding  of  what pollutant reduction practices  will  be  recognized,
minimizing transaction uncertainty.

How the Idaho Clean Water Co-operative tracks trades—In the Lower Boise, the tracking
system was designed to establish chain of custody,  maintain accountability, and  provide the
public with a means of readily tracking all reductions bought and sold. Key elements  of the trade
tracking system are 1) a record keeping and reporting protocol, and 2) a trade tracking database.
The system strives to minimize transaction costs by  setting clear and reasonable expectations for
reporting. Market  friction is managed by providing reasonably direct communication channels
between  participants, the Co-op, and the regulatory agencies.

Trading parties will be required to gather documentation and retain specific information pertaining
to trades and then  report selected information to the Co-op using standardized forms.  For each
point-source to  point-source trade, a Trade Notification Form is required to  officially  register the
trade,  transfer  reductions  from seller  to  buyer,  and  trigger the enabling  NPDES permit
provision(s) to adjust allowable discharge limits.  For trades  involving nonpoint sources, both a
Trade Notification Form and a Reduction Credit Certificate must be submitted by the point source
to certify the nonpoint source reduction and  generate a credit against the point source's discharge
amount.  The  Co-op will maintain a trade tracking database  as well as  individual trade and
account information and  produce a Monthly Trade Report  tor each source.

Managing transaction and market risk in the Lower Boise market—The Lower Boise market
will manage the transaction and market risks associated with WQT through its trading framework
and  private  contracts.   The  market mitigates  the risk  that specific  transactions  will not  be
recognized by regulatory authorities by including in the  market driver (applicable TMDLs and
implementation  plans), as well as the  regulatory mechanism (NPDES permits), and  the  state
trading document,  the explicit requirements for defining marketable reductions and their proper
                           Water Quality Trading          Handbook

conveyance to  other sources.  This  information  is publicly available, so  buyers  and sellers of
reductions jointly assume the  risk that the paperwork documenting their transaction is proper and
filed with the required entities.

A defining feature  of the Lower Boise market is  how it manages the risk that an agreed upon
reduction will not be achieved. Water quality regulatory agencies in the Lower Boise  have limited
or no authority over nonpoint sources' discharge behavior.  Although nonpoint sources are issued
load allocations by the  TMDL, they  are  not issued NPDES (or state equivalent)  permits that
create  CWA  regulatory  liability.  Nonpoint  sources  involved in creating the  market wanted to
maintain their independence from CWA regulatory liability and still be allowed to participate in the
market.  Faced with supporting point source trading while  maintaining regulatory  independence
for  nonpoint sources, market designers decided that CWA liability would reside with  NPDES
permit  holders, while the liability for failing to produce purchased credits would  be  handled,
particularly in the case of nonpoint source trades, through private contracts  between sources.

In the Lower Boise WQT market, trading parties agree on the specific terms of a trade by entering
into a private contract that identifies  the trading parties, reduction measures to be  undertaken,
reduction  amounts to  be achieved,  effective  date,  responsibilities  of each  party, price  and
payment provisions, and remedies for failure to deliver reductions.  Although private contracts
cannot shift regulatory liability from one source to another, they can assign  the financial liability of
regulatory non-compliance to the seller of  pollutant reductions.  Subject  to applicable contract
law, the parties to the trade  can decide between them who will  pay  for damages  in the event
reductions are not delivered and the  purchasing source is consequently found to be violating its
NPDES permit.

Private contracts in the Lower Boise  allow parties to the trade to decide how great  they believe
the  risks of the trade  are and who will bear them.   Writing the contract  may require legal
assistance, which  may be relatively  expensive for some nonpoint sources.   It is  important to
remember that  the contract terms used to manage risk will be based on the buyer's and seller's
perceived risk.  High perceived risk  may result in large price discounts and erode  the financial
attractiveness of trading.

Providing  information  to  the public  and  facilitating their participation—The  public
participation mechanism in the Lower Boise  relies on transparency in the Co-op's activities and in
the  issuance of relevant NPDES permits.  This  is extremely important because  pre-approved,
dynamic trading in the Lower Boise  requires market designers to  generate and  maintain trust
from non-discharging stakeholders and also satisfy CWA public notice  and  comment  procedures.
A point source wanting to trade remains subject to the standard NPDES permitting process.  The
usual CWA public notice and  comment procedures will give stakeholders the opportunity to learn
about and participate in the consideration of issues surrounding market participation  by a specific

The Co-op will  be  responsible for making transaction information accessible to the  public.  The
marginal cost  of  providing  the  information—whether on  demand  or  published at  regular
intervals—will be minimal, as  the trade tracking database already manages the information likely
to be requested. In the Lower Boise,  non-discharging stakeholders have a  forum to question and
influence the permitted discharge  limits  and then  easy  access to  information  keeping them
informed of actual discharge behavior.
                            Water Quality Trading          Handbook

In 1985,  the  Cherry  Creek  Basin  Water Quality  Master  Plan  was created to  manage
development's environmental impact on the Cherry Creek Reservoir in Colorado.  In the basin,
point  source and  nonpoint  source nutrient discharges  cause  eutrophication  problems that
preclude attainment of the reservoir's designated uses. Rapid economic development in the area
was forecasted to strain the ability  of local POTWs to serve the  burgeoning  population without
further degrading water quality in Cherry Creek  Reservoir.  As dischargers of predominantly
soluble phosphorus, which is readily available biologically and promotes rapid algal growth, seven
utility  districts  operating POTWs were challenged to limit their phosphorus contribution to the
Cherry Creek Reservoir. A Total Maximum Daily Load was developed for phosphorus discharged
into the reservoir, and the wastewater facilities received  a total allocation of 2,310 pounds per

Two counties, four cities, and the seven utility districts reached an intergovernmental agreement
chartering a state empowered government entity, the Cherry Creek Basin Water Quality Authority
(the Authority), to develop and administer a water quality trading program facilitating continued
economic  growth while  minimizing adverse  impact on water quality in the reservoir. Although a
pilot trading program has been in  place for several years,  few  trades  have been completed.
Recently, an effort has been made to elicit more market activity. The Authority has been charged
with designing a  market in which POTWs and other point source dischargers would be able to
purchase credits  included in the POTWs' 2,310 pound phosphorus allocation  while funding new
phosphorus reduction  projects.  These  credits  may increase  an  individual  point  source's
wasteload  allocation  and allow it to  expand its  services to  new developments,  which would
otherwise  cause  the  POTW to exceed its  wasteload allocation.   The trading market requires
POTWs to fund  phosphorus  removal  projects  in  exchange for  an allocation  of additional
phosphorus discharge.

In the Cherry Creek market, the Authority manages two sources of credits for use by POTWs, a
Phosphorus Bank and a Reserve Pool. The Authority functions as a phosphorus  reduction bank
by owning  and allocating purchasable phosphorus credits associated with four nonpoint source
phosphorus control projects built by the Authority in the 1990s. These projects have reduced the
net amount of  phosphorus discharged, creating additional loading capacity in the  reservoir. The
credits from these projects have been placed in the Phosphorus  Bank from which  POTWs may
draw credits to meet  their regulatory obligations.  A total of 216  annual  pounds of phosphorus
credits were allocated to the Phosphorus Bank by the TMDL.

The  control technologies  used  in the  Phosphorus  Bank  nonpoint source projects  include
retention/detention  ponds, constructed wetlands, and shoreline stabilization  above and  beyond
required BMPs, leading to phosphorus discharge reductions that can offset  discharges from a
POTW.  The Authority has control over these credits and decides who may purchase them.
Funds raised from the sale of the credits will be used by the Authority to fund  additional projects
to further improve water quality.

The Authority also manages an additional 216 pounds of phosphorus credits  generated by other
parties.  These allowances give POTWs the  right to purchase  reductions from non-Authority
phosphorus reduction projects and receive an increased WLA.  The TMDL allocated these credits
to a  Reserve  Pool.  POTWs  wanting to increase their phosphorus allocation  may  construct

projects and/or compensate third-party landowners, local governments, or other POTWs to do so
for them.9  Credits tied to these reductions enable the Authority to transfer a portion of the
Reserve Pool phosphorus allocation to POTWs.   A phosphorus reduction  project will  be
evaluated by the Authority before a specific agreement is reached to use  the credits. The total
number of credit allowances third-party projects may generate for redistribution to the POTWs is
currently capped at 216 pounds annually.

Important Market Functions in the Cherry Creek Basin

Defining marketable  reductions—Marketable reductions in  the Cherry  Creek  market  are
defined as reductions accruing from the implementation of control technologies in excess of those
expected from the Mandatory Best  Management  Practices  identified  in  the Cherry Creek
Reservoir Control Regulations.  Mandatory BMPs include temporary measures  implemented to
mitigate construction runoff (e.g., filter fences,  re-vegetation, and hay bales) and/or permanent
water quality improvements required by drainage criteria and land use regulations for all new
development (i.e., detention ponds, swales, and constructed wetlands).10

The Reserve Pool marketable reductions evolve from one of six different types of projects.

        BMPs added  to  Existing  Development—Phosphorus   removals from  BMPs  not
        completed during land development prior to January 1, 2000 are eligible for trading.
        Expanded or Retrofitted BMPs—Phosphorus removals from BMPs that are added to
        land development undertaken prior to January 1, 2000 that result in additional reductions
        are eligible for trading.
        Projects  Beyond Required BMPs—Phosphorus  removals from BMPs that result in
        reductions in excess of the removals from required BMPs are eligible for trading.
        Cooperative Authority Projects—Phosphorus removals from Authority and third party
        co-development projects are eligible for trading. Credits placed in the Reserve Pool will
        be limited to the proportion constructed or funded by the third party.
        Engineered  Authority Projects—Phosphorus  removals  from  any nonpoint  source
        project for which the Authority completes preliminary engineering and design and which
        the Authority agrees to third party construction of that project are eligible for trading.
        Water Supply Operations—Phosphorus removals beyond the incidental reductions from
        regular, normal operations are eligible for trading.

Not every  pound  of phosphorus overcontrol  from  a project  may  be  associated with  credit
allowances in the  Reserve Pool.   A project specific "Trade Ratio" is applied  to calculate the
proportion of phosphorus reduction that results in credit allowances recognized  by the Authority
and the regulatory agencies.

Defining and executing the  trading process—Similar to  other trading programs, the  Cherry
Creek Authority and stakeholders have developed a trading  framework clearly defining the roles
and responsibilities of all parties (the buyer, the seller,  and the Authority) in  reviewing reduction
projects  and trades and administering the allocations of  credits.   Program evaluations have
identified the following five steps for executing trades.
 A more detailed description of these projects is provided below.
10 Phosphorus Credit Trading in the Cherry Creek Basin: An Innovative Approach to Achieving Water Quality Benefits.
Water Environment Research Foundation. Project 97-IRM-5A. 2000.
                           Water Quality Trading          Handbook

    1.   Project Evaluation and Approval—Authority constructed phosphorus reduction projects
        have already  been  evaluated  and  their  credits placed  in  the Phosphorus  Bank.
        Interested  parties may nominate other projects for consideration by the Authority  for
        inclusion in the Reserve Pool. The  technical specifications of the project, the estimated
        pollutant reductions,  reliability of the project operations, comments from Colorado's Water
        Quality Control Division, consistency with the Master Plan, trading guidelines, and control
        regulations, and the effect on water quality are all considered  by the Authority.  Other
        stakeholders may contribute input at a public meeting.  The Authority's Board of Directors
        votes to recognize the validity of the phosphorus reductions.
    2.   Credit  Calculation—After  voting  to  include  reductions  in  the  Reserve  Pool,  the
        Authority's Board of Directors determines the amount of credit  allowances that will  be
        associated with the project based on projected reductions and a project-specific trading
    3.   Credit Allocation—Point sources seeking to adjust their permitted discharge limits may
        apply to acquire phosphorus credits from the Phosphorus Bank or credit allowances from
        the  Reserve Pool.  Trades are reviewed  based  on the buyer's history of regulatory
        compliance and operating abilities, as well as the trade's conformance to the Master Plan
        and control regulations. Potential Sale Credit applicants are also reviewed based on their
        "need" as defined by the  Authority. A Technical Advisory Team reviews all trades and
        makes recommendations  to the Authority Board of Directors.  The Board then approves
        or disapproves each specific trade.
    4.   Trade Review—After a transaction is  completed, the  Authority retains the  right and
        obligation to review reduction performance and periodically adjust the number of credits
        or credit allowances awarded to point sources based on actual reduction performance.
    5.   NPDES Permitting—Prior to discharging phosphorus in excess of its existing NPDES
        permit, the credit or credit allowance purchaser must be issued a new or modified permit.

The trading guidelines used in the Cherry Creek market provide all participants  with a clear
understanding of what's  expected of market participants. Transaction costs are  likely to  be
relatively known prior to  initiating a trade, as the information needed  and the process used to
evaluate a  trade  are  well  defined.   Market participants are  also likely to understand  the
transaction costs associated  with the permitting process.

Ensuring water  quality  equivalence and avoiding hotspots—The  focus  of water quality
trading in this market is to maintain the condition of the Cherry Creek Reservoir,  not to address
water quality within specific stretches of  rivers  or tributaries.  Water quality equivalence is
therefore confined to the effect each sources'  individual discharge has on the concentration of
phosphorus in the reservoir.

Each  Reserve Pool transaction receives a  trade ratio, which translates phosphorus reductions
into credit allowances, set between a  minimum of 2-to-1  and a maximum of 3-to-1.  The trade
ratio varies  based  on the relative load of soluble and non-soluble phosphorus  between the two
parties and/or the attenuation of discharged phosphorus as it moves through the watershed.  For
example, the ratio may be increased when the credit allowance  buyer is closer to the reservoir
than the credit producer to avoid localized impacts  in the  intervening  reach  and ensure  an
equivalent reduction in the reservoir. Ratios are based on site-specific monitoring data, empirical
modeling, and/or best available scientific evidence
                            Water Quality Trading          Handbook

Communicating  between  buyers and sellers—Use  of this  market model influences  the
transaction costs associated with trading  partner identification, product comparison, and  deal
negotiation and their effect on market efficiency.  All available credits or credit allowances are
held or managed by  the Authority.  Buyers  do not have to contact several  potential trading
partners to find a mutually beneficial deal.  This market model  can limit interactions between
certain buyers and sellers. The Authority explicitly identifies and selects trading  partners allowed
into the market by placing  reductions  from  specific  projects into the Phosphorus  Bank and
allowing certain  buyers, based on Authority-defined "need,"  to apply for the  right to  buy the
credits. For the Reserve Pool, the Authority only approves or disapproves the transfer of credit
allowances for individual transactions.   The  Authority has limited justifications for stopping a
transaction.  As such, participation in the Reserve Pool segment of the market is not limited.

The Authority manages product comparison for Phosphorus Bank reductions by quantifying them,
applying a project-specific trade ratio, and establishing the price of credits. For these reductions,
the authority sets the terms of the trade based on the Authority's costs of building, operating, and
monitoring current and future phosphorus reduction projects, as well as the costs of establishing
and administering the trading market.  The  Authority also  manages  product  comparison for
Reserve  Pool trades by  quantifying  available  credit allowances  based on  the trade ratio.
However, the Authority does not  price these allowances;  price is negotiated by the  parties to the

Tracking Trades—The Authority is in a unique position to track trading activity because it plays
an active role  in all transactions.  In addition, trades are  considered to last in perpetuity, limiting
the number of actual transactions that will take place during any given period. It is anticipated that
the Authority will  develop a  trade tracking system as  trading activity increases.  Most  likely, a
spreadsheet managed by the Authority will be used to ensure that reductions and their associated
credits or credit allowances  are  traded to other sources only once.  Trades approved by the
Authority are documented in Appendix A of the  Cherry  Creek Water Quality Authority  Trading
Program Guidelines.

Assuring compliance with  the  CWA and regulations  in Cherry Creek Basin—Although the
Authority administers  the transfer of credits and  credit  allowances  in the Cherry Creek water
quality market, transactions do not automatically  alter a source's  obligations to federal, state, or
local water quality regulations.  In this watershed, Colorado's Water Quality  Control  Division
(WQCD)  is responsible for administering NPDES permits. The WQCD does not  acknowledge
Phosphorus Bank or Reserve Pool credits as immediately off-setting the phosphorus  discharge
limit in the source's NPDES permit limit.

As stated in the Trading Guidelines, "It shall  be the sole responsibility of the  (credit buyer) to
obtain  any approvals or modifications to their discharge permits necessary to allow increased or
modified phosphorus discharges." Therefore,  a source wishing to use 10 pounds of credits must
go through the normal permit modification process.  Sources  purchasing credits must work with
the WQCD to amend their NPDES permit  limits prior to discharging  phosphorus at  increased
levels. Monitoring and reporting protocols are detailed in their individual NPDES permits.

Managing transaction and market risk in the Cherry Creek Market—As is typical of water
quality banks,  Phosphorus Bank  credits are made up of credits from various projects co-mingled
together. A quantity of credits sold out of the Phosphorus Bank likely includes reductions from
several projects that have different risks associated with them.  The Cherry Creek market model
                            Water Quality Trading          Handbook

both actively and passively manages the risk that reductions do not conform to market rules, the
risk that specific reductions fail to materialize, and the risk that reductions fail to have the  required
impact on water quality.

The Cherry Creek Authority is delegated the responsibility of evaluating and allocating credits by
the regulatory and administrative agencies responsible for watershed oversight. The Authority, a
water quality bank operated  as  a quasi-government  entity,  plays an active role in  defining
marketable reductions. For both Phosphorus Bank and Reserve Pool transactions, the Authority
is only allowed  to allocate credits  if reductions conform to market rules. Therefore, the Authority
manages the buyer's risk  of purchasing non-marketable reductions  by acting as a  certifier of

The Authority's certification role also helps manage the risk that the  credits  purchased by the
buyer do not reflect actual phosphorus overcontrol.  The rigorous certification of reductions during
project approval coupled with  the trade ratio creates a safety margin for each credit. In addition, if
phosphorus reduction projects begin to  perform poorly,  the Authority  may revoke or adjust the
number of credits downward.  For Phosphorus  Bank credits, if re-evaluation results in  lowering
the reductions achieved (and therefore the credits), the Authority relies on surplus credits in the
trading pool that have not been allocated and sold to other sources to make up the difference.  If
there are insufficient surplus credits in the Phosphorus Bank, the Authority  notifies all Phosphorus
Bank credit holders that their credits have been reduced on a  pro-rata basis for three years.  If
additional credits become available from the Phosphorus Bank during  those three years, credits
will be restored. After three years, the credit reductions are permanent.

Transaction  risk  for  Reserve Pool transactions,  where  the credit allowances  are  merely
"warehoused" by the Authority until a private deal is struck, is not as actively managed by the
Authority.  The  Authority also  certifies these credit allowances.  However, purchasers of  Reserve
Pool credits cannot be awarded the credits if negotiated reductions fail  to materialize. They must
negotiate another trade and pay for additional credits.

Providing information to the public and  other stakeholders—The ongoing public participation
mechanism in Cherry Creek relies on standard  public notice and comment procedures  used for
NPDES permits. In the Cherry Creek market, non-discharging stakeholders have opportunities to
play an active  role  in trading activity, including open forums to  question  and influence project
evaluation, credit allocation, and permit  modification. For project evaluation  and allocation, the
Authority is required to issue  a public notice of its intent to  review specific proposals and hold a
public hearing. A similar procedure is used  during permit modification.

The Authority is responsible  for making transaction information  accessible to the  public.  The
marginal cost  of  providing  the   information—whether on demand  or  published at  regular
intervals—will likely be minimal as the Authority  already possesses or generates all the pertinent
information.  Trades approved by the Authority are documented in Appendix A of the Cherry
Creek Water Quality Authority Trading Program Guidelines.
   "•   •  '                                     .  ,'v

In 1990, Connecticut, the State of New York, and EPA adopted a Comprehensive Conservation
and Management Plan (CCMP) for the Long Island Sound. The CCMP calls for the reduction of

nitrogen to increase dissolved oxygen in Long Island Sound and mitigate hypoxia damaging the
Sound's ecosystem. The CCMP was designed to reduce the total enriched nitrogen load coming
from point and nonpoint sources by 58.5 percent between 2000 and 2015.  A TMDL, approved in
April 2001, includes wasteload allocations for point sources  and  load  allocations for  nonpoint
sources in the watershed.  Connecticut chose to  develop a trading  program for contributing point
sources within its borders to lower the cost of implementing the CCMP and the TMDL.

The  main  mechanism facilitating  trading in  Connecticut is a general, or  watershed, permit.
Connecticut's program uses both its general state authority and its NPDES permitting authority to
issue a single general permit for the total nitrogen discharges  of 79 wastewater treatment plants
(most of which are POTWs). Facilities can opt out of the general permit  and  receive a traditional
NPDES permit and  implementation schedule.   However, all facilities have chosen to take
advantage  of trading under the general permit.  The general permit sets a cap for total annual
nitrogen discharges from all facilities at 2000 levels, and reduces the total  nitrogen discharges
allowed in each year between 2000 and  2015 on a percentage basis.   Individual point sources
under the permit  (called sub-dischargers) are required to lower their proportional share of the
annual percentage reduction based on their discharge in 2000.

Market designers  faced a number  of challenges. The Connecticut market area is predominantly
urban, with few opportunities for low-cost nonpoint source controls.  To achieve the 58.5 percent
nitrogen reduction from all identifiable sources, 79 wastewater treatment  plants (WWTPs) located
within the watershed were tasked with lowering their nitrogen discharge by 64 percent from 2000
baseline  levels.    Other challenges involved the  proximity  to  the  hypoxia  zone  of certain
dischargers in western  Connecticut compared  to their eastern  counterparts,  and the state's
previous efforts to fund nutrient  removal  projects at WWTPs near Long Island Sound.  Western
Connecticut had been the focus of pre-trading nitrogen removal grants. Market designers felt that
market  models used  in other  pilot  projects might lead to  inequities across  the  regulated
communities, as  affluent western communities  would likely  be able to generate  marketable
reductions by relying on previously installed control technology.

The  trading program  that  evolved is  described as a "Nitrogen  Credit Exchange."   Sources
discharging  less  than their  annual  limit receive credits for overcontrol. The Connecticut
Department of Environmental Protection (CTDEP) is obligated by state  law,  enacted specifically
to implement the  Exchange, to purchase all nitrogen credits from these sources.  Facilities that
exceed their limit  must purchase nitrogen credits from CTDEP to  meet compliance  obligations.
CTDEP is obligated by state law to sell the credits it purchases from overcontollers to facilities
that under-control  their discharge.

Important Market Functions of the Connecticut Nitrogen Credit Exchange

Defining marketable  reductions—Marketable  reductions in the Nitrogen Credit  Exchange are
defined  as  reductions in  excess  of a facility's total  nitrogen permit obligations for each  calendar
year. As described in the February 2003  General Permit for Nitrogen Discharges and Nitrogen
Credit Exchange Program,  by March 31 of each  year, the Nitrogen Credit Exchange (NCE) and
the CTDEP compile the calendar year monitoring data for each individual source. The average
nitrogen discharge for each month is calculated and the end-of-pipe surplus or deficit is reported
as a  yearly average. Credits are generated when the actual, sampled yearly average load of total
nitrogen is less than the annual  discharge limit. A Nitrogen  Equivalency Factor, based  on a
source's contribution of nitrogen to the hypoxia  zone in Long Island Sound, is then applied to
                           Water Quality Trading          Handbook

calculate the number of credits that the NCE buys from that source.  Appendix 1 of the general
permit provides a schedule of each sub-discharger's individual Annual  Discharge Limit for total
nitrogen as well as a Nitrogen  Equivalency Factor.

Defining and executing the  trading process—Unlike the other two models discussed in this
section, Connecticut's trading  process is stipulated  in state law. Public Act No. 01-180 describes
the processes used  to transfer marketable reductions from WWTPs achieving overcontrol  to
WWTPs out of compliance with their NPDES permit.

Trading in this market is executed through a multi-step process completed on an annual basis.
The first step is the setting of the annual discharge limits in the general permit. These limits, set
by the Nitrogen Credit Exchange Board, are based on a 2000 baseline for each WWTP, reduction
goals ensuring consistency with  the TMDL by 2015, and the projected nitrogen reductions to be
achieved by control projects likely to be operating during the year. The annual limits require each
WWTP to attain an equal percentage reduction from  its  2000 baseline. WWTPs monitor and
report their discharge throughout the ensuing year pursuant to language in the general permit.

WWTPs unable to meet their new limits may elect to  install nitrogen control technology. Grant
and loan funding for control projects  is available on a competitive basis through the Connecticut
Clean Water Fund.  WWTPs that do not directly reduce their discharges must purchase credits
from the NCE at the end of the year.

At the end of the year, the Nitrogen Credit Exchange Board, in  conjunction with the CTDEP,
analyzes the discharge for individual WWTPs for compliance with the annual permit limit.  This
analysis includes the calculation of credits produced by dischargers able to overcontrol and the
number of credits needed by  WWTPs failing  to meet  their limits.  The  Equivalency Factor
translates the overcontrol into  credits automatically  purchased by the NCE, and the under-control
into credits that a WWTP must buy from the NCE.

The NCE Board then calculates the price of credits for both buyers and sellers. The dollar value
of credits is determined annually, based on the average capital and operating costs of all  nitrogen
removal projects operating during that year and the total reductions achieved by those  projects
during that year. This is the uniform price (per pound of total nitrogen) that buyers of credits are
charged or sellers of credits receive. Those WWTPs exceeding compliance with their annual limit
receive a check for their credits.  Those WWTPs that have  not met their annual limit receive a bill
for the total cost of all credits that would bring them  into  alignment with the general permit.

Ensuring water  quality equivalence and  avoiding hotspots—The  focus of water quality
trading in this market is to attain the designated uses of Long Island Sound. Thus, water quality
equivalence factors were established to equate the impacts on the  Long Island  Sound  hypoxia
zone  from discharges (and  load reductions) at  different locations throughout the state.  A peer-
reviewed water quality model  was developed to delineate the impact that nitrogen discharges in
the large area covered by the TMDL have on oxygen  concentrations in the  hypoxia zone. The
model identified six different impact zones closely aligned with the major watersheds or basins in
the state.   Some zones were  further broken down into tiers to account for attenuation  in  rivers
flowing into the Sound. Based on this analysis each WWTP was assigned an equivalency factor
that could be used to relate their impact  to the impact of any other facility and to the  zone  of
concern in Long Island Sound. For example, a WWTP located on the Sound close to the hypoxia
zone  would have a factor of 1.0 (no  pollutant attenuation)  while a WWTP located far up river in
                           Water Quality Trading          Handbook

the eastern part of the state would have a factor of .18 (only about 18% of nitrogen loads or
reductions reach the zone of concern).

To  avoid localized impacts, each WWTP  continues to retain an individual  permit limit for all
pollutants other than total nitrogen. This includes individual permit limits for ammonia nitrogen
designed to protect local receiving waters from ammonia toxicity.  Regardless of the number of
total nitrogen  credits a plant uses from the  Exchange, it must meet its individual ammonia limits
and all other individual pollutant limits.

Communicating between  buyers and  sellers—The Connecticut water quality trading model
does not promote contact between individual dischargers.  The NCE manages the transaction
costs that would otherwise be associated with trading partner identification, product comparison,
and deal negotiation because redistribution of the cost of nitrogen  control is handled exclusively
by the NCE as it carries out its statutory  responsibilities.  As previously discussed, the NCE
gathers information from regulated dischargers, rewards WWTPs for overcontrolling, and charges
others  that have not achieved their annual  limits. This results  in  redistributing the  cost of
overcontrolling nitrogen between the two groups.

Tracking Trades—NCE administrators  need  three sets of information to facilitate  and track
trades—discharge loadings  from each WWTP, nitrogen reductions achieved by control projects,
and the cost of those control projects.  In this program, trading is  an annual process.  By March
31 of each year, the NCEP notifies each individual facility regarding their credit balance. After the
credit checks  and bills are paid or redeemed, the books are "closed" for that year and the process
begins again.

Assuring compliance with the CWA and  regulations in the Connecticut Market—Trading in
the Connecticut NCE takes place within the framework of the general permit, which regulates the
annual discharge of total nitrogen. The aggregated general permit  discharge  limit  is lowered
each year to ensure steady  progress towards full implementation of the TMDL in 2015 as well as
providing a buffer in case total  reductions achieved fall  below those anticipated in the annual
allocation. Each individual discharger is  issued a permit limit incorporating the annual reduction
of the aggregated general permit.

Trades are based on actual, sampled discharge performance.  Monitoring and  reporting protocols
for  point source discharge  are  set out  in the  general permit  and follow standard NPDES
monitoring and reporting mechanisms. Sampling frequency and  procedures are based on the
volume  treated by the WWTP on a daily basis.  The collected chemical analysis samples are
entered into a  Nitrogen Analysis  Report and  Monthly Operating  Report and submitted to the
CTDEP.  In  addition, each  WWTP calculates a monthly  mass loading of  total nitrogen and
submits it to the CTDEP in a Discharge Monitoring Report.  Each WWTP is also responsible for
retaining a copy of all reports submitted  to CTDEP as well as the data used to generate those
reports for at least five years.

WWTPs  failing to meet their permit limits must purchase credits from the NCE by July 31st of
each year for their previous year's discharge.  Failure to purchase credits by  this date results in
non-compliance and opens the WWTP to enforcement actions by the CTDEP.

Managing transaction and market risk among parties in the  Nitrogen Credit  Exchange—
Credits are  based on the level of nitrogen discharged during the year compared with the permit
                           Water Quality Trading          Handbook

limit and can  only be  generated by WWTPs  subject to the general  permit. The  authorizing
legislation (Public Act No. 01-180), the general  permit, and CTDEP publications clearly describe
the process used to create the annual permitted limit, calculate discharge, and the analysis used
to compute the surplus or deficit of credits. Nitrogen credits are  only available from the NCE,
making the program the de facto certifier of credits and eliminating the risk of purchasing non-
marketable reductions.

The Connecticut  Nitrogen Exchange  executes trading at the end  of the year, when actual
discharge volumes and amount of over- or under-control are known. The NCE is obligated by
state law to sell all the credits needed by all sources to meet their regulatory obligation under the
general  permit.  This statutory requirement eliminates the  risk to individual dischargers that
specific credits will fail to materialize, regardless of the actual supply that year.

There are two market risks inherent in  this model. The first  is the risk that during the year the
WWTPs, in aggregate,  will create more credits than are needed to offset the WWTPs that fail to
meet their annual limits. Since the NCE is obligated by law to purchase all credits and is unable
to sell them  to other  sources,  the  NCE annually runs the  risk of subsidizing  the  surplus
overcontrol.   For example in 2002, the NCE purchased $2,757,323 worth of credits from 39
dischargers.  The program sold $1,317,233 worth of credits. The $1,440,110 difference was paid
for by NCE funds.

The second market risk is that during the year the WWTPs, in aggregate, may fail to create the
number of credits needed by other WWTPs. In years when the demand for credits is larger than
the supply, the NCE receives a net  infusion of cash  because all sources must purchase the
necessary credits.  This infusion of cash is intended to pay off any deficits from previous years
when there is a credit surplus.  In either case, the aggregate annual limit may be adjusted in light
of the previous year's deficit or surplus and the projected control to be completed during the year.
This helps manage the annual deficits and surpluses, both in terms  of nitrogen control and
funding, while continuing to implement reductions under the TMDL.

Finally, the market manages the risk that reductions generated and traded in the market will not
achieve the designated uses of the waterbody by providing for periodic review of both the TMDL
and the  general permit allocations. The TMDL includes a periodic review schedule, during which
the TMDL allocations may be modified up or down. In turn, a change in the TMDL allocation could
result in a modification of the annual allocations in the general permit.

Providing  information  to  the  public and  other  stakeholders—The  on-going  public
participation   mechanism  in  Connecticut  relies on  traditional public  notice  and comment
procedures used for NPDES permits. The NCE is operated within the framework of the general
permit, providing the opportunity for public comment for the permit when it was issued and when
it is renewed.

In addition, the NCE  annually  produces a  publication  listing the  price of nitrogen credits as
calculated by the NCE Board.  Included with the report is a Long Island Sound  Total Nitrogen
Credit Exchange Final Balance detailing the dollar value of the credits bought by the NCEP from
WWTPs  discharging  less than  their  annual  limit as well as the dollar value of credits to be
purchased by facilities exceeding their annual limit.
                           Water Quality Trading          Handbook

This section illustrates the core functions that water quality trading  markets must serve and
reviews different approaches employed by  three  different  market  models.  This range  of
approaches is  presented to stimulate your thinking on possible market infrastructures that could
be  adapted  to your watershed. All water quality trading  markets share  a common  set  of
necessary functions.  At the same time, the market examples make it clear that how these
functions are addressed can vary substantially. Developing your market may involve borrowing
approaches from one or more existing market models but will also be heavily influenced by the
state  regulatory  agency and consultation with affected  stakeholders.   Assessing stakeholder
readiness for water quality trading, and engaging stakeholder interests, is the subject of the next
                           Water Quality Trading          Handbook


The preceding chapters of this Handbook suggested how to assess your watershed's potential to
create a  viable water  quality trading  market based on  pollutant  suitability, watershed  and
discharger characteristics, the financial  attractiveness of likely trades, and  an understanding of
the infrastructure required  to  enable trading.   As you  pursue further consideration of trading
opportunities in your watershed, you will need to  reach out to other potential participants and
stakeholders to assess their interest and potential  participation  in trading. This chapter will  help
answer the following questions:

       Which participants will be needed to create a  viable water quality trading market in  your
       Do key participants have a reasonable level of interest in  considering trading as a water
       quality management option?

After completing this section and reflecting  on the  information in the  other chapters, you should
have a better understanding of how to engage other stakeholders to discuss water quality trading
opportunities. Because each situation will present  unique  circumstances, this chapter does not
prescribe  a specific path but  offers  suggestions to assist  you  in identifying and engaging the
necessary participants.

This chapter recognizes that water quality trading requires the participation of certain parties.  In
addition  to  dischargers, there are other watershed stakeholders that must  be  engaged  in
development of a viable water quality trading system.  Each watershed will have a unique set of
potential participants. The first step in this chapter involves identifying potential participants by
using tools such as a checklist of possible participants, a description of roles they may play, and a
series of questions that can help evaluate how watershed conditions will influence the choice of
essential participants (e.g.,  if agricultural reductions would be needed to generate credits, farming
groups and  extension agents  might be essential participants).  The next section of the chapter
summarizes some of the likely interests of various participants so that you will be better prepared
to engage them.  It includes a review of benefits that trading can provide where it is suited to the
water quality conditions at hand, as well as several likely stakeholder needs and interests. Finally,
this  chapter gives three examples of  how trading  programs  have provided  for  stakeholder

                        • •

A wide range of parties may have an interest in participating  in discussions about water quality
trading in your watershed.  To begin the process of identifying key parties, you should focus on
the water quality problem that is being addressed.  Looking at potential solutions to the problem
will help you identify those parties that can contribute to the solution through various roles.

Discharge sources in  the watershed.   Dischargers  include  municipal and industrial  point
sources,  and nonpoint sources  located in  relevant urban and  rural  areas.  You should focus
especially on any sources that need to achieve substantial reductions for water quality goals to be
met and those that may be capable of overcontrolling their loadings. These sources make up the
pool of potential trading partners. As discussed in Chapter II,  it will  be important to engage  point
source dischargers and other sources to gather information for evaluating financial attractiveness.
It will also be  important to build an understanding of the water  quality  challenges  individual
dischargers face to help identify those that will be essential parties to  viable water quality trades.
For example, at an early decision point in the Lower Boise River trading discussions, the group
recognized that a viable  program could not be developed without the  involvement of nonpoint
sources from the agricultural community. Other watersheds may need the participation of a major
point source facing imminent and stringent permit limitations.

Some sources, however, may be reluctant  to participate in discussions, particularly if trading is
not well  understood.   Techniques to encourage engagement include utilizing existing, trusted
channels of communication. For example, if the agricultural community has a strong relationship
with a  local  soil  conservation  commission,   you could  direct communication  through  the
commission.  If a group  of discharging industries  has  a local business association,  you could
approach them through the association.

An important component  of engaging stakeholders involves building  trust, both among the trading
partners  and in the trading  process  itself.   In some cases, various stakeholders may enter the
process with a  history of  competition or distrust.  The process of establishing a marketplace can
be a lengthy endeavor that requires  strong  working relationships among stakeholders based on
trust. It is important to be cognizant of the trust building process for all  stakeholders.

Another potential challenge to engaging stakeholders could be disparate  benefits  from trading
among the potential participants. Since participation in trading is voluntary, stakeholders will be
judging whether it's worthwhile for them to participate. Some stakeholders may have a significant
financial  incentive to participate  (such as a large point source discharger), while others may be
more focused  on the water  quality benefits (such as the local environmental organization).  On
the other hand, some stakeholders may  not see  any value  in participating.   In  engaging
stakeholders, it is important to identify and evaluate the benefits  that may appeal  to  each
stakeholder to determine  their potential willingness to participate.

Federal, tribal, state, and local government.  The participation of federal,  tribal, state, and  local
regulatory agencies in the watershed will be essential to assess whether and how trading might fit
within current regulatory requirements.   EPA has  federal oversight responsibilities  under the
Clean Water Act (CWA) and also implements the NPDES program in some states.  Most states
and some tribes have delegated CWA authorities.  Participation of NPDES  permitting  and TMDL
development authorities will be needed to interpret CWA and state/tribal requirements, formulate
new rules or guidance if necessary, and perhaps to provide technical and scientific expertise.
                            Water Quality Trading Assessment Handbook

Depending on the market's design,  it is also likely that these agencies will  need to approve
elements  of the  trading program.   Other governmental  agencies may need to be  involved
because of their responsibilities for protecting fish and wildlife, regulating water supply, managing
irrigation projects, land management, or other activities affecting the watershed.  These agencies
may also be able  to provide valuable technical assistance. Tribal governments may be interested
for a variety of reasons, including potential impacts on businesses they operate and their treaty
rights to harvest fish and shellfish in the watershed.

Municipal  government agencies often operate wastewater treatment  plants  that are NPDES
permittees. Other agencies may operate water or power utilities that impact water quality in the
watershed or need to be involved because their activities contribute to nonpoint source runoff or
storm water discharges related to transportation, construction, or urban drainage systems.

Local businesses.  Some local businesses  will have  a direct interest in water quality trading
because they are permitted dischargers subject  to more stringent  discharge limits.  Certain
businesses may utilize public water treatment facilities. As indirect dischargers,  these businesses
may face  rate increases resulting  from  investment in  control technologies  and will  have  an
interest  in  trading.   Affected  businesses may include  significant industrial water  users, land
owners, developers,  recreation, and  tourism interests in the watershed, commercial fishermen,
and others.

Citizen and Interest groups.  Groups or associations representing affected  citizens, businesses,
and  local  governments will have  an interest in  discussions  about trading in the watershed.
Examples  of  these  groups  include  Farm  Bureau  chapters,  water  users associations, and
associations of local county officials  or wastewater treatment authorities.  Of critical importance
are active  citizen environmental groups in the  watershed, many of which are very knowledgeable
about watershed  conditions and challenges.   In  addition,  some watersheds  have councils or
watershed management organizations with various planning and  implementation responsibilities.
It is important to include these groups in trading program design.

College and university resources.  Local colleges and  universities  may  be good sources of
information and technical assistance to support trading development efforts.

The  checklist  below may assist you in  identifying the  range of potential  participants in your
watershed's trading effort.
Checklist of Potential Participants

Dischargers in the Watershed
    Individual Point Sources (including wastewater and storm water dischargers)
       - Municipal
       - Industrial (Direct and Indirect)
    Individual Nonpoint sources
       - Urban entities
       - Farmland owners/operators
       - Irrigation or drainage districts
       - Forest land managers
       - Range land managers
                            Water Quality Trading Assessment Handbook

Federal agencies
    The Regional U.S. EPA Office
    U.S. Department of Agriculture
        - Natural Resource Conservation Service (NRCS)
        -Cooperative State Research, Education and Extension Service
    U.S. Bureau of Reclamation (USBR) (related to irrigation activity)
    U.S. Fish and Wildlife Service
    National Marine  Fisheries Service

State/Tribal Government
    Department of Environmental Protection, Dept. of Environmental Quality, or similar agencies
    Agriculture Departments
    Department of Fish and Game
    Department of Water Resources
    Court-appointed water master
    Tribal Councils

Local Government
    Municipal utilities
        - Wastewater treatment
        - Water suppliers
    City or county government
        - Public Power Utilities
        - Resource Conservation and Development Councils
        - Soil and Water Conservation Districts

Local Businesses
    Significant industrial users (dischargers to POTW treatment systems)
    Agricultural service providers
    Certified Crop Advisors
    Certified Professional Crop Consultant
    Conservation bankers, e.g.,  wetlands mitigation bankers
    Power companies

Interest Groups
    Associations of Water users and local business (e.g., Farm Bureau)
    Environmental and conservation groups
    Watershed councils or associations

Colleges and Universities (and other water quality research facilities in the area)
Although  all of these  groups  may  have  an interest  in water quality trading,  not all of them
necessarily need to be included  in a  stakeholder dialog  about trading in  the  watershed.   To
assess the importance of each  potential participant,  it may  be helpful to  ask the  following

        Which dischargers will need  to achieve  substantial reductions that will  contribute to
        solving the water quality problem?
        Which dischargers appear capable of overcontrolling their discharge?
        Which agencies must be involved to assure regulatory compliance?
        Which groups might be able  to assist with trading transactions?
                             Water Quality Trading Assessment Handbook

       What type of expertise or technical  assistance is  needed and  where is  it  likely to be
       Which groups were involved in the development of the TMDL?
       Which groups are a trusted voice  on environmental issues in the community and thus
       have the ability to influence adoption and implementation of a new program?

Based on the answers  to these  questions, you should be  able to create a  list of essential
participants in the design and/or implementation of the trading program.
Before attempting to engage essential  participants, begin by assessing their interests in water
quality trading and try to view the issues from their perspective. Why might water quality trading
be attractive to them? Why might it seem unappealing? What information might help encourage
their participation in discussions? As with any unfamiliar program, participants may need more
information about the  potential benefits  of trading for the watershed and may have questions or
If you have progressed to this chapter of the handbook in your consideration of trading,  it  is
assumed that trading is a potentially good fit for the water quality challenge in your watershed.
Given that, when discussing  trading opportunities with potential participants, it may be helpful to
keep in mind the following benefits that can accrue where trading  is a good fit with the water
quality problems and financial profile in the watershed.

Water quality  trading may result in significant cost  savings.  Typically,  a party  facing
relatively high  pollutant reduction costs compensates another party to achieve an equivalent,
though  less costly, pollutant reduction. In the  right  circumstances, trading markets can help
participants  achieve needed water  quality improvements at  the lowest cost to society.   Cost
savings for  a municipality could result in  lower sewage treatment costs for citizens.  For an
industry, trading may  translate  into lower operating  costs  and/or more capital  available for
productive investment enabling a stronger competitive position. For some sources, trading may
be a source of revenue.

Water  quality  trading  provides  flexibility to  dischargers  in meeting  pollutant  load
reductions.  Trading  might  help identify  additional options for meeting  more restrictive  water
quality-based NPDES  permit  limits  and may  provide greater  flexibility  in  implementation
schedules for individual facilities.

Water quality trading is voluntary and  does not impose  CWA  requirements  on federally
unregulated sources. Successful  trades will occur only if both parties perceive they will gain
benefits from the trade.  Some parties, especially  nonpoint sources, are more likely to come to
the table to discuss pollutant reductions in  a voluntary context.  Some nonpoint sources may be
concerned  that trading or other water quality initiatives represent an attempt to extend new
regulatory controls. Because most trading systems are designed to fit within existing regulatory

frameworks, trading typically will not create  new regulatory control  obligations. However,  all
sources that choose to participate  in trading will have to adhere to accountability mechanisms
established by the trading program to ensure that promised pollutant reductions are generated.

Water quality trading provides incentives for overcontrol beyond  current limits.  For point
sources,  trading provides financial  incentives for installing  pollutant control technology beyond
TMDL wasteload allocations because increments of pollutant reduction beyond TMDL allocations
can be sold to other dischargers.  Nonpoint sources can be compensated for installation of best
management practices that result  in pollutant reductions  beyond  meeting their allocations.
Trading provides additional incentives to create reductions where the incentives and disincentives
(such as enforceable  requirements for nonpoint source management) are relatively weak or
nonexistent. These additional incentives can accelerate the rate of water quality improvements.

Water quality trading can result in other ancillary environmental benefits. Trading provides
incentives to  use control options such as wetland  restoration,  floodplain  protection, or other
management practices that both improve water quality and  provide additional benefits such  as
improved fish and wildlife habitat and co-control of other pollutants.
                              • •   T, ''"••'     •

Even if participants understand the positive aspects of trading, they will likely have questions or
concerns that must be addressed.  The following is a list of issues and concerns that often arise
in discussions of trading programs and includes suggestions for responding to them.

Issue:  Lack of a  Market  Driver.   Permitted  dischargers  may  be interested  in  exploring
alternative pollutant reduction options only if they are facing an imminent change to their permit

       Possible Response: In the watersheds being evaluated for trading viability, the market
       driver is usually  the TMDL  (or similar framework).   The TMDL  provides  wasteload
       allocations for point sources  and load allocations for nonpoint sources.  Wasteload
       allocations often  drive more stringent NPDES  permit limitations that require pollutant
       reductions.  Watersheds with completed TMDLs generally have a sufficient incentive to
       explore trading.

Issue:  Monitoring or assessment of nonpoint source loadings could be intrusive and lead
to increased regulation.  Some  nonpoint  stakeholders  may be concerned that trading  will
require on-site  monitoring to measure pollutant  reductions. Monitoring by  regulatory agencies
may be perceived by these stakeholders as intrusive, costly, unreliable,  and a  precursor to
additional regulatory requirements.

       Possible Response: Effective assessment of nonpoint source management actions for
       trading  purposes  is designed to determine the value  of the pollutant  reduction credits
       being generated.  These credits,  when  confirmed  through  assessment,  become  a
       commodity that can be  sold to willing buyers. Confirmation can be achieved in various
       ways including using  trusted  and competent professionals such as  Certified Crop
       Advisors to make onsite  verifications.  Trading program  documentation can include

       explicit language explaining  that the regulatory  burden remains  solely with  existing
       permitted sources.

Issue: Trading  reduces the degree of certainty in meeting water  pollutant reduction
targets.  With point/nonpoint source trading,  some may be concerned that trading could forego
almost  guaranteed,  enforceable  reductions from   point  sources  in  return  for  uncertain,
unenforceable (under the CWA) nonpoint source reductions elsewhere.

       Possible Response: As discussed  earlier in the Handbook, there is greater variability
       and uncertainty in pollutant reductions from land-based management practices compared
       to point sources due to site-specific variables and impacts of weather. Accounting and
       compensating for this greater uncertainty is  essential to the environmental results and
       eventual acceptance of any point/nonpoint trading program. Various means are available
       for addressing  this uncertainty including  using nonpoint source  screening  criteria,
       conservative  BMP  performance assumptions, and  uncertainty discounts for nonpoint
       source credits.  As  with any water quality management program, monitoring at the point
       of intended impact will be important for assessing overall program performance.

Issue: Trading can create  "hotspots" or localized  areas with high levels of pollution within
a watershed. Concerns may be raised that a trading program may improve the watershed's
overall water quality but leave certain areas with highly degraded water quality.

       Possible Response:   Trading  programs  can and  must  be  designed to  avoid
       unacceptable localized impacts. As discussed in Chapter II, this can be achieved by
       considering the characteristics of the pollutant, watershed conditions, location of potential
       trading partners, and type of trades, and by incorporating specific mechanisms to prevent
       hot spots.    Options  include  limiting the direction  of trades,  e.g., upstream  versus
       downstream,  imposing discharger-specific limits for  pollutant(s) that are likely to cause
       localized concerns,  and imposing limits on the number of credits that may be used by a
       particular discharger.

Issue: Trading may provide less opportunity for public participation in pollutant reduction
activities.  There is rising public interest in watershed related activities.  Citizen groups are often
actively involved in decisions that affect local watersheds.  Some  may  be concerned about
whether trading will change existing public participation opportunities such as public notice and
comment for NPDES  permit modifications.

       Possible Response: All required public participation opportunities that apply to TMDLs
       and NPDES  permits remain in place, without trading or with a trading program.  In
       addition to these traditional mechanisms, it is valuable to solicit and consider public input
       during the  development of a  trading program and provide meaningful opportunities for
       input on issues  of interest or concern. Early participation will help all parties better
       understand the information and assumptions used in the market's development, and what
       to expect as the program  is implemented.
                           Water Quality Trading          Handbook

Each  of the  trading programs described in  the Market  Infrastructure  chapter  provided for
stakeholder involvement during the development stage. This section briefly describes,  for two
programs, the range of stakeholder participants, the function of the stakeholder group, and any
key opportunities for stakeholder involvement that were provided.

Lower Boise River Effluent Trading Demonstration Project

As described  in the Market Infrastructure section, participants in the Lower Boise  River project
worked together to develop a trading program framework.  The project was launched with a state
workshop to educate all attendees about the trading concept and to solicit participation in the
Lower Boise.  Participants included wide representation from federal, state, and local agencies
with water quality responsibilities,  agriculture,  municipalities, industry,  and the environmental
community.  Participants included: the Idaho Water Users Association; the Idaho Farm Bureau;
Pioneer Irrigation District; the Payette River Water Master; the Canyon Soil Conservation  District;
the Idaho Soil Conservation Commission; the Natural  Resources Conservation Service; Idaho
Rivers United; the Ada County  Highway District;  the Association of Idaho Cities;  the Cities of
Boise, Meridian,  Nampa, and Middleton; the U.S. Bureau of Reclamation; the  Southwest Idaho
Resource Conservation and  Development Council; Micron;  Simplot;  American Wetlands; Idaho
Power Company;  Idaho  Division of Environmental  Quality; US EPA; and  the  Boise State
University Environmental Finance Center.

Participants were supported  by  a contractor providing neutral facilitation,  process  support, and
various forms of analysis.  Process support from a neutral facilitator was important  for recruiting
participation and managing the program development process.

As the participants worked  together  to  pursue  the  development of a  trading  system, they
recognized that state and federal regulatory agencies would maintain their existing authorities,
but the group would develop and provide recommendations for their consideration that would
likely  carry significant weight.  The participants  were divided into  three  main teams:  1) the
Framework Team, charged with  developing the  mechanisms, rules, and  procedures for dynamic
trading in the watershed; 2) the Point Source-Point Source Model Trade Team, responsible for
developing a  model trade between two point sources;  and 3) the  Point Source-Nonpoint source
Model Trade Team, tasked with developing a model trade between a point source and a nonpoint
source.  Smaller workgroups were  also formed to work through specific parts of the  trading
system.  These workgroups also provided an opportunity for stakeholder groups to identify and
resolve issues specifically  related to their interests and needs. These included the Agriculture
Workgroup, the Ratios Workgroup, the Trading  Framework Workgroup, the Indirect Dischargers
Workgroup, and the Association Workgroup.  Stakeholder participation was supported by a state-
run small grants program, facilitating  production of materials for the workgroups.  Idaho DEQ also
prepared for public comment a state water quality trading guidance, model permit  language for
point source to point source trading, and the BMP list for the Lower Boise project.

Connecticut's Nitrogen Credit Exchange Program

As described  in the Market Infrastructure section, a nitrogen trading program was established in
Connecticut as a means for attaining the nitrogen reductions outlined in the TMDL for Long Island
Sound. Connecticut's program does not include nonpoint sources of nitrogen  discharge  and is

limited to the 79 municipal wastewater treatment plants in the region.  Because of this limitation to
point sources, the range of participating stakeholders was generally more restricted than trading
projects that also include nonpoint sources.

Public involvement in the program has been provided through an administrative process of public
workshops and hearings, through  the  legislative process required during the passage of state
implementing legislation, and through ongoing meetings of the Nitrogen Credit Advisory Board.
In addition, a number of individual meetings were  held with affected sources, cities and towns,
and other interested parties.

Administrative Process

Prior to  the development of the trading program, a series of six informational public workshops
were  held in the region on the  wasteload allocations  proposed in the nitrogen TMDL for Long
Island Sound.  Nitrogen trading  was one of the options discussed at the workshops for meeting
the TMDL allocations.  These workshops were attended  by  affected  point sources,  local
communities, and local and national environmental groups.

Another series of public workshops was held  by the Connecticut Department of Environmental
Protection to increase public understanding of the General Permit for Nitrogen Discharges and
the Nitrogen Credit Exchange  Program.  Invitations and public  notices were issued for these
workshops and they were attended by point sources and other interested parties.

Following the  informational meetings,  a  two-day formal  public hearing was held  to  receive
comments  on  the General Permit  for Nitrogen.   The agency formally responded to these
comments and made several changes to the general permit.

Legislative Process

Legislation was introduced  in the Connecticut General Assembly to implement the Nitrogen Credit
Exchange Program.  Opportunity for stakeholder groups and  the general public to comment on
the program was provided through the legislative  process,  which included hearings in relevant
legislative committees. As  a result of the legislative process, a number of changes were made to
the proposed program.

Nitrogen Credit Advisory Board

The legislation  established  a  Nitrogen  Credit  Advisory Board  to  assist and advise the
Commissioner of Environmental Protection in administering the program. In addition to  three
representatives of  state agencies,  the board  includes nine  public  members.  The  legislation
requires that public members reflect a range of interests and  experience and that  it is balanced
with regard to  buyers and  sellers of credits, large  and small municipalities, and representatives
from  different  geographic regions of the state.   In  addition,  members  with experience  in
wastewater treatment, environmental law, or finance are included. The Board conducts regular
meetings that are open to the public.
                           Water Quality Trading          Handbook


With the right participants engaged, you will be ready to put together the results of your analysis
on pollutant suitability and financial attractiveness with an understanding of the basic functions
that your WQT market must deliver.  From this assessment you should have a good sense of
whether watershed conditions do or do not favor large scale trading at this time.  If watershed
conditions are favorable  for WQT, you are now well positioned to engage state  and local clean
water authorities to commence the design and implementation of a WQT program.
                           Water Quality Trading          Handbook

Best  Management Practice (BMP):   A  method that has been determined to be the  most
effective, practical means of preventing or reducing pollutant loadings, typically from a nonpoint

Credit, or Pollutant Reduction Credit:  A measured or estimated unit of pollutant reduction
representing a level of control beyond that needed to meet a water quality based effluent limit (for
an NPDES permittee) or a TMDL allocation (for a nonpoint source) which may be exchanged in a
trading program.   A  buyer or user of credits compensates  another party for creating  this
overcontrol and uses the resulting pollutant reductions, typically to meet a regulatory obligation.
A seller or provider of credits has overcontrolled pollutant loadings and can receive compensation
from a party wishing to use the surplus reductions.

Designated  Uses: Water uses identified  in state water quality standards that must be achieved
and maintained as required under the Clean Water Act.  Uses can include cold water fisheries,
public water supply, irrigation, and others.

Discharge Monitoring  Report (DMR):   The form used by NPDES permittees to report self-
monitoring results to delegated states or EPA.

Downstream Trade:  A water quality trade in which one source compensates another source
located downstream of its position within the watershed for producing pollutant reductions.

Effluent: Wastewater that flows out of a treatment plant, sewer, or industrial outfall.

Incremental cost:  The average cost of control for the increment  of pollutant reduction  required
for an individual source to  meet a regulatory  limit  or achieve  a specified level of pollutant
reduction. Incremental cost is an alternative to average cost. For example, if a discharger needs
a 5 Ibs./day  reduction to  comply with  requirements  but that drives a $10 million technology
investment that actually reduces 20 Ibs./day, then the incremental cost would be  $2 million, four
times higher than the average cost of $500,000.

Indirect  Discharge:  A non-domestic discharge introducing  pollutants  to a  publicly owned
treatment works.

Load allocation: The portions of a TMDL that are allocated to nonpoint  or diffuse  sources of a

National Pollutant Discharge Elimination System (NPDES):  The national program for issuing,
modifying, revoking and reissuing, terminating, monitoring, and enforcing permits for discharge of
pollutants into waterways. An NPDES permit is issued to all point source dischargers.

Nonpoint source:   Diffuse  pollutant  sources (i.e.,  without  a  single point of origin or not
introduced into a receiving stream from a specific outlet). The pollutants are generally carried off
                           Water Quality Trading Assessment Handbook

the land by stormwater.  Common nonpoint sources are agriculture, forestry, urban areas, and
historical mining sites.

Overcontrol:  Taking steps to reduce pollutant discharge below the water quality based effluent
limit for individual  point sources or below the TMDL-based  load allocation,  or other specified
baseline, for nonpoint sources.

Point source:  Any discernible  confined and discrete conveyance,  including, but not limited  to,
any  pipe,  ditch,  channel, tunnel,  conduit,  well, discrete  fissure,  container, rolling  stock,
concentrated animal feeding operation,  landfill  leachate  collection system, vessel, or other
floating craft from which pollutants are or may be discharged, excluding those exempted by CWA
or regulation. A discharging point source must have an NPDES permit.

Publicly Owned Treatment Works (POTW): Wastewater treatment facilities owned by the State
or any political subdivision thereof, such as a municipality, district, quasi-municipal corporation or
other public entity, responsible for handling local water supplies and includes any  devices and
systems  used in  the storage, treatment,  recycling, and  reclamation of municipal sewage  or
industrial wastes of a liquid nature.  POTWs receive and treat sewage and/or wastewater from
residences, commercial activities, and industries.

Total Maximum Daily Load (TMDL): A quantitative expression of the amount of a pollutant that
can  be present in  a waterbody without  causing  an impairment  of the applicable water quality
standard for any portion of that water.  A TMDL must include wasteload allocation(s) for point
sources and load allocation(s) for nonpoint sources plus a margin of safety.

Upstream Trade:   A  water  quality trade in  which one source compensates  another source
upstream of its position within  the watershed for surplus pollutant reductions.

Wasteload Allocation: The portions of a TMDL that are allocated to individual point sources of a

Water Quality Equivalence:  The  establishment of the physical inter-changeability  among
pollutant reductions made at different points within a watershed, usually through application of a
ratio, intended to ensure that the impact of pollutant reductions at a designated area of concern is
equivalent. Water quality equivalence concentrates solely on water quality  impacts of pollutant
control actions and does not include non-water impacts such as habitat enhancement.

Water Quality Standards: State-developed standards that include the following components: a)
designated uses for waters, such as water supply, recreation, fish  propagation, etc. (b) numeric or
narrative water quality  criteria which define the amounts  of  pollutants the  waters  may contain
without impairing  their designated uses; and  (c) antidegradation  requirements, which  protect
existing uses and otherwise limit degradation of waters. TMDLs must be designed to meet water
quality standards.
                           Water Quality Trading

Water Quality Trading Suitability Profile for Phosphorus
The EPA Water Quality Trading Policy supports nutrient trading, such as total nitrogen and total
phosphorus. Sources of phosphorus include background sources  such  as  natural springs, point
sources such as municipal sewage treatment plants and food processors, and nonpoint sources
such as agriculture.  Water quality trading pilot projects have shown that total phosphorus can be
successfully traded,  i.e., that cost-effective  trades can reduce overall pollutant loadings without
creating  locally  high  pollutant concentrations. These projects  have  found that  phosphorus
discharges and in-stream  concentrations can be readily measured at points within a watershed,
and that the pollutant is relatively stable  as  it travels through  river systems.  As a  result,
phosphorus dischargers will have a  reasonable ability to establish water quality  equivalence
relationships among  themselves and/or with  an area of water quality concern.

TMDLs address phosphorus to control a number of water quality problems including aquatic plant
growth,  low dissolved oxygen, and high pH.  To  establish  equivalence appropriately, trading
parties will need to  understand how their loadings connect to the specific problem.  Excessive
phosphorus contributes to exceeding the narrative or numeric water quality standards established
by many  states  relating  to nuisance  aquatic  plant growth, deleterious  materials, floating,
suspended,  or submerged  matter,  and  oxygen-demanding materials.   Excessive phosphorus
concentrations have both direct and  indirect effects on water quality.  Direct effects include
nuisance algae and  periphyton growth.  Indirect effects include low dissolved oxygen, elevated
pH, cyanotoxins from  blue-green algae production, trihalomethane production in drinking  water
systems, and maintenance issues associated with public water supplies.

Many TMDLs are intended to address the  correlation between phosphorus  concentrations and
these water quality concerns.  Excess nutrient loading causes excess algal growth which  in turn
affects levels of dissolved oxygen  and pH  in aquatic systems. In some TMDLs, concentration
levels are  established for  both chlorophyll a  and total phosphorus  to  ensure that nutrient
concentrations do not result in excessive algae or other aquatic growth, which may impede the
attainment of water quality standards for dissolved oxygen and pH.
A.  Phosphorus Pollutant Form(s)

Total  phosphorus TMDLs—Most TMDLs  establish  allocations for total  phosphorus,  although
levels of both total phosphorus and ortho-phosphorus are often monitored.  Total phosphorus is
comprised of two forms:

       Soluble—also known as dissolved ortho-phosphate or ortho-phosphorus—includes highly
       soluble, oxidized  phosphorus.  Because of its solubility, ortho-phosphorus is commonly
       more available for biological uptake  and leads  more rapidly to  algal growth than non-
       soluble phosphorus.
       Non-Soluble—also  known  as  sediment-bound  or particulate-bound  phosphorus—is
       mineral phosphorus incorporated in sediment and is not as likely to promote rapid algal
       growth, but has the potential to become biologically available overtime.

The concentration of total phosphorus is calculated  based  on  the sum of the soluble and non-
soluble phosphorus.   Due to phosphorus  cycling in a waterbody (conversion  between forms)
TMDLs usually consider total phosphorus concentrations. Total phosphorus then represents the
phosphorus that is  currently available  for growth as well as that which has  the potential to
become available overtime.

Sources covered by a total phosphorus TMDL will be measuring discharges and reductions using
a common metric. Use of this common metric for measuring phosphorus reductions in a TMDL
should provide a high potential for matching phosphorus discharges from various sources in the
watershed.  It will be important, however, to understand the actual forms of phosphorus being
discharged because some trades may not represent an equivalent impact on water quality.  For
example,  if individual dischargers  have substantially divergent load  characteristics (e.g., one
primarily   discharges  soluble  phosphorus  while  another primarily discharges  non-soluble
phosphorus)  then  a  trade between the  two may not be  environmentally  equivalent.  This
determination will be  site specific.  Most nonpoint  phosphorus from croplands is sediment-bound,
non-soluble phosphorus.  Most phosphorus loadings from grasslands and pastures are in soluble
form.  Phosphorus discharges from POTWs are comprised primarily of soluble phosphorus. If a
high  percentage  of the total phosphorus is present as soluble  ortho-phosphate, it is more  likely
that rapid algal growth will occur than if the majority of the total phosphorus is mineral phosphorus
incorporated in sediment.  Adjustments, using a trade ratio or other  means of establishing  an
equivalence relationship, may be needed to account for such differences.

Other Phosphorus-Related TMDLs—To the extent that  a TMDL establishes load allocations in
terms of individual phosphorus forms, challenges to trading may exist. If a TMDL provides load
allocations for different forms, participants in  the  watershed will be limited to trading within two,
smaller, more constrained markets for each form.  Alternatively, a reliable  translation ratio may be
generated to create broader trading opportunities.

There may be circumstances  where some  dischargers receive  phosphorus allocations while
others receive dissolved  oxygen  allocations.   There  is a  well-characterized link  between
phosphorus concentrations and dissolved oxygen  problems.  This  relationship provides  an
opportunity to establish a  specific translation ratio between  total phosphorus and dissolved
oxygen, potentially enabling additional trading opportunities.   For example, a power company
might be given a load allocation for DO, while municipal, industrial, and agricultural sources have
received total phosphorus allocations.  The development of a total phosphorus/dissolved oxygen
translation  ratio  is  possible that  would enable  the power company to become a  potential
purchaser of surplus reductions from other sources.
                           Water Quality Trading
                                      Appendix A-86

B.  Impact

Adjusting for Fate, Transport, and Watershed Considerations—In general, phosphorus fate and
transport are sufficiently well  understood, and the models used  to develop phosphorus TMDLs
are reasonably well suited, to  support the development of water quality equivalence relationships
among potential phosphorus  trading  parties.  The phosphorus "retentiveness" of a water body
describes  the rates that nutrients are used relative  to their rate of downstream transport.  As
ratios are set for trading opportunities,  the factors  that contribute to retentiveness should be
considered.  Areas of high  retentiveness are usually associated with  low flows, impoundments,
dense aquatic plant beds,  and  heavy sedimentation.  Trades that involve phosphorus loading
through these areas will likely require higher ratios to achieve water quality equivalence between
dischargers.   In  areas with  swift  flowing water and  low  biological  activity,  phosphorus  is
transported downstream faster than it is used by the  biota, resulting in  low levels of retentiveness
and  minimal  aquatic growth.  In areas of low retentiveness, where phosphorus is transported
rapidly through the system,  lower ratios may be appropriate.

Other factors, including substrate stability and light  contribute to plant growth and factor into a
segment's "retentiveness." Sedimentation is another condition that can  affect how phosphorus will
move through and be  utilized in a system.   Phosphorus is often found in  sediments and will
persist longer in  them.  As a  result,  the presence of these  factors  should  be  an explicit
consideration in setting water quality equivalence ratios.

Examining Local Considerations—In  a downstream  trade, the upstream source will not directly
reduce its discharge to the  permit limit because it is  purchasing  reductions from another source
downstream. Discharges from the upstream source  may not be reduced and, if so, water quality
will not be improved in the  segment between  the two sources.   Overcontrol  by the downstream
source will result in improved  water quality only further downstream.  In general, these types of
trades will only avoid unacceptable localized impacts  if the segment between the two sources has
not reached  its assimilative  capacity.

Additionally,  a trade,  irrespective  of its direction (up or  downstream),  involving sources
discharging  substantially different phosphorus forms could be  more likely  to create  localized
impacts.  In  particular,  a trade that involves offsetting a  primarily soluble phosphorus discharge
with a sediment-attached discharge will leave  a  greater quantity  of readily available phosphorus
in the water body than otherwise would have been the case. This readily available phosphorus
has greater potential to contribute to short-term, local  nuisance aquatic growth problems.

C.  Timing

The key timing element to  consider  when examining  phosphorus trading is  the seasonal load
variability among sources. Agricultural nonpoint source loadings will vary seasonally, with greater
loadings likely during the growing season  and during  storm events associated with soil runoff.
Point sources generally discharge all year round.  The relative importance of this difference  plays
out in the context of how TMDL phosphorus allocations are set.  Many TMDLs provide seasonal
phosphorus  load  allocations  that apply  only  during the months of the growing season.   The
potential for  excessive algal growth occurs predominately in the summer when sufficient light and
temperature  conditions support plant growth.   Under  these  circumstances,  both point and
nonpoint  sources will  likely receive  a seasonal allocation, and  their  ability  to match reduction
needs with the timing of phosphorus reduction  credits will overlap and readily support trading.
                            Water Quality Trading
                                       Appendix A-87

However,  allocations to  lakes or other large  water bodies may be  annual because  of  the
relationship in these water bodies between annual phosphorus loadings and eutrophication.  In
such cases, sources receiving year-round allocations may be restricted from trading with sources
that produce seasonal loads.

D.  Supply of Surplus Reductions

Typically, phosphorus TMDLs establish WLAs and LAs in terms of concentration or mass based
reductions. For the most part, these allocations provide a straightforward means to establish over
control for purposes of identifying marketable reductions.  For example,  a  WWTP with a permit
limit established at 700 Ibs./day that currently discharges 600 Ibs./day, will have 100 Ibs./day of
potential marketable reductions.  For some nonpoint sources, estimates may need to be utilized
to establish  the level of phosphorus  reductions.   This will likely be  needed  when sampling a
discharge  is complex, infeasible,  and/or not cost  effective.  Pilot projects have used estimation
methods based  on the  type  and degree  of  BMP  implementation to  establish  phosphorus
reductions. Such estimates should be based on the type and extent of BMP implementation and
local conditions.   While less precise,  if conservative assumptions are  utilized, the degree of
control that  can be  achieved with various BMPs can be  estimated  and utilized  for trading
purposes.  Thus, in either case, reasonably well established methods exist for understanding  the
degree of over control  achieved  by phosphorus sources and enabling trading parties to  clearly
verify the existence of marketable reductions.
                           Water Quality Trading
                                      Appendix A-88

Water Quality Trading  Suitability Profile for Nitrogen
The 2003 EPA Water Quality Trading Policy supports nitrogen trading. Anthropogenic sources of
nitrogen to receiving waters include  point sources such as municipal sewage treatment plants
and industrial discharge, nonpoint sources such as agriculture, and atmospheric deposition from
nitrogen initially released by combustion sources. Human activity has had an important influence
on nitrogen  cycles causing a dramatic increase of mobilized nitrogen.  In particular,  nitrogen
fertilizer use in the United States has increased nitrogen input to receiving waters between 4-fold
and  8-fold  since widespread  use began in the 1950's.  Furthermore,  fossil-fuel  combustion
activities leading  to atmospheric deposition, and more recently manure from animal feedlots,
have also contributed significantly to anthropogenic conversion  of nitrogen from inert forms to
biologically available forms that may contribute to water quality impairment.11 In addition, both
natural and human-caused disturbances of natural ecosystems (e.g., forest fires,  forest clearing)
can also contribute significant quantities of biologically available nitrogen to receiving waters.

Pilot trading  programs have demonstrated that total nitrogen from some of these sources can be
successfully traded, i.e., that cost-effective trades can reduce overall pollutant loadings without
creating locally high  pollutant concentrations.  These projects have found that nitrogen discharges
can be effectively measured or calculated  and tracked in their course through a watershed. As a
result,  watershed participants  have  reasonably reliable  models  to establish  water quality
equivalence  relationships and can engage in trading.

Effects  of  excessive  nitrogen  include   those  related  to  eutrophication—such  as  habitat
degradation, algal blooms,  hypoxia,  anoxia, fish kills as well as direct toxicity effects.12  Most
nitrogen-related TMDLs recognize the relationships between nitrogen concentrations and these
water quality concerns.  In considering a new nitrogen trading marketplace to address water
quality concerns, participants will need to understand how their load connects to  the specific
problem. While nutrient and eutrophication impacts associated with excess phosphorus may be
more commonly of concern in freshwater systems, nitrogen  is  generally the limiting nutrient in
marine  environments  and thus has  a greater impact  in  estuarine systems.  The increasing
prevalence of hypoxic "dead zones" in the world's coastal areas (such as the Gulf of Mexico and
Chesapeake Bay) is notable evidence of nutrient enrichment problems.
11 National Research Council, 2000
12 Paerl, 2002

      .  •    ing

A.  Nitrogen Pollutant Form(s)

Total Nitrogen TMDLs—Most TMDLs prepared to address water quality problems associated with
nitrogen establish  load allocations for total nitrogen. Total nitrogen is, however, comprised of
several forms.

       Organic nitrogen refers to nitrogen contained in organic matter and organic compounds
       and may include  both dissolved  and particulate  forms.  Sources  of organic nitrogen
       include decomposition of biological  material,   including  plants  and animals;  animal
       manure, either from feedlots or from organic manure fertilizer; soil erosion; wastewater
       treatment plant discharges; and  some  industrial discharges.   Organic  nitrogen is not
       available to aquatic plant uptake, but eventually organic  forms will mineralize and go
       through nitrification in conversion  to inorganic, bio-available form.  It is important to note,
       however, that some nitrogen-containing organic compounds, such as those found in soil
       humic material, may be extremely persistent, and the nitrogen may not become available
       for many years.
       Inorganic nitrogen includes nitrate (NO3~), nitrite (NO2~), ammonia (NH3)  and ammonium
       (NH4+). The primary  sources of inorganic  nitrogen are  mineralized  organic matter,
       nitrogenous fertilizers,  point source discharge, and atmospheric deposition  nitrogen.
       Inorganic nitrogen  is available for aquatic  plant life, including nuisance growth algae.

While many nutrient calculations focus on measures of concentration, total nitrogen is typically
calculated  based  on the total load.  When it is assumed  that all of the organic nitrogen will
become bio-available (i.e., mineralized) within a relevant time period, Total nitrogen may be used
to represent the nitrogen  that is  currently  available  for growth as well as that which has the
potential to become available for growth over time. Because the primary water quality concern is
the nutrient availability for nuisance growth leading to  eutrophic conditions, and because it is
often assumed that most or all of the organic nitrogen  present in the system will be mineralized to
a bio-available form within  a relevant time  period, TMDLs are based on total nitrogen.

TMDLs' focus on total nitrogen will facilitate trading in a watershed by using a common  unit of
measure among all potential trading participants.  However, there are some forms of nitrogen that
may pose  particular problems and warrant specific attention. High levels of ammonia can be toxic
to the point where there may be a  need for local limits (applying local permit limits for ammonia is
common practice in total nitrogen trading). For instance, if there are a large number of  animal
feeding operations, there  may be a high  level of ammonia run-off from manure which has the
potential to cause  localized  toxicity problems.  In addition, high concentrations of  nitrate in
drinking water may raise concerns for human health.

Also, although the total nitrogen load is the most important measure, you should note if individual
dischargers may  have substantially different load characteristics.  A variety of sources  in a
watershed  that include both  nonpoint sources  and  point  sources may result in  a  markedly
different load  of nitrogen  forms that have  differing environmental impacts (e.g., one primarily
discharges sediment  containing organically-bound  nitrogen  while another primarily discharges
soluble inorganic nitrogen).  Adjustments, using a trade  ratio or other means of establishing an
equivalence relationship, may be needed to account for such differences.
                                 Quality Trading           Handbook
                                       Appendix B-90

Atmospheric  deposition  nitrogen  (AD-N)  originates  from a  number  of  sources  including
combustion activities and ammonia volatilized from agricultural areas. Although AD-N can be an
important factor in  impaired  estuarine and  coastal water  bodies  downwind of NOX  and NH3
(ammonia) air emissions, such sources have not yet been incorporated into water quality trading
markets. Nitrogen TMDL budgets can include AD-N in models and have shown AD-N accounting
for 10%-40% of total nitrogen loads.  Deposition occurs either in wet form, in which gaseous and
particulate matter is removed from the atmosphere in snow or rain precipitation, or dry form, in
which removal occurs by physical processes such as gravitational settling of particles or high-
energy fixation caused by lightning. In the future, relatively advanced air dispersion modeling may
help to include air sources  of nitrogen in a watershed trading marketplace.  For the  time being,
potential nitrogen trading marketplaces  should  be sure to consider AD-N in any  nitrogen load
modeling, especially in TMDL nutrient budgeting.

B.  Impact

Adjusting for Fate, Transport, and Watershed Considerations—In general, tools are available to
predict nitrogen fate and transport and to support the  development of water quality equivalence
relationships  among  potential nitrogen trading parties.  A key consideration  in determining any
equivalence ratios will be to understand the nitrogen loss from the watershed system. In addition
to exiting the watershed system to the land via  irrigation diversions, marketplace  participants
should note  conditions  in  the watershed  conducive to nitrogen  attenuation.  For  instance,
vegetation, such as wetland grasses,  can draw dissolved inorganic nitrogen (NO3~ and NH4+) from
the system.   In fact, some management programs may utilize enhanced forested filter zones to
remove surface water nitrogen.  The associated attenuation will need to be accounted for.  When
nitrogen  loads pass through areas of relatively high vegetation uptake, not all of the nitrogen will
reach the zone of impact.  This will need to  be considered in establishing trading ratios. At the
same time, watershed participants should be cognizant of the possibility that through the nitrogen
cycle (i.e., decomposition and mineralization of vegetation in filter zones) the nutrients removed
from the water column by plant uptake could eventually re-enter the receiving water.

Another form of attenuation involves the process of "denitrification" whereby nitrate is reduced to
gaseous nitrogen mainly  by microbiological activity. Particular  forms of bacteria  enable the
denitrification process throughout the watershed, and areas of  high denitrification  are usually
associated with low, shallow flows.  For those nitrogen dischargers whose load passes through
areas of high denitrification, if the  nitrogen  is mainly in the form of nitrate, a (potentially large)
portion of their nitrogen  may  not reach the zone of water quality concern and may have higher
equivalence ratios.  Conversely, nitrogen loads that  travel  in swift, deep waters will have less
opportunity for denitrification and may have lower equivalence ratios.

Another  factor important to water quality impacts in  estuarine  environments is the degree of
flushing activity, particularly from tides. For instance, some areas  of a marine  coastal water body
may have a  low level of tidal activity,  mixing, and flushing.  It is likely that these zones will retain
the nitrogen for long periods of time (potentially up to a  few years) and have significant water
quality concerns.  In fact, most estuarine areas with water quality impairment are  likely to have
limited tidal  mixing  influences.  Discharges  directly into  such a  zone will have a direct water
quality impact.  On  the other hand,  nitrogen discharges near the mouth of an estuary may  be
flushed out of the system, and therefore less nitrogen would be  delivered to the zone  of water
quality concern.
                            Water Quality Trading

Examining Local Considerations—In a downstream trade, the upstream source will not attain its
TMDL wasteload allocation through direct onsite controls because it is purchasing reductions
from another source downstream. Discharges from the upstream source will not be reduced by
the full amount targeted by the TMDL, and water quality will not be fully improved in the segment
between the two sources.  Overcontrol by the downstream source will result in improved water
quality further downstream.  These types of trades will only avoid  unacceptable localized impacts
if the segment  between the  two sources has not reached its  assimilative capacity or is not
affected by the water quality impairment affecting downstream waters.

C. Timing

Nitrogen TMDLs in coastal areas and large water bodies often  set allocations and  associated
permit limits in terms of annual loads.  Nitrogen TMDLs take this approach because the residence
time  is often very long, the area of concern is far-field, and the long-term average Total nitrogen
load  over time,  rather than a  short-term maximum pollutant load, is of concern.13  Unlike some
other nutrients  (e.g.,  phosphorus)  that  can  have a  more direct  and  immediate impact in a
watershed, nitrogen is processed in several steps which have buffers and  delays between the
time  the nutrient is discharged and the time the nutrient has  its  full effect.  Of course,  all local
water quality standards  must be met.  Since nitrogen typically  has  the greatest water quality
impact in estuarine areas, most nitrogen TMDLs will assign annual loads. However, in the event
that freshwater watersheds develop nitrogen TMDLs, they may specify shorter time periods, such
as monthly  loads.  Sources  receiving  annual  allocations  may be restricted  from trading with
sources that have seasonal or monthly allocations.

A key time element to consider when examining nitrogen trading  is any seasonal load variability
that  may exist  among dischargers.   While point sources such  as WWTPs are likely to have
relatively consistent discharge timing,  agricultural  nonpoint  sources will  likely have variable
loadings that change seasonally  based on land management activities.  In addition, precipitation
variation can impact the nutrient loading in a system with increased nitrogen levels during periods
of high rainfall.  The relative importance of this  difference plays out in the context of how TMDL
nitrogen allocations are set.  In the case where TMDLs set annual  limitations, the seasonal load
variability  will  have limited impacts.   However, allocations  in  river systems  and  freshwater
systems may have monthly  allocations, in which case seasonal variability will complicate the
trading marketplace.

D. Supply of Surplus Reductions

Typically, nitrogen TMDLs establish wasteload allocations and load allocations in terms of mass
based reductions. For the most part, these allocations, when reflected in an  NPDES permit limit,
provide  a straightforward means  to establish  overcontrol for purposes of identifying marketable
reductions.  For example, a WWTP with a total nitrogen permit limit of 700 Ibs./day that currently
discharges 600 Ibs./day, will  have 100 Ibs./day of potential  marketable reductions (before any
ratios are applied).

Nonpoint sources may also be able to measure their load  and their ability to create reductions;
however, in  many cases it will be necessary to estimate reductions. This will  likely be needed
13 Chesapeake Bay Memorandum, 2004
                           Water Quality Trading

when sampling a discharge is complex, impractical, and/or not cost effective. Pilot projects have
used estimation  methods based  on the type and  degree  of BMP  implementation to establish
nitrogen  reductions.   Such  estimates should be based  on the  type  and  extent of BMP
implementation  and local conditions.  While  less  precise than point  source measurements,
conservative assumptions about BMP performance and/or the use of uncertainty discounts  can
enable BMP performance estimates to be utilized for trading purposes. Thus, in general, methods
exist for measuring or estimating the degree of overcontrol  achieved by  nitrogen sources  and
enabling trading parties to verify the existence of marketable reductions.
                           Water Quality Trading

Water Quality Trading Assessment Handbook
             Appendix B-94

Water Quality Trading Suitability Profile for Temperature
Unlike nutrient trading, which has been piloted in a number of areas around the country, there is
very little experience trading to reduce water temperature.  The EPA Water Quality Trading Policy
does recognize that trading of pollutants other than nutrients and sediments has the potential to
improve water quality and achieve ancillary environmental  benefits if trades and trading programs
are properly designed.  Issues related to determining the tradeable commodity for temperature
and  establishing water quality  equivalence have been considered in a  couple of watersheds.
These  efforts indicate that temperature  impacts,  fate,  and  transport are sufficiently well
understood  to support  at least some  level of trading  among sources  of elevated  water
temperature. It is currently anticipated that water quality equivalence can  be  established through
models used in TMDL development and other tools, supported by monitoring.

Temperature standards have been established  to protect beneficial  uses such as  cold water
biota, salmon spawning and rearing, and fish  passage.  Water temperature is also an important
consideration because a number of salmon species listed as threatened or endangered under the
Endangered Species Act (ESA) inhabit waters and  require  improved water quality  to support
survival  and recovery.  Water temperature  has direct and indirect impacts on native  salmonids,
bull trout, and other species listed under the  ESA.  Water temperature affects all life stages of
these fish including spawning, rearing, feeding, growth, and overall survivability.  The incidence
and  intensity of some diseases are directly related to  increased water temperatures.  Indirect
effects include changing food availability, increasing competition for feeding  and rearing habitat,
and  enhancing the habitat for predatory fishes.   Increased water temperature also indirectly
affects water quality by increasing the toxicity of many chemicals, such as un-ionized ammonia.
High water temperatures reduce DO concentrations by increasing plant respiration rates and
decreasing the solubility  of oxygen  in water.  For example, TMDLs  in the Pacific Northwest
address water temperature primarily to protect cold water fish (salmonids) as the most sensitive
beneficial uses. In that region, water temperature has been addressed  in at least 240 TMDLs.

Sources of elevated temperature usually include both natural  loading (from high air temperatures
and  solar radiation)  and anthropogenic loading  (from point source  discharges  and nonpoint
sources such as devegetation of riparian areas, agricultural and stormwater drains, and tributary
inflows).  Nonpoint sources contribute to solar radiation heat loading  by removing near stream
vegetation and decreasing stream surface shade. In urban areas, impervious surfaces  reduce the
cooling effect of natural infiltration of surface runoff and increase the temperature  of stormwater
inflows.   EPA14  identified the  four largest sources of increased temperature  in  the  Pacific
Northwest to be 1) removal of streamside vegetation, 2) channel straightening or diking, 3) water
withdrawals, and 4) dams and impoundments.
14 Pacific Northwest State and Tribal Water Quality Temperature Standards (US EPA, April 2003, 901 -B-03-002)

      .  •   ing

A.  Temperature Pollutant Form(s)

Temperature TMDL allocations are designed to limit human-caused water temperature increases
and to meet the applicable water quality standards.  The standards are  usually expressed as
specific limitations on surface water temperatures,  as expressed in degrees.  For example,
temperature load  capacity in the Snake  River-Hell's  Canyon TMDL is defined  (through  Oregon
state standards) as no measurable increase over natural background levels.  The quantitative
value used by  Oregon Department of Environmental  Quality as "no measurable  increase" is
0.25°F(0.14° C).

Most TMDLs provide temperature wasteload allocations to point sources in degrees Centigrade,
(°C), degrees Fahrenheit (°F), or as heat per unit time, such as BTU's or Kilocalories per day.  In
effect, allocations establish what volume of discharge at a given temperature may enter a water
body over a given period of time.

For nonpoint sources, temperature load allocations  are often  expressed  as "no anthropogenic
increase"  or no loading  by human sources.   For ease of implementation, these  may  also be
expressed in terms of percent of stream area  shade required, providing site-specific targets for
land managers.  In temperature  impaired reaches, nonpoint sources could meet this target by
allowing stream banks to revegetate naturally until it attains "system potential," or the near stream
vegetation  condition  that would naturally grow and  reproduce on a site, given elevation, soil
properties, plant biology, and hydrologic processes.

Although point and nonpoint sources  tend to receive different forms of temperature allocations,
models  have been developed to convert the effect of increased stream shade  into degrees
cooling. One model uses multiple data sources related to temperature, vegetation, and hydrology
to predict stream temperature at 100-foot distances.  Other models are used to simulate stream
temperatures for various hypothetical  riparian restoration  strategies.   These models provide a
basis for converting between point and nonpoint source temperature reductions for purposes of
trading allocations.

B.  Impact

Adjusting  for Fate, Transport, and Watershed  Conditions—In general,  temperature fate and
transport are  sufficiently well understood, and the models to develop temperature TMDLs are
reasonably well suited to support the development of water quality equivalence  relationships
among potential temperature trading  parties.  Moreover, EPA temperature  guidance currently
supports the establishment of a mixing zone for temperature discharges.15  If a similar provision is
included in the state's water quality standards and utilized in the development of the  WLAs in the
TMDL, this provides for some mixing  between the discharge water and receiving stream.  If the
receiving water is sufficiently cool as a result of upstream overcontrol, additional mixing  may be
allowed provided that the temperature standard is met at the edge of the mixing zone.

However,  water temperature fluctuates in response  to natural conditions, such as ambient air
temperature, solar heating, and  flows.  Thus, the temperature  effects of control  options can
  Pacific Northwest State and Tribal Water Quality Temperature Standards (US EPA, April 2003, 901 -B-03-002)
                           Water Quality Trading          Handbook
                                      Appendix C-98

dissipate quickly as water bodies rapidly reach a  new water temperature equilibrium with  the
atmospheric and hydrologic conditions.  As a result, although models and sampling can be used
to predict and track the impacts of water temperature reductions at locations in a watershed,
major water temperature effects  are  not  likely to be  seen at distant locations.   For trading
purposes, this suggests that potential trading parties will likely need to be relatively close to each
other for an environmentally equivalent trade to emerge.

A second  aspect of assessing the water quality equivalence of temperature reductions relates to
the potential importance of cold water  refugia in streams  which provide salmonid  habitat.
Although temperature load allocations  are designed to meet the numeric criteria of applicable
water quality standards, narrative  standards  also often address the need to protect ecologically
sensitive cold-water refugia.   Thus,  it  will  be important to identify how sources of temperature
impacts are connected to these refugia. If these connections can be modeled to determine how
overcontrol  options  can  benefit refugia,  then  trading   opportunities that  provide  targeted
temperature improvements to refugia can be explored.  In this context, and as discussed under
the Quantity section below, certain locations of temperature reductions will be of higher quality
(more valuable to protection of the desired beneficial use) and therefore more desirable. To the
extent a trading system can  recognize  this value and help to steer reductions to these  areas it
can substantially support the TMDL goals.

Examining Local Considerations—Certain forms of temperature trades hold the potential to create
localized impacts.  In some areas,  high  water temperatures  can have harmful or even  lethal
impacts on fish populations.  In other  areas, fish  may be able to avoid the  hotspots with little
effect on  the species. Any established threshold temperature level will be  site and condition
specific, and  watershed participants should expect that the presence of cold water refugia  will
almost  certainly require limitations on the  degree to  which  a  source could exceed their
temperature allocation and mitigate through trading.   Caps  on purchasing activity  placed in
NPDES permits can be used to avoid unacceptable local temperature impacts.

C.  Timing

Exceedances of temperature-related water  quality standards are  more likely to  occur in  the
summer months.   As a result,  temperature  TMDLs have focused allocations seasonally, with
required temperature  reductions typically applying during the  warmest times of the year.   In
response, many wasteload allocations  provide (or are expected to  provide) different allocations
for various times of the year, with more  stringent  limits  during summer months and salmonid
spawning  or other life  cycle  periods that  are critical to fish survival.  In general, this seasonal
approach  supports opportunities for point sources and nonpoint sources to consider temperature
trading options.  Irrespective of the temperature allocation cycle,  nonpoint source temperature
reduction  efforts in the form  of shade  are seasonally dependent, as greater  cooling effects  are
provided by the shade during the warmer seasons. Most nonpoint source temperature allocations
are not seasonal—thus encouraging the vegetation to be in  place year-round and indirectly
support channel stability and other key channel characteristics.  Under a seasonal temperature
TMDL,  point sources'  need for reductions will coincide  with the  nonpoint  sources' ability to
influence  stream temperature,  thus establishing  a  strong match  for trading  from a timing
                            Water Quality Trading

D.  Supply of Surplus Reductions

Based on the  nature of temperature allocations and  related control options,  both  point and
nonpoint sources of temperature impacts have the ability to overcontrol their "discharge" and
create temperature credits.   For point  sources, overcontrol  would take the form of lowering
discharge temperature below that identified in a TMDL.  In instances where the point source is a
significant contributor to elevated  in-stream temperatures, the  impact of overcontrol will likely  be
discernible for some distance.  This situation would readily support  upstream trading  with other
point  or nonpoint sources.  In the case that  point sources of heat are relatively  small and have
limited thermal loads, it  is anticipated that  their overcontrol  would quickly  be  offset by more
dominant in-stream and riparian conditions, constraining trading opportunities to those sources in
close  proximity.

In order to attain nonpoint source allocations in many temperature TMDLs, land along streams
would need to  achieve site  potential shade. Natural re-vegetation varies with species, climate,
and local conditions, requiring a minimum of 20 years to achieve site potential shade. If there are
no state  or local measures  in place requiring landowners to plant  and restore riparian areas,
nonpoint sources can overcontrol by influencing stream area shade  in three ways: 1) earlier
shade creation through tree planting; 2) more  effective shade creation  through selection  of
planted vegetation with a denser canopy; and 3) increasing the total shaded area of the stream.

In some areas, tree planting  programs that substantially advance the  creation of  shade  as
compared to natural re-vegetation have  emerged as strong candidates for creating overcontrol.
Current thinking indicates that generating temperature benefits sooner than would be present
under either natural or required stream bank re-vegetation could be used, at least temporarily,  as
reduction credits available for trading.  The value of these credits may be quite high, as they are
potentially available for at least five and possibly up to fifteen years, allowing other sources to
delay what might  otherwise  be very  substantial  capital  expenditures to  reduce  discharge

Other means of nonpoint source overcontrol are more theoretical at this time. Although it remains
an  untested  concept, certain  trees that create  a denser and/or  higher  canopy  than  natural
vegetation may produce greater shading and thus reduce the warming effects of sunlight.  Under
such an approach, tree planting would not only produce temperature benefits  earlier than  natural
re-vegetation, it would create a more consistent and/or greater area of shade than described in
the TMDL.  If utilized, tree selection should take  into consideration a diversity of native species
and the ability of the re-vegetated community to sustain other functions of the riparian area.

Additionally, in instances where TMDL allocations do not call for site potential shade throughout a
watershed,  expanding the area  of stream  bank  vegetation  beyond TMDL allocations could
represent overcontrol.  However,  temperature TMDL experience  to date indicates that a typical
approach  would be to call  for natural  re-vegetation throughout the TMDL  area,  substantially
reducing the likelihood of this option.

Both  point and nonpoint  sources may have  two  additional  options  for creating temperature
reduction credits for either their own use or for sale to others.   First, modifications to channel
complexity that return streams to more  natural width-to-depth ratios may result in temperature
reductions.   Moreover,  reestablishing tree-covered islands in mid  stream is another channel
modification that can create additional shading effects to reduce water temperature.
                            Water Quality Trading

Second,  water volume and  flow  are  critical factors affecting water  temperature.   Creative
solutions to  water temperature  problems often involve changes in  flow regimes.   Water
temperature improvement measures relating to flow include  changes in location  of discharges,
increases in irrigation efficiencies, and water right purchases or leases. Any such changes in flow
regimes that result in improved temperature conditions could  likely be accounted for with models
used in the development of the TMDL.

Irrespective of the means by which nonpoint sources achieve overcontrol, these actions hold the
potential to be more attractive than point source temperature reductions from the standpoint of
overall watershed  health. Nonpoint source  overcontrol options that accelerate the return of
vegetation  in riparian areas provides important benefits  to  water quality and  fish and wildlife
habitat.   Increased vegetation along stream banks helps to maintain temperature improvements
from other sources.  Increased vegetation in riparian areas supports other water quality objectives
by reducing erosion and sediment loads and providing natural filtration  of water entering the
stream.   Vegetated stream banks improve the health of riparian areas,  which provide important
habitat for many types of wildlife and aquatic species.  As a result, a trade in which a point source
opts to  pay for nonpoint source overcontrol  may prove highly desirable for overall watershed
                            Water Quality Trading

Water Quality Trading Assessment Handbook
            Appendix C-100

Water Quality Trading Suitability Profile for Sediments
The 2003 EPA Water Quality Trading Policy Statement specifically supports trading to reduce
sediment loads. Sediment is defined as fragmented material that originates from weathering and
erosion of rocks or unconsolidated deposits, and is transported by, suspended in, or deposited by
water.  The erosion, transport, and deposition of sediment is an essential natural process in the
right amount, but sediment  becomes a  problem and a pollutant when significant increases  in
sediment supply exceed the water body's ability to move it.  Most sediment problems involve the
presence of excess fine sediment such as silt and clay particles  that increase turbidity when
suspended and form muddy bottom deposits when they settle. Excessive fine suspended and
bedload sediments both cause numerous kinds of impairments of aquatic life.

Two major sources  account for nearly all sediment discharge: soil erosion  carried by surface
runoff; and within-channel erosion of banks and bedload sediments. Natural  and anthropogenic
influences can strongly affect the amount and timing of sediment discharge from these sources.
In minimally impacted areas,  runoff and in-channel erosion during average flows and rainfall
patterns transport sediment in  moderate quantities  at fairly  consistent rates.  Erosion from
extreme flow events can  generate a greater  sediment  load than occurs  all  year from average
flows.  Because these events are infrequent, aquatic systems adjust over time and return to a
healthy condition.

In watersheds where human activity has markedly increased overland and in-channel erosion and
sediment load, excess sediment may be  a common rather than infrequent event with impairment
resulting.  Nonpoint sources  of excess  sediment include:  streambank  destabilization due to
mowing and riparian tree  removal; cropping without buffer zones; livestock hoof shear; channel
flow redirection; urban/suburban sources including construction; stormwater runoff and irrigation;
agricultural sources such as  unmanaged runoff from croplands; forestry sources  such  as
unmanaged  runoff from  logging operations  and unmaintained access  roads; gravel  mining;
roadside ditch maintenance; and other sources.  It is also possible to have impairments from too
little sediment supply, such as when dams  reduce the downstream replenishment of bedload
gravels to the point that salmonid spawning habitat is reduced.  Point sources  can also contribute
to sediment problems.

Water quality standards are developed to protect the most sensitive designated use  and have
generally been established for sediments to protect designated uses associated with aquatic life.
They are often based on both a numeric standard related to turbidity and a  narrative standard that
protects designated uses.  Narrative standards are translated into a wide range of numeric criteria
depending on the conditions in the watershed, the fish species present, and the interpretation of
the agencies and stakeholders in the area.  State standards for sediment vary widely.  EPA  is
currently developing  updated national guidance for sediment water quality criteria.

TMDLs address sediments to meet water quality standards and control a number of water quality
problems.  To  establish appropriate water quality  equivalence, trading parties  will  need to
understand how their sediment loads connect to the specific problem.  High concentrations of
sediment can have both direct and indirect effects  on water quality.  Excessive amounts of
sediment can directly impact aquatic life and fisheries. Excessive sediment deposition can choke
spawning gravels, impair fish food sources, and reduce habitat complexity in stream channels.
Excessive suspended sediments can make it more  difficult for fish to find prey and at high levels
can cause direct  physical harm, such  as scale erosion, sight  impairment, and  gill clogging.
Stream scour can lead  to destruction of habitat structure.  Sediments can  cause taste and odor
problems  for drinking  water,  block  water supply  intakes,  foul treatment systems,  and fill
reservoirs. High levels of sediment  can  impair swimming and boating by altering channel form,
creating hazards due to reductions in water clarity, and adversely affecting aesthetics.

Indirect  effects  associated with  sediment  include  low  dissolved  oxygen  levels  due to the
decomposition of organic sediment materials, and water column enrichment by attached  pollutant
loads, such as nutrients. Elevated stream bank erosion rates also lead to  wider channels which
can contribute to increased temperatures.  Sediment targets and monitored trends often function
as indicators of reductions  in transport  and delivery  of these attached  pollutants.   These
additional  pollutants would  likely be addressed in  other types of remediation tools other than
sediment trading.  Sedimentation can also be  an important consideration  because a number of
species  listed as threatened or endangered under the Endangered Species Act  (ESA) inhabit
impaired waters and require cold, clear, well oxygenated water and spawning gravels unchoked
by fine sediments to support spawning, survival, and recovery.
 •  ;

A.  Sediment Pollutant Form(s)

Sediment  TMDLs—Sediment  is discharged by sources in  a  wide range of particle sizes  and
weights. TMDLs generally provide separate load allocations for sediments based on two different

       Suspended or "water column" sediments are particles  that are small and light enough to
       remain suspended in the water column, generally less than 1  mm.  Sources discharge
       two different types of these suspended sediments: geological particles, which are derived
       from rock and  soil, and  biological particles such as  planktons  and other microscopic
       organisms.  These different forms of suspended sediments may have different impacts
       on water quality. As discussed below, TMDLs often establish different allocation forms for
       point and nonpoint sources to control water column sediments.
       Bedload  sediments are generally larger particles that are too heavy to be suspended in
       the water  column.    They are  generally discharged  by nonpoint sources and  are
       transported  by sliding, rolling,  or  bouncing  along the bed of  the  stream.   Bedload
       sediments can range in  size from fine clay particles to  large boulders.  TMDLs often
       establish mass-based allocations for bedload  sediments such as  pounds per day or
       tons/square mile/year of  sediment loading,  or  use a  percentage of fines deposited in
       stream bottoms.
                                Quality Trading Assessment Handbook

TMDLs  often establish different allocation  forms for point and nonpoint sources. Wasteload
allocations  for point sources often  use concentration-based limits, such as an average weekly
limit of 45  mg/L of Total  Suspended Solids (TSS).  Load  allocations for nonpoint sources are
often expressed in mass-based  allocations, such as tons/square miles/year of sediment loading.
Point source dischargers with similar sediment discharge forms and wasteload allocation metrics
may have  trading opportunities.  For example, two WWTPs from neighboring jurisdictions in
Virginia  have entered  into a cooperative agreement  whereby one WWTP  has agreed  to a
reduction in its permit limit for discharging total dissolved solids so the other facilities can have an
increased limit.   The allocations are both expressed in  terms of kg/day of total dissolved solids.
The two plants  discharge into the same stream segment, and the Virginia DEQ has determined
that the agreement would  not result in a decrease in water quality.

B.  Impact

Adjusting for Fate and Transport Characteristics and Watershed Considerations—As dischargers
consider trading opportunities, it will be important to understand the specific water quality impacts
of each potential trading partner.  Sediment load reductions by sources may be measured directly
by sampling, with the  models used to develop sediment TMDLs, or using surrogate measures,
such as percentage of fines in stream bottoms. Other site specific watershed conditions, such as
velocity,  slope,  channel  conditions,  and  type of sediment, are important  considerations for
understanding water quality impacts and  matching  potential trading partners.  For  example,
assessing  channel measurements and bedload  composition can verify whether  a stream is
relatively stable, or unstable and undergoing  channel  evolution.  Potential trades can then be
evaluated in the context  of these dynamics.  For example, a trade involving establishment of
riparian vegetation in a stream segment that is or can be readily stabilized would be more likely to
produce positive results than the same effort undertaken on a portion of stream channel that is
actively cutting and likely to continue doing so until the channel is reestablished.

For  suspended  sediments,  models  are  available to  determine  the impacts  of  reductions.
However, depending  on the  watershed conditions, and the water quality problem that is  being
addressed, geological and biological forms of suspended sediments may have different impacts.
It is more likely that trading between similar forms  (e.g.,  geological to geological, and biological to
biological) will support water quality improvements.

Watershed  flow patterns are also likely to define market  areas for trading. Sediment movement in
a stream varies as a function of flow. Suspended sediments discharged into high flow areas will
travel longer distances and may define a large market area. The boundaries  of markets may be
defined by  lower flow areas.  The areas usually occur in the lower sections of watersheds where
flows decrease  and  the  lighter, smaller suspended sediments  fall  out.  Upper sections of
watersheds with higher flows often transport more bedload sediment.   Impoundments  create
significant  barriers that restrict sediment transport and create areas  of sediment deposition.
These distinct areas, based on flow patterns, are likely to delineate defined trading market areas,
with trading limited to within each defined area.

Examining  Local Considerations—Because watershed conditions relating to velocity, slope, and
channel conditions will directly affect the impact of sediment reductions, each trade will have to
be  assessed to determine  the potential for localized impacts.    As with  other pollutants,
downstream trades will only avoid unacceptable localized impacts if the segment between the two
sources has  not reached its assimilative capacity.  Additionally,  a trade,   irrespective  of its
                           Water Quality Trading

direction (up or downstream), involving sources discharging substantially different sediment forms
may be vulnerable to creating localized impacts. For example, a trade that involves offsetting a
biological form of suspended sediment discharge with  a geological form of suspended sediment
discharge will leave a greater quantity of biological sediments in the water column.  This form of
sediment may have a greater impact on dissolved oxygen levels and may lead to unacceptable
dissolved oxygen-related water quality problems.

C.  Timing

Although sediment delivery to streams from nonpoint sources is usually episodic and sometimes
seasonal, sediment allocations are generally applied  year round.  TMDL allocations  are often
expressed as an average amount of sediment per year. To account for variability between years
(i.e., years with  high snow melt or other extreme  weather events will  have  higher sediment
delivery), some TMDL load allocations are expressed as ten  year rolling averages.  Because
sediment load allocations are generally applied on an average basis year round, participants will
likely be able to align reductions between potential buyers and sellers.

D.  Supply of Surplus Reductions

There are a number of ways that sources can  apply control options to reduce sediment  loads.
These  controls can be sampled and/or modeled to  estimate the amount of sediment reduction
beyond TMDL expectations.

Point sources can apply technological control  options that result in a measurable  change in
sediment concentration  and  associated loads.   Sediment limits for  point sources are usually
based on a technology-based limit which may be sufficient to meet the TMDL target.  Under the
Clean Water Act, point sources are required to comply with their technology-based  limits without
trading  unless trading  is  explicitly  incorporated  in the  effluent guidelines.  Under such
circumstances, there is no  incentive  for such sources  to become  purchasers  of  sediment
reductions.  However, in  circumstances where the technology-based limit is not sufficient to meet
water quality standards, incentives for trading may exist.

In many watersheds, point sources may be  relatively  minor contributors to excessive sediment
loads.  Therefore, they may have a limited capacity to overcontrol in a meaningful way to improve
water quality.  As discussed above, point sources also discharge a different form of suspended
sediment.   Point sources may be  limited to  trading with other sources  discharging similar
sediment forms.  Nonpoint sources have the ability to overcontrol using more  aggressive controls
than required to meet load allocations, using controls that cover broader areas, or using controls
that target more valuable areas for sediment reduction.

Nonpoint sources can overcontrol using Best Management Practices (BMPs). Aggressive BMPs,
such as conversion to drip irrigation on agricultural lands, have the ability to reduce sediment
loads below TMDL allocations.  BMPs can also  be applied to cover broader areas than specified
in a  TMDL.  Another potential overcontrol option is for nonpoint sources to  select  higher value
areas to implement BMPs,  thus  achieving greater pollutant  reductions in the waterbody of
concern.   Marketable reductions may  be generated by applying control options that focus  on
areas with highly erodible soils, or areas that have a direct impact on the designated  use, such as
salmonid spawning areas, and may create a greater improvement in water quality than specified
under the TMDL allocation.
                           Water Quality Trading

Capital Cost Annualization Factors

Interest Rate
1 .00%
1 .50%

Interest Rate


Interest Rate
1 1 .00%
1 1 .50%
Water Quality Trading

Participant Pollutant Management Options Characterization

1.   Background Information
    a.  Model Trade Participant Organization Name:
    b.  Organization Representative Contact Information:
        i.  Name:
       ii.  Address:
       iii.  Phone Number:
       iv.  E-mail:
2.   Pollutant Load Source(s) for Consideration:
    a.  Source A:  (provide name of load source e.g., Trout Growers, Inc. at Bhule)
    b.  Source B:
    c.  Source C:
3.   Individual Source Characterization (Source A)
    a.  Source Description:
    b.  Source Location (river mile):
    c.  Source Discharge Location (river mile):
    d.  Source Type(s):
    e.  Source Discharge Quantity (from TMDL):
    f.   Source TMDL Target Load (from TMDL):
    g.  Source Current Load (by type if possible):
    h.  Source Expected Future  Load  (annual growth/decline rate and time horizon):
    i.   Seasonal or Other Cyclic Load Considerations:
4.   Source  Control Option(s):
    a.  Option A:
    b.  Option B:
    c.  Option C:
5.   Source  Control Option  Description (Option A):
    a.  Description:  (include technology/management practice, ability to scale/size to specific
       control  levels,  seasonal  variability of control,  and design,  construction,  shakedown
       periods along with overall lifespan)
    b.  Currently in Place:  (yes or no, and provide date of completion and expected lifespan)
    c.  Capital Cost:
    d.  Annual O&M Cost:
    e.  Control Achieved/Expected (in Ibs./day)

Water Quality Trading Assessment Handbook
            Appendix F-108

National Research Council. Clean Coastal Waters. 2000.

Paerl, Hans. Connecting Atmospheric Nitrogen Deposition to Coastal Eutrophication.
Environmental Science and Technology, August 2002.

US EPA. Water Quality Trading Policy.  January 2003.

US EPA. Chesapeake Bay Memorandum. March  3, 2004.

US EPA. Pacific Northwest State and Tribal Water Quality Temperature Standards. 901-B-03-
002, April 2003.

Water Environment Research Foundation. Phosphorus Credit Trading in the Cherry Creek Basin:
An Innovative Approach to Achieving Water Quality Benefits.  Project 97-IRM-5A, 2000.

Water Quality Trading Assessment Handbook