United States          Region 10
       Environmental Protection Agency   (EMI-163)
         July 2003
    Water Quality Trading
   Assessment Handbook:

EPA Region 10's Guide to Analyzing
          Your Watershed
       Prepared Under EPA Contract 910-B-03-003

                                      .Water Quality Trading Assessment Handbook

Water quality trading can be a business-like, cost-effective, local solution to problems
caused by pollutant discharges to surface waters. Generally, water quality trading (WQT)
involves a party facing relatively high pollutant reduction costs who compensates another
party to achieve a less costly, pollutant reduction with the same or greater water quality
benefit.  The concept of using "market-based" innovations is not entirely new, but  there
have been relatively few successful trades in the U.S. While trading  is not a panacea, it
can be a useful tool for water quality enhancement in the right circumstances and some
dischargers will welcome the flexibility it can provide.

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 she "needs" 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 potentially create the "need" to alter behavior by reducing pollutant
loadings  discharged  to waterways.  TMDLs and similar  frameworks  are sometimes
described as "budgets" for  the  introduction of pollutants  into watersheds.  Scientific
studies  estimate the  volume of discharge a specific  watershed,  or  segment of the
watershed, 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 and non-point sources  located in the watershed.   The
allocation of discharge limits forces sources in the watershed to analyze current practices
to see if they need to alter their discharging behavior and the associated costs to do so.

The United State Environmental Protection Agency's (EPA's) Region 10 office has  taken
an active role in exploring the mechanics of water quality trading and developing  water
quality trading markets in hopes of lowering the cost of improving water quality.  For
example, working with the Idaho Department of Environmental Quality and a wide variety
of stakeholders, Region 10 has been helping dischargers to the Lower Boise River create
the detailed  knowledge, regulatory framework, and techniques for cooperation needed to
achieve phosphorus reductions through trades. Region 10 has also  supported trading in
the Middle Snake River by preparing model NPDES permits that would facilitate trading
by the City of Twin Falls and a local business. In Washington and Oregon, Region 10 is
supporting assessments to  identify opportunities for individual trades or broader trading

Careful analysis is required  to identify watersheds with the combination of characteristics
to support cost-effective  trading. Region 10 encourages stakeholders  to be  active in
identifying potential new trading markets.  To that end, this Handbook is designed to
provide  you,  the  watershed participant, with an  efficient  means to  assess your
watershed's water quality trading potential and the attractiveness of  trading for particular

Such an assessment  involves several types of analysis. Water quality specialists may
need to call  on specialists in engineering, finance, and/or regulatory interpretation. This
Handbook is intended to help you identify what you need to know, with whom you need to
consult, and where you may find the information you need.

Water Quality Trading Assessment Handbook,

                                                         , Water Quality Trading Assessment Handbook
                   Table of Contents

                   Introduction	-\
                   Pollutant Suitability	4
                     Purpose	4
                     Approach	  4
                     What is needed for a pollutant to serve as a "tradable commodity" that dischargers can
                     buy and sell in a given watershed?	5
                     The Six Step Suitability Analysis	'.'.. 5
                       Step One: Create a Watershed Discharge Profile	6
                       Step Two: Identify Type/Form of Pollutant Discharged by Sources	9
                       Step Three:  Determine the potential environmental equivalence of different
                       discharge points	12
                       Step Four: Determine the potential for aligning the timing of load reductions and
                       regulatory timeframes among dischargers	16
                       Step Five: Determine if the supply of and demand for pollution reduction credits is
                       reasonably aligned within the watershed	18
                       Step Six:  Review the results of Steps One through Five to Complete the Pollutant
                       Suitability Determination	20
                   Financial Attractiveness	22
                     Purpose	22
                     Approach	22
                     What Makes Water Quality Trading Financially Attractive?	23
                       Stage 1:  Calculating Incremental Cost of Control for a single source	24
                       Stage 2:  Examining the Watershed	30
                       Stage 3:  Analyzing  the Results	32
                   Market Infrastructure	40
                     Purpose	40
                     Approach	40
                     Considerations: Market Sizing	42
                     What Is Driving the Market?	42
                     What Are the Essential Functions of a Water Quality Trading Market?	43
                       1.     Defining marketable reductions	43
                       2.     Communicating among buyers and sellers	44
                       3.     Ensuring environmental equivalence	44
                       4.     Defining and executing the trading process	45
                       5.     Tracking trades	46
                       6.     Assuring Compliance with Clean Water Act and state/ local requirements.... 47
                       7.     Managing transaction risk among parties to a trade	47
                       8.     Providing information to the public and other stakeholders	48
                     Current Market Models	49
                       A Private, Non-profit  Co-operative Facilitating Pre-Approved, Dynamic Trading	49
                       A Public Authority Banking and Managing Phosphorus Credits	54
                       A Nitrogen Credit Exchange	59
                   Stakeholder Readiness	65
                     Purpose	65
                     Approach	65
                       Identifying and Prioritizing Potential Participants	65
                       Recruiting Essential Participants	68
                       Benefits of Water Quality Trading	68
                     1  Likely Participant Needs and Interests Relating to Water Quality Trading	69
                       Stakeholder Participation in Market Infrastructure	72
                   Glossary	75

Water Quality Trading Assessment Handbook.
Appendix A	77
  Water Quality Trading Suitability Profile for Phosphorus	".	77
    Trading Suitability Overview	77
    Key Trading Points	77
Appendix B	81
  Water Quality Trading Suitability Profile for Temperature	81
    Trading Suitability Overview	81
    Key Trading Points	82
Appendix C	86
  Water Quality Trading Suitability Profile for Sediments	86
    Trading Suitability Overview	86
    Key Trading Points	87
Appendix D	91
  Capital Cost Annualization Factors	.91
Appendix E	93
  Participant Pollutant Management Options Characterization	93

                                       .Water Quality Trading Assessment Handbook

In January 2003, the United  States Environmental Protection  Agency issued a Water
Quality Trading Policy enabling and supporting 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 SOpercent of lakes that had been
assessed in the United States failed to support their designated  uses.2 Faced with CWA
statutory obligations to achieve their watershed's designated uses, stakeholders have
been looking for  innovative, supplementary ways to  achieve federal, state,  tribal, and
local water quality goals.  The policy specifically enables and endorses the use of "water
quality trading" to accelerate compliance.

Water quality trading can  be a cost-effective solution  to  local problems  caused  by
pollutant discharges to surface waters.  A party facing relatively high pollutant reduction
costs might elect to compensate another party who can achieve an equivalent, though
less costly, pollutant reduction with similar water quality benefits. The flexibility offered by
water quality trading is one of its strongest selling points

This Handbook is designed to provide you, the watershed participant, with  an efficient
means for assessing  your watershed's potential to capitalize on this innovative "trading"
policy.  The viability of trading, as discussed in this Handbook, depends on conditions
discussed  in EPA's Water Quality Trading Policy,  including: a market structured around
the  current CWA regulatory framework; voluntary participation;  a suitable pollutant; and
public participation.

Today, several trading markets are already helping to  reduce the cost of improving water
quality.   Experience with  these  markets  offers  insights into the opportunities and
challenges trading may present in your watershed. Experience teaches that  success in
water quality trading markets will be influenced by several factors, including:

•   the pollutant in question;

•   the physical characteristics of the watershed;

•   the cost of pollution control for individual dischargers;

•   the mechanisms used to facilitate trading; and

•   the 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 your ability to create and sustain a water quality trading market.  During
the assessment, you will focus on each of the individual factors that make trading viable.
As these factors are  examined, you will organize disparate types  of 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 much simpler
if most stakeholders  speak a common language. This Handbook will help provide that
common language, giving  you a  methodology for organizing critical information into a
logical, easy-to-follow format.
 1 Water Qualify Trading Policy (EPA, January 2003)
 2 Ibid.

Water Quality Trading Assessment Handbook.
The first chapter of the Handbook—Pollutant Suitability—addresses whether a "common"
or "tradable" commodity exists that is important  to  the  water quality goals for the
watershed.  Certain pollutants and watershed conditions are more suitable for trading
than  others. Pilot projects in Region 10 and elsewhere have demonstrated that nutrients
can be successfully traded.  Less information  is available about trading other pollutants.
After  reading  the Pollutant Suitability chapter and  examining your  own  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 pollution 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 their
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 of increased (non-compliance) risk.
Assessing the incremental cost spreads associated with specific transactions provides
information on whether  trading - in practice  - will  be financially attractive to potential
market participants.  After reading the Rnancial 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
infrastructure needed to facilitate trading can be built.  The analysis will not provide a
specific blueprint for  creating a market, but will highlight likely challenges and identify
ways in which your watershed can benefit from lessons learned in other markets. After
reading the  Market  Infrastructure  chapter,  exploring  the examples  provided, and
reflecting on the lessons from the first two chapters of the Handbook,  you will  better
understand the watershed's  unique  market infrastructure needs, possible mechanisms
suited for the watershed, and the commitment level likely needed to create a market.

Finally, the Stakeholder Readiness chapter addresses the level of stakeholder interest
and support needed  to  pursue water  quality  trading.   If you decide to  pursue trading
opportunities, you will need to work with other potential participants and stakeholders  in
the'watershed.  They may  need to be convinced  that  the time they spend exploring
opportunities will  lead  to worthwhile,  currently unavailable  options.   Parties  with the
greatest potential to produce and/or consume reductions are necessary participants.   In
addition, there must be a reasonable level of support from non-discharging stakeholders,
including citizen's groups and regulatory authorities concerned with water quality issues
in the watershed. After reading this chapter, you should have a better understanding  of
how to engage other stakeholders.

The Handbook offers common themes that are important to your assessment and market
creation efforts.  Among these is the recognition that water quality trading  involves a
variety of risks and market development costs. Potential trade participants will  face the
possibility that, despite their  hard work, the market they desire will not emerge.  Friction
around regulatory issues may emerge  as  the federal,  state, and local  regulatory
framework, as  well as  necessary stakeholder involvement,  add costs or complicate
market design.  After the market emerges and trading begins, transaction costs will be

                                      .Water Quality Trading Assessment Handbook
associated with information gathering, trade execution, and compliance efforts.  The
attractiveness of pollution trading markets will be affected by these cost and uncertainty
factors.  Higher development and transaction costs, market uncertainty,  and regulatory
impediments can  suppress market activity  to the point where trading  will  not occur.
Lessons learned from other markets and discussed in this Handbook will help you assess
whether costs and friction can be managed in your watershed to support a viable market.

 Water Quality Trading Assessment Handbook,
 Pollutant Suitability
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:

•   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.  Less information is available about trading other pollutants, although
pilot projects have explored sediment, ammonia, and  selenium trading.  The EPA Water
Quality Trading Policy specifically supports  nutrient (e.g., total  phosphorus and total
nitrogen) and sediment trading.  However, the policy indicates that other pollutants, such
as metals  and pesticides,  will require more scrutiny to  ensure that trading can lead to
meeting water quality standards. EPA will support trading of these pollutants only under
limited conditions  as part  of a pilot project.   For  temperature, total  dissolved gas,
BOD/Ammonia, and bacteria, this Handbook cannot provide a clear "yes" or "no" answer,
but this chapter should suggest whether to continue consideration of water quality trading
using the following chapters.
This chapter discusses conditions needed for a pollutant to serve as a commodity that
can be bought and sold in a trading system. 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 must  establish  a
common understanding of the commodity that is being bought and sold, including the
effects of trading on water quality.

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 opportunities.

                                     .Water Quality Trading Assessment Handbook
What is needed for a pollutant to serve as a "tradable
commodity" that dischargers can buy and sell in a given

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  must not  trade "apples  and oranges."
    Generally, they must identify a single pollutant, 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 "equal" overall effect on water quality.

•   Impact:  There must be environmental equivalence between the discharge points of
    purchase and sale to ensure that the water quality impact will be at least equivalent
    to, if not in excess of, established water quality-based requirements.   For example,
    participants  must  predict the water quality  effects  of a  one  pound phosphorus
    reduction  as required by a  TMDL at  one point in a watershed compared  to a
    reduction of one pound (or more or less) at another point downstream.

•   Time: Participants must consider and work to align two time dimensions to support a
    trade.  First, purchased reductions must 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,  TMDL compliance  deadlines must reasonably  align as  sources consider
    their options for meeting future reduction obligations.

•   Quantity:  Overall supply and  demand must be reasonably aligned.  The total
    amount and increments of reductions available must reasonably align with the needs
    of potential purchasers.

For water quality trades to occur, potential trading partners must be able to align all four
suitability factors.
The Six Step Suitability Analysis	

This section will help you examine the four trading suitability factors.   For each factor -
Type, Impact,  Time, 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
tradable commodity.  To help answer the questions, the inherent characteristics of a
number  of common pollutants are provided.  Appendices A,  B, and C contain  this
information.  Stakeholders should also consider TMDLs, implementation plans, NPDES
permit language, and other  local  assessments  and requirements to evaluate specific
sources or conditions in your watershed.

  Water Quality Trading Assessment Handbook.

  The purpose of this step is to characterize the pollutant(s) of concern that are discharged
  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
  pollutants being discharged from point and non-point sources.

  One way to display this information is to use a simple chart, as  in Figure 1.1.  You will
  complete only certain columns during this step; in subsequent steps you will gather more
  information to fill in additional columns.  In the example that follows, this same format is
  used to create a profile for the sources in a hypothetical watershed.
              Figure 1.1:  Template for Creating a Watershed Discharge Profile
Name ol
Drain, or
Source 11
Source 12
Diversion t1
Return *1
Source <3

River Mite

Form ol Pollutant
As !
Addressed by i As
TMDL I Discharged
™------"T-'— ---'™"--'—~" —*— • - -•

seasonal, Obligation
cyclical, etc.) : (Regulatory)


I Total
Baseline Current : Target Reduction
Load' Load' i Load' Needed*
(Ibs /day) (IbsVday) .; (bs./day) (lbs./day)
	 • 	 •- 	 - 	 - 	

I |
1 \
•' The Baseline Load is the amount ol discharge used to develop a TMDL. During TMDL development, a specific year or flow rate is
type any chosen to characterize the discharge behavior of point and non-point sources. This information can be found in the TMDL.
iThe Current Load is the amount of pollutant discharged as you analyze the w atershed for trading viability. The Target Load is the
arnounl of pokitant discharge allocated to each source in the TMDL. The Total Reduction Needed is the difference betw een the
Current Load and the Target Load.
  You can typically find information to complete the chart in the text of a TMDL, in the
  TMDL implementation 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 quantities discharged during a selected baseline period (e.g.,
  1995), current discharges (or "loads"), and the TMDL's specified waste load 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 reaches, inflows, or
  tributaries.  Additional information about cropping  patterns and agricultural practices in
  each area will be needed to estimate current loads from individual sources.

  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 discharge 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

                                         . Water Quality Trading Assessment Handbook
sources of the same pollutant may present opportunities for water quality improvements
and other environmental benefits 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 quantity.

For each source of the selected pollutant in the watershed:

•   What is the geographic location of the discharge (by 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.
Overview of Happy River Basin
 To demonstrate haw you will use the information gathered to assess trading opportunities, a
 hypothetical watershed, the Happy River Basin, is presented below.

 A number of segments along the Happy River currently experience  nuisance aquatic growth
 conditions.  A TMDL for phosphorus has recently been completed for the main stem of the river,
 providing Waste Load Allocations for the permitted point sources and Load Allocations for the
 nonpoint sources and tributaries.  The TMDL indicates that, to achieve water quality standards, the
 concentration of phosphorus in the water column must be at or below .07 milligrams per liter
 along the entire river with monitoring stations established for compliance purposes.  Eight sources
 of phosphorus discharge in the basin.

 •   Herb's Farm, a  family-owned farm growing a range of crops, is located on an irrigation
    district controlled return flow which 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, is located at RM 567.

 •   Acme Inc., a food processing facility, is located four miles up Nirvana Creek, a tributary to
    the Happy River. The creek currently meets water quality standards and is not subject to a
    TMDL; therefore, Acme has not received a Waste Load Allocation.  However,  the Happy
    River TMDL provides a Load Allocation requiring a reduction  in the phosphorus  loads
    entering Happy River from Nirvana Creek.  The creek's confluence with the Happy River is
 •   Hopeville POTW, a municipal wastewater treatment plant, owned and operated by the City of
    Hopeville, is located at RM 546.
 •   AAA Corp., a sugar mill owned and operated by a multinational corporation, is located three
    miles up Lucky Creek, a tributary to Happy River. AAA Corp. is required to meet a Waste
    Load Allocation provided in the Lucky Creek TMDL, which was finalized two years ago.
    Lucky Creek enters the Happy River at RM 544 and has been given an  allocation at its
    confluence with the main stem.

Water Quality Trading Assessment Handbook...
    Easyville Dam, owned by Peaceful 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 has been given a load allocation
    under the TMDL to improve depressed levels of dissolved oxygen (DO) in the reservoir. The
    Dam sits at RM 490.

    Laughing Larry's Trout Farm, a privately owned aquaculture facility, is located at River Mile
    489, below the Easyville Dam.
                    Figure 1.2: Schematic Map of Happy River Basin
                                           Return 25%
                                            Pleasantvilie POTW
                                           Easy/ills D?m
                                           Laughing Larry's
                                            Trout. Farm

                                      ,,, Water Quality Trading Assessment Handbook
    Figure 1.3: Chart of Sources with Location, Pollutant Form, and Quantity Information

Name of Discharge Source, Diversion,
Agricultural Drain, or Tributary
Drain A—Herb's Farm
Pleas antv ills
Acme Inc. (Nirvana Creek Confluence)
A"AArCofp7"(Lucky Creek Confluence)
Ortho Company
Laughing Larry's Trout Farm
River Mile
570 '
" 546"
Forn of Pollutant
As Addressed by
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total PhospTiorus
Total Phosphorus
Total Phosphorus
; Total
Baseline : Current Target Reduction
Load* Load" Load' : Needed
(lbs./day); (IbsJday) ; (Ibs./day) (IbsVday)
"632 753 527 226
760 791 633 158
492 547 410 137
"60 62 "50"" 12
199 " 195 166 29
786 1645 655 990
185 250 154 96
•Note: Nirvana Creek and Lucky Creek have received allocations at their confluene w itn Happy River. The Baseline, Current,
and Target Loads displayed are for the actual point of discharge to the tributary and are derived from the discharges'
environmental impact at the confluence w ith Happy River.


 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 pollutant
 trading systems use  an identified controllable  pollutant common to all potential  market
 participants.  This establishes a "common currency" with which  market participants can
 evaluate offers of behavior change from others.

 A. Determine  if sources are  discharging the same form  of pollutant as
    regulated by the  TMDL.

 Using the information developed in  Step One, identify the form of pollutant addressed in
 the TMDL, and the form discharged  by each identified source.  In some cases, the form-
 suitability determination may be simple.   If the TMDL has provided the majority of
 dischargers an allocation  expressed as  the  same  form of  the  pollutant  (e.g., Total
 Phosphorus), then potential trading participants will have a solid match.  For example,
 phosphorus  loading  is often  regulated  in TMDLs  because  excessive  phosphorus
 concentrations encourage nuisance aquatic growth, reduce dissolved oxygen levels, and
 result in violations of water quality standards.  In many cases,  TMDLs provide load
 allocations for Total Phosphorus,  rather than soluble or non-soluble forms because Total
 Phosphorus can be easily measured in monitoring samples.

 Although  Total Phosphorus  is  the  pollutant form  being  measured,  most  sources
 discharge a combination of phosphorus forms (e.g., soluble  or non-soluble). However,
 certain pollutants, including phosphorus, may pose difficulties  even if  the TMDL assigns
 allocation of a single  pollutant form to all dischargers.  (See Appendix  A for more
 information.)  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

Water Quality Trading Assessment Handbook...
may not be environmentally equivalent.  As trading opportunities are  considered in a
watershed, it will be  important to understand the actual  forms of the pollutant  being
discharged by each source to assure that trades represent an equivalent impact on  water

The following questions are intended to help assess whether the pollutant can be treated
as a "tradable commodity" based on commonality of the form of the pollutant  being

•   What is the form of pollutant addressed in the TMDL?  For each pollutant, does the
    TMDL provide load allocations for more than one form?

•   Do sources discharge the  same form  of  the  pollutant?   If not,  what form  is
•   What are the impacts of concern for this pollutant and do they vary by the different
    forms (if any) discharged?

In answering these questions, if you find that, 1) the TMDL provides load allocations for a
single pollutant form;  and 2) sources in  a watershed discharge and measure that  same
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  environmental
equivalence.   If this  is not the case,  use the next set of questions in  Step Two (B)  to
consider whether you can establish translation ratios between different pollutant types  or

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 load
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 "equal"
effect on water quality.  Without a reliable, scientifically defensible translation basis, it
may be impossible to  trade different forms of a pollutant.

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 EPA Water  Quality  Trading  Policy
supports cross-pollutant trading for oxygen-related  pollutants when translation ratios can
be established.

The following questions should be answered if you are considering trading  more than one
form of the same  pollutant, or if  you  are considering trading two different types  of
pollutants.  (This  will also help you  identify situations where a TMDL provides load
allocations for a single form, but sources actually discharge very different forms that have
different impacts on  water quality.)   Establishing translation ratios requires adequate
data and analysis about how pollutants behave under specific watershed conditions. If it
appears that the data or analysis cannot be developed, water quality trading opportunities
will be limited.

                                                             .Water Quality Trading Assessment Handbook
                        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 direct regulatory limits to indirect
                        effects been established?
                        Is there  a typical causal relationship between this pollutant and others?   Has a
                        specific translation relationship been established between  two pollutants within this
                    Type/Form: Exploring Potential Trading Opportunities Between
                    The hypothetical TMDL provides Total Phosphorus load allocations for all 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. Because these dischargers have allocations for the
                    same form of phosphorus, and their loads have reasonably similar form characteristics, they will
                    be sufficiently matched to proceed with further consideration of trading.

                    The  following examples of potential trades illustrate how pollutant form and type play a role in
                    assessing the viability of trading in a watershed.

                    Plcasantville POTW  and HopevUle POTW.  The discharges from the two POTWs located at
                    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 POTW.  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 compliance  with the  TMDL load
                    allocations.  The discharge from the Pleasantville POTW, 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.  Although both dischargers will be measuring and reporting the same form
                    of phosphorus, this  trade might raise concerns because these sources  are discharging different
                    combinations of phosphorus forms. However, in practice, the trade is not likely to create localized
                    impacts, and trading opportunities between these two sources can exist.

                    Easyville Dam and  Hopeville POTW. 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 violations of
                    water quality standards related to DO.  Hopeville POTW has a waste load 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 types and the two
                    sources, trading opportunities between these two sources  can exist. In the absence of such a

 Water Quality Trading Assessment Handbook.
 translation ratio, however, Easyville Dam would lack the basis for trading in the Happy Basin
  Figure 1.4, Chart of Sources with Type of Pollutant in TMDL, and Type of Pollutant actually
Name of Discharge Source, Diversion,
Agricultural Drain, or Tributary

Herb's Farm
Pleas ant ville
Acme Inc. (Nirvana Creek Confluence)
AAA Corp. (Lucky Creek Confluence)
Ortho Company
Laughing Larry's Trout Farm
River Mile

Form of Pollutant
As Addressed by
: As
(% Soluble/
\ % Non-
! Soluble)

Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
Total Phosphorus
: 30/70
! 100/0
; 100/0
: 100/0
i 50/50


 The purpose of Step Three is to evaluate the location of potentially tradable discharges
 and relevant receiving water conditions to determine whether the environmental impact is
 equivalent.  Environmental impact is the second of the four factors that must be aligned
 for trading to be viable. Your Step One watershed discharge information will give you the
 location of the pollutant discharges.  Participants must 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 environmental equivalence.   First, the  fate and transport
 characteristics of a pollutant (e.g., how it behaves in a river system) must be considered.
 Second,  the  unique conditions of the watershed  must 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, a pound of phosphorus discharged into a
 river can "disappear" 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 discharge point.  Some trading systems
 use pollutant "equivalence ratios", or similar mechanisms, to establish  the  necessary
environmental  equivalence relationships.    In these systems,  each source  or trade
transaction  is  assigned a ratio to account for  the effects  of inputs,  withdrawals,  and
diversions between the seller's and buyer's discharge points and all relevant compliance

                                                             .Water Quality Trading Assessment Handbook
                    points. These ratios depend on pollutant parameter stability as well as the distance, river
                    hydrology, and other relevant environmental conditions.

                    In general, the greater the geographic distance between discharge points, the greater the
                    chance of high volume pollutant uptake and settlement, and/or complex hydrology in the
                    receiving waters between those points.  Therefore, sources in close geographic proximity
                    are more likely to be able  to establish a  straightforward  environmental equivalence
                    relationship. In some cases, the influence of diversions and tributaries may be too great
                    to establish reliable impact relationships.
                           How Ratios Are Used to Establish Environmental Equivalence
                      Most trading systems use equivalence ratios, or similar mechanisms, to adjust for the complex
                      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 ol
                      inputs, withdrawals, and other effects on the pollutant between the seller and buyer's discharge
                      points, and any other monitoring points, to assure the equivalent environmental impact from
                      pollutants present in the water column. Ratios allow trading partners to adjust the amount ol
                      reductions to  assure  trades create environmentally equivalent outcomes at the point(s) ol
                      environmental concern.   Ratios are often based on each source's location along the  river,
                      tributary, or agricultural drain in relation to other market participants and/or designated instream
                      compliance points.   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 rivei
                      location  and other site location factors.  Others use a composite ratio that accounts for all

                      The example of phosphorus helps illustrate why equivalence ratios are needed.  A pound ot
                      phosphorus discharged upstream may not arrive as a pound of phosphorus at a given point
                      downstream. Some may be lost as the stream is diverted for agricultural use or for 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 effect of a reduction that will be realized at the buyer's
                      discharge point, or other compliance points.  For example, a 3:1 ratio indicates that for every
                      three pounds of phosphorus released by a discharger,  one pound will reach and have an
                      environmental effect on water quality at the critical monitoring point.  River location ratios are
                      often calculated  using modeling.  Often, modeling (such as mass balance calculation) has
                      already been used for TMDL development.
                    Appendices  A, B,  and  C  of this Handbook provide  information  about  the  inherent
                    characteristics of selected pollutants that is 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, conditions for trading may not be favorable.

Water Quality Trading Assessment Handbook.
                                Localized Impacts

  Some potential trades that could result in a general water quality improvement in a broad area
  may also result in acute, localized impacts. Trades that create "hot spots" ~ localized areas
  with high levels of pollution within a watershed - should be avoided.  The following factors
  should be considered.

      •   Characteristics of the Pollutant-
          >   Each pollutant poses different risks to local water quality.
      •   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 impacts.
              The presence of other pollutants will affect the potential tor localized impacts.
      •   Type of trade-
          >    Downstream trades  (i.e.,  a source compensates  a  source downstream  to
              overcontrol its discharge) have greater risks of localized impacts because if the
              buyer's discharge exceeds its TMDL allocation,  loads in the stream segment
            .  between the sources may be too high.
              Upstream trades (i.e., a source compensates a source upstream to overcontrol its
              discharge) present lower risks because overcontrol by the upstream discharge/
              will result in improvements to water quality beyond those specified in the TMDL in
              the segment between the sources.
      •    Use of monitoring-
          >    Monitoring programs  designed  to support  trading should  identify  potential
              localized impacts and provide for control regime modifications to mitigate impacts.
Answering the  following questions  will help you  assess the potential environmental
equivalence  between  discharges.  Information to help answer these questions can be
found in the  Watershed Discharge Profile developed in Step One, in Appendices A, B,
and C, 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 environmental  impact
    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 pollution 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.  It is possible to use predictive  models to estimate the
environmental 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 Trading Assessment Handbook
                    Environmental Equivalence:  Exploring Potential Trading
                    Opportunities Between Dischargers
                    Information on the  general  fate and transport  characteristics of phosphorus is  provided  in
                    Appendix A.  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 environmental equivalence
                    and trading opportunities among dischargers.

                    The following examples of potential trades illustrate how environmental equivalence can play a
                    role in assessing the viability of trading.

                    Herb's Farm and Pleasantville POTW
                    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 close to
                    1:1.  (Trades involving other sources will require calculation of separate ratios.) Because of the
                    low equivalence ratio  between Herb's Farm and Pleasantville POTW, opportunities for  water
                    quality trading between these two dischargers can exist.

                    Pleasantville POTW and Hopeville POTW
                    The Hopeville POTW is located over 21  miles from the Pleasantville POTW. Between Hopeville
                    and Pleasantville is one major agricultural diversion, which diverts 75 percent of the flow of the
                    river.  Because of the diversion and resulting slower river flow, as well  as plant uptake and other
                    factors, trades between Hopeville and Pleasantville will have a 5:1 ratio.

                    There are two potential options  for trading between die POTWs.  One option is an "upstream
                    trade," in which Pleasantville overcontrols phosphorus reductions beyond its waste load allocation
                    to create reduction  credits.  In  this case, Hopeville would  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 its
                    plant.  (This may or may not be cost effective for Hopeville.) Pleasantville would then reduce its
                    phosphorus discharges beyond its waste load allocation and water quality in the 21 mile segment
                    would be improved beyond that specified by the TMDL.  This trade should also result in improved
                    water quality in the river segment below Hopeville.

                    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 meet its TMDL waste load allocation and this  will result in
                    no phosphorus reduction in the 21 mile  segment between the  two dischargers.  However, water
                    quality downstream  of Hopeville would improve as a result of its overcontrol.  A downstream
                    trade such as this would satisfy the TMDL only if the water quality impairment occurs in the river
                    segment below Hopeville  and not between Pleasantville and Hopeville.  It is possible that,
                    Pleasantville's TMDL waste load allocation was  established to  reduce  its contributions to
                    impairments  below  Hopeville. However, except in such  unique circumstances,  the  elevated
                    concentrations of phosphorous in the 21 mile segment between  the sources is likely  to cause
                    unacceptable localized adverse impacts.

 Water Quality Trading Assessment Handbook.
 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.  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 allowing Laughing Larry's to trade in the Happy River market area.


 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 must be considered. Alignment of all three is needed to match trading

 Load variability: A discharger's load is likely to vary from time to time.  You will need to
 identify only major load variations that occur over the course of  the  year, not minor
 fluctuations in discharges. For example, some POTWs reduce discharges to zero 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 load allocations in the TMDL are  seasonal or annual.
 Potential trading partners must meet TMDL timing  requirements and also 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.

 Compliance determination variability:  Because of the  different  considerations  in
 establishing appropriate NPDES permit limits, as well as other factors such as the cost of
 monitoring,  the  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 or  other regulatory
requirements.  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
 must  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 pollution control technology needed to meet those requirements.
Such  a potential purchaser cannot wait 18 months while a potential  reduction  provider

                                                         .Water Quality Trading Assessment Handbook
                  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 in Step Four will be
                  found in the TMDL and NPDES permit language specific to each watershed and source.
                  Appendices A,  B, and C also include a discussion  of the  typical  range of regulation for
                  each pollutant.

                  Answering the  following questions  will  help  determine the  potential  alignment of
                  schedules in terms of seasonal requirements, metrics for  pollutant limits, and deadlines
                  for compliance.  If participants are unable to align  all three dimensions of time, trading
                  may not be viable.   It is not necessary for  all sources in the watershed to  align their
                  compliance schedules; however, a sufficient number must be aligned to support one or
                  more beneficial trades.

                  •   Permit and  TMDL Compliance Periods-
                          >    Does the TMDL establish seasonal allocations or year-round reductions?

                          >   What units of time are used to define and monitor compliance with relevant
                              permit limits?
                          >   What time  period  is  used by  non-permitted dischargers (e.g., nonpoint
                             sources) to measure and, where applicable,  report discharges?  (Hourly,
                              daily, weekly, annually?)
                          >    Do any sources have significant seasonal or other cyclical load variability?

                  •   TMDL Compliance Deadlines-
                          >    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., permit  requirements based on
                              national effluent guidelines) that must be considered?
                   Timing: Exploring Trading Opportunities Between Dischargers
                   Three types of timing issues present challenges to potential trading partners in the Happy River
                   Basin.   The following examples  illustrate issues relating to (1) seasonal load variability, (2)
                   compliance determination variability, and (3) compliance deadline variability.

                   Herb's Farm and Pleasantville POTW (load variability)
                   Pleasantville 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 only during the
                   growing season.  In  the winter, when farmland is frozen over,  the farm contributes very little

                   If the TMDL required year-round load reductions to meet Pleasantville's waste load allocations,
                   Herb's Farm would not be able to produce reductions for the entirety of the relevant time period.
                   However, the Happy River phosphorus TMDL is typical of  other  phosphorus TMDLs and

  Water Quality Trading Assessment Handbook,
  establishes only seasonal load allocations which are applicable between April and September.
  Therefore, opportunities for trading between these two dischargers can exist.

  Hopeville POTW and Pleasantville POTW (compliance determination variability)
  In this hypothetical, both POTWs  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 POTWs.

  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 waste load allocation under the
  Lucky Creek TMDL. The Lucky Creek and Happy River TMDL 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 able 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 in order to participate.


 The watershed discharge information developed in Step One should include quantities of
 the relevant pollutant discharged by the 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 reductions that can be supplied must
 meet or exceed the quantity of reductions needed to ensure compliance.

 Demand for  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
 (what the TMDL allows  sources to discharge).     For individual nonpoint sources,
 estimates of these quantities are not normally specified in the TMDL, and so will need to
 be calculated, using aggregated nonpoint discharge data from the TMDL along with other
 information, such as data developed by soil conservation districts. The TMDL will provide
 information about current and target  loads from inflows and tributaries. Methodologies for
 calculating historical, current,  and target loads for individual  non-point 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 discharger's ability to "overcontrol," or reduce its discharges below
 the target load specified by the TMDL. The volume of reductions achieved beyond TMDL
 obligations represents the stock of  potential surplus reductions 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 product production
levels or land management practices, substituting inputs such as raw materials and
agricultural chemicals, or investing in new technology.

                                                           .Water Quality Trading Assessment Handbook
                   In the next chapter, the financial feasibility of various control options are 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 reductions can reasonably meet the demand,
                   then trading may be a viable tool to address water quality problems.

                   •   For each relevant discharger, what are  the  quantities  of current/future  loads
                       compared to target loads?
                   *   For each discharger,  what is the capacity to provide reductions beyond applicable
                       required TMDL load allocations (i.e., do they have the technical capacity to generate
                   Supply and Demand:  Exploring Trading Opportunities Among
                   It is often difficult to project the balance of supply and demand for reductions. In the Happy Basin
                   hypothetical, you have a general idea of the total amount of reductions needed by all sources to
                   meet TMDL load 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

                   Acme Inc. and Hopeville POTW (Supply and Demand in Balance)
                   Hopeville has projected that it will need to reduce phosphorus discharges by 12 pounds per day to
                   meet TMDL target allocations.  (See Figure 1.5, Chart of Sources with total reductions needed by
                   Happy River dischargers.)  Hopeville may consider purchasing reduction credits from Acme Inc.
                   rather than investing  in control  technology that is projected to produce considerably greater
                   pollutant loadings reductions than it needs.   To meet its load allocation, Acme also expects to
                   install control  technology with potential to overcontrol, thus  generating potentially saleable
                   reduction credits.   Other dischargers in the Basin also have potential to generate a sufficient
                   supply of reduction credits to meet Hopeville's demand.

 Water Quality Trading Assessment Handbook.
 Ortho Industries, located at River Mile 541, is a major discharger of phosphorus.  To meet its
 TMDL waste load allocations, Ortho will need to reduce its discharges by about 990 IbsVday.
 Ortho is considering an on-site control option that will meet its allocation.  It is also considering
 purchasing reductions from other dischargers in the Basin. For cost reasons, Ortho has decided to
 focus on a "one size fits all" control technology package. There is no available alternative that
 would allow for a blended strategy that includes the use of both a less  effective, less costly
 technological treatment control option and purchased reductions from other dischargers. Ortho
 must choose trading or on-site control.  As Ortho considers purchasing reductions from other
 dischargers, it will need to project whether the potential supply of reductions will meet its demand
 (i.e., enable it to comply fully with its waste load allocation). The calculated ratios needed to
 ensure environmental equivalence are likely to at least double the reduction needed, increasing
 Ortho's demand to approximately 2000 IbsVday.   Using Figure 1.5, Chart of Sources, you can
 calculate that it will be almost impossible for the remaining dischargers in the Basin to create a
 sufficient supply of reduction credits to meet Ortho's demand. Even if all other sources reduced
 their phosphorus discharges to zero, the supply of reduction credits generated by such overcontrol
 would total only about 1900  IbsVday.  Ortho can see that trading will not be an option for its
 compliance plan because the supply of reductions cannot meet its demand.

Before moving on to the next chapter, review the outcome of the suitability analysis in the
five steps above.    Pollutant suitability requires a high  potential that all four suitability
factors will be in alignment for at least two market participants.  If  any one of the five
Pollutant Identification steps (i.e., watershed discharge profile, type/form, location, timing,
and supply/demand) show low potential for  alignment, the pollutant is probably not
suitable for water quality trading in this watershed.  Unless the pollutant has a medium to
high potential for all four factors, further analysis to assess water quality trading of this
pollutant in your watershed is probably not warranted.  However, the  user may wish to
consider whether other pollutants discharged by  sources in the watershed may have
potential trading.
           Rgure 1.5, Complete Discharge Profile with all pertinent information

Name of Discharge Source, Dims ion.
Agrculural Drain, of Tributary
Herb's Farm
Acme he. (Nirvana Creek Conlkience)
AAA Corp. (Luck/ Creek Confluence)
Ortho Company
Laugfthg Larry's Trout Farm
River Mle
Form of Potjtant
; As
As Addressed by ; on-
TMDL Soluble)
Total Phosphorus : 30/70
Total Phosphorus 90/10
Total Phosphorus ' 100/0
Total Phosphorus • 90/10
Total Phosphorus 100
Total Phosphorus : 100
Total Phosphorus 50/50
Discharge (e.g..
seasonal Obfgafon
cyclical, etc.) (Regulatory)
Seasonal June-Sept-
Year-round June-Sepl
Year-round June-Sept
Year-round June-Sepl
Year-round June-Sept.
Year-round June-Sept.
Seasonal June-Sepl
Quantity |
Basebie . Current Target Reduction
Load' • Load* Load1 Needed'
(fcsJday) (bs Jday) (Ibs./day) (fes.ttay)
632 r 753 527 226
760 791 633 158
492 > 547 410 137
60 62 50 12
199 • 195 166 2»""~|
786 1645 655 990
185 : 250 154 96 |

                                                              .Water Quality Trading Assessment Handbook
                    Outcome of Six Step Suitability Analysis
                    Of the seven Happy Basin sources identified at the beginning of the Six Step Suitability analysis,
                    five appear to reasonably meet the four 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
                        environmentally equivalent  water  quality  improvements.  (Trading  Suitability  Factor:
                        Environmental Equivalence)

                    •   Ortho Company will require more pollution reductions than could possibly be generated from
                        all the sources in the basin when likely trading ratios are factored in. Its demand far outstrips
                        potential supply. (Trading Suitability Factor: Supply/Demand)

                    In the next chapter, the remaining five 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.
 Financial  Attractiveness
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?

•  What should I do next?

After reading this chapter, considering the examples provided, and employing the tools or
methodologies discussed, the watershed participant will be able to screen out unlikely
trading scenarios  and make  an informed decision  as to whether further pursuit of
pollutant trading is warranted. Although this chapter discusses detailed calculations, a
rigorous analysis will not typically lead to a definitive answer. However, the reader will be
able  to locate  an individual  trade's position along  a relative continuum  of financial
attractiveness, from "high" to "low".  This chapter will also help  improve the reader's
ability to discuss water quality trading with other watershed participants by creating a
common "language" to describe their needs and issues.  In watersheds across the
country, people are talking with one another and developing new, non-traditional ways to
"trade" and solve their problems.  Understanding the financial challenges potential trading
partners face can help you identify such opportunities in your watershed.

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

Possible barriers to a viable trading market are discussed.  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

                                                        .Water Quality Trading Assessment Handbook
                  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 hypothetical will be used to illustrate the analytical process and some of the
                  common barriers.

                  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.  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 fully sufficient for basic
                  screening purposes.  More precise analysis will typically require in-depth interaction with
                  individual  discharge  sources  and  may quite  quickly encounter barriers  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


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

                  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  tradable commodity.   Moving on to  calculate  the cost of  producing the
                  commodity in the form of surplus pollution reductions will show whether the relative cost
                  efficiency of some dischargers' control options can lead to economically efficient trades.
                  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 compliance. For example, if a
                  discharger needs  a 5 Ibs./day reduction to comply but the only reasonably  available
                  technology costs $10 million and produces a 20 ibs./day reduction, then the  incremental
                  cost associated with the 5 lbs./day reduction is substantial relative to the average cost of
                  reductions.   Traditional average cost  would divide costs by  20 Ibs./day;  incremental
                  analysis divides the costs by  5 lbs./day and would be four times higher than average
                  cost.  As discussed  earlier, incremental cost represents a good approximation of the
                  upper-bound of a source's willingness to pay others within their watershed to alter their
                  discharging behavior.

 Water Quality Trading Assessment Handbook.


 The first step to assess financial attractiveness is to calculate the incremental cost of
 control for each pollution source. You may have ready access to needed data for at least
 one source. (Gathering information from other sources is discussed later.) 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 long-term future load (considering anticipated growth and
    other relevant factors);

 •  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.

 Taskl:  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 waste  load
 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  changing  demand  to influence
 discharge control  choices; therefore, multiple timeframes may require examination.  The
 motivation for cost savings will materialize when a looming compliance date presents the
 possibility of enforcement and penalties if discharges are  not reduced. Currently, NPDES
 permits implement TMDLs for point sources and typically give sources three to five years
 to control  their discharge.   This normally  gives dischargers a window of opportunity to
 evaluate their options, select the best alternative, and implement it. In the Happy River
 Basin hypothetical, the NPDES permit holders have five years to comply.

Water pollution 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.

                                                            .Water Quality Trading Assessment Handbook
                   Sources therefore need to examine the implications of their available options over an
                   extended period.

                   in the hypothetical, the 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 Incremental Cost of Control
                   Projecting Hopeville's Needed 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 POTW's current
                   TP load is 62 lbs./day3. 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  waste load
                   allocation, or Target Load, of 50 lbs./day and this is an enforceable compliance requirement in its
                   permit.  The following table 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 reductions to meet its
                   permit under the TMDL.  At current discharge  levels, the POTW needs to reduce TP discharge by
                   12 lbs./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 lbs./day, depending on
                   demand for its services. Looking further into the future, Hopeville will need to generate between
                   19 and 84 IbsVday of TP reductions to remain in compliance.  For the purposes of examining
                   financial attractiveness, you will focus on reductions needed in five years for compliance and
                   assume that  Hopeville  will experience  moderate growth.   Therefore,  the assumption is  that
                   Hopeville wiD be  generating 72 lbs./day of TP and will have to reduce that discharge by 22
                   lbs./day in five years.
                    31lb = 453592.37 milligrams and 1 gallon =3.785411784 liters

 Water Quality Trading Assessment Handbook.
                     Figure 2.1, Hopeville's POTW Load Projections




Hopeville POTW Load Projections
! Annual Target !
J Growth TP Load Load I
Current Baseline
! 0% 62 50 I
5 years (Compliance Date)
\ 1.0% J___ 66 1 50 i
j 3.0% 72 ! 50
j 8.0% ! 92 50
10 years (Capital Budgeting)
I 1.0% | 69 50
j 3.0% J33 	 	 50
I 8.0% j 134 ! 50




 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 help address water quality impairments.   The cost
 and  efficacy of control  options varies.    Usually, more control equals 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 pollution, the facility may
 need to invest in more control and/or take the next "technology step."
HopeviDe's 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.   Advanced Primary
Treatment (APT) is capable of removing 16 Ibs7day. After an investment in APT, the next "step"
is Biological Nutrient Removal which would remove an additional 24 Ibs^day. Finally, additional
aeration basins  and secondary  clarifiers would eliminate 55 IbsVday of additional  total
Task 3: Calculating 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.

                                                             .Water Quality Trading Assessment Handbook
                                         Figure 2.2, Hopeviile's POTW 5-Year Projection

Step 1 ""
Step 2
"Step" 3

Step 1
Step 2
Step 3

Step 1
Step 2
Step 3

Hopeville POTW 5-Year Projection
	 (I jjs;/da y ) 	

Low Growth
i ; ; : ) : Incremental
! i ! i ; i Reductions
; ; • Total Cumulative Needed
Annual ; TP Target , Reduction Reduction Reduction for
Growth ; Load ' Load : Needed Achieved Achieved ' Compliance
1.0% ; 66 50 ; 16
22 38 " N/A 	
""" ' " " 30 ; 68 "N/A

Moderate Growth
t - • i Incremental
i < ; : ' : Reductions
\ ' • Total : Cumulative Needed
Annual \ TP Target ) Reduction i Reduction : Reduction ; for
Growth Load i Load ; Needed I Achieved Achieved Compliance
3.0% : 72 50 22 r
	 ; 	 : 	 i'e " :' ' " 16 	 e
	 	 ." '22 ' 	 38' : 	 N/A
: 	 r 	 	 " 	 30 	 "68 	 	 N/A 	

High Growth
, Incremental
> Reductions
; ; iTotal ' . Cumulative ', Needed
Annual >TP ;Target sReduction Reduction Reduction for
Growth lLoad iLoad ;Needed Achieved ; Achieved Compliance
8.0% = 92 •: 50 : 42 :
' : IS i 16 ' 26
! 22 ; 38 , 4
" "" 	 ""; 	 	 	 	 " 	 3~6~~ 	 ' 	 68' " 	 ; 	 N/A

                    Hopeviile's Incremental Reductions Needed for Compliance
                    Under low growth assumptions, Hopeville faces a reduction need of 16 lbs./day.  As the table
                    demonstrates, APT generates 16 Ibs^day of reductions, the exact volume of reductions required 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 require Hopeville to reduce its discharge by 22 lbs./day.  The difference between
                    the reductions achieved with APT (16 lbs./day) and the total reductions needed (22 lbs./day )
                    would equal  6 lbs./day.  These represent the incremental reductions  needed for compliance.
                    Similarly, under high growth assumptions, implementing APT and Biological Nutrient Removal
                    would generate 38 lbs./day of reductions,  while Hopeville would be required to reduce its TP
                    discharge by 42 lbs./day. Under these assumptions, the POTW would fall short of compliance and
                    need 4 lbs./day of incremental reductions.

 Water Quality Trading Assessment Handbook.
 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

 The following worksheet describes the calculations4:
                Calculation of Annualized Control Costs
      Cost of Installing Control Option
      Time Period of Financing (Expressed as years)
      Interest Rate for Financing (Expressed as a decimal)
      Annualization Factor*
                        CosTTCalculate (1)x(2)]
      Annual Cost of Operation & Maintenance"
      Total Annual Cost of Control [(3)+(4)J
      * Appendix D 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 <
      he 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 approximately 2.5 percent being average.  In some circumstances, certain private
entities are also eligible  for loans from these below market funds.  Borrowers from the
capital markets currently face interest rates of approximately 6 percent.
 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 in
a logical manner.

                                                            .Water Quality Trading Assessment Handbook
                    Hopeville's Annualized Control Costs
                    Hopeville is analyzing its 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). Currently, 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);
                    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 then- discharge and maintain compliance by
                    investing in APT.
                    Task 5: Calculating Incremental Control Cost

                    The final task is to 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 POTW
                    and produced the following table for its five-year projection.
                                 Figure 2.3, Hopeville's POTW 5-Year Projection Including Costs
                                                  Hopeville POTW 5 Year Projection


Step 1
Step 2
Step 3"

Step 1
"Step 2'
Step 3

Step 1
Step 2
Step 3

\ - Total
Annual: Target! Reduction ,
Growth TP Load: Load ; Needed i
1.0% ; 66 ; 50 ; 16 i

	 ;-- 	 : 	 ; 	 ;

: ; Total ,
Annual! i Target; Reduction
Growth iTP Load: Load i Needed ;
3.0% 72 50 ; 22

; } Total
Annual' Target; Reduction
Growth TP Load Load : Needed
8.0% 92 50 42




Low Growth
; i Reduction
Cumulative Needed
Reduction ', for
? Achieved I Compliance
: i 16
> 16 i 0
38 : N/A
i 68 	 i N/A

Medium Growth
i Incremental
'. Reduction
Cumulative Needed
! Reduction ; for
: Achieved i Compliance
; 22
16 r 	 "6
38 " N/A 	
68 "N/A" 	

High Growth
: 'Incremental
, Reduction
^Cumulative- Needed
' Reduction for
Achieved Compliance
16 26
" "38" 	 4
68 N/A

Control Increment \
: Annualized >

$56,032 :
: $219,622 ;
"$339,456 i"

Control Increment
: Capital/O&M ;
: Incurred >
'. Annualized ;
: $56,032
'[""" $219,022
" $339,450

Control Increment ;
Capital/O&M '.





: COSt

; $9.59
'• $27.28
: $31.00

{ Average
' Control

: Average
Cost '

 Water Quality Trading Assessment Handbook.
 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, die incremental control cost for
 Step 1 is equal to $56,032 (the annualized cost) divided by 16 IbsVday (the incremental reduction
 needed for compliance with no additional control) or $9.59/lb./day.5  If the city experiences
 medium growth over die next five years, Step 1 will fall 6 Ibs7day short and force Hopeville to
 implement both Step 1 and Step 2. The incremental control cost for Step 2 is equal to $219,022
 (the annualized cost of Steps 1 and 2) divided by 6 lbs./day (the incremental reduction needed for
 compliance using Step 1 control) or $100.01/lb7day. However, Step 1 and Step 2 togedier would
 not produce compliance under a high growth scenario. Consequendy, die incremental control cost
 would be  $339,450 (die annualized cost of Steps 1, 2, and 3) divided by 4 IbsVday (die
 incremental reduction needed for compliance using Steps 1 and 2) or $232.50/lb7day.

 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.
 Analyzing incremental costs for  all dischargers  in a  watershed may  be seen as  a
 premature segmentation of the market into high cost reduction producers (likely buyers)
 and low cost pollutant reducers (likely sellers). However, 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
 consumed by other financial and market factors that are discussed in Stage 3.  At this
 time, you are concerned only with identifying the range of 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 family farms,
 POTWs, and  publicly traded corporations.  These potential market participants, while
 under pressure from the same market  driver (e.g., the need to meet a TMDL allocation),
 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 E 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.)
s Most pilot 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 Assessment Handbook
                   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 from individual industrial dischargers to the public system. 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 Non-point Sources

                   Soliciting information from private sources is more challenging.  Creating  a water quality
                   trading market is an unconventional  approach to improving water quality which 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  water  quality 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.   It is  even possible that some entities  may  attempt to  secure
                   bargaining power by providing inaccurate cost information. This could allow them to buy
                   reductions at a price lower than their willingness to pay or selling reductions at prices
                   higher than their actual willingness to accept.  Although these incentives may muddy the
                   financial analysis, private sources are unlikely to game themselves out of participating in
                   a water quality trading market.

                   Sources for Non-Point Source Cost/Pollutant Reduction Information

                   In many cases, non-point sources have  access to information resources pertinent to their
                   likely costs.   If they are unwilling or unable to share the information, non-point 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
                   studies and  published them on the Internet.  Other information sources include the U.S.
                   Department   of  Agriculture's  Natural   Resource  Conservation  Service,  Agricultural
                   Research Service, and agricultural extension  programs at colleges and universities.

                   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
                   hypothetical, as in many pilot phosphorus trading projects, the pollutant is measured in

 Water Quality Trading Assessment Handbook.
  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 hypothetical 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.
 A Financial Snapshot of the Happy River Watershed
 Combining the Deeded Data
 Hopeville and its fellow sources exchanged the needed information and produced the following
 spreadsheet, cataloging each source's incremental control cost in five years under a moderate
 growth scenario.  Sources are listed from upriver to downriver and all possible technology steps
 for each source are listed.
                 Figure 2.4, Happy River Watershed Combined Analysis


— 	 	 ;. 	 	 	 	 _ 	 	 .„ 	 	 . _ 5 Year Projection

; Annual -: TP -Target
Facility ^Growth ; Load ^ Load
Pleacantvllle 3.0% 917 633
Step I : ! i
step 2 : ;

Herb i Farm • 3.0% i 873 < 527 .
Stop 1 i !
Step I , ( I f
Acme Inc. ; 5.0% 698 410 .

-s""".. _ : i J. i
Step! .|I)
Steps ; i i s

Total ; | Total
Reduction i Reduction {Reduction
Needed \ Achieved ! Achieved
284 i
i 662 I 682
! 107 i 769

346 I t
! 91 ; 91 '
< 623 • 714 '-
288 i 506 1 506 r

; 16 f 16 ;
J_ 2* 	 !_ 40 i
'- 55 i 95 *

incremenlal : Control
Reduction : Increment ; ;
Needed j CapitaVOlU ! !
for i Incured : Incremental >
Compliance ' Annuabad < Control Colt i


i t 2,074,297 i
i t 5.222.364 :~

(20.01 i
N/A t
255 TT 49".823~: N/A~ 	 i 	


i S 464.444 '
i S 6.308.251

: S 56,032 i
I t 219,022
: t 339.450

S4.S9 •
S60.01 !
N/A ~!




Available to




Task 1: Identifying Potentially Viable Trades

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

                                                        .Water Quality Trading Assessment Handbook
                  •   Hopeville $100.01;
                  •   Acme $60.01;
                  •   Pleasantville $20.01;
                  •   AAACorp. $14.99; and
                  •   Herb's Farm $4.99.

                  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 list. Using this simple assumption, the following nine possible transactions
                  appear to be financially attractive:
                  •   Hopeville compensates Acme Inc. to overcontroi;
                  •   Hopeville compensates Pleasantville to overcontroi;
                  •   Hopeville compensates AAA Corp. to overcontroi;
                  •   Hopeville compensates Herb's Farm to overcontroi;
                  •   Acme compensates Pleasantville to overcontroi;
                  •   Acme compensates AAA Corp. to overcontroi;
                  •   Acme compensates Herb's Farm to overcontroi;
                  •    Pleasantville compensates AAA Corp. to overcontroi;
                  •    Pleasantville compensates Herb's Farm to overcontroi; and
                  •    AAA Corp. compensates Herb's Farm to overcontroi.

                  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 ail locations in the watershed are environmentally equivalent;
                  •   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 is subject to deterioration  as  these and other
                  complicating factors are  included in the analysis.  Pilot project experience indicates that
                  an organized analysis is needed to add the relevant additional considerations  as  an
                  overlay to  the preliminary 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, the stakeholder 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

 Water Quality Trading Assessment Handbook.
 may decide that trading is not viable.  If a reasonable level of financial attractiveness
 remains, additional factors can be considered.

 Uncertainty Discount Adjusted Incremental Control Cost

 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 infeasible  or very costly.   Reductions for these
 control options  are often  estimated based on scientific modeling for the  watershed.
 Loading reductions from Best Management Practices  (BMPs) used by non-point sources
 are most likely to be calculated.

 BMPs perform differently  based  on a variety of site specific factors that may not be
 included in the model, introducing the chance for variable and unpredictable results.  In
 pilot projects,  the relatively variable and unpredictable performance of  BMPs has been
 handled by discounting the associated estimated reductions available for  trade.   The
 uncertainty discount ensures that estimate errors in the BMP reduction equation  (derived
 from the model) will not jeopardize the environmental equivalence  between  different
 types of pollutant reduction methods.  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.
Analyzing the Happy River Watershed
Pleasantville and Herb's Farm                                      ,
Herb's Farm can use its Step 1 and 2 control options — sediment ponds and constructed wetlands -
to control discharges from its fields and trade the overcontrol to Pleasantville.  Research shows
that, on average, these options could reduce phosphorus loadings from the farm by 623 lbs./day.
At an annualized cost  (based on the length of the growing season when the farm can generate
reductions) of $464,444 the  incremental control cost for Step 1 is $4.99/lbVday6.  However,
reductions by Herb's Farm are likely to vary based on  its unique (and sometimes unknown)
characteristics. It would be too costly to measure the actual phosphorus reduction achieved on a
daily basis. Potentially, stakeholders could ask that an uncertainty discount factor be applied to
the projected reductions achieved.  A 50 percent discount would mean, in effect, that the farm
must produce 2 Ibs. of projected reductions for every 1 Ib.  it wishes to trade. Consequently, from
Pleasantville's perspective, the total cost of achieving its needed increment of control through
trading will increase because it will need to purchase more credits to achieve an environmentally
equivalent reduction. The price per pound of reduction increases from $4.99 to $9.98, modestly
eroding the financial attractiveness of a trade between Herb's Farm and Pleasantville.
 "Hie cost per pound per day is based on the same incremental costs analysis performed for Hopeville. As per
Figure 2.4, Herb's Farm Step 1 reduces discharge by 91 Ibs. The farm would need an additional increment of
255 Ibs. to comply with the TMDL.  As such, to calculate the incremental control cost, the annualized cost for
Steps 1 and 2 ($464,444) must be divided into 255 Ibs.

                                                          .Water Quality Trading Assessment Handbook
                   Environmental 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.  Environmental equivalence ratios  must sometimes be established to
                   ensure that the overall pollutant  load does not impair  beneficial uses of the river at
                   specific monitoring points. But ratios can be distributed within a market to find the least
                   cost pathway to achieving the load goal.

                   Pilot projects have used different environmental 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  environmental equivalence  only between  two
                   sources, 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
                   environmental equivalence ratios are introduced.  As suggested by the previous chapter,
                   Alpha Trades are not likely  to involve sources separated by  significant distances or
                   sources with significant water diversions in the stream segment separating them.

                   Alpha Trades that may merit analysis in the Happy River Watershed are:

                   •   Hopeville compensates Pleasantville to overcontrol;

                   •   Hopeville compensates Herb's Farm to overcontrol;

                   •   Pleasantville compensates Herb's Farm to overcontrol; and

                   •   Acme Inc. compensates Pleasantville to overcontrol.

                   Environmental equivalence ratios can have a profound effect on financial attractiveness.
                   As the ratio between buyer and seller increases, the volume of purchased reductions 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. The following hypothetical illustrate various  key nuances of
                   this relationship.
                   Hopeville, Pleasantville, and Herb's Farm
                   Hopeville faces incremental control costs of $100/lb. Pleasantville is able to control for $20Ab.
                   creating an incremental control cost difference of $80/lb.  Financial attractiveness appears high
                   assuming the reductions have an equivalent effect on water quality. However, as a mass balance
                   model indicates, the long distance between the two sources and  an intervening river diversion
                   between create an environmental equivalence ratio of 5.0. Therefore, Hopeville must purchase 5

 Water Quality Trading Assessment Handbook.
 Ibs. of reductions from Pleasantville for every 1 Ib. of its own required reduction.  The cost to
 Hopeville of a one pound reduction purchased from Pleasantville increases from $20 to $100,
 completely eroding any potential gains from the trade.

 In contrast, Herb's Farm is  able to overcontrol for $5/lb., creating an incremental control cost
 difference between  Hopeville and  the farm of  $95flb.    The  river diversion  creates  an
 environmental equivalence ratio of 3.0 between the POTW and me farm.  Therefore, Hopeville
 must purchase 3 Ibs. of reductions from Herb's Farm for every 1 Ib. of its own required reduction.
 In this case, the unit cost to Hopeville of a one pound reduction purchased from the farm increases
 from $5 to $15.  The difference between Hopeville's cost of controlling one pound of phosphorus
 or purchasing the environmental equivalent from the farm is ($100 minus $15) $85. This appears
 to be a highly attractive potential trade.

 Pleasantville's close  downstream proximity to Herb's Farm means  that almost every pound of
 phosphorus the farm can remove from the river achieves more environmental benefits than if
 Pleasantville made the pollutant reductions itself. Mass balance modeling shows that Pleasantville
 needs to purchase only six-tenths (0.6) of a pound of overcontrol for every pound of reduction it
 needs. The cost to Pleasantville per pound of equivalent reduction purchased from the farm would
 be $3 rather than $5.

 Acme and Pleasantville
 Environmental equivalence ratios in  downstream trades can reverse the relationship between
 higher and lower  incremental control cost sources. Acme's index to the compliance point at the
 confluence of its  tributary and the mainstem is (0.9).  The large diversion downstream  of
 Pleasantville means only a portion of the discharge from its facilities remain in the mainstem of
 the river at the compliance point  Pleasantville has received an index  of (0.25).  In this case,
 Pleasantville would need to buy a little over a quarter of a pound (0.25/.9=.2777)  of reductions
 from Acme for every one pound of required reductions at its facility to lower the watershed's
 Total Phosphorus at the compliance point.  This means  the unit cost to Pleasantville of a one
 pound reduction purchased from Acme is approximately $16.66/lb.  $3.34 less than the $20/lb.
 Step  1 would achieve  at Pleasantville's  own facility. Therefore, in this case, the  lower  cost
 producer of reductions may find it beneficial to purchase reductions from a higher cost source.
 Transaction Costs

Transaction  costs influence the financial attractiveness of a trade.   Transaction costs
represent all the  resources needed to affect 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

It may be helpful  to consider transaction costs in your financial attractiveness analysis.
Transaction  costs are highly variable,  depending on such factors as the  volume  of
trading, the  infrastructure  needed  to  facilitate trading, and the  number and types  of
participants involved. Regulatory agencies may have significant influence on the relevant
variables, and are  therefore  key controllers of transaction  costs.     Trading system

                                                         ...Water Quality Trading Assessment Handbook
                   designers  must  be attentive to the transaction costs they design  into each trading
                   arrangement.  Failure  to adequately take account of  financial realities  by controlling
                   transaction costs can diminish or even eliminate the potential benefits of trading.

                   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. New equipment needed for effluent and
                   instream monitoring and data management may be  needed and/or fees for  laboratory
                   analysis may  be  incurred.   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 in  incremental control costs estimates will increase.


                   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 trade can be difficult
                   and highly complex. The costs involved can be substantial.  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 other 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.  Because 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 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

 Water Quality Trading Assessment Handbook.
  Implications of Transaction Costs, Risk, and Market Design

  Transaction costs and risk can be mitigated to some extent through thoughtful market
  design. Chapter 4 more fully describes the building blocks and key functions of a market
  and offers  specific advice 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 meets, at a minimum, two
  goals: 1)  reduced risk and 2)  lower 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
  frictionless, costs and risks associated with communication and  understanding can be
  reduced.   Similarly,  transparency  and the free flow of information  create stable
  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
 nuanced 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 pollution 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 the only available 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 Ib. reduction is reliably  available. If that 200 Ib. reduction is available only
 from diffuse sources with small individual surplus reductions, the associated transaction
 costs and risks may be so significant that trading is not viable.

 Missing the Market

 The ratio of fixed to variable costs associated with control  options, combined with  the
 timing of 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 return.

It is especially important to consider the fixed/variable cost profile in cases where supply
will lag behind demand.  In such situations, the potential reduction purchaser will need to

                                                           .Water Quality Trading Assessment Handbook
                   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  reduction suppliers
                   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).

                   Alternative Scenarios

                   In light of the various factors influencing financial attractiveness and market participation,
                   a watershed participant would  be wise to assess  market resiliency  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 environmental equivalence
                   ratios; or projecting  alternative TMDL reduction requirements.   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 or
                   impossible 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.  Identifying the most sensitive factors in your watershed will help you build a
                   more robust understanding of trading viability in your watershed as well as highlight
                   specific relationships to keep in mind as you move forward and design your market.

Water Quality Trading Assessment Handbook.
 Market Infrastructure
The first two 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 projects?
•   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 challenges you will face and
identify ways to benefit from lessons learned in  other watersheds. With this information
you will be better able to decide whether trading is viable and 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)
regulations and administrative procedures.  As such, WQT markets may require different
and/or additional infrastructure to ensure  environmental  equivalence and  practical
enforceability, while providing the opportunity for cost savings.

                                                          . Water Quality Trading Assessment Handbook
                   This chapter of the Handbook will introduce you to the primary functions of a viable WQT
                   market. These functions are to ensure that, along with satisfying the efficiency criteria for
                   conventional markets, WQT markets provide for environmental equivalence and practical

                   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 challenges.

                   In  addition to  market development costs,  transaction  costs include  information
                   gathering, trade  execution, and compliance monitoring efforts undertaken while trading is
                   underway. These transaction costs  will be driven largely  by  the  procedures, trade
                   execution  methods,  and tracking infrastructure  established by the market for  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 constraints.

                   High   market  development   costs/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.  The market's infrastructure will
                   contribute to or  reduce this friction.  Therefore, the infrastructure designer's goal is to
                   create the smoothest  transaction path consistent with regulatory requirements and water
                   quality improvement goals.

                   WQT markets are intended to provide for improved water quality at a  lower societal cost.
                   In most situations, market drivers are primarily concerned with attaining environmental
                   goals and allow  trading only as one option to further that effort.  Federal, state, and local
                   laws and  the need  for stakeholder involvement  may require complex infrastructure
                   mechanisms (monitoring regimens, auditing practices, public participation opportunities,
                   etc.) that increase costs and may restrict and/or complicate market infrastructure design.
                   For purposes of this  analysis,  you may think of  these  considerations as "regulatory
                   friction".  When designing a WQT market  you need to look for ways to minimize both
                   market friction and regulatory friction.

                   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 were asked to develop
                   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.

 Water Quality Trading Assessment Handbook.
 Considerations:  Market Sizing
 This section  is intended to help you find  ways to substantially reduce market and
 regulatory friction  by appropriately sizing your market infrastructure to your watershed's
 unique  trading characteristics.   The first two chapters  of  this Handbook,  Pollutant
 Suitability and Financial Attractiveness, 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 an unknown  number of  viable trades among both point and  non-point sources.
 These trades  would be for limited  durations and  require frequent negotiations and
 approval, while potentially saving millions of dollars.  For the watershed with  only one
 viable trade, a market infrastructure consisting of a web-based trading platform linked to
 state agency databases would be unnecessary and so expensive that, if it were required,
 it would likely make the trade unattractive. On the other hand, if participants in the large,
 dynamic market were required to continually revise their NPDES permits to reflect every
 new trading arrangement, the costs and uncertainty in the market would diminish  or
 eliminate the value of trading to  many if not all of them. The  following information and
 examples illustrate ways to tailor  your "overhead" costs to the potential size  of the market
 in your watershed.
 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 reducing pollutant
 loadings  discharged to waterways..   TMDLs  and similar frameworks are sometimes
 described as "budgets" for the introduction of pollutants into  watersheds.   Scientific
 studies estimate the  volume  of discharge a  specific watershed, or segment of the
 watershed, 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 and non-point sources located in the watershed, as well
 as a federal mandated "margin of safety."  The allocation of discharge  limits forces
sources in the watershed to analyze current practices to see if they need  to alter their
discharging behavior and the associated options and costs to do so.

Although  the EPA  Water Quality Trading Policy  indicates,  "[A]ll  water quality trading
should occur within a watershed or a  defined  area for which  a TMDL  has been
approved,"  the EPA's 1996  Draft  Framework  for Watershed-Based Trading  also
acknowledges  trading   may be possible  in  equivalent analytical and  management
frameworks like the Lakewide  Area Management  Plans (LaMPs)  and Remedial Action
Plans (RAPs) found in  the Great Lakes. The Water Quality Trading Policy also supports
"pre-TMDL trading in impaired waters to achieve progress towards or  the attainment of

                                                       .Water Quality Trading Assessment Handbook
                  water quality  standards,"  as  well  as "pre-TMDL trading  that  achieves  a  direct
                  environmental  benefit relevant to the conditions  or causes  of impairment to achieve
                  progress towards restoring designated uses where reducing pollutant loads alone is not
                  sufficient or as cost-effective."  This chapter assumes that your watershed has a TMDL,
                  or similar framework, driving your interest in creating a WQT market.
                  What Are the Essential  Functions of a Water Quality

                  Trading Market?	

                  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,  the  regulatory environment,  and the  characteristics  of  the
                  watershed. In some cases, specific mechanisms  may perform more than one function,
                  potentially increasing market efficiency.

                  The eight essential functions are:

                  1.   Defining marketable reductions;
                  2.   Communicating among buyers and sellers;
                  3.   Ensuring environmental equivalence of trades;
                  4.   Defining and executing the trading process;
                  5.   Tracking trades;
                  6.   Assuring  compliance  with relevant federal Clean Water  Act  and state  and  local
                  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 and regulatory friction.


                  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, some  people need shelter,
                  prefer to live in treehouses, and have the skills  and time to build it  themselves.  Such a
                  person might not be open to purchasing a townhouse.

                  Marketable Products in  WQT Markets—TMDLs  are intended to set a budget for local
                  pollutant discharges that ensures water quality standards, including designated uses, are
                  attained in a  watershed.  Discharge "overcontrol" is the marketable product and is
                  produced when the reduction of pollutant loadings  goes beyond a discharger's  regulatory
                  obligation.  A WQT market must do two things to create a marketable product.  First, the
                  market must identify the relevant pollutant control obligations. Overcontrol  cannot exist

 Water Quality Trading Assessment Handbook...
 until a regulatory framework sets the baseline obligations.  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 differences will create
 little, if any, value even if the regulatory framework allows offsets.


 Conventional Market Function—All conventional  markets are first  and  foremost
 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

 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  discharge reductions potentially executable 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 pollution 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 leam what  quantity of discharge reductions are
 being offered and demanded, when they can/will be delivered, their duration, their likely
 impact on water  quality at the point of purchase/sale and all relevant compliance  points,
 and how much they will potentially cost to acquire.  A WQT market is more likely  to
 succeed if ft 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.


 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 volume 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 mentioned earlier, trading requires that the impact of
the purchased pollutant reduction is (at least) environmentally equivalent to the required

                                                        .Water Quality Trading Assessment Handbook
                  reduction.   Market participants and other stakeholders must be able to evaluate the
                  environmental equivalence of reducing pollutants at the points of purchase and sale. For
                  example, hydrologic conditions in the stream between the two trading points must be
                  evaluated because they can have a profound impact on environmental equivalence.

                  Demonstration WQT projects have used various mechanisms to perform the  essential
                  market function of facilitating  environmental 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 scientifically precise approach,
                  your 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 artificially high to ensure
                  equivalence with a margin of safety, even though this might drive  up the cost per unit of
                  needed reductions. A good equivalence mechanism will keep 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.


                  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, subcontracting special elements of
                  the work, 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 environmental equivalence;

                  •   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 other stakeholders;

 Water Quality Trading Assessment Handbook.
 •   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:  For example, if the process  requires control
 technology installation and monitoring to confirm reductions prior to allowing sale of such
 reductions, dischargers may be reluctant to commit scarce resources to overcontrol.  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 those with demonstration projects underway, have
 developed "State Trading Documents"  to 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 while maintaining
 the state's ability to control water quality administration.  Great care should be taken to
 review your state's document (if it has one) and  design the market within its guidelines.


 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 trades are not double counted (i.e., one source does not sell
 the same reductions to more than  one buyer) and to provide an  easy audit trail  for
 compliance assurance purposes. The two crucial pieces of information  a water quality
 trade tracking mechanism must include are volume of 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 helps
 ensure that the goal of the TMDL, improved water quality,  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 and regulatory 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 help limit transaction costs. When  regulators can access trade information
efficiently, they are less  likely to intervene on particular trades or in the market system.  A

                                                        .Water Quality Trading Assessment Handbook
                  poor trade tracking mechanism will drive up the cost of administering individual trades to
                  the point where  it  erodes the value  of  trading.   It may require trading partners  or
                  regulatory agencies to perform non- value-added administrative tasks (i.e., completing
                  unnecessary paperwork,  reconstructing market activity  from inconsistent transaction


                      LOCAL REQUIREMENTS

                  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. According to the EPA Water Quality Trading Policy, trading programs must be
                  developed  in  the  context  of  regulatory  and  enforcement  mechanisms,  which
                  predominantly  rely  on 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 (reductions) that are traded." EPA's 1996 Draft
                  Framework  for Watershed-Based Trading  suggests a  market  must meet  conditions,
                  standards, and procedures for ensuring that agencies maintain their ability to enforce the
                  intent of a specific regulation.  The appropriate regulatory agency(s) therefore will need a
                  process to  authorize, evaluate,  permit,  verify, and audit trading  programs  or  even
                  individual trades.  Demonstration projects have performed this function in a variety of

                  A good regulatory compliance assurance mechanism minimizes the regulatory friction,
                  transaction  costs, and  transaction uncertainty associated with  any  potential trade  by
                  achieving consistent approval decisions—in both outcome and timing—based on the data
                  needed to   ensure  environmental  equivalence, prevent degradation, and  preclude
                  localized impacts. A poor mechanism increases regulatory friction, 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.


                   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

 Water Quality Trading Assessment Handbook.
  Managing Transaction Risk in WOT Markets—WQT markets involve three facets of
  transaction risk:

  •   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
     certain 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 required 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 nonperformance of discharge reduction obligations are less certain and the
 number of parties involved in enforcement issues (regulators, lawyers) increase and/or
 they become adversarial.

 A good  transaction risk management mechanism identifies and assigns the three risks
 associated with WQT 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

 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 managers to
 notify the public when they decide to 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 other federal, state, and  local
water quality regulations  require provision of opportunities  for public participation,
including public notice and opportunity for comment.  WQT markets, given this regulatory
framework, 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

Although 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," informing the public about on-going operations
and trades may be even more important.  Easy and timely .public access to transaction
information may increase market efficiency.  Improving water quality takes sustained

                                                        .Water Quality Trading Assessment Handbook
                  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 have produced 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;

                  «   Volume(s) of reductions generated and sold; and

                  «   Price(s) paid for reductions.

                  Additional information may be important to participants in your watershed.  The value of
                  satisfying all interests should be weighed against 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. This leads to higher transaction costs and
                  can have serious regulatory  friction consequences.  As watershed participants work
                  harder to get information, their  level  of trust may diminish, thereby 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.  After reviewing them, you will have a better
                  understanding of approaches potentially suitable for your watershed.



                  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 regulatory friction.  Participants
                  identified seven  design  principles they felt  were crucial to a  viable market in  their
                  watershed, including the following:

 Water Quality Trading Assessment Handbook.
 «   Avoid trade-by-trade changes to the TMDL;

 •   Avoid trade-by-trade changes to NPDES permits; and

 •   Minimize trade-by-trade agency review and approval.

 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.7

 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 requested and agreed to by its members.

 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  non-point  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 non-
 point source generated  reductions.  This  was  done to eliminate the need for an
 intermediary in  any transaction and create  the opportunity for direct participation of non-
 point sources in dynamic trading.  Non-point sources that can demonstrate they follow
 the appropriate  protocols have reductions automatically recognized as valid and fungible.

 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
 As of the publication of this document, trading in the Lower Boise market has not been initiated. Several steps
and mechanisms have been created to enable tradipg, including the creation of the Idaho Clean Water Co-
operative, reporting forms, model NPDES permit language, model TMDL language, and the State Trading

                                                         .Water Quality Trading Assessment Handbook
                   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 environmental  equivalence—One  significant  barrier to  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.

                   Assuring compliance with the Clean Water Act—The  Lower Boise market supports
                   consistent approval decisions—in both timing  (immediate) and outcome (if protocols are
                   followed). This limits friction in the market through use of specific mechanisms to marry
                   the pre-approval process to compliance assurance.

                   In this market, the pertinent TMDLs will contain base phosphorus waste load  allocations
                   (WLAs) for point sources and a provision for trade-dependent WLA variability.  Sources
                   will then  receive a new or modified  permit incorporating their WLA as a limit and,  if
                   desired, a provision enabling a trade-dependent variable limit.  As  explained  below, the
                   enabling  provision will allow monthly changes to either the sources' discharge limits (the
                   amount of discharge both  sources are allowed to put into the river) or the recognized
                   discharge volume (the amount of discharge counted against the limit) based  on trading

                   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 environmental 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 non-point 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  volume  of  environmentally  equivalent
                   reductions that have been traded from the non-point 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 non-point source reductions if they fail to meet BMP protocols and
                   retain full authority to enforce  the corresponding  point  source's  effluent limit without
                   crediting  its discharge volume.

                   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 Trade Report created  by the Co-op.  DMRs and Trade Reports include actual
                   discharge, point source trades lowering or increasing their discharge limit, and non-point
                   source credits reducing their  recognized discharge  volume.   The EPA  uses this
                   information 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

 Water Quality Trading Assessment Handbook.
 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 environmental
 equivalence; 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 work together to audit trades and
 assure regulatory compliance. EPA is responsible for regulatory enforcement actions.

 Without trade-by-trade regulatory review, transactions could fail to maintain or improve
 water quality.   To prevent the  need  for trade-by-trade review without increasing
 transaction costs or transaction uncertainty, the Lower Boise market uses three market
 mechanisms to eliminate the potential adverse environmental effects of individual trades.
 The use of known, published ratios lowers transaction costs because this eliminates the
 need for potentially time and resource intensive discussion with regulators over individual
 trades. The pre-qualified BMP list provides participants a clear understanding of  what
 reductions will be  recognized, minimizing transaction  uncertainty.  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.

 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.  Regulatory friction is  managed by
 providing  reasonably direct communication channels between participants, the Co-op,
 and the regulatory agencies.

 Trading parties are 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 non-point sources,  both  a Trade Notification Form  and a  Reduction  Credit
 Certificate must be submitted by the point source to certify the non-point source reduction
 and generate a credit against the point source's discharge  volume.  The Co-op will
 maintain a trade tracking database as well as  individual trade and account information
 and produce a Monthly Trade Report for each source.

 Managing  risk among Lower  Boise market  participants—The  Lower Boise  market
 manages the three 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 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.

                                                          .Water Quality Trading Assessment Handbook
                   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 non-point sources' discharge behavior.  Although
                   non-point sources are issued "load allocations" by the TMDL, they are not issued NPDES
                   (or  state equivalent) permits that create CWA  regulatory liability.   Non-point 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  non-point 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 non-point source trades, through private contracts.

                   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 pollution
                   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.

                   As  in  all markets, the water quality science is still imperfect and there is some risk that
                   the TMDL analysis was mistaken.   The  TMDL's  waste  load  allocations,  along with
                   associated trading may not be strict enough  to achieve water quality standards, including
                   protection  of  the watershed's desired  beneficial  use.   The TMDL allocations  may
                   ultimately be ratcheted down by  regulators  if  water quality improvement  is  insufficient.
                   Sources committing to discharge reduction strategies—whether through trading, control,
                   or a combination of the two—could find themselves looking for additional reductions after
                   making capital expenditures and/or purchasing/selling reductions. Private contracts help
                   manage  this risk in two ways.  First,  the duration of  individual trades is up to the parties.
                   This allows  participants to manage uncertainty about future load allocations by choosing
                   the length of time they are willing to commit to a certain strategy.  Private contracts can
                   also provide for a party to  cancel its contractual obligations  in the event that  the trade
                   does  not ensure compliance with future, more stringent TMDL allocations.

                   Private contracts in the Lower Boise allow parties to the trade to decide how great they
                   believe  the  risks are and who will bear them.  Writing  the  contract may require legal
                   assistance,  which  may be relatively expensive for  some  non-point 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 source. Where appropriate,  the new or revised NPDES

 Water Quality Trading Assessment Handbook...
 permits will then include language supporting trading. As already noted, .trade enabling
 permit provisions will include: the authorization to trade; the adjustment of the discharge
 limit or discharge  volume; trading  caps to prevent localized impacts; and trading
 procedural requirements.  Once a trade enabling permit  has been issued, the source's
 discharge limits and/or discharge volume may be adjusted without further  administrative
 process for each qualifying trade, thereby minimizing transaction costs and uncertainty.
 The permit will be renewed according to the standard permit cycle schedule (e.g., once
 every five years).

 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 an open forum to question and influence the permitted discharge limits and then
 easy access to information keeping them informed of actual discharge behavior.


 In  1985  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  non-point 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 Publicly Owned
 Treatment Works' (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 Annual Load (TMAL) for
 phosphorus  discharged into the reservoir was set at 14,270 pounds. The wastewater
 facilities received a total allocation of 2,310 pounds per year.

 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 basin. 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 TMAL
 allocation  and allow it to  expand its  services to new  developments,  which would
 otherwise  cause the POTW to exceed its Waste Load 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 functions as a "Water Quality Bank" by owning
 and  allocating purchasable  phosphorus credits associated with  four non-point source
 phosphorus control projects built by the Authority in the 1990's with taxes levied by  the
Authority on watershed residents.  These projects have reduced  the net amount of
 phosphdrus discharged, creating additional loading capacity in the reservoir. The credits
from these projects have been placed in the "Phosphorus Bank" from which POTWs may

                                                         .Water Quality Trading Assessment Handbook
                  draw credits to meet their regulatory obligations.   A total of 216 annual  pounds of
                  phosphorus credits were allocated to the Phosphorus Bank by the TMAL.

                  The control technologies used in the non-point source projects include retention/detention
                  ponds,  constructed wetlands,  and shoreline stabilization above and beyond  required
                  BMPs, leading to phosphorus discharge overcontrol.  The Authority has total control over
                  these "Sale Credits" and decides who may purchase them. Funds raised from the sale of
                  Sale Credits will be used by the Authority to  fund  additional projects that  will further
                  improve water quality.

                  The Authority also manages an additional 216  pounds of phosphorus credit allowances
                  that give  POTWs  the  right  to  purchase reductions from non-Authority phosphorus
                  reduction projects and receive an increased WLA. The TMAL allocated the allowances 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. 8 Transfer 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 Transfer Credits.  An approved project's reductions are registered with
                  the Authority and create 'Transfer Credits."   A POTW may seek additional phosphorus
                  discharge capacity by compensating the owner  of the Transfer Credits for their use. 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 (i.e., 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).9

                  The Reserve Pool marketable  reductions, as defined in the draft guidelines, evolve from
                  one of six different types of projects.

                   •   Additions  to  Existing  Development—Phosphorus  removals  from  BMPs   not
                       completed  during land development prior to January 1,2000 are eligible for trading.
                   •   Expanded or Retrofitted BMP Removals—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.
                   * A more detailed description of these projects is provided below.
                   9 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 Assessment Handbook.
 •   Engineered Authority Projects—Phosphorus removals from any non-point 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

 •   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 volume 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 various 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 four steps  that support these efforts in the
Cherry Creek basin.10  The fifth step described below provides  for regulatory review and
transforms the trade into a regulatory obligation.
    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. The technical specifications of the project, the estimated  reductions,
    reliability of the project operations, comments from Colorado's Water Quality Control
    Division  (WQCD), 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 reductions.

    Credit Calculation—After voting to include reductions in the  Reserve Pool, the
    Authority's Board of Directors determines the volume of credit allowances that will be
    associated with  the  project  based on projected reductions and a project specific
    trading ratio.

    Credit Allocation—Point sources looking to exceed 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 (TAG) reviews all trades and makes recommendations to
    the Authority Board of Directors.   The Board  then  approves or disapproves each
    specific trade.

    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

    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.

                                                           .Water Quality Trading Assessment Handbook
                    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 environmental equivalence—The focus of water quality trading in this market
                    is to maintain the designated uses of the Cherry Creek Reservoir, not to improve water
                    quality within specific stretches of rivers or tributaries.   Environmental 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. This adjustment
                    is  based on site-specific  monitoring  data, empirical modeling,  and/or best available
                    scientific evidence to account for environmental equivalence.  Institutional and scientific
                    uncertainty factors help ensure the ratios reflect actual benefits to the reservoir.

                    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
                    inherently limit interactions between  certain buyers and sellers. The Authority explicitly
                    identifies and then selects trading partners allowed into  part of 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 Sale 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, market participation in this segment of the market is not limited.

                    The Authority  manages  product  comparison for Phosphorus  Bank  reductions  by
                    quantifying their volume, 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
                    authority funded  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 trade.

                    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.  The trading  activity to  date has  imposed minimal tracking burdens on the
                    Authority.   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.

 Water Quality Trading Assessment Handbook.
 Compliance assurance with regulations in the 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 Sale or Transferred Credits as immediately off-setting the
 sampled, actual phosphorus discharge counting against 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  Sale or Transfer Credits must go through the  normal  permit  modification
 process to increase their discharge by 10 pounds.  Sources purchasing credits must work
 with the WQCD  to amend their  NPDES permit limits, prior to discharging   excess
 phosphorus.  Monitoring and  reporting  protocols for the POTWs are set  out  in their
 individual NPDES  permits and  follow the  standard  reporting mechanisms used for
 NPDES permitting.

 Managing  risk among parties trading in the Cherry Creek Market—As is common
 with most 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 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 the designated
 uses of the watershed for these transactions.  The risk management mechanisms are
 largely a result  of the banking  model  and  the trading guidelines developed   by
 stakeholders specifically for Cherry Creek.

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

 The Authority's  certification role also helps manage the  risk that the  credits or credit
 allowances  purchased  by the buyer are  not connected to  actual  overcontrol.  The
 rigorous reduction certification during project  approval  coupled with the  trade ratio
 creates leeway between the desired environmental benefit and the reductions outlined in
 the transaction agreement. In addition, rf phosphorus reduction projects begin to perform
poorly, the  Authority may revoke or adjust the number of credit or credit allowances
 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.


                                                        .Water Quality Trading Assessment Handbook
                  Transaction risk management 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, Reserve Pool credit allowance purchasers, who have negotiated with a specific
                  reductions producer for specific reductions, cannot  be awarded surplus Reserve Pool
                  credit allowances if reductions fail to materialize. They must negotiate another trade and
                  pay for additional allowances.

                  Finally, the market manages the risk that new development and use of reductions fail to
                  protect the designated uses of the  waterbody.  The TMAL driving the Cherry Creek
                  market has a periodic review  schedule, during which the TMAL  allocations may be
                  modified, up or down. Allocations may be adjusted to reflect the volume of phosphorus
                  being discharged  into the reservoir or existing water quality.  Therefore, the TMAL
                  allocation process  manages the risk that reductions will fail to maintain designated uses
                  by ratcheting  up and down the volume of  phosphorus permitted  into Cherry Creek
                  Reservoir by changing the allocation among POTWs and by  adjusting the volume of
                  credits and credit allowances available for use.

                  Providing information  to the  public and other stakeholders—The  on-going public
                  participation mechanism in Cherry Creek relies on standard public notice and comment
                  procedures commonly used for NPDES  permits.  In the Cherry Creek market, non-
                  discharging stakeholders have  several opportunities to play an active role  in trading
                  activity, including open forums to question and influence project evaluation, credit and
                  credit  allowance  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 listen to stakeholders attending that hearing. A similar procedure is used
                  during permit modification.  These  steps  are necessary to create transparency and
                  engender trust in the trading system.

                  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.


                  In  1990, Connecticut,  the  State of  New  York,  and  the  federal EPA  adopted a
                  Comprehensive Conservation and Management Plan (CCMP) for the Long Island Sound
                  National Estuary Program, known as  the Long Island Sound Study (LISS). 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 non-point sources by 58.5 percent
                  between  2000 and  2015.   A  TMDL,  approved in  April 2001, includes Waste Load
                  Allocations  for  point  sources  and  Load  Allocations  for  non-point  sources  in  the
                  watershed. Connecticut chose to develop a trading program  for the 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 Watershed Permit."
                  Connecticut's program  uses both its general state authority  and  its  EPA delegated
                   NPDES  permitting authority to issue a single General Permit for the nitrogen dischargers
                   it regulates in the  watershed.  The General Permit covers the  nitrogen discharges of all
                   point sources willing to trade on a voluntary basis through a single permit.  POTWs can

 Water Quality Trading Assessment Handbook.
 have opt out of the General Permit and receive a traditional permit and implementation
 schedule.  However,  all  POTWs have chosen to take advantage  of trading under the
 General Permit.   The General Permit sets a  ceiling for annual, permitted,  nitrogen
 discharges 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 normalized discharge in  2000.

 Market  designers faced two challenges.  The Connecticut market area is predominantly
 urban, with very few opportunities for low-cost nonpoint source  controls. To achieve the
 58.5 percent nitrogen reduction from all identifiable sources, Connecticut's 79  POTWs
 located within  the watershed were tasked with lowering their nitrogen  discharge  by
 64percent from 2000  baseline levels.  The second challenge  involved several factors,
 including the proximity of certain dischargers in  western Connecticut compared to their
 eastern counterparts,  Connecticut's previous efforts to fund nutrient removal  projects
 near Long  Island Sound, and the economic disparity between communities in  western
 and eastern Connecticut. The communities in western Connecticut are generally more
 affluent and able to absorb  the cost of  implementing new control technology.  They also
 had been  the focus  of  pre-trading  nitrogen  removal grants.  Eastern  Connecticut
 communities are  relatively  less affluent.  Market  designers felt that  the water quality
 trading  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
 environmentally equivalent reductions  by relying  on  previous  control  technology
 investments and their larger tax bases. Under some market models,  the generally poorer
 eastern communities would  then have to pay for available western reductions.

 The trading program that  evolved from  this effort is best described as a "Nitrogen Credit
 Exchange."   Sources  discharging less than their annual limit receive "credits" for
 overcontrol.  CTDEP is obligated by state law to purchase  all nitrogen credits from these
 sources.  Facilities that exceed their  limit are  considered out of compliance.   These
 sources are  allowed  to  purchase nitrogen credits from  DEP to meet compliance
 obligations.   DEP is  obligated by state law  to  sell  the  credits it  purchases from
 overcontollers to facilities that fail to comply.

 Important Market Functions of  the Connecticut Nitrogen Credit Exchange

 Defining marketable  reductions—Marketable  reductions in  Connecticut's  Nitrogen
 Credit Exchange are defined as reductions  in excess of a point source's Waste Load
 Allocation. As described in  the February 2003 General Permit for Nitrogen Discharges
 and Nitrogen Credit Exchange Program publication, by  March 31 of  each year,  the
 Nitrogen Credit Exchange   Program  (NCEP)  and  the  Connecticut  Department  of
 Environmental  Protection (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.  Marketable reductions
 emerge  if the actual, sampled yearly average is less than  the WLA  for that year.  A
"Nitrogen Equivalency  Factor," based  on  a source's contribution  of  nitrogen to Long
 Island Sound, is then applied to calculate the number of credits that the Nitrogen Credit
 Exchange (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-

                                                        .Water Quality Trading Assessment Handbook
                  180 describes  the  processes used  to  transfer  marketable  reductions from  POTWs
                  achieving overcontro! to POTWs 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 POTW, reduction goals ensuring compliance 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  POTW to attain an equal  percentage
                  reduction from its 2000 baseline.

                  POTWs unable to meet  their new limits may  elect to  build  nitrogen control projects.
                  Funding for projects is available on a competitive basis through the Connecticut Clean
                  Water Fund.  Funding consists of a 30 percent grant  with the balance loaned at 2 percent
                  interest.  Alternatively,  POTWs  may choose to  find  alternative revenue sources.
                  Regardless of their approach to meet their annual regulatory obligations, POTWs monitor
                  and report their discharge throughout the ensuing year pursuant to language in the
                  General Permit.

                  At the end of the year, the Nitrogen Credit Exchange Board (NCEB), in conjunction with
                  the CTDEP,  analyzes the discharge  for individual dischargers for compliance with the
                  annual WLA.  This  analysis includes  the calculation of credits produced by  dischargers
                  able to overcontrol  and the number of credits  needed by POTWs failing to meet their
                  WLA.  Credits are generated if the actual, sampled yearly average nitrogen discharge of
                  a particular POTW is less than its WLA for that  year. The Equivalency Factor translates
                  the overcontrol into credits automatically purchased by the NCEP.  Conversely, if the
                  actual, sampled yearly average is  more than the WLA for that year, the POTW needs to
                  purchase credits.   The Equivalency Factor translates  the difference between actual,
                  sampled discharge and the WLA into the number of credits that the POTW must buy from
                  the NCE.

                  The NCEB 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) buyers
                  are charged to reach permit compliance or sellers credited for their overcontrol. Those
                  POTWs exceeding  compliance with their annual WLA receive a check for their credits.
                  Those POTWs out of compliance  receive a bill  for the total cost of all credits that would
                  bring them into compliance with the General Permit.

                  Ensuring environmental equivalence—The focus of water quality trading in this market
                  is to attain the designated uses of the Long Island  Sound, not to improve water quality
                  within  specific  watersheds  or  basins  that drain  into  the  Sound.   Environmental
                  equivalence is therefore confined to the effect each  sources' individual discharge has on
                  the concentration of nitrogen in the Sound itself.

                  As part of the LISS, a peer-reviewed  water quality model was developed to delineate the
                   impact nitrogen discharges in the large area covered  by the  TMDL has  on  oxygen
                  concentrations in Long Island Sound.  This broke the area affected by  the TMDL into six
                   different zones closely aligned with  the major watersheds or basins and  relates their
                   nitrogen to oxygen impacts.  Some zones were further  broken down into tiers.  Further
                   modeling was done to relate nitrogen discharges within  each of the identified zones or
                   tiers.  The final step used to calculate environmental equivalence involved multiplying the

 Water Quality Trading Assessment Handbook.
 two factors together to create an Equivalency Factor that relates  the  impact  of  all
 individual discharges across the market to one another.

 Communicating between buyers and sellers—The Connecticut water quality trading
 model does not promote contact between individual dischargers.  The NCEP 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 NCEP as it carries out its  statutory
 responsibilities. As previously discussed, the NCEP gathers information from regulated
 dischargers, rewards  POTWs for overcontrolling, and charges others for failing to comply
 with their permit.  This results  in redistributing the cost of  overcontrolling  nitrogen
 between the two groups.

 NCEP administrators of the program need three sets of information to facilitate trading in
 this market—discharge  volumes,  nitrogen reductions achieved  by control  projects, and
 the cost of those control projects.  Actual, sampled discharge volumes are collected  by
 CTDEP as part of its General Permit administration responsibilities.

 The NCEP  relies  on  funds  from the  purchase  and  sales  of  nitrogen credits for
 administration  of the  NCEP.   Currently, the  NCEP is staffed by 2.5 FTEs assigned to
 several programs throughout the CTDEP.

 Tracking Trades—In the  Connecticut  market,  trade  tracking consists  of analyzing
 discharge, overcontrol,  and cost  redistribution.   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.  The additional burden  of  trade
 tracking (on top of the year-end analysis) borne by the NCEP entails collecting payments
 from dischargers buying credits to reach compliance.

 Assuring compliance  with regulations in the Connecticut  Market—Trading in the
 Connecticut  market takes  place  within  the  framework  of  the General  Permit, which
 regulates the annual  discharge of nitrogen into  Long Island Sound.  The aggregated
 General Permit discharge  is  set 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  WLA incorporating the annual reduction of  the  aggregated  General Permit
 and their baseline discharge in 2000.

Trading in this market is performed based on actual, sampled discharge  performance.
 Monitoring and reporting protocols for  point source discharge are set out in the General
 Permit and follow  the  standard  reporting  mechanisms used  for NPDES permitting.
Sampling frequency and procedures are based on the volume treated by the POTW on a
daily basis.   The collected chemical analysis samples  are entered into a  Nitrogen
Analysis Report (NAR) and  Monthly  Operating  Report (MOR) and  submitted to the
CTDEP. In addition, each POTW calculates a monthly mass loading of total nitrogen and
submits it to the CTDEP in a Discharge  Monitoring  Report (DMR).  Each POTW 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.

 POTWs failing to reach compliance must purchase credits from the NCEP 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 POTW to enforcement actions by the CTDEP.
K -S

                                                        ..Water Quaiity Trading Assessment Handbook
                  Managing risk among parties participating  in  the Nitrogen  Credit  Exchange
                  Program—In  the  Connecticut  market,  credits  are based  on the  level of nitrogen
                  discharged during the year and the WLA. Implicitly, they can only be generated by the
                  sources subject to the General Permit, which are all POTWs.  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 for compliance  purposes.
                  Nitrogen credits are only available from the NCEP, making the program the de-facto
                  certifier of the credits and eliminating the risk of purchasing non-marketable reductions.

                  The Connecticut Nitrogen  Exchange  Program executes trading at the end of the year,
                  when actual discharge volumes and overcontrol  are known. The NCEP 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

                  There are two risks created by this market model because  of  its  reliance on cash
                  management  and  load allocations lower than TMDL  implementation requirements to
                  maintain active participation from the POTWs .  First is the risk that during the year the
                  POTWs, in aggregate, will create more credits than are needed  to offset the POTWs that
                  fail to meet their regulatory obligations.  As the NCEP is obligated by law to purchase all
                  credits and unable  to sell them  to other sources, the  NCEP  annually runs the risk of
                  subsidizing the surplus overcontrol.   For example in 2002, the  NCEP  purchased
                  $2,757,323 worth of credits from  39 dischargers. The program  sold $1,317,233 worth of
                  credits. The $1,440,110 deficit was paid for by NCEP funds.

                  The second risk is that during the year the POTWs, in aggregate, may fail to create
                  enough credits for other POTWs  to maintain compliance.  In years when the demand for
                  credits is larger than the supply, the NCEP receives a  net infusion of cash because all
                  sources  must  purchase credits  to  meet compliance and the NCEP must  sell them,
                  regardless of  their actual availability. This infusion of  cash is designed  to pay off any
                  deficits from previous  years when there is a credit surplus.  Purchasing credits from the
                  NCEP relieves the POTW from regulatory consequences under the General Permit.  The
                  annual   allocations  are  low  enough  to   maintain   compliance  with  the  TMDL
                  implementation. In addition, allocations 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 control and dollars, while encouraging
                  additional nitrogen projects.

                  Finally, the market manages the  risk that reductions generated and traded in the market
                  do not achieve the designated uses of the waterbody by providing for periodic review of
                  both TMDL allocations and the General Permit allocations. These are adjusted to reflect
                  actual progress towards the designated use. The TMDL driving the Connecticut market
                  includes a periodic review schedule, during which the TMDL allocations may be modified,
                  up or down.   A change in the TMDL allocation could force a modification of  the annual
                  allocations of  the General  Permit.  Therefore, the TMDL and General Permit allocation
                  process manages  the risk that reductions will fail to achieve designated uses by
                  ratcheting up and down the volume of nitrogen allowed to enter Long Island Sound.

                   Providing information to the public  and other stakeholders—The on-going public
                   participation mechanism in Connecticut relies on traditional public notice and comment
                   procedures commonly used  for NPDES permits.  The NCEP is operated within the
                   framework of the General  Permit,  providing the opportunity for public comment for the

Water Quality Trading Assessment Handbook.
permit when it was issued and when it is renewed.  Public comment is only allowed on
the aggregated General Permit  and not allowed  for  the  WLAs for  individual sub-
dischargers regulated.

In addition, the NCEP annually produces a publication listing the price of nitrogen credits
as calculated by the NCEB.   Included with  the report  is a US Total Nitrogen Credit
Exchange Final Balance detailing the dollar value of the credits bought by the NCEP from
POTWs discharging less than their WLA as well as the dollar value of credits to be
purchased by facilities exceeding their WLA.

                   Stakeholder Readiness
                                                         . Water Quality Trading Assessment Handbook
                   The first three 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, you  will  need to reach out to other potential
                   participants and stakeholders to begin exploring water quality trading opportunities in the
                   watershed. This chapter will help answer the following questions:

                   •   Which other participants will be  needed to create  a viable water quality trading
                       market in your watershed?

                   •   Do key participants have a reasonable level  of interest  in considering water quality
                       trading as a potential mitigation option?

                   After completing this section and  reflecting on the lessons in the  first three chapters of
                   this  Handbook,  you should have  a better  understanding  of  how  to  engage other
                   stakeholders in the watershed to discuss water quality trading opportunities. The previous
                   chapter on market infrastructure, may have helped you begin to identify parties to include
                   in discussions about water quality trading in your watershed.  Because each situation will
                   present unique  challenges, this chapter does  not prescribe a specific path for you to
                   follow, but  does  offer tools to assist you  in  identifying  and engaging the necessary

                   This chapter recognizes that water quality trading requires the participation of certain
                   parties.  In addition to dischargers, there are many other critical players that must be
                   engaged in development of a viable water quality trading system.  Each watershed will
                   have a unique set of potential participants. This chapter suggests a two step approach
                   for engaging stakeholders.  The first  step involves identifying essential participants by
                   using tools such as a checklist of potential participants, a description of their roles, and a
                   series  of questions  that can help evaluate how the conditions in your  watershed will
                   influence your priority list of participants.  The second step is designed to improve your
                   understanding of the interests of priority participants so that you will be better prepared to
                   recruit  them. It includes  a review of key benefits of trading that can  help you begin
                   discussions.  It  also suggests several likely stakeholder needs and interests and offers
                   tips for responding to them.  Finally, this section gives with three examples of how trading
                   programs have provided for stakeholder participation.


                   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 whose behavior needs to

 Water Quality Trading Assessment Handbook...
 change.  The first  Chapters have  prepared you for this phase by  increasing your
 understanding of the suitability  of the pollutant,  the conditions  in the watershed, the
 control cost  differentials among dischargers,  and the market infrastructure needs.  In
 identifying parties that need  to work together to consider the viability of trading, each
 category of participants can be important for different reasons.

 Dischargers  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 dischargers that need to achieve substantial reductions and may
 be capable of overcontrolling their discharges.  Dischargers make up the pool of potential
 trading partners.  As discussed in Chapter 2, it will be important to engage dischargers  to
 gather information to evaluate 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 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 more stringent permit limitations.

 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  (e.g., Idaho and Alaska).  Most states and some  tribes have
 delegated CWA authorities.  Participation of NPDES permitting and TMDL development
 authorities will be needed to interpret  CWA requirements, formulate new rules  where
 possible and  necessary, and, perhaps, to provide technical and  scientific expertise.
 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

 In addition to local government agencies that operate treatment plants which are NPDES
 permitted point source dischargers, other agencies may operate water or power utilities
 that impact water quality in the watershed.  Other government agencies may 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 dischargers.  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,  canal
 companies, developers, recreation  and tourism interests in the watershed, commercial
 fishermen, and others.

 Interest groups.  Groups or associations representing affected  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

                                                         .Water Quality Trading Assessment Handbook
                   importance  are  active  citizen   environmental  groups  in  the  watershed.    Many
                   environmental groups  are  watching  trading efforts  carefully to ensure that all  CWA-
                   related substantive and procedural requirements are met and that TMDL water quality
                   objectives are fully supported by proposed water quality trades.  Many environmental
                   group members 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 market design.

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

                   As you consider  which participants should be  included,  the first step is to identify the
                   range of potential participants. The checklist provided below will assist you in this effort.

Water Quality Trading Assessment Handbook.
                      Checklist of Potential Participants

         Dischargers in the watershed
             Individual Point Sources (including wastewater and storm water dischargers)
                         Industrial (Direct and Indirect)
             Individua Nonpoint Sources
                         Urban entities
                         Farmland owners/operators
                         Canal companies
                         Irrigation districts
                         Forest land managers
                         Range land managers
         Federal agencies
         .    77?e Regional U.S. EPA Office
         >    U.S. Department of Agriculture
                     Natural Resource Conservation Service (NRCS)
                     Resource Conservation and Development Councils
                     Soil and Water Conservation Districts
             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 Conservation (DEC, DEO, etc.)
             Department of Pish and Game
             Department of Water Resources
             Court-appointed water master
             Tribal Councils
         Local Government
         >    Municipal utilities
                     •    Water supply
                     •    Power
         •    Cities
         Local Businesses
             o   Significant industrial users (dischargers to POTW treatment systems)
             o   Developers
             o   Power companies
         Interest Groups
             o   Associations
                     •    Water users
                     •    Local business  (e.g.,  Farm Bureau)
                     •    Local government
             o   Environmental Groups
             o   Watershed groups
         Colleges and Universities (and other water quality research facilities in the area)

In discussing  water quality trading  opportunities with  potential participants, it  may be
helpful to keep in mind the following benefits.

Water quality trading can result in significant cost savings.  Water quality trading is a
business-like way to solve water quality problems by focusing on  cost-effective, local
solutions. Typically, a party facing relatively high pollutant reduction costs compensates

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

                  Water quality trading  provides flexibility to dischargers in  meeting pollutant load
                  reductions. Trading opens up new options for  meeting TMDL load allocations. Although
                  water  quality trading  cannot compensate for common technology based  standards,
                  trading can be used to  access the water quality improvements that are created by other
                  discharger's adoption of different technologies, expanding options for  meeting TMDL
                  obligations.  In addition to possible cost reduction benefits, trading provides opportunities
                  for creating new value to businesses and consumers through the use of creative ideas for
                  improving water quality in the watershed.

                  Water quality trading is  voluntary.  Successful trades will occur only if both parties
                  perceive they will gain  benefits from the trade.  Some dischargers, especially nonpoint
                  dischargers, are more  likely to come to the table to discuss reductions in a voluntary
                  context.  Voluntary approaches may lead to more effective and  immediate water quality
                  improvements.   Because most  trading systems are  designed to fit within  existing
                  regulatory frameworks,  trading typically will not  create new regulatory control obligations.

                  Water quality trading provides incentives  for overcontrol  beyond  current limits.
                  For  point sources,  trading provides financial  incentives for installing  pollution control
                  technology  beyond TMDL waste  load allocations because  increments of pollution
                  reduction beyond TMDL allocations can be sold to other dischargers.  Nonpoint sources
                  can  be compensated for installation of best management practices that result in pollution
                  reductions  beyond meeting their load 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 in  many

                  Water  quality trading places  a  greater emphasis on  measuring  water quality
                  outcomes and will provide additional data about the watershed. Trading will provide
                  additional information, through monitoring and specific nonpoint  source screening criteria,
                  regarding water quality in and  the dynamics of the watershed.  This information will
                  provide a better understanding of watershed conditions and increase awareness of the
                  progress 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 fish and wildlife habitat.


                   QUALITY TRADING

                   Even if participants understand  the benefits of trading, they will have legitimate needs
                   and concerns that must be addressed.  The  following list of likely needs and  interests
                   also includes some suggestions for responding to them.

 Water Quality Trading Assessment Handbook.
 Lack of a Market Driver.  Dischargers are likely to be interested in exploring alternative
 pollution reduction options only if they are facing an imminent change to their regulatory

        Response:  In the watersheds being evaluated for trading viability, the market
        driver is the TMDL (or similar framework).   The TMDL provides  waste load
        allocations  for  point  sources  and load  allocations  for nonpoint  sources
        dischargers that generally require new pollutant discharge reductions.   The
        allocations will result in new permit limits for point source dischargers and goals
        for nonpoint sources.  Watersheds with new TMDL's generally have a sufficient
        incentive to explore trading as a possible cost-effective pollution control option.

 Monitoring of nonpoint discharges will be  costly, technically challenging, and will
 lead to increased regulation.   Some nonpoint dischargers may be concerned  that
 trading will require on-site monitoring to measure pollution reductions. Monitoring may be
 perceived as  intrusive,  costly,  unreliable, and a precursor to  additional  regulatory

        Response:  Effective monitoring of  nonpoint source  discharges  for  trading
       purposes is designed to  determine the value  of the pollution reduction credits
       being generated. These credits, when established through monitoring, become a
        valuable commodity that can be sold to  willing buyers. Those who participate in
       the discussions  about trading  in  the watershed can help  shape a monitoring
       program that meets  their  needs.   Depending on  the market  infrastructure
       developed, the cost burden associated with monitoring  can be assigned to an
       appropriate party.

It is better to wait for regulators to enforce TMDL requirements than to proactively
expend resources designing a new, untested compliance strategy.  Participation in
discussions about trading in the watershed could represent  a significant investment in
time and resources.  Unless participants see the potential benefits, they will be reluctant
to  commit the resources and prefer to see greater emphasis on meeting TMDL load
allocations employing traditional approaches.

       Response:   Trading discussions among dischargers and regulators provides
       new opportunities for meeting the TMDL requirements for improved water quality
       that incorporates the concerns of local participants. Potential participants should
       also be made aware of the key benefits of trading suggested above, especially
       the opportunity trading provides for more effective and immediate water quality

if trading results in more efficient pollution reduction, it  could provide incentives
for additional  development in the  watershed.  Participants  often bring different
perspectives about the broad goals of water quality trading.  Some groups may only
support trading if they believe it will achieve early reductions and improve water quality
beyond the requirements of the TMDL.  They may not support the flexibility of trading if
they believe it will lead to growth and development in the watershed.

       Response:  It will be important to come to an early understanding about the
       goals of water quality trading in the  watershed.  For example, is  the goal for
       trading to produce more cost-effective TMDL implementation or do stakeholders
       expect trading to produce environmental improvements beyond those required by
       the TMDL?   In general,  the focus  has  been  on cost-effectiveness, while

                                                       ...Water Quality Trading Assessment Handbook
                          producing some ancillary benefits.  There is no  CWA  requirement or EPA
                          guidance that requires trading programs to achieve environmental outcomes  in
                          excess of TMDL requirements.   However, there are water quality benefits from
                          more  active engagement by nonpoint sources that leads to more immediate
                          improvements, additional habitat improvements, and increased instream flows,
                          rather than simply end-of-the-pipe traditional controls.

                  Trading reduces the  degree of certainty  in  meeting  water pollution reduction
                  targets.  Some groups are concerned that trading does not include enough safeguards
                  to ensure that it will produce  real reductions in the amount of pollutants entering the
                  watershed.   They perceive that trading  could sacrifice almost guaranteed,  enforceable
                  reductions from point sources  in return for  uncertain, unenforceable nonpoint source
                  reductions elsewhere.

                          Response:   Trading  systems  can  be designed  to  use monitoring, specific
                          nonpoint source screening criteria, and other mechanisms to assure that only
                          verified reductions can be traded. They also use discounting factors to account
                          for the uncertainty of nonpoint management practices.  Conservative river ratios
                          are also used  to predict the amount  of pollution  that will reach downstream
                          compliance points.

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

                          Response:  Trading programs can be designed to  avoid unacceptable localized
                          impacts  by considering  the  characteristics  of the pollutant,  the watershed
                          conditions, the location of potential trading partners, the type of trades, the scope
                          of the trading area, and the use of effective monitoring programs in the design of
                          trading programs. Programs should consider specific mechanisms related to the
                          direction of trades (e.g., upstream versus downstream) and the use of caps and
                          ratios to avoid localized impacts. EPA's Water Quality Trading Policy supports
                          trades only in the same watershed or the boundary  established by a  TMDL. This
                          policy helps ensure that water quality standards  are maintained  or achieved
                          throughout the trading area and contiguous waters.

                   Trading provides  less opportunity for public participation in pollution reduction
                   activities.  There is rising public interest in watershed related activities.  Citizen groups
                   are interested in becoming involved in decisions that affect local watersheds.   These
                   groups will  be  concerned about whether trading  will  change conventional  public
                   participation  opportunities such  as public  notice and comment for NPDES  permit
                   modifications. Representatives of these groups will want to be engaged  in discussions
                   about the design and implementation of trading programs. Groups will  be particularly
                   sensitive to issues relating to monitoring and enforcement.

                          Response:  Participating in the early stages of a trading program development
                          provides a  more meaningful opportunity for public  involvement than responding
                          to an already developed proposal.  Concerns about enforcement  and monitoring
                          can be  raised during program design.   All public participation requirements
                          applicable during implementation must also be satisfied by the market according
                          to EPA  guidance. However, it  may be  harder to influence the specifics of a
                          market approach once the details have been established.  Early participation will

 Water Quality Trading Assessment Handbook.
        help all parties understand the information and assumptions used in the market's


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

 Lower Boise River Effluent Trading Demonstration Project

 As described in the market characterization, 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 direct
 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 neutral  parties  was
important for recruiting participation and managing the program development process to
allow EPA and Idaho DEQ to be involved as project participants.

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  is  also preparing 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.

                                                         .Water Quality Trading Assessment Handbook
                   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 reduction requirements
                   outlined in the TMDL waste load allocations.  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
                   interested  stakeholders was generally more restricted than other trading  projects that
                   included rural and urban nonpoint sources.

                   Public involvement in the program has been provided through a traditional administrative
                   process of public workshops  and hearings,  through the legislative  process  required
                   during the  passage of implementing legislation, and through ongoing monthly 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 Waste Load 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 load allocations.  These workshops
                   were attended by affected point sources, local  communities,  and  local  and national
                   environmental groups.

                   Another series  of  public workshops were 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

                   Several  components   of the  program  required  enabling  state  legislation  for
                   implementation.  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 were provided through the normal
                   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

                   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 is
                   well balanced with regard td buyers and sellers of credits, large and small municipalities,
                   and representatives from different geographic regions of the state. In addition, members

Water Quality Trading Assessment Handbook.
with experience in waslewater treatment, environmental law, or finance will be included.
The Board has been conducting monthly meetings that are open to the public.

                                                         , Water Quality Trading Assessment Handbook
                   Best Management Practice (BMP): A method that has been determined to be the most
                   effective, practical means of preventing or reducing pollution from non-point sources.

                   Designated Uses: Those 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  EPA uniform national form, including any
                   subsequent additions, revisions,  or modifications for the reporting of self-monitoring
                   results by permitees.  DMRs must be used by approved stated as well as by EPA.

                   Discharge:  Flow of  surface water in  a stream or canal or the outflow of groundwater
                   from a flowing artesian well, ditch, or spring. Can also apply to discharge of liquid from a
                   facility or to chemical emissions into the air through designated venting mechanisms.

                   Downstream Trade:  A  water quality trade in which one source  compensates  another
                   source downstream of its position within the watershed for producing an environmentally
                   equivalent pollutant  reduction impact at all  pertinent  compliance points within  the

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

                   Incremental cost: The  average cost of control for the increment of reduction required
                   for an individual source to meet  compliance.  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 associated with
                   the 5 IbsVday  is  substantial relative to the average cost of reductions.   Traditional
                   average cost would divide costs by 20 lbs./day; incremental analysis divides the costs by
                   5 Ibs./day and would be four times higher than average cost.

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

                   Load Allocation:  The portion of a receiving water's loading capability that is attributed to
                   either one of its existing or future non-point sources of pollution or to natural background
                   sources.   Load allocations are  best  estimates  of  the  loading which can range from
                   reasonable accurate to  gross allotments, depending  on the availability of data  and
                   appropriate techniques for predicting loading.

                   National Pollutant Discharge Elimination System (NPDES): The national program for
                   issuing, modifying, revoking and  reissuing, terminating, monitoring, and enforcing permits
                   and imposing  and enforcing pretreatment requirements under Sections 307, 402, 318,
                   and 405 of the Clean Water Act.

                   Non-point source:   Diffuse  pollution 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 Ihe land by stormwater.  Common nonpoint sources are agriculture, forestry,
                   urban mining, construction, dams, channels,  land disposal, saltwater intrusion, and city

Water Quality Trading Assessment Handbook.
 Overcontrol:  Taking steps to reduce pollutant discharge below the waste load allocation
 for individual point sources or the load allocation 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.

 Total Maximum Daily Load (TMDL):  The sum of the individual waste load allocations
 (WLAs)  for point sources and  load allocations (LAs) for nonpoint sources and natural
 background.  TMDLs can be expressed in terms of mass per time,  toxicity, or other
 appropriate measure that relates to a state's water quality standard.

 Upstream Trade: A water quality  trade in which  one source compensates another
 source upstream  of its  position within the watershed for producing an environmentally
 equivalent pollutant  reduction  impact at all  pertinent compliance points  within  the

                                                       ,, Water Quality Trading Assessment Handbook
                   Appendix A
                   Water Quality Trading Suitability Profile for Phosphorus

                   The EPA Water Quality Trading Policy supports nutrient (e.g., total phosphorus and total
                   nitrogen) trading.  Sources of phosphorus  include background sources such as natural
                   springs, point sources such  as municipal sewage treatment plants and food processors,
                   and non-point sources such as irrigated agriculture.  Water quality trading pilot projects
                   across the country have demonstrated that phosphorus from these and other sources
                   can be successfully traded.  These projects have found that phosphorus discharges and
                   in-stream concentrations can be readily measured at key 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  environmental
                   equivalence  relationships  between  themselves  or between  a discharger  and  a
                   compliance point.

                   TMDLs address phosphorus and nitrogen 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 load
                   connects to the specific problem.  Phosphorus and nitrogen are nutrients which are often
                   associated with eutrophication in fresh waters.  Excessive phosphorus contributes to
                   exceeding  the narrative water quality criteria established by many states relating to
                   nuisance aquatic plant growth, deleterious  materials, floating, suspended, or submerged
                   matter, oxygen-demanding materials, or other similar standards.  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, increased methylmercury production,  elevated pH, cyanotoxins from blue-green
                   algae production, trihaiomethane production in drinking water systems, and maintenance
                   issues associated with domestic water supplies.

                   Most TMDLs recognize the correlation between  phosphorus  concentrations and these
                   water quality concerns.  Excess nutrient loading causes excess algal growth within the
                   water column, which in turn affects levels of dissolved oxygen and pH in aquatic systems.
                   This correlation between phosphorus concentrations and other water quality concerns
                   can be seen in the Draft Snake River- Hell's  Canyon TMDL recently developed  by the
                   states of Idaho and Oregon.  In this TMDL, 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.

                   KEY TRADING POINTS

                   A.  Phosphorus Pollutant Form(s)

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

 Water Quality Trading Assessment Handbook.
 •  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 available to plants over time.

 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 over time.

 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. 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 and  equivalence relationship, may be needed to account for such

 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

There may be circumstances where some dischargers receive phosphorus allocations
 while  others  receive dissolved oxygen  allocations.   There  is a known  and 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, under the  Draft Snake  River-Hells Canyon TMDL, Idaho
 Power  Company was given a load  allocation for DO, while municipal, industrial, and
 agricultural sources have received Total Phosphorus allocations. Idaho DEQ is exploring
 the development of a total phosphorus/dissolved oxygen (TP/DO) translation ratio, which
 would enable Idaho Power to become a  potential purchaser of TP surplus reductions
 from other sources.

 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

                                                         . Water Quality Trading Assessment Handbook
                   phosphorus TMDLs are  reasonably well  suited,  to support  the  development of
                   environmental 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 high ratios (e.g., 3:1) to achieve environmental 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, low  ratios (e.g., 1.1/1) will likely

                   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 environmental equivalence ratios.

                   Examining  Local Considerations—In a downstream trade, the upstream source will not
                   meet  its allocation  under the  TMDL  because it is purchasing reductions from  another
                   source downstream.   Discharges  from the upstream  source will not be reduced, and
                   water quality  will not be 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.

                   Additionally, a trade, irrespective of its  direction (up  or downstream),  involving  sources
                   discharging substantially different phosphorus  forms may be  vulnerable to  creating
                   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 the potential, as discussed earlier, to contribute to
                   short-term, local nuisance aquatic growth problems.

                   C.  Timing

                   The key time element to consider when examining phosphorus trading is the seasonal
                   load variability  among  dischargers.  Agricultural  non-point sources  usually  discharge
                   during the growing season only, i.e., between April and October.  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 those 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 non-point 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.   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

Water Quality Trading Assessment Handbook.
 D.  Quantity

 Typically, phosphorus TMDLs establish WLAs and LAs in terms of concentration or mass
 based reductions. For the most part, these allocations provide a straight forward means
 to establish over control for purposes of identifying marketable reductions.  For example,
 a POTW with a permit limit established  at 700  lbs./day that currently discharges 600
 lbs./day, will have 100 lbs./day of marketable reductions.  However, for some non-point
 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 which
 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 Assessment Handbook
                  Appendix B
                  Water Quality Trading Suitability Profile for


                  Unlike nutrient trading, which has been piloted in a number of areas around the country,
                  there is very little experience trading 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
                  tradable  commodity  and  establishing environmental  equivalence  are  currently being
                  considered in a few watersheds in EPA Region 10. These efforts, as well as discussions
                  within Region 10, indicate that temperature impacts, fate, and transport are sufficiently
                  well understood to support at least some level of  trading among sources of elevated
                  temperature sources. The current expectation is that environmental equivalence can be
                  established through direct sampling and through the  models used in TMDL development.

                  Temperature standards have been established to protect beneficial uses such as cold
                  water biota, salmonid spawning and rearing, and anadromous fish passage.  TMDLs in
                  Region 10 address water temperature primarily to protect cold water fish (salmonids) as
                  the most sensitive beneficial uses. As of 1996, water temperature was addressed in 240
                  TMDLs in Region 10 (38 by Idaho,  141  by Oregon, and 61 by Washington).  Water
                  temperature  is also  an important consideration in Region  10 because  a number  of
                  salmonid species listed as threatened or endangered under the Endangered Species Act
                  (ESA) inhabit these waters and require improved water quality to support survival and

                  In Region 10, 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. It directly affects 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.

                  Sources  of elevated temperature increases 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).  Non-point 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.   The  Pacific

 Water Quality Trading Assessment Handbook.
 Northwest State and Tribal  Water Quality Temperature Standards11 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.


 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 waste load 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 non-point sources, temperature  load  allocations are often  expressed as  "no
 anthropogenic increase" or no loading  by human sources.   For ease of implementation
 these are also expressed in terms of percent of stream area shade required, providing
 site-specific targets  for land managers.  In  temperature  impaired reaches, non-point
 sources often 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  non-point sources tend to receive different forms of  temperature
allocations, models have been developed to convert the effect of increased stream shade
into degrees cooling.   Oregon  DEQ  uses several  different  models during  TMDL
development.  The  "Heat Source"  model  uses  multiple data  sources   related  to
temperature, vegetation, and hydrology to accurately 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  non-point source temperature reductions for purposes  of trading

 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 environmental
 equivalence relationships among potential temperature trading parties.  Moreover, EPA
 Region 10 temperature guidance currently supports the establishment of a mixing zone
 for temperature discharges. 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
11 Pacific Northwest State and Tribal  Water Quality Temperature Standards (US EPA, April 2003, 901-B-03-

                                                         ..Water Quality Trading Assessment Handbook
                   some mixing between the discharge water and receiving stream.  If the receiving water is
                   sufficiently cool as a result of  upstream overcontroi, 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  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 reside in relatively close proximity to each other
                   for an environmentally equivalent trade to emerge.

                   A second  aspect of assessing  the environmental 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 overcontroi 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.  The creation of a mixing zone under NPDES
                   permits will provide some flexibility in this context, although the expectation is that even if
                   standards are met at the zone's edge, there will be elevated temperature impacts at and
                   in close proximity to the discharge point.  Any established threshold temperature level will
                   be  site and conditions 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.
                   In general, caps on purchasing activity placed in NPDES permits will be a primary means
                   to control for 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 applying at the typically hottest times of
                   the year.  In response, many waste  load 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
                   non-point sources  to  consider  temperature  trading options.   Irrespective  of  the
                   temperature allocation  cycle, non-point source temperature reduction efforts in the form
                   of shade  are seasonally dependent, as  greater cooling  effects are  provided from the
                   shade  during  this  period.   Most  nonpoint source temperature  allocations are not

 Water Quality Trading Assessment Handbook.
 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 or willingness to overcontrol will
 coincide with the  non-point sources  ability  to  influence stream temperature, thus
 establishing a strong match for trading from a timing standpoint.

 D. Quantity

 Based on the nature of temperature allocations and related control options, both point
 and non-point sources  of temperature  impacts  have the  ability to over  control their
 "discharge" and  create temperature  credits.  For point sources, overcontrol would take
 the form  of lowering discharge temperature below that required  in a TMDL.  In instances
 where the point  source is a significant contributor to elevated in-stream temperatures
 (e.g., the discharger's  flow is greater than the in-stream flow with a temperature  50
 percent higher),  the impact of over control will likely be discernable for some distance.
 This situation would readily  support upstream trading  with  other point or  non-point
 sources.  In EPA Region 10, however, most point sources of heat are relatively small and
 have  limited thermal loads.  As a result, it is  anticipated that  their over control would
 quickly be offset by  more  dominant  in-stream  and  riparian conditions.   Trading
 opportunities, as a consequence,  would be constrained to  other sources in very close
 proximity to the source of over control.

 In order to  attain most non-point source allocations in temperature TMDLs, land along
 streams would need to achieve site potential  shade. Natural re-vegetation varies with
 species, climate,  and local conditions, requiring between 20 and 80 years to achieve site
 potential shade.  If there are no state or local measures in place requiring landowners to
 actively plant and  restore  riparian areas, non-point sources can  over control  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 Region 10, tree planting programs that substantially advance the  creation  of shade as
compared to natural re-vegetation  have emerged as strong  candidates for creating over
control.   Current thinking  indicates  that generating temperature benefits  sooner than
would be present under either natural or required stream bank re-vegetation can 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 temperatures.

Other means  of non-point source over control 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 sun light.  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 species and the ability of the re-vegetated
 community to sustain other functions  of the riparian area.

 Additionally, in instances where TMDLs do not  require site potential shade throughout a
 watershed,  expanding the area of stream  bank vegetation beyond TMDL allocations
 could represent over control.  However, Region  10 temperature TMDL experience to date
 indicates that a typical TMDL approach will be to require natural  re-vegetation throughout
 the TMDL area, substantially reducing the opportunity for this option.

                                                          .Water Quality Trading Assessment Handbook
                   Both  point  and  non-point  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.

                   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.  It is
                   likely that any such changes  in  flow  regimes  that result  in improved  temperature
                   conditions can  be easily accounted for with models used in  the development of the

                   Irrespective  of the means by which  non-point sources achieve over control, these actions
                   hold the potential to be  more attractive than  point source temperature reductions from an
                   overall watershed  health standpoint.   Non-point  source over  control  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 support  other water quality  objectives  by  reducing  erosion, sediments,  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 non-point
                   source over control may prove  highly  desirable from  an  overall  watershed  health

 Water Quality Trading Assessment Handbook..
 Appendix C
 Water Quality Trading Suitability Profile for Sediments

The EPA Water Quality Trading Policy specifically supports sediment trading.  Sources of
sediments include both natural and anthropogenic sources. Soil erosion from surface
water flow is the largest natural  source of sediments.   Erosion from high flow events,
such as flash floods or snow melt can result in greater sediment deposition in a single
large event than occurs all year from  average  flows.   Nonpoint sources of sediment
include agricultural sources such as plowing and flood and furrow  irrigation,  forestry
sources,  such  as  logging and stream bank  disturbance, and  urban/suburban sources
including construction, stormwater runoff, and irrigation.  Point sources generally contain
sediment discharge limits in their NPDES permits but are usually not  major contributors
to sediment concentrations.

Region  10  has had limited  experience  considering sediment trading  opportunities.
However, other areas of the country have had more experience with sediment trading,
with pilot projects involving sediments conducted  in the Delaware River, PA, the Truckee
River, NV, and the Lower Smith River, VA.

Water quality standards are developed  to protect the most  sensitive beneficial 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
(e.g., 50  NTU's above background), and a  narrative standard that protects beneficial
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.

TMDLs address sediments to meet water quality standards and control a  number of
water  quality problems.  To  establish appropriate environmental 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, or legacy application of DDT or mercury-based seed
treatments.  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.

                                                        .Water Quality Trading Assessment Handbook
                  Sedimentation is also an important consideration in  Region 10 because a number of
                  species listed as threatened or endangered under the Endangered Species Act (ESA)
                  inhabit impaired waters in the region and require cold, clear, well oxygenated water to
                  support spawning, survival, and recovery.

                  KEY TRADING POINTS

                  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 particles sizes.

                  •   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 also
                      discharge  two  different types of these suspended sediments.  Nonpoint sources
                      discharge geological particles, which are derived from rock and soil. Point sources,
                      such as wastewater treatment plants, usually discharge biological particles as part of
                      the treated wastewater.  These different forms of suspended sediments may have
                      different impacts on  water  quality. As discussed  below,  TMDLs  often establish
                      different load allocation forms for point and nonpoint sources to control water column
                  •   Bedload sediments are 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 consist of particles greater than 1 mm in diameter and can range  in size
                      from sand and gravel to small pebbles or large boulders. TMDLs often establish
                      mass-based load 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.

                  TMDLs often establish different  load allocation forms for point and nonpoint sources.
                  Waste load 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 waste load allocation  metrics may have trading opportunities. For example,
                  two POTWs from  neighboring jurisdictions in Virginia have entered into a cooperative
                  agreement whereby one  POTW has  agreed to a reduction in  its permit limit  for
                  discharging total  dissolved  solids so  the other 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.   However, point
                  sources will also need to be aware of the  form of sediment being discharged.  A point
                  source discharging a biological form of sediment can have different water quality impacts
                  than a source discharging a geological form.

                   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

 Water Quality Trading Assessment Handbook.
 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 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 likely that trading between similar forms  (e.g., geological  to
 geological, and biological  to biological) will support water quality improvements.  But
 trading between different forms of suspended sediments will be dependent on the  water
 quality impacts that each reduction is intended to address.  For example, if a source's
 reduction  in geological suspended sediments is intended primarily to reduce  levels  of
 attached phosphorus, then  a trade with  a  source discharging  a biological form  of
 suspended sediments will not  meet the water quality improvement needs of the
 watershed.  However, if suspended sediment reductions are intended primarily to reduce
 turbidity, then a trade between two different forms may be supported.

 While bedload sediment reductions may also be easily modeled, the impacts of bedload
 sediments are generally experienced relatively close to the source of discharge as the
 heavier particles are transported very slowly along the river bottom.  Thus, opportunities
 for trading bedload are likely to be limited to geographically smaller market areas.
 Because suspended sediments and bedload sediments will have  different impacts on
 water quality, it is unlikely that there will be direct opportunities for trading between these
 two different forms of sediment.

 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 flows 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 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.

                                                         .Water Quality Trading Assessment Handbook
                   C. Timing

                   Although sediment delivery to streams from nonpoint sources is an inherently seasonal
                   phenomenon, sediment allocations are generally applied year round.  Allocations are
                   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 be  likely to align reductions between potential buyers and

                   D.  Quantity

                   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 determine the amount of
                   sediment reduction beyond TMDL allocations.

                   Point sources can apply technological control options that result in a measurable change
                   in sediment concentration  and  associated loads.   Permit limits for point sources are
                   usually based on a technology-based limit which may be lower than required to meet the
                   TMDL target.  Under the Clean Water Act, point sources are required to comply with their
                   technology-based limits, irrespective of watershed conditions or  their opportunities to
                   trade.  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 higher than the water quality standards, incentives for trading may exist.

                  . In many watersheds experiencing sediment related water quality problems, point sources
                   are often only 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  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 sources to select higher value areas to apply
                   nonpoint BMPs, thus  achieving  higher 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  beneficial  use, such
                   as salmonid spawning areas, and may create a greater improvement in water quality than
                   specified under the TMDL allocation.

                   BMPs  can be modeled to  project the reduction in  sediment loading.  However,  models
                   used in TMDL  development usually provide only  very  coarse estimates of sediment
                   loading. Because of the limitations of models in projecting sediment reductions, TMDLs
                   often use surrogate measures that provide a more direct connection to the beneficial use
                   that is being protected.  Measures such as the depth of  sediment fines in riffle pools are
                   used in addition to the numeric targets to assess sediment reductions. These methods

Water Quality Trading Assessment Handbook.
should allow nonpoint sources to calculate the amount of reductions beyond TMDL load

                          .Water Quality Trading Assessment Handbook
Appendix D
Capital Cost Annualization Factors

Interest Rate
1 .50%
0.1 172

Interest Rate


Water Quality Trading Assessment Handbook.

Interest Rate


1 1 .50%


                                                     .Water Quality Trading Assessment Handbook
                 Appendix E
                 Participant Pollutant Management Options


                 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.   Phosphorus 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 Phosphorus Type(s):
                     e.  Source Baseline 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 Phosphorus Control Option(s):
                     a.  Option A:
                     b.  Option B:
                     c.  Option C:
                  5.  Source Phosphorus 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
                     c.   Capital Cost:
                     d.   Annual O&M Cost:
                     e.   Phosphorus Control Achieved/Expected (in Ibs. Phosphorus/day):

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