TRADING AND OTHER MARKET INCENTIVES
TO ACCELERATE NUTRIENT REDUCTION
- A proposal to the Implementation Committee -

Issue: Developing practical options to determine how nutrient trading and other market
incentives could accelerate reduction of nutrients, to restore water quality in the Bay and its tidal
tributaries by 2010. This initiative would build upon the general policies in the Chesapeake Bay
Nutrient Trading Guidance Document, and help respond to financial issues which the
jurisdictions are facing in their tributary strategy processes.

Proposal: To make experienced CBPO staff time available to the tributary teams to explore
options associated with market incentives or trading. Options for best utilizing these limited
resources include creation of a Market Incentives Task Force (consisting of signatory
representatives, trading/market incentive experts, and stakeholders) or an informal process of
working with each jurisdiction, meeting with tributary teams to discuss trading/market incentive
fundamentals, and then providing a short paper to the team of how trading/market incentives
might work in that tributary.

This proposal takes into account comments made at the August Implementation
Committee concerning flexibility of timing (i.e. some jurisdictions are more ready than others to
develop trading/market incentive proposals) and group membership.

An appendix to this paper discusses some fundamental issues and ideas associated with
trading, based on EPA's most recent experience with this mechanism. It is provided so that
Implementation Committee members have a chance to see, and react to, the kinds of issues
which might be discussed in a tributary team meeting.

Background:

-	The Bay Program convened a stakeholder group and issued a Chesapeake Bay Program
Nutrient Trading Guidance Document which was endorsed by the Principals' Staff Committee in
March 2001. Since then, national interest and experience in trading (and hybrid market incentive
programs) has continued to grow among water quality managers, especially regarding reduction
of nutrients.

-	The EPA Office of Water recently issued a national Water Quality Trading Policy dated
January 13, 2003, and is supporting three pilot trading projects in Region 3, two of which are in
the Chesapeake Bay basin (Conestoga, PA; World Resources Institute Nutrient Net in DC). The
Chesapeake Bay Program has an immediate opportunity to work with the EPA Office of Water
to obtain assistance and possible financial support for analysis of trading/market incentive
options.

-	Currently, the Bay Program does not have a work group devoted specifically to trading or

1

-------
market incentive mechanisms. However, the EPA Chesapeake Bay Program Office has retained
an expert, Bob Rose, from the EPA Office of Air and Radiation to assist program partners in
evaluating trading and market incentive program concepts based on EPA's experience with air
trading and climate change voluntary incentive programs.

- Given the estimated multi-billion dollar cost of achieving the nutrient-sediment reductions to
meet the 2010 water quality criteria, and the scheduled completion of the tributary strategies by
April 2004, looking seriously for approaches which could achieve the criteria at less cost is
timely and appropriate.

Options:

Option 1: Create a Chesapeake Bay Program Task Force on Market Incentives

The Task Force would be formed on an "as interested" basis; that is, not every jurisdiction would
have to send an official representative. Members of the Task Force would meet with tributary
teams who want to explore trading/market incentives as a possibility for reducing the costs of
implementing required nutrient load reductions. The goal of each tributary team meeting would
be to share some basic fundamentals of market incentives (see appendix) and develop qualitative
priorities for the tributary team. The Task Force at large would then meet to discuss the priorities
of each tributary team and lay out what might be a workable trading or market incentive
option(s) for that watershed. CBPO would provide administrative and technical writing support.
In this process the tributary teams would experience minimal disruption, yet benefit from a Task
Force of state, federal, local, and academic experts.

Option 2: No formal Task Force

Under this option, CBPO staff would continue to reach out to state, federal, local, and academic
experts and would continue to meet with tributary teams. Not having a formal Task Force may
be practical as many people who might compose the Task Force are active on tributary strategies
already, in one jurisdiction or another. The advantage of this option is one less Bay group. The
disadvantage is the loss of the potential for collaborative problem-solving. Under this option it is
likely that an ad hoc group of interested experts and stakeholders would regularly communicate
with each other.

APPENDIX

Discussion of Trading and Market Incentive Fundamentals

2

-------
Enforcement is an essential ingredient.

Trading and market incentive policies are typically sought on the basis of reduced costs and
faster implementation, and are often an alternative to traditional regulatory policies. While
trading and market incentive policies offer more flexibility, they require increased (but not
necessarily more costly) enforcement. The reason for this is that if two parties are engaged in
trading, both want assurance that traded credits are real. In such an arrangement, it is in the
interest of both parties that if the other's claims are not real, states will react with swift action.

As an example, California established one of the few trading policies where farmers are trading
pollution credits with each other. Farmers in this case work together to effectively cost share. If
one farmer can reduce pollution at a lower cost, it is in the interest of other farmers to see that the
lowest cost reductions occur. The California example centers around irrigation ditches, water
use, and leaching of heavy metal pollution. Enforcement is simple. Offenders have their water
supply cut off. To date the compliance rate is 100 percent, thus no need for such enforcement.
Farmers are indeed reducing pollution and costs are lower than otherwise would have been under
traditional command & control policies.

As a second example, sulfur credits for the U.S. electric power industry currently are valued at
roughly $150/ton. On an annual basis, power plants must either reduce sulfur emissions, or
purchase credits, or face a penalty. Power plants who elect not to reduce emissions or purchase
credits at $150/ton, face instead a $2,000/ton penalty, no questions asked. As result, the
compliance rate since 1995 has been 99+ percent. Without swift enforcement, industry would
learn that no action is the most cost-effective strategy.

In Connecticut, wastewater treatment plants that do not reduce nitrogen loads affecting Long
Island Sound must instead pay into a common pot of funds. The compliance rate in Connecticut
is 100 percent. Unlike traditional environmental policies where delayed enforcement results in
delayed environmental improvement, trading and market incentive policies will collapse under
weak enforcement. As with the sulfur trading example, weak enforcement would drive the
market price for sulfur to zero, thus killing the motivation for trading. As also mentioned, trading
and market incentive policies also serve to create industry incentive in knowing enforcement is
swift. Trading policies are therefor more sensitive to enforcement, yet create a natural incentive
to see that enforcement takes place.

Verification is essential, and challenges the science and practice of monitoring.

All three examples above either measure loads as they exit smokestacks, end-of-pipe, or an
irrigation ditch. The California example works because the large scale irrigation ditches used in
California agriculture are conducive to easy measurement of runoff. In the Connecticut example,
trading regulations also strengthened the measurement and verification process to ensure higher
integrity.

3

-------
Measuring and verifying loads is much more complex with non-point sources. To date, there are
no examples of point sources routinely trading with non-point sources. The main barrier
preventing non-point source trading is the uncertainty of agricultural BMPs. Uncertainty is
translated into risk, and in the business world, risk is synonymous with higher costs. There is no
avoiding the fact that high uncertainty carries high cost, and thus stymies the potential for
trading. Policy makers may create trading ratios to their own satisfaction, but must be sure the
private sector will be willing to trade millions of dollars based on such ratios. Will a regulated
wastewater treatment plant forego the purchase of nitrogen removal technology on the promise
that a farmer will continue to use cover crops for the next thirty years? The point is not that
trading ratios will not work. The point is how does a trading ratio retain its value many years into
the future.

Verification science for non-point sources is possible, but not in all cases. In watersheds
dominated by urban or agricultural loads it may be possible to use in-the-water verification on a
watershed basis. There would still exist some level of uncertainty, but it may be the case that
uncertainly is much less when BMP efficiencies are combined with in-the-water verification.
The non-tidal water monitoring workgroup under Monitoring & Assessment
Subcommittee will look into this issue at the request of the CBPO.

The broader the trading area and the more potential parties, the greater the potential cost
savings.

Trading across watersheds to meet the Bay main stem allocation should not be precluded out of
hand, but there must be assurance that local tributary water quality standards are being met. The
Chesapeake Bay Nutrient Trading Guidance Document currently recommends against trading
across watersheds. This decision, however, was made prior to the Bay Program nutrient
allocations published in April 2003. These allocations were based on modeling the effects of
different levels of nutrient loads on the quality of tidal tributaries and the Bay main stem. The
same modeling tools could be used to assess the minimum reductions necessary for individual
tributaries concerning local water quality, and the incremental amount Bay wide necessary for
the most critical area in the Bay main stem (CB4). It is this incremental amount that may allow
for more trading then currently perceived.

If all tributaries meet their tributary water quality standards/TMDL allocations, yet one tributary
in particular can further reduce nutrients cheaply to meet the more stringent main stem Bay
requirements, other watersheds now considered clean may prefer to pay someone else to "save
the Bay" as a practical alternative to further reducing their own loads to the Bay.

It's important to take advantage of what can be done now.

Trading limited to point sources does not solve the issue of accelerating non-point source
reduction, but progress is progress. Perhaps just a few watersheds at this time have dominant
non-point sources (i.e., mostly agricultural or mostly urban) and sufficient in-the-water
measurement capability, but those may be areas to start with.

4

-------
Policy options need to be consideredfor establishing the cap.

Trading is sometimes known as cap & trade. Cap & trade is where a legally-binding cap for
loads allows no more than a fixed amount of pollution. TMDLs can be used to establish a cap in
the case of nutrient loads to a Chesapeake Bay tributary or the Bay itself. Cap & trade allows
parties to trade as means of meeting the overall cap at a lower cost. All trading schemes
essentially boil down to elaborate cost-sharing where money and credits are exchanged as a
means of sharing, and thereby minimizing, the overall cost for all parties. The challenge in cap &
trade is trying to do so where there is no legal cap. Another challenge is establishing the legal
cap for the correct trading area (i.e. for the Bay Program, what size watershed, or state by state).

An alternative to cap & trade in the absence of a legal cap is to bid allocations as part of a futures
market. In this case, parties may be willing to bid (pay a cost) to receive allocations that are
redeemable post-2011. The basic idea is that parties who think they have inexpensive reduction
opportunities will buy allocation today at say $2/lb, which they hope to sell in post-2011 at say
$3/lb. Another type of bidding process possible prior to TMDLs is bidding public funds. Parties
who submit the lowest bid, $/lb, for reductions would receive public funds. The incentive is not
just receiving public funds, but hoping to use the public funds to reduce loads early and avoid
being on a future TMDL hit list, if you will. Both of these early bidding schemes encourage early
reductions prior to legal binding TMDLs. Both could in concept be based on Bay modeling that
first assumes a the minimal reductions necessary for local water quality. At this time most if not
all stakeholders are interested in public funds and avoiding future TMDLs. Early bidding for
public funds or early bidding for future allocations fit the current status of Chesapeake Bay in
relation to the Clean Water Act.

Keeping the goal in mind over the long run is important.

As with any worthwhile effort, halfway through one may ask why such a process was started. To
give a quick glimpse, imagine the following examples. Let's say a tributary strategy requires X
and Y reductions from point sources and non-point sources respectively, yet there will be no
legal TMDL requirement until 2011. Let's also say that this watershed has headwater areas that
are dominated by agriculture that are more easily measured using in-the-water verification. If the
verification is robust, a wastewater treatment plant down-river may be willing to offset some of
the costs for agricultural reductions. The agreement might be that when TMDLs are developed,
the wastewater treatment plant will have effectively bought itself more room to expand its loads.
In this example, trading could result in early reduction prior to TMDLs, and when TMDLs do
exist, the wastewater plant and upstream farmers will have learned to trust each other under a
unique business arrangement. Trying to gain such trust once TMDLs exist is more difficult since
TMDLs can be, or are perceived to be, a disincentive for creativity.

In the above example, trading was used to gain trust and experience prior to TMDLs. Not
mentioned were lower costs for the wastewater plant or agriculture receiving a partial offset of

5

-------
its costs, not necessarily profit per se. Also not mentioned was the common interest in having the
state monitor in-the-water loads. In this case the farmers and wastewater plant managers need to
know the reductions are real. If they are not real, then farmers lose out on a potential long-term
business arrangement with steady revenue, and the wastewater treatment plant must spend more
money to keep up with population growth. The state too will want to verify in-the-water
reductions, for the state's 303(d) listing and TMDL purposes.

A second example may include a post-2011 era in which two watersheds have satisfied their
local TMDL requirements. Let's say the one watershed contains Scranton, PA, and the other
watershed is in the Potomac watershed on the VA side. Because the Bay is still impaired, a rural
wastewater treatment plant in VA may realize that switching to an irrigation system that supplies
treated wastewater to local farmers may be an inexpensive way to further reduce loads and create
sellable credits. Meanwhile the Scranton wastewater plant must further reduce loads not for local
water quality, but for an elusive Bay 50 miles to the south. Once ratepayers in Scranton realize
they must carry part of the cost to clean "Maryland's Bay" with no measurable benefit to local
water quality, they may demand to know whether trading could have allowed them to meet their
load allocation goal at lower cost.

The lesson of this example is that today interstate and inter-watershed trades are perhaps
controversial because local waters AND the Bay are currently impaired. If a time comes when
local waters are no longer impaired yet the Bay remains as such, dischargers may in fact demand
that trading be allowed whether policy makers are prepared or not. The motivation at that point
would be purely economic.

A third example of what one might envision under trading concerns agriculture. The existence of
the chicken manure pellet plant in Delaware demonstrates that a higher value use of manure can
be cost-effective, or close enough that the Purdue was willing to make a $12M investment. Right
now, however, manure is viewed as a free source of fertilizer. Once loading caps are present for
the Bay, manure will become an increased liability in terms of runoff and groundwater leaching.
Liability carries with it a dollar figure, which makes pellet technology and manure-to-energy
enterprises more attractive. If an early bidding process were established, a market price for
nutrient reductions would develop. Knowing the market price today for nutrient reductions,
assuming the market price would increase once TMDLs are established, would allow for more
informed decision making.

Putting it all together in this example for agriculture, if a particular watershed had high
agriculture loads that could be verified using in-the-water measurements in addition to BMP
efficiencies, agriculture may be interested in bidding for public funds or future allocations. Let's
assume in this case they are bidding for public funds, and win the bid at $2/lb of nitrogen. The
$2/lb bid would essentially establish a cost associated with runoff, which allows for more
informed decision making. Manure processing plants may become more cost effective as result
as would a new optimal practices for fertilizer rates. More than just a traditional incentive or
subsidy, one could also allow agriculture in the watershed to earn future credits if they exceed
their contractual reduction agreement and/or reduce loads beyond their Bay allocations. Future
credits would have value in a post-2011 era in which TMDLs are being enforced.

6

-------
7

-------