Trading Programs for Trading Programs for Environmental Environmental

Protection: Lessons Protection: Lessons and Experiencesand Experiences

Kurt Kurt StephensonStephenson

Virginia TechVirginia TechMay12, 2005May12, 2005

Objective for this afternoonObjective for this afternoon

1.1. Rationale & Requirements for Market- Rationale & Requirements for Market- based Environmental/Natural based Environmental/Natural Resource Trading PolicyResource Trading Policy

2. Experiences and Lessons2. Experiences and Lessons• Cap and Trade ProgramsCap and Trade Programs• Trade outside a cap – credit offsetsTrade outside a cap – credit offsets

First Principles: Anatomy of First Principles: Anatomy of an Market Exchangean Market Exchange

Compensation ($)

Rights to the CarBuyers Sellers

GovernmentFacilitate trade

Address third-party effectsPolice (Monitor & Enforce)

Characteristics of Well-Functioning Characteristics of Well-Functioning MarketsMarkets

• Decentralized (private) decision-Decentralized (private) decision-makingmaking• Low transaction costs Low transaction costs

• Stable system of rights that limit uncertainty, Stable system of rights that limit uncertainty,

• but dbut define unacceptable behaviorefine unacceptable behavior• Clear and timely penalties for rule violationClear and timely penalties for rule violation

Why Markets? Why Markets?

Private incentives that create public benefitsPrivate incentives that create public benefits

• Dynamic incentives, discovery/creationDynamic incentives, discovery/creation

• Incentives for cost-effectiveness (least Incentives for cost-effectiveness (least cost)cost)

Knowledge is disperse, sometimes tacit, and Knowledge is disperse, sometimes tacit, and incompleteincomplete

Application of Market-basedApplication of Market-based Principles to Environmental Principles to Environmental

Protection: Protection:

Cap and TradeCap and Trade

Cap and Allowance Trading Cap and Allowance Trading

GovernmentProtect Environmental Quality (Define Cap/Commodity)

Address Third-Party Effects Monitor and Enforce

100 100

100 100 AllowancesAllowances

100 Allowances100 AllowancesCompensation ($)

Allowances/Rights

125 Allowances125 Allowances 75 Allowances75 Allowances

125 75

Characteristics of Well-Functioning Characteristics of Well-Functioning MarketsMarkets

• Decentralized (private) decision-Decentralized (private) decision-making (“internal” and “external” making (“internal” and “external” flexibility)flexibility) • Low transaction costs Low transaction costs

• Stable rules that limit uncertainty about Stable rules that limit uncertainty about allowance ownership and use, butallowance ownership and use, but

• DDefine unacceptable behaviorefine unacceptable behavior• Clear and timely penalties for rule violationClear and timely penalties for rule violation

Why Markets for Environmental Why Markets for Environmental Protection?Protection?• Caps provide the public assurance that Caps provide the public assurance that

EQ goals are achieved over timeEQ goals are achieved over time• Opportunity to trade Opportunity to trade

• allows movement of resources to allows movement of resources to higher valued useshigher valued uses

• creates continuous private incentives creates continuous private incentives to discover new EQ technologies & to discover new EQ technologies & strategiesstrategies

• Compliance more timely and effectiveCompliance more timely and effective

GovernmentProtect Environmental Quality (Define Cap/Commodity)

Address Third-Party Effects Monitor and Enforce

100 100

Compensation ($)

Allowances/Rights

200 acre 200 acre ftft

200 acre 200 acre ftft

Market-based environmental policy and Market-based environmental policy and conventional policyconventional policy

ConventionalConventional Market-basedMarket-based

““Push” mentality Push” mentality ““Pull” mentality Pull” mentality

Regulator’s job: Regulator’s job: technical engineertechnical engineer

Regulator’s job: Regulator’s job: police officerpolice officer

No negative impactNo negative impact BalancingBalancing

System-wide “best” System-wide “best” options can be options can be

calculatedcalculated

““Knowledge problem”Knowledge problem”

Experiences from the Clean Air Experiences from the Clean Air Act: Act: Air program has the most extensive Air program has the most extensive experience with EQ trading programs. experience with EQ trading programs.

• SOSO22 cap and allowance trading cap and allowance trading• Emission Reduction Credit Programs Emission Reduction Credit Programs (ERC)(ERC)

Not all programs are designed the Not all programs are designed the same & not all programs produce same & not all programs produce same outcomessame outcomes..

SOSO22 Cap and Allowance Trade Cap and Allowance Trade• Congressionally identified annual Congressionally identified annual

national SOnational SO2 2 allowance cap. Allowance allowance cap. Allowance defined in advance as permission to defined in advance as permission to discharge 1 ton of SOdischarge 1 ton of SO22/yr./yr.

• Utilities have discretion to determine Utilities have discretion to determine control strategiescontrol strategies

• Utilities may bank, buy, or sell Utilities may bank, buy, or sell allowances with minimum cost of allowances with minimum cost of transacting.transacting.

• EPA tracks allowances (trades and use) EPA tracks allowances (trades and use) and monitors/enforcesand monitors/enforces

SOSO22 Cap and Allowance Outcomes Cap and Allowance Outcomes

SOSO22 prices (control costs) lower than prices (control costs) lower than estimatedestimated

• Mining industry responseMining industry response• Rail industry responseRail industry response• Scrubber industry responseScrubber industry response

Trading light during initial stagesTrading light during initial stages100% Compliance100% Compliance

Other Experiences: ERC ProgramsOther Experiences: ERC Programs

• Extensions of conventional regulator-Extensions of conventional regulator-directed technology-based standards & directed technology-based standards & permittingpermitting

• Standards define baseline & transferable Standards define baseline & transferable commodity (“credit”) created if commodity (“credit”) created if documented discharges below baseline documented discharges below baseline

• Buyers are other regulated partiesBuyers are other regulated parties

ERC Program: ExperiencesERC Program: Experiences

• Disincentives for participation Disincentives for participation Uncertainties with credit (Will baseline be Uncertainties with credit (Will baseline be

lowered in the future for superior lowered in the future for superior performance? Will credits be certified?) performance? Will credits be certified?)

High cost of transacting – negotiating a credit High cost of transacting – negotiating a credit salesale

• Limited decision-making flexibility for Limited decision-making flexibility for regulated parties. regulated parties.

• Possibilities for net increases in emissionsPossibilities for net increases in emissions

Lessons: Market Design MattersLessons: Market Design Matters

• Market design is difficult – often requiring Market design is difficult – often requiring significant change (behavior & rules)significant change (behavior & rules)

• Different programs designs for the same Different programs designs for the same environmental “medium” can produce environmental “medium” can produce very different behavior and outcomes.very different behavior and outcomes. Cap and trade programs based on market-like Cap and trade programs based on market-like

principles create new incentive structures & principles create new incentive structures & behaviorbehavior

Trading Beyond Caps:Trading Beyond Caps:Credit OffsetsCredit Offsets

Trade Outside a Cap Trade Outside a Cap

100

Credits

Compensation ($)

GovernmentRegulatory Requirement

OpportunitiesOpportunities

• Create markets for conservation activitiesCreate markets for conservation activities

• Create “win-win” situations for regulated Create “win-win” situations for regulated community and larger communitycommunity and larger community

• Get more ecological bang per $ spent.Get more ecological bang per $ spent.

• Regulatory compliance flexibilityRegulatory compliance flexibility

ExperiencesExperiences

To date reality hasn’t equaled promise or rhetoricTo date reality hasn’t equaled promise or rhetoric• Very little market development/activity Very little market development/activity

Examples:Examples: • Point-Nonpoint Offset Trading Point-Nonpoint Offset Trading • Wetland Mitigation BankingWetland Mitigation Banking

ExperiencesExperiences

Challenges:Challenges:

• Regulatory rigidities that limit choices and Regulatory rigidities that limit choices and dampen incentives dampen incentives (high transaction costs, (high transaction costs, uncertainties, inflexibilities limit supply uncertainties, inflexibilities limit supply and demand of credits)and demand of credits)

• Defining a “credit” -- Agreement on Defining a “credit” -- Agreement on environmental “equivalency” and accounting.environmental “equivalency” and accounting.

100100100100

100Point-Nonpoint Source OffsetsPoint-Nonpoint Source Offsets

Government:Identify and

approve acceptable N

control technologies

50505050

Government: Define and Impose limits of control technology

Government: Impose limits more stringent than LOT (e.g. zero discharge)

Compensation

Government assigns responsibility for nonpoint controls to point source

Offset ExamplesOffset Examples

• Rahr Malting, MNRahr Malting, MN• Sacramento Mercury, CASacramento Mercury, CA• Delaware Inland Bay, DEDelaware Inland Bay, DE• Sediment, ILSediment, IL• Dillon Reservoir, CODillon Reservoir, CO• Charles River, MACharles River, MA• Others …Others …

Most NPS offsets are isolated individual permit Most NPS offsets are isolated individual permit modificationsmodifications

Not market-oriented – Not market-oriented – • No competitive market for NPS credits.No competitive market for NPS credits.• Regulated parties have few choices/flexibilityRegulated parties have few choices/flexibility• High transaction costsHigh transaction costs• No transfer of control responsibility.No transfer of control responsibility.

Nonpoint Source Offsets: Nonpoint Source Offsets: ExperiencesExperiences

100Wetland Mitigation CreditsWetland Mitigation Credits

Government:1. Avoid & minimize to max extent practicable

2. Preference for on-site, “in kind” mitigation

Defines geographical scope of potential credit transfers

Private Mitigation BankPrivate Mitigation Bank

Government:Approves banks, establishes performance criteria & certifies credits

Compensation

Credits

Government: Sets conditions and approves trade

Mitigation Banking ExperienceMitigation Banking Experience

Case by case “tri-lateral” deals & no real “market” Case by case “tri-lateral” deals & no real “market” for wetland credits.for wetland credits.

• Regulatory program creates credit demand Regulatory program creates credit demand uncertainty. uncertainty. • Limited scope of trade and high approval costs Limited scope of trade and high approval costs limit supply and competition limit supply and competition • Limited discretion based on cost effectiveness.Limited discretion based on cost effectiveness.

Offers some options for compliance with Offers some options for compliance with regulatory conditions. regulatory conditions.

Common Themes:Common Themes:• Regulatory control over decision-makingRegulatory control over decision-making• High uncertainties and transaction costsHigh uncertainties and transaction costs• “ “No negative impact” perspectiveNo negative impact” perspective

Consequences:Consequences:• No marketsNo markets• No credit creation in advanceNo credit creation in advance

Water Quality (NPS) and Wetland Water Quality (NPS) and Wetland Program: LessonsProgram: Lessons

Compensating one type of loss in environmental Compensating one type of loss in environmental services for an equivalent “lift” (conservation services for an equivalent “lift” (conservation credit) elsewhere.credit) elsewhere.

How many credits is enough?How many credits is enough?What type of credit? (type and location) What type of credit? (type and location)

Obviously important because it defines the Obviously important because it defines the “commodity” to be traded“commodity” to be traded

Environmental Equivalency in Credit Environmental Equivalency in Credit Creation/TransferCreation/Transfer

The challenge to defining a credit is as much a The challenge to defining a credit is as much a social/political problem than it is a technical onesocial/political problem than it is a technical one..

Defining an Equivalency: ExperiencesDefining an Equivalency: Experiences

Water Quality – NPS Credits for PS loadsWater Quality – NPS Credits for PS loads Load for load (BMPs, land conversion, temp)Load for load (BMPs, land conversion, temp) Water quality impacts (cross pollutant trading)Water quality impacts (cross pollutant trading) Load for flow (GW recharge, proposed) Load for flow (GW recharge, proposed)

Wetland (Section 404) Wetland (Section 404) Stream restoration credits (dam removal) to Stream restoration credits (dam removal) to compensate for wetland/stream fillscompensate for wetland/stream fills Water quality credits for steam fillsWater quality credits for steam fills

Natural Resource Damage AssessmentsNatural Resource Damage Assessments Habitat equivalency proceduresHabitat equivalency procedures

Determining “environmental equivalency” is:Determining “environmental equivalency” is:• most often site specificmost often site specific• subject to some irreducible uncertaintysubject to some irreducible uncertainty

These features then force These features then force case-by-case case-by-case determination of an “equivalent credit” determination of an “equivalent credit”

How much flexibility, “burden of proof”, and How much flexibility, “burden of proof”, and negotiation (costs) will be needed to reach negotiation (costs) will be needed to reach agreement on equivalency varies from case to agreement on equivalency varies from case to case and is a function of trust among all of the case and is a function of trust among all of the negotiating parties. negotiating parties.

Defining an Equivalent CreditDefining an Equivalent Credit

A Few Parting Thoughts A Few Parting Thoughts

A variety of institutional arrangements, however, A variety of institutional arrangements, however, can accomplish many of the same objectives:can accomplish many of the same objectives:

1)1) Government Credit Resale Arrangements (reduce Government Credit Resale Arrangements (reduce credit demand uncertainty and create competition credit demand uncertainty and create competition among credit suppliers)among credit suppliers)

2)2) Associations/Cooperatives of regulated parties Associations/Cooperatives of regulated parties (reducing transaction/regulatory costs)(reducing transaction/regulatory costs)

Conventional markets for credit offsets have not Conventional markets for credit offsets have not developed.developed.