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Harnessing Markets to Improve Water Quality

Using a free-market approach can save money and reduce pollution

In this age of environmental concern, talk about the failure of markets to provide environmental quality is common. Many people believe that while markets are good at providing things like cars, groceries, and CD players, they can’t deliver when it comes to reducing pollution. In fact, some argue that markets are the real source of the problem—that pollution and free markets go hand-in-hand.

But this view is misplaced. Property rights and incentives are what cause the market to be effective in providing other goods, like food, cars and housing. Merchants own the goods on their shelves (through property rights) and get to keep the gains obtained when they please us, so they have incentives to do so. Similarly, the innovative auto producer who gains market share gets to keep some of the resulting profit. As consumers, we too have incentives to choose carefully, since we will become the owners of what we buy. The process works the other way as well. Merchants and producers who miss the mark when seeking our patronage must cover their costs or go out of business. And if we consumers goof when making choices, we suffer. Thus, property rights and incentives lead both buyers and sellers toward decisions that are satisfactory to both.

Can property rights and market incentives be harnessed to bring environmental goods, like water quality? The answer is yes.

Water quality markets

If producers of improved water quality—higher levels of in-stream dissolved oxygen, for example—could sell their improvements to people willing to pay for better water quality; just as auto producers sell autos to people looking for better ones, we would see better water quality. We would see this especially if those who desire good water quality—the consumers of water quality—like consumers of automobiles, could search for low-cost producers, make a selection and pay for the water quality they consume and no more.

However, lack of property rights enforcement has made it difficult for water quality markets to emerge.

No one has been allowed to own the water quality in rivers in the United States, or even to own fishing rights that would be threatened by pollution (as in the United Kingdom). In addition, the historical common law protection of water quality through protection of riparian rights in court has been blunted by statutes. In the United States, rivers have been managed as common property. Thus, no one has had an incentive to exhibit owner-like concern for water quality.

The result is that water quality declined to the point that regulatory action was required, resulting in the Clean Water Act of 1972 and its subsequent amendments. Today, regulations specify how dischargers to streams and rivers must operate their plants. The technology-based rules focus on point sources and make it illegal for one discharger to pay another to clean up its discharge. Each producer must meet technology-based standards at each point of discharge. The old-fashioned rules allow little room for markets, property rights and incentives.

The Tar-Pamlico Story

A visit to North Carolina’s Tar-Pamlico River Basin Association suggests there is still hope for market solutions.

In 1983, a serious fish kill occurred in the nearby Pamlico Sound. The fish kill was the result of oxygen depletion from heavy discharge of nutrients—phosphates and nitrates—into the rivers. The U.S. Environmental Protection Agency (EPA) and state authorities that regulated the industrial and municipal dischargers recognized that their system of command-and-control just could not do the job. Every one of the 26 regulated dischargers was in compliance with the law. Of these, 24 were publicly owned treatment works (POTWs); two were industrial firms.

Runoff from farms, dairies and timber operations accounted for more than 80 percent of the pollution of the sound. Yet these nonpoint polluters were, by statute, outside of EPA’s control. In short, there were two groups of water quality users. One group, the industrial firms and sewage treatment plants, was cutting back, but the other group, farmers, had unlimited access to the rivers. Imagine if one group of customers at the local grocery store paid more and more to cover the costs of others who had free access to food. There would never be enough food to go around. It became evident that all users of water quality needed to become part of the solution.

After considerable debate and discussion, the regulators set a limit on the maximum amount of nutrients to be allowed in the rivers and then allowed for a newly formed not-for-profit river association—the Tar-Pamlico—to take on the problem of managing the river. The association, formed in 1989, included most of the POTWs and one industrial firm. The others had recently met strict EPA regulations and saw no advantage to joining. Acting to meet the nutrient discharge limits for the river, the association matches water quality consumers—those who seek to discharge waste—with water quality providers—those who find ways to reduce discharge and runoff. Tar-Pamlico is held accountable for the outcome.

Facilities that discharge nutrients directly to the Tar and Pamlico Rivers are not bound by their former EPA permits. Water quality outcome, not discharge, is what matters. All point-source discharger members must either pay the association for discharge privileges or obtain reductions from another discharger such as a farmer. Monthly discharge reports are provided to the association. Association members that fail to comply can lose their membership and be forced to meet the strict EPA regulations. With revenues received from the industrial firm and sewage treatment plants, the association pays farmers to change their practices, thereby producing more water quality to be sold in the regulated water quality markets. In addition, some operators of lower cost treatment works are selling treatment services to others who face higher costs. The association searches for low-cost water quality providers and matches them with consumers. A crude market has thus emerged.

What’s so great about water quality trading?

The result of all this is interesting for several reasons. First, the river is healthy again. No more fish kills have occurred as of this writing. Second, a large amount of money has been saved. EPA has estimated that using command-and-control technology to reduce a pound of nutrient discharge would have cost from $860 to $7,861. The cost for farmers doing the same thing ranged from $67 to $119 per pound.

The opportunities for gains from trade are obvious. Instead of spending $50 to $100 million to protect water quality the old way, Tar-Pamlico spent around $10 million. Part went for the costs of operating the association, modeling the effects of discharge on water quality and for consulting engineering activities designed to make the entire system operate effectively. Another part went to farmers who modified their agricultural practices. In addition to having an improved river and saving money, the association has accomplished something else. There is now a lively community of interests who care about the rivers. When these interested people want more water quality, they simply ante up the money, just as they do when they want more cars, clothes, and food. They no longer file lawsuits, protest or sign petitions.

Tar-Pamlico is working in North Carolina with the blessings of the EPA and the Environmental Defense Fund. The approach is applicable elsewhere, too.

In Shakopee, Minn., Rahr Malting Co., helped form the Minnesota Corporate Sponsorship program. This encourages market-like transactions between industry and farmers along the Minnesota River. Rahr is now paying farmers to change grazing practices and to reduce agricultural runoffs. By paying for the farmers’ change in practices, Rahr can produce more malt, which involves increased discharge to the river. the result is that water quality is improving, farmers are made better off and Rahr is producing more malt.

According to the EPA, trading programs for improving water quality that involve a wide variety of pollutants are now in place or are being planned for 10 U.S. locations.

Future Markets

Markets can work to improve water quality, just as they do to provide a wider choice of high-quality food, clothing and automobiles. But for these new environmental markets to emerge, government regulators must get out of the way. Instead of specifying technologies and fine-tuning each and every discharge, government agents must help to define and enforce property rights just as they do in other markets.

When property rights to water quality are defined clearly, when the rights can be defended in court, and when the rights can be bought and sold among water quality users, the miracle of the market can deliver environmental quality at lower cost.

What we need today are hundreds of Tar-Pamlicos. With more experience, the day may come when ordinary people will be allowed to establish watershed or fishing communities where property rights to water quality will be firmly established and markets will quietly dependably deliver environmental goods.

Environmental Protection Magazine
March 1999

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