Point-Nonpoint Heresy?! An Endogenous Risk Explanation for Point-Nonpoint Trading Ratios Less than One

Extant point-nonpoint trading programs involve trades of relatively certain point source emissions reductions for highly uncertain estimates of nonpoint reductions. Trade ratios, or uncertainty ratios, define the rate at which these imperfect substitute commodities are traded. Economic research on optimal trade ratio design provides support for ratios greater than or less than one, depending on how nonpoint source emissions uncertainties respond to trading. While this implies optimal trade ratio magnitudes are an empirical issue, guidelines for extant programs universally call for ratios that exceed one. Such guidelines are implicitly based on a priori assumptions about risk that are akin to treating risk as a fixed, exogenous measure rather than as an endogenous one that responds to policy-induced behavioral changes. Perhaps this should not be surprising, as prior analyses do not clearly illustrate out-of-equilibrium tradeoffs involving abatement costs and environmental risks, obscuring the endogenous nature of risk. We develop a new approach that illustrates these tradeoffs explicitly. Unlike prior studies that only illustrate the unique, optimal equilibrium ratio, our approach allows us to examine economic tradeoffs and abatement outcomes associated with different trade ratios. Our results show that an optimally designed trading program reallocates abatement to nonpoint sources to reduce abatement costs or to reduce environmental risks from nonpoint sources, but not both. This outcome is in direct contrast to the stated goals of the EPA’s national trading rules. Our methodology is also useful for examining second-best program design. Here, we find theoretical support that smaller ratios may be optimal.