Potential Cost Savings from Discharge Permit Trading to meet TDMLs for Phosphorus in the Passic River Watershed

We use the non-tidal Passaic River Watershed as a case study to investigate the size of potential cost savings associated with allowing phosphorus emissions trading amongst Waste Water Treatment Plants (WWTP) to achieve a significant reduction in ambient phosphorus levels. To measure the cost saving, we specify a trading-ratio system similar to that proposed recently by Hung and Shaw (JEEM, 2005) that minimizes the abatement cost of meeting environmental standards. Because there are relatively few potential traders and abatement costs are relatively homogeneous across firms, the cost savings to the 22 municipal waste water treatment plants relative to the base case will be on the order of 7%. We believe that these results fail to support efforts to establish a permit exchange market structure in the Passaic Watershed such as the one celebrated with the success of the U.S. acid rain trading program. Rather, our results suggest quite a different strategy for water quality trading in small watersheds such as the Passaic, where there are relatively few potential traders and abatement costs are relatively homogeneous across firms. In these situations, trading programs should instead be designed to identify the subset of firms that will gain substantially from trade in pollution permits and to nurture trade amongst these firms. Furthermore, because markets in such watersheds are relatively thin and investments in pollution abatement capacity are costly and lumpy and must be framed within five-year permit cycles, it is likely that these “structured bilateral” opportunities for trade will need to take the form of multiyear contracts.