International Review of Environmental and Resource Economics > Vol 2 > Issue 2

The Economics of Water Quality Trading

James S. Shortle, Distinguished Professor of Agricultural and Environmental Economics, Department of Agricultural Economics and Rural Sociology, Penn State University, USA, , Richard D. Horan, Associate Professor, Department of Agricultural, Food, and Resource Economics, Michigan State University, USA
Suggested Citation
James S. Shortle and Richard D. Horan (2008), "The Economics of Water Quality Trading", International Review of Environmental and Resource Economics: Vol. 2: No. 2, pp 101-133.

Publication Date: 24 Oct 2008
© 2008 James S. Shortle and Richard D. Horan
Environmental Economics
Permit tradingEnvironmental marketsEnvironmental policy designNonpoint source pollutionStochastic emissions


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In this article:
1 Introduction 
2 Us Water Quality Trading Initiatives 
3 Water Quality Trading Elsewhere 
4 Designing Water Quality Markets: Basic Design Issues 
5 Commodity Definition 
6 Trading Ratios 
7 Caps, Trading Rules, and Commodities: An Ecological Perspective 
8 Caps, Trading Rules, and Commodities: An Economic Perspective 
9 Moving Forward 
10 Concluding Remarks 


Textbook pollution permit trading markets are appealing due to simple market designs and their ability to solve allocation problems without firm-specific information. Neither of these features is true for water quality markets, which may explain why emerging programs in this area have with few exceptions not fulfilled the promise of trading. We review water quality trading programs, and examine market design by focusing on three tasks that must be addressed to cost-effectively achieve environmental targets: (i) defining the point and nonpoint commodities to be traded, (ii) defining rules governing exchanges of the commodities, and (iii) setting caps on the commodity supplies so as to achieve an environmental target. Our examination of the third task, the cap and its role in determining trading rules (e.g., trading ratios), is novel. We examine this task from both an ecological and an economic perspective, and obtain new insights about the challenges of designing water quality trading programs.