Trading Efficiency in Water Quality Trading Markets: An Assessment of Trade-Offs

36 Pages Posted: 24 Dec 2011

See all articles by Hugh McDonald

Hugh McDonald

Motu Economic and Public Policy Research Trust

Suzi Kerr

Motu Economic and Public Policy Research Trust

Date Written: December 21, 2011

Abstract

Declining water quality as a result of increased nutrient leaching is a serious and growing concern, both internationally and in New Zealand. Water pollution issues have traditionally been addressed with command-and-control type regulation, but market-based nutrient trading schemes are becoming more widespread. In New Zealand, a cap-and-trade system has been implemented in Lake Taupo and another has been designed for Lake Rotorua. Despite the importance placed on avoiding transaction costs in water quality trading markets, there has been little discussion in the literature of practical policies to decrease these transaction costs, or any real assessment of when it is and is not optimal to decrease transaction costs. This paper begins to address these issues. We find that strong efforts to control time-of-trade transaction costs are most likely to be worthwhile in schemes with heterogeneous participants and large expected values and volumes of trading. The trading inefficiency that results from search and bargaining, and trade registration costs can be minimised at some cost. Regulators can reduce trade approval costs if they establish baseline leaching levels for all participants and design standardised leaching monitoring systems as part of the set-up of the system, and monitor all sources equally regardless of whether participants trade instead of estimating and approving changes in traders’ leaching at the time of each trade (as occurs in a baseline-and-credit system). Finally we find that while regulators may be tempted to restrict trading or increase measuring and monitoring requirements to increase the environmental certainty of a scheme’s outcome, environmental risk may be better addressed through a less certain but more stringent environmental target.

Keywords: water quality markets, transaction costs, nutrient trading markets, trading ratios

JEL Classification: Q53, Q15, D23

Suggested Citation

McDonald, Hugh and Kerr, Suzi, Trading Efficiency in Water Quality Trading Markets: An Assessment of Trade-Offs (December 21, 2011). Available at SSRN: https://ssrn.com/abstract=1975598 or http://dx.doi.org/10.2139/ssrn.1975598

Hugh McDonald (Contact Author)

Motu Economic and Public Policy Research Trust ( email )

Level 1, 93 Cuba Street
P.O. Box 24390
Wellington, 6142
New Zealand

Suzi Kerr

Motu Economic and Public Policy Research Trust ( email )

Level 1, 93 Cuba Street
P.O. Box 24390
Wellington, 6142
New Zealand
+64 4 383 4250 (Phone)
+64 4 383 4270 (Fax)

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