Endogenous Risk and Point‐Nonpoint Uncertainty Trading Ratios

20 Pages Posted: 16 Apr 2020

See all articles by Richard D. Horan

Richard D. Horan

Michigan State University - Department of Agricultural Economics

James S. Shortle

Pennsylvania State University - College of Agricultural Sciences - Department of Agricultural Economics and Rural Sociology

Date Written: March 2017

Abstract

Point‐nonpoint trading enables highly uncertain nonpoint pollution abatement to be substituted for relatively certain point source pollution abatement. Market designers use uncertainty trade ratios to address imperfect substitution between these commodities. Guidance from government agencies and other entities recommends large ratios that penalize trades for nonpoint abatement, and extant programs universally implement this guidance. Previous research has shown that the standard guidance is based on an inappropriate framing of the risk effects of substituting nonpoint for point source pollution abatement, and has demonstrated that the trade ratios should be set to encourage or discourage substitution, depending on whether the substitution is risk‐reducing or risk‐increasing. However, the Pigouvian pricing approach used to develop this result obscures the underlying economic calculus because it does not recognize or characterize the tradeoffs between abatement costs savings and environmental risk that must be considered in an economic evaluation of alternative ratios, and that would be key to explaining why ratios recommended by economic analysis would be preferred to received wisdom. We develop a new approach that explicitly identifies and characterizes the tradeoffs associated with the choice of ratio. The approach is examined both in first‐best settings where trade ratios and initial permit allocations are jointly determined, and in second‐best settings where permit allocations are taken as given. We provide a numerical analysis of trading in the Susquehanna River Basin in Pennsylvania to illustrate theory. We find theoretical and numerical support suggesting that smaller ratios may be optimal.

Keywords: Point‐nonpoint trading, water quality, permit markets, emissions

Suggested Citation

Horan, Richard D. and Shortle, James S., Endogenous Risk and Point‐Nonpoint Uncertainty Trading Ratios (March 2017). American Journal of Agricultural Economics, Vol. 99, Issue 2, pp. 427-446, 2017, Available at SSRN: https://ssrn.com/abstract=3577034 or http://dx.doi.org/10.1093/ajae/aaw088

Richard D. Horan (Contact Author)

Michigan State University - Department of Agricultural Economics ( email )

303A Agriculture Hall
East Lansing, MI 48824
United States
517-355-1301 (Phone)
517-432-1800 (Fax)

James S. Shortle

Pennsylvania State University - College of Agricultural Sciences - Department of Agricultural Economics and Rural Sociology ( email )

University Park, PA 16802-3306
United States

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