Collaborative Research: The Proper Scale for Environmental Markets with Application to Nitrogen Trading in the Neuse River Basin

One of the most striking developments in public policy over the last several decades is the widespread acceptance of the use of markets to achieve environmental regulation goals. Environmental markets now span air and water pollution, fishing quotas, endangered species habitat, wetlands, and streams. In a market for water pollution, for example, a regulator specifies the total amount of emissions, but the individual emissions by various sources are determined by trading in the market. Each environmental market is defined by a particular spatial scale, that is, the size of the geographic region over which trades are allowed to take place. In practice, there is substantial variation in spatial scale. The sulfur dioxide market encompasses the continental U.S., yet markets for water pollution are often constrained to relatively local watersheds. Despite this observed variation, little research has examined whether the scale of a given market is environmentally and economically optimal. Determining the optimal scale of a pollution emissions market necessitates the simultaneous analysis of economic costs of firms complying with pollution reduction; spatial pattern of pollution and corresponding damages to ecosystems and human populations; and the behavior of humans in the marketplace, particularly the ability to manipulate prices. This collaborative research project will integrate all three of these factors and determine the optimal spatial scale for nitrogen pollution trading in North Carolina's Neuse River basin. A theoretical economic model that combines compliance costs and human behavior will determine the spatial pattern of emissions of nitrogen from wastewater treatment plants. This model will be coupled with a hydrological and biogeochemical model that maps emissions into a spatial distribution of water quality. A series of economic laboratory experiments will be conducted to test the predictions of the economics model. The experiments also will analyze the degree to which feedback about compliance costs and the spatial distribution of water quality mitigates price manipulation. Using these elements, the investigators will analyze various spatial scales and select the one that yields the greatest net benefits to society.

The most immediate impact of this study is the market design for the Neuse river basin. This will inform the future debate over North Carolina water quality regulation. The general principles will be directly applicable to similar local water quality regulations, such as the market for nitrogen trading in the Long Island Sound. The study project will impact water quality regulation more broadly. It will provide a framework to compare the current water quality regulation as specified by the Clean Water Act to an alternative framework based on the optimal spatial scale. The project also will influence the design of more general environmental regulation as its methodology provides a template for analyzing the optimal spatial scale of many other environmental markets. This project is supported by the NSF Dynamics of Coupled Natural and Human Systems (CNH) Program.