Experimental tests of water quality trading markets

Many watersheds in the U.S. have established water quality trading programs to help realize cost-effective reductions in water pollution; however, the success of these programs has been limited. This study highlights some of the unique features of water-based credit trading markets that may explain the lack of success, and uses laboratory experiments to isolate their effects. In particular, we compare two forms of a baseline-and-credit institution, a Pigouvian tax/subsidy regulation, and – characteristic of air quality programs – a textbook cap-and-trade regulation. Across these institutions we examine the effects of abatement technology adoption. We find that a baseline-and-credit program, when it requires firms to make upfront investments to generate tradable credits, is less efficient than cap-and-trade and tax/subsidy institutions. Furthermore, we find that when efficient trading requires costly technology adoption, institutions that involve inter-firm trading, including cap-and-trade, are less efficient than the tax/subsidy.