When the Levee Breaks: Can Multi‐Pollutant Markets Break the Dam on Point–Nonpoint Market Participation?

Abstract

High transaction costs and thin participation plague water quality trading and prevent markets from delivering expected efficiency gains. Little prior work explores the relationship between transactions costs and market performance. We develop a model of point–nonpoint trading that includes transactions costs. Point sources (PS) generate a single pollutant, whereas nonpoint sources (NPS) generate multiple, complementary pollutants. Trading occurs via bilateral negotiation: regulated PS must find and contract with unregulated NPS to obtain pollution offsets. Each PS bears search and contracting costs that depend on the number of potential trading partners. The NPS sector does not pay search costs but may incur some contracting costs. These costs may affect participation decisions. Transactions costs may generate strategic complementarities that lead to multiple equilibria, characterized by large or small levels of market participation. The equilibrium at which the market arrives depends on sources' expectations about others' participation. We explore the effect of different market structures on trading outcomes. Allowing NPS to participate in multiple, distinct markets for each pollutant they abate may have little effect on the basin of attraction for trading. In contrast, integrated markets—in which regulated polluters can meet their caps by holding permits generated from abatement of either pollutant—can reduce transactions costs for both sources. This generates a larger basin of attraction around the full‐participation equilibrium and thus may improve the efficiency of pollution trading.