Chesapeake Quarterly
Trading Away Toward a Cleaner Bay
Deals between cities and farmers may benefit both
and lower the costs of cleaning up the Chesapeake Bay.
So why are there so few trades?
Mike Brubaker (top) stands amid cover crops that he grew on his farm in Mount Joy, Pennsylvania, as part of a deal with a local wastewater treatment plant to reduce nutrients flowing to the Chesapeake Bay. A market for such "nutrient trades" has yet to develop but may one day help municipalities reduce their costs of complying with federal and state rules on nutrient discharges. This wastewater treatment plant (bottom) serves Howard County, Maryland. Photographs: Jeffrey Brainard, and inset, Clark Construction and the Little Patuxent Water Reclamation Plant

MIKE BRUBAKER WILL BE THE FIRST TO TELL YOU that succeeding in dairy farming today takes a lot more than milking cows. The Brubaker family has run a farm near Lancaster, Pennsylvania, since 1929 and has seen plenty of changes as the operation grew from fewer than a dozen cows to 900 today.

The Brubakers have made it a point of family pride to reduce the farm's impact on the surrounding environment using methods that also return income to the farm's bottom line. They installed solar panels on top of their cowsheds and a digester that turns methane from cow manure into electricity, which they sell to the local power grid.

So the Brubakers considered it only natural to venture into another innovative idea for helping both their wallets and the land. In 2007, they became one of the first farm operations in the entire Chesapeake Bay watershed to enter into a deal for what is called water quality trading. This kind of trading depends on cooperation between farmers and cities, using tools drawn from economics and markets to lower the overall cost of cleaning up and preserving the Bay's water quality.

The Brubakers' trade went like this: They signed a contract with the Mount Joy Borough Authority, which operates a wastewater treatment plant that serves their town. The Brubakers agreed to plant cover crops and follow other practices on their farm to reduce its nitrogen runoff by more than 8,000 pounds a year. In return, the authority agreed to pay them about $36,000 annually. The swap was an economical way to help the authority reduce the plant's nitrogen output, which eventually flows into the Susquehanna River and the Chesapeake Bay. Pennsylvania and other states are requiring sewage treatment plants to reduce their nutrient discharges as part of a Baywide effort.

The Brubakers and the authority renewed this water quality trade, and it continues today. "It seemed to make a whole lot of sense because we're in the same watershed that they're in," says Mike Brubaker, standing on his farm in the middle of a field of rye planted as cover crop. "We're trying to add practices that provide a sustainable environment and an economic win together."

How to meet environmental restoration goals at reasonable cost is an ongoing challenge for policy makers in the Chesapeake Bay region, and water quality trading may offer a tool to lower costs, analysts say. State and local officials have grown concerned about the expense since the Environmental Protection Agency (EPA) in 2010 established its plan to reduce the excess nitrogen, phosphorus, and sediments that are flowing into and endangering the Bay. High levels of nutrients fuel processes that decrease oxygen in the water and kill aquatic life, creating the Chesapeake's chronic and well-known dead zones. In the cleanup plan, the EPA set limits (called TMDLs, or Total Maximum Daily Loads) for nutrients and sediments that flow off the land in Maryland and five other states into the Bay.

Brubaker Farms has won recognition and awards for its environmentally friendly farm practices, including a digester that converts manure from the farm's dairy operation (above) to electricity. So a nutrient trade with a wastewater treatment plant seemed like a natural fit, Mike Brubaker says. Today, Maryland treatment plants use equipment to lower nutrient discharges (above right); one day, Maryland plants may offset increased discharges by buying nutrient reduction credits from farmers. Photographs: top, Jeffrey Brainard; right, Clark Construction and the Little Patuxent Water Reclamation Plant
 

The limits reflect the EPA's analysis of how much nutrient runoff would allow the estuary to function as a healthy aquatic ecosystem. The limits also reflect how states divided responsibility for reducing nutrients among the sources that discharge them, including wastewater treatment plants, stormwater drainage systems, and farms.

Now, water quality trading is gaining attention from the EPA and the states as a key tool to help lower those nutrient-reduction costs. The costs could run into the billions of dollars, especially for cities facing upgrades to treatment plants and stormwater drainage pipes to reduce nutrient runoff. Trading looks attractive because farmers can adopt certain farm-management practices that appear to reduce nutrients more cheaply than cities would pay to trim their nutrient discharges by the same amount.

In a nutrient trade, for example, a farmer can plant cover crops, like barley and wheat, in the fall. These crops take up excess nitrogen from fertilizer before it reaches the Bay. The grower can use these and other methods not only to reach the government's TMDL target level for farms in his area — he can also reduce his own farm's nutrient runoff further still. The farmer can then create "credits" representing the additional amount of nitrogen he reduced, and he can sell the credits to a wastewater treatment plant that needs to make cuts in its nutrient discharges to hit its TMDL limit. The farmer profits, and the plant's ratepayers save money. This is a little like when a farmer generates electricity from a windmill or a methane-fueled generator: he can use what he needs and sell the excess to the power grid.

Beginning in 2005, Pennsylvania, Maryland, Virginia, and West Virginia enacted rules to allow nutrient credit trades. But, it turned out, rules alone haven't been enough to prompt trades involving farmers. Not only was the Brubakers' one of the first such trades in any of those states — to date it is one of the only ones.

"Water quality trading is often seen as a magic bullet, it's going to solve all our problems," says Lisa Wainger, an economist at the Chesapeake Biological Laboratory of the University of Maryland Center for Environmental Science. But in the Chesapeake watershed and other regions where trading has been tried, she says, "it's never really generated the success that people hoped it would."

She and other economists who have studied these outcomes suggest that markets for trading water quality credits have been slow to develop here because the state rules that govern trading were designed conservatively to protect water quality rather than ease trading. Some rules, for example, were crafted to account for the risk that farm-based practices would not reduce nutrients by as much as expected. But such a rule may also preclude the substantial cost savings that trading was meant to provide. Economists say that the states may need to consider other market-based tools besides nutrient trading in order to juggle these competing priorities successfully.

From the Air to the Water

A lot of the questions posed by water quality trading come straight out of Economics 101. What does it cost to produce something? What will people pay for it? And how well do those match up?

The idea of trading credits for reducing water pollution was borrowed from a similar approach used successfully to control air pollution. In the 1990s, the EPA allowed the operators of coal-burning power plants to trade credits to control the airborne compound sulfur dioxide. Some plants reduced their discharges by more than they were required to and sold credits to other plants that faced bigger bills to make such reductions. This kind of sale is called "cap and trade." Mandatory caps on power-plant emissions have been credited as a major reason for the reduction of acid rain and the acidification of Northeast lakes, and trading has been credited for reducing the cost.

Some studies have estimated that a trading approach could generate big cost savings in the effort to clean up the Chesapeake Bay. The beneficiaries might include the 475 municipal sewage treatment plants in the Bay's watershed. Their discharge permits require them to meet the federal targets for nutrients and sediment. To make the required reductions, the plants are facing a combined cost of $385 million annually, according to a 2012 analysis by scholars at RTI International, a nonprofit research organization in North Carolina. Plant operators, however, could cut their costs by nearly 40 percent by buying an equivalent amount of nutrient reduction credits from farmers.

The savings could be even greater for municipalities if you add in the additional cost to upgrade their stormwater systems, a big expense that hikes their total cost to $1.47 billion annually. Trading could reduce this overall bill by 80 percent, or more than a billion dollars, RTI International's analysis found.

The analysis is a best-case scenario — for example, it assumes that many farmers who could generate and sell credits by installing nutrient-reducing practices would actually do so. But trading requires both a supply and a demand — and there is little demand yet for nitrogen reduction credits produced by farms.

The Demand Side

Lack of demand is partly a result of state rules about trading.

In 2004, Maryland required the 66 largest publicly owned sewage treatment plants to achieve a low level of nutrient discharges using new treatment technology. That has remained the state's policy since the TMDL limits on nutrients in the Bay were announced. Under the rules, these plants cannot buy nutrient reduction credits until they have installed this technology.

However, Maryland's rules do allow treatment plants that have completed these upgrades to purchase nutrient credits to deal with expected future population growth. The state is projected to add 478,000 households by 2035, which threatens to pump more nutrients into the Bay. After sewage plants in Maryland install the nutrient-removal technology, they will have some capacity to accommodate more residents and more wastewater. Eventually the plants' nutrient discharges will bump up against the TMDL caps for discharges. But most Maryland plants won't hit those limits for another decade or longer. By then, operators may find nutrient trading a cheaper alternative to additional technology upgrades.

Developers may also start shopping for nutrient reduction credits from farmers. In 2013, the state finalized a new set of rules, called Accounting for Growth, to prevent newly built houses and businesses from adding nutrients above the TMDL limits. Developers will have to make compensating decreases or "offsets" in these discharges, and it may be economical for developers to pay farmers for nutrient reduction credits.

Demand for nutrient trades may also come from municipal stormwater systems in Maryland. The TMDL cleanup plan will require the largest urban systems to reduce current nutrient discharges and to compensate for population growth after those reductions are achieved. But the Maryland Department of the Environment has not yet issued regulations that would allow this trading to begin.

Using management practices like cover crops (top), farmers can reduce a pound of nitrogen at a lower expense than it costs municipalities to upgrade nutrient-removal equipment at wastewater (sewage) treatment plants or to modify pipes to control urban stormwater runoff. In a "nutrient trade" (bottom), an urban source of nitrogen or phosphorus buys "credits" from a farmer who reduces his nutrient discharges, and the credits count toward the buyer's required reduction. Nutrient trading has yet to develop in the Chesapeake Bay, and the amount of savings in practice remains to be seen. Graphics: top, excerpted from a figure from the World Resources Institute; bottom, Maryland Sea Grant figure (drawings: farm, Kim Kraeer and Lucy Van Essen-Fishman, IAN; treatment plants, Tracey Saxby, IAN)
The Supply Side

Just as some state rules limit demand for nutrient credits, they also limit supply. Economics 101 teaches that if you restrict the supply of something, its cost rises. And if the cost of nutrient reduction credits rise, the savings from nutrient trading could be less than expected.

One such rule lowers the supply of nutrient credits in Maryland, Pennsylvania, Virginia, and West Virginia by restricting trades to designated areas. Maryland, for example, allows trades within the Potomac basin, within the Patuxent basin, or within the rest of the state, but it disqualifies trading across any of these zones.

Requiring both buyer and seller to swap credits only within the same zone ensures that each river basin reaps some benefit from any trade. Otherwise, nutrient levels could rise in one basin if a wastewater treatment plant there bought nutrient reduction credits from a farmer in a different basin. Some observers have criticized nutrient trading because of its potential to create localized "hot spots" of nutrient pollution in the water near urban sources like sewage treatment plants and stormwater pipes (see Will Trading Create Pollution "Hot Spots"?).

States that allow nutrient trading require the buyer and seller to be located within the same area. The rules are meant to maximize the benefits of trading within each basin, but this restricts the supply of credits and increases their price compared to a scenario in which trading is allowed across basin and state boundaries. Map: Pinchot Institute for conservation, Washington, D.C.
THE IDEA BEHIND NUTRIENT TRADING is that the plant can save money by paying a farmer to reduce his nutrient runoff by the required amount. But the farm might be located some distance away from the treatment plant. As a result, this nutrient trade could create a "hot spot" of excess nutrients near the treatment plant that might harm water quality and aquatic life there. But whether — and where — "hot spots" would be created remains to be seen.  more . . .

Despite the environmental benefits of geographic limits on trading, economic analyses indicate that allowing trading across basins would generate significantly larger savings compared with restricting trading to within basins. It's Economics 101 again: the bigger the supply of a product, the lower the cost. If the states in the Chesapeake Bay watershed allowed water quality trading across boundaries of basins and states, this would create the largest such trading zone in the United States. But the states would first have to agree to a common set of rules for determining what is a nutrient reduction credit, and this has yet to happen.

Another kind of rule that tends to lower the supply of nutrient credits is a requirement for conserving farmland. Maryland, Pennsylvania, and West Virginia prohibit retiring "substantial" portions of farms to generate credits for trade. Putting agricultural land into conservation programs, such as planting trees on less productive land, offers some of the most cost-effective, efficient ways of reducing a pound of nitrogen from reaching the Bay. However, the trading rules restrict taking large amounts of land out of production to generate credits because this results in a smaller local farm economy.

Hedging against Uncertainty

Yet another rule that restricts the supply of nutrient credits is one that requires buyers to purchase more credits than they need, as a safety factor to protect the Bay's water quality.

Virginia adopted this kind of rule because it's very difficult to measure accurately the amount of nutrient reduction accomplished by particular farm management practices. The best-case scenarios predict that practices like planting cover crops will reduce nutrients by a particular amount, day in and day out. But they don't: agricultural researchers have found that the actual reductions are highly variable. A lot depends on factors like rainfall. (In a rainy year, more nutrients are washed into the Bay no matter what practices are in place.) Unlike at a wastewater treatment plant, there's no pipe coming off a farm field containing a gauge to record nutrient levels.

But nutrient trading depends on certainty — a buyer needs to purchase a specific amount of nutrient reduction. So to deal with the variable results of farm practices, Virginia requires buyers to purchase the equivalent of two pounds of nutrient reduction by farmers for every one pound of nutrients that buyers actually need to meet their nutrient targets. In March, the EPA issued a memorandum asking the other states with trading programs to adopt that approach in most cases when farmers sell nutrient reduction credits. (In very limited cases where reductions can be measured directly, the EPA memorandum allows for a less conservative "trading ratio" of one to one.)

The price of reducing uncertainty is that this method raises costs. An analysis by Lisa Wainger and her colleagues found that a two-to-one ratio would raise the cleanup cost for the Potomac watershed by three to four times compared to a lowest-cost scenario that used a ratio of one to one.

Wainger says we can increase trading activity by relaxing rules like these. She adds, though, that policy makers will have to find the right balance between reducing costs and protecting the Bay's water quality. Ignoring uncertainty in the results of farm practices could translate into slower progress toward meeting the Chesapeake's TMDL nutrient targets.

More scientific research could help policy makers work toward this balance, she says. Existing estimates of nutrient reductions come from formulas developed by expert panels that review available research; the formulas equate particular agricultural practices with specific amounts of nutrient reduction. But many practices have not been studied under a range of field conditions, so further research could help to make these formulas more accurate and reliable.

Meeting the Baseline

Another kind of rule that may further limit the supply of nutrient credits is called a "baseline." This rule is meant to ensure that farmers meet their own targets for reducing nutrient runoff to the Bay before they can sell nutrient reduction credits. All farms within a single region in Maryland must meet a single baseline level that is consistent with the TMDL target for that area. To reach the baseline, many farmers will have to reduce their existing nutrient runoff levels.

Before farmers can trade nutrient credits, state rules require them to carry out management practices to reduce their own nutrient runoff levels to a target, "baseline" level. Research indicates that a low ("strict") baseline level results in fewer credits for sale, and in less overall reduction of nutrients discharged into the Bay, than a higher ("not strict") baseline level. In several parts of Maryland, the baseline for farmers would be close to the "strict" level shown here. Table source: Marc Ribaudo, Economic Research Service, U.S. Department of Agriculture

However, once farmers achieve their own target, they may have relatively few nutrient reduction credits to sell to municipal buyers. That's one conclusion of research by Marc Ribaudo, an economist who has studied possible effects of state rules on nutrient credit trading in the Chesapeake Bay. He's a 30-year veteran of the Economic Research Service of the U.S. Department of Agriculture. His office in downtown Washington is far from the Bay's shores, but a souvenir sits atop his office bookshelf — a felt hat that looks like a crab. (Ribaudo says it stays on the shelf, not his head.)

Think of a baseline as the farmer's price of admission to the trading market floor. A baseline creates an incentive for farms to meet and exceed the TMDL targets for agriculture.

An incentive may be needed because the Clean Water Act — the law on which the TMDL targets are based — exempts crop farms. This means that the EPA can't require crop farmers to meet the TMDLs, as it can sewage treatment plants. Congress exempted crop farmers from the law because it's difficult to measure the amount of nutrients flowing off farms to determine compliance. However, farms are the single largest source of nitrogen and phosphorus delivered to the Chesapeake Bay.

A profit incentive might encourage farmers to put in place farm-management practices, like cover crops, that reduce the amount of nitrogen and phosphorus flowing into neighboring streams and the Bay. Other such practices include planting streamside buffers of grass or trees and using no-till planting and less fertilizer. In the Chesapeake Bay, some farmers have been doing these steps voluntarily for years, with help from government subsidies. In 2013, Maryland spent about $20 million to reimburse farmers up to $100 per acre for planting a total of more than 400,000 acres of cover crops. But even with these kinds of supports, voluntary efforts by farmers across the entire Bay watershed have not been enough to meet the voluntary reduction targets set by states before the TMDL nutrient limits were established.

Ribaudo and his colleagues wanted to know how a baseline requirement would affect farmers' willingness to create and sell nutrient reduction credits voluntarily. The researchers compared potential demand for, and supply of, nutrient credits across the entire Chesapeake Bay watershed. Ribaudo estimated demand based on the needs of large wastewater treatment plants. To estimate supply, the researchers analyzed the nutrient-management practices already in place on farmland and the potential payoffs from additional practices. They examined a scenario in which farmers received government subsidies to cover all costs of meeting the baseline.

Under the cleanup plan for the Chesapeake Bay, sources that emit nitrogen into the Bay are required to cut levels by 2025. Farmers will be required to make larger cuts than other sectors. State rules for nutrient trading require farmers to meet targets for reducing nitrogen before they can sell nutrient credits to urban sources — which may limit the volume of nutrient trading, economists say. Table source: Marc Ribaudo, Economic Research Service, U.S. Department of Agriculture

What Ribaudo found ran counter to some common expectations about nutrient trading. Even with government subsidies, a strict baseline requirement — one that allowed farmers to emit relatively few nutrients to the Bay watershed — didn't seem to prime the pump for nutrient trading or incentivize participation by farmers. To the contrary: a stricter baseline requirement resulted in fewer nutrient credits sold by farmers to sewage treatment plants compared to a scenario with no baseline requirement at all.

What is more, under a strict baseline requirement, farmers accomplished less total reduction in nutrients — the reductions required to meet the farmers' baseline and the reductions farmers sold as credits — compared with a scenario with a less strict baseline (see table above).

In other words, Ribaudo says, you can invite farmers to help out urban neighbors by selling them nutrient reduction credits. Or you can ask farmers to reduce their own nutrient runoff levels. But it's unlikely that farmers will do a lot of both under a strict baseline. Even with a profit incentive, some farmers won't meet the baseline at all. Others will, but these farmers will produce relatively few credits at a price attractive to buyers.

Ribaudo's pace quickens as he elaborates. "If you're telling point sources that they can reduce their costs through trading, and then you develop a trading program that is very stringent for the nonpoint sources [farmers], then the point sources aren't going to benefit by it," he says. Instead, operators of sewage plants will have little choice but to upgrade treatment technology to limit nutrient discharges, "and the [Bay's] water quality will improve, but it's going to be more expensive than it would be otherwise."

The analysis by RTI International — the one that predicted big cost savings from water quality trading — acknowledged that a baseline could reduce those savings. But RTI didn't estimate by how much.

Alternative Approaches

Do the states with trading programs need to relax the existing baselines? In several areas of Maryland, like the Patuxent River watershed, these levels are stricter than the lowest baseline level examined in Ribaudo's analysis.

Ribaudo explains that he didn't identify an ideal baseline, one that would best advance the dual goals of cutting costs for urban sources and reducing overall nutrients in the Bay. That would be difficult to calculate for a variety of reasons, he says.

However, Ribaudo says his findings suggest that by enacting a relatively less stringent baseline requirement, states could make nutrient trading more attractive to both farmers and urban sources. Like Wainger, he acknowledges that relaxing trading rules means that environmental rules may not be met — the farmers may not meet their own targets under the TMDLs for reducing nutrients in the Bay. To help farmers achieve their targets, he says, states could offer them additional financial incentives and support to complement trading programs.

For example, pilot projects in Ohio and Canada have used governmental and non-governmental agencies as middlemen to arrange transactions between buyers and sellers and to promote the most cost-effective reductions in nutrients. In the Greater Miami River watershed in Ohio, farmers submitted bids to supply nutrient reduction credits. A regional water authority selected the bids that offered the largest nutrient reduction at the lowest price (a process called a reverse auction.) The authority financed payments to farmers in part from fees it collected from wastewater treatment plants that had excess nutrient discharges.

In such a program, the middleman can rank bids by which ones offer the best evidence that the farm practices described would reduce nutrients consistently and reliably. This kind of approach can reduce the need for high trading ratios and stringent baselines that can hinder trading by increasing costs, says Wainger.

Economist Lisa Wainger and her colleagues studied the effect of rules that require buyers to purchase two nutrient reduction credits from farmers for every one credit they actually need. This is to provide a safety margin because farm-based efforts to reduce nutrients produce variable results. But in practice, these rules also could substantially increase the cost of the credits — and so lower the cost savings achieved through nutrient trading. Photograph: Sarah Houde

Another tool for helping farmers meet the TMDL limits would financially compensate growers whose yield of crops declined because they reduced their fertilizer applications in order to reduce their nutrient runoff levels. A pilot study in the Chesapeake Bay led by the American Farmland Trust found the cost of that approach might be lower than the cost of Maryland's cover crop subsidies.

With more incentives like those, Ribaudo says, "You can probably get a whole lot more bang for your conservation budget than we're currently getting."

Analyses of supply versus demand may not matter much if farmers don't want to participate in nutrient trading for reasons other than dollars and cents. Some farmers have voiced irritation that they are already being asked to make larger reductions in nutrients to meet the TMDL targets than urban sources are.

Farmers may also object to nutrient trading because the rules require that a monitor annually visit the farms selling nutrient credits to make sure the required nutrient reduction practices were followed. Many farmers might see such inspections as unwelcome and intrusive. The potential hassle might not be worth the money. Under Virginia's trading program, revenue would amount to only $5,000 annually on a typical, 600-acre crop farm, according to an analysis led by Kurt Stephenson, an agricultural economist at Virginia Tech. That was a fraction of the farm's annual revenue of more than $1 million.

A Farmer's Bottom Line

On the Brubakers' farm in Pennsylvania on a recent day in early spring, the short green cover crops of rye would soon make way for seeds of corn. The rye had played a part in stopping nutrients from the previous year's corn fertilizer from entering Charles Creek, which runs across the farm. About two miles south, the creek's flow enters the Susquehanna River, the Chesapeake's largest tributary.

But unless demand and prices increase for nutrient reduction credits, the bottom-line benefit to other farmers might resemble the Brubakers' experience. Although the nutrient trade has saved some money for the borough authority and its ratepayers, the trade is a losing proposition on paper for his family, Mike Brubaker says.

It cost the farm about $45 an acre to plant the cover crops that provide the nutrient reduction that is the basis for the trade. That includes the costs of seed and equipment to plant it using no-till methods. That's higher than the $36 per acre that the farm earned from the trade.

"It's a number that's good enough for us to continue," Brubaker says. He explains that the cover crops provide an added benefit to his farm that isn't reflected in those revenue numbers — they reduce soil erosion, helping to maintain the soil's productivity. Still, the lack of easily demonstrable profit from nutrient trading may be one reason there have been so few trades in Pennsylvania so far.

"It's been a couple of years" since Pennsylvania began allowing nutrient trading, Brubaker says, "and there's not a lot of excitement about it. You don't see the amount of players to make a healthy marketplace."

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