Uncertaintv and the Markets for Water Pollution Control

Market-based instruments for pollution control have received large attention during the last years due to increasing costs of pollution abatement and the need for more flexibility among emitting sources to comply with environmental regulations. The evidence, however, has shown some implementation problems with such instruments. A classic example of such problems is the Fox River permit program, in Wisconsin. This thesis focuses on the performance of transferable discharge permits (TDPs) for water pollution control, in particular biochemical oxygen demand (BOD) discharges. Uncertainty and transaction costs, among others factors , can adversely affect the trading activity in a market for water pollution as well as in others. Uncertainty comes from the fact that regulatory authority needs directly or indirectly to intervene within market to prevent future violations in the water quality standards, and also by the fact that permit prices do not necessarily remain constant over time. The effects of uncertainty and transaction costs are studied by using two models: (1) a one-period model that shows how authority's approval requirements can affect trading activity; and (2) a two-period model that shows how a conditional TDP system that accounts for price variability affects irreversible investments in waterwaste treatment capacity and hence trading incentives. The study concludes that trading incentives can be significantly reduced by these adverse factors. Despite them, however, TDPs still can offer more cost-effective solutions than command-and-control approaches in dealing with the water pollution problem. We also include some policy implications regarding these matters. Thesis Advisor: A. Denny Ellerman Title: Senior Lecturer Sloan School of Management, and Director Center for Energy and Environmental Policy Research(CEEPR) ACKNOWLEDGMENTS I would like to thank Robert Stavins and especially A. Denny Ellerman (thesis advisor) for helpful comments on previous drafts. Financial support from Fulbright and Encyclopaedia Britannica's Scholarships and particularly from a grant of the Pontificia Universidad Cat6lica de Chile is also gratefully acknowledged. I also would like to thank all people in the Technology and Policy Program. Especially, thanks to Prof. David Marks, Paulo Belloti, Jeff Goldman, and Luis A. G6mez-Ugarte for all the support and friendship during these almost two years. Finally, I would like to dedicate all this work to Paula who gave me her unconditional support, love, and an experience that I will never forget.