Less than three percent of the planet’s available water is suitable for most human uses.1 This fraction could, nonetheless, meet global demand. The problem is its uneven distribution and mismanagement, which leads to pollution and severe shortages that harm human and planetary well-being. In 2013, 1.2 billion people experienced water scarcity. Another 1.6 million were deprived of access because of limited financial resources.2 In 2000, approximately 66 percent of the world’s major river basins were polluted.3 Continued population growth, climate change,4 and existing development gaps, such as inadequate sanitation,5 will likely exacerbate these problems in the future.
Traditional solutions to meeting the water scarcity and pollution challenge have failed because they rarely tackle issues of water depletion, degradation, and uneven distribution with the sort of market-based, hybrid approach that offers the most sensitive and flexible of solutions.
Water usage can be difficult to monitor. Corporations and private interests have traditionally found it easy to externalize environmental and social costs, leaving the costly business of remediating damaged aquifers and water sources to the public pocket. Most policies addressing water usage separate the issue of water shortage from that of quality. Large-scale infrastructure, such as dams, is often constructed to meet shortages,2 but this fails to address factors that drive demand, such as inefficiencies in water use and unequal distribution (to say nothing of the social and environmental impact). For quality, effluent standards that limit the concentration of pollutants in wastewater are often imposed.6 While effective in the short-run, these standards often don’t respond quickly enough to changes in pollution sources. In the United States, for instance, the Clean Water Act only succeeded in meeting water quality objectives in the first two decades. From the 1990s, however, increases in pollution and shifts in its composition from being predominantly industrial to agricultural—an activity that is not covered by the regulation—limited its effectiveness.7
Market-based approaches for allocating water to users, along with rights to pollute, are one solution that governments are experimenting with. But despite the promise of allocative efficiency, such markets risk unequal outcomes as water use tends be equated with the ability to pay. Moreover, noncommercial uses such as maintaining flows for an ecosystem’s health are likely undervalued because financial returns are limited.8
Creating a market based around a cap-and-trade scheme on the amount of pollution any user can generate can offer a more accurate system. Yet any pollutant cap is still a somewhat artificial measure that fails to take into account changes in water levels due to consumption and natural processes like changes in seasons that in turn affect the ability of a water body to absorb waste.9
What the current market mechanisms lack is the ability to harmonize environmental effectiveness, economic efficiency, and feasibility.
The idea of a dynamic permit-trading scheme that tackles a broad range of issues is not novel. Several schemes that issue withdrawal permits or pollution caps are in operation in the United States, the European Union, Canada, Australia, and Singapore.10 However, withdrawal permits and pollution caps are defined and operated separately. The ideal set-up is to continuously account for changes in environmental conditions, demand, and pollutant load patterns to ensure that water quality goals are always reached.11 This would involve defining a target based on assimilative capacity that can integrate both concerns. Assimilative capacity (AC), which refers to water’s ability to absorb waste, is sensitive to both flows and quality of the resource stock.12 For example, AC is diminished during low water flows or when large volumes of pollutants are deposited. This, in turn, limits the ability of the body of water to provide services, making the AC trading ratio a vital measure in weighing up the relative impacts of withdrawals and pollution loading to ecosystem integrity.
Creating an AC market would then provide users with the flexibility to meet targets and could stimulate innovation and reduce compliance costs in the long run.13 An AC market would also promote efficient practices, such as water conservation measures and nutrient management, because a price on AC sends an economy-wide signal to internalize externalities.
An AC market is not without its downsides. The cost of operationalizing a trading scheme, which involves establishing baselines, monitoring, and enforcement, is not negligible. In existing pollution markets, transaction costs account for five to 25 percent of the permit price, although this can be offset by aggregating permits from other pollution sources and allowing centralized auctions instead of bilateral trades.10,14 Transparent schemes can also help with management of the scheme by allowing users to self-monitor and enforce rules.
Another problem that AC markets don’t tackle, but which policy makers need to address for the scheme to be effective, is perverse incentives such as fertilizer subsidies. In most developed countries, inefficient fertilizer application is the major cause of eutrophication, or excess nutrients that cause algal blooms. A fifth of total nitrogen and phosphorus inputs can be reduced without impacting global yields.15 An AC market would need to work together with a public information campaign to help farmers develop more efficient practices. Tax breaks may still be needed to assist poorer families cope with any price increases.
Taken together, these approaches combine regulation and market instruments to ensure that the triple bottom line of sustainability is met. As opposed to conventional approaches that measure either water quantity or quality, a trading scheme based on assimilative capacity offers a common metric with which tradeoffs in appropriating the different and often-conflicting water uses can be assessed. However, despite the promise of assimilative capacity, success is not inherent in theory. Several design measures need to be in place to overcome practical, institutional, and political barriers. These include instituting safety mechanisms that account for the heterogeneity of AC and water pollution sources, correcting policies that distort the price signal, and addressing potential distributional concerns.