Thin and lumpy: An experimental investigation of water quality trading

Water quality trading schemes have generally not delivered the volume of cost-reducing trading activity that would warrant declaring them a success. In this paper we utilize laboratory economics experiments to explore the extent to which market outcomes are influenced by the technology through which pollution abatement is achieved. Mirroring the majority of point-source water quality trading markets, the sessions utilize small trading groups composed of six participants. In a departure from the majority of emissions trading experiments, participants are able to choose both their abatement technology as well as their abatement effort. To understand the extent to which technological considerations influence investment and trading behavior, the treatments vary the degree of heterogeneity in initial pollution abatement costs, the potential for long-lived investments in cost-reducing abatement technology, and limits to specific abatement technologies. Our results reveal over-investment in abatement technology across a range of treatment scenarios, especially when participants face limited abatement opportunities with the conventional technology and are risk averse. The results also illustrate the important relationship between investment behavior and observed transaction volume and market prices.