CPR Perspective: Emissions Trading: 'Market-based' Regulatory Tools: Toward Better Bubbles

For power plant operators, the costs associated with installing pollution controls (scrubbers, for example), or of limiting pollution by switching fuels (from high sulfur to low sulfur coal), depends on where a plant is located, when it was built, and how it was designed. Owners of new plants find it relatively easy to install new technology, because they can design around it. Similarly, utilities located in the Southwestern part of the country have easy access to low sulfur coal. Conversely, it is significantly more expensive to retrofit a plant that is 30 years old, built long before the control technology at issue was invented. For utilities located in the Midwest, it is far less expensive to buy high sulfur coal from mines in West Virginia.

Such economic realities inspired Congress to establish a market-based trading system for sulfur dioxide (SO2) in the 1990 Clean Air Act Amendments, as an alternative way to combat acid rain. (SO2 emissions are a major cause of acid rain.) The theory behind the law is that all utilities should receive initial allocations of so-called “baseline” allowances to emit a ton of SO2 in a given year. Plants with lower retrofit and fuel-switching costs would install pollution control technologies and buy lower sulfur coal, in effect cleaning up for plants with higher retrofit and fuel-switching costs. The owners of lower cost plants would then have extra allowances that they did not need to cover their emissions, and could sell those allowances to owners of higher cost plants, spreading the total costs of reducing emissions more evenly. The entire system functioned under a “cap” on SO2 emissions nationwide, improving the environment in the most economically efficient way.

In general, the acid rain “cap and trade” system has been successful, fostering reductions while keeping the cost of allowances within a reasonable range. In a few cases, overly generous allocations of initial allowances, together with the absence of limits on where plant owners could sell their excess allowances, produced worse environmental conditions, as utilities cleaned up and sold their excess allowances to upwind utilities, only then to see the pollution blow back into the very nearby forests the trading program was designed to protect.

The nation’s experience with acid rain suggests that several threshold design issues determine the effectiveness of any trading system. First, the initial distributions of allowances are the focus of intense jockeying among participants. Baseline allocations to existing sources can create barriers to market entry for new sources. Inevitably, covered sources attempt to negotiate exceptions to the baseline chosen, increasing their initial allocations. This process can be quite useful politically, giving legislators and regulators currency to buy support for the overall scheme. This opportunity to encourage regulated entities to fight over how to cut up the pie, so to speak, rather than whether to decide whether to bake it in the first place, allowed Congress to break a decade-long political deadlock on how best to combat acid rain.

Another, related allocation issue is whether allowances should be based on the “actual” emissions or discharges produced in a given period, as opposed to the “allowable” emissions or discharges authorized in the participant’s facility-specific permit. Regulated entities offered an opportunity to either add a trading scheme to their compliance options or to substitute trading for regulatory requirements are likely to argue that permit limits represent acceptable levels of pollution and that baselines should be set on the basis of allowable--not actual--emissions or discharges. Because state air and water permitting systems are under-funded and erratic, applying requirements that in too many cases are outdated and overly lenient, allowable permit levels are often considerably higher than what sources have actually achieved in practice. Basing allocations on allowable permit levels, or on levels of emissions or discharges that occurred several years ago, at a time of extraordinarily high production, can result in allocations that introduce significant increases in both overall and localized emissions.

A final threshold issue for designers of new trading schemes is whether traditional regulatory requirements remain in effect, providing a back-drop–or safety net–for such regimes. Traditional pollution limits were employed as a “floor” for the acid rain trading regime that sought to accomplish additional environmental benefits. However, cap and trade systems may also be used as a substitute for traditional regulation that is already in place. Or such systems may be applied to pollution problems that are not yet regulated, in lieu of traditional regulation. The acid rain system took a conservative approach to this issue, and retained existing permit requirements while seeking even greater reductions.

What People are Fighting About

The overall success of acid rain trading has provoked extravagant claims about the desirability of cap and trade systems as a more “efficient” alternative to traditional regulation. Industry critics and conservative reformers argue that trading not only saves money but accomplishes better environmental results. But other experiments with cap and trade systems have been considerably less successful than the acid rain system, provoking many to question whether trading without restrictions does more harm than good.

For example, some industry representatives and state regulators have advocated so-called “open market trading” systems that do not impose a cap on total emissions, but instead authorize unrestricted trading of emission reductions that have already been accomplished. Under the Clinton Administration, EPA abandoned efforts to issue a federal regulation that would facilitate such programs. But the Agency recognized the validity of the approach in its 2001 Guidance for Improving Air Quality Using Economic Incentive Programs. Environmentalists have called for a moratorium on such programs, and have strenuously opposed EPA proposals to approve open market programs in Illinois, Michigan, New Hampshire, and New Jersey. The New Jersey open market trading program never received EPA approval and was cancelled by the state’s top-ranking environmental officials after a Justice Department investigation revealed fraud in its implementation.

 Even where caps on total emissions are employed, trading systems have failed when: (1) caps are set too high to motivate pollution reductions; (2) there are no effective mechanisms to count allowances, track trades, and prevent fraud; and (3) trading is applied to toxic substances without effective limits on localized concentrations of emissions, or “hot spots.” Two efforts by California’s South Coast Air Quality Management District (SCAQMD) to reduce smog in Los Angeles are examples of such fiascos.

 In the mid-1990s, SCAQMD launched the RECLAIM program, which allowed utilities and other major stationary sources to trade SO2 and nitrogen oxide (NOx) credits under a cap on total emissions, and the Rule 1610 “Car Scrapping” program, which allowed operators of large stationary sources to buy their way out of compliance with CAA controls by paying owners of old, dirty cars about $600 per vehicle to take them off the road. The RECLAIM program’s cap was set too high, in part because planners based initial allocations of credits on historically higher levels of pollution for covered sources, as opposed to the lower levels of actual emissions at the time the program began. Compounding this error, the program supplanted, as opposed to supplemented existing technology-based requirements, leaving no “safety net” to prevent excessive emissions from individual sources. As a result of these threshold mistakes, in the first three years of its operation, the program resulted in a decrease in actual emissions that was very modest--about 3 percent.

Because the initial cap did not create a sufficient scarcity of allowances to motivate covered plants to install pollution controls, few installed controls that would enable them to generate additional allowances as the cap declined. Apparently, most owners and operators concluded that they could purchase credits later, as the cap declined. In fact, at one point, NOx allowances were so plentiful that sources gave 85% of them away for free.

The ultimate calamity for the system came in the spring of 2001, when a short supply of allowances pushed the price of NOx allowances as high as $45,000/ton. In the midst of the hysteria provoked by the California energy crisis, SCAQMD hastily pulled utilities from the system, giving them a three-year grace period to return to compliance with traditional regulatory requirements.

The SCAQMD car scrapping program contained similarly fundamental flaws in design, placing no limits on the amount of allowances stationary sources were able to purchase and failing to supervise the retirement of the cars that supposedly generated emissions reductions. The predictable result was the creation of extreme toxic hot spots containing intolerably high levels of pollution in the neighborhoods located in the vicinity of four marine terminals owned by Unocal, Chevron, Ultramar, and GATX. Exposure to these hot spots resulted in a cancer risk greater than 150 in 1,000,000 for people living in those neighborhoods, the vast majority of whom were people of color. Compounding these problems, SCAQMD auditors found rampant fraud in the program because owners of old vehicles were paid to retire their vehicles, the bodies of the cars were scrapped, but the engines were transferred into other vehicles that kept on running. Further, stationary sources appear to have underreported their emissions significantly, in order to save money by purchasing fewer allowances.

A Progressive Perspective

From an ethical perspective, there is a difference between having the government award sources a legally sanctioned opportunity to pollute and having the government use its authority to impose limits on pollution. Many think that trading conflicts with the moral precept that environmental quality belongs to the public at large and should not be for sale. Trading allowances for money is premised on the notion that the government not only is entitled to place an economic value on the public interest in natural resources, but remains free to sanction the buying and selling of those resources. For the same reasons, trading confounds the idea that we hold the earth in trust for our children. Activists, particularly those attuned to the environmental-justice implications of trading, often protest such schemes on moral grounds, asserting that trading marks a significantly worse approach to controlling pollution than traditional regulation. From this perspective, the government controlled by today’s adults has no moral authority to sanction economic transactions involving compromises in environmental quality over a period beyond our expected life span.

 Of course, these ideas also apply to more traditional approaches to controlling pollution. In that context, we also tolerate the degradation of nature, in effect appropriating our children’s interest in environmental quality, because we do not wish to pay -- or we have not been able to find a way -- to clean up our own mess. Still, the government’s active participation in facilitating the buying and selling of such compromises can be viewed as a significant ethical departure from traditional regulation, which at least recognizes that pollution should be controlled, as opposed to traded like any other commodity.

For these reasons, as well as the demonstrable harm caused by unrestricted trading systems, CPR believes that the following strong principles must be satisfied before any trading regime is sanctioned by the federal or a state government:

At the threshold, trading systems should do no harm, either with respect to the overall condition of the ambient environment or with respect to localized concentrations of pollution. In order to verify the absence of harm we must understand -- and continue to monitor -- the conditions of the ambient environment that will be affected by trading.

All trading systems must be based on continuously declining caps on overall pollution, producing added benefits for the environment and public health. So-called open market trading without such caps should not be sanctioned by regulators.

Trading schemes that allow trading of toxics must also employ comprehensive ambient monitoring to ensure that pollution is not pooling around specific facilities located near population centers, especially where there is no underlying health-based standard that is incorporated in a site-specific permit that remains in effect. If monitoring detects a problem, regulators must have authority to stop trading immediately until the hot spot is eliminated.

So-called “cross-pollutant” (one chemical for another) and “cross-media” (air emissions for water discharges) trades should not occur in the absence of reliable scientific evidence that they will not worsen environmental conditions, or cause and exacerbate hot spot problems. These expansions of traditional trading can result in exchanges of markedly more benign chemicals for their far more toxic cousins, as well as the substitution of poorly characterized pollution in one medium for pollution in another medium the effects of which are better understood.

Trading regimes must not only prohibit, but punish, sham trading, which deprives the public of the immediate benefits promised by such programs. If allowances are worth significant sums of money -- and this outcome is a threshold premise of trading schemes, failure to verify allocations and track trades not only discredits trading but directly rewards those guilty of the fraud.

CPR Scholars hope that EPA and its state counterparts not only consider, but apply, these principles to all trading proposals. If they do not, trading is likely to cause more harm than good and eventually will be discredited as a viable, environmentally protective alternative.