Abatement Cost Heterogeneity in Phase I Electric Utilities

Rezek, Jon, Blair, Benjamin F., Contemporary Economic Policy

I. INTRODUCTION

Title IV of the Clean Air Act Amendments of 1990 established a system of tradable emission allowances as a market-based mechanism designed to reduce sulfur dioxide (S[O.sub.2]) emissions in the U.S. electric utility industry. Economists have traditionally supported such decentralized, property rights approaches to solving the problem of environmental externalities. (1) The attractiveness of market-oriented pollution reduction policies, such as emission allowances, lies in their ability to achieve a given level of pollution reduction at the lowest cost. In addition, such programs allow plants the flexibility to choose their own emission reduction strategies, spurring competition among the previously independent abatement technology industries, which leads to additional cost savings.

The changes in deposition patterns since the S[O.sub.2] trading program began and the accompanying environmental impacts have been dramatic. The first phase of the program began in 1995 and affected 110 of the largest fossil fuel burning electric plants in the eastern and midwestern United States. Emission reductions from phase I plants occurred ahead of schedule, with environmental benefits observed in the eastern and northeastern United States. The General Accounting Office (2000) reports that wet sulfate deposition in three selected environmentally sensitive areas decreased by an average of 19% since 1995. While other factors, such as the increasing availability of inexpensive, low-sulfur Western coal, certainly contributed to these reductions in acid deposition, it is encouraging that they occurred simultaneously with the adoption of the Title IV provisions. Recently, spawned by the success of the Acid Rain Program, several legislative proposals have been designed to further reduce harmful emissions such as S[O.sub.2], nitrogen oxides (N[O.sub.x]), mercury, and carbon dioxide (C[O.sub.2]) from electric utilities. (2) The specific provisions of the proposals differ in various aspects, but they all advocate marketable permit-based systems as the preferable method of emission reduction.

This study evaluates the performance of the first phase of the program concentrating on plant-level economic responses to the change in the institutional framework. Under a tradable allowance system, low marginal abatement cost plants reduce emissions below their initial allowance allocation and sell the resulting excess allowances, with the difference between the market price and their marginal abatement cost captured as gains from trade. Alternatively, low marginal abatement cost plants may opt to save current allowances for future use if marginal abatement costs, or market prices, are expected to rise due to increased regulatory stringency. Conversely, high marginal abatement cost plants find it economically advantageous to increase emissions beyond their initial allocation and supplement these allowances with open market purchases. These plants also capture gains from trade by purchasing allowances for prices below what they otherwise would have paid to reduce emissions. Absent binding regulatory constraints or uncertainty over future economic conditions and allowance allocations, an efficient plant will emit up to a point where its marginal abatement cost equals the market price of the allowance. Montgomery (1972) showed that voluntary allowance exchanges, via an efficient market, guarantee that the total cost of aggregate emission reduction is minimized. Any additional heterogeneity across marginal abatement costs indicates additional cost savings that have not been realized, and therefore potential gains from trade have not been exhausted.

This article has three main objectives. First, we calculate plant-specific shadow prices for S[O.sub.2] emissions for a panel of affected plants during the Acid Rain Program's phase I period (1995-1999). These shadow prices measure the opportunity cost of pollution abatement and therefore provide an indirect calculation of marginal abatement costs. By comparing these shadow prices with observed allowance prices, the extent to which the market price reflects the prices implied by the hyperplanes tangent to the production frontier can be determined. We find that the calculated shadow prices are indeed consistent with the allowance prices observed during the period.

Second, we use the shadow prices to examine how abatement cost heterogeneity evolved during the period. Market-based policies offer plant managers economic incentives to set marginal abatement costs equal to the allowance price. As managers gain confidence in the nascent allowance market and learn to react to market signals, they will begin to respond to these incentives. The dispersion of plant-level shadow prices would be expected to decrease as they converge to the market price. A more rapid convergence to the minimum marginal abatement cost likely translates into larger cost savings attributable to the new market-based regime. Our findings suggest there was a rapid reduction in the distribution of shadow prices with the initial implementation of the Title IV provisions in 1995, with somewhat slower convergence thereafter. However, cost savings reached a peak only in the program's third year.

Finally, we examine the role of allowance trading in reducing abatement cost heterogeneity. In the permits approach to pollution control policy, the existence of a trading mechanism and the potential for gains from trade are instrumental in allowing for the convergence of marginal abatement costs. We find that among plants open to trade, marginal abatement cost heterogeneity decreased throughout phase I, while plants choosing autarkic compliance methods showed no evidence of a change in the distribution of these shadow prices.

The ability of a tradable permit program to achieve its goal of pollution reduction at the lowest cost depends critically on participants' responses. As the current legislation demonstrates, the success of the Acid Rain Program will undoubtedly have ramifications on both policymakers' and polluting firms' acceptance of market-based environmental policies in other realms, particularly in the area of greenhouse gas production and carbon trading mechanisms developed to reduce such emissions. This article shows that, even in a regulated environment, cost savings from allowance exchange can occur rapidly.

The remainder of the article is organized as follows. Section II provides a brief background of the allowance trading system and the literature on shadow prices of undesirable outputs. Section III details the theoretical model used to obtain S[O.sub.2] shadow prices. Section IV describes the data and the procedure for the calculation of shadow prices. Section V discusses the study's results. Conclusions are provided in Section VI.

II. S[O.sub.2] EMISSIONS AND SHADOW PRICES

A. The Acid Rain Program

The reduction of acid deposition, often referred to as acid rain, has been a primary concern of clean air legislation for decades. Such deposition is considered a primary cause of the acidification of lakes and streams in the northeastern United States and southeastern Canada. Environmentalists express concern about damage to vulnerable, high-altitude ecosystems in the Adirondack, mid-Appalachian, and southern Blue Ridge Mountains (General Accounting Office, 2000), but also stress increased morbidity and mortality rates as a major external cost of electricity production. (3)

In the United States, fossil fuel-fired electric utility plants account for approximately 70% of sulfur dioxide emissions--one of the major sources of acid deposition. During the past three decades, technology and performance standards imposed by clean air legislation comprised the backbone of U.S. environmental policy toward acid rain. Under technology or "engineering" standards, adoption of specific abatement technology, such as flue gas desulfurization (FGD) units, was mandated, while performance standards legislated a limit to the amount of emissions allowed per unit of heat input. Neither of these command-and-control approaches addressed aggregate emissions at the industry level. Title IV focuses the regulatory effort at the industry level, establishing an aggregate emission cap of 8.95 million tons annually when it is fully implemented in 2010. This represents a reduction of more than 50%, or approximately 10 million tons, below peak emission levels reached in 1980. Current legislation proposes even more aggressive cuts in aggregate emissions starting in 2010.

The Acid Rain Program was instituted in two phases. Phase I, which began in 1995, affected 263 generating units at 110 of the largest electric plants in the eastern half of the United States. (4) During phase I, each affected unit was allocated a number of S[O.sub.2] emission allowances annually based on its historic generation and fuel consumption patterns. (5) Allowances were fully transferable between parties or they could be banked for future use. Each affected unit was required to deposit one allowance into its Environmental Protection Agency (EPA) account for each ton of sulfur it emitted during the calendar year. (6) The year-end account was settled with current-year allowances or banked allowances of any previous vintage, with plants not holding sufficient allowances subject to a fine based on the tonnage of excess S[O.sub.2] produced. Phase II began in 2000 and enlarged the pool of affected units to include most plants with more than a 25-megawatt capacity. Annual allocations continue to be based on historic generation and fuel consumption patterns, although allowances are distributed less liberally. (7) Ellerman et al. (2000) provide an excellent resource for a more comprehensive exploration of the Acid Rain Program.

Much of the early literature concerning the S[O.sub.2] allowance market has dealt with two prevailing and potentially interrelated observations. (8) First, trading activity, both in terms of the number of trades and the trade volume, has been sparse, much lower than what was originally thought necessary to allow for the establishment of an efficient market. The implication is that sparse trading activity left substantial gains from trade unexploited, particularly in the early phase I period. In 1994, 16.7 million allowances were exchanged, however, only 329 transactions, totaling 1.9 million allowances, occurred between economically distinct organizations. (9) The remaining trades were intrautility, and thus only represented simple accounting transfers and not actual open market activity. In contrast, in 1999, 18.7 million allowances were traded, more than 1,700 of these transactions, totaling 6.2 million allowances, were conducted in the open market.

Bohi and Burtraw (1997) suggest that the initial low levels of trading …

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Publication information: Article title: Abatement Cost Heterogeneity in Phase I Electric Utilities. Contributors: Rezek, Jon - Author, Blair, Benjamin F. - Author. Journal title: Contemporary Economic Policy. Volume: 23. Issue: 3 Publication date: July 2005. Page number: 324+. © 2003 Western Economic Association International. COPYRIGHT 2005 Gale Group.

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