Academic journal article Contemporary Economic Policy

The SO2 Emissions Trading Program: Cost Savings without Allowance Trades

Academic journal article Contemporary Economic Policy

The SO2 Emissions Trading Program: Cost Savings without Allowance Trades

Article excerpt

I. INTRODUCTION

Title IV of the 1990 amendments to the Clean Air Act (CAAA) initiated a historic experiment in incentive-based environmental regulation by permitting electric generating facilities to trade allowances for emission of sulfur dioxide. Many economists (including the author), predicted the program would perform less well than textbook theory might suggest and the program's proponents hoped.

Critics and proponents alike most often cite liquidity of the allowance market as the measure of success. By this measure the program has fallen short of aspirations (Wald, 1995). "Almost all involved agree that the rate of trading among utilities is not as high as had been expected (and) ... is not nearly enough to realize the kind of financial savings originally envisioned" (Zorpette, 1994).

From an economic perspective, one can measure success of incentive-based environmental regulation in two ways. One is productive efficiency or cost-effectiveness--the attainment of environmental standards at minimum abatement costs. The second is allocative, or market efficiency--the internalization of social opportunity costs of resource use in prices. This paper considers cost-effectiveness the measure.

In contrast with allowance market illiquidity, the industry's cost of compliance has been surprisingly low. Coupled with information about how these low costs have been achieved, the evidence indicates that thus far the program has been largely successful (Rico, 1995; Strauss, 1995). The purpose of this paper is to address the apparent paradox-that the allowance trading program may not require (very much) trading in order to be successful.

A variety of mechanisms achieve compliance under Title IV in addition to allowance trading. These include intrafirm reallocation of emission allowances, fuel switching and/or blending, installing scrubbers (flue gas desulfurization), retiring plants, repowering plants, energy conservation, reduced utilization, and substitution among facilities. Clearly, in principle an active allowance market is neither a necessary nor sufficient condition for cost effectiveness. For instance, if permits were allocated so as to equate exactly marginal cost among facilities, cost effectiveness would be achieved without any trading. Under Title IV, however, allowances are allocated on the basis of historic emissions without reference to cost, so one might anticipate ample trading.

In fact, not much allowance trading has occurred, but since 1990 the prices of abatement options available to utilities have undergone dramatic changes. These changes stem from changes in the prices of rail transport of low sulfur coal and increased productivity in mining as well as from innovations in the use of fuel blending and in the design and use of scrubbers.

This paper develops the hypothesis that changes in compliance costs are to a significant degree attributable to regulatory innovation embodied in Title IV. Even in the absence of robust allowance trading, the program has empowered utilities with the flexibility to take advantage of exogenous changes in input markets, such as a decline in the cost and an increase in the availability of low sulfur coal. Moreover, this flexibility has promoted competition between input markets, which in turn has encouraged innovation and amplified cost savings.

Although Title IV is widely known for instituting a system of allowance trading, it actually represents two giant steps forward in environmental regulation. The first step moves from traditional command and control to performance-based regulation. This means that the regulation provides a performance standard but does not specify what actions the firm should take to achieve compliance. In contrast, rules implementing the 1977 Clean Air Act Amendments effectively mandated the use of scrubbers for new sources, and emissions from existing sources were largely ignored with respect to long range transport of S[O. …

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