Emissions trading as a means of controlling sulfur dioxide emissions appears inevitable as Congress prepares to enact legislation providing for a revised Clean Air Act. But will this kind of market-driven program work in an industry as highly regulated as that of electric utilities? At stake is not the degree of environmental protection achieved, but the cost of achieving it.
In the annals of air pollution control policy, 1990 will be remembered as a watershed year for the use of economic incentives to reduce the cost of meeting pollution control goals. In this year, Congress agreed to institute a major economic incentive program under the Clean Air Act to control acid rain caused by emissions from electric utilities. The proposed emissions trading program promises drastic cuts in sulfur dioxide (SO2) emissions at far lower cost than the costs projected for other types of regulatory programs. What is more, emissions trading provides the most polluting utilities with a way of sharing their high costs of cleanup with less polluting utilities—a feature that was useful in reducing opposition to steep emissions reductions from Midwestern utilities, which are forced to make the deepest cuts in emissions. Whether the promise of this program is realized depends on how well the details of the emissions trading are crafted, a task made difficult because the electric utility industry is already regulated in many ways.
Simply, the idea behind any emissions trading program is to fix the amount of emissions reductions that are desired in total, to allocate emissions reduction responsibilities to each emissions source, and to authorize any sources that discharge less emissions than legally permitted to sell emissions "allowances" to sources that discharge more than permitted. The costs to society of attaining the desired emissions reductions is minimized, in theory, because those plants that can control emissions most cheaply will find it in their interest to reduce their emissions below their standard and to sell their allowances for the emissions that are controlled in excess of that required by law. Buyers of allowances will be those higher-cost plants that find it is cheaper to purchase allowances than to control their emissions.
Cost-effectiveness is not the only benefit of emissions trading. Trading of allowances also provides a more flexible mechanism for accommodating the addition of new sources of emissions than a command-and-control system does. New plants wishing to begin operations enter the allowance market as buyers in with existing plants. These newcomers will bid up the price of allowances to encourage existing plants to further reduce their emissions. This is because under any system with a fixed level of total emissions, newcomers can only obtain allowances from tighter controls on or retirements of existing plants. In contrast to arbitrary emissions allocations under a command-and-control system, a market for allowances encourages voluntary compliance with a tighter emissions standard and allows greater flexibility in making room for newcomers.
A market for allowances encourages voluntary compliance with a tighter emissions standard.
An additional advantage of an emissions trading system is the enhanced incentive to find more efficient methods of controlling emissions. Since emission allowances are valuable property rights, firms will be encouraged to search for and develop more cost-effective ways of reducing emissions in order to make allowances available for sale. Thus improvements in emissions control technology are expected by-products of emissions trading.
While a final clean air bill has yet to emerge from Congress, the broadest provisions of the SO2 trading proposal seem certain to become law. In order to reduce SO2 emissions by around 10 million tons annually, or to 50 percent of 1980 emissions levels, probably by the year 2001, existing electricity generation units (boilers) burning fossil fuel would be endowed with specified amounts of annual SO2 allowances consistent with the overall SO2 reduction goal. Emissions would have to be less than or equal to allowances held, and the Environmental Protection Agency (EPA) would levy heavy fines for emissions exceeding allowances. Excess allowances would be held for future use or traded among units of the same utility, to other electric utilities, or to new generators of electricity, which do not receive allowances. A portion of the initial allocation of emissions allowances would be set aside for purchase as a safety precaution should the market price of allowances rise too high.
Potential pitfalls
Whether the potential benefits of an SO2 trading program are realized depends on how the program is implemented in the special circumstances of the electric utility industry. Since the industry is subject to economic regulation by state and federal authorities—which control prices, the disposition of assets, and the earnings of shareholders, among other things—it is possible that the opportunities offered by emissions trading will not lead to the kind of responses from electric utilities that would otherwise be expected from profit-making firms. For example, the incentive to purchase allowances may be distorted by regulations governing the types of expenses for which plants earn or do not earn a rate of return. (Plants earn a return on the capital costs they incur but not on the fuel they use.) If the cost of emissions control equipment is added to the asset base on which a rate of return is earned, while the cost of allowances is treated as an operating expense, then plants will be encouraged to add control equipment even when the cost exceeds that of purchasing pollution allowances. Unless these costs are treated symmetrically, the demand for emission allowances may be smaller than that which is cost-effective.
On the supply side of the allowance market, the incentive to overcontrol emissions to generate surplus allowances for sale may be diluted by regulations that limit the property rights of utilities. If a plant has limited rights to hold allowances for future use (as when allowances expire if not used within a certain time), or if the revenues from the sale of allowances accrue entirely to ratepayers and are not shared with shareholders, then the supply of allowances in the market will likely be less than the cost-effective amount. Owners of plants with lower control costs would not be encouraged to reduce emissions as much as they otherwise would. For the same reasons, incentives to develop improvements in control technology would be weaker, and the cost of reducing emissions would not decline as swiftly over time, as they would in a well-functioning market.
Economic regulation of the industry could dilute incentives for electric utilities to buy and sell allowances.
If there is a reduction in the incentives to buy and sell allowances, there will be fewer trades, the price of allowances will be subject to greater volatility, and the market will be more susceptible to influence by the actions of individual buyers and sellers. Any emission control plan that places an upper limit on the total volume of allowances that would be available to all current and future sources arouses a concern that allowances would become increasingly scarce and expensive over time—that is, their price would rapidly increase, posing a barrier to the entry of new generation plants. Uncertainty about the price and availability of allowances could make it difficult for new generators to arrange financing, particularly for those plants being developed by independent generating companies that have no captive markets and that must compete with established utilities. Further, regulators expecting rapid allowance price increases would treat allowances as a scarce resource that would restrain electricity supply and future economic growth. Therefore they would attempt to block the sale of allowances by utilities under their jurisdiction.
It is possible that the market for allowances could be controlled by individual participants where trades were few. In particular, a utility may have an incentive to inflate the price of allowances when its shareholders can obtain capital gains. Ironically, granting the utility a property right in the allowances is necessary to make the market work efficiently, even though this property right provides an incentive to earn capital gains by withholding supply from the market.
Apart from any gains that may be earned from the sale of allowances, utilities have an unambiguous incentive to limit competition in their markets for electricity. The exercise of power in the allowance market could be aimed at reducing competition in power markets. This strategy would be difficult to implement, however, because of the broad areas in which trades might occur. A bias in favor of selling allowances to utilities rather than to independent power producers will not effectively limit competition since many utilities also own subsidiaries that compete in wholesale power markets.
A more subtle bias may work against independent power producers, however. Even within an active market, the time and expense of arranging a transaction in allowances is greater for new—and particularly for independent—generators that must compete with existing utilities in wholesale power markets. The latter enjoy the option of transferring emissions allowances from existing to new generating units. Utilities also might favor selling their excess allowances to their own subsidiaries over any other potential buyer since the earnings of subsidiaries are less regulated than those of the parent company. If this preference is exercised, independent generators would face a competitive disadvantage relative to utility-owned generators. In the worst case, this could derail the deregulation of the utility industry that has evolved over the last few years.
Emissions from electric utilities as far away as the Midwest cause acid rains that kill spruce trees in the Camel's Hump forest in Vermont
Making trading work
In spite of this impressive list of potential problems, there is reason to believe that emissions trading in the electric utility industry can deliver cost-effective SO2 emissions reduction. This optimism is based, in part, on the fact that the proposed SO2 trading law incorporates the essential features of a well-functioning tradable emissions permit system. By endowing polluters with tradable emissions allowances, such a system reduces political resistance to the SO2 cleanup through implied cost-sharing. In response to the major disadvantage of allowance endowment—that it creates too much uncertainty about the price and availability of allowances for new generators, particularly those that are not owned by a utility—the proposed law has set aside allowances for purchase, at either fixed price or auction, by new generators. Finally, by legislating the right to trade and bank allowances (subject to regulations set by the EPA), companies are granted maximum flexibility in how they meet the SO2 emissions limits.
Trading and banking of allowances would permit companies to have maximum flexibility in how they meet SO2 emissions limits.
A second reason for optimism about the success of emissions trading is a prediction that allowance prices will rise—if they rise at all—more slowly than the rate of interest. If this prediction is correct, it makes sense to sell allowances today even if they will be needed in the future for expansion of capacity. Allowances that are not immediately needed for compliance would be offered for sale as soon as possible, while prospective buyers of allowances would put off their purchases as long as possible in response to the declining real value of allowances. Under these conditions, new generators would not be overly concerned about being locked or priced out of the market, and even state regulators would find less reason to be concerned about the need to hold allowances for future economic growth. Consequently, this optimistic view of the future would lead to a more active market in allowances today.
Whether this optimistic view prevails will depend, in large part, on the availability of clean coal technologies that are economically competitive and on the willingness of utilities to aggressively adopt them. Newer technologies such as fluidized bed combustion and integrated coal gasification and combined cycle units, which permit the removal of 95 to 98 percent of the sulfur content of coal burned, may be economically superior to traditional pulverized coal technologies over a wide range of assumptions about input costs and operating performance. However, because they are newer, clean coal technologies offer less certainty about construction costs, operating costs, and operating performance than do traditional technologies. Thus the newer technologies will be adopted more rapidly if regulators allow a higher than normal return on investment in them, at least until a track record is established.
A third reason for optimism about the SO2 trading program comes from a recently completed analysis of state regulatory behavior conducted at Resources for the Future. According to RFF's findings, regulators can and will support the SO2 trading program if they are not forced to follow specific practices with regard to allowance transactions. Moreover, Congress, the EPA, and the Federal Energy Regulatory Commission (FERC) can take actions to encourage state regulators' voluntary compliance with the program. By providing clear language concerning the benefits of allowance trading and the steps required to develop efficient markets, they can help regulators to justify their decisions under the program and to reduce uncertainty within the electric industry about the nature of the property right being created and the rules for engaging in transaction. In particular, the language of legislative history and congressional and conference committee reports on SO2 trading can make it clear that allowances should be "bubbled" (traded between units owned by the same utility), banked, and leased without restrictions.
If the emissions trading market fails, flexibility in accommodating new emissions sources would be lost.
The FERC can play a key role in establishing precedent for the treatment of allowances by state regulators by giving blanket approval to interstate trades once compliance plans are filed and approved. This will encourage state regulators to do the same. Further, the FERC can establish accounting practices to clearly define the allowance property right, allow the sharing of capital gains, and permit the cost of allowances to enter the rate base. In doing so, the commission will have to take cognizance of the generally higher rate of return required for risky investments in both allowances and clean coal technologies.
The EPA can also establish and maintain a data reporting and dissemination program for conveying information about allowance trades to all interested parties. This information would improve the efficiency of the market and would reveal the value of allowances. The gains to ratepayers from creating and selling allowances will be clear to state administrators and state regulators, whose support is critical to the success of the program.
The prospects for a successful SO2 emissions trading program in the electric utility industry are good. However, even if emissions allowance trading does not work, the result will be the same environmental protection that would have been achieved using a command-and-control approach. If the allowance market fails, each individual state or utility system must internally achieve compliance with the emission standard as if there were no option of achieving offsets from outside the system or state. The cost of meeting the standard by existing emissions sources would be higher if trading fails, but no higher than that prevailing if a command-and-control approach were applied to individual systems or states at the start. In addition, while trades between utilities may be few if expectations are for rapidly rising prices, cost-reducing trades between plants owned by the same utility are quite likely, irrespective of the future course of allowance prices. Flexibility in accommodating new emissions sources would also be lost if the market fails, but again the problem would be no greater than that which would occur if a command-and-control system was used initially.
In implementing the SO2 trading program, the one danger that economic and environmental regulators must guard against—and the one that set-aside allowances for purchase by new generators addresses—is placing the emerging independent power segment of the industry at a disadvantage during the initial transition period when trading proves to be a success or a failure. Despite this danger, the downside risk of the emissions trading program is low, and the potential gain in lower environmental protection costs is large.
Alan J. Krupnick is a senior fellow and Dallas Burtraw a fellow in the Quality of the Environment Division at RFF. Douglas R. Bohi is the director and a senior fellow of the Energy and Natural Resources Division at RFF.
A version of this article appeared in print in the June 1990 issue of Resources magazine.
A version of this article appeared in print in the June 1990 issue of Resources magazine.
