Regulatory Reform in Air-Pollution Control

As anyone who has tried it knows, regulatory reform concepts that appear disarmingly simple in theory turn out to be distressingly complex when they are applied. Regulations that, from a distance, seem inherently insupportable are discovered, upon closer inspection, to have significant support among special interest groups. Since the status quo engenders so much inertia, many promising ideas languish by the wayside.

In some ways, the emissions-trading program—the Environmental Protection Agency's (EPA's) new approach to air pollution control—seems an unlikely candidate for survival. Significant pockets of opposition to the use of economic incentive approaches such as this one exist within Congress, as well as within the EPA itself. Nonetheless, the emissions-trading program has become a new wave in environmental policy.

Why has the emissions-trading program survived its critics? And what price has been paid to achieve this survival? With these questions in mind, I spent my 1983-84 sabbatical year looking at the manner in which the theoretical concept had been translated into practice. My objective was not only to gain some understanding of the process of regulatory reform as it was applied in this case, but also to provide some foundation for the further evolution emissions trading.

The nature of the reform

The 1970 amendments to the Clean Air Act established an approach to controlling pollution from stationary sources that has become known as the "command-and-control approach." Stripped to its bare essentials, it involves the specification of a separate emission standard (that is, a legal emission ceiling) for each major pollution discharge point, such as a stack, a vent, or a production process. The enormity of the regulator's task in defining these standards becomes clear when one realizes that the typical industrial facility contains many such discharge points, with some facilities having more than one hundred.

The emissions-trading program attempts to make this approach more flexible by allowing polluters more options in meeting their assigned control responsibilities. The general thrust of the program is to allow polluters to seek alternative, cheaper means of reducing emissions so long as the substitute has an equivalent, or better, effect on air quality.

Specifically, any source reducing its emissions further at any discharge point than that required by law may apply to have this excess reduction certified as an emission reduction credit. Once certified, the credit may be applied to other discharge points or may be sold to other sources. The conditions under which these credits can be created, stored, transferred, and used are defined by the bubble, offset, banking, and netting components of the emissions-trading program, as described below.

The bubble policy

Despite the fact that studies indicated that the potential cost savings from implementing emissions trading were huge, the program got off to an inauspicious start. Following some five years of industry pressure, the EPA published its first application of emissions trading, called the "bubble policy," in December 1975. Under this policy, an entire plant would be regarded as if it were within a giant bubble, with only the total amount of emissions leaving the bubble being subject to regulation. Its thrust was to excuse existing plants undergoing expansion or modification from meeting the tough new-source performance standards so long as any resulting emission increases would be offset by decreases elsewhere in the plant. In current parlance, this approach afforded regulatory "relief' rather than regulatory "reform." The specifics of this approach were ruled unacceptable by the courts as being inconsistent with the intent of Congress when it passed the Clean Air Act, though the principles of emissions trading emerged unscathed.

The offset policy

A second attempt to introduce emissions trading, which concentrated on regulatory reform rather than relief, was more successful. By 1976, it had become clear that a number of regions would fail to attain the ambient air quality standards by the deadlines mandated in the Clean Air Act. Thus the EPA was faced with the unpleasant prospect of prohibiting any new sources from entering these regions. As an alternative to out-and-out prohibition, the EPA established an "offset policy," which enables new sources to enter such regions provided that they meet strict emission standards and acquire sufficient offsetting reductions from other facilities so that total regional emissions will be lower after their entry than before. In essence, this program provides a way to improve air quality by reducing emissions at existing sources, but it does so by forcing new sources to find and finance the offsetting reductions.

With the advent of the offset policy, emissions trading had established a precarious foothold in air pollution policy, but at a high price. Although the EPA has achieved its objective of allowing new sources to enter nonattainment areas, it has become very expensive for the sources to commence operations. By shifting all of the financial burden to new sources, existing sources (and existing jobs) are protected—but at the detriment of modernization and technological progress in industrial production that otherwise would have been possible. Compared to an approach that forces new and existing sources to bear a more equitable share of the financial burden of pollution control, the offset policy gives existing sources in nonattainment areas a significant competitive edge over their potential new rivals by perpetuating the traditional regulatory bias against new sources.

The 1977 Amendments

When writing the 1977 Amendments to the Clean Air Act, Congress provided legislative authorization for the offset program. To this day the offset program remains the only component of the program specifically authorized by statute; the others are purely bureaucratic creations, resting solely on general principles articulated in the act. As such, they remain especially vulnerable to hostile judicial interpretation.

Emissions banking

The next component of the emissions trading program—banking—was added in 1979 as the EPA issued new regulations designed to bring the interim offset program into conformance with the 1977 Amendments. Emissions banking allows sources of emission-reduction credits to store those credits for subsequent sale or use. Prior to the 1979 regulations, banking had been disallowed on the grounds that it was incompatible with the EPA's statutory responsibility to assure that nonattainment areas achieved the ambient standards as rapidly as possible. Confiscation and retirement of emission reduction credits not immediately used had been seen as a rapid means of improving air quality. Since the 1977 Amendments and the associated implementing regulations provided specific procedures for attaining the standards by the new statutory deadlines that were compatible with emissions banking, these objections were overcome.

Potentially, this was an important boost to the program, since in the absence of banking, the incentives for controlling emissions beyond the minimum legal requirements are diminished substantially. Without banking, excess control is valuable to its source only if another source simultaneously needs an offsetting reduction. One can easily imagine what would happen in more traditional markets, such as furniture, if the product were confiscated by the state whenever a buyer could not be found soon after the product was finished. Less furniture soon would be available. The same principle holds for emission-reduction credits. The polluter has absolutely no incentive to undertake additional control voluntarily unless be retains an exclusive and transferable property right over the emission-reduction credit until it can be used or sold.

Successful banking programs do exist, as is illustrated by the bank established in Louisville, Kentucky. By May 1984, this bank had some fifteen deposits of emission-reduction credits for total suspended particulates, sulfur dioxide, volatile organic compounds, nitrogen dioxide, and carbon monoxide. This program clearly has been successful in stimulating additional reductions and in facilitating the search for lower-cost means of controlling pollution.

The revised bubble policy

Whereas the establishment of the offset program had been a response to a specific, passionately felt political need to remove the prohibition on growth in nonattainment areas, during the late 1970s, interest in expanding the application of the emissions' trading concept grew. Since the 1975 attempt at a bubble policy had been overruled by the courts, the EPA had to proceed cautiously. In view of its need to build a constituency while protecting its flanks from judicial attack, the agency initially proposed heavily circumscribed programs designed to assuage fears and to move slowly. By taking this approach, the EPA sought to assure that the first trades would demonstrate clear, unambiguous benefits and set a useful precedent. At the same time, the number of possible trades would be intentionally limited, giving the states time to adjust to a new program before they were overwhelmed by a flood of applications.

The reincarnated bubble policy allowed able, existing sources some flexibility in attuning their assigned control responsibilities. Whereas the original bubble policy sought to limit the applicability of rule regulations, this policy focused on making compliance easier. Instead of forcing each source to produce the stimulated emission reductions at each and every discharge point (as would be required by strict adherence to the previous command-and-control policy), the bubble policy allows each source to choose its own mix of emission reductions so long as the the air-quality effects remain equivalent.

The relatively slow pace of trading following these initiatives convinced the EPA that the substantive reforms would have to be accompanied by procedural reforms if the program were to live up to its potential. Originally, the bubble policy could be used only if the approving state included the intended trade in a formal revision to its state implementation plan (SIP). Because the SIP approval process is the primary means by which the EPA exercises its responsibility for assuring state compliance with the Clean Air Act, SIP revisions are bureaucratically cumbersome. For example, when the Reagan Administration took office in 1981, a backlog of 643 proposed changes in SIPs awaited the EPA's approval. Because any SIP revision has to fulfill a large number of procedural requirements, state control authorities are reluctant to file revisions unless they are absolutely necessary. Requiring bubble trades to be approved through SIP revisions proved a surefire way to limit the state control authority's interest in the program.

In 1981, the EPA significantly lessened this burden by approving the generic rules that the states intended to use to govern trades. So long as subsequent trades conformed to these rules, no SIP revision was required for each trade. For the first time, the state control authorities were able to see the bubble policy as something other an a procedural nightmare.

Resurrecting regulatory relief

The design and fate of the netting program—the final component of the emissions trading package—provides an interesting example of what happens when the irresistible force associated with a bureaucracy committed to regulatory flexibility runs into the immovable object represented by rigid statutes. Both the offset and revised bubble policies are regulatory reform measures in that they offer flexible ways to comply with the statutes. However, not all areas of pollution policy allow this flexibility. In particular (as the treatment of the first bubble policy by the courts indicates), the statutory language permits little opportunity for expanding or modifying sources to use emissions trading in complying with the new-source performance standards; such sources have to achieve the stipulated reductions at each discharge point. It remained an open question, however, as to whether emissions trading could be used to limit the applicability of the new-source review process, an additional layer of regulatory control imposed by the 1977 Amendments. By providing a means of gaining relief from this additional regulatory burden without relieving the source of the obligation to meet the new-source performance standards, the EPA attempted to open a new channel for emissions trading while respecting the previous court decision.

The netting program

Netting allows modifying or expanding sources to escape the burden of new-source review requirements so long as any net increase (counting the emission-reduction credits) in plantwide emissions is insignificant. By "netting out" of review, the facility may be exempt from the need to acquire pre-construction permits as well as from meeting the associated requirements, such as modeling or monitoring the new source's impact on air quality, procuring offsets, and meeting the most stringent emission standards. It is not exempt from any applicable new-source performance standards.

While this program could have exempted a large number of modified sources from review, it was successfully challenged in court by the Natural Resources Defense Council. Ruling that exemption of modified sources from review in areas with air quality worse than the standards was inconsistent with the statutory intent to reach attainment as expeditiously as possible, the appeals court voided the netting rules as they applied to sources in those areas. By constantly referring to netting as the "bubble policy," the court cast a cloud over the application of the bubble policy as well as over the application of netting. The U.S. Supreme Court reversed this ruling, but not before a lengthy period had passed, during which the use of netting and the bubble policy was suspended as states awaited the outcome of judicial review.

An appraisal

There is little doubt that emissions trading has improved upon the command-and-control policy that preceded it. The EPA estimates that more than 2,500 emission trades have taken place since the program's inception. The frequency and significance of these trades has triggered a new set of private support institutions. For example, in 1984 a new brokerage house was established solely for the purpose of facilitating emission-reduction credit transactions.

Many of these transactions have facilitated the modernization and expansion of existing plants as well as the construction of new ones in areas of the country not meeting ambient air-quality standards. Each of these trades represents an affirmation of the basic premise of emissions trading—allowing sources to trade emission-reduction credits reduces the cost of complying with the law.

One of the substantial benefits of this lower compliance cost has been an increase in the number of firms complying with the terms of their permits. It no longer pays for non complying sources to engage in expensive litigation to avoid compliance. In many instances, the bubble policy was the means by which previously non complying sources were brought into compliance for the first time. In two cases the actions taken under the bubble policy contributed to the state authorities' ability to demonstrate that the ambient standards in the affected nonattainment areas would be achieved.

The enduring role that the EPA emissions trading program is playing is directly attributable to the fact that it was preceded by a very cost-effective regulatory policy. Not only did this create a demand for approaches that offered to reduce costs, but also it provided a ready-made baseline for the trades, smoothing the transition to emissions trading. Had the command-and-control policy been more cost-effective, it is doubtful that the emissions trading policy could have gained the foothold it has.

Paradoxically, the ability to overlay this program on an existing but cost-ineffective policy was a key to its political success, but it also has diminished the effectiveness of the program in several specific ways:

• In response to command-and-control regulation, a great deal of capital equipment already had been installed prior to the inception of the emissions trading program. Since much of this installed durable capital was cost-ineffective and its owners were unable to benefit from the emissions-trading program, this has reduced the savings achievable by the program from what would have been possible if the program had started with a clean slate.
• A particularly unfortunate side effect of overlaying emissions trading on a preexisting command-and-control allocation also arose when some sources complied rather rapidly and others proved more recalcitrant. Because the emissions-trading option appeared late in the game, sources that immediately complied with the command-and-control regulations were precluded from using the emissions-trading program to their greatest advantage, while those who were able to fend off the earlier expensive standards could, with the advent of emissions trading, reach compliance at a substantially lower cost. In this way the introduction of an emissions-trading program rewarded slow compliance, which strikes many potential supporters as patently unfair.
• The bias against new sources that characterized the command-and-control policy has persisted, albeit to a lesser degree, in the emissions-trading program. Not only are new or expanding sources required to buy emission-reduction credits to offset any emission increases that remain after the installation of required controls, but new sources typically must meet the prescribed emission standards by installing the control equipment necessary to meet the mandated reductions at each discharge point. In contrast, existing sources are not required to acquire credits to offset their remaining emissions, and they can use emission reduction credits to meet their statutory responsibilities rather than producing the mandated emission reduction at every discharge point. This bias effectively delays the replacement of older, heavier-polluting facilities with newer, less-polluting facilities.
• The notion that firms might have a property right in surplus emission reductions was not a part of the command-and-control system and has been hard for some control authorities to swallow. In some jurisdictions confiscation of certified credits is a distinct possibility, destroying much of the incentive to create additional emission reductions.

These flaws must be kept in perspective. Although a definite price has been paid for survival, it is not so large as to overshadow the very positive accomplishments of the program. The emissions-trading program loses its utopian luster upon closer inspection, but it nonetheless has made a lasting contribution to environmental policy. The realms of the possible and of the desirable rarely overlap completely; it is comforting to know that the overlap is not inconsequential.