The allowance trading program for sulfur-dioxide (SO2) emissions is a good example of a legislative initiative that is both an environmental and an economic success. As the centerpiece of Title IV of the 1990 amendments to the Clean Air Act, the allowance trading program is reducing annual emissions of SO2 by nearly 50 percent and is doing so for about one-half to one-third of the cost that would have been incurred using the approach taken throughout the first twenty years of federal air pollution control.
At the same time, however, the volume of trading between utilities of SO2 emission allowances is well below original expectations, with only about 2 to 3 million allowances traded in 1995, the first year of the program's first phase (one allowance equals one ton of SO2).
How is it that the program has generated tremendous cost savings with few allowances changing hands? The major reason is, in a word, flexibility.
The new flexibility
The success of the SO2 program comes as no surprise to many scholars. They predicted that the largest share of economic benefits from a trading program would come not from the trading of allowances per se, but from what economists call "dynamic efficiency"—innovation, competition, and discovery of new ways of compliance. Title IV freed electric power companies from the constraints of traditional regulations, which effectively spelled out exactly how a requirement was to be met, and instead gave the utilities the flexibility to figure out for them-selves how to achieve compliance.
Given the new flexibility, many firms have found ways to reduce the cost of controlling SO2 emissions that do not rely either directly or very heavily on the allowance trading program. For instance, some utilities have switched entirely to low-sulfur coal, whose price has fallen substantially over the last five years. Other power plants have begun blending coals with varying sulfur content in order to reduce average SO2 emissions, something thought impractical just a few years ago. Deregulation of the railroad industry has also led to a steep drop in the cost of shipping low-sulfur coal from west to east.
Many firms have found ways to reduce the cost of controlling SO2 emissions without relying directly on the allowance trading program.
The fact that few emission allowances have been traded may be seen as ironic as well as paradoxical, given the controversy that the program provoked at the time of its enactment. Many environmentalists opposed the program for authorizing (and implicitly endorsing) the sale of the right to pollute. But as groups such as the Environmental Defense Fund point out, traditional command-and-control regulations had been giving away the right to pollute for free. Federal air pollution regulations, for example, have allowed SO2 emissions from electric utilities to grow along with increased production and as new plants are built.
Under the Title IV amendments, however, the utilities face the first cap ever on SO2 emissions. In Phase I of the program (1995–2000) the nation's 110 dirtiest coal-fired electric power plants are required to reduce SO2 emissions averaged across these facilities to about 2.5 pounds per million British thermal units (mmBTUs) of electricity generated. In a quid pro quo for the cap, the facilities receive annual allowances for emissions, which they can transfer to other plants within their own systems, sell to other utilities, or save for later use. In the absence of robust inter-utility trading, the program's cap on emissions operates like a performance standard applied to individual utilities.
Few trades, low prices
Just as the volume of trading is lower than what was expected at the time the Title IV program was enacted, so are the prices of allowances. As the table on page 4 indicates, before passage of the Clean Air Act amendments in 1990 estimates of marginal emission abatement costs were as high as $1,500 per ton, which is the figure stipulated in the act for direct allowance sales by the U.S. Environmental Protection Agency (EPA). In debates surrounding the 1990 amendments, EPA cited estimates of marginal abatement costs about half as high, which became the bases for estimates of allowance prices. After passage of the amendments, estimates plummeted still further. In early 1995, the price of allowances traded privately was about $170 per ton and fell to the low $100s by year end. The marginal price of 1995 allowances in the EPA auction administered by the Chicago Board of Trade (CBOT) ranged from $122 to $140 per ton.
The fall in prices was a product of low demand relative to supply. But the new flexibility that the utilities are enjoying under Title IV and the array of low-cost compliance options they have to choose from are not the only reasons the market is not more active. In trying to explain the low prices, the role that state public utility commissions (PUCs) play has to be considered.
Many of the rules that states have imposed on the utilities potentially inhibit allowance trading. Depending on what the rules say, allowances may look less attractive than other available cost-cutting strategies. What the rules say, for example, about the recovery costs of investments (such as the allowed rate of return, the depreciation rate, and the risk that expenses might not be passed on to ratepayers) often differs across compliance strategies and sometimes is designed to create preferences for one strategy over another.
Furthermore, what the rules say is not always enough to go on. Neither the Federal Energy Regulatory Commission nor the PUCs has provided adequate guidance about cost recovery rules yet. Uncertainty about what shape these regulations will take has contributed to the cautious reception allowance trading is receiving.
A related problem is explicit prohibition by legislatures on trades that might undermine local economic activity. Nearly every state with substantial Phase I compliance obligations has enacted rules or incentives to promote the use of local coal, for instance, by offering pre-approval for cost recovery of investments in scrubbers.
Marginal cost estimates and realizations for compliance options (dollars per ton).
Not a perfect program
In trying to understand the program's few trades and low prices, many analysts also have criticized EPA's annual auction of 2.8 percent of allowances, which began in 1993 to jump-start the market. As set out in the statute, the auction is a discriminating-price, sealed-bid one that provides bidders and sellers with strategic incentives to underbid their reservation prices. Critics say it is a poorly designed mechanism that generates prices below those emerging from trades between utilities.
Low allowance prices are best explained by the changing market fundamentals in coal and scrubber markets, rail transportation of coal, and equipment suppliers.
Still another reason for low prices is the extra 3.5 million allowances introduced in Phase I. The purpose of this provision in the 1990 amendments was to subsidize utilities that install scrubbers and thus cushion the blow to states producing high-sulfur coal. The effect has been to encourage scrubbing even if it is not really the least-cost option, as well as to increase the supply of allowances and depress the price.
The most important explanation for low allowance prices, however, has to do with changing market fundamentals in coal markets, rail transportation of coal, and equipment suppliers. In particular, falling prices in the coal and scrubber markets have had a profound effect on how the industry has complied with the SO2 emissions cap in Phase I of the program. In 1990 many analysts projected average prices for low-sulfur central Appalachian coal to reach $40 per ton by 1995, but last year the price was less than $25. According to the U.S. Government Accounting Office (GAO), scrubber prices fell by nearly half over this same period.
One explanation for this turn of events is the unanticipated degree to which markets have been drawn into direct competition. The result is a decline in prices below those forecast in every potential option for compliance.
Compliance options of choice
Using the freedom that Title IV gave them, electric utilities have met their clean air requirements in innovative ways. The process of fuel switching to and fuel blending with low-sulfur coal is the most widely used compliance option. The low cost of this strategy is one reason; that it is relatively noncapital-intensive in a period of general change in the industry is another.
Like fuel switching, fuel blending has lower capital costs associated with it than scrubbing. Experimentation prompted by Title IV has led to an improved understanding of the ability to blend coals with varying levels of sulfur contents. Detrimental effects of incompatible blending on plant equipment designed to operate using a particular type of coal are fewer than originally supposed.
Many observers of the development of the 1990 amendments foresaw bottlenecks in rail transport that would preclude western coal from playing a big role in the compliance plans of eastern utilities. Thus, forecasts hinged on prices for low-sulfur Appalachian coal locally available to eastern utilities. But these bottlenecks have failed to materialize.
One reason rail has responded so enthusiastically to the potential new markets for low-sulfur coal created by Title IV is that rail itself was deregulated under the Staggers Act of 1980. Lines moving low-sulfur coal out of the Powder River Basin in northeast Wyoming and southeast Montana are now the busiest in the world. Indeed the experience of the deregulated railroads may foreshadow the experience to come of utilities subject to the Clean Air Act, which follows a pattern of regulatory reform that has also touched telephones, airlines, and natural gas over the last two decades.
Title IV has also inspired a reduction in costs within the scrubber industry to stay competitive. For the first time, an incentive exists to improve the efficiency of scrubbers, since each ton of SO2 saved is one allowance earned. New scrubbers exhibit increased efficiency and reliability. Improvements in scrubber design and use of materials have reduced maintenance costs and increased utilization rates.
Title IV "star" is still in the wings
Inter-utility allowance trading—the aspect of the Title IV program that observers anticipated would be the leading star—thus far has been the option least commonly used. Illinois Power is the only utility to rely heavily on allowances for Phase I compliance. Only Carolina Power and Light and Georgia Power seem likely to do so in Phase II.
Even in the absence of extensive trading, however, allowances are proving useful. For example, utilities are saving millions by not having to purchase spare scrubber modules for use during maintenance periods and outages; they are relying on allowances instead. Similarly, utilities are able to delay capital investments in scrubbers by relying on allowances. This is particularly useful at a time when many utilities are reluctant to make new investments until more is known about the direction that the regulation of the electricity industry is likely to take.
In the face of uncertainty surrounding compliance strategies, performance standards alone may be inadequate to stimulate innovation because utilities may be unwilling to experiment if failure has a high cost. The allowance offers a convenient value as insurance, even if it is not a primary compliance strategy in itself.
What the future holds
One question looms: will de facto performance standards that exist in the absence of active allowance trading remain sufficient to keep down the costs of controlling emissions? This uncertainty becomes especially pertinent with regard to Phase II of the Title IV program, which will take effect in 2000 and apply to all fossil fuel power plants greater than 25 megawatts in size. To add to the challenge in Phase II, utilities also will have to cut the total amount of averaged emissions to 1.2 pounds of SO2 per mmBTUs.
Right now, the availability of low-priced, low-sulfur coal has allowed most utilities to comply with Phase I of Title IV relatively cost-effectively. Even without institutional obstacles to allowance trading, robust trading would not be expected when this low-cost option is commonly available. Obstacles to a more liquid allowance market are not too important in the short term. But that may change.
Whether low-sulfur coal will continue to provide a commonly available low-cost compliance strategy may be the crux issue. Current estimates show costs increasing over time as the result of an expected depletion of Appalachian low-sulfur coal and of allowances banked during Phase I.
If the supply does in fact dwindle, some utilities will turn to other options, such as the installation of scrubbers. Such a move will likely result in significant differences in marginal costs across companies. It is then that utilities may take a second giant step by moving beyond performance-based standards to broad-scale trading of emission allowances among themselves.
For that reason, flaws in how trading is currently implemented in Title IV and the obstacles to it created by state regulators should be addressed before Phase II is under way. Unless corrected, inadequate and parochial regulations that stymie allowance trading will grow in importance, and Title IV may be much less successful than it has been to date.
Will allowance trading ever become the star that its fans expected it would become when the 1990 amendments to the Clean Air Act were being drafted? Projected annual costs using alternative compliance options indicate that significant cost savings may continue to accrue mainly from the flexibility afforded by Title IV. But that doesn't rule out the possibility of an active trading program waiting in the wings. If utility regulators decide to improve the prospects for a more liquid allowance trading market, the savings will be all the more dramatic.
SO2 Program Saves Billions—and Could Save a Billion More
Dallas Burtraw is a fellow in the Quality of the Environment Division at Resources for the Future. This article is based on his RFF discussion paper 95-30, "Cost Savings Sans Allowance Trades? Evaluating the SO2 Emission Trading Program to Date," which will appear in a forthcoming issue of Contemporary Economic Policy.
A version of this article appeared in print in the January 1996 issue of Resources magazine.
A version of this article appeared in print in the January 1996 issue of Resources magazine.
