Abstract:
Two decades have passed since the Clean Air Act Amendments of 1990 launched a grand experiment in market-based environmental policy: the SO2 cap-and-trade system. That system performed well but created four striking ironies. First, by creating this system to reduce SO2 emissions to curb acid rain, the government did the right thing for the wrong reason. Second, a substantial source of this system’s cost-effectiveness was an unanticipated consequence of earlier railroad deregulation. Third, it is ironic that cap-and-trade has come to be demonized by conservative politicians in recent years, since this market-based, cost-effective policy innovation was initially championed and implemented by Republican administrations. Fourth, court decisions and subsequent regulatory responses have led to the collapse of the SO2 market, demonstrating that what the government gives, the government can take away.
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Two decades have passed since the Clean Air Act Amendments of 1990 launched a grand experiment in market-based environmental policy: the SO2 cap-and-trade system. That system performed well but created four striking ironies. First, by creating this system to reduce SO2 emissions to curb acid rain, the government did the right thing for the wrong reason. Second, a substantial source of this system’s cost-effectiveness was an unanticipated consequence of earlier railroad deregulation. Third, it is ironic that cap-and-trade has come to be demonized by conservative politicians in recent years, since this market-based, cost-effective policy innovation was initially championed and implemented by Republican administrations. Fourth, court decisions and subsequent regulatory responses have led to the collapse of the SO2 market, demonstrating that what the government gives, the government can take away.
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Beginning in 1995 and over the subsequent decade, the SO2 allowance-trading program performed exceptionally well along all relevant dimensions. (Early assessments of the system’s design and performance were provided by Schmalensee et al 1998 and Stavins 1998.) The program was environmentally effective, with SO2 emissions from electric power plants decreasing 36 percent – from 15.9 million to 10.2 million tons – between 1990 and 2004 (U.S. Environmental Protection Agency 2011b), even though electricity generation from coal-fired power plants increased 25 percent over the same period (U.S. Energy Information Administration 2011). The program’s long-term goal of reducing annual nationwide utility emissions to 8.95 million tons was achieved in 2007, and by 2010 emissions had declined further, to 5.1 million tons. Overall, the program delivered emissions reductions more quickly than expected, as utilities took advantage of the possibility of banking allowances. With its $2,000/ton statutory fine for any emissions exceeding allowance holdings (and continuous emissions monitoring), compliance was nearly 100 percent.
The costs of achieving these environmental objectives with cap-and-trade were significantly less than they would have been with a command-and-control regulatory approach. Cost savings were at least 15 percent and perhaps as much as 90 percent, compared with counterfactual policies that specified the means of regulation in various ways and for various portions of the program’s regulatory period (Carlson et al. 2000; Ellerman et al. 2000; Keohane 2003). In addition to static cost effectiveness, there is evidence that the program brought down abatement costs over time by providing incentives for innovation in equipment and operating procedures that are generally much stronger than those provided by traditional command-and-control regulation (Ellerman et al 2000, pp. 235-48; Popp 2003; Bellas and Lange 2011).
While the program was less costly than a conventional approach, the costs may not have been as low as they could have been. Marginal abatement costs varied significantly across facilities, at least in the program’s first two years (Carlson et al. 2000). On the other hand, there is evidence that the intertemporal allocation of abatement cost (via allowance banking) was at least approximately efficient (Ellerman and Montero 2007), and the pattern of voluntary compliance was consistent with cost-effective compliance strategies (Montero 1999).
The following factors may have kept costs above the theoretical minimum, though the influence of each has been debated: (1) provisions in the CAAA that encouraged early use of flue-gas desulfurization (using devices called “scrubbers”) instead of switching to low-sulfur coal – in an effort to limit impacts on high-sulfur coal producers (Ellerman et al 2000, pp. 301-2); (2) lack of information about marginal abatement costs on the part of market participants, particularly in the early years; (3) state regulation that, particularly in the early years of the program, had the effect of distorting or constraining utilities’ responses to federal environmental regulation (Arimura 2002; Bohi and Burtraw 1992; Ellerman et al 2000, pp. 190-5); (4) interactions between the SO2 program and other federal regulations, such as New Source Review and New Source Performance Standards, which constrained the program’s operation; and (5) policy uncertainty when regulators and policy makers subsequently considered further reductions in the national SO2 cap.
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Whereas some studies at the time of the program’s enactment predicted that its benefits would be approximately equal to its costs (Portney 1990), more recent estimates have pegged annual benefits at between $59 and $116 billion, compared with annual costs of $0.5 to 2 billion. More than 95 percent of these benefits are associated not with ecological impacts (including acidification of aquatic ecosystems), however, but with human health impacts of reduced levels of airborne fine sulfate particles less than 2.5 micrometers in diameter (PM2.5) derived from SO2 emissions. Epidemiological evidence of the harmful human health effects of these fine particulates mounted rapidly in the decade after the CAAA was enacted (Chestnut and Mills 2005).
Estimates of these health benefits vary widely, but they appear to be on the order of $50 billion to more than $100 billion per year (Burtraw et al. 1998; Burtraw 1999; Chestnut and Mills 2005; National Acid Precipitation Assessment Program 2005; Shadbegian, Gray, and Morgan 2005; U.S. Environmental Protection Agency 2011a). As Table 1 shows, strict ecosystem benefits are probably considerably less than program costs, though at least one study (Banzhaf et al 2006) suggests that ecosystem benefits alone have exceeded program costs. In any case, estimated human health benefits of the program have exceeded annual costs by a factor of more than fifty! The government did what turned out to be the right thing for the wrong reason.