Friday, August 31, 2012

The SO2 Allowance Trading System: The Ironic History of a Grand Policy Experiment

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.
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.
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.
In the 1980s, President Ronald Reagan’s Environmental Protection Agency put in place a trading program to phase out leaded gasoline. It produced a more rapid elimination of leaded gasoline from the marketplace than had been anticipated, and at a savings of some $250 million per year, compared with a conventional no-trade, command-and-control approach (Stavins 2003). Not only did President George H. W. Bush successfully propose the use of cap-and-trade to cut U.S. SO2 emissions, his administration advocated in international fora the use of emissions trading to cut global CO2 emissions, a proposal initially resisted but ultimately adopted by the European Union. In 2005, President George W. Bush’s EPA issued the Clean Air Interstate Rule, aimed at reducing SO2 emissions by a further 70 percent from their 2003 levels. Cap-and-trade was again the policy instrument of choice in order to keep costs down and achieve rapid reductions at minimum economic pain. (This rule was later invalidated by the courts)
A major source of uncertainty about any government-created market is that the government can undo what it created — possibly unintentionally. In essence, this is what has happened in the SO2 allowance market. Prices for SO2 allowances were remarkably stable throughout the program’s first decade (Figure 1). But in 2004, prices began to rise, ultimately topping $1,200/ton in 2005. Why did this happen? It was widely recognized by the late 1990s that SO2 reductions in excess of those resulting from the trading program of Title IV would be required by other provisions in the Clean Air Act and would in any event be warranted, given the significant adverse health effects of fine particulates associated with SO2 emissions.

But Title IV did not give EPA authority to adjust the program, such as by tightening the overall cap, in response to new information about the benefits (or costs) of emissions reductions. This led to a chain of events that ultimately brought about the virtual collapse of the SO2 allowance trading program.
In early 2002, President George W. Bush proposed the Clear Skies Act, which would have greatly tightened the SO2 cap. The lack of an initial allowance market reaction suggests it was no surprise when this proposal died in March 2005, having failed to move out of committee. The Administration then promulgated its Clean Air Interstate Rule (CAIR) in May, 2005, with the same purpose of lowering the cap on SO2 emissions (to 70 percent below the 2003 emissions level). CAIR did this in part by applying more stringent emission requirements on states that were contributing to violations of EPA’s primary ambient air quality standards for fine particulates in the eastern United States (Palmer and Evans 2009).

It required sources within those states to surrender two additional allowances for every ton of SO2 emissions, effectively reducing the cap by two-thirds. Because CAIR provided that firms could bank their SO2 allowances for use in the new program, prices rose further in anticipation of CAIR’s more stringent cap, with spot prices increasing from $273 per ton in EPA’s 2004 auction to $703 in the 2005 auction
After peaking in 2005 at more than $1,200 per ton, SO2 allowance prices dropped just as fast as they had risen, aided by EPA’s announcement that it would re-examine CAIR (Samuelsohn 2005) and speculation about impending legal challenges (Samuelsohn 2006a; Kruse 2009). The speculation was proven to be correct on June 26, 2006, when North Carolina and other states and a number of utilities sued EPA over CAIR (Samuelsohn 2006b). The states argued that the interstate trading allowed under CAIR was inconsistent with a provision in the Clean Air Act that obliges each state to prevent emissions that interfere with any other state’s attainment or maintenance of air quality standards.
Two years later, on July 11, 2008, the Circuit Court of Appeals for the District of Columbia responded to the lawsuit by vacating CAIR in its entirety, and thereby invalidating the core of prior SO2 regulation, the cap-and-trade system with unlimited trading across states, by asserting that under the Clean Air Act EPA did not have authority to ignore the relationship between sources and receptors (U.S. Environmental Protection Agency 2011a). On that single day, the SO2 allowance price fell from $315 to $115 (Figure 1) (Burtraw and Szambelan 2009). The Bush administration – and the subsequent Obama administration – chose not to appeal that ruling. In December, the court allowed CAIR to remain in effect while EPA devised a replacement that addressed its concerns, but it remained clear that unlimited interstate trading was doomed. Expectations of a more stringent SO2 cap, which had fueled the run-up in allowance prices, became less defensible, and prices continued to fall, returning to the range of their pre-2004 levels. At EPA’s 2009 auction, spot allowances (which could be used in 2009 or later) sold for $70 per ton, compared with $390 a year earlier (Burtraw and Szambelan 2009).
The shift from CAIR to CSAPR was the death-knell for the SO2 allowance trading program, though the program remains nominally in place, since it dramatically reduced the scope for cost-effective interstate trades. The SO2 market collapsed, with allowance prices falling to record low levels. By the time of EPA’s 2012 auction, market-clearing prices had fallen to $0.56 in the spot auction and $0.12 in the seven-year advance auction.

The full report is available free of charge at

by Richard Schmalensee and Robert N. Stavins
Resources For the Future (RFF)
RFF Discussion Paper 12-44; August, 2012

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