The Pitfalls of Pollution Allowance Trading

Although Congress killed the Obama administration’s plans for a cap-and-trade program for controlling power plant emissions of carbon dioxide, many advocates of that policy approach, including some important electric utility companies, continue to push for allowance trading. The argument is that trading mechanisms are more efficient than conventional command-and-control. But a new policy analysis from the environmental think tank Resources for the Future (RFF) highlights the problems cap-and-trade programs have faced in regulating emissions of sulfur dioxide and oxides of nitrogen. According to the analysis, changes in just one program—the sulfur dioxide rules—have wiped out some $3 billion in the value of utility-held emissions allowances.

Through a complex interaction of changing administrative rules, court decisions, and economic behavior on the part of regulated utilities, cap-and-trade programs, says the RFF analysis—"Banking on Allowances: The EPA’s Mixed Record in Managing Emissions Market Transitions" —cap-and-trade programs have suffered from declining credibility and market support. Say Arthur Fraas and Nathan Richardson, "After the basic rules for an emissions-trading program are in place, changes by regulators in the rules governing the use of allowances can significantly affect the certainty and credibility of the emissions-trading programs and the value of allowances. Such changes may lead to undesirable market behavior, including an emissions increase as sources use up or dump their banked allowances."

Banking is a key component of emissions trading schemes that introduces uncertainty and doubt into their operation. The prototype trading programs for SO2 and NOx have all allowed utilities to bank excess pollution reductions, giving the allowance owners flexibility in timing and financing their reductions. But all of the programs changed substantially as time passed—particularly as the Environmental Protection Agency (EPA) has sought to tighten caps over the years. And that raises vexing questions about how to handle allowances banked by utilities as savings accounts for future reduction costs.

"Because emissions allowances convey certain rights," says the RFF discussion paper, "it is important that emissions-trading programs maintain clear and consistent rules of the use of allowances in order to limit uncertainty and assure a smoothly functioning market." But that has not been the case, as the EPA and the courts have implemented emissions trading under the 1990 Clean Air Act amendments and the alphabet soup of programs the agency has created over the years to implement the law. The rules pursuant to the Ozone Transport Commission, the Ozone Transport Assessment Group, the SO2 trading titles, and the Bush administration’s stillborn Clean Air Interstate Rule (CAIR, struck down by the courts) have all impacted banked allowances in varying ways.

Pushed by internal and external policy and political dynamics, the EPA has repeatedly ratcheted down emissions targets, or caps. "This creates a fundamental tension between the rights and value associated with banked allowances and the environmental goal of reduced emissions," says the RFF discussion. "If banked allowances are used in the new, stricter program, emissions will be greater than desired in the short term until those banked allowances are drawn down. If the new caps are substantially stricter than the old ones, this delay before the new caps ‘bite’ will be perceived as problematic and will create pressure to reduce or eliminate these ‘excess’ allowances."

"Striking the right balance" between the need for greater reductions and the value of banked allowances "is not easy," says the RFF paper, "and the EPA has faced this issue through all the transitions between markets" discussed in the analysis. "Though the problems have been consistent, the EPA’s response has not." The agency’s inconsistent and sometimes incoherent approach has produced "market distortions—in the form of very high or very low allowance prices and price volatility."

The damage to cost-effective reductions can be significant, says the analysis. "If EPA’s handing of transitions in the NOx and SO2 markets leads to uncertainty for regulated entities about the credibility of allowance banking, these actions will adversely affect market behavior in the future, reducing the effectiveness and cost savings of market-based programs." In the policy tug-of-war over new emissions reductions, environmental groups and their allies have pushed to eliminate the use of banked allowances, while business interests have argued for preservation of the value of the emissions.

Part of the problem is that the government has specifically avoided treating banked allowances as property; however, doing so might clarify the disputes considerably. Property is a well-understood element of the U.S. economic and legal system, with a fairly well-understood set of definitions, rights, and obligations. Both Congress and the EPA have insisted through the law and implementing regulations that an allowance "does not constitute a property right." The RFF paper says the best way to understand the emissions allowances is to see them as "carrying some (but not all) of the rights in the property bundle. For example, holders can exclude others from using allowances they hold. But the statutory provisions and government agency decisions that create allowances limit allowance holders’ rights." One of the problems in the property "bundle" is "the extent to which banked emissions allowances hold value as emissions caps decline and new programs are created."

The EPA and the courts have treated the value of banked allowances inconsistently. Although the EPA historically has sought to preserve the value of banked allowances during program shifts, most recently the agency proposed to wipe out banked allowances from the CAIR program to apply its successor "Transport Rule" regulatory regime. This EPA move, says the RFF paper, "represents a shift" in the EPA’s traditional approach "that can only be detrimental to the overall efficiency of the EPA’s cap-and-trade programs."

What kind of damage can the administrative and litigation-driven program changes yield? RFF visiting scholar Fraas and resident scholar Richardson note that "regulators consider the rights embodied in banked emissions allowances to be subordinate to the environmental requirements of these programs. This has been a hard lesson to absorb. The Title IV [of the 1990 Clean Air Act amendments] SO2 allowances are now essentially without value—they can be purchased for the price of a lottery ticket—representing a loss to holders of banked allowances of $3 billion. The price of CAIR NOx allowances also has declined substantially, with an attendant loss to holder of as much as $1 billion."

—Kennedy Maize is MANAGING POWER’s executive editor.

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