Cost-Effective Control of Urban Smog
Smog in urban areas creates serious health and welfare problems for residents in the United States and across the world. This book examines a pioneering governmental effort to reduce emissions in the Chicago ozone nonattainment region by a complex market designed to allow trading of pollution permits. Cost-Effective Control of Urban Smog utilizes empirical data gathered over the past four years to critically assess and evaluate the disappointing performance of the Chicago cap-and-trade market. The authors describe the political economics of the early market design process. In doing so, they identify one of the main causes of subsequent performance deficiencies: the continued use of traditional centralized regulation together with the use of decentralized market incentives. That is, two policy instruments are used to try to achieve one environmental goal, and they ended up in conflict. The authors develop extensive data to test and elaborate these findings, and to establish a firm basis for an improved market design, which could improve market performance. The cap-and-trade market approach to controlling urban smog could then be a model for use elsewhere. Richard F. Kosobud is Professor Emeritus of Economics and Houston H. Stokes is Professor of Economics, they are both at the University of Illinois at Chicago, USA. Carol D. Tallarico is Assistant Professor of Economics at Dominican University, USA. Brian L. Scott is Visiting Assistant Professor of Economics at the University of Alabama in Birmingham, Alabama, USA.
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Cost-Effective Control of Urban Smog The significance of the Chicago cap-and-trade approach Richard F. Kosobud, Houston H. Stokes, Carol D. Tallarico and Brian L. Scott
Cost-Effective Control of Urban Smog The significance of the Chicago cap-and-trade approach
Richard F. Kosobud, Houston H. Stokes, Carol D. Tallarico, and Brian L. Scott
First published 2006 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016 This edition published in the Taylor & Francis e-Library, 2006. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” Routledge is an imprint of the Taylor & Francis Group, an informa business © 2006 Richard F. Kosobud, Houston H. Stokes, Carol D. Tallarico, and Brian L. Scott All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Cost-effective control of urban smog: the significance of the Chicago cap-and-trade approach / Richard F. Kosobud . . . [et al.]. p. cm. Includes bibliographical reference and index. 1. Air – Pollution – Economic aspect. 2. Smog – Economic aspects. 3. Emission trading. I Kosobud, Richard F. II. Title. HC79. A4C66 2005 363.739'26–dc22 ISBN10: 0–415–70202–X ISBN13: 978–0–415–70202–7
2006003838
Contents
List of figures List of tables Foreword Preface Acknowledgments List of abbreviations 1
Introduction
ix xi xiii xvii xxi xxiii 1
Objectives 1 The political economy of the Chicago market design 3 Expectations and actual market performance 5 Traditional regulations and market incentives 7 Simulated performance of alternative market models 7 Explaining market performance 9 Hot spots, spikes, and emissions trading 10 Banking horizons of tradable permits: an experimental approach 11 Conclusions and policy recommendations for market redesign 12 2
The political economy of the Chicago market design Introduction 15 Health and welfare motivations for market incentive regulation 15 The regulatory options 18 The cost-effectiveness motivation for market incentive regulation 20 The market design dialogue and decisions 23 Expectations of cap-and-trade market performance based upon simulation modeling 28
15
vi Contents 3
Expectations and actual performance
30
Introduction 30 Actual market performance 30 The sources and uses of tradable permits 36 Explaining market performance 38 Were there industry level effects of traditional regulations? 41 Conclusions 47 4
Traditional regulations and market incentives
48
Introduction 48 A brief history of air pollution regulation 50 Regulatory tools applied to VOC pollutants under traditional systems 53 Weighing the alternative regulatory tools 56 5
Simulated performance of alternative market model features
61
Introduction 61 Overview of the findings 62 Specifying the cap-and-trade model 63 Empirical implementation of the model 66 Simulations of the performance of the model 67 The simulation results 69 Market performance with spatially restricted trading 76 A normative theory of banking 77 Tradable permits as private financial assets 79 Conclusions and research directions 81 6
Explaining unanticipated market performance Introduction 83 Responses of participants to the new market: a survey 84 Were there market problems, such as monopsony? 86 Were program design deficiencies affecting market decisions? 89 Statistical tests of the hypotheses 93 Conclusions 99
83
Contents vii 7
Hot spots, spikes, and emissions trading
102
Introduction 102 The invisible hand of the market and concern about hot spots 103 Delineating the appropriate sub-area 104 Detection and analysis of actual hot spots 108 Should spatial trading restrictions be placed on the market to prevent hot spots? 123 8
Alternative market designs: the experimental approach
125
Introduction 125 Experiment parameters 126 The experiments 129 Experiment outcomes 131 Conclusions 136 9
Conclusions and policy recommendations for market redesign
138
Introduction 138 What specific flaws in the original market design need to be fixed? 140 Four sources of guidance on appropriate market designs 143 Policy recommendations for market redesign 154 Appendix A: measurement of daily ozone, precursor concentrations, and selected meteorological variables
158
Appendix B: explanation of generalized least squares and generalized additive models estimation techniques
160
Glossary Bibliography Index
164 167 173
Figures
5.1 5.2
5.3
5.4
5.5
5.6 6.1 6.2 6.3 6.4 7.1 7.2 7.3 7.4
Price determination and cost savings with a homogenous pollutant The relationships between the rate of reduction of emissions and cost savings and number of ATUs (allotment trading units) traded The relationships between the variance of emitter marginal cost slopes and cost savings and ATU (allotment trading unit) prices when the aggregate target rate of reduction is 12 percent Individual emitter purchases and sales of permits at a VOC reduction rate of 0.12, a permit equilibrium price of $258, and a free allocation of permits Individual emitter purchases of permits at a reduction rate of 0.12 and an equilibrium price of $258, assuming the government auctions the permits Determination of the optimum level of banking given expected prices Dependent variable holdings by emissions size of participants in 2000 Dependent variable holdings by emissions size of participants in 2001 Buying and selling by emissions size of participants in 2001 Variation in REG ratios by emissions size of participants The 1999 population by zip code for the Chicago ozone nonattainment region Maximum baseline emissions by zip code for the Chicago ozone nonattainment region The 1998 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region The 1999 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region
65
71
73
75
75 78 87 88 88 91 111 112 115 116
x 7.5 7.6 7.7
7.8
7.9
Figures The 2000 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region The 2001 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region The 2002 estimated emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region The 2003 estimated emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region The 2004 estimated emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region
117 119
120
121
122
Tables
2.1 2.2 2.3 3.1 3.2 3.3 3.4 3.5 4.1 4.2
5.1 5.2 5.3 5.4 5.5 5.6 6.1 6.2 6.3
Ozone morbidity damage reductions obtained by reducing ozone concentrations Requirements for ozone nonattainment areas Urban area classifications for the eight-hour ozone standard Market-wide ATU (tradable permit) transactions and prices for the years 2000–3 Participant sources and uses of tradable permits (ATUs) during year t (2003 IEPA aggregate data) Yearly changes in emissions by SIC code Expirations and permit banks by SIC code Tradable permit purchases and sales by SIC code Selected stationary-source emitters and processes subject to RACT and MACT controls with government oversight Case studies of additional control costs of reducing VOC emissions by various control options in the Chicago ozone nonattainment area Estimated effects of changes in emission reduction rates under free allocation Estimated effects of changes in the variance of marginal control costs (12 percent reduction rate) Estimated effects of changes in transactions costs (12 percent reduction rate) Estimated effects of changes in emission reduction rates under an auction market Estimated effects of sub-area trading restrictions (12 percent reduction rate) Comparison of simulated and actual data for the Chicago cap-and-trade market in 2001 Individual participant variable definition and measurement Probit determinants of market participation in 2000–4 The dynamics of the VOC trading system driven by enormous banks of permits
17 19 20 31 37 42 45 46 54
58 70 72 73 74 76 82 93 95 97
xii Tables 6.4 7.1 7.2 7.3 7.4 8.1 8.2 8.3 8.4 9.1 9.2 B.1
Zero-order correlations of individual participant emissions (Baseline, 1998, 1999, 2000, 2001) Yearly percentage changes in emissions by county Yearly percentage change in emissions for hot spot townships Yearly percentage change in emissions for hot spot zip codes Demographics for hot spot zip codes Experiment attributes Marginal abatement costs by firm (listed in experimental dollars) Experimental results of banking, expirations, and use of permits Experimental results of trading Comparative design features and performance of five current cap-and-trade markets Linear multivariate analyses of determinants of ozone concentrations OLS and GAM analyses of determinants of ozone concentrations
99 106 107 109 113 127 128 132 134 144 152 162
Foreword
The natural human tendency is to trumpet success and to sweep failure under the rug. How welcome and refreshing it is then to encounter the work of a dedicated group of policy-minded scholars who have resisted this tendency and have resolutely sought to find out what went wrong and what can be done about it. The Chicago VOC trading program would have been worthy of study for any number of reasons, and its lack of success adds yet another, and more compelling one. Failure is a better teacher than success, and anyone interested in the use of market-based instruments for environmental regulation will find this book rich in lessons and well worth the read. The underlying issue in this work is one that must be considered in the implementation of most cap-and-trade programs: how is the new market-based system to relate to the conventional, prescriptive regulation that is already in place? The story is a cautionary tale concerning the use of two instruments to meet the same objective. In this case, the cap-and-trade system became, as the authors put it, “window dressing” (of appropriate market design) for the traditional, prescriptive system that did the real work. While the environmental objective was handily achieved, the market-based system can take little credit for the emissions reduction, not to mention any significant cost reduction. Indeed, its main contribution may have been only to add to the already higher cost by the need to account for allowances and emissions for what turned out to be a largely redundant regulatory mechanism. Previous cap-and-trade systems also co-existed with pre-existing, conventional, prescriptive regulation, but there is an important difference between the Chicago VOC system and those predecessors. In the earlier cases, traditional regulation had largely spent its force, or had proved either politically infeasible or unable to achieve further emissions reductions. The cap-and-trade addition aimed either to go beyond what could be achieved by the traditional means of regulation, as in the RECLAIM or NOX Budget Programs, or to achieve a different environmental objective, as in the Acid Rain/SO2 Trading Program. In the Chicago VOC trading program, the usual form of regulation was alive and well, and, as amply demonstrated in this book, fully capable of meeting the environmental objective, albeit at greater cost and perhaps less equity in the distribution of the regulatory burden.
xiv Foreword The most that can be said of the cap-and-trade overlay is that it permitted a few firms facing very high costs of compliance with the conventional prescriptive regulation to gain some relief. For the vast majority, the trading system was simply an irrelevant, extra burden. For the reader, there are a number of interesting sub-plots in this story. One is the rationale for using two instruments. The two were happily heralded as being complementary: the cap-and-trade system would reduce costs and the prescriptive system would ensure against hot spots and other micro-level worries. That the result was something else is not so much an argument against market-based systems as it is a caution against wishful thinking and failing to pay close attention to interactions with the conventional regulatory system. The authors make an apt analogy to the well known failure of the liberalization of electricity markets in California, which was also an instance of failing to understand interactions and an attempt to have the best of both worlds. Another interesting insight in this book is the glimpse into how a conventional regulatory system actually works, an area in which very little research has been done and which the authors can address because of the micro-data that were available to them. They offer a vivid metaphor of a hammer that randomly falls on a line of nails with varying force, driving some deeply into the wood, others not nearly so much, and some hardly at all. Emissions are reduced but in a haphazard manner that makes one wonder why people worry about the unpredictable results of markets. As the authors point out, the cause is not laxness, sloppiness, or corruption of the conventional regulatory system, but the workings of separate prescriptions concerning inputs, particular processes, and other aspects of production that fall with uneven and uncertain effect on the emissions of the regulated firms. The research presented in this book offers many other interesting insights. The Chicago experience shows that a nonbinding cap does not mean that all allocations to firms are slack. Some firms can still be short and, in the absence of good information about the status of other firms, pay good money for permits that would otherwise be priced at zero. The phenomenon of positive prices in a slack system also provides a warning against thinking that observed prices necessarily reflect control costs. The authors have not attempted to estimate the cost of the emissions reduction that was achieved by traditional regulatory means, but they demonstrate that market incentives were not operating, and that, more than anything else, the prices observed reflected poor information and transactions costs. As advocates of the use of market-based incentives in environmental regulation, the authors admit that they were hesitant in advancing their critique of the Chicago experiment for fear of “rekindling old arguments” about emissions trading. Their brave decision to do so nonetheless, in order to produce this model of policy-related academic research, is commendable. The architects and participants in the Chicago VOC trading program are fortunate to have this soundly based and clearly argued research as the basis for needed changes to
Foreword xv the present system. Policy analysts and designers of future cap-and-trade systems will be forever in their debt for not sweeping the whole subject under the rug and describing what can result when two instruments are used to achieve the same objective. A. Denny Ellerman Center for Energy and Environmental Policy Research Massachusetts Institute of Technology January 2006
Preface
The authors hope this book conveys their enthusiasm about studying up closely the pioneering implementation of a cap-and-trade market to reduce stationarysource volatile organic compounds (VOC) emissions in the Chicago ozone nonattainment area. Among the reasons for this enthusiasm are the promises that this decentralized environmental regulation by market incentives can bring about cost-effective, innovation stimulating, flexible, and nonconfrontational reduction of pollution in comparison with traditional regulations. Earlier efforts to utilize cap-and-trade markets to reduce air pollution, and notably the documented achievements of the US sulfur dioxide program, have converted a number of doubters and skeptics into supporters. Other implementations then followed, among them the cap-and-trade market to reduce nitrogen oxides in the US and preliminary efforts to reduce carbon dioxide emissions through the use of cap-and-trade markets in the European Union. To be able to add a useful book on the Chicago VOC program seemed appropriate and well timed. This research could contribute new information to the growing but as yet small knowledge base on the use of market incentives in environmental policy. The pollutants, the hydrocarbons that make up VOC, are precursors of low-level ozone concentrations, which have been found to be harmful to human health and welfare. The VOC emissions are numerous and contain a subset of hazardous air pollutants (HAPs) that are harmful in themselves. The pollutants arise from a diversity of sources found in the production processes and inputs of a wide variety of emitters, large and small. Few of the emissions giving rise to VOC concentrations can be tracked with continuous electronic monitoring equipment, adding to the problems of emissions measurement and regulation. In addition, a dense set of centralized traditional command-and-control regulations, devised over a long period of time and worked out in detail, were already in existence, with accompanying protocols, monitoring and enforcement procedures. These regulations, extensive as they were, resulted in only modest reductions of the stubborn VOC and ozone concentrations, partly because they failed to cap VOC emissions. However, command-and-control measures were familiar, easy to understand, and gave the impression of action on the pollution front.
xviii Preface Traditional regulations were characteristic of US environmental policy for much of the twentieth century. They were responsible for some reduction of pollution, although in most cases not to acceptable levels, but at the cost of rising marginal control costs and increasing confrontation between the regulating and regulated communities. Environmental groups were frequently dissatisfied with the activities of both sides. There was concern among some observers that the problems being encountered would slow the momentum for improving environmental quality, unless alternative regulatory measures were implemented. This brought about the authors’ interest in bringing to the attention of the reader the gains that could be achieved by a new application of a cost-effective, decentralized form of regulation. The introduction of any new complex form of decentralized regulation into this system cannot be free of problems. These problems and the efforts to resolve them are explained in detail for the interested reader. This book is not only a case study of the implementation of a dramatic regulatory innovation in a difficult setting, but also an effort to relate the Chicago program to the larger economic and political issues of the use of market incentives to control a major urban pollutant. The authors are aware that many other urban areas in the US and elsewhere suffer the harms and welfare losses of ozone and its precursors. Readers from these areas could have a special interest in the outcomes of the Chicago VOC cap-and-trade market that are explained in this book. The reader interested in the authors’ qualifications should know that the authors were involved in the implementation of this program from the design start in 1995 through the current date. They were thus able to pay close attention to the development and execution of the market, including discussions with all participants and observers. The authors were also able to assemble a detailed database on the design and recorded activities of the market, which proved of great value in analyzing its performance during the first five years of the program, from 2000 through 2004. Before the start of market trading, the Illinois Environmental Protection Agency (IEPA) set up a dialogue group to bring together regulators, affected businesses, local environmental groups, and academics, such as the authors, to discuss and debate the many design decisions to be made about the features of the VOC cap-and-trade market. This discussion can be very revealing to the reader interested in the political economy of a cap-and-trade market and is reported in detail in this book. The setup for trading in quantities of pollution in a cap-and-trade market differs in important ways from the trading practices in private markets, for instance in bread or wine. The IEPA must determine which firms are to be included in the market and the reduction from benchmark emissions (the cap) that is required for the protection of air quality. Then, decisions must be made about the definition and pollutant content of the tradable permit, the allotment of permits to individual emitters, and the length of life of the permit after issuance. Finally, decisions are required about the monitoring of emissions and the enforcement of market rules. These design decisions affect the performance of the environmental market, and they can affect the confidence the public will have in supporting the market
Preface xix and in understanding its role in regulation. Having the government allot permits to pollute rather than reduce these unpleasant substances to zero can be explained by the careful consideration of these decisions that is provided in the text. Reducing these emissions to zero is both practically impossible and prohibitively costly. The final design of the market was a compromise of the various positions taken in this dialogue debate, especially the positions taken by the business and environmental communities. A summary of these discussions and the important final decisions are provided in this volume for the reader, since they will have a significant bearing on the final analysis. After the design decisions are made, the new regulation then requires the government to step back and allow emitters to manage their permit portfolios and to reduce emissions, to the extent and by whatever control measures they wish, all, hopefully, with cost minimization in mind. Managing the permit portfolio involves buying or selling permits, returning them to the government to cover emissions, or banking them for future use, guided by market incentives. An effective market at equilibrium will find all emitters equating their marginal control-costs to the equilibrium price of the permit, thus achieving a level of aggregate control cost that, in almost all cases, will be below the level achieved by centralized implementation of traditional regulations on all emitters. The authors modeled these private emitter decisions in an abstract, ideal model in order to provide forecasts of what might be expected prior to the start of the actual trading in 2000. These forecasts could then be compared with observed market outcomes. The enthusiasm of the authors was challenged by the departures of the actual performance of the VOC market over the first four years, when compared with the forecasted, and expected, outcomes. Emissions were much lower than predicted, permit banks were much higher, and permit prices were well below expected values. Most surprising were large expirations of tradable permits. Something had gone amiss, after years of good work by all involved. While some problems had been anticipated and were thought to be amenable to small adjustments, the scale of the problems being encountered had not been foreseen by any of the participants or observers. A good idea for environmental regulation that runs aground in a particular implementation can yield valuable knowledge, not only to facilitate correction of the problems, but also to provide lessons for others planning similar innovations. This was the position taken by the authors, who were determined to find answers to the many questions posed by the surprising and unsettling market performance. The authors harnessed their original enthusiasms, in order to embark on an exploration of reasons for these perplexing market outcomes and to search for ways to resolve these problems. The authors invite the reader to join in this exploration. It will cover such market imperfections as monopsony and imperfect information. It will also deal with such matters as the recession and the possibility of over-allocation by the regulating agency. Finally, it will confront the dual regulation character of the VOC market in Chicago in which a particular compromised market design came into
xx
Preface
contact with the dense set of traditional regulations that impacted on market incentives. That is, two regulatory instruments were utilized to achieve one environmental goal, the reduction of VOC emissions. Therein lies the problem. The authors believe their search has been successful in revealing the reasons for the problems encountered thus yielding valuable knowledge about the pitfalls of implementing a new regulation, and a reward for the research effort. The reader will see these findings explored and tested empirically. What emerges is a sorting of the reasons for the unexpected performance that stands up to rigorous statistical analysis. The objective is not only to identify the reasons for the problems but also to lay a firm basis for correction of the market design deficiencies. To propose a redesign of a complex cap-and-trade market is a serious undertaking that will have to hold out the promise of success and will have to secure the support of concerned groups. The authors have utilized several sources of information and undertaken original research in an effort to realize these objectives. These efforts include: a study of tradable permit banking horizons, based upon simulated markets devised by experimental economic methods; an estimation of the appropriate cap for the redesigned market, based upon daily ozone and precursor data for the Chicago area obtained during the hot summer of 2005; and a comparison of the VOC approach with that of other cap-and-trade markets. What results from this work is a recipe for redesign of the VOC market that can be presented to all the participants in the Chicago program, and to the reader, for their evaluations. While the current market performance turned out different from first expectations, the good work invested in the innovative program can be modified along the lines set forth in this volume to increase the chances of reaching the original environmental goals. Urban ozone is an important problem and reducing the precursors of urban ozone is a necessary step in its control. Such control had not been achieved by traditional regulations, nor was it expected to be easily achieved by the use of a cap-and-trade market. However, the authors believe their work will further the prospect of success in the not too distant future.
Acknowledgments
The authors are indebted to numerous people and institutions for comments and data that proved invaluable in this book. The list enumerated below is by no means complete, but may suffice in giving a representative sample of the sources upon which the authors have drawn. The following people listed alphabetically were among those who gave helpful comments or research assistance at various stages in the work: DePriest, William, Manager, Environmental Services, Fossil Power Technology Group, Sargent & Lundy LLC, Chicago, IL. Ellerman, A. Denny, Senior Lecturer, Sloan School of Management and Faculty Associate, Center of Energy and Environmental Policy Research, Massachusetts Institute of Technology, Cambridge, MA. Harley, Keith, Chicago Legal Clinic, Chicago, IL. Hermanson, Robert, Environmental Consultant, BP West Coast Products, LLC, Naperville, IL. Hoelscher, Joanna, Citizens for a Better Environment, Chicago, IL. Jiric, Alan, Director of Regulatory Affairs, Corn Products International Inc., Bedford Park, IL. Kanerva, Roger, Adjunct Faculty, University of Illinois at Springfield, Springfield, IL, USA. Formerly Chief Policy Adviser, Illinois Environmental Protection Agency, Springfield, IL. Kosobud, Adam D., Research Assistant, Department of Psychology, University of Chicago, Chicago, IL. Kroack, Laurel L., Manager, Bureau of Air, Illinois Environmental Protection Agency, Springfield, IL. Linn, Joshua, Professor of Economics, University of Illinois at Chicago, Chicago, IL. McGrath, Daniel T., Associate Director, Institute for Environmental Science and Policy, University of Illinois at Chicago, Chicago, IL. Scheff, Peter A., Professor of Environmental and Occupational Health Sciences, University of Illinois at Chicago, Chicago, IL. Summerhays, John, Air Program Branch, US Environmental Protection Agency, Region V, Chicago, IL.
xxii Acknowledgments Stokes, Diana A., Editorial Processing Manager, American Medical Association, scientific publications, retired. Theis, Thomas, Director, Institute for Environmental Science and Policy, University of Illinois at Chicago, Chicago, IL. Among the places that presentations were made of work in progress were the following: Center of Energy and Environmental Policy Research, Massachusetts Institute of Technology, Cambridge, MA. Illinois Economics Association, Chicago, IL. Illinois Environmental Protection Agency, Springfield, IL. Institute for Environmental Science and Policy, University of Illinois at Chicago, Chicago, IL. Midwest Economics Association, Saint Louis, Mo. Special mention must be made of those who helped by contributing important data and explanations of data concepts: Bloomberg, David E., Manager Compliance Unit, Illinois Environmental Protection Agency, Springfield, IL. Ostrem, Stan, Environmental Analyst, Illinois Environmental Protection Agency, Springfield, IL. Price, Chris, Environmental Analyst, Illinois Environmental Protection Agency, Springfield, IL. Wachowski, Frank, Meteorologist, National Weather Service, retired.
Abbreviations
ACMA ATU BACT CAA CAAA CAIR CAMR CO CO2 CTG DIP ERC ERG ERM ERMS GAM GLS HAP HAPDUM IEPA LADCO LAER LMOS MACT NAAQS NESHAP NO NO2 NOX NSR O3 OLS OTAG
Alternative Compliance Market Account Allotment Trading Unit Best Available Control Technology US Clean Air Act of 1970 US Clean Air Act Amendments of 1990 Clean Air Interstate Rule Clean Air Mercury Rule Molecular formula for carbon monoxide Molecular formula for carbon dioxide Control Technology Guideline Variable name for the 2001 recession Emission reduction credit Emission reduction generator Variable name for the effect of market incentives Emissions Reduction Market System Generalized Additive Model Generalized least squares Hazardous air pollutants Variable name assigned to emitters with HAP emissions Illinois Environmental Protection Agency Lake Michigan Air Directors Consortium Lowest Achievable Emission Rate Lake Michigan Ozone Study Maximum Achievable Control Technology US National Ambient Air Quality Standards US National Emissions Standards for Hazardous Air Pollutants Molecular formula for nitrogen oxide Molecular formula for nitrogen dioxide Molecular formula for nitrogen oxides New Source Review Molecular formula for ozone Ordinary least squares Ozone Transport Assessment Group
xxiv Abbreviations OTC RACT RECLAIM REG ROG SCAQMD SIC SO2 US EPA VOC VOM WBMCC
Ozone Transport Commission Reasonable Available Control Technologies Regional Clean Air Incentive Market Variable name for the effect of traditional regulations Reactive organic gases South Coast Air Quality Management District Standard Industrial Classification Molecular formula for sulfur dioxide US Environmental Protection Agency Volatile organic compound emissions Volatile organic material Variable name for World Bank-estimated marginal control costs
1
Introduction
Objectives Any comprehensive effort to describe and analyze a pioneering and innovative environmental regulatory measure based on market incentives designed to control a serious urban air quality problem deserves more than the customary brief introduction. This serious problem concerns the harms and welfare losses attributable to low-level ozone and one of its precursors, volatile organic compound (VOC) emissions. This book aims to be that comprehensive effort covering the initial contentious market design discussions, the expectations and actual performance of the regulation during the first years, the surprises and problems encountered, the search for and diagnosis of the causes of the problems, and, finally, the proposals to redesign the market to achieve improved air quality. While each of the four authors had a special responsibility for particular chapters dealing with these topics, the separate contributions were thoroughly discussed and integrated so that the book is meant to be read from start to finish, with subsequent presentations building on prior work. Nevertheless, it is recognized that some readers may be more interested in the market performance, others in the statistical analysis of problems, and yet others in the policy conclusions. Therefore, this introduction has been prepared as a guide outlining the major topics presented in each chapter. This introduction may also be valuable for readers desiring a substantive overview before taking up the important content and details. As a general introduction, the authors call attention to the recent development of emissions trading, especially the cap-and-trade variant, as a now well-received and potentially more cost-effective, flexible, and less confrontational choice than traditional regulations for control of environmental quality. By traditional regulations the authors refer to centralized mandating by the US Environmental Protection Agency (US EPA) of pollutant emission rates and/or control technologies. Marginal control costs are typically not equalized under this regulatory regime, frequently termed command-and-control. By cap-and-trade market the authors refer to the decentralized design of an environmental market in which the government allocates tradable permits to emitters that reduce prevailing or historical pollution levels. The emitters,
2
Introduction
assumed to be cost minimizers, are free to trade permits, bank them, or choose control measures. The government collects a permit for each unit of pollution emitted and monitors and enforces market rules, but allows emitters to make the micro-control and permit portfolio decisions. In theory, marginal control costs are equalized across all emitters when the market is in equilibrium, leading to control costs typically below those of centralized regulation. This latter model and departures from it underlie much of this book and is explained in detail in Chapter 5. Not long ago, the use of decentralized market incentives was hardly on the agenda of the regulating and regulated communities, and certainly not on the agenda of the environmental communities. It was to be found in the table of contents of economic journals where the theory was under serious consideration. Such studies while demonstrating the cost-effectiveness and flexibility of market incentives were not sufficient in and of themselves to have them adopted as a matter of public policy, as the authors shall explain. What mattered more were the increasing costs imposed by traditional regulations. The national sulfur dioxide (SO2) trading system, a cap-and-trade market, established by the US Clean Air Act Amendments of 1990 (CAAA 1990), was a major breakthrough and is now widely regarded as a success (Ellerman et al. 1997: 64). Other cap-and-trade markets, for example, the US EPA-managed nitrogen oxides (NOX) trading system is being closely monitored and now seems well on its way to a successful implementation. The European Community is developing cap-and-trade systems in an effort to reduce carbon dioxide (CO2) emissions (Kruger and Pizer 2004: 8–23). An extension to other pollutants, such as VOC emissions, seemed a natural next step. Both VOC emissions as a precursor of urban ozone concentrations and the concentrations themselves have adverse health and visibility effects and are important constituents of urban smog. This book is focused on the market control of VOC and urban ozone because designing a market for these pollutants raises special considerations and challenges. The authors evaluate the performance of a cap-and-trade market to reduce stationary-source air emissions of VOC in the Chicago ozone nonattainment area, one of the first market systems implemented in an effort to reduce an urban pollutant rather than a regional, national, or global air quality problem. The diversity of hydrocarbons that make up VOC emissions, the inclusion of hazardous air pollutants as a subset, the wide variety and complexity of sources of these emissions with challenging problems of measurement, and the existence of a complex set of traditional regulations already in effect all created special issues and choices in designing a market system, and in formulating effective market rules and emission measurement protocols. Despite these complications, the expectations were for another success story when the new program began in 2000. In general, the merits of a decentralized trading approach to reducing pollution have often been expressed and analyzed by economists in abstract models and a version of that analysis will be presented in a later chapter. However, there remained an unease among some observers, including many environmental groups, a number of businesses, and even some regulators, about possible problems with the use of autonomous and anonymous markets in environmental
Introduction 3 regulation. For example, environmental groups were concerned about hot spots, business participants about benchmarks and permit prices, and regulators about emissions measurement and monitoring. Many of these views were contentious and entered into the market design decisions. They also were influential in the decision by the Illinois Environmental Protection Agency (IEPA) to retain and extend traditional regulations while developing an emissions trading approach to be placed along side the former. This unique feature of the pioneering Chicago program, a dual centralized and decentralized regulation of VOC emissions, has played a major role in the cap-and-trade market design and its implementation. A detailed explanation and analysis of the consequences of this combined regulation will be one of the major objectives of this book. The book has other important objectives. It aims to provide a detailed description of the first four years of performance of the VOC cap-and-trade market, presenting the facts given by the IEPA plus data generated by our own accounting. That is, the authors provide seasonal data on benchmark emissions, allotments of tradable permits, emissions covered by the return to the agency of tradable permits, banks, and prices of permits in addition to our estimates of expirations or non-use of dated permits. The intention is to evaluate these data to determine the extent to which the VOC cap-and-trade market has met its air quality, cost-effectiveness, and flexibility goals. Whether these goals have been met by the performance of the market will require a probing beneath the observable data. To the extent the program has fallen short of its goals, as the authors find in this research, it provides a strong motivation to search for and provide evidence on the relative importance of each cause or explanation of the shortfall as a preliminary guide to redesign of the market. Also, it is our intention to evaluate the extent to which the cap-and-trade approach used in Chicago can be recommended to other urban areas confronted with VOC emissions and low-level ozone. To satisfy these objectives requires that the authors first provide information on the origin and design of the innovative market approach.
The political economy of the Chicago market design As an essential background, in Chapter 2 the authors review air quality trends in the Chicago region and the currently known health and visibility impacts of VOC emissions and low-level ozone concentrations. While the body of knowledge on these impacts is by no means complete or definitive in all aspects, and a detailed benefit–cost analysis is not yet available, there is general agreement about adverse health effects and the welfare consequences of poor visibility. The authors summarize relevant knowledge about these local effects that comprise a central motivation for government to take further regulatory action. The VOC emissions and resultant ozone concentrations from these and other precursor emissions have proved historically stubborn to efforts at control. The VOC emissions comprise many hydrocarbons that arise from numerous coatings, solvents, and glue solutions to emissions from factory processes, paints, and food
4
Introduction
and drug preparations. This multiplicity of sources translates into a wide diversity of enterprises, private and public, that must be taken into account in the design of a market program, if reductions are to be realized. The authors describe this diversity and point out the problems they create for government decisions in measuring emissions and in determining benchmark and allotment quantities as well as other market features. The initial plan of the IEPA had been to develop a cap-and-trade market to reduce NOX emissions, and hence concentrations, another precursor of urban ozone interacting with VOC concentrations. VOC emissions would continue to be controlled by traditional regulations. This NOX plan would have involved a simpler market design, as the authors will explain. When it was discovered that incoming concentrations of NOX were already high coming from regions outside the Chicago area, it was clear that a national program was required to reduce these concentrations. The IEPA then turned to the application of a market incentive program to reduce VOC emissions, which were more local in their emission sources and concentration patterns, and much more complex in their market design requirements. They too, like NOX emissions, had posed problems for regulation: they had been stubborn in the face of controls, they were a matter of confrontation between regulating and regulated communities, and they were subject to increasing marginal control costs as more restrictive control measures were instituted. An important part of this chapter is a detailed account of the long and contentious process of VOC market design carried out by the IEPA, a process that not only built on the theory of a cap-and-trade market but also was greatly influenced by the comments and arguments of various consultative groups, including government, business, environmental, and academic communities. The objective at this point is not to apply a theory of government environmental regulation of either the public interest or pressure group variant, but to note the positions of the various groups on particular market features. A cap-and-trade market is built up of a number of features, each of which must function effectively for successful results. Each of these features can be specified in different ways by the regulating agency, and the particular way in which a feature is specified can significantly affect market performance. A detailed account of these features as they were decided upon in the Chicago approach can provide a guide to the anatomy of the cap-and-trade market and important information about possible design deficiencies. The authors participated in a number of early design discussions of the Chicago program, called dialogues, among concerned groups and the IEPA, which raised a long list of concerns about the design. The discussions revealed wide and often contentious differences in views about vital market features that were reconciled in a series of compromises by the IEPA, as explained in Chapter 2. One important market design problem for the government, infrequently addressed or worked out in detail, is how to integrate the design of the cap-andtrade market program into existing, traditional regulations. Integration is easy to overlook or set aside when confronting the many decisions in designing the
Introduction 5 market. The authors find that this relationship between these dual regulatory approaches is a unique and key factor in explaining the current performance of the market as described in Chapter 2. Before the start of the market, the agency heralded this dual regulation in the final design, one of the key compromises, as combining the strengths and overcoming the weaknesses of each regulatory approach. The market system was essentially placed on top of traditional regulations in the expectation that it could function in isolation from that foundation. This dual relationship exists in most cap-and-trade markets and our research in this area could be valuable in evaluating the future performance of such markets and devising more successful ways to integrate the two systems. The cap-and-trade market design decisions were subject to the monitoring and approval of the federal layer of environmental government. Traditional regulations are most frequently promulgated and guided by the US EPA with important implementation procedures developed by the states. A number of options are left to be initiated and developed by the states in their efforts to meet national environmental goals. So it was with the VOC cap-and-trade market that was chosen by the IEPA as an option for the Chicago ozone nonattainment area to be added to the existing traditional regulations. This option was available under the onehour ozone concentration standard for urban areas with episodic ozone concentration exceedances at or above above 125 ppb (parts per billion). Under this standard, Chicago was a severe ozone nonattainment area. A new standard at which exceedances occurred when concentrations rose at or above 85 ppb averaged over eight hours was put in place by the US EPA, beginning in 2005. According to present classifications, under the new standard the Chicago region becomes a “moderate” ozone nonattainment area. The VOC cap-and-trade market regulatory choice continues under the new classification. However, the lower acceptable threshold for ozone concentrations suggests that a redesign of some features of the market will be in order. Redesigning the existing market in light of the new ozone goals and integrating it with traditional regulations will be a demanding assignment for the IEPA. The efforts in this book to analyze the present functioning of the market are intended to be the basis for the authors’ recommendations for that fundamental redesign.
Expectations and actual market performance In Chapter 3, the authors stress that the actual performance of a pioneering environmental market innovation requires a careful analysis, given the differences from the standard market model and given the differing expectations of the interest groups. The first year or two may be viewed as a learning experience on the part of both regulated and regulating communities. After this initial period, patterns can be treated more seriously. The first four years of performance of the market, presented in summary form in Table 3.1, reveal that the market was working in the sense that participants accepted market rules and reported emissions and transactions as required. The new regulatory system was underway for a wide variety of enterprises, large and
6
Introduction
small, indicating the feasibility of decentralizing facility level control decisions. The results in Table 3.1 also reveal unexpected, puzzling, and even startling results, departing from earlier predictions of researchers and significantly different from expectations of emitters, the regulating agency, environmental groups and academics. These results included: 1 2 3 4 5
emissions far below the cap; transactions fewer than expected; banks of permits that grew to enormous values; prices much lower than anticipated; and, perhaps most surprising, many valuable permits allowed to expire without use.
These results are based upon agency data reported in the annual performance reports in addition to some calculations by the authors to achieve consistency demanded by our tabular presentation, as will be explained. Inconsistencies and gaps in agency-provided data led the authors to construct a tradable permit sources and uses table that provides a framework for checking the consistency of data. It also provides a framework for a deeper analysis of the flow of transactions in the market. The agency has not yet adopted such a table. The authors illustrate the advantages of the table in an application presented in Chapter 3. The fact that emissions were reduced far below the cap was regarded by the agency as a success of the market system. While the authors too applaud this reduction, our findings, which will be supported later, are that continuing and extended traditional regulations were binding in reducing emissions and not the market system or cap. Enormous banks, large expirations, and very low prices of tradable permits call for careful appraisal as they suggest design imperfections. Such surprising market outcomes led the authors to a reconsideration of the existing market design and to concerns that the Chicago cap-and-trade approach, locally called the Emissions Reduction Market System (ERMS), was performing far below its potential in achieving cost savings, innovation, and flexibility. There is every indication from information emanating from the agency that such outcomes continued after the first four years; that is, the market suffers from certain design, rather than transitory, problems. No evaluation of the cap-and-trade program would be complete or of value without a full account and analysis of these perplexing outcomes. A number of explanations are put forward in an effort to understand this market performance, several of them discovered in subsequent research and others obtained from discussions with concerned observers. One of the major research efforts reported in this book is to formulate hypotheses to test the soundness of these explanations and their capacity to point the way toward remedial action. This will require the search for and development of data and statistical methods that will enable us to reach new conclusions about how market design imperfections interacted with external constraints on market incentives. These conclusions could be of great help in the forthcoming redesign of the market and provide guidance to other urban areas considering this new tool to reduce their smog problems.
Introduction 7
Traditional regulations and market incentives Environmental regulation for improvement of land, air, and water quality for much of the twentieth century was mainly of the centralized, prescriptive type, often called command-and-control regulation. Certainly, the important national legislation of 1970 that set standards for VOC among other air pollutants and established the US EPA, envisioned centralized or traditional regulations as the main measures to be used to obtain improved air quality. Market incentives are a relatively recent regulatory measure that to date have been combined in varying ways with traditional regulations. Chapter 4 describes how centralized traditional regulations are expected to work before analyzing how they may work in combination with decentralized market incentives. Traditional regulations, as the authors have mentioned, set limits on the rate of emissions for particular processes or prescribes technologies often based on particular control techniques to be applied to specific processes. On occasion, emission limits are set in advance of known capabilities in an effort to “force control technology” to be developed by the firm. Traditional regulations also set limits on the VOC content of certain inputs that vary widely in type and pollutant content. By congressional mandate, the regulating community was to consider health impacts and not the costs of control in setting these limits. Given the wide diversity of pollutants, production processes, and inputs, the environmental protection agencies have been hard pressed to develop regulations to cover all of these, not to mention keeping up with new information and changes. When the acceptable rates of emissions were established, it was clear that marginal control costs would not be equalized among emitters, and therefore a least aggregate control cost would not be achieved. That was not the objective of the regulations. Note that controlling the rates of emission or the use of particular inputs does not limit the aggregate volume of pollution that can vary by rate of economic activity or by entrance of new emitters into the pollution area. Chapter 4 describes relevant features of this centralized regulation as they were applied to VOC emissions control. These measures continued during the market period and increased in number and intensity, especially for the hazardous air pollutants (HAPs) components of VOC, which are numerous and not yet completely prescribed by acceptable levels and control techniques. While much of this regulation was specified in guideline fashion at the federal level by the US EPA, implementation, monitoring, and enforcement was left to state and local levels of government. One important question raised in this chapter concerns how the limits prescribed by traditional regulations could constrain market decisions made under the particular design of the Chicago program. For example, traditional regulations, by lowering emissions below tradable permit market allotments for the firm or by setting a ceiling on emissions levels, could constrain market transactions.
Simulated performance of alternative market models Interested researchers like the authors were eager to prepare estimates of the performance of the proposed market before the start-up date even though data
8
Introduction
were limited on enterprise control cost functions, an essential part of any forecasts. As described in Chapter 5, the authors, making use of limited data, developed a model based on the theory of emissions trading. It will be valuable to repeat the aspects of this theory in preparation for the simulations. This normative theory asserts that in a competitive market with cost-minimizing emitters, the regulating agency allocates quantities of tradable permits to pollute below prevailing levels to achieve desired air quality. These are then allocated to individual emitters according to some agreed upon rule, such as the emitter’s share of pollution. The regulating agency allows emitters to decide on the basis of permit price whether to reduce emissions by any available technique that they choose, to emit and return permits, to trade them, or to bank permits for later use with the objective of stimulating cost-minimizing control choices. Tradable permits are denominated in a quantity of VOC emissions, and participants in the market are required to return a permit to the government for every like volume of VOC they emit. At equilibrium, with well-behaved cost functions, all cost-minimizing emitters will equate the marginal costs of control to the market price of permits. Equality of marginal costs across all emitters will yield a minimum of aggregate control costs usually well below costs of traditional regulations (Montgomery 1972: 359–418; Stavins 2000: 55). The model excluded traditional regulations in an effort to focus on the results of the optimization framework. That is, the market is expected to work as a standard market once permits were allocated. An important part of Chapter 5 reports on simulations of this model. It utilizes an algorithm that searches for a price clearing equilibrium, based upon estimated marginal control costs obtained from IEPA reports that vary from one Standard Industrial Classification (SIC) group of emitters to another (Dunham and Case 1997: 23). That equilibrium generates predictions of transactions and emissions for individual firms and for the aggregate market as well as predictions of tradable permit prices. The outputs of the model, all prepared prior to the market’s start date of 2000, could then be compared to the later, actual performance of the market as portrayed in Chapter 3. When subsequently compared, the abstract model predictions varied markedly from observed values by greatly over-predicting emissions, over-predicting transactions, completely missing the expirations of permits, and over-predicting permit prices by a wide margin. This comparison is shown in tabular form to highlight the discrepancies that set the authors on a long and involved research quest to determine what imperfections in the actual market design brought about these discrepancies. Experimentation with several variations of the model did not improve the predictions. A survey of other efforts by other researchers to model the VOC market and prepare forecasts led to the discovery that similar wide discrepancies had been made. Initial errors in forecasting SO2 permit prices had also been made by researchers studying that market, but these errors were later corrected after the discovery that low-sulfur coal prices were lower than expected (Joskow et al. 1998: 668–685). Clearly, the VOC market was responding to constraints on
Introduction 9 market incentives. One of the objectives of this book can now be further defined; it will be to identify these constraints and to determine whether the market can be redesigned to bring into play the decentralized incentives that appear to have been seriously impeded. This research requires a broader approach and more inclusive framework or model than the ones used by researchers so far. It will also open a window on what worked and did not work in the cap-and-trade market, and reveal where redesign may be most productive.
Explaining market performance While keeping in mind the normative theory of emissions trading and its important conclusions about cost savings and flexibility, when a well designed market is working effectively, the authors turn in Chapter 6 to a wider framework of analysis that enables the research to consider constraints impeding the market. The theoretical model continues to provide a benchmark of performance against which the authors can consider various deviations. The economic literature has worked out many of the consequences of the failure of assumptions to hold in an abstract model of the standard sort, and these provide the logical starting place to consider possible reconciliation of market results with predicted outcomes. Among these problems are high transactions costs (Stavins 1995: 137–148) that can limit trading and the advantages of market incentives, or the lack of competition that can cause the market to fall short of performance goals (Hahn 1984: 753–765). We review available evidence on these matters and find little that would support these failures of the assumptions to hold. Another possible explanation is that both the regulated and regulating communities initially lacked essential information to make the market function as expected, a variety of learning behavior theory. The authors carried out a careful review of the preparations for the start of the market, including the training sessions and discussions among all concerned communities. The authors also considered the trends in data over the first years, which provided little evidence in support of this explanation. Rather than the lack of information, it may be conjectured that emitters, well informed about market incentives, were led to search for and introduce emission controls, thus leading to low control costs and prices. However, the survey reported in Chapter 6 indicated that few if any new control technologies were installed. The excess of tradable permits and their low price provided little incentive for control measure innovations. Turning to external constraints, the authors devised a broader framework or model within which statistical tests of hypotheses could be formulated and implemented. One frequently mentioned hypothesis was that the recession affected the region in 2001 with a subsequent decline in output and emissions. The authors constructed a variable measuring the decline in emissions that could be attributed to the recession and found it to have marginal significance in equations with permit transactions as the dependent variable. Emissions continued to decline after the recession ended. Thus, there is little support for the recession hypothesis as a major factor in explaining the unexpected results.
10
Introduction
An alternative candidate was the suggestion made by IEPA officials in a meeting in 2003 that there was probably an over-allotment of permits in relation to benchmark emissions. One variable constructed to measure extra permits turned out to have limited significance in equations with transactions as dependent variables. In addition to this finding, the authors’ objection to the over-allotment hypothesis is that emitters did not increase emissions by relaxing control measures and use their excess permits to cover this increase. The hypothesis explaining the puzzling results that survived the most critical assessment was that the continuance and extension of traditional regulations greatly weakened market incentives and impeded the cap-and-trade program. This was an unexpected effect as during the design phase the IEPA heralded this unique feature of the program, stating that it combined two regulatory systems each of which would offset the limitations of the other. The authors’ finding was that traditional regulations, when combined with such market design deficiencies as a small reduction in emissions and a short, one-year banking horizon, greatly diminished market incentives. That is, to put it starkly and clearly, traditional regulations were binding on most participants in reducing emissions rather than the cap-and-trade market. In effect, there were two policy instruments designed to achieve the objective of reducing emissions, and one became redundant. A variable constructed to measure this effect of traditional regulations proved highly significant in equations explaining tradable permit purchase and sale transactions in all the years for which data are available. The variable also was significant in equations explaining emission reductions, the large banks, and the associated expirations of tradable permits. A detailed description of these results and the statistical methodology is provided in Chapter 6. Discovery of this result is explored and tested in detail in this chapter as it opens up many avenues for the proper design of a market for control of VOC emissions and other substances, such as carbon dioxide. It also opens up many avenues for the redesign of the Chicago program and provides direction for other urban areas considering this new regulation.
Hot spots, spikes, and emissions trading Among the contentious issues influencing the design of the market were the questions of hot spots, local sub-area or neighborhood increases in emissions due to trading, and spikes, increases in emissions over one or more years due to banking. These problems were frequently raised by environmental groups during the premarket dialogue meetings, and on occasion raised as reasons for not using a cap-and-trade market. The Los Angeles region experience was often in the background of the Chicago dialogue. In the Los Angeles region, an earlier attempt to establish a cap-and-trade market to reduce emissions of Reactive Organic Gases (the Los Angeles equivalent of VOC emissions), under the acronym of RECLAIM (the Regional Clean Air Incentive Market), was reported to be stymied in large part by local group protests against enforcement rules, toxics, and hot spots (Lents 2000: 221). The IEPA had sent staff to the South Coast Air Quality Management District
Introduction 11 in the region, an agency that managed RECLAIM, to review this past history. The staff was well aware of the potential risk of protests against the Chicago program. In a decentralized system without emission ceilings established by traditional regulations, it is clearly possible for trading to increase sub-area emissions over benchmark values, and for spikes to occur. Even with traditional regulations such increases could occur either because participants had been below their prescriptive ceilings in a prior period and subsequently increased emissions, or because new participants had moved into the sub-area. Or both developments could occur. New entrants into the market are usually not assigned allotments of permits; they must buy them in the market to cover emissions. The phrase “Environmental Justice” was introduced into this problem area by some observers noting that the sub-area or neighborhood could be the residence of low-income or minority groups and thus adversely affected by the hot spot. It could be pointed out that any income or ethnic group in a neighborhood could be so adversely affected, but the counter is that lower income groups would have fewer resources to deal with the problem. The IEPA attempted to meet the issues head-on by promising to make sub-area data on emissions and trades available for each trading season. Consequently, the annual performance reports contained township emissions data compared season by season. Very few townships revealed emission increases over baseline values, and the few that did were in outlying areas affected by large installations with few residents. With respect to spikes, the season-to-season aggregate data reveal declines in total emissions. The issues have dropped out of sight. In our studies, the authors carried the matter further by obtaining data on smaller geographic areas. Making use of emissions data by participant, provided by the IEPA, and making use of a geographical information software package (ArcView ® GIS), the authors found hot spots when data were plotted by zip codes, a US Postal system area designation more equal in population than area. These codes, where emissions exceeded baselines, again were primarily in outlying areas with small populations or in areas with a single large emitting firm. Being unable to secure participant data for other years, the authors devised a way of translating transactions of permits into enterprise emissions and thus plotting zip code emissions for later years. These results show the potential for hot spots but do not indicate definite cause for concern at this time. Details on the methods and results are presented in Chapter 7. These studies do not assure that hot spots or spikes will not occur in future years, so the research should continue. It should be noted that hot spots are much less likely to occur when appreciable reductions in pollution are required by the cap.
Banking horizons of tradable permits: an experimental approach Governments rarely have the luxury of experimenting with new designs by changing one feature and testing these changes over future years. The experience of other cities and countries could provide some guidance, but the Chicago VOC
12
Introduction
approach was a pioneering effort. Furthermore, such comparisons rarely reveal the consequences of changing specific features of a complex system like a cap-and-trade market. An approach devised to circumvent this problem was to employ experimental economics in which simulations of alternate designs could be tested in a laboratory setting. Representatives are selected to act as traders with varied characteristics, such as costs, and with stated objectives, such as cost minimization. Variations in design can then be tested and compared for their consequences for emitters, and market outcomes can be compared with traditional regulations. A main feature singled out for redesign was the one-year banking horizon. Experiments indicated that the performance of the market could be improved by increasing the permit life after issuance. These results are reported fully in Chapter 8 and were of value in formulating our policy recommendations.
Conclusions and policy recommendations for market redesign This book is a detailed description of a complex innovative regulatory approach to reducing stationary-source emissions of VOC and the varied expectations and hopes for the performance of the program. It must be confessed that the authors were among those observers with high expectations and ready to find, at best, minor difficulties that could be readily fixed. They now find themselves among the growing body of observers who believe the program will not right itself in the future without significant redesign. Such a belief can be a motivation for the research effort required for the redesign of a valuable regulatory tool adapted to a serious urban air quality problem. The problems should be kept clearly in mind: they are the startling reduction of emissions far below the benchmark and the required cap reduction, the few transactions, the excessive banks of permits no matter how one tries to rationalize them, the unexplainable expirations of valuable permits, and the low and downward trend of prices of permits with no relation to marginal control costs. Any estimates of cost-savings and flexibility gains of the market would be far below the potential as pointed out by the following questions. 1 2
3 4
How could a market induce substantial cost savings with so few transactions? How could the market induce control measure innovations when permit prices were so low and when most participants held excessive permits soon to expire? How could the market induce wise allocation of costs over time when the banks of permits were so large that most of them would expire? How could the market induce flexibility in participant choices to reduce emissions or trade or bank when the pressing problem for most of them was how to dispose of huge banks of nonsalable permits?
In a review of the findings reported earlier, the authors first considered problems within the market, such as transactions costs, information failures, or
Introduction 13 imperfections of competition, and found that these causes had small or no effects. Further training of account officers at participant firms, and improvements in the details and frequencies of price postings, could help in a redesigned market. The lack of any significant broker activity was a clear demonstration of the market’s design deficiencies. Getting brokers interested in the market and adding to liquidity will require redesign of a number of the market’s features. Next to be considered were external constraints, such as the recession that occurred during the first two years and the possible over-allotment of permits. External constraints contributed little to an explanation, when examined in the light of statistical information. A major finding that stood up well under quantitative scrutiny was that traditional regulations were binding, and seriously weakened market incentives. The cap-and-trade market was window dressing in the sense that it attracted attention up front as a pioneering regulatory effort while behind the scenes, traditional regulations were doing most of the work. If the advantages of a market system are to be achieved, the question is how to free it from the fetters of centralized regulation. One benefit that might be claimed of the market incentive program was the decline in confrontation between regulating and regulated communities: the former because emissions were dramatically reduced, thus contributing to cleaner air to the satisfaction of the political leadership and the public, and the latter because government monitors were not as frequently at the door. Serious issues, which were rarely raised, were the real causes of the emission reductions, the costsavings and flexibility not being realized, and the cost of administering an imperfectly designed program, both in staff time and related expenses. This book raises these issues in the hope that redesign can be achieved, that the benefits of emissions trading can be realized, and that the redesigned program can offer a choice to other urban areas. Several general redesign options should be considered in any thorough review. Eliminating the cap-and-trade market would get rid of the administrative costs of the program that surely exceed by any measure its present benefits. This policy option would receive the approval of many of the environmental groups and probably some of the government regulators. It would disappoint many of the business participants and most academics. It is not clear how the increasing marginal control costs and increasing confrontations brought about from relying solely on traditional regulations are to be avoided, especially in view of the further reductions of VOC emissions required by the new ozone standards. Failure of this pioneering effort would not be an encouraging signal to efforts to make use of market incentives for VOC control in other urban areas, many of them in developing countries. A diametrically opposed policy option would be to eliminate or reduce traditional regulations by redesigning the market with new features, such as a greatly reduced level of emissions (a much tighter cap) and a lengthened permit-banking horizon. Alignment of opponents and supporters to relaxing of VOC traditional regulations would be the reverse of dismantling the market system. It would almost surely be a contentious issue and engender a long-lasting debate.
14
Introduction
The authors develop different and specific policy options, based on findings and results of this study. Foremost would be a more stringent cap and a lengthened banking horizon on permits. Determining a new cap in light of the new eight-hour ozone standard is an important task for the IEPA. To assist in this effort, the authors carried out a regression analysis of daily ozone concentrations, weather conditions, and precursor concentrations during the hot summer of 2005 in the nonattainment area. These data open up new areas for research, including the range of reductions in VOC emissions (the cap) that could be required to achieve the new standard. Determining a new banking horizon or shelf life of the tradable permit is an equally important task. Experimental trials led to the conclusion that lengthening this shelf life could bring about cost savings and reduce the expirations of permits encountered with a one-year life after issuance of the permit. In other areas, additional account officer training, encouragement of broker activity, and fine-tuning of the provision of price information could enhance the workings of the market. The authors propose a tradable permit or ATU sources and uses table in sufficient detail to track and quantify each type of market transaction. Such consistent information would greatly facilitate analysis of annual and inter-temporal market activity. This redesigned market system could be combined with existing traditional regulations to help in achieving the new air quality goals with gains in cost effectiveness, flexibility, and lessened confrontation. Traditional regulations would become binding only when hot spots were revealed or inter-temporal emission spikes threatened. Such a better-integrated dual system might not enable the cap-and-trade market to achieve its maximum gains, but improvements in the performance of the market should be demonstrable shortly. Such a redesigned system would continue to have two policy instruments, each designed for a different objective. What the authors propose is not a blueprint for a successful redesign of the dual system, but rather a recipe for varying the features of the market system so as to achieve more effective outcomes in terms of air quality and decentralized control cost reductions. Such a recipe could prove helpful for other urban areas designing market systems to reduce air pollution, by allowing them to incorporate their own preferences and make allowances for the local environment.
2
The political economy of the Chicago market design
Introduction Introducing a pioneering, even radical, regulatory innovation on top of a long-established, tested, and traditional set of ozone control regulatory measures, which many believed should be extended instead, is not a trivial exercise in environmental governance. This chapter describes the setting for this action, including information on the local health impacts of urban ozone, the contending views on design of this innovative regulation, the subsequent compromised design, and the resulting hopes and expectations as the new regime was launched. The actual performance of the first years of this new regulation is described in Chapter 3.
Health and welfare motivations for market incentive regulation The Chicago region was previously classified by the US Environmental Protection Agency (US EPA) as a severe ozone nonattainment area. This classification arose from the 1990 US Clean Air Act Amendments (CAAA) and is based upon the number of seasonal episodes of high concentrations of urban ozone that adversely affect human health and visibility. A severe classification carries with it the information that concentrations of urban ozone have equaled or exceeded the one-hour standard of 120 ppb. It also carries with it significant mandatory requirements for regulatory actions at the federal, state, and local levels, and the timing of such actions. It was long recognized in health research that low-level ozone had adverse effects over a wide range of concentration values (Spengler 1993: 121). After lengthy public comment and litigation, a new, eight-hour standard of 85 ppb was introduced by the US EPA to replace the old standard. The Chicago region is currently classified as a moderate ozone nonattainment area under the new standard. Most of the mandatory requirements carry over from the prior standard. The Illinois Environmental Protection Agency (IEPA) is charged with preparing a state implementation plan, subject to federal agency approval, and due in 2007, that will demonstrate how attainment will be achieved by 2010. Attainment
16
The political economy of the market design
requires no exceedances above 85 ppb over a three-year period. If attainment is not reached by 2010, the region may be “bumped” to a level demanding more stringent controls. The hot summer of 2005, with the chemical mix of volatile organic compounds (VOCs) and nitrogen oxides (NOX) atmospheric concentrations, brought about a number of violations of the new standard, indicating that much work lies ahead. The authors give their detailed views in Chapter 9 on how the cap-and-trade market can be redesigned to help achieve attainment. To return to the national legislation, there were clear signs that the Congress in 1990 was impatient with the progress obtained in improving air quality under prior legislations, such as the 1970 Clean Air Act that, among other features, established the US EPA and listed six criteria pollutants, including emissions of VOC and NOX, precursors of low-level ozone. That 1970 act also set a five-year goal for significant progress to be achieved. While some improvements in air quality were discernible, research into the health and visibility costs of air pollution indicated that sufficient progress had not been achieved in VOC and NOX emissions in the 20 years since 1970, not to mention during the five-year interval 1970–5. While lead emissions were dramatically lower, and carbon monoxide (CO) and sulfur dioxide (SO2) emissions were considerably lower, other pollutants revealed smaller declines and low-level ozone concentrations were essentially the same (US EPA 2003:11). The VOC and NOX concentrations make up only some of the constituents of urban smog, which is a mixture of pollutants, many highly correlated with each other. Over 3,000 chemical substances have been identified in ambient air, including anthropogenic originating SO2, CO, NOX, lead, total suspended particulate matter, oxidants (including ozone, O3), and nonmethane hydrocarbons (a subset of VOC). Some of these chemicals are allergens, others irritants, and yet others pathogens that all contribute to mortality, morbidity, and other physiological responses extending over a wide range of pollutant concentrations (Spengler 1993: 123). Identifying each constituent as a cause or marker for a specific disease has proved to constitute difficult research that is still very much underway. The composition of urban smog varies markedly among urban areas so that each urban area requires separate monitoring and analysis of the characteristics, causes, and severity of its smog problems. Los Angeles, for example, has significant emissions from the petrochemical industry but hydrocarbons in the air are mainly from mobile sources. Houston has significant emissions from mobile sources but hydrocarbons in the air are mainly from the petrochemical industry. Chicago provides a good case study of a typical mix of these constituents and a common proportion of sources (Tolley et al. 1993: 10). What can be concluded about ozone exposure is that it can cause irritation to lung airways and destruction of living tissue. Continuing exposure can lead to loss of lung function. High ozone concentrations are associated with restricted activity of sensitive people, asthma symptoms, respiratory admissions to hospitals, and an increase in daily mortality (Schreder 2003: 1–120). A study of the impacts of ozone concentrations in Los Angeles and New York City suggests that a tripling of ozone concentrations from 50 to 150 ppb can be expected to increase
The political economy of the market design 17 daily mortality from 3 to 4 percent (Kinney and Ozkaynak 1991: 99–120). As new research reveals the extent of these damages, the number of people living in communities with high levels of ozone has remained relatively constant. Under the revised, eight-hour standard of 85 ppb now being implemented, close to 150 million people live in communities where ambient air quality exceeds that level on an episodic basis (US EPA 2003: 1). In the Chicago region over 8 million people are exposed to episodic ozone concentrations above that level. Obtaining monetary estimates of the damages to health caused by ozone would provide an important part of a benefit–cost analysis. Such estimates are as yet uncertain and the likelihood of their being underestimated has led legislators in the past to prohibit using such estimates in devising regulatory measures. However, the advantages of a benefit–cost analysis are very evident in an area such as Chicago, where the marginal control costs of additional reductions are increasing. As a consequence, more attention is being paid to obtaining credible damage reduction data. A careful study of the Chicago Metropolitan region provides valuable guidance on the damage reduction that would result from lowering the ozone concentrations from 190 to 120 ppb, the latter being the prior, one-hour standard. These damages include restricted activity days (RADs), respiratory symptoms, and asthma attacks. As the authors have mentioned, the adverse effects extend over a wide range of concentrations in approximately a linear manner so the data of Table 2.1 provide a valuable insight into the benefits of ozone and precursor reductions. Valuable as the table guidance is, it provides only a partial list of monetary estimates. Mortality consequences are not estimated and would increase the totals appreciably (Burtraw et al. 1997: 1–40). Further damages result from hazardous VOC hydrocarbons, such as benzene and other smog components with particulate matter that can carry cancer-inducing substances deep into the lungs. Smog also affects visibility in many urban areas, a problem that many residents are willing to pay to reduce (Thayer 1998: all pages referenced). Reducing these damages produces a stream of welfare benefits extending into the future, offset in part by the control and regulatory costs of lowering emissions Table 2.1 Ozone morbidity damage reductions obtained by reducing ozone concentrations (from 190 to 120 ppb)
Mid-range estimate, total Respiratory symptoms Restricted activity days Asthma attacks
Reduction in millions of cases
Value per case (in 1989 dollars)
Total damage reduction ($000,000)
26.80 15.83 10.10 0.87
NA 6.00 22.5 30.00
348.33 94.98 227.25 26.10
Source: Adapted from Tolley (1993: 14). Note The authors also give low and high estimates of total damages that range from a total of $68 million to $1.1 billion.
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The political economy of the market design
and hence ambient concentrations of pollutants. While the total benefits of such reductions would appear to exceed any reasonable estimate of control costs, the body of knowledge of these costs is even more sparse than the benefits of damage reduction. The reasons for this lack of knowledge will become more apparent as the authors detail the variety of sources of emissions and the wide range of control measures in later chapters. Despite the sparseness of information on control costs, enough is known from engineering and spot surveys to establish that marginal control costs have been increasing since 1970 in addition to the expenses of confrontation between regulated and regulating communities, and the expenses of administering complex on-site traditional regulations (IEPA 1996: 1–69).
The regulatory options The variation in control costs, depending upon the amount of reduction of ozone concentration to be achieved, was recognized under Title I of the 1990 CAAA that specified a five-fold classification of urban areas by the extent of air pollution. The legislation spelled out an escalating set of regulatory measures for each classification, together with a date for reaching attainment of air quality ambient goals. Ozone concentrations derive from VOC and other precursor emissions under certain meteorological conditions and are not emitted directly. The relationships between emissions and concentrations are not exact, depending on the composition of emissions and climate conditions, but are sufficiently correlated for the public agencies to focus on emissions for regulatory purposes. Not unimportant in this connection is that emissions from specific sites are much easier to regulate. Reductions in VOC emissions were to be secured among stationary, mobile, and small area sources: stationary sources included factories, large retail establishments, refineries, and government enterprises, while small area sources included certain engines on lawn mowers and motorboats. Regulatory measures were specified for each type of source, depending upon the severity of the ozone concentration problem. Selected measures for stationary sources relevant to this study by urban area classification are listed in Table 2.2. Mobile and small area source reductions were to be achieved by such command-and-control measures as requiring reformulated gasoline to reduce emissions per vehicle mile, enhanced vehicle inspection to reduce the number of high-emitting vehicles, and the elimination of two-stroke lawnmowers. Only Los Angeles was included in the extreme category; Chicago and Houston were among the urban areas included in the severe group. While market incentive programs were not mandated by the federal legislation for VOC reductions and ozone problems, in contrast to the sulfur dioxide program, they were among the contingent measures that were optional for state and local decision. For local and state officials concerned about attracting new enterprises to their area, there were clear incentives to design programs to move to less demanding categories as fast as possible by reducing the number of ozone episodes. Noteworthy among the requirements is the development of a more reliable emissions inventory both for VOC and NOX emissions some 20 years after
The political economy of the market design 19 Table 2.2 Requirements for ozone nonattainment areas Classification
Selected regulatory requirements for stationary-source emitters
Attainment deadline for all measures
Marginal
Emissions inventory due in 2 years, Reasonably Available Control Technology (RACT) on VOC modifications due in 6 months, New Source Review (NSR) requiring best control technologies due in 2 years All of the above plus future RACT on major sources due in 2 years All of the above plus contingency measures including market incentive programs if progress is not achieved NSR required on modifications to existing plants All of the above plus fees on major sources if attainment is not achieved All of the above plus clean fuel requirements for Boilers–plan due in 3 years
Nov. 15, 1993
Moderate Serious Severe Extreme
Nov. 15, 1996 Nov. 15, 1999 Nov. 15, 2007 Nov. 15, 2010
Source: Adapted from Calcagni (1993: 190). Note New source review applies more stringent controls to new or major modifications of existing emission sources.
the 1970 legislation. During the period, “little attention had been paid to developing a credible database” (Calcagni 1993: 191), which clearly must play a key role in measuring progress toward the air quality goal and in laying the foundation for any market-based incentive scheme. Achieving that database had proved a challenge involving more expense and effort than anticipated. The challenge remains to this date, despite some progress. The difficulty is indicated by the fact that no state had completed the database in any satisfactory manner two years after the 1990 Act. Making US environmental policy is neither a simple nor always a transparent process. The federal and state government elected branches are clearly active and important participants, together with the US EPA, as in the 1990 CAAA. The 50 environmental agencies in the states play active roles in regulatory implementation and in certain discretionary areas, such as the choice of a cap-and-trade decentralized approach. Having so many government agencies involved in policy making and in implementation has been criticized as having “too many cooks in the kitchen” and increasing opportunities for evasive lobbying. It has also been praised as furthering experimentation and strengthening policy selection. The eight-hour standard was initiated in the first instance by the US EPA under legislative authority to set requirements in terms of health considerations, and the initiation withstood challenges in the federal courts. As the authors have mentioned under the new standard, each urban area was classified, or reclassified, in terms of concentration data; the Chicago area, unchanged in spatial dimensions, was reclassified as a “moderate” nonattainment region in June 2005.
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The political economy of the market design
Table 2.3 Urban area classifications for the eight-hour ozone standard Area class
Eight-hour design value (ppb ozone)
Maximum period for attainment dates in state plans
Emissions inventory
Marginal Moderate Serious Severe
From 85 up to 92 From 92 up to 107 From 107 up to 120 From 120 up to 187 (in two sub-classes) Equal to or above 187
Up to June 03, 2007 Up to June 06, 2010 Up to June 15, 2013 Up to June 15, 2021
Required Required Required Required
To be determined
Required
Extreme
Source: Adapted from US EPA 2005 http://www.epa.gov/ozonedesignations/ozonesample requirements.htm (accessed June 18, 2005).
The option of redesigning the cap-and-trade market remained very much on the state’s agenda given the reductions in VOC emissions that would be required. The agency has stated, “Further VOM reductions will be needed to meet the new standard, and the ERMS program is expected to have a role in obtaining those reductions” (IEPA 2003: 2). VOM stands for volatile organic material, which is equivalent to VOC, and ERMS stands for the Emissions Reduction Market System. Thus, an opportunity has been created to redesign the market in ways more compatible with traditional regulations and more consistent with the new air quality goals. The authors have prepared a summary Table 2.3 that specifies the eight-hour ozone levels not to be exceeded and the new attainment dates required for state implementation. Reasonable further progress is required for each urban area classification; for example, Chicago should achieve a 15 percent reduction in VOC emissions from baseline by no later than 2008 and attainment by no exceedances over the prior three years now to be reached by the later date of June 15, 2010. Several requirements are relaxed for moderate nonattainment areas compared to severe categories, such as tests of vehicle emissions by basic inspection and maintenance measures rather than enhanced inspection and maintenance, the latter involving longer tests of vehicles on rollers with the motor running. Other requirements carry over by and large from the one-hour standard, including the option of utilizing market incentive programs. Moderate nonattainment areas run the risk, as do other areas, of more stringent classification if ozone concentrations increase beyond the threshold or design values.
The cost-effectiveness motivation for market incentive regulation The difference between a decentralized market incentive system, especially of the cap-and-trade variety, and a centralized, traditional or command-and-control regulation for most plausible cases is wide and deep. In one, the decisions at the enterprise level to emit, to reduce emissions by control technologies, or to
The political economy of the market design 21 manage a portfolio of tradable permits is made under the reasonable assumption that the goal is to minimize control costs. The government designs market rules, monitoring and enforcement, but steps back from making control choices on the control front line. In the other, the government determines acceptable rates of emissions or pollutant content of inputs, often with specific control technologies in mind that are uniform across all emitters, and then calls on the appropriate level of government to implement, monitor, and enforce the controls. Under traditional regulations, the government, together with the enterprise, must be on the control front line with all that implies about the number of staff and the opportunities for confrontation. Only in the unusual case in which each emitter has identical control measures or in the case of very deep emission reductions required will the two regulatory systems approach each other in costeffectiveness. The authors will have much more to say about these two systems shortly, but a brief general history will be valuable at this point in setting the stage for the Chicago approach. Traditional regulations, it is fair to say, dominated the regulatory scene and discussion until about the mid-1990s, being specified in earlier national and state legislation. They were applied to air, water, and land pollution control, where the goals were a certain quality level such as air pollutant emissions or ambient air concentrations. More detail on the importance of these traditional regulations on the VOC market is provided in Chapter 4. Economists, on the other hand, had a record of studies purporting to show that many such regulations were costineffective and could be bettered from a cost standpoint by incentive regulation, such as emissions trading (Stavins 1998: 69–88). These studies appear to have had much less influence than the mounting evidence on control costs. The US EPA was aware of this problem and experimented after 1970 with a cautious, tightly-controlled emissions credit trading program in selected areas for selected pollutants requiring pre and post-approval of trades that had to meet strict measurement requirements (Tietenberg 2002: 278). Few trades were carried out in the light of these heavy transactions’ costs. California led the way in the late 1980s in developing a less restrictive cap-and-trade approach in the Los Angeles area in an effort to reduce local urban smog constituents, such as NOX and sulfur dioxides (SOX), under the rubric of a Regional Clean Air Market plan (RECLAIM). Under this program, the pollutant control decisions of utilities and other large emitters were more completely decentralized (Lents 2000: 237–238). These two markets were the first of their kind and attracted wide attention. An attempt to design a cap-and-trade market for VOC emission reductions ran into strong opposition and was aborted for reasons the authors will describe. The RECLAIM markets provided an example that stimulated further studies and discussion, including the path-breaking US CAAA of 1990. The 1990 national legislation specified among other features a cap-and-trade market for reducing SOX emissions by about half in two stages for the nation as a whole. Coal-burning electric utilities were most affected. The political economy of the legislation has been well described in several studies (Ellerman et al. 2000). Several features of this market are highly relevant for our purposes. SO2 emissions
22
The political economy of the market design
were accurately measured for the most part by continuous electronic monitoring in smokestacks. This system permitted real time monitoring by the US EPA. The legislation called for a reduction of almost half of historic emissions (the cap) by allotting tradable permits to individual emitters, based on their own historical emissions after some adjustments. Tradable permits could be traded, used to cover emissions by returning permits to the government, or banked indefinitely. It is important to note that given the current enthusiasm for market incentives, the 1990 legislation initially was not greeted with broad applause, and passed the US Congress by a small margin. The affected business community was largely opposed or indifferent. For example, the Edison Electric Institute, an organization of electric utilities, did not buy into the allowance system and trading at the start (Rosenberg 1997: 97). The system was supported by the US EPA, many economists, and an influential environmental organization, then called the Environmental Defense Fund. The latter may have had important political significance among elected officials. Traditional regulations had been the dominant measures chosen to reduce local VOC and NOX emissions in the Chicago region, although questions were being raised in the early 1990s about the mounting costs and the slow progress in reducing emissions. The functioning of the RECLAIM markets and the growing recognition that the SO2 cap-and-trade market was effective added further motivation to seek alternative courses of action. The first effort proposed by a small leadership group within the IEPA was to develop a cap-and-trade approach to reducing local NOX emissions (Gade 1993: 4–8). Apparently, this was due to the feasibility of designing a market to cover the relatively few companies with large boilers, giving rise to more easily measured NOX emissions and to the earlier unsuccessful effort to use this market system to reduce ROGs, as VOC are called, in Los Angeles. There a number of businesses had strongly protested the emission baselines proposed and the allotment of tradable permits. At the same time, environmental groups had expressed deep concerns about hot spots and inter-temporal emission spikes that could result from autonomous and anonymous trading decisions. In the face of this opposition, the VOC cap-and-trade market was abandoned and traditional regulations continued (Lents 2000: 221). An unforeseen complication to this early Chicago plan arose from air shed modeling work of the Lake Michigan Air Director’s Consortium, made up of states bordering on the lake, that revealed that incoming concentrations of NOX from other states were very high. This regional movement of NOX concentrations called for a regional or national research and regulatory effort that was later implemented (Ozone Transport Assessment Group 1997: 57). The IEPA then turned to the development of a VOC cap-and-trade market that was to be a pioneering venture into a much more difficult and complex market design and implementation process. The VOC emission sources are ubiquitous and highly variable, arising from industrial solutions, paints, combustion processes, various inputs and the like, most of which could not be monitored by the kind of continuous electronic monitoring that was used to measure and monitor SOX emissions from
The political economy of the market design 23 smokestacks. Instead, reliance was placed on VOC emission rates from particular processes and control technologies and from purchase records of inputs. As an aside, it should be noted that emissions from mobile and small area sources were even more difficult to measure. Such hurdles at the emitter level would clearly affect the availability of aggregate data. Not only emissions but also ambient concentrations of VOC, NOX, and ozone molecules in the atmosphere proved expensive and difficult to measure accurately. A collaborative effort by states bordering Lake Michigan carried out studies attempting to close these gaps, but it did not have the formal agreement of the Northeast states to form a commission to develop an emissions inventory and to carry out control measures (Ozone Transport Commission 1998: 2–1 through 2–3). A step toward more information was obtained by setting up a number of ozone-concentration monitoring stations around the state and in the nonattainment area. The VOC emissions data remain subject to uncertainty, some of it inherent. The 1990 CAAA operating permit or authorization required detailed information from individual emitters on processes and inputs, giving rise to pollutants and contained provisions for reporting annual emissions based upon emission rates or factors from processes and VOC content in inputs. These authorizations were the basis for IEPA determination of baselines and allotments. They were incomplete in a number of respects. Besides the issue of accuracy, there were omissions, such as the reporting of hazardous air pollutants (HAPs) emissions and separate reporting of seasonal emissions. A separate report on HAP emissions was not required until 2001 and then only for a subset for which standards had been determined. Seasonal emissions from May through September, as distinct from estimates based on annual values, were required just before the start of the market in 2000. The matter of uncertain emissions data poses problems for any urban area planning a market incentive system to reduce smog, as it includes not only VOC emissions but also particulate matter. It was not only the difficulty of obtaining reliable emissions data, but also the lack of knowledge about, and experience with, VOC cap-and-trade markets that occupied the IEPA. These market incentive systems were permitted but not specified by the 1990 legislation, unlike the SO2 market. Thus, there was little guidance on what the detailed features or design of a cap-and-trade market should look like. The failure of the Los Angeles attempt was hardly the information desired by the IEPA.
The market design dialogue and decisions The first administrative steps were to hold large forums, inviting comments on the proposed VOC market system and asking interested groups to participate in an on-going dialogue about the design features of the VOC cap-and-trade approach. Such large emitters as a BP Amoco Refinery, Caterpillar, Abbott Labs, and Corn Products agreed to participate in the dialogue. Small emitters were represented through the Illinois Chamber of Commerce. Environmental groups, such as the Citizens for a Better Environment and the Chicago branch of the American Lung Association, joined the effort. Notably absent, because they
24
The political economy of the market design
lacked local chapters, were the nationally important Environmental Defense (Fund) and the National Resources Defense Council, the former having played a major role in support of the SO2 market. The authors were asked to participate as academics. The regulatory community, in addition to the IEPA, was represented by the regional office of the US EPA. Needless to say, there were contending views on the specific features of the market that were debated over a long period of time, requiring postponement of the start-up date until 2000. There was little discussion of the use of pollutant taxes rather than emissions trading. In circumstances of full information and certainty about market and environmental outcomes, the two decentralized regulatory measures, pollution taxes and emissions trading, can be shown to be equally cost-effective. In circumstances of uncertainty, the slopes of the marginal cost and marginal benefit functions can enter the decision and favor one or the other measure in terms of achieving desired pollution reductions. These considerations played little or no role in the public discussions. Taxes were unpopular with the business community and the free allotment of tradable permits eased the resistance of that community to the new program. What resulted from the debate was a compromised market that the authors describe feature by feature as a guide to an understanding of the anatomy of a capand-trade market. This detail will also provide insights into the contending views of interested groups. Most important, it will provide an introduction to the possible design deficiencies that resulted from the compromises made by the IEPA. The authors emphasize that there were few precedents or guidelines for the design of a local cap-and-trade market to reduce stationary source VOC emissions. The agency was on the frontier is this effort. The major features and the decisions may be summarized as follows (IEPA 1998: 3–4): 1 The benchmark of emissions, both aggregate and for individual emitters, is an important design feature that must be determined within the geographic area of concern, based on historical information or projected future information. Obtaining accurate benchmark data is not a trivial exercise, and concerns about accuracy were expressed by environmental groups and academics. The IEPA final decision was to use the average of the historical period 1994–6 as reported by emitters located in the six-county-plus-two-township Chicago nonattainment area. The business community objected that that period might not be representative for all firms, so substitution was allowed for cause in the range 1990–7. 2 The reductions of the aggregate volume of emissions from these benchmarks are measured by the cap that is determined by the government, taking into account the desired improvement of air quality, and the support of emitters. Typically, this essential design feature is negotiated, as was true in this case, with the business community arguing for a small reduction and the environmental community arguing for a larger one. The final IEPA decision was a 12 percent reduction in emissions (an 88 percent cap) that should be compared with the 50 percent reduction of historical SO2 emissions from
The political economy of the market design 25
3
4
5
6
affected electric utilities. The small reduction required in the Chicago program eased the resistance of emitters to the market system. The allotments of tradable permits to individual emitters measured in units of emissions that add up to the aggregate volume of acceptable pollution must be determined by the government and either auctioned off or allotted free to each enterprise, based on their individual benchmarks. Emitters argued that the required, strict control measures for HAP emissions, a subset of all VOC emissions, left them little leeway and added that many had made important state-of-the-art improvements in controls under the stimulus of traditional regulation. The agency awarded permits in full rather than 88 percent for HAP emissions and also for emissions controlled by state-of the-art technologies. These exceptions comprised about 18 percent of all VOC baseline emissions and set an overall design reduction of about 10 percent (a 90 percent cap). The academics argued for an auction, but the permits were allotted free of charge in accordance with the wishes of the business community. Government procedures for receiving and recording permits for measured emissions from individual participants in the market and recording transactions must be established in a way that inspires confidence on the part of observers that emissions are being properly limited and the market is working as expected. In the Chicago program, no prior or post-approval was required for a trade. VOC emissions and ozone concentrations are fund pollutants, meaning they do not accumulate in the environment like lead or mercury, but are gradually transformed into less harmful substances. They are harmful in the transition and the agency’s data on emissions are important for this reason, as well as for keeping informed on observance of market rules. To assist in the tracking effort, the agency required that tradable permits be numbered for measurement and recording purposes. Environmental groups argued for separate reporting of HAP emissions due to their toxicity, but the regulated community countered, and the IEPA accepted their argument, that such reports would be difficult to obtain and expensive. Permits may be traded, used to cover emissions, or banked. The horizon for banked permits is a vital market design decision for the IEPA. The environmental groups had been reluctant to support any banking, believing that hot spots and inter-temporal spikes could result from banking, an important issue in the Los Angeles controversy. The regulated community argued for the inter-temporal control cost savings that could result if emitters could bank for later use. The one-year horizon on tradable permits, that is, permits were good for only one year after issuance, was a crucial compromise by the IEPA whose consequences were not clearly foreseen at the time. This decision was in stark contrast to the decision to have a long-lived SO2 permit. Dated permits not used or traded by the end of the one-year period expired without value. Future dated permits could be traded but not used prior to that date. The environmental community argued for subdividing the market into smaller areas and denying trade across areas, in an effort to avoid hot spots
26
The political economy of the market design
or local neighborhood increases in emissions. Furthermore, HAP emissions were singled out as deserving special attention. Not all such pollutants are equal in toxicity, and there was interest in having separate data on speciated HAPs for which toxicity is known to vary. Members of the business community pointed out that subdivision of the market would limit its costeffectiveness, and obtaining data on speciated HAPs was not presently available and would be difficult and costly to obtain. The agency decided on a unified market but agreed to publish emissions data, including a category for recorded HAPs, on a small area basis (township basis) to facilitate the analysis of possible hot spots. 7 Monitoring and enforcement procedures must be established by the government and understood by emitters if the market is to work properly. The business community expressed concern about the availability of permits and the extent of fines for emissions in excess of permits. The agency agreed to establish a secondary market, using a small set-aside account of permits that could be acquired above market price. The agency also agreed to limit fines and negotiate problems encountered in recording permits. 8 There were strong views from the environmental groups and many representatives of the regulating community that traditional regulations were not only to continue but also to be extended and actively pursued, although some business participants complained about this dual regulation. Since many of the traditional regulations were mandated in detail by the US EPA, dismantling of these measures would have required active cooperation between state and federal authorities. No attempt was made in this direction, even to relaxing certain measures. Rather, the IEPA considered the market system to be installed on top of command-and-control regulation, assuming that each would act independently, the strengths of one offsetting the weaknesses of the other. As the IEPA home page on the web stated on June 6, 2005, “Command-and-control requirements are not altered by the adoption of ERMS.” ERMS stands for the Emissions Reduction Market System, the Chicago cap-and-trade program. The lack of integration of the dual system proved to be a major design issue. 9 The agency reported it would publish annual performance reports providing data on market activity. The reports were prepared primarily in administrative terms and did not systematically track emissions from sources to uses. As a result there were gaps, inconsistencies, and difficulties in analyzing transaction flows. The authors developed and proposed a table describing sources and uses of tradable permits to assist in this effort. Such a table, the authors believed, would enable the IEPA to track and quantify the market activities of emitters in the program and to check the accuracy and consistency of transactions’ data. The table was not adopted by the agency, although it would have prevented numerous errors in the annual ERMS performance reports. The table is reproduced in the chapter on performance as it provides a framework for understanding the interrelationships of market transactions and enabled the authors to check for consistency errors in agency data. Such a
The political economy of the market design 27 tradable-permit ATU sources and uses table is recommended for all cap-and-trade markets. 10 There were few, if any, threats by the business community to move out of the nonattainment area because of the new market system. It was well known that traditional regulations applied to most other areas and that the rules for prevention of significant deterioration of air quality in more pristine areas could impose new and more stringent standards. At one point, the authors considered examining changes in the value of stocks for comparable firms within and outside the market area to estimate one economic impact of the program, but the very low price of tradable permits, as revealed in Chapter 3, suggested that little was to be gained by this complicated research. 11 The contentious dialogue process took several years to run through the various features, to give vent to the diversity of views, and to allow time for the agency to make final design decisions, often based on compromises of interest group positions. Whatever time lines the agency had for the initial implementation had to be postponed for a year to give the dialogue its due and to prepare operating licenses for emitters that incorporated the new market system. The problems confronting the agency are difficult to over estimate. They may be best described by contrasting the features of a cap-and-trade market for trading pollution with the standard private market within which most of us carry out customary transactions, with little thought of the institutional or design framework. This customary market may be termed the Standard Economic Market Model (SEMM) embedded in a setting of standard features. Only in the case of concentrations of economic power or imperfect information is much attention paid to these features or assumptions. A well-defined commodity is typically assumed in the SEMM with specifications that can be checked and verified by the purchaser. Use or consumption of the commodity or its services is surrounded by a bundle of rights making up private property. Whether it is bread or wine, toasters or glassware, a punch press or computer, the buyer, having purchased the item, can consume or use it but a neighbor or competitor cannot legally do so. In the SEMM setting, there are assumed to be many buyers or sellers so that the withdrawal of one from the market cannot influence price. There are usually no spatial constraints on use or production of the commodity. In most cases the buyer can store the commodity as long as desired. There is ordinarily no requirement to report transactions to the government or to keep detailed records. Market prices should make available valuable information on marginal production costs or satisfaction to the consumer. Usually, the government did not explicitly design the market, although it ordinarily regulates the quality of the commodity, the degree of competition, and the health and welfare consequences of consumption or production. In contrast with these features, governments in most instances create and design environmental markets to correct the externalities of the SEMM that affect health and welfare. Which enterprises must participate in the market is mandated by the government, typically in terms of the importance of the emitter pollution output
28
The political economy of the market design
compared to the total. Thus, entry into the market is a decision of the government. Exit is not permitted, unless the enterprise reduces pollution below some threshold or goes out of business. These constraints on entry and exit can create opportunities for noncompetitive behavior that do not arise in customary markets. The commodity in a cap-and-trade market is a tradable permit to emit a predetermined amount of pollution, a concept not easily grasped or supported by all observers. This permit is, according to legislative mandate or administrative regulation, not to be considered private property in order to protect the government from legal liability if new health or welfare information requires a change in the value or number of permits. The permit may be denominated in a ton of sulfur or 200 pounds of VOC emissions, but the content, not the weight, may change when the permit is transacted. That is, one emitter with a certain content of hydrocarbons in the permit may sell to another emitter who will use it to cover emissions with a different hydrocarbon content but the same weight. The permits remain homogeneous with respect to weight. Also, unlike the commodity of customary markets, the pollutants in the permits are in most cases subject to traditional regulations that constrain the rates of emission or require control technologies or limit the pollutant content of inputs. There are spatial constraints on the market: a permit valid in the Chicago area cannot be sold or used in the Los Angeles area. There can be limitations on how long the permit can be stored or banked; for example, the VOC tradable permit can be banked for only one year after issuance compared with the SO2 permit that can be banked indefinitely. Transactions ordinarily do not require pre- or post-approval of the government but permits are invariably numbered and a full accounting of transactions is required. Marginal control costs of reducing emissions should vary significantly among emitters or processes if cost effectiveness is to result from intra-firm (intra-process) or inter-firm trading. A well-functioning cap-and-trade market can provide valuable price data bearing on current and future marginal control costs. Governments will typically record permit allotments and transactions, some of which are made public, and monitor and enforce market rules, but the key to decentralization is to allow emitters to make micro-decisions on control decision and permit transactions, thus achieving environmental regulation at a cost below that of centralized regulation. Making clear these important differences between the SEMM and the cap-andtrade markets provides essential background for the complex negotiations and bargaining required in the latter case, and, perhaps more important, provides a basis for understanding the potential for design flaws that can affect the latter’s performance. It should be added that deficiencies in the SEMM markets and sub-par performance are not unknown.
Expectations of cap-and-trade market performance based upon simulation modeling During this pre-market period, several studies were carried out by researchers modeling an abstract cap-and-trade market in an effort to estimate permit prices
The political economy of the market design 29 and transactions. These provide such an interesting insight into the researcher’s interpretation of the market design and expectations of its performance that the authors discuss these estimates and the methods used to obtain them in more detail in Chapter 5. It is highly relevant to note at this point that permit price estimates ranged around $250 a permit, or $2,500 a ton per VOC reduction, and transaction estimates were sufficiently numerous to indicate cost savings. The regulating agency itself had carried out an early study, based on an abstract model that produced estimates in this range also (IEPA 1996). Actual prices turned out to be significantly lower than anyone expected, a matter given much more attention in later chapters. These generally available price estimates indicate the expectations held by almost all researchers prior to the first transactions. The authors confess to having expectations in this range also, based on their own study to be reported in a later chapter. While this research into the performance of abstract models of competition and cost-minimizing emitters was underway, there was little or no research that the authors are aware of into the performance of a market with dual regulation and the design features of the VOC program. There was no systematic study of aggregate emissions data and their adequacy, nor detailed study of individual emitter emissions trends over time. No one expected unusual banks or expirations of permits. Rather, there was an urgency to get the market underway after the long discussions The position of the IEPA was well expressed in an early performance report that noted, “Unlike other emission trading systems across the country, Illinois does not allow sources to avoid other emission limits by participating in the market” (IEPA 2001: 4). One prescient voice expressing doubts came from an experienced environmental manager who wrote, “this new system will not achieve its maximum potential because of the fact that it is an overlay on the existing technology-based command-and-control system” (Zosel 2000: 299). The authors turn in Chapter 3 to the actual outcomes of the first years that may be compared to these early hopes, predictions, and expectations.
3
Expectations and actual performance
Introduction After a long period of discussion among interest groups concerning market design changes and agency decisions, the start of the market in 2000 was launched amidst considerable uncertainties and concerns. The business community was divided, with many smaller businesses concerned about the availability of tradable permits and their price. The environmental community was greatly concerned about hot spots and spikes in emissions. The Illinois Environmental Protection Agency (IEPA) seemed edgy about achieving emission reductions and the difficulties of monitoring emissions under the new regulatory regime. The academic community was perhaps most eager for the start of the market in order to test models and to estimate the improvement in air quality and cost-effectiveness of this new regulatory measure. Much to the surprise of many in the involved communities, the first years of performance of the market, 2000–3, revealed unexpected and puzzling results, which departed from early model predictions by researchers and differed markedly from many of the concerns of emitters, the regulating agency, and environmental groups. Perhaps the greatest surprises were experienced by academic researchers, who found their forecasts wide of the mark. Unexpected performance was revealed in reported emissions, transactions, permit banks, expirations, and prices. This performance redirected the authors’ research into new areas to provide explanations for these puzzling results and to provide a basis for redesign of the market. Therefore, a detailed report on these outcomes is essential for that purpose, and for an understanding of what went wrong with the market design.
Actual market performance The authors’ record of the market outcomes during the observed performance of the new market, contained in Table 3.1, is based upon agency data, in addition to calculations by the authors. Such surprising developments led to a reconsideration of the market design and new concerns that the Chicago cap-and-trade approach, locally called the Emissions Reduction Market System (ERMS), was performing far below its potential in achieving cost savings and flexibility.
Expectations and actual performance 31 Table 3.1 presents basic aggregate data on baselines, allotments, and market activity over four years in the Chicago six-county-plus-two-townships-urbanozone nonattainment area. While most data were obtained from annual reports of the IEPA, they have been arranged by the authors in a more unified format, supplemented by new calculations, and corrected in a number of places as indicated. Table 3.1 contains obvious inconsistencies that should be made clear before interpreting the data. Table 3.1 Market-wide ATU (tradable permit) transactions and prices for the years 2000–3 Category
1 Baseline in ATU units 2 Allotted ATUs 3 ATU retirements (reported emissions) 3.1 Vintage 2000 ATUs 3.2 Vintage 2001 ATUs 3.3 Vintage 2002 ATUs 3.4 Vintage 2003 ATUs 4 ATU transactions 4.1 ATUs traded 4.2 Number of buyers 4.3 Number of sellers 5 Banked ATUs 5.1 Vintage 2000 ATUs 5.2 Vintage 2001 ATUs 5.3 Vintage 2002 ATUs 5.4 Vintage 2003 ATUs 6 Expired ATUs 6.1 Vintage 2000 ATUs 6.2 Vintage 2001 ATUs 6.3 Vintage 2002 ATUs 7 ATU prices 7.1 Average price 7.2 Price range 7.3 Vintage 2000 price 7.4 Vintage 2001 price 7.5 Vintage 2002 price 7.6 Vintage 2003 price 8 Number of participants
Year 2000
2001
2002
2003
105,479 95,398 59,112
107,777 97,124 51,703
108,718 98,164 51,164
108,424 97,859 43,601
58,848a
21,407 30,215
1,643 35 23
3,702 27 21
31,575 19,410a 4,483 33 25
30,380 13,181a 6,902 35 31
37,435 73,401 82,358 84,678b 13,924 33,760 48,374b $75.87 $50 to $150 $75.87
179
$51.93 $38 to $100 $50.54 $63.93 172
$32.85 $20 to $50 $32.06 $31.04 172
$18.75 $8 to $30 $18.34 $20.65 175
Sources: IEPA Annual Performance Review Reports, 2000, 2001, 2002, and 2003. Notes Units are in ATUs: an ATU 200 pounds of VOC emissions. The internal consistency of the table is affected by several types of transactions not enumerated, as explained in the text. a Denotes calculated data. b Denotes corrected data.
32
Expectations and actual performance The data for each year should generally fulfill the equation: ATU allotments(t) ATU banks (t1) ATU retirements(t) ATU retirements(t1) ATUs banked(t) ATUs expired(t1),
(3.1)
where t refers to the date the permit was issued, retirements refer to permits returned to the government to cover emissions, and ATUs, or Allotment Trading Units, refer to tradable permits measured as 200 pounds of volatile organic compounds (VOCs). The equation does not hold exactly for the years 2000–3 because of the following changes not recorded in Table 3.1, and in some cases not reported by the agency: 1 2 3 4 5 6 7
permits donated to environmental or community groups; permits purchased from a special compliance account managed by the IEPA; permit changes resulting from continuing negotiations with emitters over baselines, allotments, and reported emissions; permit changes resulting from emitters who drop out of the market by reducing emissions below the 15 ton per season threshold; permit changes from new emitters that increased their emissions above 15 tons per season, but were in operation as of May 1, 1999; permit changes resulting from shutdowns of emitters; and permit errors made in reporting.
These various transactions affect the internal consistency of Table 3.1 and could be resolved by increasing the number of rows in the table, but at the cost of making it almost unreadable. As these changes are relatively small, the authors have chosen to leave these minor inconsistencies in the table, since the main points are still clearly revealed and would not be affected by incorporating these various changes. Data for the year 2003 is the exception to this reasoning. For that year, the inconsistencies reported by the agency are too blatant to ignore. The totals reported for banked permits and expired permits were corrected so that a level of arithmetical sense could be restored. In addition, the authors have used the equation (3.1), building on the most reliable data available, to calculate a number of remaining entries that were not included in the performance reports. A particular ATU sources and uses table is presented later in this chapter, which provides an accounting framework for tracing transactions and reconciling discrepancies in the Chicago cap-and-trade market. The agency has been informed of this table and of these omissions and errors; however, a correction sheet has not been issued at the date of publication of this book. The first category in Table 3.1 presents the baseline or benchmark emissions of market participants in tradable permits or Allotment Trading Units (ATUs) each measured as 200 pounds of VOC emissions. Each participant’s baseline was
Expectations and actual performance 33 determined as the participant’s choice of the average of two ozone seasons (May 1 through September 30) of VOC emissions during the 1994–6 period, although some exceptions were made. One exception was that any season between 1990–7 could be substituted in the baseline if the emitter was able to prove to the agency that the 1994–6 period was not representative of its average seasonal emissions. Approximately 16 percent of emitters performed a substitution for one of their base years, while approximately 4 percent performed a substitution for both of their base years. These revisions of baseline emissions credited to the firm, while generally positive in number, were not extensive in magnitude, amounting to only a few percent of the total. The aggregate baseline is the sum of individual participant baselines as calculated by the IEPA, and varies slightly from year to year as negotiations continue over the historical period, as a few new participants, with increased emissions, enter the market who were already emitting as of 1999, and as a few old participants chose to drop out when their emissions declined below the 15 ton per season threshold. The second category presents aggregate allotments of tradable permits distributed free of charge to emitters. Those with emissions greater than 15 tons of VOC during the ozone season were required to participate in the market, while those with emissions between 10 and 15 tons could opt in voluntarily. Emitters with levels below 10 tons of VOC per ozone season were considered too small and were excluded from participation in the Chicago cap-and-trade program. As mentioned, allotments were to be a 12 percent reduction from individual baselines or an 88 percent cap. In addition to the negotiations over the baselines, there were adjustments made to allotments. Permits were allotted in full for hazardous air pollutants (HAPs) emissions on the grounds that they were already subject to the most stringent controls, and allotted in full for any emissions limited by new, more advanced control technologies that performed better than required traditional regulations. Approximately 50 percent of emitters had some portion of their emissions exempted from further reduction, but these exempted emissions make up only about 18 percent of the total baseline emissions. Therefore, the aggregate emission reduction, the difference between categories one and two, is about 10 percent, somewhat less than the policy goal of 12 percent. Not all VOC emissions are equal in their ozone-creating potential, nor are all HAP emissions equal in their toxicity potential. The first problem was simplified by considering VOC emissions to be emitted in fixed proportions. The second problem of dealing with HAP emissions raises issues of hot spots that receive separate treatment in Chapter 7. The third category presents data on aggregate emissions during each year as measured by permits retired (returned) to the government by market participants for each 200 pounds of VOC emissions as measured during the ozone season. Most of these figures were obtained from the IEPA performance reports. As permits may be banked for a year, retirements to cover emissions after the first year may be made with current or previously allotted permits as noted. In some cases, however, the current vintage retirements were not reported. In these cases the authors provided an estimate of the current vintage retirements by subtracting
34
Expectations and actual performance
permits purchased from the IEPAs special compliance account and retired permits of the previous vintage from the total retirements. Emissions were selfreported with monitoring checks by the agency. The deep reductions in emissions as revealed in this category, far below the requirements of the cap, make up one of the central puzzles of the market thus far. These reductions were on average about 50 percent of the aggregate baseline and a slightly higher percentage of the allotments during the four years. That reported emissions continually declined during the four-year period is a remarkable fact that calls for an explanation. The fourth category presents data on market transactions of permits, another of the important decisions made by emitters. As is readily apparent, these transactions were a small share of allotments, gradually increasing to about 7 percent in 2003. In 2000 approximately 32 percent of emitters participated in the market, indicating that most transactions were small in magnitude. There was relatively little turnover among participants; the same firms, typically, were repeat buyers or sellers. The approximately one-third participation rate seen in the Chicago market is well below the participation rate seen in the national sulfur dioxide (SO2) allowance program. The fifth category presents aggregate banks of permits held at the end-of-the year reconciliation period. It is worth repeating that under current rules, dated permits may be banked for only one year after issue so that each banked permit must be used in the following period, or it will expire. Consequently, another puzzle of the market performance is the rapid and continued growth of banked permits to the point that by 2001, they exceeded emissions in the following years. The problem facing participants with such large banks is that many of them will expire, while the problem facing observers of the market is to explain these large banks. The sixth category presents data on expirations of valuable tradable permits and should equal zero if cost minimization occurs. It did not for each of the years following the first year, when no prior banks existed. Instead, expirations grew in magnitude year by year to the extent that vintage 2002 tradable permit expirations in the year 2003 made up close to 70 percent of vintage 2002 allotments. This is among the most perplexing problems of reported market activity, as it would seem to amount to giving away valuable permits. It raises the question of why emitters did not increase emissions, which could then be covered by unused permits. Note that the number of vintage banked permits need not equal exactly the next year’s sum of the same vintage retirements or expirations, because a number of banked permits could be donated to community or environmental groups as a contribution to cleaner air, as explained earlier. These contributions, which would have public relations value, if not tax implications, were small in number during the four years. The seventh category presents data on average permit prices calculated by the agency from individual transaction prices after the transactions period closed. Individual prices of transactions are not reported. The average price is calculated as the total price of all permits traded divided by the total number of permits
Expectations and actual performance 35 traded. Prices were not included in the average for intra-firm transactions, for purchases from the agency’s special compliance account, or for the several transfer agreements involving multiyear permits. Due to these exemptions, 69 percent of trades were included in the 2001 average price of $51.93, while 78 percent of trades determined the 2002 average price of $32.85, and only 40 percent of trades were included in the 2003 average price of $18.75. The steady decline in average price from about $76 in the first year to less than $20 in the fourth is a trend and level that no one would have predicted at the start, including the authors. In addition to seasonal trades, emitters can engage in transfer agreements where a future stream of permits is traded in perpetuity. In 2000 there were three transfer agreements, two of these were inter-firm transfers, with an average price of $1,013.04 per permit involving a total of 230 permits. This price implies a discount rate of 7.5 percent, based on the $76 average price of a seasonal permit in 2000. Over the next three years, another ten transfer agreements occurred, but all of them involved special circumstances, so no prices were recorded. Several more comments are in order on the price patterns of category seven. As permits of two vintages could be traded after the first year, given the banking rule, there are in effect two different permit commodities with a different time dimension during those following years. Given that a permit that could be used in a current or subsequent year provides more options than a permit that will expire at the end of the current year, the observer would predict the former would command an equal or higher price than the latter. That was true for 2001 when the differential was over $13 a permit, but the vintage 2001 price was based on only four of the 35 trades that occurred. That was not true of the differential for 2002, when the difference was reversed to a negative $1.02 for the later longerlasting vintage. This kind of backwardation creates another puzzle in the pricing realm that is difficult to explain or interpret in any optimizing framework. The fact that the 2002 vintage price was based on trades involving only 106 permits, or approximately 2 percent of permits traded, might explain part of the puzzle. In 2003, the price difference for the later vintage was a positive $2.31, with the 2003 average price based on trades involving 184 permits or 3 percent of total permits traded. The final category presents data on the number of emitters that participated in the market. The threshold level of 10 tons of VOC emissions during the fivemonth ozone season as a requirement for participating in the market was established to exclude small emitters. This reduced the 1,958 stationary sources identified in the 1990 VOC inventory to 283. Further reductions in numbers occurred due to negotiations over existing controls and prior emission reductions, so that finally 179 participants were included in the year 2000 start date. This start date, as mentioned, was a delay of one year from the original plan, given the number of decisions to be made and the complexity of the negotiations among all concerned parties (IEPA 2000: 1–3). The number of emitters could change as new emitters located in the area, emitters that qualified dropped out, or emitters opted in, but the number of such changes was relatively small.
36
Expectations and actual performance
There were eight emitter shutdowns during this period that continue to receive year-by-year allotments after their shutdown less a set-aside fraction. This important category deserves further analysis, as an observer could attribute such shutdowns to the impact of new regulations. Most of the shutdowns refer to closing of particular processes in a firm to be replaced by other techniques. None of the shutdowns appeared to be relocations of the firm (IEPA 2000: 18). The number of such shutdown permits made up less than 3 percent of total allotments and almost all of the tradable permits so earned were allowed to expire without being sold (IEPA 2003: 20). There is little evidence that the market led to movement of firms out of the nonattainment area or led to shutdowns in an effort to realize gains from sale of tradable permits. Whether the market discouraged new firms from entering the area is a difficult question that will require, in order to obtain answers, an extensive research project extended over a longer period of time. In 2000, the IEPA lists a total of 250 eligible firms in the area. A total of 179 are participating sources in the Chicago cap-and-trade program, while 67 were exempted due to the 15-ton per season limit and another four were exempted due to having already performed an 18 percent reduction in emissions. Changes over the years in the number of firms participating, due to the shutdowns and new exemptions, bring about minor fluctuations in the baseline emissions. It is important to note, however, that no new firms are recorded as entering the market, meaning that all of the firms in the market in all of the years must have been in operation as of May 1, 1999.
The sources and uses of tradable permits The reader may wish for a framework within which the various flows of transactions could be better interpreted, analyzed, and tested for consistency. To provide such a framework, the authors have developed a sources and uses table for individual participants that can be aggregated for the market as a whole. It is reproduced at this point and data for 2003 are entered to illustrate the adjustments made by the authors to the information provided by the agency. Table 3.2 can be used by an individual emitter in order to perform an accounting of their tradable permits, but can also be used in aggregate by the agency or observers to reproduce most of the results presented in Table 3.1. First, the sources of tradable permits for an individual participant in the current year are permit allotments, permits purchased from the open market, permits purchased from the special compliance account run by the IEPA, called the Alternative Compliance Market Account (ACMA), and permits banked in the previous year. Participant allotments in Table 3.2 include both regular allotments and emission reduction generator (ERG) allotments. These ERG allotments are received by participants who, with the approval of the IEPA, have proven a reduction in emissions through the shut down of a particular plant or process. In return for their reduction in emissions, they receive a certain fraction of their allotment of tradable permits that they can trade on the open market. Therefore, the total
6,902 _______ _______ _______ _______ _______ _______ 40
82,358
189,860
S2 Participant purchases of ATUs from the market S2.1 Seasonal purchase of vintage t1 ATUs S2.2 Long-run transfer purchase of vintage t1 ATUs S2.3 Seasonal purchase of vintage t ATUs S2.4 Long-run transfer purchase of vintage t ATUs S2.5 Purchases involving ATUs of future vintages
S3 Participant purchases of ATUs from ACMA (Alternative compliance market account)
S4 Participant bank of vintage t1 ATUs
Total ATU sources
U3 Participant donations of ATUs to ACMA U3.1 Donations of vintage t ATUs U3.2 Donations of vintage t1 ATUs U4 Participant bank of vintage t ATUs U5 Participant donations of ATUs to special participants U5.1 Donations of vintage t ATUs U5.2 Donations of vintage t1 ATUs U6 Expirations of vintage t1 ATUs U7 Statistical discrepancy Total ATU uses
Notes Units are in ATUs: an ATU 200 pounds of VOC emissions. Corrected data used to reduce the statistical discrepancy are in parentheses. a These values differ from those presented in Table 3.1, due to the inclusion of ERG permits.
Sources: IEPA Annual Performance Review Reports, 2002 and 2003.
U1 Participant retirements of ATUs to cover emissions U1.1 Retirements of vintage t ATUs U1.2 Retirements of vintage t1 ATUs
100,560a
S1 Participant allotment of vintage t ATUs
U2 Participant sales of ATUs in the market U2.1 Seasonal sale of vintage t1 ATUs U2.2 Long-run transfer sale of vintage t1 ATUs U2.3 Seasonal sale of vintage t ATUs U2.4 Long-run transfer sale of vintage t ATUs U2.5 Sales involving ATUs future vintages
Uses of ATUs
ATUs
Sources of ATUs
Table 3.2 Participant sources and uses of tradable permits (ATUs) during year t (2003 IEPA aggregate data)
_______ _______ 40,370a (51,056a) 7,193 (3,160) 189,860
268 _______ _______ 105,717 (84,678) 195
_______ _______ _______
6,902 _______ _______
_______ 30,380
43,601
ATUs
38
Expectations and actual performance
allotment for 2003 shown in Table 3.2 is the participant allotment of 97,859 ATUs plus the ERG allotment of 2,701 ATUs. Adding to this, the participant purchases of 6,902 ATUs from the open market and 40 ATUs from ACMA as well as the previous year’s bank of 82,358 ATUs, one finds the total sources of permits equal to 189,860 ATUs. Next, the uses of tradable permits include retirements of permits to cover emissions, sales of permits on the open market, expirations, banks, and donations of permits to ACMA or special participants. These special participants cannot retire or sell the permit, and have included environmental groups and academics. Most of the figures on the uses side of the table are obtained from the IEPA performance reports; however; the data provided for banks and expirations were so incorrect that the authors chose to include their corrected numbers in parentheses in order to provide a comparison. The IEPA reports that participants banked 105,717 ATUs in 2003 to save for use in 2004. This is impossible, given that only 100,560 ATUs were allotted in 2003. To arrive at a more acceptable banking number, the authors calculated the bank in 2003 as the number of ATUs allotted in 2003 minus the number of vintage 2003 ATUs retired in 2003. This provided a more logical figure of 84,678 ATUs as the bank of 2003 permits. Next, to provide a more plausible calculation of expirations, the authors simply took the 2002 allotment minus the vintage 2002 permits retired in 2002 and 2003, presuming that the remainder expired. Note that these expiration figures differ from those presented in Table 3.1, because of the inclusion of the expiration of ERG allotments. It is also possible that there may be a slight error in this calculation because the donations of 297 permits in 2002 and 463 permits in 2003 are not included. It is not clear what vintage those donations were. These donations, however, cannot explain the approximately 11,000 vintage 2002 permits that the IEPA does not account for in their performance reports. When using the IEPA values of banks and expirations, the statistical discrepancy between sources and uses is 7,193 permits; when using the authors’ values, the discrepancy is 3,160 permits. These large discrepancies clearly show the importance of using a sources and uses table in order to maintain an accurate accounting of tradable permits. In addition, this table provides a way for individual participants to effectively manage their tradable permit portfolio by including various entries for the different vintages of permits that can be traded, retired, or donated under the market system.
Explaining market performance To return to the discussion of the puzzles created by the first years of the ERMS program, the authors note that there remained 175 market participants emitting VOC in the year 2003 that varied widely in size, in SIC codes, and in their production processes and inputs. This diversity should augur well for a cap-and-trade market since it implies a wide range of cost functions. This diversity also means that numerous, different, and expanded traditional regulations affected these
Expectations and actual performance 39 various participants differently. As these regulations play an important role in the analysis of market performance, a more detailed description of them is provided in Chapter 4. Given the effort put into market design, the early studies of researchers, and the high expectations of concerned observers, what can explain the disappointments of market performance? Table 3.1 shows that: 1 2 3 4 5
reported emissions were far below the cap (category three); transactions were fewer than expected (category four); banks of permits grew to enormous values (category five); many valuable permits expired without use (category six); prices were much lower than anticipated (category seven).
A number of explanations arise for these surprising outcomes, some discovered in the authors’ subsequent research and others obtained from discussions with concerned observers. No evaluation of the cap-and-trade program would be complete or of value without a full account and analysis of these perplexing results. One of the major research efforts reported in this book is the development of hypotheses to test the soundness of these explanations and their capacity to point the way toward remedial action. This will require the search for and development of data and statistical methods to test these hypotheses. The surviving ideas can then form the basis for reaching recommendations for redesign of the market. A preliminary survey of explanations developed by the authors and other observers is presented in this chapter. There were warning signs for those alert to market design problems. The electronic bulletin board established by the agency showed a predominance of sell offers compared with buy bids. Informal discussions by the authors with market participants elicited such comments as, “I’m fat with tradable permits I cannot sell” or “I would accept a lower price if I could find a buyer.” In addition, the authors were actually able to buy permits on the open market for $5 each, since the supply of permits available was so large compared to the demand. The fact that emissions that required tradable permits to be returned to the agency were far below allotments and that banks were so large compared to allotments meant that the market was awash with tradable permits. What could account for this huge oversupply? Economists, in appraising the market problems, would turn to the possibility of imperfections in competition, large transaction costs, or information gaps. Monopoly power as an imperfection makes little sense here, given the oversupply and low price. Monopsony power could be considered, but no participant the authors interviewed felt it financially worthwhile to collaborate with others to lower permit prices. Transactions’ costs, especially the cost of finding buyers, could possibly explain why sellers offered permits at a positive price in order to cover their search, negotiation, and contract expenses. Information gaps or market learning behavior might be another possible explanation, but over 25 percent of emitters used environmental management companies as account officers, which
40
Expectations and actual performance
would imply a reduced effect of information gaps or market knowledge. These possible market imperfections will be considered in more detail in later chapters. Given the scant evidence on market imperfections, the authors turned to the presence of external constraints or design deficiencies that could distort market incentives. A first hypothesis of this external type was one given by the IEPA. They suggested that there was an over-allotment of permits. In order to get the market underway, the agency apparently made an effort to make businesses feel comfortable with the availability of permits. In order to do this, they accommodated emitter demands by allotting permits in full for HAP emissions on the grounds that maximum achievable control technologies (MACTs) were already in place, leaving little room for reductions. The agency also made additional allotments for up to 100 percent of VOC emissions for emitters using the lowest achievable emission rates. Other additional adjustments were apparently negotiated on a case-by-case basis for voluntary over compliance with traditional regulations (IEPA 1998: 7). The agency also allowed substitution of years between 1990 and 1997 for the baseline average calculated during the 1994–6 period, but these substitutions required approval by the agency and a determination that the 1994–6 interval was unusual. It is also possible that emitters estimated baseline emissions at their highest levels to receive additional allotments, although this would have invited the agency to apply a tightening of traditional regulations. Despite these revisions, it is hard to conclude that these various adjustments led to reported emissions 50 percent below the baseline level, given that the emissions exempted from reduction made up only 18 percent of total baseline emissions and that only 22 percent of emitters substituted baseline years outside of the 1994–6 period. Moreover, if over-allotment occurred, why did so few participants attempt to increase emissions covered by excess permits rather than allow them to expire? The next hypothesis in this vein that has been raised is the impact of the economic recession. This could also potentially explain some of the strange market outcomes that resulted. In this situation, demand for emitter products would decline, causing them to reduce their production. Since emissions are often a by-product of the production process, a reduction in production could imply a reduction in emissions. As emissions fall with production, firms are again left with an excess supply of permits. Firms do not need their full allotment to cover their emissions so they enter the market with hopes of selling their permits, but since many firms have been negatively impacted by the recession, a number of permits are available on the market with very few buyers. As a result, prices are low for those few sellers who are actually lucky enough to find buyers for their excess permits. The remaining permits that could not be sold on the market are banked and eventually left to expire, with no one needing to use them to cover emissions. This hypothesis leaves something to be desired, namely that over the four years the market for permits has continued to deteriorate, when the recession has improved and production increased. As the years go by, an upward pattern in emissions, prices, and trades should occur with a downward trend in banks and
Expectations and actual performance 41 expirations. Instead, the exact opposite has been occurring as the economy righted its way out of the recession. It may be argued that technological progress in evidence over the recent past has extended to traditional regulations, thus acting to reduce marginal control costs and hence VOC emissions. There is little evidence to support this view of innovations in the face of continuing and expanding traditional regulations. There is considerable economic reasoning to indicate that such regulations create little incentive to innovate. There is little if any anecdotal evidence in support of extensive innovation. The surprisingly low permit prices, roughly an order of magnitude less than estimates made in the region and elsewhere, could hardly be a measure of innovation. Instead, the decline might be indicative of the binding effects of existing traditional regulations. The hypothesis that seems to have the most merit in explaining the perplexing market performance is the continuing effects of traditional regulations. Although the Chicago cap-and-trade program is a decentralized pollution control measure, it was created as an overlay on top of the centralized control of traditional regulations. This hypothesis argues that, prior to the start of the market and during the four years recorded in this study, traditional regulations were continued and tightened, requiring participants to further reduce their emissions and leaving them with excess permits. Although participants may have tried to enter the market to sell these permits, they were likely to find that there were few if any buyers, because almost all firms were being subjected to the new, tightened controls. This led to an oversupply of permits with little demand, resulting in low prices and few trades. The excess supply of permits was then banked and allowed to expire in the subsequent year. Traditional regulations also put a ceiling on increasing emissions, thus helping to explain permit expirations. This hypothesis not only explains the strange market outcomes shown in Table 3.1, but also explains the continuing deterioration of the market. This hypothesis will be tested statistically in a later chapter. If traditional regulations were important in affecting market outcomes, the authors would expect to find differences among firms due to the fact that such regulation has a varying effect on emitters, depending upon the different production processes and inputs. That is, such centralized regulations would not affect all emitters in the same ways, but they could affect emitters that share similar processes in similar ways. For this reason the authors have included an analysis of emissions, permit banks, permit expirations, and permit trades by Standard Industrial Classification (SIC) code, within which production processes would be more similar among firms, to see if there are any general patterns that can be found over the first four years of the market’s operation.
Were there industry level effects of traditional regulations? Table 3.3 reveals yearly percentage changes in emissions by the two-digit SIC code for emitters included in the Chicago cap-and-trade program. The number of emitters as well as the number of HAP emitters in each SIC code were calculated
Food products Textile products Lumber and wood, except furniture Furniture and fixtures Paper products Printing and publishing Chemical products Petroleum refining and related Rubber and plastic products Leather products Stone, clay, glass, and concrete products Primary metal industries Fabricated metal products Industrial and commercial machinery Electronic and electrical equipment Transportation equipment Motor freight transportation Pipelines Electric, gas, and sanitation services Wholesale trade-nondurable goods Personnel services Miscellaneous repair services
20 22 24 25 26 27 28 29 30 31 32 33 34 35 36 37 42 46 49 51 73 76
13 2 2 3 19 22 26 5 19 2 1 11 21 9 3 4 3 2 5 11 2 2
Number of emitters
Sources: Individual participant data provided to the authors by the IEPA.
Description
SIC code
Table 3.3 Yearly changes in emissions by SIC code
1 1 2 3 11 4 12 3 7 2 1 8 18 7 1 3 1 0 1 2 2 2
Number of HAP emitters 10,214 499 384 1,867 19,709 5,193 18,377 6,480 9,992 326 144 6,606 10,228 3,368 849 7,757 1,382 675 839 2,853 242 1,328
Maximum baseline emissions in ATUs 1999 38.37 11.62 54.17 53.24 51.23 41.13 44.00 15.35 69.77 2.15 51.39 47.73 46.55 69.63 62.90 43.28 35.38 70.81 61.38 47.35 11.98 36.07
1998 30.48 17.64 50.00 51.79 51.78 36.74 36.02 21.37 40.41 13.19 11.81 38.18 39.54 57.48 66.43 43.97 35.46 33.04 64.36 46.34 7.85 17.77
31.92 23.25 30.99 50.46 51.16 41.83 47.67 23.63 66.51 3.68 48.61 42.98 56.80 60.07 57.24 37.40 30.10 59.26 61.03 39.26 35.95 13.40
2000
23.98 32.06 20.31 52.17 66.52 44.91 56.27 30.79 63.27 51.53 70.14 53.19 57.85 60.39 83.98 53.90 39.73 61.93 74.02 40.90 54.13 27.56
2001
Percentage change in emissions from baseline
Expectations and actual performance 43 from data provided to the authors by the IEPA for the 189 emitters for which the authors have data by SIC code. The diversity of the economic base of the Chicago region with respect to VOC emissions is brought out vividly by the table; no code has more than 20 percent of the total. About 56 percent of all firms in the Chicago cap-and-trade program are in 5 of the 22 SIC categories: paper products (26), printing and publishing (27), chemical products (28), rubber and plastic products (30), and fabricated metal products (34). These 5 emitted a little over 60 percent of all emissions and exhibited marked declines in emissions from baselines during the 4 years. Other codes also revealed marked declines such as stone, clay, glass, and concrete products (32), industrial and commercial machinery (35), electronic and electrical equipment (36), pipelines (46), and electric, gas, and sanitation services (49). The trend toward ever-increasing reductions from baselines is noteworthy, lending credence to the view that it was not primarily the recession but the continuing pressures of traditional regulations that accounted for these reductions. The authors will describe the range of traditional regulations that undoubtedly played a role in these reductions in Chapter 4. A note is in order about data preparation at this point. Individual firm baseline emissions are constantly changing for various reasons but not in large amounts as discussed earlier. As a result, a consistent measure of the baseline emissions for each firm is difficult to determine. In order to resolve this issue of continually changing baselines, the authors simply chose to take the maximum value of baseline emissions for each participant supplied by the IEPA. These maximum baseline emissions for each participant are measured in ATUs. The individual participant maximum baseline emissions were then aggregated by SIC code. SIC class engineering, research, etc. (87) was dropped from the data set because it contained only one firm, which experienced a drastic change in allotments and baseline over the four-year period. Miscellaneous manufacturing industries (39) were excluded due to missing data in the IEPA performance reports. Measurement and control equipment (38) and educational services (82) were excluded because there were no firms in these categories until after 2001. The remaining columns display the yearly percentage change in emissions from maximum baseline emissions calculated as yearly emissions minus maximum baseline emissions divided by maximum baseline emissions. The table shows that in general SIC codes that reduced by large amounts did so over all four years, 1998–2001, while those that reduced by small amounts also did so over all four years. This provides further evidence of the role of traditional regulations. Those SIC codes heavily affected by tightened traditional regulations continually felt the tightening, while the unaffected or lightly affected SIC codes were not impacted during the four years of the market. For example, paper products (26) experienced reductions from baseline starting at 52 percent in 1998 and increasing to 67 percent in 2001. By comparison, petroleum refining and related (29) had a 21 percent reduction in 1998, which increased to only 31 percent by 2001, half of the percent reduction experienced by paper products.
44
Expectations and actual performance
This story gets even more interesting in Table 3.4 in which data on permit banks and expirations as a percentage of allotments are presented by SIC code. First, allotments by SIC code are listed to give the reader some idea of the aggregate emissions allowed in the Chicago area under the new cap-and-trade program. The shown allotment is for 2001, but this number remains relatively constant for each SIC code over all four years. The permits expired each year by SIC code are divided by the 2001 allotment for the SIC code in order to find the percent of the allotment expired in that year. The same logic is true of the percentage of permits banked in Table 3.4, as well as the percentages of permits bought and sold in Table 3.5. In Table 3.4, industries that bank permits heavily also have high levels of expirations, while those with small banks have few permit expirations. A comparison with Table 3.3 reveals that emission reductions are also highly correlated with banks and expirations. In addition, industries with large banks and expirations have them over all four years, while those with small banks and expirations also have them over all four years. These facts provide further evidence of traditional regulations affecting emissions on an industry or process-specific level. Here, paper products (26), which experienced heavy emission reductions, have consequently higher percentages of banks and expirations than petroleum refining (29), which experienced lower emissions reductions and consequently lower banks and expirations. This indicates that paper products were subject to more stringent traditional regulations. These firms could not increase their emissions due to the tightened regulations, so they had to bank or sell their excess permits. If these permits could not be sold on the market, they expired as shown. To examine whether an industry experiencing the tightened control of traditional regulations is capable of selling its excess permits, the reader may turn to Table 3.5. This table provides further evidence supporting the impact of tightened traditional regulations. The SIC codes with high percentages of permits sold often have low percentages of permits bought and vice versa, implying that trading behavior is related to firms within the industry level. This again implies that traditional regulations affect entire industries rather than only specific firms, and continually affects them since behavior is generally similar over all four years. There is also evidence that those industries that are experiencing large reductions, banks, and expirations are also net sellers as expected, while those experiencing small reductions, banks, and expirations are net buyers. As an example, according to this hypothesis, paper products (26), which have large reductions, banks, and expirations, would have more selling activity and very little buying. The opposite would be true for petroleum refining (29). This is indeed the case, with paper products selling 10.6 percent of its allotment in 2001 and purchasing only 1 percent. By comparison, petroleum refining purchases 3.1 percent of its allotment in 2001 and sells only 0.6 percent. These various statistics shown in Tables 3.3, 3.4, and 3.5 add further support to the argument in favor of the traditional regulations hypothesis. As traditional regulations affected different processes or SIC codes differently, it also affected their market behaviors in terms of emissions, permit banks, expirations, and
Food products Textile products Lumber and wood, except furniture Furniture and fixtures Paper products Printing and publishing Chemical products Petroleum refining and related Rubber and plastic products Leather products Stone, clay, glass, and concrete products Primary metal industries Fabricated metal products Industrial and commercial machinery Electronic and electrical equipment Transportation equipment Motor freight transportation Pipelines Electric, gas, and sanitation services Wholesale trade-nondurable goods Personnel services Miscellaneous repair services
20 22 24 25 26 27 28 29 30 31 32 33 34 35 36 37 42 46 49 51 73 76
9,009 459 386 1,653 17,384 4,583 15,977 4,788 7,878 281 127 5,918 8,969 3,109 766 6,836 1,252 642 798 2,516 219 1,169
2001 allotment in ATUs 0.8 0.0 0.0 6.9 7.4 7.9 11.3 0.0 45.7 0.0 0.0 13.1 24.5 29.1 42.4 14.4 17.4 24.1 39.0 0.6 0.0 0.0
10.5 0.0 0.0 39.1 49.8 25.1 25.4 2.8 53.4 25.6 66.9 37.5 51.5 36.1 28.0 6.4 26.8 45.7 56.8 27.6 22.4 0.0
22.0 12.6 0.0 42.2 15.6 28.2 33.8 3.6 61.4 62.6 72.4 55.9 76.7 45.9 42.4 56.5 26.7 63.1 54.0 35.4 22.4 30.1
14.2 0.7 NA NA 7.3 4.3 0.3 0.0 6.0 NA 28.3 9.9 2.4 7.4 14.9 NA 2.1 NA NA 8.2 NA 1.3
35.7 41.6 49.7 82.6 87.2 62.6 75.4 24.8 73.5 75.4 94.5 65.7 72.3 75.3 100.0 62.3 41.2 93.0 81.2 57.7 78.5 25.3
2001
63.1 53.4 50.3 88.4 92.9 91.6 81.6 47.5 77.4 100.0 100.0 86.1 82.2 83.2 42.1 88.6 50.0 85.6 100.0 83.9 100.0 50.5
2002
2000
2003
2001
2002
Percent of allotment banked
Percent of allotment expired
Sources: IEPA Annual Performance Review Reports, 2000, 2001, 2002, and 2003.
Description
SIC code
Table 3.4 Expirations and permit banks by SIC code
85.9 66.9 51.6 99.8 149.1 90.0 93.2 46.1 46.0 100.0 100.0 83.9 114.0 80.3 58.2 97.5 64.4 106.2 93.9 122.9 100.0 34.0
2003
Food products Textile products Lumber and wood, except furniture Furniture and fixtures Paper products Printing and publishing Chemical products Petroleum refining and related Rubber and plastic products Leather products Stone, clay, glass, and concrete products Primary metal industries Fabricated metal products Industrial and commercial machinery Electronic and electrical Equipment Transportation equipment Motor freight transportation Pipelines Electric, gas, and sanitation services Wholesale trade-nondurable goods Personnel services Miscellaneous repair services
20 22 24 25 26 27 28 29 30 31 32 33 34 35 36 37 42 46 49 51 73 76
9,009 459 386 1,653 17,384 4,583 15,977 4,788 7,878 281 127 5,918 8,969 3,109 766 6,836 1,252 642 798 2,516 219 1,169
2001 allotment in ATUs 2003
3.6 5.9 0.0 0.0 1.1 6.3 0.9 3.9 4.5 0.0 13.4 1.7 1.2 2.2 3.9 0.0 2.3 0.0 0.0 4.1 0.0 6.0
6.2 0.0 0.0 0.0 1.0 9.1 1.1 3.1 7.8 0.0 0.0 0.0 0.0 0.9 3.9 0.0 0.0 0.0 0.3 0.6 0.0 0.0
6.6 0.0 10.9 0.0 0.5 18.0 0.3 0.0 5.7 0.0 0.0 0.2 3.3 0.0 3.9 0.0 0.0 0.0 0.0 10.5 0.0 1.1
4.5 0.0 11.7 0.0 4.5 8.3 0.0 0.0 6.2 0.0 0.0 0.0 8.6 0.0 3.9 0.0 0.0 0.0 0.0 7.1 0.0 86.1
1.3 0.0 0.0 0.0 0.5 4.5 1.1 0.0 0.9 0.0 0.0 2.3 0.8 6.5 0.0 0.0 0.0 0.0 0.0 1.9 0.0 0.0
5.6 0.0 1.0 0.5 10.6 10.1 0.8 0.6 0.6 0.0 0.0 0.0 6.0 0.0 0.0 0.0 0.0 0.0 11.8 6.0 0.0 0.0
2001
2.9 0.0 0.0 0.0 3.3 5.9 0.3 0.0 1.7 0.0 0.0 3.7 5.6 13.8 78.9 0.0 0.0 0.0 0.0 0.1 0.0 0.0
2002
2000
2002
2000
2001
Percent of allotment sold
Percent of allotment bought
Sources: IEPA Annual Performance Review Reports, 2000, 2001, 2002, and 2003.
Description
SIC code
Table 3.5 Tradable permit purchases and sales by SIC code
0.2 0.0 0.0 10.4 11.2 17.8 1.4 0.3 0.0 0.0 0.0 3.7 2.3 15.3 39.4 0.0 0.0 0.0 25.1 7.1 0.0 123.0
2003
Expectations and actual performance 47 permit buys and sells. The industries that experienced tightened regulations had large percentage emission reductions, percentage of permits banked, and percentage expirations. They also had a large percentage of permits sold compared to the percentage of permits bought. By comparison, the industries that did not experience tightened regulations had small percentage emission reductions, percentage of permits banked, and percentage expirations. They also had a small percentage of permits sold compared to the percentage of permits bought.
Conclusions The authors will later formulate these various hypotheses about external constraints in a form more suitable for statistical testing, and develop measures of variables appropriate to these tests. It is clear from the unexpected character of these market outcomes that the market system was expected to work independently of constraints such as traditional regulations, and the latter were expected to work independently of the market system. That is, two systems apparently designed to work effectively in isolation when operating as a dual regulation system had adverse effects. This could be especially true of the effect of traditional regulations on market incentives. Two regulatory systems designed to reduce emissions ended up in conflict. This finding could be of great importance in designing cap-and-trade markets in similar circumstances. Proper diagnosing of this conundrum requires that the authors analyze first in more detail how each regulatory system was expected to work in isolation, before analyzing their interactions.
4
Traditional regulations and market incentives
Introduction Efforts to control US air quality have evolved in scope and depth over the last 40 years or so to become a massive body of regulations affecting almost all industries and dealing with hundreds of substances being emitted into the atmosphere. The dominant form of this regulation, and the form to be dealt with in this chapter, is traditional, centralized regulation, often termed command-and-control. It was the type of regulation that the political leadership, until very recently, believed the public supported in order to secure protection from the harms and welfare losses imposed by air pollutants. A history of the various proposals and legislation calling forth a range of traditional regulations, including the expectations, the debates, the accomplishments, and the disappointments, would make an interesting and lengthy story that has yet to be fully told. The authors will only present a brief, selected account within this story, with an emphasis on those aspects that bear on the focus of this book, the decentralized market-based approach to reducing stationary-source volatile organic compounds (VOC) emissions. The basis for any emission control regulation, as is well known, is the presence of market externalities, or imperfect information, that cause harms and welfare losses to the public, not captured in the profit and loss statements of emitters. Even with a clear definition of property rights or health affected by the externality, it will often not be possible to have private parties negotiate or adjudicate compensation for externalities, positive or negative, because of the number of people involved, the time lags of effects, or other complicating factors (Coase 1960). Without government intervention, resources are not allocated efficiently by the market. The above reasoning is generally accepted by most parties involved in air quality matters. However, the problems multiply and grow in complexity when priorities are attached to specific pollutants, when the level of government involved in regulation is to be discussed, and when the types, extent, degree, and timing of regulations are considered. Even the first question that comes to mind, which air pollutant to regulate, raises issues and choices. The important national legislation of 1970 addressed six conventional or criteria pollutants for priority attention, largely setting aside many others. Conventional pollutants, such as nitrogen oxides (NOX) and VOC,
Traditional regulations and incentives 49 figure in the Chicago cap-and-trade program. Hazardous air pollutants (HAPs) were given more attention in later legislation. That 1970 legislation also broke new ground in specifying the level of government to be directly involved in air pollution control. Prior to 1970, state and local governments were largely involved in early regulatory efforts, with the federal government providing mainly encouragement and subsidies for research. After 1970, the federal government was to assume a much more active role in setting standards, specifying control measures, and coordinating the implementation work of the states. The pendulum would appear to have swung back a bit to the states after 1995 as the Illinois Environmental Protection Agency (IEPA) took the lead in designing the Chicago cap-and-trade program to reduce VOC emissions, albeit with the US Environmental Protection Agency (US EPA) looking over its shoulder. The question of the extent of regulation raises complex issues about risk assessment and tolerance for some air pollution. There has been a history of tension between those advocating zero emissions, or zero pollution, regardless of costs, and those arguing for a weighing of benefits and costs in the final analysis. A cap-and-trade market brings out the issue clearly, as any cap less than a 100 percent emission reduction implies acceptance of some air pollution, and no extant cap-and-trade market has set a 100 percent reduction goal. In fact, the logic of emissions trading, which exploits the differences in emitter control costs to achieve overall cost savings, is inconsistent with such a goal. In the case of the Chicago program, the official cap was set to achieve a 12 percent VOC emissions reduction. A consequence of a cap-and-trade market is that some emissions different from zero will continue. The geographical dispersion of an air pollutant provides one basis for the spatial extent of regulation. Greenhouse gases, such as carbon dioxide (CO2), for example, disperse quickly in the global atmosphere and will require international agreements for their effective limitation. Acid rain precursors, such as sulfur dioxide (SO2) and nitrogen oxides (NOX), drift over large regions and require national or regional agreements for their regulation. Urban ozone (O3) concentrations and VOC emissions are more local in spatial terms and are transformed into less harmful substances more quickly than the other pollutants just mentioned. For purposes of ozone and VOC regulation, national legislation distinguishes urban ozone nonattainment areas, such as the six-county-plus-two-townships Chicago region. Traditional regulations raise a set of equally complex questions about the roles of different layers of government. Centralized regulations require setting emission limits or control technologies for a vast number of different production processes, or determining the pollutant content of numerous inputs into the production process. Problems of emissions measurement, monitoring, enforcement, and record keeping arise under this type of regulation and present thorny issues of their own. The federal government generally sets emission limits, standards, and control technology guidelines and requires that the state governments submit implementation plans for approval. These distinct but closely tied together roles are indicative of the organizational complexities that arise.
50
Traditional regulations and incentives
The time it takes for traditional regulations to take effect is a variable that is often overlooked, but is of great importance. The US Congress has expressed impatience over the progress in obtaining improved air quality, but devising effective regulation is not done on the fly. The 1970 legislation set a limit of 5 years for reaching ambient goals, some of which have yet to be achieved (Portney 1995: 72). Later legislation set more reasonable time lines for progress, such as the Chicago region to be in ozone attainment (no exceedances above the threshold) by 2010. The process between legislation and final improvement in air quality has only to be outlined to perceive the problems. The US Congress frequently requires the US EPA to specify the standards of pollutant reduction that will protect the public’s health. Most health impairment functions vary continuously over the range of ambient air concentrations, so time-consuming studies must be launched. Even when desired concentrations are specified, the federal agency will often have to draw up control technology guidelines that the states can then use to implement particular control measures. The control technologies are then introduced to emitters, and the state must monitor and enforce their installation. This is by no means a complete list of the steps that are taken for traditional regulations, but they may suffice to make the main point: there are many steps to implementation and significant time lags at each step of the way. Although the Chicago market incentive program got underway in 2000, there was a continuance and extension of traditional regulations that had been going on before the market started and continued while the market was in operation. In summary, the regulating community must have a large staff and expertise to address these issues and to oversee, monitor, and enforce the entire range of micro or on-the-spot pollution control decisions to be made by emitters. Even then, the aggregate volume of emissions is not under control as production times can vary. Not only can traditional regulations get increasingly expensive but also they can give rise to increasing confrontation between regulating and regulated communities. In contrast, the alternative, decentralized Chicago market approach enables emitters to choose micro-pollution control options, subject to general oversight of emissions and market transactions by the IEPA. The aggregate volume of emissions is determined by the issuance of tradable permits, while the volume of emissions by any individual emitter is not determined. These questions about traditional regulations are not trivial; they continue to be among the most vexing issues concerning environmental protection and its costs. The authors’ analysis of them in the context of the Chicago market approach will tell us much about the problems of the Chicago market design. It will help in that analysis to have a selected history of major environmental legislation that brought both types of regulation into existence, with an emphasis on traditional regulations.
A brief history of air pollution regulation Early occurrences of human-induced urban smog were recorded in the Los Angeles region soon after the introduction and growing use of the private passenger automobile. The now familiar complaints of low visibility, eye irritation,
Traditional regulations and incentives 51 respiratory complications, and nausea were sounded more loudly around 1943, and led to state legislation in the form of the California Air Pollution Control Act, signed into law in 1947. The Act created an Air Pollution Control District in every county of the state in an effort to reduce urban ozone and smog, and decrease movement of pollution plumes around the state. As they were introduced on the national scene, air quality controls varied greatly among states, and concerns were addressed about movement of air pollution across state boundaries. A number of businesses expressed concerns about differential state standards and the difficulties of meeting them, while others were concerned about the movement of businesses across state boundaries in a search for less restrictive legislation. The federal policy response was to attempt to induce the states to cooperate on air quality control. For example, the federal Air Pollution Control Act of 1955 subsidized air pollution research. Other legislation designed to lead to cooperation among the states was largely ineffective, leading to a major change in 1970 (Tietenberg 2002: 365). A significant federal role in air quality management was only realized in the US 1970 Clean Air Act, whose stated purpose was to defend the public’s “health and welfare and the productive capacity” that relies on air quality (CAA 1970: 8). The legislation created the US EPA, consolidating the activities of other government agencies and establishing instantly a large agency with a very large agenda. Unlike federal agencies designed to deal with imperfections of competition in single industries, which then fade away when the task is perceived to be finished, (e.g., the Civil Aeronautics Board), the US EPA, dealing with numerous pollutants arising from many industries and different processes within an industry, seems destined for a long life. While contentious issues and choices arise, there are very few proposals to do away with the agency itself. An important part of the federal agency’s agenda was to set standards for anthropogenic substances emitted into the air and to coordinate the state roles in these efforts. These substances arise from mobile, small area, and stationary sources. Regulation depends in part on whether they are conventional (criteria) or hazardous pollutants. For a decade or so after 1970 the emphasis was on criteria pollutants, including the six major ones: carbon monoxide (CO), lead (Pb), NO2, VOC, particulate matter (PM), and SO2. Ozone (O3 ) is formed from precursors, mainly VOC and NOX, and climate conditions. The legislation mandated that the US EPA establish ambient (atmospheric) standards for the six pollutants, both a primary standard concentration for health reasons, not to be exceeded, and a secondary standard for other human welfare effects, both without regard to costs. States were charged with devising implementation plans for achieving these standards, subject to US EPA approval. Ordinarily, different control measures were to be devised for reducing stationary-source emissions in contrast with those from small area and mobile sources. Also, different control measures were ordinarily required for conventional and hazardous emissions. The authors will discuss the different tools and consider in more detail the specific VOC substances in the later section on regulatory tools. The enormous amount of work required to carry out these
52
Traditional regulations and incentives
instructions seems to have been seriously underestimated both by the US Congress and the US EPA. The 1977 legislative amendments to the 1970 Act paid more attention to matters such as the workload and timing problems by extending deadlines, further defining nonattainment areas, and providing more detail on regulatory tools, such as Reasonably Available Control Technologies (RACTs). These tools were further advanced in 1979 legislation under which the US EPA developed Control Technology Guidelines (CTGs) that specified emission limits on particular processes or specific technology options for states to incorporate into their implementation plans. Almost 30 of these CTGs were issued over the next several years, apparently in an effort to increase the body of knowledge about regulatory tools and to increase the pace of environmental regulation. While some progress in improving air quality was in evidence, it was uneven and several conventional pollutants, including NOX, VOCs, and the resultant O3, were not reduced significantly (US EPA 1995). Only eight hazardous air pollutants had been listed for control by 1989 (Tietenberg 2002: 383). A major revision of national policy concerning air quality was undertaken in the 1990 Clean Air Act Amendments (CAAA 1990: 7401–7671q). Several titles of this far-reaching national legislation are of interest for the purposes of this book. Title IV mandated a cap-and-trade approach to reducing an acid rain precursor, SO2. In recognition of the increasing marginal costs of controlling this pollutant by traditional regulations, and in recognition of the slow progress to date in achieving significant reductions, the US Congress spelled out in detail how tradable permits were to be allocated to (primarily) electric utilities in order to reduce SO2 emissions by about half from historical volumes. The authors have already mentioned this path-breaking effort to introduce incentives into control of a pollutant by allowing sources to trade or bank permits, or reduce emissions by choosing a least-cost abatement plan. Sources must return a tradable permit to the government for each unit of pollution emitted. The success of this effort in reducing SO2 control costs and in greatly reducing the administrative efforts and expenses of the regulating communities stimulated interest in emissions trading in the United States, and elsewhere. Title I established new requirements for ozone nonattainment areas, increasing the stringency of control measures for areas classified as having moderate, serious, severe, or extreme air quality deficiencies with respect to ozone concentrations. The act allowed more time for attainment, depending on the classification; the more serious the classification, the longer the time allowed. The deadline for Chicago, a severe nonattainment area under the one-hour standard, was set for 2007. When the area was reclassified to a moderate level in June 2005 under the eight-hour standard, this attainment date was changed to 2010. The reduction from severe to moderate in attainment status was in recognition of the gradual improvement of air quality in the region and the relative position of the Chicago area to others. It was by no means a statement that the major effort to improve air quality was accomplished. The 15 days exceeding the eight-hour standard during the hot summer of 2005 attested to the work remaining to be done.
Traditional regulations and incentives 53 Rather than rely on distant future guidelines with respect to meeting attainment, the 1990 CAAA required that reasonable further progress be achieved by reductions in 1990 VOC baseline emissions of 15 percent by 1996 and 3 percent per year thereafter. More demanding requirements were formulated for emission inventories, which had proved difficult and expensive to develop. Perhaps most relevant to this study is the provision in Title I that allows states, as an option, to develop market incentive programs to reduce VOC emissions. The range of regulatory tools and the variation in their required use depends upon the ozone attainment status of the urban area. This variation in tools is listed in Table 2.2 in Chapter 2. The requirements are listed for the one-hour standard but remain by and large in force for the eight-hour standard, although the dates of attainment were extended. For example, for moderate areas like Chicago, the extension was until 2010, and the IEPA was given until 2007 to develop a detailed implementation plan for the new standard. The authors turn now to a more detailed description of the variety of traditional regulatory tools that were prescribed for the various VOC emissions, and for the areas of different air quality.
Regulatory tools applied to VOC pollutants under traditional systems Several key distinctions can provide guideposts through the maze of regulatory tools. Requirements for regulatory tools will differ between conventional and hazardous pollutants. Applicable tools can also differ between attainment and nonattainment areas, and among nonattainment areas of varying degrees of ozone concentrations, as the authors have shown in Table 2.2. The Chicago region being a moderate nonattainment area will require some different and fewer tools than the extreme Los Angeles region. New or modified sources will ordinarily require more stringent controls and tools than existing sources. Other distinctions apply to the characteristics of the VOC emissions. Not all of them are the same when it comes to the ozone reactivity and ozone formation potential. For example, ethylene, propane, and butene have high reactivity coefficients, whereas those of methyl alcohol, propane, and acetone are low. Their ozone formation potential takes into account reactivity and the tons per day emitted. Ethylene ranks high in this regard and butene lower (IEPA 2000: 61). To design different tools for these specific hydrocarbons was believed to be too costly, so they are treated as a group. It was another matter for hazardous air pollutants that differ in toxicity. For example, glycol ethers, naphthalene, and 1,3-butadiene have high Community Risk Inventory toxic weights, whereas that of m-xylene is low (IEPA 2000: 1–2). The more toxic HAP emissions were given priority attention for control and, where possible, different tools were to be prescribed substance by substance. As a group, these HAP emissions require more stringent reduction measures by the use of particular tools. While many health studies deal with concentrations of pollutants and population exposure, most implementation plans deal with emissions arising from the varied sources, since it is at the source level that the tools can be most feasibly applied.
54
Traditional regulations and incentives
RACT: tools applied to existing VOC sources of non-hazardous emissions in ozone nonattainment areas The workhorse of traditional regulations is the application of RACT to existing nonhazardous VOC emission sources in nonattainment areas. These range from limits on VOC content in solvents, paints, solutions and the like to technologies such as add-ons, including carbon and liquid absorbers of fumes, and then on to afterburners, such as regenerative thermal oxidizers, that incinerate VOC emissions. Federal RACT activity was considerably enlarged in the 1977 amendments to the CAA that led to CTGs specified by the US EPA for specific processes and technologies. These were later implemented by the states in their choice of RACT tools required of emitters. A significant tightening occurred for certain RACT tools to be applied in the Chicago region after the State of Wisconsin filed a lawsuit in the middle 1980s demanding that the IEPA reduce the volume of low-level ozone originating in Chicago that drifted into neighboring Wisconsin counties. The RACT control measures comprise a massive and dense set of options that can be applied to a long list of VOC emitters and specific processes within an emitter’s enterprise. The Chicago region contains a representative cross section of these emitters and processes. Table 4.1 provides a selected list of these sources found in the Chicago market area that will give some idea of the range of tasks falling on the environmental agencies in managing the implementation, monitoring, and enforcement of traditional regulation tools. MACT: tools applied to existing VOC sources of hazardous air pollutants in ozone nonattainment areas With respect to hazardous pollutants, the earlier legislation had instructed the US EPA to identify these pollutants and the means for their control. By 1989, as Table 4.1 Selected stationary-source emitters and processes subject to RACT and MACT controls with government oversight Can coating Fabric coating Large appliance coating Petroleum refinery processes Solvent metal cleaning Auto-light duty truck coating Manufacture of synthesized pharmaceuticals Perchcloroethylene dry cleaning Chem/polymer/resin manufacturing Bakeries Coke byproduct recovery plants
Glass forming Highway panels Iron/steel foundries Landfill gas controls Leather surface coating Offset lithography Plastic parts Publicly owned treatment works Pulp and paper Textile finishing Wood products
Source: Adapted from Ozone Transport Commission 1998: 1 A2. Notes RACT stands for Reasonably Available Control Technologies. MACT stands for Maximum Achievable Control Technology.
Traditional regulations and incentives 55 the authors have mentioned, the agency had identified only eight such pollutants, including among them only one hydrocarbon, benzene. The 1990 CAAA then listed 189 HAP emissions that were acutely or chronically toxic for priority attention. Standards or guidelines were to be set for these pollutants and stringent regulatory tools for their control were to be developed. About one-third of the hundreds of VOC emissions in the Chicago area are HAP emissions (IEPA 2000: 1). The guidelines for hazardous VOC emissions were specified in the National Emissions Standards for Hazardous Air Pollutants (NESHAP) for all 189 HAP emissions mandated by the 1990 CAAA for control. Firms emitting these substances were to be subjected to Maximum Achievable Control Technology (MACT) as spelled out in state implementation plans (IEPA 1995: 59). The plans, when approved by the federal agency, would apply to each firm and to each process from which a particular HAP was emitted. In this manner, any single firm may have a number of specific MACT controls. There has been a long gestation period for the US EPA in establishing guidelines. The 1990 CAAA stated that the most harmful substances should be dealt with first and MACT controls put in place within five years. This deadline was not met and standards continue to be issued to this date. The MACT deadlines have been difficult to meet, due to the complexity of the damage functions for particular HAP emissions, the lack of thorough studies on harms and exposures, and the research required to issue defensible standards. Many compliance dates extended beyond the start-up date for the Chicago market approach of 2000. Only 25 percent of the categories of production processes subject to control had compliance requirements set before that date. The implication is that MACT controls continue to be implemented during the market period described in this book. These controls acted to reduce emissions at the same time that the cap-and-trade market was supposed to be reducing emissions. This is another example of the continuing trend of implementation of traditional regulations that was not taken fully into account in the design of the market system. LAER: tools applied to new or modified VOC sources in ozone nonattainment areas The 1990 CAAA considerably modified prior legislation in the requirements placed on new and modified sources of VOC emissions. These sources were required to obtain a new operating permit giving more details on their processes that produced emissions. They were also subject to new source review that could require more stringent controls than those on existing sources. These controls were labeled the Lowest Achievable Emission Rate (LAER) to be established whenever possible by comparing the new source or modification with the lowest emission rate from other sources. The issue of when a modification becomes significant and different from regular maintenance or repair has become a bone of contention, as new source review can impose significant reductions in emissions and increased control expenditures.
56
Traditional regulations and incentives
BACT: tools applied to new or modified VOC sources in ozone attainment areas The programs controlling emissions in attainment areas, where ozone concentrations meet national standards, call for application of Best Available Control Technology (BACT) to be applied to new or modified sources. These areas fall outside the scope of this book. However, there is one interesting feature of environmental protection that operates in these areas and that is the prevention of significant deterioration policy. Under this policy, three classes of areas are distinguished in which possible increases in emissions are considered. Class I covers national parks and wilderness areas, where the smallest increment in emissions is allowed over baseline. There has been recent attention paid to the increases in haze in some national parks and wilderness areas caused in part by the movement of atmospheric pollutants from nonattainment areas. Class II and class III allow larger increases but not in amounts sufficient to move the areas to nonattainment. The imposition of BACT controls can act as a deterrent to firms considering a move away from urban nonattainment areas to attainment areas.
Weighing the alternative regulatory tools There are alternative measures to reduce air pollution not discussed in detail in this book. Protection of air quality may be sought in voluntary actions ranging from private conservation of land to ozone action days, or Air Pollution Action Days as they are now called in the state of Illinois. In the latter, an appeal is made to the public to use less pollution-emitting activities on those days that threaten high ozone concentrations. In Chapter 3, the authors evaluate that voluntary effort by making use of a unique daily set of readings on key variables. Another control option is to have the government subsidize pollution control efforts or research by private parties. Such measures are worth more detailed analysis than the authors can give them here. The evidence that such alternative control measures have been effectively utilized or have achieved reductions in pollution is sparse. Traditional regulations, the main topic of this chapter, have been and continue to be the dominant system chosen to control environmental quality, both in the United States and elsewhere. The characteristics that have secured for them this place in the regulatory mix are not difficult to discern. For many types of water, land or air contamination caused by the presence of highly toxic wastes, traditional regulations seem to provide visible tools tailored to the waste that can be monitored and enforced by the government. For example, complex incinerators set at their highest levels of efficiency can transform benzene into less harmful substances. An inspector can examine the apparatus, check the records, monitor the process, and enforce compliance with guidelines, thus assuring the public that all is being done that can be done. In like vein, prevention of hot spots, or neighbor increases in emissions, can be checked at specific locations of sources. Inter-temporal spikes in emissions appear to be under control also, as traditional regulations typically do not allow banking of emission reductions.
Traditional regulations and incentives 57 These programs have often been termed technology driven. They were geared to reduce emissions by reducing the rate of emissions per unit produced or evaluating the pollution potential of inputs used in the production process. Cutting edge technology may be used, but only rates of emissions are controlled, not aggregate levels of emissions. A firm may reduce emissions to 80 percent during one shift, but by doubling output during two shifts, the aggregate level of emissions could increase. Therefore, even though emission reduction programs are instituted, aggregate emissions over time could exceed what they were prior to implementing the program. This was only one and not the major problem or weakness of traditional regulations. One can imagine that regulations containing words such as “Reasonably Available,” “Maximum Achievable,” or “Lowest Achievable” would not come with a low price tag. The focus of all the traditional regulations reviewed here was not on spreading the cost of emissions reduction so that low-cost emitters would do most of the control, thus attempting to equate marginal abatement costs and achieve economic efficiency, but rather on using the specific technologies to obtain the desired levels of emissions reductions. An economic implication of relying on traditional regulations is that the marginal control costs for reducing emissions will vary from facility to facility and process to process. A survey carried out on sample facilities reveals the range of these costs for selected facilities as presented in Table 4.2. Applying traditional regulations across these facilities would result in widely varying control costs, far from the equalization of these costs required for obtaining maximum savings. In revealing the range of costs, the table also indicates the potential gains from emissions trading by allowing firms with low incremental costs to sell tradable permits to those with high incremental costs. This potential for high-cost emission remediation of traditional regulations is not the only major problem to be found with command-and-control-based programs. Once firms are operating within the boundaries set by the regulating agency, they have little incentive to reduce emissions further. Taking extra steps, and extra expense, to reduce emissions further will likely gain them little and may risk much. Innovative control measures could result in a lowering of permissible emissions. Also, if the operating permit dictates that specific control equipment, production processes, or inputs must be used, researching other avenues of emissions reductions would seem fruitless. If alternative methods of emissions reductions were found, they would need approval of the governing agency. Thus, innovation in control methods would seem to be stymied. Additionally, creating a customized operating permit for each of the hundreds of emitters that provides details on the allowable technologies and their performance can be costly. The regulating agency needs a large, coordinated staff to carry out these programs. After the regulations have been issued, monitoring and enforcement must commence. This is true for any abatement program, but when the requirements can differ for each pollutant, emitter, and control technology, the regulatory duties grow considerably, adding to the expenses of administration.
58
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Table 4.2 Case studies of additional control costs of reducing VOC emissions by various control options in the Chicago ozone nonattainment area Facility type
Coating operations Plastics Leather products Can coating Rubber and plastics Lithographic printer Petroleum refining Felxographic printer Organic chemicals Polymer and resins manufacturing
Historical seasonal emissions (tons)
Emissions after reduction (tons)
Control option
Control cost of reduction (1987 $ per ton)
27
21.9
Afterburner
18,000
14.6 20.8
11.8 16.8
Afterburner Afterburner
16,600 15,900
66.7 30.2
54 24.5
13,200 11,400
35.6
12.7
Afterburner Regenerative thermal oxidizer New afterburner
285
36
32
7
220
165
285
39
Secondary seals on internal floating roof storage tanks Lower VOC cleansing solutions Increase control efficiency Increase control efficiency
8,900 1,620 650 430 430
Source: Adapted from Dunham and Case (1997: 18).
With this many issues, it is worthwhile to look for alternatives that create decentralized incentives for emitters to reduce pollution. One alternative is to impose a tax on each unit of emission. This would limit emissions on the grounds that firms would not want to pay the tax and would reduce emissions to avoid it, if cheaper control methods could be found. Under the tax, firms, of their own accord, would seek out the lowest cost emissions reductions. This could include researching and developing new, innovative ways to reduce emissions, if the firm felt the search was less costly than paying the tax. Also, note that firms will reduce emissions until the incremental cost of reducing emissions is equal to, or greater than, the tax. If the firm can reduce emissions at a lower cost than the tax, they will do so. This includes obtaining emission reduction equipment, modifying their production process, modifying their inputs, or switching production from a high-emission facility to a low one, all without the aid of the regulatory agency. The concept of a tax on emissions is not without its own problems. Like the command-and-control program, absolute upper limits on emissions are not guaranteed. Firms may be willing to pay higher taxes to produce more, if the revenue from their final product warrants the higher taxes. Additionally, the regulatory agency must set the tax with care. The goal may be to set the rate so as to make
Traditional regulations and incentives 59 the polluter pay initially for all damages caused, or to set the rate so as to achieve the desired air quality in a cost-effective manner. If the tax is too low, the emissions reductions will fall short of the goal. Set too high, reduction goals will be exceeded, with higher abatement costs than needed, and the possibility of retarding the economy. In these cases, frequent adjustments to the tax rate may be in order, with obvious impacts on the regulated community. However, the advantages of decentralizing environmental control decisions to firms seem clear. The firm has the detailed knowledge that may be difficult for the regulating agency to duplicate. The government can reduce its role to that of establishing the rules of the decentralized system and overseeing the results. This line of reasoning sets the stage for emissions trading and the cost-effectiveness, flexibility, innovation stimulation, and reduction of confrontation between regulating and regulated communities that should result from a well-designed market incentive program. The US EPA was well aware of the cost-ineffectiveness of traditional regulations and experimented with a number of limited tradable credit systems before the 1995 innovation of the sulfur dioxide cap-and-trade market. Emission reduction credits were devised under a number of programs that could be used for offsets, bubbles, emissions banking, and netting transactions. In each instance, the transaction required prior and post-transaction approval by the agency and certification that the emission reduction had characteristics such as permanence and quantifiability. Offsets allowed existing firms to sell credits earned by reductions to new firms entering an area. Bubbles were created, permitting transactions within a usually small area. Emissions banking enabled firms to store earned credits for later use. Netting allowed firms to escape new source review by using earned credits for modifications of their facilities. After experience with emission reduction credits, it became apparent that the program resulted in few transactions and was utilized mainly by a few large firms. It very likely resulted in cost savings, although the extent is hard to measure. The drawback was the active involvement of the US EPA in requiring extensive evidence of the reduction and in approving in detail each transaction. The resultant high level of transactions costs significantly limited the emission reduction credit programs. The economic rationale of emissions trading came closer to realizing its full potential in the cap-and-trade market of which the SO2 program provides the best example. The authors will show in the next chapter how a well-designed market of this type can perform. A cost-minimizing firm can be expected to manage its portfolio of tradable permits and its decisions to reduce emissions, all with the aim of minimizing current and future control costs. The government can step back after specifying market rules and engage in monitoring and enforcement activities. This variant is not without its own problems. Should tradable permits be allocated on the basis of historical or future estimated emissions? The allocation could vary appreciably, depending on this choice. The Chicago program was based on historical emissions favoring long-established enterprises. How the
60
Traditional regulations and incentives
allocation is to be made raises further knotty issues. Should tradable permits be auctioned off with the proceeds going to the government? Or should they be allocated free with the gains to the emitter? Or should they be allocated free to environmental groups or all citizens? Businesses in the Chicago area objected strongly to auctions and were mollified by a free allocation. A potential weakness of the market approach is the possibility of monopsony power being seized by one or a few emitters who obtain or buy a significant share of permits. Our evidence in Chapter 6 reveals no evidence of such power in the Chicago market. Emissions trading in which transactions are autonomous and anonymous could also lead to neighborhood increases or hot spots despite aggregate reductions, or to inter-temporal increases in emissions due to banking. The authors examine this important issue in Chapter 7. A cap-and-trade market approach, despite these problems, presents an attractive alternative on paper. How it could be expected to work is the subject of the next chapter. It may be well to ask why traditional regulations should not be completely replaced by other methods, especially market systems? It is unlikely that environmental quality control will be completely entrusted to the anonymous and autonomous market system, given the demand for specific protection from toxic substances. Furthermore, traditional regulations can be designed to prevent hot spots and inter-temporal spikes, thus complementing emissions trading. A market system could be allowed to do the heavy lifting with respect to achieving cost-effectiveness by setting the cap and allowing banking at the appropriate levels, with traditional centralized regulations filling in where appropriate.
5
Simulated performance of alternative market model features
Introduction Two regulatory systems to control a pollutant, although well designed when considered independently of each other, when combined can emasculate one or the other in performance. This is especially true of the market incentive cap-and-trade program, which is sensitive to the constraints of external factors such as traditional regulations. In this chapter, the authors present simulations of alternative features of the cap-and-trade market model exclusive of these constraints while in the subsequent chapter, the authors analyze how these constraints affected market incentives and consequently market performance. In this chapter, a cap-and-trade simulation model is developed that is driven solely by cost minimization and an estimate of the costs of abatement. The key assumption is that markets clear. For every firm that buys a tradable permit or Allotment Trading Unit (ATU), another firm in the market must sell. Assuming no transactions costs or other market imperfections, the authors assume that when the price of an ATU in the market, p, is above the marginal cost of emission reduction, cri(ri), the ith firm will be induced to sell tradable permits since it can reduce emissions and make a profit of p cri(ri). The jth firm, on the other side of the transaction, will buy permits because p cjr(rj) is negative or the cost of a permit is less than the cost of reducing emissions to achieve compliance. These model simulations enable the authors to: 1 2 3
estimate equilibrium tradable permit prices and quantities and calculate compliance costs for comparison with traditional environmental regulations; estimate the consequences for prices and quantities of introducing changing emitter costs; estimate the impacts on prices and quantities of changes in market features such as auctioning tradable permits instead of a free allocation, introducing spatial constraints, and changing the emissions cap.
It must be emphasized that the model is based on estimated marginal control costs for individual emitters and on forward-looking, well-informed expectations. That is, the model simulates a well functioning market at equilibrium. The authors
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Simulated performance
believe that it will be valuable to have the results of this modeling effort available to compare predictions of the model against future observed values in the Chicago program in order to evaluate the performance of the actual VOC market. The actual performance could be affected by factors, discussed earlier, such as information gaps, varying concerns about public acceptance of pollutant trading, unusual transactions costs, and other slippages (Tolley 1993: 25–26). Most important, the performance of the market also could be affected by external constraints like traditional regulations not considered in this chapter.
Overview of the findings The authors assume volatile organic compound (VOC) emissions result in uniformly mixed concentrations that lead to low-level ozone concentrations over an unconstrained urban market area, with resulting uniform harms to the population. This chapter deals with control costs and market variables and not the monetary estimates of these harms, which were discussed in Chapter 2. The first finding is that, given the cost assumptions, an equilibrium tradable permit price of $258 per 200 pounds of emissions is established, which the simulations reveal lead to cost savings of about $1 million per year compared with traditional regulations. These cost savings free resources for alternative uses by the private sector or government. This model assumes cost-minimizing behavior on the part of emitters, flexibility of choice about control options, full information about control and trading opportunities, no uncertainty about trades and their public reception, and no transactions costs. This model forecast provides a benchmark for appraising market prices and transactions under different conditions. The authors simulated the effects of policy changes by reducing further VOC emissions by means of changing the cap. As the cap is reduced and emission reduction rates increase, there is an increase in equilibrium tradable permit prices, volumes traded, and cost savings when compared with traditional regulations designed to achieve the same reductions. Next, the effects of changes in the variance of control costs were simulated. The finding was that as the variance of marginal control costs increased, the equilibrium price increased and the relative savings of the market model increased over what would have occurred with traditional regulations. As an experiment, a simple form of transactions costs was added into the model to estimate their impact on market variables. Higher transactions costs increase equilibrium tradable permit prices, reduce trading, and reduce cost savings. To test the effect of an alternative method of tradable permit allocation, an auction market was simulated. Free allocation and allocation by auction led to the same equilibrium permit price, quantities traded, and cost savings in the static case as predicted by the Coase theorem. The primary difference between the two methods of allocation is the transfer of wealth that goes to emitters under free allocation and to the government under auction. Concerns have been expressed about increases in neighborhood concentrations of emissions that could result from trading. To examine one aspect of this issue,
Simulated performance 63 the authors imposed spatial constraints on the market, simulating a change in government policy. Trading restrictions led to reduced equilibrium permit prices and reduced cost savings compared with the unconstrained market design.
Specifying the cap-and-trade model Emitter firms, with their allocated portfolio of dated permits, are assumed to know their marginal control costs and those of others in the market. Knowing these costs, their endowments of permits, and the exogenous permit price, the firm’s objective is to make cost-minimizing decisions about the degree of trading and reduction of emissions by control measures. In the model simulations, perfect and symmetric information is assumed to exist in the regulated and regulating communities. Because of the fundamental rule that each participant must return a permit to the government for every 200 pounds of emissions during the season, the following identity holds for n emitters: hi qi ri ti
i 1, . . . , n,
(5.1)
where hi refers to the historical or benchmark emissions of the ith firm, qi is the allocation of currently dated permits for the ith firm, ri is the reduction in emissions during the season for the ith firm, and ti is the number of permits bought (if positive) or sold (if negative) during the season for the ith firm. Permits that are banked for one year are considered a self-sale and included in ti. Permits may not be bought or borrowed from the future for current use. All variables are measured in 200 pound units of emissions. Under traditional regulations, ti 0 and equation (5.1) reduces to ri hi qi, where all values of the variables are determined by the government. Under emissions trading, equation (5.1) must be fulfilled and ri and ti become decision variables of the firm. The optimal value of one determines the optimal value of the other. The emitter’s objective function under trading is to minimize reduction or control costs and trading costs, knowing the control cost function, cri(ri), which is increasing in r and differentiable, and the trading cost function, cti(ti), or Min cri(ri) cti(ti),
(5.2)
Subject to ri 0.0.
(5.3)
Knowing that cti(ti) pti because p is the exogenous permit price, and also knowing that ti ri 1, because of equation (5.1), the equilibrium conditions can be written as cri(ri)ri p 0,
(5.4)
64
Simulated performance ri[cri(ri)ri p] 0,
(5.5)
ri 0.
(5.6)
The solution to equations (5.4), (5.5), and (5.6) yields the firm’s optimal reduction, r*i , and therefore the optimal trades, t*i . Note that r*i could be zero or equal to hi , and t*i could be positive, negative, or zero. For every cost-minimizing firm, marginal control costs are equated to p. The aggregate control costs are also minimized when this condition holds. The optimal values for the firm’s reductions and trades may be used to obtain a measure, S, of the aggregate cost savings of trading compared with traditional regulations. S may be estimated as the difference in aggregate control costs between regulatory regimes, or S
m
m
m
ci (hi qi) i1 cri (r*i ) i1 cti (t*i ). i1
(5.7)
The first term to the right of the equality sign is aggregate control costs under traditional regulation, the middle term is aggregate control costs under trading, and the last term is the sum of equilibrium purchases and sales of tradable permits. Except in the unusual case of equal marginal control cost functions and equal historical emissions for all firms, S is expected to be positive, meaning that emissions trading leads to cost savings when compared with traditional regulations. The authors also hypothesize that the greater the variance of control cost functions, the greater the aggregate cost savings. Demand and supply curves for permits may be derived from the estimated marginal control cost schedules of firms. Demand and supply in the market can be simulated under the cap by varying prices until sales equal purchases, or until the last term in equation (5.7) is zero. This approach may also be used to determine equilibrium permit prices when model constraints, parameters, and emissions targets are changed. A geometric description of this procedure is provided in the next section. An implication of emissions trading theory in a competitive market is that any change in the allocation to individual emitters will not affect the permit price or cost savings in the static case (Montgomery 1972: 395–418). Under the current program, the firm’s allocation, free of charge, is determined by the relationship qi (1)hi where lambda is the fraction reduction (0.12) of the firm’s historical emissions, hi. One interesting alternative allocation would be an auction of the same number of tradable permits as were allocated free. Such an auction is simulated and the results reported later in this chapter, with the expected outcome that the permit price, quantity of trades, and cost savings will be the same as under free allocation. The difference is that under the free allocation, emitter firms receive a significant transfer of wealth, whereas under the auction the government receives the wealth in the form of revenues. These results hold for the
Simulated performance 65 p
MCCi b
c MCCj
d
p1
f a e 0
r i*
r0
r j*
r
Figure 5.1 Price determination and cost savings with a homogenous pollutant. p $ per 200 lbs of emissions. r reduction in 200 lbs. of emissions units. MCCi and MCCj are marginal control costs for firms i and j, respectively.
cap, based on a 12 percent reduction, as well as for other hypothetically tightened caps. Recent research, however, has indicated that auctioning of permits can induce more innovations in the dynamic or evolutionary case than a free allocation (Milliman and Prince 1989: 247–265; Jung 1996: 95–111). In Figure 5.1 the authors’ method of estimating the equilibrium price of permits and calculating the cost savings from emissions trading is illustrated. The increasing and linear approximation to the marginal cost schedules of two emitter firms, i and j, are drawn under the assumption that distance 0r measured in 200 pound units, reflects the total possible reductions of both firms. Unless otherwise noted, all references to intervals in the figures are indicated by lines over the endpoints. For ease of visualization, assume that the government allocates rr0 permits to both firms, resulting in a 40 percent cap on emissions. Under traditional regulation, each firm would reduce by 0r0, with total control costs measured by the triangles ⌬0r0 b ⌬0r0 a. Allowing the firms to trade opens up new possibilities. At the equilibrium price in the market, the number of permits firms wish to purchase equals the number of permits other firms wish to sell. At all other prices there will be unsatisfied buyers or sellers. Given marginal control cost schedules for both firms and costminimizing behavior, a unique equilibrium price of 0p1 exists. Emitter j sells r0r*j permits and reduces by the amount 0r*j . Emitter i buys the amount r0r*i where r0r*i r0r*j , and reduces by the amount 0r*i . Total control costs under trading are measured by the triangles 0r*i d 0r*j c and net savings compared with traditional regulations are areas r*i r0bd r0 r*j ca, clearly a positive number, measured by triangles dfb fac. The argument generalizes to more than two firms and to integrals under nonlinear cost functions. Thus, permit valuation depends upon the marginal pollution control cost functions, given the policydetermined cap. The allowance of banking for one year introduces expectations of next year’s cost functions into the model. Expectations of future changes in
66
Simulated performance
control costs affect permit valuations and prices, since future-dated permits may currently be bought or sold, but not used until that future date. For example, expectations of future reductions in costs will lead well-informed emitters to acquire and use current permits, which raises current prices because it will be cheaper to buy permits to cover emissions now and control emissions later.
Empirical implementation of the model To measure the variables described requires detailed information on individual emitter marginal control costs. To obtain the critical information on marginal control costs, the authors rely on a large study carried out by the Illinois Environmental Protection Agency (IEPA) that surveyed the numerous control measures for emission reduction available to participants in the market before the start-up date (IEPA 1996: 43–65). The survey estimated the costs at about the 12 percent emission reduction level for a number of emitters for various standard industrial classification (SIC) codes. The survey estimated these marginal control costs by making use of engineering data and US Environmental Protection Agency (US EPA) estimates of the costs of Reasonably Available Control Technologies (RACTs). These marginal control cost estimates were then extended to other emitters in the same SIC code. Capital and operating costs were estimated in the study in present value terms. The underlying structural relationships of the model are the marginal control cost curves that were fitted for each firm by passing the curve through the origin and the 12 percent emission reduction cost value. These costs may be viewed as independent of traditional regulations. They are understood to be linear approximations of marginal costs over the relevant range. Based on these structural relationships, estimates of permit equilibrium prices and control costs under trading and traditional regulations at equilibrium output levels were obtained from a specially written optimization program that was built using the B34S® matrix programming language (Stokes 1997: 1–445). Basic to the approach was the specification of the excess demand functions. These depend upon the desired targeted level of reduction, which was 12 percent in the case of the current program. Summing the excess demand functions for all the firms and selecting the price that made this sum equal to zero determined the equilibrium price. In other words, at the equilibrium price the number of permits sold must equal the number of permits bought as demonstrated in Figure 5.1. The price was restricted to be greater than or equal to zero in the model specification, and an optimization routine determined the equilibrium price where the sum of excess demands was zero. An advantage of the optimization approach is that it allows the user to easily change constraints, parameters, and emissions targets or caps in the model and observe the results. Some observers have expressed concern about hot spots or sub-area increases in emissions over baseline, despite the reduction in aggregate emissions that could result under emissions trading. In Chapter 7 actual data are used to map potential trouble spots. In this chapter, the effect on price and trading of various public initiatives involving spatial constraints that restrict firms from participating in the market
Simulated performance 67 as buyers of permits are simulated. Using the optimization model, it is possible to restrict purchases of tradable permits within a certain zip code, or group of them, enabling the authors to gauge the effects of such proposed changes on permit prices. In addition, mapping of these emission patterns could provide a means of evaluating the changes in the distribution of emissions that result from these spatial constraints. The optimization approach also enables the authors to highlight the flexibility of the model by changing the emissions reduction targets and reporting the consequences.
Simulations of the performance of the model To simulate performance requires development of an implementation methodology to specify the excess demand function in the case of a 12 percent emission reduction goal. The key variables in the dataset of 179 firms are: 1 2 3
cri(ri), the marginal cost of emission reduction for firm i; 0, the reduction goal 12 percent, making the cap 88 percent of historic emissions; hi and qi as given by prior recorded emissions and government allocation policy where qi (1 0)hi.
In other words, if the firm’s reported historic emissions, hi , is 100 units, the firm is allocated 88 permits, qi , for the ozone season, when 0 is equal to 12 percent. The next task is to estimate the marginal control cost, based upon reported values of cri(ri) at a 12 percent reduction. In this preliminary model, the authors assumed the constant rate case, or linear cost curve, where the marginal cost curve for each firm was fitted to the 12 percent reduction value and the origin. These estimated marginal cost curves underlie the excess demand functions and are used to generate equilibrium prices, quantities of permits traded, and control costs under both traditional and trading regulations. These values are derived in the next section where the authors illustrate the flexibility of the model by explaining the implications of varying emission caps or by varying the cost functions and the excess demand curves. Assume 0 base reduction rate (0.12) and j the reduction rate mandated in period j, then cri (ri, j) cri (ri, 0)[j0],
(5.8)
where j is introduced to indicate a comparison of the cost value of a different cap point along the curve, although the slope remains the same. In other words, if the marginal costs of reducing emissions was $258, assuming the base reduction was 12 percent (cri(ri,0.12) $258) and the reduction rate was mandated to increase to 18percent, then marginal costs will rise to $387 or 258 (0.18/0.12). If ri( ) is defined as the amount of emissions that firm i needs to reduce, given any , the relation ri hi qi will hold if there is no trading under traditional regulations, and when trading is permitted ri hi qi ti. If ti(, p) is defined
68
Simulated performance
as the amount firm i sells (if negative) or buys (if positive), given the required reduction and the market price of a permit, p, it will be shown that the price of a permit, p, is an increasing function of , the required percentage reduction. Equations (5.9) and (5.10) explain how optimal trading is calculated for the firm, that is, how the authors determined ti(, p), given the allocation of permits and the marginal control cost. In theory, a firm will consider selling permits if the market price is above the marginal cost of reducing emissions p cri(ri, ) and will consider purchasing permits if the cost of reducing emissions is greater than the market price, p cri(ri, ), subject to constraints. Equation (5.9) formalizes the sellers’ constraints while (5.10) formalizes the buyers’ constraints. For p cri (ri, ), ti(, p) min((p cri (ri, ) (ri ( ) / cri (ri, )), or qi()). For p cri (ri, ), ti (, p) max((p cri (ri, ) (ri, ) / cri (ri, )), or hiqi()).
(5.9)
(5.10)
Note that equation (5.9) limits the absolute value of the maximum sales (ti(, p) 0) to the amount the firm has been allocated, qi(), while equation (5.10) limits the amount bought (ti(, p) 0) to what the firm needs or historic emissions minus the allocation. Here historic emissions are assumed to be equal to current emissions. The optimization problem is to find p such that 179 i=1 ti(j, p) 0 for a j value. Given p1 is the equilibrium price, the empirical work shows that, everything else equal, p1 / > 0 or the greater the required rate of reduction, the higher the price of the permit. The higher price results in more permits traded due to the increased incentive to acquire permits as marginal control costs mount. It also revealed that cost savings of trading increase compared with traditional regulation. The above analysis assumes that each firm was given an allocation of permits, qi(), and that some firms would buy permits and some firms would sell permits, depending on their individual cost functions. If there is a government auction of permits, each firm must either reduce all emissions or buy from the government to cover emissions at an auction where a single price clears the market. As in the free allocation case, the market clears when all permits offered by the government are sold and the sum of excess demands equals zero. The approach to estimating prices, quantities traded, and costs is the same in both the auction and free allocation scenarios. It will be noted that both scenarios yield, in the static case of a competitive market, the same prices, same number of permits traded, and same cost savings, although the transfer of wealth is different. This turns out to be an application of the Coase theorem (Coase 1960). In all cases costs of traditional regulations have been calculated as ri()cri (ri, )/2 and trading costs as (r*i() + ti (, p))2 cri (ri, )/2r*i ()) (as shown in Figure 5.1). The gain from trading for firm i then becomes (cri (ri, ) ri()) 2 ((r*i () ti (, p))2(cri (ri, ) 2r*i ())).
(5.11)
Simulated performance 69 The percent reduction for the firm becomes (r*i () ti(, p)) hi, which indicates that the more a firm sells tradable permits, the more it reduces its emissions, while the more a firm buys permits, the less it reduces its emissions. By using a general, nonlinear optimizer to solve the model, it is possible to add other parameters to the model and place complex, nonlinear constraints on the solution. The B34S® program contains a function that supports nonlinear programming with nonlinear constraints. This function was not needed in this preliminary analysis, since the only constraint placed on the solution was that p must be greater than or equal to zero. The authors’ model has been designed to highlight both the price and spatial effects of such changes.
The simulation results Establishing the cap or emissions reduction target may be viewed as the government acting as the citizens’ purchasing agent for air quality. The cap or target may change from time to time, as new information comes to light or new citizen pressure comes to bear on air quality. Similarly, the choice of a regulatory instrument may be viewed as the purchasing agent’s efforts to obtain the desired air quality in the most cost-effective way. This model presents a methodology to evaluate the agent’s policy options and their consequences for the valuation of tradable permits. Table 5.1 shows the equilibrium permit price, volume of permits traded, the control costs under emissions trading compared with traditional regulation, and the cost savings to be realized by using market incentives for the present program reduction rate of 12 percent from the historical benchmark. The authors also present additional simulation results for hypothetically increased reduction rates up to 36 percent, both as a test of the model and as a relevant exercise in view of the current policy debate on reducing acceptable urban ozone levels. The results are as expected from emissions trading theory. As the reduction in emissions increases from 12 to 36 percent, the tradable permit price increases from $258 to $773 as shown in Table 5.1. According to the model, control decisions in the cap-and-trade market at the 12 percent reduction rate can bring about $1 million in savings annually in the model per year compared with traditional regulation. These savings increase to just under $10 million as the emissions target rate of reduction increases to 36 percent, implying that as the number of permits allocated decreases and prices increase, the incentives to trade strengthen with the consequence of a more than proportionate increase in savings. The adopted approach enables the authors to report the number of permits traded at each reduction rate, as in the last column of Table 5.1. Recall that the reductions in emissions are obtained by issuing tradable permits to pollute in amounts below the benchmark or historical emission level. The benchmark emissions utilized in the cap-and-trade program were equivalent to 109,211 permits; thus, to achieve the 12 percent reduction required that 96,106 (109,211 0.88) permits be allocated for the year 2000 season. A slight difference between these numbers and those reported in the IEPA Performance Report occurs due to
70
Simulated performance
Table 5.1 Estimated effects of changes in emission reduction rates under free allocation Emissions Number of Permit Estimated control cost reduction permits equilibrium Under Under rate allocated price ($) traditional cap-andregulation trade market ($1,000) ($1,000)
Savings ($1,000)
0.12 0.18 0.24 0.30 0.36
1,061 2,388 4,245 6,633 9,551
96,106 89,553 83,001 76,448 69,895
258 386 515 644 773
2,749 6,186 10,994 17,179 24,737
1,687 3,797 6,749 10,546 15,186
Number of permits traded
3,743 5,615 7,486 9,358 11,229
Source: Model simulations using individual participant data provided to researchers by the IEPA. Note N 179 firms.
renegotiation of benchmarks for a few emitters (IEPA 2003: 12–13). The amounts allocated decrease as the policy-determined reduction rate increases, so that 69,895 permits would have to be allocated to achieve a 36 percent decrease in emissions. The number of permits traded in the 12 percent scenario is 3,743, about 4 percent of those allocated in that case. The number of permits to be traded if the reduction rate were set to 36 percent increases to 11,229, or 16 percent of the total allocated in that scenario. These results confirm expectations based on rising marginal control cost schedules: as reduction rates increase and permit allocations decrease, cost-saving opportunities through trade increase even more rapidly. This result is shown graphically in Figure 5.2. Emissions trading theory suggests that the greater the spread in marginal control cost slopes among emitters, the greater the opportunities for savings and the higher the permit price. To check these assertions, the absolute spread among emitter slopes was changed by varying percentages up and down, with a consequent change in the variance among these slope coefficients. The confirming results are presented in Table 5.2 for the policy reduction rate of 12 percent. At the base case of 100 percent, or no change in slope, the control cost under the Chicago VOC program is $1.687 million and the cost savings is $1.061 million when compared with traditional regulations as revealed in Table 5.1. If the variance increases to 150 percent, the same number of trades (3,743) will now generate a cost savings of $1.592 million. This occurs because the control cost under traditional regulations increased to $4.123 million, while control cost under the emissions trading model only increased to $2.531 million. The equilibrium permit price also increases as the variance of emitter marginal control cost increases. Figure 5.3 depicts the relationships between the variance and cost savings and permit prices. Note that while holding the reduction rate constant, if there is an increase or decrease in the spread of all slopes by the same percentage, the number of permits that emitters find it advantageous to trade does not change, even though the gains from trade increase.
Cost savings (x $1,000) and number of ATU straded
Simulated performance 71 NTRADED
11,000 10,000
COSTSAVE 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000
.12
.14
.16
.18
.20
.22
.24
.26
.28
.30
.32
.34
.36
Rate of reduction of VOM emissions
Figure 5.2 The relationships between the rate of reduction of emissions and cost savings and number of ATUs (allotment trading units) traded. Note that the permit reduction rate of 12 percent results in cost savings of about $1,000,000.
Introducing transactions costs into the emissions trading section of the model is expected to decrease cost savings, increase permit prices, and decrease the number of trades (Stavins 1995; Montero 1997). In essence, transactions costs drive a wedge between the sale and purchase price. These costs were introduced into the model in the case of the 12 percent reduction rate, with both seller and buyer sharing the transactions costs equally. The results are as expected and are reported in Table 5.3. Savings from trading and the number of trades decline appreciably as transactions costs increase. This simulation confirms that extremely high transactions costs can eliminate a market. For example, when transactions costs are equal to $250, the number of permits traded falls to 594 or 16 percent of the number traded (3,743) in the base case of no transactions costs. The IEPA has attempted to reduce transactions costs by maintaining a free electronic bulletin board of offers and bids and by requiring training of the account officer of each emitter. Transactions costs typically include search and negotiation expenditures, but they may also include anticipated emitter expenditures for legal and public relations assistance in the case of regulator challenges to trades or public disapproval of trades. Transactions costs of the latter kind have been nonexistent during the four years analyzed in this book. A powerful implication of emissions trading theory is that changes in the allocation of permits among emitters ought not to affect prices, quantities, or
72
Simulated performance
Table 5.2 Estimated effects of changes in the variance of marginal control costs (12 percent reduction rate) Percent of original slopes of marginal control cost curves variance ( ) ($1,000)
Permit equilibrium price ($)
50 (23) 55 (28) 60 (34) 65 (39) 70 (46) 75 (52) 80 (60) 85 (67) 90 (76) 95 (84) 100 (93) 105 (103) 110 (113) 115 (123) 120 (134) 125 (146) 130 (158) 135 (170) 140 (183) 145 (196) 150 (210)
129 142 155 167 180 193 206 219 232 245 258 270 283 296 309 322 335 348 361 373 386
Estimated control cost Under traditional regulation ($1,000)
Under cap-and-trade market ($1,000)
Savings ($1,000)
1,374 1,512 1,649 1,787 1,924 2,061 2,199 2,336 2,474 2,611 2,749 2,886 3,023 3,161 3,298 3,436 3,573 3,711 3,848 3,985 4,123
844 928 1,012 1,097 1,181 1,266 1,350 1,434 1,519 1,603 1,687 1,772 1,856 1,940 2,025 2,109 2,194 2,278 2,362 2,447 2,531
531 584 637 690 743 796 849 902 955 1,008 1,061 1,114 1,167 1,220 1,273 1,327 1,380 1,433 1,486 1,539 1,592
Number of permits traded
3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743 3,743
Source: Model simulations using individual participant data provided to researchers by the IEPA. Notes Column 1 contains the percent by which original marginal cost curve slopes were shifted, with the variance of all slopes in parentheses multiplied by $1,000. Therefore, a 50 percent change means a decrease of 50 percent for each slope. N 179 firms.
savings in the static case, presuming that the market remains competitive and free of uncertainties and transactions costs (Montgomery 1972: 395–418). The authors simulated an auction in which all firms paid the same price. The final equilibrium price balances the given supply and demand schedules derivable from the marginal cost schedules. The results of this simulation are shown in Table 5.4. When the cap or reduction rate is changed, the authors found that the auction results are the same as those under free allocation. The difference between these two methods of allocation is the transfer of wealth. Under the free allocation, the value of the permit is transferred to the emitter, while under the auction, the revenues go to the government. The transfers of wealth may be estimated by multiplying the number of permits allocated by the price. At a 12 percent level of reduction, about $25 million (96,106 $258) will be transferred to the
Cost savings(x $1,000) and ATU price
COSTSAVE 1,400 1,200 1,000
800 600 400
ATUPRICE
200 40
60
80
100
120
140
160
180
200
Variance of marginal cost curve slopes (000)
Figure 5.3 The relationships between the variance of emitter marginal cost slopes and cost savings and ATU (allotment trading unit) prices when the aggregate target rate of reduction is 12 percent.
Table 5.3 Estimated effects of changes in transactions costs (12 percent reduction rate) Transactions costs ($)
0 10 20 30 40 50 60 70 100 200 250
Permit equilibrium price ($)
258 264 270 276 283 289 295 301 320 375 419
Estimated control cost Under traditional regulation ($1,000)
Under cap-and-trade market ($1,000)
Savings ($1,000)
2,749 2,749 2,749 2,749 2,749 2,749 2,749 2,749 2,749 2,749 2,749
1,687 1,689 1,694 1,701 1,712 1,726 1,743 1,763 1,842 2,264 2,341
1,061 1,060 1,055 1,047 1,036 1,022 1,005 985 906 484 407
Number of permits traded
3,743 3,588 3,433 3,278 3,123 2,968 2,813 2,658 2,194 765 594
Source: Model simulations using individual participant data provided to researchers by the IEPA. Note N 179 firms.
74
Simulated performance
Table 5.4 Estimated effects of changes in emission reduction rates under an auction market VOC reduction rates
Permit cap: number of permits auctioned
Permit equilibrium price ($)
0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30 0.32 0.34 0.36
96,106 93,922 91,738 89,553 87,369 85,185 83,001 80,816 78,632 76,448 74,264 72,080 69,895
258 300 343 386 429 472 515 558 601 644 687 730 773
Estimated control cost Under traditional regulation ($1,000)
Under cap-and-trade market ($1,000)
Savings ($1,000)
2,749 3,741 4,886 6,184 7,635 9,238 10,994 12,903 14,964 17,179 19,545 22,065 24,737
1,687 2,297 3,000 3,797 4,687 5,671 6,749 7,921 9,187 10,546 11,999 13,546 15,186
1,061 1,444 1,887 2,388 2,948 3,567 4,245 4,982 5,778 6,633 7,546 8,519 9,551
Source: Model simulations using individual participant data provided to researchers by the IEPA. Note N 179 firms.
government or emitters, depending on the method of allocation. This transfer of wealth would increase to about $54 million (69,895 $773), if the reduction rate were 36 percent. Individual firm purchases and sales of permits also differ under the auction and free allocation methods. Assuming a free allocation, the authors have arrayed emitter firms from low to high marginal costs in Figure 5.4 and plotted their purchases and sales at a 12 percent level of reduction. Note Figure 5.4 confirms the previous point that marginal control costs differ significantly among emitters, a precondition for an efficient market. In the case of an auction, shown in Figure 5.5, almost all emitters would be purchasing permits. The number purchased would be positive for each emitter making a bid. In both the auction market and under free allocation, emitters are equating their marginal costs to the tradable permit price. Total purchases for each emitter in the auction market, where all permits must be purchased from the government, are the algebraic sum of what they would have gotten under free allocation, qi, plus their trades, ti, which is positive for buys and negative for sells. Emitter control costs are the same in both markets but not their balance sheets. It should be noted that there are also reasons to believe that auctioning tradable permits can induce greater innovations and diffusion of pollution control technology than free allocation, because of the incentives created by the price of auctioned permits.
Purchases (+) and sales (–) of ATU permits
400
200
0
–200
–400
–600
–800
–1,000 20
40
60
80
100
120
140
160
Individual emitter firms arrayed from low to high MC curve slopes
Figure 5.4 Individual emitter purchases and sales of permits at a VOC reduction rate of 0.12, a permit equilibrium price of $258, and a free allocation of permits. The ordinate values are permit purchases if positive and permit sales if negative. The abscissa values are 179 individual emitters arrayed from lowest marginal control cost slope value on the left to the highest on the right. 10,000
Purchases (+) and sales (–) of ATU permits
9,000 8,000 7,000 6,,000 5,000 4,000 3,000 2,000 1,000 0 20
40
60
80
100
120
140
160
180
Individual emitter firms arrayed from low to high MC curve slopes
Figure 5.5 Individual emitter purchases of permits at a reduction rate of 0.12 and an equilibrium price of $258, assuming the government auctions the permits. Almost all firms are buyers.
76
Simulated performance
Market performance with spatially restricted trading Spatial restrictions on cap-and-trade markets by the government have been proposed to allay concerns that neighborhoods could experience increases in emissions despite a regional or nonattainment area reduction. An example might be if for an individual firm i a cap ␥i is placed on the amount the firm can buy so that (ti(, p) ␥i). In the extreme, if ␥i 0, the firm can only sell permits or (ti(, p) 0.0). The authors examine how such restrictions can result in a possible loss in cost savings in the market, if spatial segmentation is imposed. This loss would have to be balanced against any gains in the reduction of neighborhood harms due to the redistribution of emissions. There is a second, more subtle, consequence of spatial constraints. Restrictions on purchases of emissions in one neighborhood mean changed or increased emissions in others. Total emissions remain capped, of course, but the decline in permit price caused by spatial constraints may lead other emitters to reduce emissions less by control measures and buy more permits, allowing them to emit more. Only a careful spatial analysis can reveal the changing emissions patterns that result from imposing spatial constraints on the market. The loss in efficiency caused by special constraints in the market can be explored in the model by starting with the 98 zip codes in which emitters are
Table 5.5 Estimated effects of sub-area trading restrictions (12 percent reduction rate) Restrictions on permit purchases in selected zip codes
Permit Estimated control cost Number of equilibrium permits price ($) Under Under Savings traded traditional cap-and-trade ($1,000) regulation market ($1,000) ($1,000)
No restrictions Restrictions on purchases in 10 zip codes Restrictions on purchases in 20 zip codes Restrictions on purchases in 30 zip codes Restrictions on purchases in 40 zip codes
258 238
2,749 2,749
1,687 1,964
1,061 784
3,743 2,942
230
2,749
2,047
702
2,597
213
2,749
2,242
507
1,917
208
2,749
2,289
460
1,709
Source: Model simulations using individual participant data provided to researchers by the IEPA. Note N 179 firms.
Simulated performance 77 located and restricting permit purchases by those emitters located in specific zip codes. The first simulation restricted purchases by emitters in those zip codes in the southern part of the region on the grounds that prevailing winds blow emissions from south to north. Once these emitters are restricted from buying, the price falls as expected from $258 to $238 as shown in Table 5.5. The next simulation eliminated the zip codes located in Chicago where population densities are greatest, which caused the price to fall further to $230. A further simulation restricts purchases in both the Chicago and the southern zip codes causing the simulated equilibrium price to fall to $213. The results in Table 5.5 reveal that permit prices, trades, and cost savings decrease as expected as spatial constraints are imposed on the market. Control cost savings fall from $1.061 million in the case of no spatial restrictions to $0.46 million when restrictions were imposed on 40 zip codes.
A normative theory of banking The VOC cap-and-trade market design allows permits to be banked for one year after the year of issuance, but does not allow permits to be borrowed from the coming year. This asymmetric rule means than banking can never be negative, only zero or positive. Under what circumstances, then, would a participant want to bank permits for use in the next period? It will be argued that the expected price next year would have to be at or above the current price times (1 i), where i is the current market rate of interest. That is, the expected price would have to be equal to or above the cost of holding a permit one year. The authors propose an analysis of this banking decision for a participant assumed to minimize inter-temporal emission reduction costs. To analyze this banking decision the following variables are defined: Bt banked permits in period t B*t optimum bank in period t At allotted permits in period t Et emissions in permit-equivalent units in period t Pt purchases of permits in period t pt price of a permit in period t St sales of permits in period t Xt number of permits that expire in period t. In the following theory of banking, the subscript t refers to time periods and not to transactions as in the previous discussions. Considering the fundamental rule of the market that a permit must be returned to the IEPA for every 200 pounds of VOC emissions during the ozone season, the rules of the cap-and-trade program require that at the end of the season the identity Bt At Et Pt St Bt1 Xt
(5.12)
must hold, ignoring certain small items such as permit donations or purchases from set-aside accounts. Equation (5.12), a further specification of equation (5.1),
78
Simulated performance
explicitly breaks up the terms qt , ht , tt and rt to allow for analysis of the banking decision. Note that At qt, Pt St Bt 1 Bt Xt tt and Et ht rt. Substitution of these values in equation (5.12) reproduces equation (5.1) for period t or 0 qt ht rt tt. Next, the conditions for positive banking in a competitive market are introduced. Suppose a participant expects the price p 2e in the next period to be higher than the current price, p, times (1 i). In this case, it is not correct to assume that the participant will save all permits allocated because that would imply an increased cost of reducing emissions in the current period. The participant’s problem is that more banking in the current period means higher marginal control costs. Any banking by the participant in the current period means incurring increasing costs of control to reduce emissions, so the participant has to calculate the incremental benefits of banking permits versus the increased costs of reducing emissions. This calculation is illustrated in Figure 5.6, where the participant’s expected price p 2e is drawn. The participant receives allotment At, which is shown as the line segment rtr. In order to minimize costs in period t, the firm would reduce emissions by 0r*t where current marginal control cost equates to the current price p1. This leaves the firm with excess permits of rtr*t , which can be sold on the market for the price p1 in the current period. Now, assume the expected price for the next period is p 2e which is equal to or greater than p1(1 i). In this case, the firm would reduce emissions in the current period by 0b*t , where the marginal cost of reducing emissions in the current period equals the expected price in the next period. In this case, the firm has excess permits equal to rtb*t . Of these, distance rtr*t would be sold in the current period for price p1. The remaining permits measured by distance r*t b*t would be banked for the next period. Lastly, the permits measured by distance b*t r would
p
e
p2e p1
c
MCC
d
0
rt
rt*
bt*
r
B t*
Figure 5.6 Determination of the optimum level of banking given expected prices.
Simulated performance 79 be turned over to the agency to cover current emissions. Emission reductions are carried out for purposes of banking to the point where marginal control costs are equal to the expected price or (1 i) times the current price. To bank that amount of permits requires increased control costs measured by the area r*t b*t e c. The determinants of optimal banking may be shown with the help of Figure 5.6. The optimal quantity to be banked in period t is B*t . The rectangle part of costs, or area c d b*t r*t , is equal to B*t p1. The remaining triangle area of cost is equal to 1/2 of B*t ed . Note that ed pe2 p1. The slope of the marginal cost angle, ␣, is equal to ed cd . That is ed ␣ cd ␣B*t . The triangle area is thus equal to .5␣(B*t )2. Thus, total extra costs carried over to the next period as required by banking are the two areas added together or (B*t p1 .5␣(B*t )2)(1 i). At equilibrium incremental costs are (B*t p1 .5␣(B*t )2)(1 i),
(5.13)
which can be solved for net benefit when we note that expected incremental benefits are B*t pe2, or B*t pe2 (B*t p1 .5␣(B*t )2)(1 i)
(5.14)
and maximized by setting d/dB 0 which simplifies to pe2 (p1 ␣B*t )(1 i).
(5.15)
The optimum quantity to be banked in period t is thus B*t
(pe2 p1(1 i)) . ␣(1 i)
(5.16)
Equation (5.16) may be interpreted as meaning that banking depends positively on the expected price in period 2, pe2, negatively on the current price, p1, and inversely on the slope ␣. That is, the lower the incremental cost to reduce emissions, the greater the incentive to bank. The higher the market rate of interest, the smaller the bank, as one would expect. Equation (5.15) solves equation 5.16 for expected price in period 2 or pe2. Expected prices may vary among participants, so researchers would have to survey them, or develop an expectations model. The slopes of the marginal control costs vary among participants, as is known. The slopes would also have to be discovered by survey or modeled perhaps with engineering data. This method of generalization could then be aggregated to estimate the quantity of banking. Note that the optimum amount of banking could differ, if the one-year horizon for the life of the permit were relaxed to permit a longer horizon.
Tradable permits as private financial assets Market participant holdings of tradable permits represent intangible assets that must be disclosed, measured, valued, and placed on the firm’s profit and loss
80
Simulated performance
statement and balance sheet in the appropriate places. Full and fair reporting of these assets will allow careful readers to form their own judgment and correctly assess their economic potential. While tradable permits are dated and have a oneyear life after the year of issuance, the government is committed, unless the policy cap changes (always a contingency), to issue a future stream of future-dated tradable permits. Investors, as well as firms, can buy, sell, or bank their current issue, and they can buy or sell future-dated permits for use at the proper time. In a competitive market with well informed traders, the equilibrium price of the permit will reveal the marginal pollution control costs. Every trading firm will have equated their own costs to that equilibrium price. As shown, our model, simulating that efficient market, estimates that equilibrium price, based on the policy cap and the estimated firm cost functions. The market responds to demand and supply curves of the firms so that at equilibrium, some buyers enjoy a buyer’s surplus for those acquired permits they valued above the equilibrium price, and some sellers enjoy a seller’s surplus for those permits they would have sold below the equilibrium price. The efficient market maximizes the sum of these surpluses, as is true of any efficient market. The market for tradable pollution permits is no different in this respect than other markets, and many of the finance and accounting principles carry over. The firm has a problem, as do finance and accounting experts, in discovering price. The IEPA maintains an electronic bulletin board for recording bids and offers, but does not publish particular transaction prices. Brokers in the market could provide some information if they were more active. The agency does publish average prices from time to time that give indications of where the price is heading. It should be noted that tradable permits are given free to firms giving rise to interesting questions about their valuation. They have value in the market; therefore their use in covering emissions is not free, but should be valued at the market price as a cost of production. If they are banked, they also have a value that is the estimated price during the next period. Here they appear on the firm’s balance sheet. There is an additional interesting question about accounting for the future stream of tradable permits that the government will issue to the firm. These clearly have value and should be noted for the record. Note the tax implications that arise if permits are sold, since they were obtained free of charge. There are similarities in the pricing of permits with other production inputs. The tradable permit is valued by the firm, because it can be used in place of expensive control equipment. That value is based on the marginal control cost function of the firm. The forward looking firm is aware that marginal control costs can change, due to technological progress or technological difficulties. Therefore, the present price depends upon expectations of future control cost developments and public policy changes. If costs are expected to decline in the future, that expectation will increase the present price of the permit, since it is advantageous to use permits now rather than later. Because the anticipated future stream of dated, tradable permits may be banked for one year, they enter the balance sheet at market prices subject to fluctuation as future marginal control costs change and public policy changes. This makes
Simulated performance 81 tradable permits comparable to the company’s stock in this respect, which can be priced at the present, as the discounted value of future earnings. New environmental regulations, such as a longer life for permits, can affect earnings and consequently stock values. Whether the new cap-and-trade market affected stock values of firms in the Chicago ozone nonattainment area compared with those outside the region is an interesting but difficult research question involving a search for comparable firms not subject to a cap-and-trade market. The hypothesis might be that the market diminished stock values. However, firms in attainment areas are still subject to traditional regulations, and to the extent that the cap-and-trade market brings about control cost savings, the value of the stock of firms in a market area could be higher.
Conclusions and research directions Emissions trading theory compels the authors to take a fresh look at, and ask different questions about, the workings and impacts of environmental regulation. Under a trading system, the government makes key policy decisions about the cap and devises general market rules and appraisal procedures, subject to the scrutiny and comment of the regulated community and public interest groups. The regulated or business community, in turn, makes decisions about the choice of control options, the search for new options, and the management of the tradable permit portfolio. The model developed in this chapter can help reveal the potential of emissions trading under a variety of assumptions about the parameters of relationships and changes in emission targets or goals. It must be remembered that the market is being analyzed in isolation from external constraints, so that only the direction of changes can be discussed. Compared with traditional regulation, the simulation results of the market model indicate the potential for the present program to bring about cost savings. The results also point out the direction of movement of key variables as features of the market change. If emitters confront transactions costs in the market, the model demonstrates that the higher these costs, the lower the permit price, the fewer the trades, and the lower the cost savings. The model also allows simulation of government changes in policy objectives, such as tightening the cap. Allocating fewer aggregate permits causes higher prices, more trades, and greater cost savings compared with traditional regulations. The model shows that if the government chose to allocate permits through an auction rather than through free allocation, in a competitive market, there would be no change in current permit equilibrium price or cost savings. However, there would be a change in the transfer of wealth and the incentives to innovate. Auctioning of tradable permits typically encounters serious resistance from emitters, due to the charge that it constitutes a layer of taxation, and also due to the change in the transfer of wealth that would occur. The authors have also been able to show that if spatial constraints are placed on the market, the permit price falls, cost savings are reduced, and the distribution of emissions over the area is altered.
82
Simulated performance Table 5.6 Comparison of simulated and actual data for the Chicago cap-and-trade market in 2001 Variable
Observed
Model forecasts
Discrepancy
Emissions Permits traded Permits banked Expirations Permit price
51,703 3,702 73,401 13,924 $51.93
96,106 3,743 NA 0 $258
44,403 41 NA 13,924 $206
Sources: Observed data from Table 3.1. Model forecasts from Table 5.1. Note All data in terms of ATUs denominated as 200 Pounds of VOC emissions. N 179 firms.
Although this chapter considered the market activity in isolation from imperfections and internal constraints, the market model provides a reference point for comparison with observed data, such as those presented in Chapter 3 where design deficiencies and external constraints could exert their influence. Table 5.6 reveals how forecasts of the market model compared with observed outcomes for the important variables. The discrepancies shown in Table 5.6 provide strong motivation to probe more deeply into the causes of such differences. The tradable permit price discrepancy resembles the forecast of high SO2 permit prices made by others (Burtraw 1996: 79–94; Joskow et al. 1998: 668–685) that proved to be well over actual prices. In that case it was the unexpected use of low-sulfur coal by many electric utilities instead of the more expensive sulfur scrubbing that led to lower marginal control costs and hence lower permit prices. In the Chicago case, the differences in the number of banked permits and expirations between model simulations and observed performance are striking. It seems unlikely that any simple explanation, such as a change in the prices of inputs containing VOC material could account for these disparities. The differences between simulated and observed market outcomes in the Chicago case point toward more complex research necessary to untangle the causes for the observed market performance. The authors now turn to that research.
6
Explaining unanticipated market performance
Introduction The prior chapter presented simulations representing how an idealized cap-and-trade market might perform, given standard assumptions about its features. No underlying traditional regulations were assumed to be in place interacting with market design features such as the cap and banking horizon for tradable permits. The object was to show the theoretical effects of changes in the cap, transactions costs, and sub-area or spatial restrictions on the ability of a firm to trade. This preliminary analysis was carried out before the market got underway in an effort to anticipate the results of actual performance. This chapter now turns to recorded market performance and an analysis of the unanticipated outcomes. During the first four years of actual performance, as revealed in Table 3.1, the Illinois Environmental Protection Agency (IEPA) reported that recorded volatile organic compound (VOC) emissions from the stationary sources covered by the pioneering Chicago cap-and-trade program were far below allotments of tradable permits and thus even further below the baseline of historical emissions values (IEPA 2000–3). The agency explained the lowered emissions as a benefit from the implementation of the new market. Furthermore, recorded emission values were not associated with an increase in township spatial hot spots or neighborhood increases in emissions during this period, nor were inter-temporal spikes in emissions recorded. This record and evaluation of performance have largely turned aside the prior intense local debate about possible hot spots and spikes resulting from this new regulation. The authors welcomed this good news about the market performance, but the authors’ deeper probing of the first years of market performance, 2000–4, has revealed serious questions about the causes for such deep emission reductions. In addition, there were unexpected market outcomes, such as very large banks, surprising expirations, and unforeseen low prices of tradable permits, all observable in Table 3.1. The authors review, and test, a number of hypotheses purporting to explain these puzzling outcomes. A survey of selected participants in the market reveals their perceived problems in managing tradable permits and their explanations of the large banks, expirations, and low prices for permits. Their answers provide
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one source of valuable information in formulating hypotheses about the unanticipated performance. Another possible hypothesis was the presence of monopsony power, concentrations of economic power to restrict permit purchases by one or more participants in an effort to drive down prices, as an explanation of observed performance. However, the data on prices and trades does not support such a theory, as the authors will demonstrate. A number of other hypotheses, such as imperfect information or excessive transactions costs, were found to have little or no support. The authors finally turn to statistical tests of hypotheses bearing on constraints on the workings of the market, including original design deficiencies. Among these hypotheses were external limitations on market activity, such as the recession and the over-allotment of permits by the regulating agency. An important hypothesis to be tested was the possible interaction of traditional regulations with the particular, and unique, market design. While the IEPA had heralded the use of two policy instruments to attain the emission reduction goal, a cap-and-trade market and traditional regulations, the authors had early concerns about possible conflicts between the two instruments, concerns that grew in magnitude as the research progressed. To evaluate these hypotheses on puzzling market activity required, to the extent possible, the innovative construction of variables reflecting these problems, and the devising of appropriate tests for the significance of these variables. It will be noted that the theoretical model of Chapter 5 was extended to provide the appropriate framework for interpreting these tests. In summary of the results obtained, the authors’ analysis led to the main conclusion that the continuance and extension of an array of traditional regulations accounted for most of the emissions reductions and associated puzzles. That is, the level of traditional regulations, and not the cap-and-trade market rules, were dominating and binding on emitters. There was a conflict between the two regulatory instruments, and one, the market system, became redundant. These traditional regulations overwhelmed a market design that included such features as a small reduction in emissions (the cap) and a one-year limit to banking of permits after the date of issuance. The regulating agency’s pioneering efforts to design a compatible dual approach to environmental regulation, incorporating both a decentralized incentive and a centralized prescriptive system, was not successful in this particular effort. The authors’ findings indicate the critical importance of the appropriate market design if the cap-and-trade approach is to achieve the hoped for emission reductions, cost-effectiveness, control innovation stimulation, and flexibility, when combined with traditional regulations.
Responses of participants to the new market: a survey In preparing for the survey, the authors developed four main questions about banking and market activity to be asked of six experienced market participants one year after the start date. Respondents were assured that they would remain
Explaining market performance 85 anonymous. Each major question was followed by additional questions to probe the reasons given. As researchers, the authors recognize that the survey responses were preliminary, few in number, and the views of the regulated community. They were not necessarily the views of other groups. The participants were asked about: 1 2 3 4
the many permits that were banked during the first year (2000); their views on the prospects for trading and banking in the second year (2001); the long-run prospects for trading and banking of permits; banking decisions in their particular company (the participants surveyed had banked 20 to 40 percent of their allotments).
In answer to the first question, respondents gave as a reason for their banking decisions the continuing regulatory programs, such as Maximum Achievable Control Technology (MACT) and Reasonably Available Control Technologies (RACT) requirements. These programs had reduced emissions below allotments and led to forced or unwanted banks of permits. The MACT requirements reduced both hazardous air pollutants (HAPs) and non-HAP VOC emissions at the same time. Other regulatory requirements were also reported to have played a role. There had been an interval of three years between the determination of benchmark emissions by the agency and the allotment of tradable permits under the cap. During this interval, emissions had been reduced by traditional regulations. Participants, and observers, before the start of the market had not accurately foreseen the extent and depth of this pressure of traditional regulations. Furthermore, these regulations put a ceiling on increasing emissions, limiting permit use for this purpose. Other reasons given were that participants were not accustomed to optimizing the use of tradable permits. If the credit expired, it was “not big bucks.” Emitters wanted certainty and chose “not to rely on the market.” Many of the participants, and certainly the smaller ones, are “not emissions traders by inclination if there seems to be no reason to do so.” It was not that participants over controlled in reducing emissions because they expected high permit price; these clearly were declining both in the bid-offer electronic bulletin board and in the average prices reported by the agency. More likely, participants paid little attention until the end-of-the-year reconciliation period, when permits and emissions had to be matched, and were caught mainly by surprise with a surplus of permits. Despite these problems, there were a few reports of market transactions that suggested incentives did play a minor role. The cap-and-trade approach to emissions reductions decentralizes micro-control decisions to participants, who have an incentive to buy permits if marginal control costs exceed the observable market price, and sell if costs are less than the price. A few examples of these transactions were reported, as the cap-and-trade approach created incentives for cost-saving transactions in these instances. These purchases and sales, available only in aggregated numbers, are analyzed in this chapter. There was no mention of major capital investments or innovations during this period. One respondent
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Explaining market performance
mentioned minor innovations of the “process type,” such as tightening seals, changing paint composition, and fine-tuning liquid scrubbers. In response to the second question, there was little evidence from the answers that many plans were being made for a reduction of banks in 2001. The buildup of banked permits seemed to be widely viewed as a result of the lack of profitable trading opportunities. No mention was made of a possible spiking problem, or burst of emissions, in 2001 due to the large banks. On the contrary, emissions were generally expected to be about the same in the coming year. Expectations could play a role in the banking decision, but it was not yet clear that participants believed it was important to formulate plans for future market activity, given the massive supplies of permits. In response to the third question, several respondents replied that they expected the cap to be tightened and traditional regulation, especially MACT, to be extended. The latter concern was thought to inhibit participants from managing their permit portfolios in a cost-minimizing manner, because specific technologies or rates of emission are prescribed by traditional regulations. One respondent envisioned emissions rising with economic growth, causing permit prices to rise over time and banks to be adjusted to that trend. For another respondent, the lack of demand would persist as participants would continue to handle permits simply as a compliance effort and a cost of doing business. That is, there would not be significant changes in the small proportion of permits traded. In reply to the fourth question, one respondent mentioned that banking avoided the risk of enforcement problems. Business wanted certainty of compliance. A second respondent reported that the company he represented did not object to having emissions below allotments of permits, with resultant large banks, because they wanted to avoid entering a new, unfamiliar market and risking enforcement activity. As for the disposal of the banked permits, one respondent expressed the view that tax guidance was needed on the topic of permit donations to charities or environmental groups. A certifiable tax credit would be advantageous. Another respondent mentioned donating permits to a state new-source pool for firms locating in the region. A small survey does not permit a refined statistical analysis. It has the merit of providing an opportunity to develop issues valuable in a more systematic investigation of the range of factors affecting transactions and the banking decision. Such an enquiry can pave the way for obtaining additional data and formulating hypotheses to be subjected to more rigorous statistical tests.
Were there market problems, such as monopsony? Concerted participant activity to influence price is a problem confronting every market analysis, and monopsony power comes to mind as a possible explanation of low permit prices. As a start to a more systematic consideration of such noncompetitive behavior by one or more participants to withhold purchases in order to drive permit prices down, the authors present a Lorenz Curve analysis of
Explaining market performance 87 the pollution size distribution of market participants. Theoretically, larger participants, measured by their volume of emissions, could exert undue influence on key decision variables, such as permit transactions, allotments, and banks. The Lorenz curves can also provide statistical insight into the diversity of VOC market participants by emissions size. In the Lorenz curves that follow, pollution size of emitter was measured as a ratio of each emitter’s Allotment Trading Unit (ATU) allowance in 2001 divided by the maximum individual ATU allowance in 2001. Individual participant data were obtained from the IEPA. The distribution of participants reveals many small firms and about 20 large firms. Figures 6.1, 6.2, and 6.3 bring out important aspects of these Lorenz distributions. Participants are arrayed from smallest to largest by emissions size along the horizontal axis. Then, shares of total permit allotments, emissions, banks, purchases and sales, and expirations of permits are calculated as possessed by each size fraction and plotted on the vertical axis. For the year 2000, as portrayed in Figure 6.1, the authors may estimate that the smallest 50 percent of participants had less than 25 percent of allotments, emissions, and banks, whereas the top 10 percent, about 20 firms, had some 50 percent of these variables. The curves for the distributions of the fractions of allotments, emissions, and banked ATUs held by participants were close together when arrayed against the emissions size of participant, indicative of a fairly uniform management of these variables under the circumstances by emitters of varied size. In sharp contrast, the curves for purchases and sales reveal a markedly different distribution in Figure 6.1, the few traders in numbers being much more evenly distributed among the participants by size. In fact, the top 10 percent of the firms had relatively few transactions. An explanation of this pattern of transactions was sought and found, and will be provided in a later section.
Fraction of variable held
1.00
0.75
0.50
0.25
0.00 0.
.1
.2
.3
.4
.5
.6
.7
.8
.9
1.
Fraction of participants arrayed by size BUY00 DIAGONAL
EMISSIONS00 BANK00
ALLOTMENT00 SELL00
Figure 6.1 Dependent variable holdings by emissions size of participants in 2000. N 168.
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Explaining market performance
Fraction of variable held
1.00
0.75
0.50
0.25
0.00 0.
.1
.2
.3
.4
.5
.6
.7
.8
.9
1.
Fraction of participants arrayed by size EXPIRE01 ALLOTMENT01
EMISSIONS01 BANK01
DIAGONAL
Figure 6.2 Dependent variable holdings by emissions size of participants in 2001. N 168.
Fraction of variable held
1.00
0.75
0.50
0.25
0.00 0.
.1
.2
.3 .4 .5 .6 .7 Fraction of participants arrayed by size BUY01
SELL01
.8
.9
1.
DIAGONAL
Figure 6.3 Buying and selling by emissions size of participants in 2001. N 168.
The profiles are similar for 2001, where expirations of vintage 2000 credits have been added to Figure 6.2. Again, the top 10 percent accounted for close to 50 percent of allotments, emissions, banks, and expirations, but few of the purchases and sales. These 2001 purchases and sales, plotted separately in Figure 6.3 for ease in reading, reveal distributions in Figure 6.3 similar to those of 2000, indicative of a strong lagged effect of transactions over the two years. From the curve for the expirations of credits, the authors note that the larger emitters, specifically the top 20 percent, allowed about 70 percent of the total permit expirations to lapse a year after issuance (as may be estimated from
Explaining market performance 89 Figure 6.2). Expirations of permits continued to increase year after year as recorded in Table 3.1. In addition to the distribution of transactions by emissions size of emitters, there is the observed downward trend in prices, some being offered at $5 per ATU in 2005, that casts doubt on the presence of monopsony power. For emitters to withhold purchases year after year without attempting to seek economic gain by such behavior seems implausible, especially when it is remembered that permits expire one year after issuance.
Were program design deficiencies affecting market decisions? What the Lorenz curves do not tell the observer are the reasons for the transactions among the few emitters who entered the market and, more important, the reasons the vast majority of emitters did not enter the market. What then does explain the low emissions, resulting in large banks, which in turn led to permit expirations, limited profitable trading opportunities, and consequent low prices of permits? The search for major determinants of the puzzling performance of the market turns now to outside constraints that could have limited participant market incentives. As noted, surveys of participants suggested the continuance of traditional regulations as a major determinant for reducing emissions. Discussions with the IEPA suggested an over-allotment of permits and the recession of 2001 as other important factors to consider. To test these hypotheses requires the development of variables that could measure or reflect the impacts of these external restrictions or constraints on individual participant market decisions. Such variables, reflecting the impacts of agency policies and the macroeconomic environment, had to be developed for individual emitters, one of the most challenging tasks of this investigation. There are several ways of introducing these variables into the optimization model of Chapter 5. They could be introduced as control variables, bounding the values for transactions. The model could then be solved to obtain an estimate of market activity and the loss in cost savings brought about by the boundary values. Such a procedure was followed, for example, in Chapter 5 in estimating the impact of spatial restrictions on trading. Or the constraint variables could be introduced into the model specification of equations determining market activity to test their impact and significance, together with more customary variables, such as marginal control costs. The authors chose the latter course, as it provides a test of the importance of these constraint variables in comparison with the more customary variables. It must be emphasized that a finding that participants are not equating marginal control costs to permit prices does not imply irrational behavior; rather, it implies that decisions are being limited by the constraints. The first constraint variable, labeled REG, was developed to represent the pressure of traditional regulations. The authors sought a measure of the continuance and extension of command-and-control regulations that would impact on the
90
Explaining market performance
VOC emissions and transactions of market participants. As these regulations are formulated and monitored by the government, they may be considered truly exogenous to participant decisions relating to transactions, banks, and permit expirations. This is an advantageous statistical property in the estimation method utilized. The variable REG was measured by dividing individual participant annual emissions reported during 1998 by their baselines, as determined by the IEPA, generally in the period 1994–6. Using these prior years for measurement purposes would yield a variable providing a rigorous test of the impact of traditional regulations on emissions before market incentives could exercise their sway. It was to be a test of whether technology-based rules, which continue to be extended and further implemented, could act and continue to act – rule by rule, process by process, and input by input – to reduce individual participant emissions below baseline. The authors chose not to include later years, 1999–2001 in this measure, even though traditional regulations continued and were expanded during this period, in order to make a conservative assumption about the influence of this variable on later decisions. The key assumption made is that traditional regulations were the primary reason for changes in emissions during the period from the benchmark until 1998, and thereafter, although other factors may have played a role. The discussion in Chapter 4 about the continuing and expanded set of traditional regulations during this period lends credence to this assumption. It is also important to recall, as stated in Chapter 4, that traditional regulations in the form of RACT rules frequently start as Control Technology Guidelines (CTGs), formulated by the US Environmental Protection Agency (US EPA) and then are implemented over time by the states. This lag between formulation and implementation is one reason for the continuing pressure of the REG variable. The MACT regulations were introduced in a continual stream by the US EPA after 1990 and implemented by the states, typically with a lag. Therefore, the impacts of this comprehensive set of regulations, as reflected in the REG variable, were considered to exert continuing pressure over time. As the REG variable is destined to play an important role in our analysis of the performance of the market, the authors prepared a further description of its variation by emissions size of individual emitters in Figure 6.4. Participants arrayed from smallest to largest, as measured by emissions size, are plotted along the abscissa and the REG ratios along the ordinate. What is revealing is the lack of a relationship between the REG ratio and the size of emitter. Also revealing is the vivid portrayal of the wide diversity of REG ratios among emitters. If each bar in the figure initially were a nail at unity, it is as if the hammer of traditional regulation had struck widely different blows on the nails, driving most of them below unity, and some very much below. The variation in the impact of traditional regulations may be expected to have differential affects on participant market transactions. These results of Figure 6.4 are further evidence that the complex and varied technology-based regulations are geared to separate production processes and inputs and not to enterprises simply by their emissions volumes. Command-and-control
Explaining market performance 91 3
2.5
REG ratio
2
1.5
1
0.5
0
20
40 60 80 100 120 140 Participants arrayed by emissions size from small to large
160
Figure 6.4 Variation in REG ratios by emissions size of participants. N 168.
regulations do require the same reductions among emitters, but only for those with the same processes and inputs. Another feature of Figure 6.4 important to note is that most values are below unity, indicative of the strong downward pressure of traditional regulations upon emissions. The generally low REG ratios of 1998 emissions to 1994–6 benchmark emissions indicates that most participants had experienced this downward pressure of regulations on emissions after the benchmark period. Allotments would still equal 88 percent of the benchmark, with the result that many participants would have a surplus of permits and an incentive to sell. A high REG ratio above unity for a few participants would imply that emissions had increased despite any effect from traditional regulations, with the implication that allotments in these instances would have to be supplemented by purchases of permits. The REG variable is calculated to have a mean of 0.671, a variance of 0.155, and a range from 0.006 to 2.811, indicative of this general downward pressure. The variance and range indicate the wide variability of the impact of traditional regulations on emitters with differing technologies. The discussion of the downward pressure on emissions caused by traditional regulations assumes that the numerator of the REG variable has been reduced by continued and expanded command-and-control regulations. The alternative hypothesis of an over-allotment of tradable permits assumes that the denominator of the ratio has been increased by agency adjustments to the baseline, as previously discussed in Chapters 2 and 3. To test this idea, the authors developed a ratio of emissions exempt from the cap to the stated baseline emissions, and
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Explaining market performance
variations on this theme, but none of these variables proved significant in explaining transactions or lack of them. The final decision was to build a proxy for over-allotment by coding 1, labeled HAPDUM, for those participants with some fraction of HAP emissions on the basis that their individual emissions reduction would be less than 12 percent, because such emissions were not counted in the cap reduction. This over-allotment would leave more incentive to sell and less incentive to buy permits. A hypothesis that the recession of 2001 temporarily reduced outputs and emissions of a number of participants is less of an external constraint and more of a macroeconomic impact on the microeconomics of emissions trading. The effect of the 2001 recession was tested by calculating the ratio of 2001 emissions to 2000 emissions, a proxy variable labeled DIP. The hypothesis was that DIP reflects the additional or extra impact of the recession on production and hence on emissions, which leads to an excess of permits and increased incentives to sell. Continuing traditional regulations continued to exert their influence during this time period, but the authors weighted the analysis against the REG variable by assuming that any additional reduction of emissions during this period could be attributed to the recession. Again, other factors could play a role in determining this ratio, but the timing suggests that the recession would be the primary cause of any change. The DIP variable reveals a mean of 0.902, a variance of 0.26, and a range of 0.0001 to 4.592. To determine the possible influence of market incentives under the cap on the relatively few emitters who bought or sold, a proxy measure was prepared by calculating the ratio for each participant of their 2000 emissions divided by 1998 emissions. While traditional regulations would continue to exert their sway, the authors again weight the analysis against the REG variable, in order to test the significance of the market cap. A high ratio would imply that the emitter found it difficult or expensive to reduce emissions and would be in the market to buy permits. A low ratio would imply the opposite. This variable is labeled ERM and reveals a mean of 1.401, a variance of 17.95, and a range from 0.0103 to 49.20, all estimates affected by one outlier emitter. More detail on these variable definitions and measurement procedures are provided in Table 6.1. The authors have constructed three variables, REG, DIP, and ERM, from data available during three different and distinct time periods that are hypothesized to circumscribe market decisions for a number of participants. The REG variable is hypothesized to have a continuing effect on decisions, whereas the DIP and ERM variables are hypothesized to have a more temporary effect. One possible determinant of emitter decisions that has not been discussed is the matter of transactions costs. Based on excess supplies of permits in the market, it is apparent that transactions costs were asymmetric during this period. The few buyers could check the bulletin board and find a number of sellers willing to sell, and then negotiate from strength over price. For buyers, search, negotiation, and settlement costs were at a minimum. For sellers, these costs were much higher, as most frequently no buyers were listed on the electronic board and they would
Explaining market performance 93 Table 6.1 Individual participant variable definition and measurement Variable name Dependent variables Bank 2000 Bank 2001 Buy 2000–4 Emissions 2001 Expired 2001 Sell 2000–4 Independent variables REG HAPDUM ERM
DIP WBMCC Lagged dependent variables
Definition/measurement Number of vintage 2000 tradable permits banked in 2000 calculated using the identity for vintage 2000 permits: bank allotment buys sells emissions Number of vintage 2001 tradable permits banked in 2001 Dummy variable equal to one if the participant bought permits in the specified year, zero otherwise Number of vintage 2000 or vintage 2001 tradable permits returned to the IEPA to cover 2001 emissions Number of vintage 2000 tradable permits expired in 2001 Dummy variable equal to one if the participant sold permits in the specified year, zero otherwise Calculated as the ratio of 1998 emissions to baseline emissions for each emitter. Represents the impact of traditional regulations on emission reductions Dummy variable equal to one for participants with HAPs as a portion of VOCs, zero otherwise Calculated as the ratio of 2000 emissions to 1998 emissions for each emitter. Represents the impact of the Emission Reduction Market, a measure of market incentives Calculated as the ratio of 2001 emissions to 2000 emissions for each emitter. Represents the impact of the recent recession Calculated as the World Bank marginal cost for the participant’s SIC code divided by the highest World Bank marginal cost by SIC code Bank 2000, emissions 2000
Note Further variable description and sources located in the text.
have to contact the full list of participants. If brokers were active in the market, and few were, they had an interest in finding buyers. Transactions costs may have discouraged sellers, but it is difficult to believe that lowering these costs significantly would have increased market activity, as few participants required permits at any price.
Statistcial tests of the hypotheses The authors can now more fully exploit the data on individual participant transactions over the five years, or lack of such activity, by incorporating the constraint variables, together with other plausible determinants of transaction decisions. One of those determinants is a measure of the variation of marginal control costs
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Explaining market performance
among emitters. This was constructed by making use of a World Bank study of costs by Standard Industrial Classification (SIC) codes, and assigning the measure to each participant in a particular category (the WBMCC variable). For the dependent variables, the authors first chose the number of permits bought or sold by individual emitters during each of the five years, 2000–4. Data were available for the first four years from the IEPA Performance Reports and online for 2004 from the agency. Buyers are analyzed separately from sellers because the REG variable implies a buyers’ market with an excess of permits available for sale. Separate equations for each of the years will test the robustness of the results. The statistical test of the REG variable should reveal different signs in the separate equations for sellers and buyers. For example, a low REG ratio, revealing that emissions had been greatly reduced by traditional regulations, would indicate a surplus of permits and an incentive to sell as the authors have mentioned, and thus a negative sign could be expected in the sell equation. A high REG ratio would create an incentive to buy and lead to a positive sign in the buy equation. This would provide a striking confirmation of the impact of traditional regulations upon market transactions. The other set of dependent variables to explain includes the banks of tradable permits, permit expirations, and emissions. The unexpected values of these variables, as revealed in Table 3.1, provide challenging tests for the newly constructed explanatory variables. Probit analysis can be used to study the determinants of the decision to enter the market, while controlling for the influence of large transactions. Probit analysis is achieved by coding a unit value for buyers and sellers and zero elsewhere. Statistical analysis on permit purchases and sales is carried out for each of the five years, both to check the robustness of the results over time and to introduce selected variables that could be expected to have lagged affects. Ordinary least squares, applied to continuous variables, is utilized to test hypotheses about banks, expirations, and emissions. Selected years for which data are available were analyzed in these cases. Given the timing periods for construction of explanatory variables, it seems reasonable to assume that they are orthogonal to the disturbance term in each equation, thus avoiding ordinary least squares simultaneous bias. Explaining participant purchases and sales of tradable permits The results for permit buying and selling transactions are presented in Table 6.2. The most striking result is found for the impact of REG, the proxy variable representing traditional regulations. In each of the five years, it is positive as hypothesized and significant at the 95 percent level in the buy equations, and negative as hypothesized and significant at the 95 percent level in the sell equations. That is, to repeat our previous hypothesis, the REG ratio when low represented the force of traditional regulations in reducing emissions, leading to excess tradable permits and an incentive to sell, and when high represented the lessened pressure, the fewer reductions, and an incentive to buy.
Explaining market performance 95 Table 6.2 Probit determinants of market participation in 2000–4 Explanatory variables
Dependent variables (N 168) Buy 2000
REG HAPDUM ERM WBMCC
2.414 (4.942)a 0.755 (2.302)a 0.117 (2.345)a 0.002 (1.232)
DIP
2001
2002
2003
2004
1.222 (3.439)a 0.104 (0.319) 0.086 (2.211)a 0.002 (1.589) 0.268 (0.921) 2.891 (5.404)a
1.183 (3.491)a 0.391 (1.316) 0.093 (2.066)a 0.002 (1.322) 0.504 (2.195)a 2.961 (6.000)a
1.294 (3.669)a 0.120 (0.380) 0.083 (2.182)a 0.002 (1.384) 0.627 (2.282)a 3.172 (5.924)a
0.795 (2.576)a 0.005 (0.017) 0.073 (1.885) 0.0003 (0.224) 0.759 (2.494)a 2.589 (5.702)a
Constant
3.634 (6.231)a
Explanatory variables
Dependent variables (N 168) Sell
REG HAPDUM ERM WBMCC
2000
2001
2002
2003
2004
1.320 (2.488)a 0.182 (0.673) 0.200 (0.870) 0.001 (0.952)
1.806 (2.946)a 0.898 (2.867)a 0.365 (1.429) 0.0001 (0.036) 0.211 (0.741) 0.377 (0.723)
2.079 (3.319)a 0.675 (2.322)a 0.429 (1.659) 0.002 (0.806) 0.005 (0.017) 0.818 (1.490)
2.077 (3.460)a 0.272 (0.989) 0.271 (1.097) 0.00004 (0.025) 0.486 (1.324) 0.908 (1.662)
0.985 (2.316)a 0.301 (1.226) 0.075 (0.743) 0.001 (0.877) 0.472 (1.446) 0.353 (0.831)
DIP Constant
0.154 (0.327)
Sources: World Bank (1994) and individual participant data provided to researchers by the IEPA. Notes t-ratios are in parentheses. a Implies the coefficient is significantly different from zero at or above the 95 percent level of confidence.
The result is interesting in that it provides further evidence that indeed the REG ratio is a proxy for the continuing effects of traditional regulations. Other shocks or effects occurring in the period from the baseline of 1998, when REG was calculated, should still not be having significant effects on trading during the years 2000–4. Therefore, there is evidence that the REG variable is exhibiting a systematic effect, in line with the authors’ assumptions. While the HAPDUM variable, a proxy of over allotment of tradable permits, was significant in the first year of the buy equations and in two years of the sell
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Explaining market performance
equations, it was of the wrong sign in all equations. That is, when the emitter was coded one and expected to sell more, the emitter did not, and when coded zero and expected to buy more, the emitter did not. The authors’ interpretation of these unexpected results is that the HAPDUM variable may be indicative of the constraining effect of traditional regulations rather than over allotment. That is, stringent MACT controls required full use of allotted permits and left little room for market maneuver. This finding leaves the over-allotment hypothesis not fully tested. However, the authors have tried alternative measures of this hypothesis, such as identifying participants that requested substitution of years in the interval 1990–7 for the benchmark period of 1994–6, only to discover that this subgroup did not reveal any significant differences in purchases and sales from participants in general. To reiterate, a flaw in the over-allotment hypothesis is its failure to explain the lack of increase in emissions that should accompany a surplus of permits. The market variable, ERM, was positive, as hypothesized, in all of the buy equations and was positive and significant at the conventional level in the first four. The authors interpret this to mean that for a number of participants, especially for the 20 percent of emitters not deeply constrained by traditional regulations, the market offered opportunities for purchases that could have reduced their control costs. This variable, while of the hypothesized negative sign, lost its significance in the sell equations, indicative of the difficulty of selling permits in an overwhelming buyers’ market. Thus, for these less restricted participants, there was evidence of the promise of the cap-and-trade approach. The WBMCC, the authors’ best estimate of marginal control costs, while of the correct sign in all but one of the equations, revealed no statistical significance, indicating that marginal control costs were driven higher than permit prices by traditional regulations and were not a major factor determining transactions. The DIP variable proved to be positive, as expected, and significant in the last three years of the buy equations, providing evidence that the more deeply participants were affected by the recession, the less likely they were to buy permits. The signs provided mixed signals in the sell equations but none were significant. These results are consistent with the view that the recession was of some but limited importance in its effect on the market. Explaining participant banking, emission, and permit expiration data Cost-effective management by a firm of a permit portfolio requires more than decisions about permit trades. In a well-functioning, competitive market with full information on prices, optimal portfolio management requires decisions on control of emissions by comparing the firm’s marginal control costs with the given price and a decision on the appropriate bank of permits, given future permit price expectations. There would seem to be no room in these decisions to ignore profitable trading opportunities by building excessive banks or letting permits expire. If the deficient market design is constrained by external factors, such as the authors have identified and measured, these puzzling results now appear understandable.
Explaining market performance 97 Therefore, the statistical evidence on the role of these constraining external factors is of great interest as possible explanations for the determination of permit banks, expirations, and emissions. First, it is important to note that once unexpected large banks of permits have been realized, despite the preferences of firms, the banks develop a dynamic of their own, comprising an overhang that determines expirations, and greatly influences future banks and emissions levels. That is, at the start of the market, if unduly large banks emerge as a result of traditional regulations, participants will find that their subsequent banks and permit expirations are driven by a dynamic process determined by the initial banks. This dynamic process is clearly brought out in Table 6.3. The first equation lists tests of the explanations of the dependent variable banks in 2000, the first year of operation of the market. The significant explanatory variables with the correct signs are REG and HAPDUM; that is, traditional regulations and the HAP overallotment effect. The negative sign for the REG variable indicates that the lower emissions were driven by traditional regulations the more surplus permits became available, and were consequently banked. The positive and significant sign for the HAPDUM variable may be interpreted as a sign that participants had an incentive to bank permits as a reserve against future HAP emissions. The market, ERM, and the marginal control costs, WBMCC, had no significant effect on banks.
Table 6.3 The dynamics of the VOC trading system driven by enormous banks of permits Explanatory variables REG ERM
Dependent variables (N 168) Bank 2000
Bank 2001
Expired 2001
237.005 (2.992)a 7.742 (1.049)
100.319 (1.074) 4.229 (0.497) 27.698 (0.393) 0.105 (0.246) 62.097 (0.857) 1.931 (21.171)a
39.805 (1.148) 1.996 (0.639) 3.183 (0.120) 0.159 (0.997) 16.414 (0.616) 0.663 (16.775) 0.281 (10.586)a 25.599 (0.618) 0.659
DIP WBMCC HAPDUM
0.158 (0.425) 137.960 (2.225)a
Bank 2000 Emissions 2000 Constant Adjusted R2
301.572 (3.994)a 0.062
95.582 (0.864) 0.749
Emissions 2001 205.63 (2.019)a 6.67 (0.719) 216.004 (2.812)a 1.078 (2.309)a 68.908 (0.872) 0.792 (7.967)a 305.07 (2.527)a 0.297
Sources: World Bank (1994) and individual participant data provided to researchers by the IEPA. Notes Coefficients estimated using ordinary least squares. t-ratios are in parentheses. a Implies the coefficient is significantly different from zero at or above the 95 percent level of confidence.
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While the adjusted correlation coefficient is not large, the significance of the REG variable is noteworthy, given the range of other factors that could have affected permit-banking decisions during the first year. Once the large banks (recall from Table 3.1 that aggregate banks were 39 percent of the first-year allotments) were accumulated in the participant portfolios, their presence set in motion a sequence over time that greatly influenced subsequent accumulations of banks, emissions, and expirations. The large permit banks of vintage 2000 are highly significant in the second equation as explanations of the even larger accumulation of banks of vintage 2001. The variable is so significant that there is little room for the other variables to exert their influence. The dynamics of the market with this initial large accumulation of banked permits is interesting to follow. The fact that permits of vintage 2000 were due to expire in 2001 may be plausibly assumed to have led firms to use these permits first in covering emissions during 2001. As a consequence, given the low level of 2001 emissions determined by traditional regulations, many of the permit allotments of 2001 remained unused, resulting again in very large banks. Reference to Table 3.1 in a prior chapter reveals that the aggregate permit banks of vintage 2001 exceeded the banks of vintage 2000. In addition, the pervasive impact of large banks of vintage 2000 permits provides the most significant explanation of the large number of expirations of permits in 2001, as revealed in the third equation. The puzzle of expirations has been solved. Many participants were left with allotted permits they could not sell, or return to the government to cover emissions, which they may have tried to increase without success. Expiration was the unwanted consequence. However, the incentive was present to increase emissions where possible and the authors have introduced a variable for emissions in 2001 in the expiration 2001 equation in an effort to detect this incentive at work. The significant and negative sign captures this effect and shows that emitters were attempting to reduce expirations to the extent possible within the constrained market dominated by the large banks of vintage 2000 permits. Considering emissions 2001 as a dependent variable in the last equation of Table 6.3 yields evidence that an important variable in this equation, with a significant and positive coefficient, was again the lagged permit banks of vintage 2000. This suggests that firms were attempting to avoid expirations of these banks by increasing 2001 emissions to the extent possible. The pervasiveness of a significant and positive REG variable is a strong confirmation of the hypothesis that these regulations limited incentives and created difficulties in managing permit portfolios in an optimal way. In this equation, the lower REG ratios can be interpreted as indicators of the pressure of traditional regulations in lowering the participants’ 2001 emissions. Also of interest is the significance and correct sign of the recession variable, DIP, and the marginal control cost variable, WBMCC, in the 2001 emissions equation. This is the first and only evidence obtained that some firms were using marginal control cost as a guide to emissions control. Market participants with higher marginal control costs would have incentives to cover emissions with permits
Explaining market performance 99 returned to the IEPA, or buy permits for that purpose, rather than choosing the expensive alternative to reduce emissions by use of control measures. In summary, there is a strong confirmation of the hypothesis about the continuing and long-lasting importance of traditional regulations in determining market activity and performance. There is also strong evidence that emissions reductions due to this factor created enormous permit banks and a dominant buyers’ market that significantly impacted market incentives. These banks created a dynamic in the market affecting future banks and expirations. Although the authors do not have individual emitter data for years beyond 2001, the aggregate data revealed in Table 3.1 provide ample confirmation of the continuing increase in banks and expirations at later dates. One question remaining is the persistence of the pressure of traditional regulations on individual emitters over time. If the pressure varied from emitter to emitter over time, it would weaken the argument by the authors about the dynamic of large permit banks. A variable pressure would suggest that individual emitters could take steps to reduce their large banks; for example, by increasing emissions and returning more permits to the IEPA. On the other hand, if traditional regulations put limits on permit purchase and continued to exert pressure on emissions, the latter could be expected to decline and to be highly correlated over time. One indication of the persistent effects of these regulations in reducing emissions would be a high correlation of individual emissions over time. The authors have calculated the zero order correlations of 168 individual participant emissions over five periods for which data are available, that is, the pair-wise correlations of baseline (average of 1994–6), 1998, 1999, 2000, and 2001 emissions. The authors find very high correlations as revealed in Table 6.4. This evidence, together with declining emissions as reported in Table 3.1, provides support for the main finding of the importance of traditional regulations.
Conclusions The main statistical finding has been that the level of traditional regulations (REG), and not market incentives (ERM and WBMCC), proved most frequently Table 6.4 Zero-order correlations of individual participant emissions (Baseline, 1998, 1999, 2000, 2001) Baseline
Baseline (1994–6) 1998 1999 2000 2001
(1994–6)
1998
1999
2000
2001
1.0000 0.9591 0.9303 0.9517 0.8457
1.0000 0.9483 0.9502 0.8770
1.0000 0.9682 0.8650
1.0000 0.9094
1.0000
Source: Individual participant data provided to researchers by the IEPA. N 168.
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Explaining market performance
significant in explaining participant market activity. There was little that participants could do about the binding effect of these regulations. They, like most observers who had forecast market outcomes, were caught by the enormous volume of excess permits that depressed prices. There was limited support found for the impacts of the recession (DIP) and the over-allotment hypothesis (HAPDUM) as explanations of the market’s performance. For a few emitters, the market did provide an outlet for buying permits. These findings support the hypothesis that the continuance, extension, and implementation of traditional regulations, before and during the market period, was the dominant policy instrument in reducing emissions. The Chicago cap-and-trade market as currently designed was relegated to a minor role. Cost-effectiveness appears to have been greatly limited by the fewness of transactions and the lack of correspondence between marginal control costs and permit prices, both in the aggregate and among individual emitters. Innovation stimulation, while not directly measured or estimated, was likely to be inhibited by the small emissions reduction required by the cap, and the very low tradable permit prices that would reduce incentives to invest in new control technologies. The lack of capital expenditures for control purposes as reported in the survey supports this contention. Some control choice flexibility, especially of the process type, may have been achieved by allowing emitters to use permits on an intra-firm basis among their in-house sources. These gains must be weighed against the administrative costs of the regulating agency that had to monitor and enforce market rules and traditional regulations. While emissions reductions surpassed air quality goals assigned to the cap-andtrade market, they were brought about by technology-based command-and-control regulations and not by market incentives. The two systems, centralized and decentralized regulation, so different in their specification, implementation, monitoring, and enforcement, and so different in their recording of emission flows and volumes, were not originally perceived as incompatible. Traditional regulations were to prevent hot spots and other problems from developing; emissions trading was to lower the cost of control and promote control innovations. The former did prevent hot spots and inter-temporal emission spikes, but it also played the leading role in reducing emissions and emasculating market incentives. These two systems proved incompatible because of the features of the market design, most notably a cap that called for very small reductions and a banking constraint that called for a one-year period of banking after permit issuance. The authors note that one of the differences between the regulatory systems can also be brought out by the sources and uses of tradable permits in Table 3.2 presented in Chapter 3. In the case of the cap-and-trade market, the total or aggregate VOC emissions can be calculated directly from the table, as total emissions are reported by participants. In the case of traditional regulations, rates of emissions or pollutant content of inputs are reported. As outputs, inputs, or the number of firms vary, aggregate emissions vary. Difficult and error-prone measurement procedures are required to estimate aggregate emissions in this
Explaining market performance 101 case. Obtaining detailed information on emissions by means of a sources and uses table that traces the volume of permits is a further argument favoring the cap-and-trade market approach. The authors take up this argument in favor of the sources and uses table of tradable permits in the final chapter, which contains recommendations. More detailed data on individual emitter marginal costs and more information on transactions costs would be desirable, but it is hard to believe that they would alter the results and conclusions of this study. The record examined in this study of unanticipated low emissions, extremely large permit banks and surprising expirations of permits, and very low permit prices paints a picture of structural market design deficiencies. Nor is it credible that if the present cap-and-trade market were to continue without redesign, the picture would be substantially changed in the future. The enormous banks and low emissions levels would continue to dominate the scene, resulting in more expirations and continuing low prices of permits. In order to improve market performance, important and complex questions arise about the nature and extent of redesign of the cap-andtrade market. To what level should the cap be adjusted? What should be the justifications for such a change? How long should tradable permits be allowed to be used after issuance if the present one-year horizon is altered? What rationale could support a three- to five-year horizon, or longer? These and other redesign questions are addressed in the concluding chapter.
7
Hot spots, spikes, and emissions trading
Introduction The spatial relationship of harmful environmental externalities to adjoining populations has received increased attention recently in the United States, with a focus on the location of incinerators, Toxic Release Inventory (TRI) emitters, landfills, and National Priority List Superfund areas (Haynes 2001: 17–31). This study addresses a new and quite different issue in the matter of spatial pollution impacts: Does market-based incentive regulation, although reducing market-wide pollution, lead to sub-area increases (hot spots) in pollution over baseline levels affecting nearby resident populations? Specifically, the authors compare the before-and-after spatial distribution of pollution that results from the application of a cap-and-trade market program to reduce stationary-source emissions of volatile organic compounds (VOC) in the Chicago severe ozone nonattainment region. This market incentive program was combined with traditional regulations, which had previously determined the before-trading, sub-area distribution of emissions. The Chicago region contains almost 200 stationary-source VOC emitters widely scattered about a large urban region in which varied socio-economic groups reside. The authors’ objective is to analyze the after-trading pattern to see what changes in the existing distribution of emissions were brought about by this novel program. In sharp contrast, the great majority of prior studies investigating spatial disamenities, or issues of environmental justice or equity, have been concerned with the siting or location of pollution sources and the definition of affected populations in terms of class and race. The focus being different, this study moves to an analysis of sub-area emission changes brought about by emissions trading. Compared with traditional regulations, the autonomy and anonymity of transactions in the cap-and-trade market make increases in emissions in sub-areas more difficult to predict, and can thus raise some concerns about spatial impacts. Moreover, market incentive programs are of recent origin, with few studies of spatial pollution patterns available as revealed in Chapter 2. It would appear that traditional regulations have a spatial, or sub-area, advantage in that pollution is often thought to be reduced in all affected sub-areas by the same proportion;
Hot spots, spikes, and emissions trading 103 traditional regulations typically setting performance standards or fixed rates of emissions per unit time for certain processes (or pipes), often requiring the same pollution control technologies for many emitters with the same production processes or inputs (Teitenberg 2002: 368). However, appreciable variations in the production processes of emitters, in the hours of production of existing firms, and in the movements of new firms into a sub-area can increase emissions over historical or baseline values. Thus, increases in sub-area emissions over the baseline can occur under both traditional and market-incentive regulations. A careful empirical before-and-after analysis is required in both cases. To explain the analysis and findings in detail, this study is divided into the following sections: first there is a description of how a cap-and-trade market may raise concerns about differential spatial impacts caused by emissions trading. Next, there is a discussion of the choice of a sub-area for the before-and-after analysis of trading. Third, there is an explanation of the before-and-after methods of detecting actual hot spots, including a detailed account of the databases. Finally, there is a series of maps displaying emissions and population characteristics in sub-areas in each case.
The invisible hand of the market and concern about hot spots The success in reducing market-wide aggregate pollution in the highly regarded US sulfur dioxide or acid rain emissions trading program (Ellerman et al. 2000) has not alleviated all concerns that emissions trading in the cap-and-trade market design can lead to sub-area or inter-temporal increases in air pollution over baseline or historic emissions. These concerns were forcibly expressed by Druy (1999: 231–277). Only detailed spatial studies and an understanding of emissions trading can deal adequately with these issues. In a competitive cap-and-trade market in which firms have varying marginal pollution control costs, it is expected that firms will reduce emissions by various percentages, implying that it should be advantageous for some firms to increase emissions over their allotment (Montgomery 1972: 395–418). As the microdecisions about reducing emissions or trading are now in the hands of the emitters, independent of the regulating agency, the spatial pattern of emissions becomes evident at the end of each trading period. The unified spatial market was adopted by the IEPA in the Chicago VOC trading program in the interest of maximizing potential control-cost savings from trading. As the authors have mentioned, environmental groups expressed interest in restricting trading in some neighborhoods to avoid the hot spot problem. The counter-argument was that continuing traditional regulations would set a pre-trading ceiling on an individual emitter’s emissions that would appear to prohibit any sub-area increases over that level due to purchases of permits. That restraint does not completely allay the concern about increases, because existing firms could expand production or new firms could move into the subarea. Neither the expanded or new firm would be allocated additional tradable
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credits, but they could enter the market to buy permits. There are no restrictions on the market that would prevent such increases from occurring. On the contrary, it is expected that firms that can reduce emissions cheaply will do so and sell permits to firms for whom reducing emissions is more expensive than purchasing permits, thus achieving cost savings in comparison with traditional regulations (Kruger et al. 2000: 115–116). Therefore, there is a need for a careful study of sub-area VOC emissions.
Delineating the appropriate sub-area How to specify an appropriate sub-area to investigate increased emissions, or hot spots, and the associated harm function are among the most difficult topics in the analysis of spatial environmental analysis. This is clearly true in the case of VOC emissions and ozone concentrations (Mendelsohn 1986: 301–312). It should be noted that these are fund pollutants that, unlike stock pollutants, dissipate in the atmosphere over time. The VOC emissions, in addition to being a precursor of ozone, can be harmful to health in their own right. They arise from a wide variety of processes in the region, ranging from candy making, to plating, to painting cars, and on to the refining of crude oil. The hydrocarbon stream may be scrubbed, burned, absorbed in carbon, or reduced in production inputs, such as less emitting paints, glues, and the like (DePriest 2000: 168–185). What remains will diffuse in space from vents, pipes, chimneys, or other openings. The spatial spread of hydrocarbons is difficult to model, since the range of emissions and formation of concentrations depend on meteorology and chemical reactions, among other variables. The effect of emissions exposure on the population depends on the number of sensitive people, inside and outside activities, the concentration of hydrocarbons at the point of contact, and other variables. While there has been some research on the general harms from low-level ozone reported in Tolley (1993: 14), there has been less research from the harms of volatile organic compounds, including those that are hazardous air pollutants, and much less research on local effects (Freeman 1972: 243–278). The US Toxic Substances Control Act requires testing rules for each chemical, but relatively few such rules have been promulgated by the US Environmental Protection Agency (US EPA). Monitoring of ambient air quality and emissions from individual or sub-area sources is proving to be more complex and costly than once believed. Setting zero risk or zero emissions for a source, or sub-area, is either prohibitively expensive or simply impossible (Portney 1995: 11–30). Low-level ozone concentrations, formed as a result of combinations of precursors such as VOC, nitrogen oxides, and weather conditions, follow complex spatial paths around the area. The 18 scattered monitoring stations in the area indicate that the ozone plume is generally moved across and out of the region by the prevailing, summer, southwesterly winds, frequently carrying the concentrations during hot summer months deep into the neighboring state of Wisconsin and across Lake Michigan to localities in the state of Michigan, such as Muskegon.
Hot spots, spikes, and emissions trading 105 Specific sub-area concentrations are difficult to measure due to the small number of actual monitoring sites in the region and yield little guidance on an appropriate sub-area for measuring harms (Lui 1996: 207–215). Lacking detailed knowledge of how to measure accurately sub-area harms, the authors focus on VOC emissions and adopt a proximity surrogate harm function that relates harms from this pollutant to the immediate area surrounding the sources of emissions. For this purpose, after balancing a number of factors, a hot spot is specified as a sub-area with population where VOC emissions have increased due to trading over the pre-trading or baseline level. The Illinois Environmental Protection Agency (IEPA) provided the authors with emitter addresses, baseline emissions, 1998 and 1999 seasonal VOC emissions, and tradable permit retirements or actual emissions during the years 2000 and 2001. The agency also made available breakdowns for those emitters for whom some or all of their VOC emissions were hazardous air pollutants (HAPs), such as benzene. However, specific data on HAP emissions are not available. In addition, the IEPA provides township emissions data, county emissions data, and information on transactions of tradable permits in its annual performance reports. Additional data on the area and population of zip codes were obtained from ArcView ® and zip code demographic data were obtained from http://www.bestplaces.net and http://mcdc2.missouri.edu In order to measure historic emissions during the 1994–6 period the authors use the maximum level of baseline emissions. They were provided three different sets of individual participant baseline emissions by the IEPA. In order to weight the analysis against hot spots or sub-area increases in emissions, the maximum amount of these various baseline measures was used for each participant. For most participants all three baseline figures were the same, but for those where there were discrepancies, it was due to the shutdown of particular production processes or renegotiation of the baseline value. These individual participant baselines were then aggregated, as appropriate, to the defined sub-area. This measure of maximum baseline emissions was then compared with the current-year emissions to determine if the sub-area is a hot spot. The effect of sub-area size on hot spot detection The Chicago nonattainment region covers all of six counties and parts of two others. There are 118 townships, averaging 32 square miles in area, 298 zip codes, varying in area but averaging 13 square miles, and hundreds of census tracts, varying widely in area. The counties appear too large in area to reveal hot spots in the detail required as shown in Table 7.1. All counties reveal a decrease in emissions from baseline in all years except Kendall County in 2003, which experienced a 3 percent increase in emissions over baseline. If one were to explore the hot spot issue solely from the county perspective, it would appear as though there is not really a problem. The townships, local government areas, have been analyzed by the IEPA but their large area and population also leave scope for more detail. In Table 7.2, it is
5,192,105 890,164 37,213 401,360 53,914 616,422 246,533 474,617 7,912,328
Cook DuPage Grundy Kane Kendall Lake McHenry Will Total
130 13 2 15 1 13 7 20 201
Maximum number of sources 76,841 6,699 4,944 4,752 614 5,504 1,637 14,930 115,921
Maximum baseline emissions (ATUs) 1999 49.4 71.53 42.25 39.1 73.78 54.67 43.86 49.79 50.3
1998 45.85 74.09 30.85 28.43 20.2 41.73 17.53 38.02 44.39
49.08 71.16 38.33 37.5 25.24 41.28 40.56 51.09 49.06
2000
Yearly percent change in emissions
57 62.9 49.03 32.72 21.66 76.85 43.19 48.11 55.42
2001
61.96 67.43 1.23 24.28 28.66 77.02 40.38 43.67 56.02
2002
69.12 68.04 43.04 27.99 2.93 82.7 39.77 40.3 62.39
2003
Notes An ATU is an allotment trading unit representing 200 pounds of VOC emissions. Only a few townships included in Grundy and Kendall counties are included in the severe ozone nonattainment region, but population estimates are for the entire county. The data for 1998–9 are prior to the implementation of emissions trading in 2000.
Sources: CACI International Inc., IEPA Annual Performance Review Reports, 2000, 2001, 2002, and 2003, and individual participant data provided to the authors by the IEPA.
1999 population
County
Table 7.1 Yearly percentage changes in emissions by county
ThorntonEast Oswego Lemont Aurora Downers Grove St Charles Wayne Schaumburg Maine Marengo Nunda Zion
3615
Kane DuPage Cook Cook McHenry McHenry Lake
Kendall Cook Kane DuPage
Cook
County
2 1 3 1 2 1 1
1 1 3 1
1
Maximum number of sources
476 164 494 49 488 162 206
614 134 1,832 429
238
Maximum baseline emissions (ATUs) 34.45
28.99 73.78 12.69 13.59 6.76 59.45 84.15 10.32 385.71 19.88 25.93 133.01
25.63 20.20 52.99 12.50 13.29 36.97 97.56 9.72 100.00 9.02 78.40 1.46
69.75 20.12 27.13 14.29 1.43 32.10 36.41
25.24 27.61 12.34 3.26
2000
1999
1998
Yearly percent change in emissions
26.05 15.24 30.57 69.39 26.02 47.53 75.24
21.66 6.72 5.95 13.29
42.44
2001
35.71 15.85 41.50 10.20 41.60 59.26 100.00
28.66 12.69 2.02 20.05
65.55
2002
0.84 28.66 70.45 95.92 40.98 61.73 100.00
2.93 17.16 16.59 23.08
47.90
2003
Notes An ATU is an allotment trading unit representing 200 pounds of VOC emissions. The data for 1998–9 are prior to the implementation of emissions trading in 2000. This table provides data for only those townships which experienced increases in emissions over baseline in one or more years.
Sources: IEPA Annual Performance Review Reports, 2000, 2001, 2002, and 2003, and individual participant data provided to the authors by the IEPA.
4008 4009 4110 4112 4405 4408 4612
3708 3711 3808 3811
Township
Township ID number
Table 7.2 Yearly percentage change in emissions for hot spot townships
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Hot spots, spikes, and emissions trading
clear the number of potential hot spots increases from 1 to 12 as the spatial area is reduced from the very large county delineation to the smaller township delineation. Only townships that experienced an increase in emissions over baseline in one or more years are included in the table. In an effort to move toward smaller and smaller neighborhood delineations in order to detect hot spots, one must also consider that if the area becomes too small, hot spots will only be detected at the plant-specific level. In this sense, the census tract appears to provide too much detail for clear mapping analysis and portrayal. The zip code, a US Postal Service area for mail delivery, appears to be the best compromise in terms of area and neighborhood delineation. The zip code has been chosen as the sub-area for other studies of hot spots (California Comparative Risk Project 1994). It also is a spatial unit for which population and socio-economic data are available. There are 298 zip codes in the nonattainment area, 99 of which contain one or more VOC emitters in their boundaries. These 99 are the potential candidates to be tested by the hot spot definition provided by the authors.
Detection and analysis of actual hot spots The authors provide information in Table 7.3 for those zip codes that experienced increases in emissions for one or more years during the period 1998–2004. These zip codes qualify for consideration as hot spots. The authors use the information obtained from ArcView® and the IEPA to obtain the aggregate zip code data presented. In this table the first column represents the zip code number and the second is the city in which the zip code is located. The next columns provide information on the relative size of the zip code in terms of area in square miles, population in number of people as measured in 1999, the number of emitters participating in the Chicago cap-and-trade program, and the maximum baseline emissions. The following columns provide information on the yearly percentage changes in emissions from the maximum baseline level for the years 1998–2004, with the market in place for the years 2000–4. For the years 1998–2001, individual participant emissions data were provided to the authors by the IEPA. After the year 2001, individual participant emissions data were not made available. As a result, the increases in emissions by zip code for these years were estimated. To estimate the zip code emissions in the years 2002–4 the authors used information available on the permit purchases made by emitters. Given that the Chicago area cap-and-trade market exhibited falling prices for tradable permits, which seem to have no relationship with marginal control costs, it seems very unlikely that participants would purchase permits for speculation purposes. Rather, emitters would purchase tradable permits to cover emissions over the allotted level. This being said, the authors assumed that all seasonal transactions made were for the sole purpose of increasing emissions over allotments. By summing the number of tradable permits allotted and the number purchased, the value of emissions for firms entering the market as buyers can be estimated.
Batavia Blue Island Chicago Chicago Chicago Chicago Chicago Crystal Lake Des Plaines Downers Grove Joliet Libertyville Marengo Niles North Aurora Schaumburg South Elgin Streamwood Waukegan Zion
60510 60406 60608 60614 60623 60629 60644 60012 60016 60515 60431 60048 60152 60714 60542 60173 60177 60107 60087 60099
19.98 5.22 6.32 3.45 5.69 7.55 3.56 16.03 10.63 11.46 27.72 31.74 95.11 6.24 4.77 7.58 7.32 7.55 15.85 22.51
Area in square miles 26,585 22,325 85,848 61,433 116,420 90,609 57,298 9,093 50,391 29,200 20,258 29,055 10,484 28,070 9,411 8,713 13,330 36,582 29,119 29,777
1999 population
4 3 3 2 4 1 2 1 1 1 1 2 2 1 1 1 1 1 1 1
Number of emitters 336 2,294 1,993 326 1,212 820 512 162 49 429 216 754 488 118 1,114 226 153 155 243 206
Maximum baseline emissions (ATUs) 1999 13.39 0.22 27.95 2.15 5.94 22.07 12.11 25.93 385.71 6.76 48.15 24.27 19.88 14.41 9.52 8.85 16.34 5.81 41.98 133.01
1998 4.76 12.51 6.37 13.19 8.42 11.59 69.73 78.4 100 13.29 64.81 3.18 9.02 12.71 12.48 3.1 1.96 0.65 44.03 1.46
46.73 27.03 11.74 3.68 8.09 44.15 20.12 31.48 14.29 3.26 34.26 0.13 1.43 5.93 5.57 8.41 14.38 34.84 21.4 36.41
2000 60.71 84 23.28 51.53 10.97 51.1 38.09 47.53 69.39 13.29 29.63 4.91 26.02 14.41 10.68 16.81 31.37 49.03 26.34 75.24
2001
Yearly percent change in emissions
– – – – – – 59.96 – 155.1 24.94 19.91 – 73.36 34.75 – 8.41 – – – –
2002
27.74
17.97
18.07
11.89 – – 298.23 – – – –
– –
– –
–
– – – –
2003
– – – – 30.2 – – – – 16.78 – – – 3.39 – 169.91 – – – –
2004
Notes An ATU is an allotment trading unit representing 200 pounds of VOC emissions. The data for 1998–9 are prior to the implementation of emissions trading in 2000 and were provided by the IEPA. The data for 2000–1 were provided by the IEPA and represent the start of emissions trading. The data for 2002–4 represent the continuation of emissions trading and were estimated by the authors. Blank data indicate that there is not evidence of an increase in emissions in that code for that year.
Sources: CACI International Inc., ArcView ®, IEPA Annual Performance Review Reports, 2000, 2001, 2002, and 2003, and individual participant data provided to the authors by the IEPA.
City
Zip code number
Table 7.3 Yearly percentage change in emissions for hot spot zip codes
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However, there are often other emitters in a zip code as well. These firms may have sold permits or decreased their emissions well below their allotted levels. In order to estimate the emissions for the entire zip code, the authors assumed that all emitters in the zip code who did not purchase permits in the market reduced their emissions to zero. This assumption provides a very conservative estimate of emissions, which can be used in the detection of hot spots. The total emissions estimated for each zip code is compared with the maximum baseline emissions and used to calculate the yearly percentage change in emissions from the baseline level. If the total emissions from those firms purchasing tradable permits in the zip code exceeds the maximum baseline emissions for the zip code, then the zip code can be identified as a hot spot. Note that the authors make no value judgments about the excess of emissions. The authors simply point out that any increase in emissions over baseline in any zip code in any year denotes a hot spot regardless of size, location, population density, or other factors. Zip codes are outlined but not numbered. Baseline emissions, population, and demographics The city of Chicago has a population of about 3 million out of almost 8 million in all affected counties, with the areas of greatest density on the near west and south sides of the city center; the latter area is located along the lake about halfway up Cook County, as revealed in the zip code map of Figure 7.1. These are also areas of residence of low-income and minority populations. The city’s north side area adjacent to the city center is also densely settled, being the residence of more middle and upper-income households. Other concentrations of population, mainly middle-income, may be seen in northwest Cook County and on the west, in DuPage County. The zip code distribution revealed in the Figure 7.2 are baseline emissions reported before trading, and are the result of years of traditional regulations, frequently termed command-and-control. Baseline emissions also reveal the location of the almost 200 major emitters covered by the cap-and-trade market. A concentration of emissions is revealed on the near south and southwest sides of the city, areas of residence of low-income and minority populations, and a concentration on the northwest side of Cook County in a more middle-income area. It is important here to note that traditional regulations led to an unequal spatial distribution of emissions. For example, zip code 60501, located in the city of Summit, had a baseline of 19,199 Allotment Trading Units (ATUs) coming from seven emitters. By comparison, zip code 60007 in Elk Grove Village, with 11 emitters, had a baseline of only 3,591 ATUs. These different levels of maximum baseline emissions are depicted in Figure 7.2. By examining Figures 7.1 and 7.2 together, the authors note the variation in potential harms that could be inflicted in a sub-area, because of the differences in population and emissions among zip codes. Zip codes with large populations in a small area, such as zip code 60623 with 116,420 people in 5.69 square miles, could experience more local harm from the 1,212 ATUs of baseline emissions
Hot spots, spikes, and emissions trading 111
McHenry
Lake
N
Cook Kane
Du Page
Kendall
Grundy
Will
Legend County boundaries Population in number of people by zip code 0–9,999 10,000–29,999 30,000–59,999 60,000–79,999 80,000–109,999 110,000–117,000
Figure 7.1 The 1999 population by zip code for the Chicago ozone nonattainment region.
spread over the area than zip code 60633, with baseline emissions of 5,999 ATUs, affecting only 12,654 people over an area of 8.05 square miles. Once it is clear what the historical (generally 1994–6) level of emissions is, based on traditional regulations, it is important to determine how the implementation of
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Lake N
McHenry
Cook Kane
DuPage
Kendall
Will Grundy
Legend County boundaries Township boundaries Baseline emissions by zip code in ATUs No emissions 1–500 501–1,000 1,001–5,000 5,001–20,000
Figure 7.2 Maximum baseline emissions by zip code for the Chicago ozone nonattainment region.
the cap-and-trade program has affected the distribution of emissions over the Chicago area. To do this, the percentage change in emissions is calculated as the yearly emissions minus maximum baseline emissions divided by the maximum baseline emissions for each zip code. Negative numbers imply a reduction in
Hot spots, spikes, and emissions trading 113 emissions from baseline, while positive numbers imply that emissions have increased over the baseline level, indicative of a hot spot. The general picture of zip code changes both before and after the start of emissions trading are calculated in this way for each of the years 1998 to 2004 to provide for an analysis of changes in the spatial distribution of emissions over time. In 1998, prior to the implementation of the trading program, there were nine zip codes out of the 99, with emitters, that increased emissions over baseline, as shown in Table 7.3. In 1999, there were 11 zip codes that revealed emissions increases over baseline. These increases prior to emissions trading reveal the impact of traditional regulations. After trading began, in 2000, this number fell to 7 and in 2001 to 6. By using the method of estimation explained earlier, the authors also find increases in emissions over the baseline level for 7 zip codes in 2002, 5 in 2003, and 4 in 2004. Demographic information for these hot spot zip codes is provided in Table 7.4. When examining these demographics, it becomes clear that the most densely populated zip codes are located in Chicago. Emissions increases in these areas may be more harmful because they affect more people. In addition, zip codes 60608, 60623, and 60644 on the west side of Chicago also have median household incomes under $30,000. These codes and 60406, 60629, and 60099 also have an average
Table 7.4 Demographics for hot spot zip codes Zip code City number
County
Population Median density household income ($)
60510 60406 60608 60614 60623 60629 60644 60012 60016 60515 60431 60048 60152 60714 60542 60173 60177 60107 60087 60099
Kane Cook Cook Cook Cook Cook Cook McHenry Cook DuPage Will Lake McHenry Cook Kane Cook/Lake Kane Cook Lake Lake
1,427.40 4,426.40 14,153.20 20,709.90 19,062.60 15,226.10 16,621.50 551.20 5,338.40 2,454.90 1,129.90 1,035.60 126.20 4,793.50 1,981.90 1,792.70 2,287.10 4,341.30 1,779.40 1,487.80
Batavia Blue Island Chicago Chicago Chicago Chicago Chicago Crystal Lake Des Plaines Downers Grove Joliet Libertyville Marengo Niles North Aurora Schaumburg South Elgin Streamwood Waukegan Zion
73,515 37,132 29,492 71,431 29,490 42,401 28,431 93,343 53,767 64,253 73,688 99,039 62,836 51,080 62,999 64,770 70,343 67,880 54,959 50,815
Average Percent income minority per capita population ($) 30,078 16,951 11,697 67,077 9,939 14,478 12,551 35,993 24,529 33,276 28,439 45,953 26,141 24,723 26,905 39,628 26,883 24,802 21,212 19,976
Sources: http://www.bestplaces.net and http://mcdc2.missouri.edu accessed 10/31/05.
10.1 62.6 87.0 14.8 98.0 76.8 97.8 6.1 32.6 7.9 12.5 9.9 11.0 19.8 16.1 41.4 22.8 31.8 46.8 41.5
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income per capita of less than $20,000. Finally, these same codes of low average income have over 60 percent minority populations, except for 60099. Based on this information zip codes 60608, 60644, and 60623 that are experiencing increases in emissions over baselines require further attention in the future, given that these areas are very densely populated, very poor, and generally the home of minorities. In addition to providing detailed information on the hot spots in terms of volume of emissions in tabular format, it is also important to examine them spatially. In the following maps, black represents zip codes where emissions have increased over baseline, gray represents zip codes where emissions have been reduced from baseline, and white represents zip codes with zero emissions. Moving from traditional regulations to the market system (1998–9) In the years 1998 and 1999, firms were in transition between traditional regulations and the market trading system. As the authors have shown in Chapters 3 and 6, traditional regulations were reducing VOC emissions up to and throughout the market period, beginning in 2000. It might be assumed, as many have, that few if any hot spots could be attributed to traditional regulations during this period, but this assumption has proved to be false. Traditional regulations do not fall evenly on all emitters, nor do they fall evenly in spatial terms. Emitters may relocate into different zip codes or expand their production processes and emissions as long as they do not exceed the emissions rates mandated by the IEPA. The spatial distribution of emissions in this period 1998–9 highlights the effects of traditional regulations on the spatial distribution of emissions. In Figure 7.3, the primary areas of increased emissions in 1998 are in zip codes located in Lake, McHenry, and Kane counties in areas of relatively small population. The increase in emissions in zip code 60644, in the center of Cook County in Chicago, contains a much larger population. Emissions in this area of only 3.56 square miles, with a population of 57,298 people, increased almost 70 percent from 512 to 869 ATUs. In Figure 7.4, the distribution of emissions appears to get even slightly worse in 1999 in terms of the number of zip codes revealing increases. There are increases in emissions in two zip codes in Kane County, two in Lake County, and seven in Cook County, the most densely populated county of all. Especially of concern are those zip codes very near the city center such as 60608, 60629, and 60644. These zip codes have populations of 85,848, 116,420, and 57,298, respectively. In addition, emissions in these zip codes increased by 27.95, 22.07, and 12.11 percent, respectively. This is a cause for increased attention, especially given that each of these zip codes had relatively large baseline emissions measuring 1,993, 1,212, and 512 ATUs, respectively. Both of these years provide some cause for vigilance, given that emissions appear to be increasing in several heavily populated zip codes in the center of Chicago. Interestingly enough, however, it must be kept in mind that at this time there is no cap on the market, so the changes in the distribution of emissions that
Hot spots, spikes, and emissions trading 115
Lake
McHenry
N
Cook Kane
DuPage
Kendall
Will Grundy
Legend County boundaries Township boundaries Changes in emissions by zip code No emissions Reduced emissions in 1998 from baseline Increased emissions in 1998 over baseline
Figure 7.3 The 1998 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region.
are occurring are those that can occur under traditional regulations. To determine if emissions trading can lead to hot spots, the authors examine the distribution of emissions in 2000 and 2001 to ascertain if they occur more frequently than in the case of traditional regulations.
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Lake
McHenry
N
Cook Kane
Du Page
Kendall
Will Grundy
Legend
County boundaries Township boundaries Changes in emissions by zip code No emissions Reduced emissions in 1999 from baseline Increased emissions in 1999 over baseline
Figure 7.4 The 1999 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region.
The effect of the market on the spatial distribution of emissions (2000–1) In the years 2000 and 2001, individual participant emissions data were made available to the authors. Using these data, the actual effect of emissions trading on the spatial distribution of emissions can be explored.
Hot spots, spikes, and emissions trading 117 In the year 2000 as shown in Figure 7.5, there are far fewer zip codes experiencing increases in emissions over baseline than in 1998 and 1999. In 1998, there were nine hot spots, in 1999 eleven, and in 2000 the number falls to six, a decrease of at least a third from previous years. This is evidence for the fact that emissions trading may actually reduce the number of hot spots, since it reduces aggregate emissions below baseline in the nonattainment area. In 2000, zip
McHenry
Lake
N
Cook Kane
Du Page
Kendall
Will Grundy Legend County boundaries Township boundaries Changes in emissions by zip code No emissions Reduced emissions in 2000 from baseline Increased emissions in 2000 over baseline
Figure 7.5 The 2000 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region.
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code 60644 in the city center is still cause for vigilance, as it continues to experience an increase in emissions over baseline of 20.12 percent. The remaining zip codes that experienced increases in emissions in 2000 have a very low baseline, a very small percent increase, or a very small population. The situation is much the same in 2001, as shown in Figure 7.6. There are still only six zip codes with increased emissions over baseline, and five are the same ones that experienced increases in 2000. Again, zip code 60644 is the primary cause for concern, with its large population and relatively large percentage increase in emissions. Generally, emissions trading has improved the situation in 2000 and especially in 2001 in terms of hot spots in the Chicago area. There were more hot spots in 1998 and 1999 in areas of large population, with large percentage increases over already large levels of baseline emissions. The authors conduct a separate analysis for the years 2002 through 2004 because of the different estimation method for emissions. The continuation of the market and spatial distributions as estimated (2002–4) It is possible to further investigate the effects of the market on the spatial distribution of emissions by examining what happened in 2002, 2003, and 2004. The hot spot situation is similar in 2002 to the situation in 2000 and 2001, with zip code 60644 remaining the primary zip code of interest as shown in Figure 7.7. In addition, there are more increases in emissions in many of the outlying zip codes in 2002 than there were in 2000 or 2001. In 2003, the situation gets worse in that zip code 60623 returns to being a hot spot as it was in 1999, and 60644 remains a hot spot. This is creating an area of increased emissions on the west side of Chicago, as shown in Figure 7.8. These areas are also populated by lower income and minority groups, a matter deserving further scrutiny for those interested in the environmental justice issues of emissions trading. The results change slightly in 2004 as shown in Figure 7.9. Zip code 60644, which has been of interest since 1998, does not show an increase in emissions over baseline in 2004. On the other hand, zip code 60623 reveals a large percentage increase over baseline emissions, moving from 18.07 percent in 2003 to 30.20 percent in 2004. Given that this zip code started with a baseline of 1,212 ATUs, a 30 percent increase is equivalent to an additional 36.6 tons of VOC being emitted into the surrounding air. This increase could have a negative impact on the large number of poor and minority citizens living in this densely populated zip code. The authors conclude this comparison of pre- and post-trading impacts on hot spots by noting that the results are mixed and ambiguous. The trading system has brought about increases in emissions in zip code 60623, when using the authors’ estimated emissions data for 2003 and 2004. Zip code 60644 has shown fairly significant increases in emissions since the start of the cap-and-trade market, but it also showed significant increases in emissions in 1998 and 1999, under
Hot spots, spikes, and emissions trading 119
McHenry
Lake N
Cook Kane
Du Page
Kendall
Will Grundy
Legend
County boundaries Township boundaries Changes in emissions by zip code No emissions Reduced emissions in 2001 from baseline Increased emissions in 2001 over baseline
Figure 7.6 The 2001 emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region.
traditional regulations. Zip code 60016 showed increases over baseline, but these increases are almost trivial, given the initial baseline of 49 ATUs. Zip codes 60515, 60173, 60714, 60431, and 60542 each contain only one firm, so any increases in emissions in these areas would most likely be due to increased production by
120
Hot spots, spikes, and emissions trading
Lake
McHenry
N
Cook Kane
Du Page
Kendall
Will Grundy
Legend
County boundaries Township boundaries Probable changes in emissions by zip code No emissions Reduced emissions in 2002 from baseline Increased emissions in 2002 over baseline
Figure 7.7 The 2002 estimated emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region.
the individual firm. These increases tend to fluctuate in volume over time. Zip code 60152 shows increases in emissions over baseline, but the population density here is so low that the harms that would be inflicted from these increases should be considered relatively small.
Hot spots, spikes, and emissions trading 121
McHenry
Lake N
Cook Kane
Du Page
Kendall
Will Grundy
Legend
County boundaries Township boundaries Probable changes in emissions by zip code No emissions Reduced emissions in 2003 from baseline Increased emissions in 2003 over baseline
Figure 7.8 The 2003 estimated emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region.
These results generally provide evidence that the cap-and-trade market has not made the distribution of emissions more inequitable. More hot spots occurred in 1998 and 1999 than under the market in 2000–4, meaning that emissions trading has not caused more hot spots than occurred under traditional regulations.
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McHenry
Lake N
Cook Kane
Du Page
Kendall
Will Grundy
Legend
County boundaries Township boundaries Probable changes in emissions by zip code No emissions Reduced emissions in 2004 from baseline Increased emissions in 2004 over baseline
Figure 7.9 The 2004 estimated emissions compared with baseline emissions by zip code for the Chicago ozone nonattainment region.
However, given that several hot spots have occurred since the implementation of the market, with one of more special concern, zip code 60623, the question arises whether actions should be taken to redesign the market and place spatial restrictions on trading?
Hot spots, spikes, and emissions trading 123
Should spatial trading restrictions be placed on the market to prevent hot spots? Constraining the market to prevent hot spots requires, in principle, either restricting flows of transactions in certain sub-areas or devising a system of weighted, tradable credits reflecting the different populations in sub-areas. Either type of constraint negatively impacts the workings of the market, increases transactions costs, and lowers control cost savings, as shown by Stavins (1995: 137–148) and Montero (1997: 47–48). The benefits of constraining the market would be the reduction in local harms, to the extent these can be reasonably estimated. The issue of constraining the market was dealt with in the Los Angles region by dividing the local cap-and-trade markets for sulfur dioxide and nitrogen oxide tradable permits into two zones, an inland and a coastal zone, and preventing trades from the former to the latter, because of prevailing winds (Lents 2000: 219–240). No estimates are available as to the benefits and costs of this constraint. The issue arose in the national cap-and-trade sulfur dioxide market established in the 1990 US Clean Air Act Amendments, when complaints were heard from New York state and other downwind states that the pollutant was blown their way by the prevailing winds from the Midwest (Burtraw 1996: 79–94). The New York legislature passed a law, signed by the governor, prohibiting electric utilities in that state from selling sulfur dioxide tradable permits to states in the Midwest. No estimates are available as to the benefits or costs of this constraint. Against these costs should be balanced the changes in harms from constraining the market. The lack of comprehensive research on these harms limits greatly this important investigation. It is also important to note that spatial constraints reduce emissions in designated areas, but can increase them in other areas. When constraints are introduced, there is a redistribution of emissions over the region, due to the change in the equilibrium price of tradable permits. As price changes, emitters in certain zip codes may choose to buy or sell more permits and emit more or less than they would have done under the unconstrained market. A detailed harm function, not yet available, would be required to appraise these net effects, although they are likely to be small in relation to the loss in control cost savings. At this point, given that only one zip code, 60623, appears to be a hot spot of continuing interest, it seems unlikely that the reduced damage or harms caused by spatially restricting the market would outweigh the increased costs associated with such restrictions. As a result, no spatial redesign of the market is recommended at this time. However, further data on emissions and their spatial distribution over time should be examined regularly in order to keep abreast of the issue, since there is some evidence that hot spots may be an issue in the future. At this point, without accurate data on emissions for individual participants, it is difficult to forecast the extent of the hot spot problem. There are possible causes for vigilance, as exemplified by zip codes 60644 and 60623. Zip code 60623 is
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only a problem when using estimated data, and zip code 60644 is a hot spot every year from 1998 to 2003. In the light of these findings, it is very important for the agency to make data available to researchers for further analysis of the hot spot issue. Although the agency does provide county and township data in its performance reports, these sub-areas are too large to prepare a meaningful analysis of the relationship between the spatial distribution of emissions, minority populations, population density, and average income.
8
Alternative market designs The experimental approach
Introduction It is the aim of this chapter to test the cost-effectiveness of an important feature of the cap-and-trade market design. The test compares the abatement costs of a banking horizon, or expiration date, of one year after issuance of a tradable permit with those of an unrestricted banking horizon. The former, the one-year shelf life, is the feature of the Emissions Reduction Market System (ERMS), examined elsewhere in this book. The experimental methodology used in this test enables the authors to prepare new comparisons of the resulting costs of pollution abatement for both banking horizons. The finding is that the abatement costs in a market with permit expiration dates were 14–26 percent higher than those of a market without this restriction. It was also observed that aggregate banking was lower in markets that included the banking restriction, when compared with their unregulated counterparts, with the exception of one experimental session. Valuable tradable pollution permits that expired and became useless due to restricted banking were observed in all experimental trials employing this banking horizon restriction. Trading volume was more than estimated in all but one experimental trial. Prices of tradable permits to pollute increased in the restricted banking markets after permit allocations were reduced, reflecting the constriction on these markets. Prices decreased in the unrestricted banking market after permit allotments were reduced in two of the three sessions, reflecting the ability of participants to shift permits to later periods. These results will be discussed in greater detail after a brief review of experimental economics and a discussion of the experimental parameters employed in this study. Experimental economics is a valuable tool for comparing two competing policies, in that one modification can be made in the laboratory market without changing any other attribute of the market. The differences in market outcomes can be attributed to the modification placed on the market. This differs from a naturally occurring field experiment, because in the laboratory complete control over all aspects of the market are maintained. In naturally occurring markets, there are many factors beyond the control of the researcher that can affect the market.
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One of the earlier experiments conducted was reported by Chamberlin (1948: 95–108). Chamberlin emulated an unregulated and unorganized market for fictitious goods, with students as buyers and sellers of the good. Later, Vernon L. Smith, a student of Chamberlin’s, explored the use of experiments in a number of different applications. His research supported many economic theories, while shedding doubt on others. Eventually, Smith received a Nobel prize for his groundbreaking, experimental work. Others have used experimental economics to look at specific markets and their associated attributes. Of interest are the experiments that look at environmental markets. A number of experiments took place prior to and during the start of the US sulfur dioxide (SO2) market, in order to better predict the outcome of this new environmental market. A subset of these experiments investigated the ability of participants in the studies to minimize abatement costs through both trading and banking tradable rights to pollute. The main conclusions drawn from these experiments were that participants were generally able to extract cost savings from both trading rights to pollute and from banking these rights, thus equating marginal abatement costs to permit prices over time and between participants (Cronshaw and Kruse 1999: 1–24; Franciosi et al. 1999: 25–44; Mestelman 1999: 45–91). Further insights into emissions markets are obtained from the experiments presented in this study. The experiments reported here were developed to show whether a more restrictive banking horizon increases aggregate abatement costs or not. The results from the experiments confirm that aggregate abatement costs are, in fact, higher when banking is restricted. The aggregate abatement costs for the unrestricted banking experiments ranged from $8,758 to $11,070. Comparing these outcomes to the experiments with the restricted banking treatment, the aggregate abatement costs ranged from $10,352 to $13,036.
Experiment parameters In order to execute this experiment, there are a number of parameters that must be defined. The parameters defined below in Table 8.1 are applied to experiments conducted with real people. In these experiments, the goal of each participant is to act as a firm maximizing its own experimental dollars. There are five participants. Participants are each given an allotment of experimental dollars each period to facilitate trading and cover abatement costs. Each participant takes the role of a firm that produces 10 units of pollution, or emissions, each period. In the context of the ERMS, a unit of experimental pollution can be thought of as 200 pounds of volatile organic compound (VOC) emissions. Each firm is allocated a predetermined number of permits. Each permit gives the firm the right to emit one unit of pollution. The firm must surrender one permit to the conductor of the experiment for each unit of pollution emitted. Every firm receives eight permits in each of the first six periods. In the remaining 6 periods of the 12-period experiment, each firm receives only four permits, half of the prior allotment. In relation to the ERMS market, this
Alternative market designs 127 Table 8.1 Experiment attributes Environment
A
B
Number of periods Emissions
12 (6, 6) 10 (6 periods) 10 (6 periods) 8 (6 periods) 4 (6 periods) Unlimited banking horizon
12 (6, 6) 10 (6 periods) 10 (6 periods) 8 (6 periods) 4 (6 periods) One-year banking horizon
Permit allocation Treatment
Source: Experiments and simulations performed by the authors. Notes The only difference between the two environments is that A allows unrestricted banking, implying that permits do not expire, while B allows banking for one year, implying, that permits expire two years after their date of issuance. Also note that emissions remain constant over all 12 periods, while permit allocations are reduced by half after the 6th period.
would be similar to a 50 percent reduction in the permit allotment. The permit reduction creates a future constraint in the experiment so that firms should, in aggregate, redistribute the use of permits over time to minimize current and future control costs. Participants have the option of using their permits (surrendering them to the conductor of the experiment), banking them for later time periods, or buying and selling them to other participants. It should be noted that permits become worthless at the end of the 12th period. Therefore, it would not make any sense to save any permits for the 13th period or later. Also, there is no interest rate or other cost for saving permits from one period to the next. Additionally, neither permits nor experimental dollars can be borrowed from future periods, from other participants, or from the conductor of the experiment. In each period, the firm must decide how many permits to surrender, which allows them to emit the pollution, and consequently how many remaining units of emissions to abate. The marginal abatement costs listed in Table 8.2 are successively higher for each unit of emissions abated. Therefore, total abatement costs per firm are increasing at an increasing rate for each extra unit of emissions abated. Also, note that each firm has its own unique abatement costs, which can be compared to permit prices in making the firm’s decisions. This allows for abatement cost minimization through inter-firm trading of permits. Abatement cost schedules do not shift over time during the periods of the experiment due either to technological change or obsolescence. Participants are told only of their own abatement costs, and do not know the abatement costs of others. They do know that there are 12 periods, and that at the end of the 12th period permits will have no value. It is common knowledge that each participant has 10 units of emissions each period, and that each participant is allocated eight permits in each of the first six periods and four permits in the last six periods. Two treatments are applied to these experimental designs; an unrestricted banking treatment and a one-year banking horizon treatment. The unrestricted
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Table 8.2 Marginal abatement costs by firm (listed in experimental dollars) Units of emissions abated
Firm 1
Firm 2
Firm 3
Firm 4
Firm 5
1 2 3 4 5 6 7 8 9 10
2 6 10 14 18 22 26 30 34 38
4 12 20 28 36 44 52 60 68 76
8 24 40 56 72 88 104 120 136 152
10 30 50 70 90 110 130 150 170 190
12 36 60 84 108 132 156 180 204 228
Source: Adapted from Cronshaw and Brown-Kruse 1999: 4–5. Notes Each firm experiences a rising marginal control cost curve for emissions reduction. In addition, these costs are different for each firm. Firms 4 and 5 are high cost and expected to be net buyers of pollution credits, while firms 1 and 2 are low cost and expected to be net sellers. Firm 3 may be a buyer or seller, depending on the market price.
banking treatment allows participants to bank as many permits as they wish for as long as they want. The one-year banking horizon treatment is the same rule that is used in the ERMS market. As noted earlier in this book, the ERMS market allows banking of permits for one year only after the year of issuance. Permits banked longer than one year expire and become worthless. The one-year banking rule can affect participant decisions. Because of the prospect of expirations and loss of permit value, the rule limits the number of banked permits despite any expectations of future price or cost changes. Assuming the participant acts rationally and uses the oldest permits first in a “first-in-first-out” accounting process, the limit or ceiling would be the amount of permits issued in the current year. Thus, participants, expecting future permit allotment reductions or possible price and cost changes, are constrained in the number of permits they can bank. Without the ERMS one-year banking horizon, firms have the ability to build their banks as large as they wish. In the prior chapters, the authors revealed the role of the one-year banking horizon in causing expirations and increasing abatement costs. In the experiments of this chapter, the number of permits that expire is also revealed under the one-year banking horizon rule. Finally, note that there are several differences between the experiments reported in this chapter and the market simulations of Chapter 5. First, the experiments in this chapter are inter-temporal in nature. The time horizons are 12 market periods, each with its trading, banking, and price activity. The simulations in Chapter 5 consider only one period, but vary market parameters to compare static solutions. The marginal abatement costs in the experiments of this chapter are predetermined and fixed throughout the 12 periods. The simulations in Chapter 5 adopt estimated abatement cost data for participants from actual
Alternative market designs 129 recorded data, and then change individual cost schedules in known ways to estimate the effects on market activity. There are similarities also: both Chapter 5 and the experiments of this chapter do not consider the effects of traditional regulations on market activity. Comparisons between and among the prior analysis of the ERMS market, Chapters 5 and 8 should be carried out with attention to these different research designs.
The experiments To gain insights into the participant’s decision process, an account of the building blocks of the experiment is reviewed. Fifteen participants were recruited from undergraduate economics courses at the University of Alabama at Birmingham. In groups of five, students were congregated in a computer lab and assigned a computer. Each of the groups of five students was engaged for 12 periods in making market decisions, and each group had a particular session assigned to them, comprising three sessions in all. Each of the periods within the three sessions was divided into two treatments, one with a restricted banking horizon and one without the restriction. Therefore, all participants made decisions during the periods under both treatments. Each student was assigned to one of the five firm types that differed by abatement cost schedule values. The overall experiment was then programmed and conducted using the z-Tree software (Fischbacher 1999: 1–93). The participants were then read detailed instructions, which explained what variables would affect their final payment in real US dollars. They were taught how to use the computer interface. They were also given detailed, written information on their marginal abatement costs and the way their total abatement costs would be calculated. The participants were given allotments of experimental dollars in addition to their allotments of tradable permits. Their stated goal was to minimize the use of these experimental dollars in trading, banking, and emissions decisions. Upon completion of the period trials in the three sessions, the experimental dollars were to be converted to US dollars at pre-announced exchange rates, which they could keep. Before embarking on the actual trials, the participants completed three trial periods, which did not affect their final earnings. Each experimental period provided three different screens in sequence, each of which allowed participants to interact with one another or offered the participant market information. The first screen was the trading screen. During this first portion of the period, participants were able to make bids, asks, or complete transactions. All bid, ask, and completed trade price information was displayed for all participants to see in real time, but participant identity was not revealed. Participants were not allowed to sell permits they did not have, nor to buy permits if they did not have enough experimental dollars to pay for them. Participants were able to trade for up to two minutes after which the first portion of the period was over. The next, or second, screen summarized the participant’s holdings of permits and provided an updated total of their available
130
Alternative market designs
experimental dollars. The participants were reminded that they had 10 units of emissions for the period, which they must either reduce by control measures, according to their abatement cost schedules, or cover by giving up tradable permits. Participants had available tradable price information from the first screen for use in these decisions. Note that in the written instructions, participants had been given their abatement costs in detail. They were given both the total cost of abating at each unit of abatement and the marginal cost of abating an extra unit as seen in Table 8.2. This information, together with price information, could aid participants in their trading decisions, and in their banking decisions. On the third screen, the computer calculated the units of emissions that must be abated, based on the number of permits that the participant chose to use instead of abatement. The cost of abatement was then calculated for each participant and subtracted from the participant’s earnings. The screen then listed the number of permits remaining to be banked for future period(s). This process continued through each of the 12 periods. During each period, the participant was involved in two treatments conducted back to back. The first had the unregulated banking treatment while the second had the one-year banking treatment. Abatement costs from both treatments could then be directly compared, since all participants were subject to both banking treatments, with all other variables remaining the same. Prior to the start of the session, participants were each paid a $10 show-up fee. At the end, participants were paid in US dollars in accordance with their final earnings, based on a predetermined exchange rate from experimental dollars to US dollars. The total cost of each session of 12 periods, containing two treatments, was roughly $150. In preparation for reporting the experimental outcomes, the authors present their methods for making comparisons, and their expectations of outcomes. To determine which treatment of the banking horizon had the lower costs, the authors aggregated abatement costs for all sessions. The banking, trading activity, and price reports, which explain the differences in the abatement costs of the two treatments, are reported. Due to the nature of the one-year banking horizon, the authors expected that participants would bank less under the restricted than the unrestricted banking treatment. Also, under the one-year restricted banking treatment, expirations of permits were expected, reducing the number of permits available for use and increasing abatement costs. Expirations of permits were a key issue to be investigated. Normally a firm, or trader, would try to avoid the expiration of valuable permits, unless caught by a constraint. The costly constraint was the one-year banking horizon, which played such a large role in causing expirations in the ERMS market. The maximum number of permits used in aggregate in any one period is calculated. This is the period with the highest emissions. The purpose of this calculation is to act as a proxy for inter-temporal emissions spikes, a matter of concern when banking is permitted in market-incentive systems. The authors expect that there will be higher concentrations of permits used in the first
Alternative market designs 131 six periods of the one-year banking treatment, when compared with the unrestricted banking treatment. The opposite is expected to be true in the last six periods. All experimental results are compared against a theoretical optimal simulation. To obtain the simulated optimum, all experimental parameters are put into an optimization program, and the computer completes a simulation for each of the periods and each of the two treatments. One simulation institutes unlimited banking, and the other institutes the ERMS one-year banking horizon, limiting each player’s bank per period to the maximum allotment per period. The simulations are programmed to minimize aggregate abatement costs. The modeling program does this simultaneously for each player, arriving at a solution only when demand and supply of permits are in balance. The solution can be used to calculate and compare aggregate abatement costs for each treatment. This simulation model does not include the interest rate costs of holding permits nor does it include a participant expectations relationship for future price changes. These model features would be important for a more thorough analysis of market activity over time. The authors have chosen to simplify the model in order to focus on the difference in banking horizons.
Experiment outcomes The results from the experiments confirm that aggregate abatement costs are, in fact, higher when banking is restricted. The aggregate abatement costs for the unrestricted experiments ranged from $8,758 to $11,070, while the experiments with the one-year banking treatment have aggregate abatement costs ranging from $10,352 to $13,036. That is, pair-wise comparison of treatments over the three sessions reveals that unrestricted banking leads to lower abatement costs in each session. The research objective now is to decipher why these differences in abatement costs between the two banking treatments occurred? Due to the laboratory setting, the differences in banking treatment outcomes can be attributed to a definite and limited number of reasons. Note that the alert participant, with the goal of minimizing abatement costs in mind, must compare the observed permit prices recorded on the screen and the abatement cost schedule before making each market decision. This comparison would be required for a fully informed decision to bank, trade, or reduce emissions. The authors will also explore the learning process and experience of participants that could cause these decisions to deviate from cost-minimizing behavior. Table 8.3 details a number of the experimental results having to do with banking activity and permit expirations. The column headings display the session and banking treatment, to provide a clear comparison of the two banking horizons. The last two column headings on the right present the simulated results for the two treatments. The first row of the table displays the total aggregate abatement cost summed over all 12 periods, which reveals, in each instance, the lower abatement costs of the unrestricted horizon. The aggregate number of permits banked in periods 1–6 to be used in periods 7–12, listed in the next row,
31 17 41 28
45
12
40
33
27
43
0
23
11,070
Unrestricted banking experiment session II
28
40
10
17
12,896
One-year banking experiment session II
32
36
0
45
9,610
Unrestricted banking experiment session III
25
37
45
51
13,036
One-year banking experiment session III
30
30
0
60
4,585
Unrestricted banking computer simulation
25
35
0
24
5,168
One-year banking computer simulation
Note One-year banking implies that permits expire two years from the date of issuance. Unrestricted banking implies that permits have no expiration date. Aggregate abatement costs measured in experimental dollars.
Source: Experiments and simulations performed by the authors.
10,352
8,758
Total aggregate abatement cost for all 12 periods Aggregate number of permits banked in periods 1–6 to be used in periods 7–12 Total aggregate permits expired in all time periods Maximum number of permits used in aggregate in any one period for periods 1–6 Maximum number of permits used in aggregate in any one period for periods 7–12
One-year banking experiment session I
Unrestricted banking experiment session I
Banking treatment and experimental session number
Table 8.3 Experimental results of banking, expirations, and use of permits
Alternative market designs 133 reveals that more permits were banked in the unrestricted horizon treatment than in the restricted horizon treatment, except for session III. This confirms the authors’ expectation that alert participants could better anticipate, and prepare for, the reduction in permits, starting with the 7th period. The important question of expirations of permits is answered in more detail in the third row in which expirations occur in significant amounts in all session trials of the restricted horizon, but only session I of the unrestricted horizon. This latter expiration occurred during the 12th and last period of the session. No expirations occurred in the simulation of market decisions. While the authors do not present individual participant data on expirations in the restricted horizon treatment, it can be reported that expirations occurred throughout the 12 periods as participants were caught with unusable permits in many of the periods. The maximum number of permits used in aggregate in any one period for periods 1–6 and the maximum number of permits used in aggregate in any one period for periods 7–12, are displayed in the last two rows. There it is revealed that participants, in total, used more permits to cover emissions, rather than reduce emissions by control measures, during the first six periods, when more permit allotments were made. To summarize, there were conducted three experimental sessions with 12 periods each. In each period, the two banking treatments were run as trials for participant decision-making. The abatement costs in aggregate show that unrestricted banking is associated with lower abatement costs. The question now is to probe more deeply into the reasons for the differences in aggregate abatement costs. The experimental trials and simulations reported in this chapter did not have the problem of two policy instruments aimed at one environmental goal, as in the actual ERMS market. That is, centralized traditional regulations did not conflict with decentralized market incentives in these experimental sessions and simulations. The 15 participants were free to compare permit prices observed with their abatement costs in their banking, trading, and emissions control decisions, all with the goal of minimizing abatement costs and maximizing their take-home US dollars. While not constrained by traditional regulations, such optimal decisions could fall short because of learning behavior, imperfect information, or miscalculation. The authors turn to both types of influences on decisions, market incentives, and participant mistakes, in explaining the difference in treatment results. The results in Table 8.4 provide answers to a number of these questions. Here, percentages of trades and average prices are reported for the three sessions and two treatments, and for the model simulations. The last two columns reveal results of the simulations that provide a benchmark for comparison with the results of the actual session trials. In the case of the simulations, prices are uniform between the two sets of periods in the unrestricted scenario, as the authors hypothesized. Unrestricted banking has permitted a smoothing of prices and consequently a reduction of abatement costs compared with banking restriction. Restricted banking has
28 48 11.48 9.32 13.98
30
63
13.18
14.19
12.22
26.8
18.31
21.72
30
23
25
Unrestricted banking experiment session II
16.64
15.82
16.27
40
16
24
One-year banking experiment session II
12.54
21.1
19.1
58
40
42
Unrestricted banking experiment session III
30.96
18.48
22.82
67
63
64
One-year banking experiment session III
37
37
37
15
20
18
Unrestricted banking computer simulation
56
26
43
43
20
28
One-year banking computer simulation
Note One-year banking implies that permits expire two years from the date of issuance. Unrestricted banking implies that permits have no expiration date. Prices measured in experimental dollars.
Source: Experiments and simulations performed by the authors.
35
41
Percentage of permits traded in all time periods out of 360 allotted Percentage of permits traded in periods 1–6 out of 240 allotted Percentage of permits traded in periods 7–12 out of 120 allotted Average permit price in all periods Average permit price in periods 1–6 Average permit price in periods 7–12
One-year banking experiment session I
Unrestricted banking experiment session I
Banking treatment and experimental session number
Table 8.4 Experimental results of trading
Alternative market designs 135 forced higher prices in periods 7 through 12 in the simulations, when permit allotments were halved. The percentage of trades falls in the unrestricted banking case, but rises sharply in the restricted case as the simulation moves from period one through six to periods seven through 12, again revealing how the banking restriction affects trading. Turning now to the results from the sessions involving participant trials, a more complex pattern is revealed indicative of the information processing abilities of the participants. The percentages of trades is revealed to increase in periods 7–12 in all sessions. This is attributed to the efforts of participants to minimize abatement costs in the face of reduced permit allotments in the later trials. Permit prices fall during periods 7 through 12 in two sessions, when participants are allowed unrestricted banking treatments, compared with their rise in all three sessions when participants are only allowed restricted banking treatments. This is evidence that unrestricted banking allows for price smoothing and consequent improved abatement cost performance compared with the restricted banking horizon. The questions of learning behavior, imperfect information, and miscalculation on the part of participants could also affect the differences in abatement costs of the two banking treatments. Two of the experimental sessions were conducted at the same time, while the third was conduced one day after the first two. Each participant was read the same instructions, and given the same materials, written instructions and abatement cost schedules, for each of the two treatments. One possible difference in experimental outcomes is the learning of the participants. Some learning takes place during the introduction and three trial periods. However, additional learning may occur during the experiment. This may include becoming more comfortable with the computer interface, finding a better reallocation of permits over time through banking, or becoming a better actor in the trading portion of the game. To minimize some of these effects influencing the results, the unrestricted banking treatment was applied first in each session. In this manner, the learning gain is placed on the one-year banking treatment, potentially reducing the abatement costs of that treatment. Yet the abatement costs were still consistently greater under the one-year banking treatment. In general, when comparing the session results of the two treatments, abatement costs were higher, expirations more frequent, and prices more variable under the restricted than under the unrestricted banking horizon. When comparing the simulations under the two treatments, abatement costs were higher, banking less prevalent during periods 1 through 6, expirations larger, and prices more variable under the restricted than under the unrestricted banking horizon. The conclusion may be drawn that the banking horizon feature in the cap-and-trade market design is of great importance, and that the unrestricted horizon improves the performance of participants in the market in making their decisions. These results, and especially the comparison of model simulations with participant session trials, indicate that students did not perfectly equate marginal abatement costs across participants or over time periods, requirements for costminimization. Despite these possible problems of learning behavior, imperfect
136
Alternative market designs
information, and miscalculation, the theoretically predicted differences in abatement costs between treatments emerged in the experimental results. As a final comment on the experimental outcomes, the use of permits in aggregate as listed in rows 1–6 and 7–12 of Table 8.3 can be viewed as intertemporal emissions spikes. The analysis would be remiss if this important part of the experiment was not discussed. The point of the one-year banking restriction is to reduce the possibility of inter-temporal pollution spikes. It would be expected that permit usage and hence emissions would be greater in the last six periods with unrestricted banking, simply due to the ability to save permits for later use. As can be seen by the last two rows of Table 8.3, the difference in emissions between the two treatments was not terribly great. The differences were within three permits when comparing emissions of the two treatments in periods 1–6. Also in periods 1–6, the unrestricted treatment exhibited lower emissions in sessions I and III, while session II was just the opposite. In periods 7–12, the inverse of what happened in periods 1–6 was observed. Sessions I and III, respectively, show participants in aggregate used 5 and 7 more permits under the unrestricted treatments, with session II having one less permit being used in the unrestricted treatment. In summary, when comparing the two different treatments, periods 1–6 exhibited little difference in permit use, and hence emissions. In periods 7–12 there were more emissions in the unrestricted models as predicted, except in session II where emissions were nearly equal between the two treatments. It is clear that the costs of the one-year banking horizon are higher abatement costs, due to less banking, a lack of smoothing of permit prices, and higher permit expirations. The benefits are lower permit use and emissions in periods after the permit allocation reduction. To relate this to the Chicago area ERMS market, if the Illinois Environmental Protection Agency (IEPA) reduced permit allocation, it would be expected that aggregate abatement costs would be higher, and emissions levels lower after a permit allocation reduction under a one-year banking treatment, as compared with an unrestricted banking rule. In contrast, if the one-year banking horizon was abandoned for an unrestricted banking rule, it would be expected that aggregate abatement costs would be lower, and emission levels could be higher in certain periods after a permit allocation decrease.
Conclusions As presented above, experimental economics can offer insights into modifications of market-based emissions reduction markets, without perturbing the actual market. The study here focuses on the differing outcomes of an emissions market, with and without a one-year banking horizon on tradable permits. The experiments here emulate a market for tradable rights to pollute. The market parameters include 5 student participants per experimental session, 12 time periods, 10 units of emissions for each period, different costs of abatement for each of the 5 firm types, permits halved between 12 periods allocated, and, most important, restricted and unrestricted banking. Participants were
Alternative market designs 137 exposed to identical training, markets and market information, and computer interfaces. An optimal simulation was completed for both the unrestricted and restricted banking treatments. The experimental outcomes affirmed the assertion that a one-year banking horizon increases abatement costs. The shortened banking horizon generally induces participants to bank less in periods of high permit allocation, and therefore have fewer permits to use when permit allocations are lean. Additionally, in the one-year banking horizon treatments, permits expired when held too long, reducing the stock of permits that were available for use, and increasing abatement costs. The overarching results are that experiments with the one-year banking horizon showed higher aggregate abatement costs, ranging from 14 to 26 percent higher than experiments with an unlimited banking horizon. Permits banked from highpermit allocation periods to low-permit allocation periods were higher in the unrestricted banking experiments when compared to the restricted banking experiments, except in session III. Expirations occurred in all restricted banking experiments, and in only one session of the unrestricted experiment. The expirations in the restricted banking experiments, paired with the reduced banking and the smoothing of prices, help explain the differences in the aggregate abatement costs between the two banking treatments. In all experimental trials, average permit prices were lower than the simulated optimal price. However, participant activity did lead to prices that reflected the permit allocation reduction, as average prices were always higher in periods 7–12 in restricted banking experiments. Within periods 1–6, average prices were higher in the unrestricted experimental trails when compared with the restricted banking trials. Within periods 7–12, the opposite was true, with the unrestricted experimental trails having lower average prices than their restricted session counterparts. The only exception to this trend is session II in periods 7–12. The unrestricted banking horizon did lead to smoother prices over time, thus contributing to cost abatement. This study makes available two more pieces of evidence, simulated and experimental, indicating that the continuance of the one-year banking horizon has adverse effects on the ability of firms to minimize abatement costs over time.
9
Conclusions and policy recommendations for market redesign
Introduction The initial motivation of this study was to evaluate the performance of the Chicago volatile organic compounds (VOC) cap-and-trade market, using economic tests of efficiency, statistical methods to appraise market variables, and judgment to assess outcomes. The intention was to provide a careful quantitative appraisal of the attainment of stated air quality goals, the cost-effectiveness of the market compared with traditional regulations, the control innovation stimulation of market incentives, and the nonconfrontational character of this decentralized and innovative approach. It was not the expectation that a pioneering local market system applied to control a precursor of low-level ozone would achieve all goals or establish a market design leaving little room for improvement. Rather, it was hoped that a thorough study could record the strengths and weaknesses of the market design and suggest areas for improvement. The Chicago approach could then be recommended for use in other urban areas beset with low-level ozone air quality problems. After extensive efforts to analyze the market, guided by economic incentives explaining the relation of permit prices to marginal control costs, after many trials to estimate the cost savings from transactions using model simulations and relating these to actual market outcomes, and after repeated attempts to calculate permit banks that made economic sense in light of reported amounts, the authors became convinced that something more basic than market imperfections or learning behavior was blunting the expected effect of market incentives. The authors’ hopes to explain market behavior in terms of the theoretical projections of a well-functioning VOC cap-and-trade market, as derived in Chapter 5, were largely swamped by the lingering effects of traditional command-and-control regulations; this is the major conclusion that has been reached. The reasons for this conclusion have been described in detail in the body of this study, especially in Chapter 3, but they are worth repeating. The VOC emissions were much lower than the cap required, and lower than anyone expected. They were almost 40 percent below allotments made by the Illinois Environmental Protection Agency (IEPA). However, this good news for air quality was found not to be attributable in the main to the cap-and-trade market but to the continuance
Conclusions 139 and extensions of traditional regulations. The performance news gets even more disappointing when other observed outcomes are considered, as described in Chapter 3. Banks of tradable permits were driven to unexpectedly large amounts at the end of the first year and generated even larger banks in later years, as firms were unable to use or sell this surplus of tradable permits. The reason for these large banks was found to be the reduction in emissions that began before the market started and continued after the start date, largely dictated by the continuance and extension of traditional regulations. In effect, there were two policy regulations in place to reduce VOC emissions and only one was effective. This problem of more policy instruments than targets has a long history of discussion in the economics literature. A good source for additional information is available in Mundell (1968: 201–216). The inevitable result of these emissions reductions and consequent large banks, given the short shelf life of permits, which had a one-year banking horizon and were good for one year after the year of issuance, was the large number of expired tradable permits, one of the most puzzling aspects of the market not recorded in any other cap-and-trade market implementation. As might be expected, this surplus of permits created a buyers’ market for the few firms requiring more permits. Transactions were thus a smaller fraction of permit allotments than were recorded in other market incentive programs. The consequence of this performance was that average tradable permit prices plunged from $76 to about $25 after four years, as reported in the performance reports published by the IEPA. Prices have trended even lower according to the IEPA electronic bulletin board postings after 2004. These values are far below the earlier expectations of a number of researchers. To argue that this price for a permit entitling the emitter to emit 200 pounds of VOC was equated to the marginal control costs of reducing emissions is to fly in the face of any current estimates of such costs of which the authors are aware. Permit prices were largely determined by the glut of permits, while marginal control costs were higher and determined by the requirements of traditional regulations. These same regulations prevented participants from utilizing permits to increase emissions beyond the benchmark. Aggregate emissions thus continued to decline. The authors are forced to conclude that the performance of the market across the board was far below expectations of all interested parties. The market design as presently constructed is hardly one to be recommended for other urban areas. It is important to stress that the idea of an innovative cap-and-trade market was not flawed, nor that the hard work of the IEPA in bringing the first-of-its-kind market to control VOC emissions into existence was not worthwhile. As the authors have found in this study, it was simply that the market design had serious flaws. This conclusion led the authors to change the study’s objectives. The revised aims were to make a thorough analysis of the design flaws and to consider those redesign options that could improve performance. It was recognized that proposals for redesign would have to be based on as much evidence as possible, would of necessity have to be complex in nature, and would raise important issues for the IEPA in garnering support.
140
Conclusions
In carrying out this analysis, the underlying model described in Chapter 5 was not discarded, but subjected to an extension to account for imperfections and constraints affecting market decisions. That is, the assumption that participants were attempting to manage their permit portfolios in a least-cost manner, even in the face of limitations, is maintained. The challenge to the authors was to develop variables to measure these constraints and to test their significance in affecting market performance. This statistical analysis, based on the extended model, was carried out and reported in Chapter 6. In summary, the authors found that the continuation and extension of traditional regulations provided the most convincing explanation of the market’s puzzling performance. Many of the participants were limited in their decisions by the lingering and overriding command-and-control regulations and had to settle for sub-optimal emissions and transactions. Other limiting variables, such as the recession and over-allotment, played minor roles. Even if tradable permits had been allotted strictly according to the cap rule, there would have been a glut of permits. For a few participants, cost-minimizing market incentives did explain the few transactions that took place. These were far fewer than had been expected and far fewer than required if the market were to fulfill its promise of transferring emissions from low-cost to high-cost emitters. It was not for the lack of variation of marginal control costs among emitters that was at the root of the problem. The authors’ recommendations cannot be made lightly or without further research into redesign options. A cap-and-trade market design not only has consequences for market participants with their objective of minimizing control costs, but also for the regulating community with its objectives of effective enforcement and attainment of cleaner air goals, and for environmentalists and observers with their objectives of program transparency and accountability. Therefore, in this difficult task, the authors will draw upon tests of experimental economics to evaluate alternate banking horizons. The authors will make a comparison with other relevant market designs to seek reasons for the VOC market design deficiencies. Finally, the authors will utilize a new and unique data set of daily ozone and precursor concentrations and meteorological readings to provide a different quantitative perspective on the proper reduction in emissions – the cap. In drawing upon these separate strands of research to support the authors’ recommendations, it will be valuable to review the perceived design flaws. Possible design flaws contributing to these problems can be subdivided into market imperfections, long studied by economists, and external constraints that could impair market incentives. Each possible flaw requires examination for its credibility and its role in redesign.
What specific flaws in the original market design need to be fixed? Defects in a competitive market, such as concentrations of economic power or imperfect information, are failures of the standard assumptions of market analysis. For example, the extremely low prices of permits could suggest the presence of
Conclusions 141 monopsony power; that is, did a few large firms withhold a significant number of purchases in order to drive down the price? It will be recalled that permits have a short shelf life, with a one-year banking horizon, so that noncompetitive efforts to drive down prices must continue year after year and eventually lead to buying cheap and using permits to cover emissions in order to profit. The data of Chapter 3, in which aggregate emissions declined throughout the four years, suggest that few firms increased their emissions significantly after purchasing permits, since traditional regulations continued to set lower and lower ceilings on such increases (Table 3.1). Furthermore, the downward trend of prices hardly created opportunities to profit by withholding current purchases and selling next year. For firm after firm, the reason for not buying was the build up of excess permits with expiration dates looming during the next year. To allow permits to expire is not the gains from monopsony behavior that the textbooks describe. Imperfect information or learning behavior could affect performance, especially in a new innovative market design created to achieve environmental purposes. The IEPA required each firm to appoint an account officer and provided training to that designee in managing the portfolio of permits and reporting on transactions. An electronic bulletin board was established by the agency to record bids and offers in an effort to reduce transactions costs. No pre- or post-trade approval by the agency was required for transactions, only a reporting of the identification numbers of permits traded. The market rules appear to have been made as simple as possible, and the IEPA made responses to questions as rapid as possible. In addition, many of the larger and medium-sized emitters employed environmental managers, who also functioned as account officers in the market, which would presumably reduce the time of learning behavior. Despite the buildup of dated permit banks and subsequent expirations, most firms did not call on brokers for help, and the latter played an insignificant role in a market awash with permits. It is possible that further efforts by the agency could improve information on managing the permit portfolio. It is hard to conceive of the many firms with surplus permits having difficulties in thinking of what to do with them in view of their short shelf life. It is equally hard to conceive of the few firms that required permits having difficulties finding sellers. Anecdotal evidence reported to the authors frequently sounded as if the low price of permits, rather than lack of information, made firms indifferent to the market. The possible over supply of tradable permits that resulted from the benchmark and allotment decisions of the IEPA was a supply-side development that could affect transactions and prices. The authors attempted to test this idea in Chapter 6 in multivariate regressions and found it had less explanatory power than variables devised to capture the effects of traditional regulations. Such over-allotment should be associated with increases in aggregate emissions and not the significant decreases actually recorded. The fact that such increases were not recorded may not be a definitive rejection of this hypothesis, as traditional regulations acted to set ceilings for many firms on the extent of such emissions increases. The authors’ view is that the over-allotment hypothesis acted as a reinforcement of the
142
Conclusions
impacts that traditional regulations had on emissions, permit banks, and permit expirations. That is, had allotments been made strictly according to the cap provision, an excess supply of permits would still have resulted, attributable to centralized regulations. The recession of 2001, to the extent that decreases in output result in decreases in emissions, is a possible explanation for the short-run market adjustment dynamics that could lower prices. A recession is not a design flaw, but a temporary shock to emissions that should diminish as the recession recedes. The recession was short and minor and the recovery period revealed neither increases in emissions nor increases in permit prices. Statistical analysis carried out in Chapter 6 attributed only a minor role to the impact of the recession on the cap-and-trade market. The primary design flaw was the lack of integration by the IEPA of the level of traditional regulations with the major features of the cap-and-trade market. The prior operation of these regulations and their continued extension and tightening during the market period significantly impacted market incentives, as revealed in Chapter 6. The variable measuring these regulations was highly significant in equations explaining individual participant purchases and sales of permits for each of the four years for which the authors had detailed data. In sharp contrast, a variable measuring marginal control costs was not significant in affecting these transactions during any of the four years. The traditional regulations variable was also significant in equations explaining banks, expirations, and emissions. The evidence supports the conclusion that these regulations were the binding policy instrument on participant decisions, and not the market incentive program. One can be both supportive of market incentives and cognizant of how design flaws can greatly limit their role in bringing about desirable market outcomes. A good example exists in the efforts to deregulate wholesale electricity markets in California in the late 1990s. Confronted by high electricity prices and perhaps stimulated by reform in Great Britain, which succeeded in lowering electricity prices to consumers in that country, a four-year debate got underway about deregulation in California reminiscent of the long debate about the VOC market in Chicago. As in Chicago, the debate among businesses, administrators, legislators, and the concerned public resulted in legislation and administrative action that created a compromised market design. The result in the electricity market was the deregulation of wholesale prices, starting in April 1998, but a continuation of regulation of retail prices for consumers that stuck with their electric utilities. The continued regulation of retail prices to protect consumers has its echo in the argument for continuation of traditional regulation of VOC emissions to protect the public from possible hot spots or spikes in emissions trading. In California, electric utilities were required, by and large, to sell off their generating plants and become intermediary distributors of electric power, buying power from independent generators and selling it in the retail market. Continued strong demand for power and supply-side shocks, such as the drought and decline in imports from outside the state, drove wholesale prices to unexpected highs of about one dollar per kilowatt-hour, while retail prices were regulated at about six cents per kilowatt-hour. These market flaws soon threatened utilities with
Conclusions 143 bankruptcy. Correction of these design flaws will likely mean relaxing the protection of consumers from all price flexibility and allowing utilities to enter into long-term contracts that can protect consumers from manipulation of the market. Creation of incentives for new power plant construction also seems essential. While the parallels to the VOC market design flaws are not exact, the California experience highlights the importance of a compatible integration of market design with traditional regulations. What is required is a careful search for guidance on improving market design features that can correct flaws and yet be compatible with traditional regulations. If the cap-and-trade market is to be designed as the effective policy instrument to achieve emission reductions and cost-effectiveness, then traditional regulations must be redesigned to achieve other objectives.
Four sources of guidance on appropriate market designs While the study of the impact of traditional regulations on participant decisions was the basis for discovery of the design flaws of the initial VOC market, it could not by itself provide a blueprint for an effective redesign. There are many values possible for the cap, and many possible banking horizons for the tradable permit, in addition to many changes in other market features that could be proposed. The authors drew on several sources of information on which to base their recommendations. Comparison of cap-and-trade markets currently in operation Emissions trading and the cap-and-trade variant are recent developments on the environmental regulation scene, with only a decade or so to accumulate experience, and even less time to accumulate data in order to guide analyses, comparisons, and evaluations. While studies were underway earlier, and planning and preliminary efforts began early in the 1990s, actual trading in environmental markets began in the RECLAIM program in the Los Angeles region in 1994 and in the national sulfur dioxide (SO2) program in 1995. However, despite the brief time in existence, a quick glance at Table 9.1 reveals that of the five major cap-and-trade markets now under government monitoring and enforcement, there are differences in design. Also, early indicators of differences in performance make a comparison worthwhile. Such a comparison can provide insight into how these markets are integrated with traditional regulations. Despite the advantages claimed for these markets by economic analysis, it must be reported that the initial responses to all of the markets as they were under consideration were hardly auspicious; they were all greeted with some lack of enthusiasm, most evident among many environmental groups, but also among significant segments of the business community, and even among some members of the regulating community. For one group the concern appears to have been the loss of transparent control of pollution, for another it was the expense of record keeping and reporting, and for yet another it was the change from traditional
30
One year after issuance
60
25
50
No limit unless policies change
Free
About 50% in 2 phases
1995 1980 negotiated
SO2
25
40
No limit; discounted if bank is large
Free
2004 1990–2000 compliance supplemental pool Varies by state about 35% for Illinois
NOX Budget
25
25
No limit unless policies change
Free
Varies markedly by county
2003 1990
EU (CO2 )
Notes ERMS is the acronym for the Chicago Emissions Reduction Market System. RECLAIM is the acronym for Regional Clean Air Incentives Market program implemented in the Los Angeles region. SO2 stands for the acid rain sulfur dioxide market. NOX Budget stands for the nitrogen oxide cap and trade market. EU CO2 stands for the European Union carbon dioxide market. a Individual emitter allotments are usually not the cap times individual benchmarks, but a negotiated amount taking into account special circumstances as noted.
Sources: For the ERMS VOC, the IEPA Performance Reports 2000–4. For RECLAIM, Lents 2000. For SO2, Ellerman et al. 2000. For the NOX Budget, US EPA web site. For EU CO2, Victor et al. Science, Sept. 2005. Most data on transactions and banks refer to estimates available in 2005.
6
Firms in two groups with 12 month overlaps 40
Free
Allotment rules to firmsa Permit life (banking)
Transactions as a % of allotments Banks as a % of allotments
Declining to 60% in 2002 for NOX and to 84% in 2002 for SO2 Free
12%
Aggregate cap on benchmark
1994 1989–92 negotiated
2000 1994–6 substitution of 1990–7 allowed
Trading start date Benchmark period
RECLAIM (SO2 & NOX )
ERMS (VOC)
Features
Table 9.1 Comparative design features and performance of five current cap-and-trade markets
Conclusions 145 regulations so long in existence and so firmly in place (Rosenberg 1997: 97). Perhaps it was only economists who were comfortable with markets as instruments to improve environmental quality and were generally united in support of this proposed innovation. The success of the SO2 program, in particular, has brought about a remarkable change in attitude. Resistance among environmental groups and others has diminished. It is almost as if emissions trading has become fashionable! Even the opposition of the present US administration to a carbon cap is combined with support for market incentives in environmental policy. The authors have hesitated in mounting their critique of the VOC market with the thought in mind that it might contribute to rekindling old arguments. However, the authors believe that the use of market incentives for environmental regulation is now firmly established and that it is appropriate to undertake studies that seek to improve on the design of these incentive programs. The authors have selected just those aspects of the five programs in Table 9.1 that could help in comparing the markets and performance, setting aside many other characteristics that would be required in a complete analysis. For example, the authors have not included such important aspects as the monitoring and enforcement procedures, or the earning of tradable permits by activities such as buying and eliminating high-emitting vehicles, or the creating of sinks for pollutants. Rather, the authors have selected those aspects that appear to bear on redesign of the VOC program. Similarities among the market programs The similarities among the market features are worthy of brief mention representing as they do the species-specific framework of a cap-and-trade market designed to affect air quality. All the markets place a cap on emissions from fossil fuels and other pollutants and hence raise their prices and induce substitutions among inputs where possible. For example, as the SO2 content varies among different types of coal and natural gas, their relative prices will alter. The VOC emissions arise from a variety of inputs, whose use will be affected, and NOX emissions arise from some inputs and combustion processes. The prices of final products will consequently be affected in a manner requiring detailed analysis. The benchmark periods for use in establishing the cap are all backward looking; that is, they are historical values of emissions or fossil fuel use calculated in various ways. Aggregate caps could also be established on the basis of estimated future values of emissions or fossil fuel use, but this option has not yet been chosen in any of the current implementations. In each case, allotments of tradable permits have been made to individual firms free of charge rather than by auction. A small fraction of SO2 allotments has been set aside for an annual discriminant-type auction, but this auction has declined in importance as the number of permits auctioned has become a small fraction of traded permits. It appears as a general rule that support for cap-and-trade markets has been strengthened by this government policy of providing permits free of charge.
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Conclusions
A common feature of the markets is that no detailed government pre- or post-approval of transactions is required. These approvals were required in earlier emission-credit trading programs and so increased transactions costs that few trades of emission credits were profitable. Differences among the programs with respect to benchmarks, caps, and allotments The differences among the markets are worthy of a more detailed investigation in the search for design deficiencies. The VOC market is composed of a wide range of firms in various industries of varied size that the authors have described in detail earlier. In this respect, this market resembles the evolving carbon dioxide (CO2) markets in which a wide range of firms in many industries generate emissions. In the other three markets, the firms covered are mainly fossil-fuel-burning electric utilities and manufacturing enterprises that utilize boilers. This difference creates both simplifications and complications. Large fossil-fuel-burning firms can typically install continuous electronic monitoring devices that yield accurate data on SO2 emissions. For VOC and CO2 emissions, the problem is much more complex and alternatives, such as recording emissions rates on particular processes or the VOC or carbon content of inputs, have to be measured and monitored. This difference of industry base suggests that, in both the VOC and CO2 markets, the regulating agencies are well advised to provide detailed and prompt information on emissions trading to observers as a contribution to transparency, and as an aid to firms in managing their portfolios. The IEPA has been late in providing annual performance reports on emissions and market activity. The reports have also contained some inaccurate data, as the authors have described in Chapter 3. This imperfect information could contribute to inferior decision-making. The authors will have a recommendation on improvement of these important reports in the last section of this chapter. The benchmark period is an issue of the suitability of the period for calculations of the cap. For the business community, the period enters into the aggregate and individual firm caps; hence, any unusual characteristics of the period, such as a recession, can be subject to contention. For the regulating agency, the accuracy of measurement of emissions in the past is likely to be a cause of concern. For the environmental community, the relation of the benchmark period emissions to the cap and the resulting impact on air quality is often an issue. The benchmark period, the cap, and the allotment of tradable permits are interrelated and constitute key market design decisions for the regulating agencies, with important implications for market performance. In principle, the cap will determine the amount or share of the pollutant that the covered sector will emit. Therefore, the cap is one determinant of air quality. Health and welfare considerations should enter the calculation as benefits, as should costs of reducing the pollutant. However, these considerations have not yet secured the consensus of environmental analysts in arriving at cost–benefit analyses
Conclusions 147 that command agreement. Therefore, it should not be a secret that political calculation must enter into the determination, hopefully based upon what is known about health and welfare impacts. The US Congress commissioned a full outside study of acid rain during the 1980s, but the study was not completed in time for the 1990 review of the Clean Air Act. Therefore, the congressional decision was to cut the stubborn SO2 concentrations in half from the values of the 1980s by the early 2000s. The NOX budget plan for states relied more on photochemical modeling, and attempted to reduce emissions of states in proportion to the impact on ozone formation inside and outside particular states. The RECLAIM caps were based on air-shed modeling available at that time, and negotiation. European Union (EU) CO2 caps were the result of member country negotiations, building upon the Kyoto agreement. The VOC cap on stationary sources was determined as one component of reductions to be achieved by other policies relating to mobile and small area sources. The IEPA entered into complex negotiations with all concerned communities so that the final cap of 12 percent was a compromise that the business community could accept, as explained in Chapter 2. The relationship of the cap to existing traditional regulations is a matter of key interest in this study. For each pollutant in Table 9.1, with the exception of CO2, there existed, prior to the start of the market, a dense and widespread set of traditional regulations that attempted to reduce the pollutant by setting emission rates on processes, by specifying specific control technologies (often the same thing), or by requiring inputs with certain pollutant content, as described in Chapter 4. These traditional regulations remained in place, by and large, after the start of the markets, but the extent of the cap or the required reduction in emissions were sufficient for the cap to be binding in all but the VOC market, which was bound by traditional regulations. Consequently, one aspect of integration of market incentives and traditional regulations in all but the VOC market was achieved by a deep cap, or deep reduction, in allowable emissions, well below the level permitted by traditional regulations. The problem is a familiar one in economics: two regulatory regimes or instruments designed to achieve one objective can be in conflict and one can be redundant. In cases where this conflict did not arise, traditional regulations were either redundant or could serve standby objectives, such as the prevention of hot spots or inter-temporal spikes in emissions. The strikingly small reduction in emissions required by the VOC cap and the nonbinding effect of market incentives is a major difference between the VOC market and the others. This difference should figure prominently in any proposal for redesign. In the case of the baseline for VOC allotments of permits, firms were allowed, subject to IEPA approval, to substitute years in the interval 1990–7 for the benchmark interval of 1994–6 on which allotments were calculated. In the case of the RECLAIM, allotments were reduced over time from an initial value above 1994 emissions levels to a reduced ending point in 2000. However, even this decline over time had to be reduced further to meet the reduction goals set for the region. The cap ended up squeezed from initial benchmark values by almost 40% for SOX
148
Conclusions
and almost 75% for NOX (Lents 2000: 225). In the case of the SO2 national program, the US Congress, in a separate appendix to the 1990 CAAA, considered past scrubber installations and other individual factors in adjusting upwards particular utility allotments (Joskow et al. 1998: 668–685). In the case of the NOX program, a Compliance Supplement Pool of permits was used to award extra permits, based on various criteria to emitters. Finally, for the EU CO2, each member country adjusted allotments to individual emitters, using varied criteria (Kruger 2000: 14). The extent of over-allotment by these adjustments, that is, a real cap less stringent than the nominal cap, and the creation of a potential for excess supplies of permits, with impacts on expected permit banks and prices, is a matter the authors have addressed in this volume. Over-allotment was found not to be a major factor in the VOC market performance. Even with some over-allotment, a sufficiently deep cap (significant reduction in emissions) becomes binding and market incentives can play their role in reducing costs as in the sulfur dioxide and nitrogen oxide markets. Clearly, in the case of the VOC market, the authors have established the point that the cap was insufficient for this purpose. In the case of the EU CO2 market, it remains to be seen how binding the various country caps will be. In 2005, the US EPA adopted several new rules that were intended to further reduce SO2, NOX, and mercury emissions in the future. These rules, involving emissions trading, have yet to be fully implemented so that the authors have not incorporated them into Table 9.1. The Clean Air Interstate Rule (CAIR) is intended to reduce annual SO2 emissions to 3.7 million tons in 2010 and to 2.6 million tons in 2015. The intention under this rule is to reduce annual NOX emissions to 1.6 million tons in 2009 and to 1.3 million tons in 2015. These reductions imply substantial caps of well over half from 2005 values. The Clean Air Mercury Rule (CAMR) is intended to reduce mercury emissions to 38 tons in 2010 and 15 tons in 2018, again a substantial cut from 2005 values. The seasonal NOX emissions reduction program as described in Table 9.1 will remain in effect. Differences among the programs with respect to banking, transactions, and prices The shelf life of the dated permit, or the period of time it can be used after issuance, is a matter that can play an important role in smoothing control costs over time, and in stimulating cost control innovations, all contributing to dynamic cost-effectiveness. In the case of the RECLAIM program, there was considerable resistance on the part of environmental groups to allowing any banking, with the result that a compromise of sorts was devised by which permits were issued for overlapping 12 month permits to two groups of market participants. Trading was permitted between these periods, thus permitting limited banking. Resistance to banking also characterized the planning period for the VOC market. In both these local programs, there was concern about inter-temporal spikes in emissions on the part of environmental groups. The compromise solution for the Chicago program was a one-year banking horizon on the life of a permit after the year of issuance.
Conclusions 149 These short banking horizons stand in sharp contrast to the unlimited life of permits in the SO2 and NOX Budget markets. The NOX program has a flow condition on permits that limits the use of banked permits for covering emissions by discounting them if banks build up over a designated threshold. The EU CO2 permit horizon appears to be unlimited, although country rules may differ despite attempts to make permits transferable among member countries and traders. Revisions of CO2 caps and the introduction of other greenhouse gas caps scheduled for the future are developments that will be carefully watched by traders. A robust environmental market with a properly designed permit banking horizon should facilitate inter-temporal cost savings, as emitters anticipate future price and market changes by establishing appropriate reserves of permits for future use. A careful study of the SO2 market found that banks smoothed the transition between the phases of that market and led to inter-temporal savings (Ellerman and Montero 2005: 30). The study also concluded that the bank amounts were close to optimal in this properly constructed market. The level of banked permits in the VOC market exhibits no such relation to optimality, and the magnitude which led to large permit expirations is yet another indication of the design flaws in this market. No other market has recorded significant expirations of permits. The short banking horizon in this market demands close attention in the redesign process. In no cases can future-dated permits be used currently, although they may be traded. In all these programs, the government reserves the right to change policy and change the use of banked permits as well as other market rules. Typically, the wording in the legislation or administrative prescriptions that states permits are not private property protect governments from liability claims if the permit value is changed by policy. A robust environmental market should also be characterized by transactions between low-cost and high-cost emitters, if static cost savings are to be realized. Even though intra-firm reallocation of permits can lead to savings without trading, as firms transfer permits from one process to another where possible, it is unlikely that appreciable cost savings can be achieved unless a significant proportion of permits are traded inter-firm. Transactions data shown in Table 9.1 from recent years indicate that significant shares of permits are being traded inter-firm in all the markets, with the exception of the VOC market in which only 6 percent of allotted permits were so traded. The lack of transactions in the latter market is another symptom of the constraints on market incentives in this flawed design. A footnote on prices is also in order. In a robust, competitive, environmental market, tradable permit prices and derivatives can reveal a great deal of information about current and expected future marginal control costs. The latest available current or spot price information reveals plausible values for SO2, NOX, and CO2 permits, but an improbable price lower than $25 per VOC permit. Brokers have been active in the other markets where trading in permits with future dates, options, swaps, and other derivatives yield information on expectations. Their lack in the VOC market is another indicator of the impact of design deficiencies.
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Conclusions
Caps in the range of 35 to 60 percent have been binding in the markets that have functioned best, and banking horizons with no limit on timing or use have served inter-temporal cost calculations. These features appear to fit well with traditional regulations and merit consideration as redesign options. The lessons from the comparisons of markets in Table 9.1 cannot be taken strictly as a prescription for redesign of the VOC market, because what works in one case for one pollutant cannot simply be copied in another. However, the comparisons of the table are suggestive and should be considered along with other evidence on design imperfections. Laboratory evaluation of banking The difference in banking patterns among the markets and the enormous importance of the overhang of large banks on subsequent VOC market activity makes a careful appraisal of banking horizons and their impact on portfolio management essential. As the VOC market system is a pioneering effort, the authors believed that a fresh and different perspective on the banking design would be fruitful and chose an experimental approach to simulate such a market arrangement. The results have been presented in detail in Chapter 8. The finding there that lengthening the banking horizon, other things being equal, can increase inter-temporal cost savings is evidence that this market feature should be given high priority for change. The authors recommend no limit on the use of a permit after date of issuance, but recognize the concern about spikes. Discounting of banked permits when the bank reaches some critical value, say half or two-thirds the amount of the next allotment, is a policy option to reduce spikes in emissions open to the government, providing that real time data are available on emissions and banks on a timely basis. The results from the experimental trials also indicated the possibility of hot spots as some traders in a neighborhood purchased permits to cover emissions greater than their benchmark. This finding of potential hot spots provides some support for continuing traditional regulations as a complement to emissions trading. It becomes a separate policy instrument designed for this new purpose. A new perspective on the VOC cap based upon daily ozone, precursor, and meteorological data recorded during the summer of 2005 A different perspective is provided on the appropriate cap, or emissions reduction, by considering the effects of VOC and other precursor concentrations and meteorological variables on the formation of ozone concentrations. The hot summer of 2005 was the first time that daily observations became available on these variables in the Chicago region. They provide a unique opportunity for estimating a relationship that could be used as one indicator of the appropriate VOC cap. The daily data also include the Air Pollution Action Days, proclaimed by the IEPA, thus providing an additional opportunity to evaluate the role of this voluntary policy to reduce emissions.
Conclusions 151 In summary, the authors find that both meteorological and precursor variables were significant determinants of ozone concentrations during the summer of 2005. This relationship was then used to estimate the reduction in VOC emissions that would keep ozone concentrations below exceedance levels. The authors also found that proclaimed Air Pollution Action Days that forecasted increases in ozone over the next day or two were significant predictors, but in a surprising way. Both these findings could be of value in the redesign proposals, as the authors will explain. The hot summer of 2005 in the Chicago region exposed the amount of work remaining to bring air quality into conformance with the new eight-hour ozone standard. From May through September, there were 15 days during which the standard of 85 ppb was exceeded. The precise current definition of a violation by the US EPA for an ozone area takes into account the average of the fourth highest eight-hour daily maximum concentration measured in each of the last three years. The authors will consider any daily reading above the 85 ppb standard as a potential violation in the making. The summer of 2005 followed several summers with below average temperatures that may have caused observers to relax; the summer of 2005 may be more typical of the future. The statistical analyses were carried out on two dependent variables; the daily eight-hour ozone concentration maximum averaged over 18 monitoring sites, and the daily eight-hour monitoring site maximum. The former provides a variable representing the daily ozone plume over the region, whereas the latter provides a variable representing the peak of the daily ozone plume. Meteorology has been found to be important in determining ozone concentrations; hot, dry, sunny days are conducive to ozone formation (Cleveland and Devlin 1988; Kenski 2004). Anthropogenic precursor emissions of NO, NO2 and VOC have rarely been available in sufficient detail for analysis. The availability of these, even on a limited basis from the IEPA, opened up new opportunities for research. The nitrogen oxides play complicated chemical roles in the formation of ozone with NO acting as a cleansing agent and NO2 as a precursor of ozone. This complex chemical transformation was captured by computing the daily average ratio of NO to NO2. The higher this ratio the stronger the cleansing effect. Hence, a negative sign would be expected to accord with atmospheric chemistry. The daily average VOC concentration was expected to have a positive sign. The analysis was carried out for the sub-period June and July of 2005 due to the limitation of daily data on VOC concentrations. During this period there were ten episodes of ozone concentrations above the eight-hour maximum. The results presented in Table 9.2 reveal that daily maximum temperature and daily ultraviolet radiation proved positive and significant in all equations. Daily maximum VOC concentrations were positive and significant in the daily maximum eight-hour ozone concentration equation and the daily average VOC concentration was positive and significant in the daily average eight-hour ozone concentration, attesting to the importance of this precursor in the formation of ozone. The daily average NO/NO2 ratio was negative and significant in the average ozone equation, but not in the maximum ozone equation. The negative sign
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Conclusions
Table 9.2 Linear multivariate analyses of determinants of ozone concentrations Dependent variables
Explanatory variables Daily maximum temperature Daily UV radiation Daily maximum VOC concentration Daily average VOC concentration Daily average NO/NO2 ratio Air pollution action days GLS coefficient: AR1 Intercept Correlation coefficient squared Durbin–Watson coefficient
Average daily maximum eight-hour ozone concentration (average of all monitoring sites) June and July 2005
Daily maximum eight-hour ozone concentration (maximum monitoring site) June and July 2005
OLS 0.84 (4.33)a 0.93 (3.86)a
GLS 0.90 (4.73)a 0.79 (3.79)a
OLS 0.99 (4.11)a 0.85 (2.62)a 0.06 (3.56)a
GLS 0.95 (3.69)a 0.71 (2.29)a 0.06 (3.89)a
0.13 (2.14)a 17.73 (2.15)a 15.49 (3.58)a
0.16 (3.35)a 14.27 (2.04)a 8.18 (1.99) 0.59 (5.26)a 43.94 (2.75)a 0.67
10.77 (0.99) 18.43 (3.25)a
9.04 (0.86) 15.47 (2.62)a 0.39 (3.04)a 36.55 (3.04)a 0.57
40.49 (2.32)a 0.68 0.98
1.88
42.68 (1.90) 0.65 1.25
1.98
Sources: Data provided by the IEPA and the US National Weather Service as explained in Appendix A. Notes Further definitions and details on variables, estimation techniques, instrumentation and errors of measurement are presented in Appendix A. Numbers in parentheses are t-ratios. a Implies the coefficient is significantly different from zero at or above the 95% level of confidence. OLS refers to ordinary least squares and GLS refers to generalized least squares estimation.
captures the cleansing effect of NO as compared to the positive precursor effect of NO2. The Air Pollution Action Days variable was found to be significant and positive. The positive sign might be a surprise to some observers who would look for a negative sign. However, this variable is a joint decision of the IEPA and surrounding state agencies and signifies incoming movements of weather and pollutants, and does not directly measure the voluntary changes sought in the activities of residents, as explained later. After testing for nonlinearities and serial correlation of the residuals, as the authors will show shortly, it was decided that the simple OLS linear specification could be used to study the relationship of maximum VOC concentration to
Conclusions 153 maximum eight-hour ozone concentrations. This relationship can be utilized to obtain a measure of the reduction needed in VOC concentrations to eliminate the exceedances that characterized two critical months, June and July. Taking the highest ozone maximum and holding the other variables constant at their mean ozone-producing levels, the authors then reduced VOC maximum concentrations until the ozone maximum was lowered to 85 ppb; that is, below the exceedance threshold. The results indicate that about a 40 percent reduction (cap) of VOC emissions is required to achieve this objective. More detail on the data, instrumentation, and errors of measurement are presented in Appendix A. Because these time series variables resulted in serial correlation of the residuals, which can compromise the estimation of tests of significance, the authors ran both ordinary least squares (OLS) and generalized least squares (GLS) regressions as explained in Appendix B. It can be seen that serial correlation was present in the OLS equations, which was corrected by the GLS estimation method, but the correction did not affect the conclusions drawn from the t-tests. The authors also investigated an alternative modeling approach involving the use of a Generalized Additive Model (GAM). The results described in Appendix B revealed little evidence of nonlinearity, given the sample period. A byproduct of this statistical analysis is that it can be used to evaluate a current policy measure called Air Pollution Action Days (formerly Ozone Action Days). This policy calls for voluntary actions by the public to use less energy intensive activities and mechanisms in work and consumption during days with forecasted high ozone readings. These days are proclaimed one day in advance by the IEPA taking into account weather forecasts (of dry, hot, windless days) and the build up of ozone, both within the nonattainment area and in the surrounding region. To the extent this policy is successful, it provides an inexpensive alternative or complement to traditional regulations and to emissions trading (Krupnick and Anderson 1996: 6). The four action days proclaimed during the June and July months of our study were coded as dummy variables, one for the action days, zero for other days. The positive significance of the coefficient of this variable is a surprise if this voluntary policy was expected to reduce ozone concentrations. It is not a surprise if the procedure for proclaiming these action days is taken into account. The IEPA official in charge is in frequent communication with like officials in adjoining states. When all agree that in their region a buildup of ozone is occurring, together with high temperatures, solar radiation, humidity, and wind speed and direction, all favoring high ozone concentrations moving about the region on the next day, an Air Pollution Action Day is announced. In effect, this procedure measures the generation and movement of ozone, precursors, and weather in the larger region and forecasts the passage of pollution and weather experienced elsewhere into the Chicago ozone nonattainment area. Whatever voluntary actions were taken to reduce ozone generation were over ridden by these incoming variables. The finding that Air Pollution Action Days possess forecasting accuracy suggests a new role for traditional regulations. It would be difficult to fine-tune
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Conclusions
the cap-and-trade market to these critical days by, for example, discounting the use of banked tradable permits because VOC emissions and banked-permit use are not monitored or recorded on a real time basis. They are reconciled at the end of the ozone season. However, the operation of market rules could be suspended for these short critical periods by substituting standby traditional regulations that call for VOC emissions reductions in excess of the cap. The degree of reduction could be related to the severity of the ozone concentration forecast. The reductions could be monitored by inspection of the records of traditional regulations. This would provide one of a number of new objectives for the policy instrument of traditional regulations. Integration of traditional regulations with the cap-and-trade market The fourth guidance study is based upon the authors’ research into the effects of external constraints or limitations on the market program presented in Chapter 6, notably the effects of traditional regulations. Regressions separately on permit purchases and sales in Table 6.2 brought out clearly the highly significant result attributable to the traditional regulations variable. This variable also proved significant in Table 6.3 thus explaining the initial build-up of permit banks that subsequently drove the dynamics of permit accumulations and permit expirations. Allowing permits to expire without use was the inevitable consequence of such a build-up for most participants. While a model limited to market incentives would not yield a satisfactory understanding of such participant behavior, the extended model provides a clarification of these outcomes without discarding the underlying economic framework. Finding the right design that balances the air quality goals and the integration of the two policy instruments requires more than a discovery of the flaws and the binding effects of traditional regulations; it requires drawing together the lessons learned from the comparison with other markets, from experimental economic trials of different banking horizons, from the study of daily ozone precursor and weather data, and from the analysis of the dominant role of traditional regulations. The authors turn to that task in the final section.
Policy recommendations for market redesign The first recommendation is simply that unless changes are made, the present design will not correct itself over time. The authors have found no evidence of learning behavior or maturation processes that would warrant the policy of sitting tight and waiting for improvements to happen. On the contrary, the enormous overhang of banked permits and the continued pressure on prices do not augur well for future developments. Without change, the market will most likely perform even more poorly. This was perceived by the agency, which at one point considered abandoning the market system completely. Several general consideration must be considered before specific market redesign changes are proposed.
Conclusions 155 The introduction of the new eight-hour ozone standard by the US EPA in June of 2005, with its requirement of further reducing allowable VOC and other precursor emissions, implies changes in the design of the market, including changes in the cap in order to achieve the new, more stringent ozone concentration goal. There are other changes on the horizon that, if implemented, could require even further reductions in VOC emissions. The US Clean Air Interstate Rule, proposed in 2005 by the federal administration, contains a plan for significant reductions of SO2 and NOX in the year 2017. If implemented, the reductions in NO and NO2 would call for further reductions in VOC emissions as well, if urban ozone is to be reduced below exceedance levels during hot, dry, and windless summer days. A simple policy change would be the elimination or reduction of traditional regulations and the substitution of a cap-and-trade approach with much more binding effect, including a deeper cap and longer banking horizon. This policy change, while making the market the effective policy instrument, would be stoutly resisted by many environmental groups as well as some regulators and segments of the public. It is conceivable, after a period of time with a redesigned and successful cap-and-trade market in operation that some aspects of traditional regulations could be relaxed, but that should be a topic for future research. Concerns about hot spots and inter-temporal spikes would have to be assuaged first. The authors believe that traditional regulations can be redesigned to achieve these goals. Abandonment of the cap-and-trade market is yet another general recommendation to consider. This action would recognize traditional regulations as the effective policy instrument, and one that has worked in the past. Such a decision would save the administrative expenses of monitoring a market system that is, at present, mainly a facade. However, such a decision would waste the agency’s good work in introducing this innovative and promising market incentive system. The promise of the system has maintained a core of support, despite the poor performance. This support could dwindle away, unless redesign of the market improves performance. Discontinuing the market could also send the wrong signal to other areas considering the use of market incentives to control low-level ozone in a cost-effective manner. What is more relevant is a specific redesign of the market to make it more binding and better integrated with existing traditional regulations. The first feature requiring change is the extent of the cap. The comparison of other markets indicates that caps calling for 35 to 50 percent reductions from benchmarks in VOC emissions have been binding and supportive of air quality goals for the pollutants in question. The study of daily ozone, precursor, and meteorological variables suggested caps calling for deeper reductions in VOC emissions would be consistent with the air quality goal of eliminating or greatly reducing eight-hour standard exceedances. This would indicate revised caps calling for at least a 40 percent reduction from benchmark VOC emissions. Such caps would now certainly be more binding and serve air quality goals well. The precise cap determination would depend in part on negotiations with all concerned groups and on changes in other VOC control measures dealing with mobile and small area sources.
156
Conclusions
Relevant to this consideration is the European Commission’s Thematic Strategy on Air Pollution that sets out air quality objectives for 2020 for that region. Studies have proposed that VOC emissions be reduced by 51 percent by that time relative to 2000 (IIASA 2005: 11). This reduction in emissions is to be achieved by traditional command-and-control regulations, although member countries may specify market-incentive programs at a later date. The second feature calling for a specific change is the banking horizon. Both the comparative study and the laboratory trials indicate that an infinite horizon would serve the interests of inter-temporal cost minimization better than the present one-year banking horizon. Other banking time periods are possible, extending 3, 5, or 10 years into the future, although such limitations introduce complications into the banking calculations of emitters. Lengthening the banking horizon is likely to appeal to the business community, which may resist tightening the cap. The shelf life of a permit introduces the expectations of participants about future events bearing on their market decisions. To the extent probabilities enter the estimation, the participant’s behavior toward risk can affect the calculation. These aspects of the banking horizon can be important in determining the cost-effectiveness of decisions over time and lend support to a longer banking horizon. The extraordinary permit banks of the VOC market and subsequent permit expirations are clear indications that redesign of the banking horizon deserves high priority by the IEPA. Given the difficulty of discounting banked permits in the VOC market, due to the lack of real time data, the authors believe that traditional regulations could be activated during the critical few days of an Air Pollution Action Day announcement. During these days, traditional regulations, which remain in effect, could be called upon to reduce emissions below the level called for by the cap. On other days, the depth of the cap and the length of the banking horizon make traditional regulations redundant. The problem of hot spots could also be addressed with traditional regulations. The authors have identified several potential hot spots or neighborhood increases in emissions, in Chapter 7. If these neighborhood increases in emissions were to continue, purchases of permits by firms in these neighborhoods could be prohibited, and, if necessary, traditional regulations requiring further reductions could supplant the cap-and-trade market on a short-term basis. There are other features of the market calling for change. Substituting deeper caps and longer banking horizons could replace part of the new source review programs frequently advocated by emitters, but adamantly opposed by many environmental groups. New source review programs call for more stringent environmental regulations on new or major modifications of existing sources, but not on ordinary maintenance and renewal. Needless to say, emitters have often claimed the latter to be the case, while regulators and environmental groups have argued for the former. This debate has surfaced in the acid rain program where the prospect of further reductions in SO2 and NOX emissions in the future have been held out by some administrators as a substitute, in whole or part, for the New Source Review program for electric utilities.
Conclusions 157 More feasible in the current situation would be to extend to the VOC program the relaxation of ceilings on emissions that has been introduced into the NOX Budget trading program. In effect, this relaxation enables emitters to buy as many permits as they determine to be cost-effective without encountering the ceilings imposed by traditional regulations. Recalling that any permit purchased implies a reduction in emissions elsewhere, this relaxation could increase the demand for permits without increasing aggregate emissions. Price information can be valuable to traders, especially when the market cap is binding. The provision of a bulletin board to facilitate bids and offers was a good idea that up to now has been little used. It should prove even more valuable when the cap and banking horizon are redesigned. Prompt publication of average prices on a more frequent basis than the present monthly reports, for example, should help traders in negotiation. Brokers may also be enticed into the market to provide further liquidity. The agency could consider training sessions for account officers of emitters on the development of derivative instruments based on spot market permits. These training sessions could also emphasize portfolio management and the opportunities for control cost minimization. The annual performance reports of the agency, promised for the first few months after the close of the year, have been very late. These reports contain detailed data on transactions, prices, buyers and sellers, and township (small area) location of emissions, among other facts, that are valuable to traders as well as observers. Unfortunately, the data have been inaccurate too often to build much confidence. The authors have made heavy use of them in Chapters 3 and 7, but only after making consistency checks and revisions. A “sources and uses” table, along the lines of the authors’ recommendations in Chapter 3, would be valuable and eliminate many errors. More prompt, accurate, and complete performance reports are essential for a well designed market. The authors’ proposals are, in effect, a range of choices for redesign of a more effective market. They are a recipe rather than a blueprint for a more successful market. Dialogue with all concerned groups would be required before any final policy decision is made, but a redesign decision is essential for this pioneering regulatory effort to be successful and a model for urban areas elsewhere. Such a redesigned market could realize many of the results of an efficient market as modeled in Chapter 5 and could serve as an example for other urban areas.
Appendix A Measurement of daily ozone, precursor concentrations, and selected meteorological variables
Ozone (O3). These dependent variables are measured in parts per billion cubic volume by means of ultraviolet ray photometry. The maximum daily eight-hour readings were recorded on a daily basis at 18 monitoring stations scattered about the Chicago ozone nonattainment area maintained by the Illinois Environmental Protection Agency (IEPA). The daily maximum eight-hour ozone concentration was the maximum ozone reading selected from the maximum of all the 18 monitoring sites scattered about the region. The average daily maximum eight-hour ozone concentration is the maximum daily eight-hour reading averaged over all 18 monitoring sites. Daily Maximum Temperature. This variable was measured as the daily maximum in degrees Fahrenheit as recorded at Chicago Midway Airport. The readings are monitored by the US National Weather Service. Daily Ultraviolet (UV) Radiation. This daily variable was measured as the average hourly reading recorded by a pyronometer in langleys. A langley is a unit of solar radiation equivalent to one gram calorie per square centimeter of a radiated surface. These measurements were recorded at the centrally located Jardine monitoring station and were maintained by the IEPA. Volatile Organic Compounds (VOC). Hourly VOC concentration readings were recorded at the centrally located Jardine monitoring station maintained by the IEPA. The VOC readings are measured in parts per billion cubic volume as recorded by a gas chromatograph. The daily maximum VOC concentration is the maximum hourly reading recorded for each day. The daily average VOC concentration is the mean of all hourly readings for each day. This complex variable is the least accurately measured reading of all variables used in this study of daily ozone formation. Daily Average Nitrogen Oxide to Nitrogen Dioxide (NO/NO2) Ratio. This explanatory variable was calculated as the ratio of average daily NO to the average daily NO2 concentration, both measured in parts per billion (ppb) and
Appendix A 159 recorded at the centrally located Jardine monitoring station maintained by the IEPA. The instrumentation was a chemiluminescence technology, which is reported to have an estimate 5 to 10 percent error. Air Pollution Action Days. These days are proclaimed by the IEPA and announced to the public in advance based on regional reports of threateningly high temperatures and high ozone precursor concentrations and their likely movement in a wider area surrounding the Chicago region. The call is for voluntary citizen action to reduce the use of VOC-emitting substances that can lead to low-level ozone.
Appendix B Explanation of generalized least squares and generalized additive models estimation techniques
Ordinary least square (OLS) models make a number of testable assumptions. One of these is that there is no serial correlation of the error term and another is the assumption that the relationships between the dependent variable and the independent variables are linear. In the OLS results reported in Table 9.2, the Durbin–Watson test statistic indicated that there was serial correlation in both of the reported models. Serial correlation, if present, will result in biased significance test results, which could lead to incorrect conclusions regarding the importance of the explanatory variables (Greene 2003: 370–373). To correct for serial correlation, a generalized least squares (GLS) model was used. Generalized least squares is best used to obtain unbiased significance tests when there is serial correlation of the errors in the original OLS model. Assume a model of the form yt 0
k
j xjt et j1
(B.1)
where xj, t is the tth observation for the jth explanatory variable. Assume that the Durbin–Watson test statistic suggests first-order autocorrelation or that et et1 ut.
(B.2)
To obtain the GLS estimating equation, equation (B.1) is lagged one period and multiplied through by the first-order residual autoregressive term 1, all of which is then subtracted from equation (B.1), resulting in ( yt 1 yt1) 0(1 1)
k
1(xj,t 1xj,t1) ut j1
(B.3)
where, if equation (B.2) is correct, ut is not serially correlated. Although only the first-order case is shown, sometimes more than one is needed to fully remove the serial correlation of the error. The degree of serial correlation of the residuals can be measured by the parameter 1, which is usually estimated jointly with the j terms. The GLS results reported in Table 9.2 confirm the statistical significance of
Appendix B 161 the OLS results for all of the explanatory variables, except Air Pollution Action Days in the average eight-hour ozone concentration equation in which it is significant at the 90 percent level of confidence. Another important part of the OLS model is the assumption that the relationships between the dependent variable and the independent variables are linear. This assumption is important in the use of OLS to estimate the relationship between ozone and its determinants. A daily ozone model for the period 1983–92 by Niu (1996: 1310–1321) used a general additive model (GAM) to investigate this linearity assumption and found nonlinearities in the response of variables, such as daily maximum temperature to ozone. Nonlinearity in OLS models, if present, will bias the estimated coefficients and lead to potentially incorrect conclusions. To test the importance of these nonlinearities, GAM estimation techniques, developed by Hastie and Tibshirani (1990: 136–171), were utilized by the authors. While equation (B.1) assumes linearity, use of GAM estimation can test this assumption. There is an important difference between the work presented in Chapter 9 and Niu’s work, regarding the determinants of daily ozone. The latter study involved data from April 1 to October 31 for nine years of data, while the former looked only at daily data in June and July of 2005. Thus, there was more potential for nonlinearity in Niu’s work, since the range of the maximum temperature was greater than in the model reported in Chapter 9. However, it was deemed wise to investigate if there were detectable nonlinearities in the data due to the variations in temperatures and, more important, whether these nonlinearities, if found, would require modification of the research conclusions. Assuming a model of the form y f (x1, x2, . . . xk), and dropping the t subscript to reduce notational clutter, where xi and y are one dimensional vectors, a GAM model can be written as E(yx1, x2,…, xk) ␣0
k
aj(xj). j1
(B.4)
The ␣j(.) are smooth functions standardized so that E[␣j (xj)] 0. Each ␣j(.) term was estimated using a spline smoother calculated with forward stepwise estimation. The user sets the degree of the smoother, and once the smoothing function is estimated, OLS is used to determine the coefficients ␣j. The main idea is that if the relationship is nonlinear, the sum of squared residuals for the GAM estimate will be less than the corresponding OLS model that assumed linearity. Table B.1 repeats the OLS models estimated and reported in Chapter 9 for comparison with the GAM results. The GAM error terms were not adjusted by Box–Jenkins, as used by Niu, so that the results could be directly compared with the OLS models reported earlier. Turning first to the average daily maximum eight-hour ozone concentration results reported in the two left-hand columns, it is apparent that the sum-of-squared errors, a measure of unexplained variation of the dependent variable, fell from 3,649.04 in the OLS model to 2,561.05 in the GAM model. The significance of the variables did not change, with the exception of the daily average VOC concentration variable. Next, in the daily maximum
162
Appendix B
Table B.1 OLS and GAM analyses of determinants of ozone concentrations Dependent variables
Explanatory variables Daily maximum temperature Daily UV radiation Daily maximum VOC concentration Daily average VOC concentration Daily average NO/NO2 ratio Air pollution action days Intercept Sum of squared residuals Correlation coefficient squared Durbin–Watson coefficient
Average daily maximum eight-hour ozone concentration (average of all monitoring sites) June and July 2005
Daily maximum eight-hour ozone concentration (maximum monitoring site) June and July 2005
OLS 0.84 (4.33)a 0.93 (3.86)a
GAM 0.76 (4.31)a 0.90 (4.13)a
OLS 0.99 (4.11)a 0.85 (2.62)a 0.06 (3.56)a
GAM 1.13 (5.06)a 0.92 (3.08)a 0.05 (3.05)a
0.13 (2.14)a 17.73 (2.15)a 15.49 (3.58)a 40.49 (2.32)a 3,649.04 0.68
0.10 (1.73) 24.66 (3.30)a 16.61 (4.24)a 29.91 (1.89) 2,561.05 NA
10.77 (0.99) 18.43 (3.25)a 42.68 (1.90) 6,234.07 0.65
13.79 (1.37) 19.28 (3.67)a 54.47 (2.62)a 4,580.86 NA
0.98
NA
1.25
NA
Sources: Data provided by the IEPA and the US National Weather Service as explained in Appendix A. Notes Further definitions and details on variables, estimation techniques, instrumentation and errors of measurement are presented in Appendix A. Numbers in parentheses are t-ratios. a Implies the coefficient is significantly different from zero at or above the 95% level of confidence. OLS refers to ordinary least squares and GAM refers to generalized additive model.
eight-hour ozone concentration results reported in the two right-hand columns, it is apparent that the sum-of-squared errors also fell from 6,234.07 in the OLS model to 4,580.86 in the GAM model. In this case, the significance of all of the variables did not change. Of interest is some sense of the relative importance of the meteorological variables (daily maximum temperature and daily ultraviolet radiation) relative to the pollution variables (daily average VOC concentration, daily average NO/NO2 ratio, and the Air Pollution Action Days variable). Looking only at the average daily maximum eight-hour ozone concentrations, a truncated OLS model, using only the meteorological variables as explanatory variables, gives a sum-of-squared residuals or unexplained variance of 11,192, while a model with only the pollution variables as explanatory variables results in a sum-of-squared
Appendix B 163 residuals of 6,009.8. While such a comparison is subject to omitted variable issues, when both sets of variables are in the model, the sum-of-squared residuals, or unexplained variance of the model, falls to 3,649.04. The authors may safely conclude that both the meteorological and human-induced pollution variables are important in the determination of ozone.
Glossary
ACMA Alternative Compliance Market Account. A government established (Illinois Environmental Protection Agency) bank of set-aside VOC tradable permits that can be sold at above market prices to emitters. ATU Allotment Trading Unit. The VOC tradable permit allotted to emitters, each of which is measured in 200 pounds of emissions of the pollutant. CAA (US) 1970 The Clean Air Act of 1970 was important environmental legislation that, among other things, set standards for a number of pollutants, including VOC emissions, and established the US Environmental Protection Agency. CAAA (US) 1990 The Clean Air Act Amendments of 1990 were important environmental legislation that, among other things, mandated a cap-andtrade market for control of sulfur dioxide emissions. Chemiluminescence Instrumentation for measuring nitrogen oxide concentrations in parts per billion cubic volume. DIP A variable constructed to reflect the impact of the 2001 recession on market activity of individual emitters by calculating the ratio of their reported 2001 emissions to 2000 emissions. Durbin–Watson Statistic A measure of the serial dependence or correlation of residuals in a statistical model. Endogenous A statistical concept of a variable dependent on the values of other variables. It is used in this study to analyze statistically the impact of other variables on individual emitter tradable permit sales, purchases, banking, expiration, and emissions activity. ERM A variable name constructed to reflect the impact of the start of the market system in 2000 by calculating the ratio of individual emitter 2000 emissions to 1998 emissions. ERMS Emissions Reduction Market System, Chicago’s VOC cap-and-trade market approach. Exogenous A statistical concept of a variable that impacts on the values of dependent variables. It is used in this study to analyze the impacts of the DIP, ERM, HAPDUM, and REG exogenous variables on emitter activity. GAM The Generalized Additive Model has been developed to test for nonlinearities in statistical relationships.
Glossary 165 Gas chromatograph Instrumentation for measuring VOC concentrations in parts per billion cubic volume. GLS The Generalized Least Squares model has been developed to test for serial correlation or dependence of the residuals in statistical models. HAP Hazardous air pollutants, a subset of hydrocarbon VOC emissions found by the US Environmental Protection Agency to be injurious to human health. HAPDUM A variable name assigned to emitters with all or part of their VOC emissions consisting of hazardous air pollutants. IEPA The Illinois Environmental Protection Agency implements state legislation affecting land, water, and air quality. It was responsible for the design and implementation of the VOC cap-and-trade approach in the Chicago ozone nonattainment region. LADCO The Lake Michigan Air Directors Consortium is an agency created by the states bordering Lake Michigan to study and make recommendations on air pollution in the region. LMOS The Lake Michigan Ozone Study was created to make air shed models of ozone formation and transport in the Lake Michigan area. MACT Maximum Achievable Control Technology. The most stringent control technologies known to the US Environmental Protection Agency to be applied to hazardous air pollutant emissions. New Source Review A regulatory measure that requires new or modified emissions sources to meet more stringent control requirements than existing sources. NOX Nitrogen oxides, when air borne, are precursors of acid rain and low-level ozone. Among these substances are molecules of nitrogen oxide (NO), nitrogen dioxide (NO2), and nitrous oxide (N2O). O3 A molecule of oxygen that is an active oxidant formed by the reaction of sunlight with atmospheric concentrations of precursors, such as VOC and NOX, and the presence of carbon monoxide. Studies have found that lowlevel ozone can cause respiratory problems and increased mortality rates. OLS Ordinary least squares. The standard linear regression model that makes a series of assumptions in order to draw statistical conclusions about the significance of relationships among the variables. These assumptions include linearity of the relationship and serial independence of residuals. OTAG Ozone Transport Assessment Group. A joint effort among state environmental agencies, supported financially by the United States EPA, to study and formulate recommendations about the control of low-level ozone and its precursors in their region. OTC Ozone Transport Commission. An agreement among east coast states of the US to join efforts to reduce low-level ozone in their region. Pyrometer Instrumentation for measuring a unit of solar radiation called a Langley equivalent to one gram calorie per square centimeter of radiated surface. RACT Reasonably Available Control Technology. A long list of control technologies and measures that can be used to reduce VOC emissions.
166
Glossary
RECLAIM The Regional Clean Air Incentive Market was initiated by the SCAQMD to implement local cap-and-trade markets for the control of airborne pollutants. Markets were established for sulfur dioxide and nitrogen dioxide. REG Variable name assigned to traditional regulation and estimated by the ratio of an emitter’s 1998 VOC to benchmark emissions. SCAQMD The South Coast Air Quality Management District is one of a number of such districts established by state legislation in California to coordinate air quality control. SIC Standard Industrial Classification. SO2 Sulfur dioxide, when airborne, is a precursor of acid rain. SO2 is emitted from natural sources and primarily from the burning of coal. Ultraviolet ray photometry Instrumentation for measuring ozone concentrations in parts per billion cubic volume. US EPA The US Environmental Protection Agency is the federal unit that implements national legislation affecting air, land, and water quality. VOC Volatile organic compound emissions, including numerous hydrocarbons. These emissions are among the precursors of low-level ozone. WBMCC A variable measuring marginal control costs of reducing a unit of VOC emissions, estimated by World Bank personnel, for enterprises in SIC codes.
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Index
Abbott Laboratories 23 acid rain (SO2) trading program xiii, 2; see also sulfur dioxide (SO2) trading system Air Pollution Action Days 150–151; definition of 159; as a determinant of ozone concentrations 152–154 Air Pollution Control Act of 1995 50 air quality trends in the Chicago region 3–4, 16 allotment of tradable permits 25, 33, 61 Alternative Compliance Market Account (ACMA) 36–37 American Lung Association of Metropolitan Chicago 23 Anderson, J. W. 153 annual performance reports of the IEPA 26, 30, 37; inconsistencies of 38, 157 asthma attacks 17 auction of tradable permits 64–65, 74, 75; transfer of wealth 72 autonomy and anonymity of market transactions 2, 102 backwardation of permit prices 35 banking of tradable permits 11–12, 25, 34; costs of various horizons 136–137; discounting of 150; lengthening the horizon 150; normative theory of 77; optimum level of 78, 79, 125–126 baseline (benchmark) emissions 24, 32–33; choice of three measures of 105 benefit–cost analysis 3, 17 best available control technology (BACT) 56
Box–Jenkins adjustment technique 161 BP Amoco refinery 23 broker activity 13, 141 bubbles (to permit trading) 59 Burtraw, D. 17 buyer’s market 139 Calcagni, J. 19 cap-and-trade market (VOC) xviii–xix, 1–2; compromised features of 24–28; constraints on 9–10; cost savings 12–13; design dialogue 23–24, 27–28; estimation of appropriate cap 153; features of 4–5; firm participation rate 34–35; integration of the market system and traditional regulations 156; monitoring and enforcement procedures 26; policy recommendations 154–157; problems of 60; redesign of xx, 12–14; redesign of banking horizon 156; redesign of cap 155–156 cap-and-trade markets compared 143–150; comparative design features of five markets 144; differences among the markets 146–150; differences with respect to banking, transactions, and prices 148–150; differences with respect to benchmarks, caps, and allotments 146–148; similarities among the markets 145–146 carbon dioxide (CO2) trading system 2, 144; see also global warming Caterpillar, Inc. 23 centralized and decentralized pollution regulation compared xiii–xiv, 4–5, 20–22, 29, 41, 82, 100, 156; see also emission trading versus standards
174
Index
Chamberlin, E. H. 126 Citizens for a Better Environment 22 Clean Air Act (1970) 16, 51; criteria pollutants 16, 51 Clean Air Act Amendments (1990) 15, 21; sulfur dioxide trading system section 22, 52; Title I 52, 55; Title IV 52 Clean Air Interstate Rule 155 Cleveland, W. S. 150 Coase theorem 62, 68 confrontation between regulated and regulating communities 13 constraint variables 82 continuous electronic monitoring 22 control technology guidelines 90–91 Corn Products US 23 Cost savings of a cap-and-trade market 12–13, 64, 65 Cronshaw, M. B. 126 daily average nitrogen oxide to nitrogen dioxide ratio, measurement of 158 daily maximum temperature, measurement of 158 daily ultraviolet (UV) radiation, measurement of 158 DePriest, W. 104 design of a cap-and-trade market xviii–xx, 3–5, 14, 23–24, 27–28, 153–158; see also cap-and-trade market (VOC) Devlin, S. J. 151 dialog among concerned groups xviii, 23–28 DIP (variable) 92, 95, 96, 97 discounting of banked permits 150 Druy, R. T. 103 Durbin Watson test statistic 160 dynamics of ERMS 96, 97, 98 economic recession 40, 82 eight-hour ozone standard 5, 19, 20 electricity market of California 142–143 electronic bulleting board 141, 157 Ellerman, A. D. 2, 21, 103 emission reduction credits 59 emission trading versus standards xiii–xiv, 3–5, 20–22, 1, 82, 100, 156; see also centralized and decentralized pollution regulation compared
emissions, aggregate 33–34 emissions credit trading program 21, 59 emissions measurement xvii, 2–3, 18–19, 22–23 Emissions Reduction Generator 37–38 Emissions Reduction Market System (ERMS: the Chicago cap-and-trade market) 6, 23–28, 30; compared with traditional regulations 82, 100, 125 Environmental Defense (Fund) 22 environmental justice 11 environmental policy instruments and targets 138–140 ERM (variable) 92, 95, 96, 97 exceedances of 8-hour ozone standard 151; current definition of a violation 151 experimental economics applied to the cap-and-trade market 12, 125–126; banking, expirations, and permit use 132; banking horizon treatment 127–128; comparison of costs of different banking horizons 136–137; experiment attributes 127; experimental design 129; experimental outcomes 131–136; experimental parameters 126–129; firm marginal abatement costs 128; transactions 134 expiration of tradable permits 31, 34, 88 Franciosi, R. 126 Freeman, M. 104 fund pollutant 25 generalized additive model (GAM) as a test for nonlinearities 153, 161, 162 generalized least squares (GLS) tests for serial correlation of residuals 153, 160; estimation method used 160–161 global warming 2, 144 Greene, W. H. 160 Hahn, R. 9 HAPDUM 92, 93, 95, 96, 97 Hastie, T. J. 161 Haynes, K. E. 102 hazardous air pollutants (HAP) xvii, 23, 53
Index 175 health and welfare aspects of pollutants 1, 15–17; effects of pollutants on 16, 17, 18; standards 15 hot spots 10–11, 66; baseline and 1998 emissions by zip code 115; baseline and 1999 emissions by zip code 116; baseline and 2000 emissions by zip code 117; baseline and 2001 emissions by zip code 119; baseline and 2002 emissions by zip code 120; baseline and 2003 emissions by zip code 121; baseline and 2004 emissions by zip code 122; definition of 105; delineation of 104; demographics by zip code 113; maximum baseline emissions by zip code 112; population by zip code 111; simulation of 76–77, 102–104; sub-area size implications 106, 107, see also neighborhood emissions, sub-area VOC emissions; yearly percentage change in emissions zip code data 109 Illinois Chamber of Commerce 23 Illinois Environmental Protection Agency (IEPA) 4–5, 15; data provided 105 imperfect information 141 inter-temporal cost savings 149 inter-temporal emission spikes 10–11, 156
market participants 87–89; distributions of participant market transactions 87–88 market redesign questions 13–14, 101 maximum available control technology (MACT) 54–55, 90 Mendelsohn, R. 104 Mestleman, S. 126 mobile sources of VOC emissions 18 moderate ozone nonattainment area 15, 17, 19–20, 53 monitoring and enforcement procedures 26 monoposony power in the market 39, 141 Montgomery, W. D. 8, 103 Mundell, R. A. 139 National Emission Standards for Hazardous Air Pollutants (NESHAP) 55 National Priority List, Superfund 102 neighborhood emissions 104–105; see also hot spots; sub-area VOC emissions netting (to earn credits for emission reductions) 59 New Source Review 156 nitrogen oxides (NOX) trading system 2, 4, 157 Niu, W. 161
Joskow, P. 8 Kenski, D. M. 150 Kinney, P. L. 17 Kruger, J. A. 2, 104 Krupnick, A. J. 153 Kruse, J. B. 126 Lake Michigan Air Director’s Consortium 22 learning behavior in a new market 141 level of government regulation 19 Lorenz curve analysis of emitter activity 87, 88, 89 lowest achievable emission rate (LAER) 55 Lui, F. 105 marginal control costs of ozone reduction 2; estimates of 28–29, 66; of ozone reduction 18; of traditional regulations 56–58, 59 market externalities 48
offsets (to sell emission reduction credits) 59 one-hour ozone standard 5 ordinary least squares (OLS) analysis 97; of appropriate cap 153; assumptions of 160; of market activity 97 over-allotment of tradable permits 10, 39–40, 89, 141–142 Ozkaynak, H. 17 ozone (low-level) formation, precursor, and meteorological determinants 150–154; regression results 152 ozone (low-level) measurement of 158 ozone (low-level) meteorological daily data 150; daily maximum temperature 150; daily ultraviolet radiation 150 ozone nonattainment area (Chicago) 15; moderate 15–16; morbidity damages 16–18; severe 15; urban area classification 20
176
Index
ozone nonattainment areas 18, regulatory requirements 19–20 ozone precursors 18; daily data on 150; nitrogen oxide–nitrogen dioxide ratio 150; VOC concentrations 150 ozone (low-level) reactivity 53 Ozone Transport Assessment Group (OTAG) 22 Ozone Transport Commission 22 performance of the VOC cap-and-trade market 5–9; deficiencies listed 138–139; evaluation criteria 138; hypotheses explaining 39–41, 83–84; monopsony 86; questions concerning 12, 31, 39 Pizer, W. A. 2 policy recommendations for the VOC cap-and-trade market 12–14, 154–157 pollutant regulatory features 18; extent 50; history 51–53; level of government 49; pollutant 48; spatial 51 Portney, P. R. 194 pre or post-transactions approval by the government 28 prices of tradable permits, estimates of 29, 34–35; information on 156 probit analysis 94; of market transactions 95 reasonable available control technology (RACT) 54, 90 recession 93, 142 REG (variable) 82–91, 95–96, 97, 98, 140, 142; see also traditional regulations Regional Clean Air Incentive Market (RECLAIM) xiii, 10–11, 21 relationship of VOC emissions to VOC concentrations 18 Rosenberg, W. G. 22 Schreder, D. L. 16 severe ozone nonattainment area 15, 53 shutdowns of market participants 36 simulation of a cap-and-trade model 8; changes in model 62–63; comparison of simulated and actual results 82; effects of spatial restrictions 76; implementation of model 67–69; objectives 61; price estimates 28–29; results of 69, 70, 71, 72, 73, 74, 75, 76;
specification of 63–64; savings expected from 64, 65–66 Smith, Vernon L. 126 sources and uses of tradable permits 36, 37, 38, 100–101 South Coast Air Quality Management District 10 spatial distribution of pollutants 49 spatial restrictions on trading 76–77, 123–124 Spengler, J. D. 15 Standard Economic Market Model (SEMM) 27–28 Standard Industrial Classification code 41–46; banking and expirations of permits by code 45; changes in emissions by code 42; effect of traditional regulations by code 41–46; permits bought and sold by code 46 State Implementation Plan 15–16, 54–55 stationary sources of VOC emissions 18 statistical findings explaining market transactions 95, 97, 99 Stavins, R. N. 8, 21 Stokes, H. H. 66 sub-area VOC emissions 105; see also hot spots; neighborhood emissions sulfur dioxide (SO2) trading system 2, 21–22 survey of market participants 84–85; responses on banking decisions 85–86 taxes on pollutants versus tradable pollutant permits 24, 58 technological progress 41 Thayer, M. 17 Thematic Strategy on Air Pollution (European Commission) 156 theory of emissions trading 8 Tibshirani, R. J. 161 Tietenberg, T. H. 21, 103 Tolley, G. 16 Toxic Release Inventory 102 Toxic Substances Control Act (US) 104 toxicity of hazardous air pollutants 33, 53 tradable permits, as financial assets 79; compared to other production inputs 80; equilibrium price of 80 traditional regulations xiv–xviii, 1, 7, 10, 21, 26, 41–42, 43–44, 45–46, 47;
Index 177 features of 56–59, 82–91, 140, 154–156; legislative history 48–53; monitoring and enforcement 54; see also REG transactions costs 9, 61–62, 71, 73; pre- or post-approval 146 transactions of tradable permits 34 uneven effect of traditional regulations upon emissions xiv, 91 urban smog xviii, 16–17; constituents of 16–17 US Environmental Protection Agency (US EPA) 5, 15; list of criteria pollutants 16, 52, 104
variables, dependent (market transactions) 93, 94, 95, 97 variables, explanatory of market transactions 93, 95, 97 volatile organic compound (VOC) emissions xvii, 2, 104; sources of 4–5; measurement of 158; ozone creating potential 33 WBMCC (variable) 93, 95–97 Wisconsin State law suit against IEPA on ozone levels 54 zero order correlations of baseline emissions 99
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