Grantee Research Project Results
Final Report: Evaluation of Phase II Compliance with Title IV of the 1990 Clean Air Act Amendments
EPA Grant Number: R828630Title: Evaluation of Phase II Compliance with Title IV of the 1990 Clean Air Act Amendments
Investigators: Ellerman, A. Denny , Joskow, Paul L. , Montero, Juan Pablo , Schmalensee, Richard
Institution: Massachusetts Institute of Technology
EPA Project Officer: Chung, Serena
Project Period: October 1, 2000 through March 31, 2003
Project Amount: $289,477
RFA: Market Mechanisms and Incentives for Environmental Management (2000) RFA Text | Recipients Lists
Research Category: Environmental Justice
Objective:
The objective of this research project was to conduct an ex-post evaluation of the first years (2000-2002) of Phase II of the sulfur dioxide (SO 2) allowance-trading program established by Title IV of the 1990 Clean Air Act Amendments, also known as the U.S. Acid Rain Program. This program provided a good opportunity to test the hypothesis and general policy presumption that market mechanisms and incentives are superior to nonmarket alternatives. It was the largest, tradable permits program that had been established to date. It was a near textbook example of having relatively few constraints on trading. Phase II was particularly important because of the much larger universe of affected units, the more stringent limits, and the opportunity to observe how the large bank of allowances was accumulated during Phase I was used. This evaluation extended the evaluation of Phase I (1995-99) conducted by the Center for Energy and Environmental Policy Research at the Massachusetts Institute of Technology (MIT), and it forms part of a broader research program concerning the aggregate performance of cap-and-trade programs, the characteristics of allowance markets, and the response of the owners of affected units to market prices signaling environmental scarcity.
Summary/Accomplishments (Outputs/Outcomes):
Banking
The most important result arising from this research is that the amount of banking undertaken by affected sources during Phase I, and the subsequent drawdown in the first 3 years of Phase II was reasonably optimal. This result is surprising given the general opinion among analysts and market observers (including the investigators) that there had been too much banking in Phase I. As would be true of any evaluation of trading through time, any finding of efficient banking depends on the discount rate used to compare costs in near and distant periods. In this instance, application of the capital asset pricing model, a standard financial approach for evaluating risk, indicated that a risk-free rate of return is appropriate because the returns from holding SO 2 allowances do not exhibit any correlation with the returns from holding a well-diversified portfolio of equities.
The finding of efficient banking also sheds light on an aspect of abatement behavior about which it is hard to draw firm conclusions: the degree of irreversibility and flexibility in abatement decisions. The general perception that there was “too much” banking was based upon the easily demonstrated and undisputed error in expectations before 1995 concerning allowance prices (i.e., that they would be higher than they turned out to be) and the assumption that most abatement decisions were irreversible. In retrospect, it is evident that as price expectations were adjusted downward in late 1994 and throughout 1995, utilities were able to adjust abatement decisions. The change in expectations affected both Phases I and II. Because banking depends on the expected disparity in marginal costs between Phases I and II and that the disparity remained relatively unchanged, the amount of banking during Phase I was affected little by the change in expectations. The amount of abatement planned to meet the current cap was cut back instead of the amount being undertaken for banking. This was possible only because the owners of affected sources were not locked into planned abatement and were able to adapt to lower prices. If these plans had been irreversible, there would have been “too much” banking.
The 1st-Year Effect
One of the remarkable features of the pattern of abatement under Title IV is that the largest reductions of emissions are made in the first year in which sources must surrender allowances, or equivalently, the first year in which a price must be paid for all emissions. This pattern is observed both for Phase I units, generally larger units with higher emission rates (“the big dirties”), and for Phase II units, which are either smaller units or ones with lower emission rates, often in response to relatively stringent pre-Title IV emission controls. As of 2002, Phase I units have reduced SO 2 emissions by a total of 5.5 million tons of which 3.9 million or 70 percent was accomplished in 1995, the first year in which these units became subject to Title IV. The far more numerous Phase II units that account for a much greater share of electricity generation have reduced SO 2 emissions by 1.4 million tons of which 1.1 million tons (79%) was accomplished in 2000, the first year in which these units became subject to Title IV. In evaluating the implications of this 1st-year effect, it must be kept in mind that all of these sources are subject to preexisting, source-specific “command-and-control” regulations usually limiting the allowable emission rate. This first-year effect shows that already regulated sources can reduce more when given the incentive to do more. As shown by the 1st-year effect, the biggest change in emissions occurs when the price for permitted emissions increases from zero to some positive number. Subsequent increases induce further abatement, but the greatest abatement effort is made in the first year.
“Hot Spots” or The Geographic Distribution of Abatement
The U.S. Acid Rain Program places no restrictions on the geographic scope of trading among affected sources, which include all sources in the lower 48 states. Because most of the damages from acidification occur in the Northeast and most of the emissions are in the Midwest, concern has been frequently expressed that emission reductions would occur disproportionately in areas outside of the Midwest where the emissions have relatively little impact on acidic deposition in the Northeast. With all electric generating sources subject to Title IV since 2000, the geographic distribution of abatement can be observed. Seventy-seven percent of national abatement is occurring in eight Midwestern states (OH, IN, IL, MO, TN, WV, KY, and PA) that account for approximately 55 percent of emissions. If anything, abatement is being undertaken disproportionately in the principal region of concern.
The reason for this happy result is not a matter of happenstance, but reflects the economics of abatement and the form of regulation. Deep-abatement technology (i.e., scrubbers) are relatively capital intensive so that a significant part of total unit cost depends on the extent to which the fixed capital costs can be spread over many units of output. In this instance, the output is abatement, or emissions avoided, and that quantity depends both on the utilization of the generating unit to which the deep-abatement technology is attached and the sulfur content of the fuel being cleaned. More highly emitting sources will be those that have some combination of large generating capacity, high utilization, and a high emission rates. Consequently, these sources have the potential to spread more units of abatement across the fixed capital cost and thus incur lower total costs on a per unit basis. When the form of regulation forces the source to “pay” on a per unit basis, as is done with a cap-and-trade system, these large, high utilization, high emitting sources will tend to adopt deep-abatement technology. The physical manifestation of this phenomenon is that approximately half of the abatement observed in Title IV is accounted for a relatively small number of sources (i.e., 34) that have installed new scrubbers in response to Title IV (instead of switching to lower sulfur coals) and that all but five of these scrubbers are located in the eight Midwestern states noted above.
Allowance Allocations and New Unit Entry
Not allocating allowances to new generating units has been argued to constitute an impediment to new entry. This assertion could not be tested during Phase I because no new units were included, but all such units would have been subject to Title IV from 2000 on. Among the approximately 1,400-1,500 generating units that became subject to Title IV in Phase II and that were significant generators of electricity (excluding little utilized units that account for two to three percent of total heat input), nearly 200 of them (as of 2001) received no allocation of allowances. Most of these were gas-fired units that would need very few allowances anyway; however, some new coal units were included and all new units, regardless of fuel, would have needed relatively few allowances because all new units are required to meet the new source performance standards. In sum, the available evidence indicates that the absence of an allowance allocation does not create any significant barrier to entry. This finding holds only so long as there exists an allowance market that is accessible to new entrants.
Cost of Abatement
As noted above, the generating units first subject to Title IV in Phase II account for less than 20 percent of the total reduction of SO 2 emissions attributable to Title IV. Moreover, two independent studies on the cost of abatement during Phase I have already been conducted, one by us at MIT ( Markets for Clean Air: The U.S. Acid Rain Program, Cambridge University Press, 2000) and the other by analysts at Resources for the Future (Carlson, et al., Journal of Political Economy, 2000), and they largely agree on the aggregate cost of abatement during Phase I. Furthermore, virtually all of the additional abatement undertaken since these studies were completed has been accomplished by switching to lower sulfur fuels, which, when motivated by Title IV, is determined by allowance prices. Finally, because of the first-year effect (going from zero to some positive price), most of the switching possibilities have been exhausted. Consequently, we did not conduct the initially proposed cost survey, but devoted those resources instead to research on the cost of the remaining abatement option—retrofitting scrubbers on the 700 plus presently unscrubbed coal-fired units. This research resulted in the construction of a marginal abatement supply curve for SO 2 based on existing units and their current utilization and use of coal. By extrapolation from these studies on observed allowance prices and the cost of abatement through scrubber retrofits on remaining coal-fired units, we can estimate early Phase II costs and project the costs for the end of the banking period. Although this work is still underway using internal resources, we can say with confidence that the costs for Phase II fall within $1.0 and $1.5 billion dollars annually, which is to be compared with the already existing estimates of Phase I cost of about $750 million annually, all in 1995 dollars. These estimates are broadly consistent with estimates made by the group at Resources for the Future (RFF) as part of their earlier study.
Combined project and internal resources also were devoted to estimating the effect on cost of another external event that has reduced the cost of compliance with Title IV, namely, the construction of significant new combined-cycle, natural-gas-fired generating capacity from 2001 through 2003. These new plants have met the demand that would otherwise have been met by generation from existing coal, oil, and less efficient gas units. These units have been displaced to varying degrees depending on fuel prices and on other transmission and electricity network constraints that tend to be region specific. The emission intensity of the displaced generation also varies by region. In total as of the end of 2003, we estimate that this new generating capacity has reduced counterfactual emissions by a total of about 800,000 tons of SO 2. This quantity implies a total cost savings of about $160 million and an allowance price that is about $20, or 10 percent, lower than it would otherwise be.
Allowance Market Developments
A considerable amount of project resources have been devoted to developing a database that would allow a firm-level analysis of allowance trading. Although this work is still incomplete and being continued with internal resources, two findings clearly emerge from the data. First, some novel forms of trading allowances have been developed. Second, the role of intermediaries, brokers, and traders, has been very large in facilitating trades. Concerning novel forms of trading, two in particular can be observed. First, vintage swaps are fairly common whereby the transaction involves no cash but the exchange of allowances of different vintages in which the distant vintages trade at a greater than 1:1 ratio with current or near-term vintages. Second, loans of allowances are observed with repayments in kind at some implicit positive interest rate. This form of trading is especially frequent with intermediary traders who thereby acquire the liquidity that allows them to trade in the market. The role of intermediaries, both brokers, who do not trade on their own account, and traders, who do, has been large from the beginning. Approximately two-thirds of all the allowances transferred through apparently arms-length transactions among economically distinct firms have passed through these intermediaries who evidently play an important role in facilitating buyer and seller matches in this market.
Journal Articles on this Report : 1 Displayed | Download in RIS Format
Other project views: | All 42 publications | 1 publications in selected types | All 1 journal articles |
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Type | Citation | ||
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Liski M, Montero J-P. A note on market power in an emission permits market with banking. Environmental & Resource Economics 2005;31(2):159-173. |
R828630 (Final) |
Exit |
Supplemental Keywords:
SO 2 emissions, acid deposition, tradable permits, emissions trading, cap-and-trade, market-based incentives, environmental property rights, cost effectiveness, Title IV, 1990 Clean Air Act Amendments, acid rain program, allowance banking;, RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, Economics and Business, Ecology and Ecosystems, Market mechanisms, environmental quality, market incentives, policy making, decision making, trading systems, environmental Compliance, emissions trading, abatement technology, tradable pollution permits, Clean Air Act, allowance allocation, pollution allowance trading, public policy, acid rain program, allowance market performanceRelevant Websites:
http://web.mit.edu/ceepr/www ExitProgress and Final Reports:
Original AbstractThe perspectives, information and conclusions conveyed in research project abstracts, progress reports, final reports, journal abstracts and journal publications convey the viewpoints of the principal investigator and may not represent the views and policies of ORD and EPA. Conclusions drawn by the principal investigators have not been reviewed by the Agency.