Grantee Research Project Results

Final Report: Multi-Lateral Emissions Trading: Political Economy and Firm Response

EPA Grant Number: R828631
Title: Multi-Lateral Emissions Trading: Political Economy and Firm Response
Investigators: Farrell, Alexander , Epple, Dennis , Dowlatabadi, Hadi , Farrow, Scott
Institution: Carnegie Mellon University
EPA Project Officer: Chung, Serena
Project Period: September 1, 2000 through August 31, 2002
Project Amount: $149,366
RFA: Market Mechanisms and Incentives for Environmental Management (2000) RFA Text |  Recipients Lists
Research Category: Environmental Justice

Objective:

The objectives of this research project focused on: (1) the political economy of creating an emissions trading regime among multiple jurisdictions, including the role of collaborative scientific assessment processes; (2) the potential for “hotspots”; and (3) the factors affecting the availability of allowances on the market.

Marketable emissions permit mechanisms are increasingly proposed as efficient means of managing environmental pollution problems, including transboundary and global pollutants. Most often, the U.S. Acid Rain Program to control SO 2 emissions from electric power plants is used as an example for such international efforts. The U.S. Acid Rain Program, however, is a domestic effort put in place through the action of a national legislature that has no parallel in international politics. Any international marketable emissions permit scheme will have to be the product of a multilateral agreement among sovereign nations that may have divergent interests and incentives to defect from inconvenient commitments; it will not be the result of an authoritative action by a superior level government and enforceable by a single legal entity. Moreover, countries of the world vary enormously in terms of legal structure, wealth, level of industrialization, scientific capability, and even interest in environmental protection relative to other societal goals. For these reasons, the applicability of lessons from the U.S. Acid Rain Program to potential international emissions trading may be limited.

Better examples for developing insights about multilateral emissions trading can be found in efforts to develop interstate emissions trading in nitrogen oxides (NO x) in the Eastern United States, the Ozone Transport Commission (OTC) NO x Budget, the Ozone Transport Assessment Group (OTAG), and the NO x State Implementation Plan (SIP) Call. These efforts are designed to combat regional smog in the eastern part of the country by significantly reducing emissions of NO x from electric power plants and other large stationary sources. The OTC NO x Budget has resulted in a successful emissions trading system that has been in place for 2 years. The OTAG and the NO x SIP Call failed to yield a state-based multilateral cap-and-trade (C/T) program. (An emissions reduction program that allowed for C/T features eventually was imposed by the U.S. Environmental Protection Agency [EPA].) Both examples involved efforts of somewhat heterogeneous and relatively independent political jurisdictions to negotiate a joint agreement on emissions trading that each implemented through state laws and regulations, although they are still imperfect analogs to international applications.

A notable (perhaps even the principal) advantage of C/T programs is that although they create a permanent limit on total emissions, they provide firms with flexibility in compliance. Concerns have been raised, however, about potential environmental and economic problems associated with this flexibility. One concern is the potential for hot spots. Environmentalists are concerned that C/T systems may allow for localized pollution problems even though the overall cap remains in place. Another concern is the availability of allowances for sale; industry is concerned that there may not be a large enough market in allowances to buy or sell at reasonable prices.

We examined the processes associated with the OTC NO x Budget, the OTAG, and the NO x SIP Call through a variety of approaches, and evaluated the OTC NO x Budget C/T program in detail for 1998-2001. We also examined other emissions trading programs to lesser extents. The issue of heterogeneity among participants in a common property regime was explored using the OTC NO x Budget as an example. Several objectives were added. The health effects of emissions trading programs in general (including emissions reduction credits as well as C/T programs) were reviewed. An article for a new encyclopedia was prepared on the topic of “Clean Air Markets.” Several review articles for the industry trade press also were developed. The EPA funding for this research was leveraged by a grant from the Sloan Foundation and Economic Policy Research Institute through the Carnegie Mellon Electricity Industry Center.

Summary/Accomplishments (Outputs/Outcomes):

Multilateral Emissions Trading

This portion of the research consisted of analyses of the conditions under which multilateral emissions trading is possible. Data for this part of the research consisted of a variety of interviews and literature reviews. The key elements are a common belief among the different jurisdictions that emissions control is needed as well as a formal structure in which coordinated analyses and policy can be developed. Nonetheless, crafting multilateral emissions trading, even in a best-case scenario, is exceedingly difficult; it requires solving difficult institutional, resource allocation, and coordination problems. The prospects for further progress on multilateral emissions trading in the United States may be limited because it is quite rare for a large number of states to have similar enough interests to meet the first necessary condition.

Surprisingly, the prospects may be internationally brighter, as many different countries have come to see regional and global environmental issues as a common threat and many routes for international cooperation on environmental science and policy now exist. The history of international agreements shows quite clearly that effective regimes start slowly in areas as divergent as environmental protection and trade. International trade agreements, arguably the most successful international regime to date, grew and evolved over time, adding new countries and new goods slowly and carefully resolving conflicts between national interests. Developing countries often received special phase-in arrangements and even perpetual opt-outs of the most demanding requirements. It is a powerful agreement, but it took 50 years of hard work.

Our most important conclusion from this part of the research is that there is absolutely no need to assume that comprehensive top-down international emissions control programs that involve significant binding commitments are the only way to develop an effective, efficient emissions reduction strategy. Indeed, such approaches will almost certainly fail because key countries may not agree to participate. A bottom-up strategy may be best if the diplomatic community can work out ways to encourage the growth of local and regional regimes and encourage their coordination so that they ultimately can coalesce into a set of global arrangements that encompass all major states.

The success of the OTC NO x Budget suggests that greenhouse gas emissions trading can be part of such an effort, bringing potentially large-cost savings to some important countries. The failure of OTAG and the NO x SIP Call resulting in a multilateral emissions-trading program, however, indicates the difficulty of creating bottom-up emissions trading. Given the absence of any overarching authority at the international level, it may offer the best hope for international management of air pollution.

Hotspots and Allowance Availability

Qualitative data used in this part of the study were gathered from interviews with participants in the NO x Budget Program, including regulators, managers in regulated firms, and brokers. Quantitative data, such as electric power plant and other plant configuration information, were compiled from several sources, including the U.S. EPA’s E-GRID database, several Environmental Impact Assessment reports, and publicly available material provided by firms with facilities regulated by the NO x Budget. Unit-specific, hourly NO x emissions data for all sources in the OTC NO x Budget for 1998-2001, along with weekly NO x allowance prices, were obtained from several brokers and industry trade publications, especially Air Daily, from 1998 to 2003. Hourly electricity data (demand, generation, imports, and prices) were obtained from the Independent System Operators for the New England, New York, and Pennsylvania-New Jersey-Maryland interconnects. Fuel prices were obtained from RDI and the New York Mercantile Exchange.

Analyses of these data support the idea that temporal variations in NO x emissions occur during the ozone season in the Northeast, with higher than average emissions occurring during ozone episodes. These hotspots, however, are very closely associated with increases in electricity generation, and would likely occur even with rate-based command and control regulation. The statistical analyses showed that although generation is by far the most important driver of NO x emissions in the OTC NO x Budget, the effect of the program is very significant as well.

More importantly, this research discovered no qualitative or statistical evidence for the 2000 ozone season that operators of large power plants respond to fuel or electricity prices by adjusting (in aggregate) plant operation to change NO x emissions. This result is further supported by the comparison of a specific ozone episode with periods similar from an electric generation standpoint. Power plants appear to operate the same during high-ozone periods as they do at other periods of the year.

Policies, both proposed and adopted, for dealing with hotspots in emissions trading systems have tended to introduce uncertainty and inflexibility into the markets. These have (or would have) reduced the efficiency of the market and thus limited the cost savings available, and in the case of RECLAIM, they probably contributed to the significant problems experienced in 2000. Although there is no doubt that emissions trading systems may hypothetically increase the likelihood of hotspots, concern for this problem may be overstated. It may be best to avoid provisions that limit trading or banking and institute a regular system of review that would impose such limits if the potential for such a problem arose. These policies should be prospective, not retrospective, to minimize the uncertainty they introduce into the market.

Nonetheless, although this research has turned up no evidence that emissions trading enhances any tendency towards greater temporal hotspots, it is undeniable that the flexibility built into such systems, plus the mismatch between the phenomenon of concern and the regulatory period, makes such a problem possible. Furthermore, this study has some limitations. Most important is that the OTC NO x market is relatively small and illiquid, which limited the opportunity for firms to vary plant operation to optimize revenues associated with NO x controls and allowance purchases. This effect likely is accentuated by the fact that only the first 3 years of the program are evaluated. For the first year, at least, there was very little familiarity with the program and no bank of allowances saved up. The relatively low prices for NO x allowances (compared to the prices for power) also may be a factor; things may change as the cap decreases and allowance prices rise.

This research suggests a number of areas for further research. First, continue to look for temporal hotspot problems in C/T systems as the caps become tighter. Second, conduct more detailed and disaggregated analyses of plant dispatch and utilization to verify the underlying causes of the residuals in the regressions performed for this part of the research. Third, analyses of the NO x Budget Program for spatial hotspots clearly are needed. Finally, air quality modeling may be needed to determine if any spatial and temporal differences in emissions caused by the OTC NO x Budget have a significant effect on pollution concentrations or on health.

Emissions Trading and Health

Virtually all of the current experience with emissions trading is found in air pollution policy in the United States. Therefore, this portion of the research reviewed and synthesized the published literature on U.S. air pollution and human health effects, as well as on emissions trading in the United States.

Epidemiological studies associate a wide range of health effects with air pollution, including increased mortality, respiratory disease, reduced lung function in children, and increased hospital admissions and emergency room visits. Studies examine the association of health effects with air pollution across different areas or day-to-day changes in health and pollution levels within a particular population. In addition to these pollutants, toxicants such as mercury and persistent organic compounds have emerged as important health concerns. These materials can travel long distances, often moving towards the poles by natural distillation processes. Because air pollution levels, however, are much lower than they were during the famous episodes that resulted in numerous deaths, there is uncertainty as to which pollutant is the culprit, making it difficult to specify a cost-effective abatement policy.

The EPA conducted estimates of the annual health effects avoided by the 1970 Clean Air Act (CAA), providing an indication of the command and control (CAC) approach up to that point. In their retrospective benefit-cost analyses, the EPA found that lead emissions fell 99 percent; NO x emissions fell by about 20 percent, with the other pollutant emissions in between. The total benefits of the CAA were estimated to be $22.2 trillion, with an uncertainty range from $5.6 to $49.4 trillion and the estimated cost of control $0.5 trillion, or 1/40th the cost. These benefits are underestimated because the study did not consider the health effects of air toxics, or numerous health effects that could not be quantified such as ecosystem damage, reduced agricultural yield, or damage to building materials.

Emissions trading emerged in the United States in the mid-1970s as centralized CAC regulation of air pollution proved to have severe limitations, and it now plays a major role in improving air quality, and thus human health. Since then, well-designed emissions trading programs have provided regulated firms with flexibility, while protecting the environment and important social values, such as fairness. Examples include the netting, bubbling, and banking of criteria pollutants, the phase out of lead from gasoline, the elimination of some ozone depleting substances, the control of acid rain, and the management of regional photochemical smog. So far, with a few minor exceptions, harmful local effects (e.g., hotspots) have not been found, the banking of allowances has not caused any significant health impacts, and no environmental justice problems have been identified. The exceptions are parts of the RECLAIM program in California (specifically mobile source emissions reduction credits) and Open Market Trading, such as New Jersey’s failed program.

This experience shows that emissions trading programs have lowered costs, often by 20 to 50 percent, and have allowed for political negotiations about environmental policy to proceed more quickly and often to more stringent (and thus more healthful) outcomes. Emissions trading programs, however, are not really about “free markets”; they typically require unequivocal, detailed rules that have to be defined carefully to ensure that both the resulting market is viable and that the desired environmental outcomes are obtained, which includes ensuring that no local population faces a decrease (or inappropriately small improvement) in air quality. An important part of such rules is that overall pollution reduction is required, although individual firms retain flexibility in deciding how to participate in the reduction.

Environmental regulators and organizations have been important in the creation, promotion, and review of emissions trading programs, and have stopped most of the poorly designed proposals. Some organizations and individuals, however, see emissions trading as unethical, despite the pragmatic advantages and despite the fact that CAC regulation has many of the same problematic features. These concerns appear to have little effect on the use of emissions trading thus far.

Journal Articles on this Report : 3 Displayed | Download in RIS Format

Publications Views

Other project views:	All 9 publications	7 publications in selected types	All 3 journal articles

Publications

Type	Citation	Project	Document Sources
Journal Article	Farrell AE, Lave LB. Emission trading and public health. Annual Review of Public Health 2004;25(April):119-138.	R828631 (Final)	Abstract: Annual Review of Public Health Abstract Exit
Journal Article	Farrell A. Multi-lateral emissions trading: lessons from inter-state NOx control in the United States. Energy Policy 2001;29(13):1061-1072.	R828631 (Final)	Full-text: Science Direct HTML Exit Abstract: Science Direct Abstract Exit Other: Science Direct PDF Exit
Journal Article	Farrell A. Emission trading-current status and future prospects. Natural Gas Industry Journal 2001;18(5):1-8.	R828631 (Final)	not available

Supplemental Keywords:

social science, electric power industry, air pollution, chemistry, ecology, market mechanisms, tropospheric ozone, allowance allocation, cost benefit, cost effective, econometrics, electricity generation plants, emissions trading, environmental compliance, environmental economics, fuel prices, pollution reduction, socioeconomics., RFA, Scientific Discipline, Economic, Social, & Behavioral Science Research Program, Air, Ecology, Chemistry, tropospheric ozone, Market mechanisms, Social Science, electricity generation plants, troposheric ozone, socioeconomics, cost benefit, fuel prices, environmental Compliance, pollution reduction, emissions trading, cost effective, allowance allocation, environmental economics

Relevant Websites:

http://www.cmu.edu/electricity Exit

http://www.eia.doe.gov/fuelelectric.html Exit

http://www.emissions.org/ Exit

http://www.energyargus.com/ Exit

http://www.nyiso.com/ Exit

http://www.pjm.com/ Exit

Progress and Final Reports:

Original Abstract

2001