[BETA] Fortnightly

In his article, "Why Taxes Don't Distort Emissions Trading" (Dec. 1, 1994, p. 37), Michael Thomas suggests that utilities should flow through the proceeds of emission allowance sales to ratepayers in the year of sale. His idea is that utilities can eliminate any net effect on current income taxes by matching the increased revenue (emissions sales proceeds) against a revenue decrease (lower rates charged to customers). Slam dunk. End of story. Unfortunately, it's not so simple. The Thomas "wash" theory disregards ratemaking realities and the legislative intent of the Clean Air Act Amendments of 1990 (CAAA). It ignores the practicalities of allowance trading and fails to take account of the corrective tax legislation proposed by Allegheny Power System and the Chicago Board of Trade, and endorsed last year by the National Association of Regulatory Utility Commissioners.

The truth is that the federal tax system seriously interferes with the intended operation of the emission allowance market.

The CAAA created a unique system of transferable sulfur dioxide (SO2) "emission allowances." The legislative history shows clearly that Congress designed these allowances to facilitate over- and undercontrol strategies at those electric generating units forced to begin curtailing their SO2 emissions on January 1, 1995, (Phase 1) and January 1, 2000 (Phase 2). Some generating facilities can curtail their SO2 emissions much more economically than others, whether by fuel-switching, scrubbing, or otherwise. That premise found support in the many economic studies circulated in the Congress during the legislative debate. At those plants where emissions can be more economically curtailed, the theory was that owners could "overcontrol" emissions and sell their extra allowances to plants that found emissions reductions more expensive. The economic benefit presumably would be shared equitably between the two owners. As the CAAA worked its way through Congress, proponents of this market-based approach predicted dramatic savings from interutility transfers. None of the economic studies that flooded Congress at the time showed any income tax effect whatsoever; yet most of the hypothetical "trades" they projected would be negated by the huge tax bite now facing prospective sellers.

Emission allowances carry a vintage by year of first permissible use, but are otherwise basically equal in the hands of their owners. They originate from two principal sources. The so-called "Table A" allowances issue from the government to the owners of the 110 units listed in Table A of the CAAA. The other 3.5 million "extension and bonus allowances" go only to those plants that install "qualifying technology" (em that is, scrubbers. In both cases, the Internal Revenue Service (IRS) assigns a zero tax basis to the allowances in the hands of the original owners. Hence, all sale proceeds are fully taxable and subject to a substantial capital gains tax. Internal uses, including stockpiling of emissions allowances, do not trigger taxation. This fact favors internal use.

Some authors, and certainly the IRS, have likened the Table A allowances to a gift or grant by the government. Unfortunately, this perception has obscured the actual effect of the CAAA.

Prior to the start of Phase 1 on January 1, 1995, owners