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The Cost of Reducing SO2 (It?s Higher Than You Think)

Fortnightly Magazine - May 15 1998

fairly closely the actual costs of Phase I when actual compliance actions are applied. At the same time, the model suggests that $0.2 billion to $0.3 billion per year of the actual costs in Phase I could be avoided (while still meeting the actual 1995 emissions levels) by further optimizing fuel choices. If so, this work suggests that possibly as much as 25 percent of the actual Phase I costs already incurred may not be permanently fixed, leaving room for some further downward revisions in the updated cost estimates discussed above. Although their work is still in progress, RFF researchers offer their own "best judgment" of $1.3 to $1.4 billion per year for total costs of Title IV SO2 reductions.

Current Allowance Prices:

Depressed by Excess Capacity

In contrast to control measure costs, allowance prices have proved much lower than expected. In a well-functioning market, allowance prices would roughly coincide with long-run marginal costs. Yet, while marginal costs for Phase I sometimes exceeded $500 per ton, allowance prices have remained around $100 per ton. How can these lower-than-anticipated allowance prices be explained?

One possible answer is unintended overinvestment in compliance. This resulted from the challenge that individual companies faced prior to Phase I in estimating full-market control costs in conditions of uncertainty to devise their control strategies, cognizant of both immediate and coming requirements.

For example, if participants overestimate marginal costs, they may invest too heavily in control measures, creating more allowances for sale than are needed to achieve the cap in any given year. Allowance prices fall. Moreover, because SO2 control measures exhibit a large degree of "irreversibility," such excess supply conditions can well persist. Thus, one benchmark for how low allowance prices might fall before companies stop creating more of them lies in the short-run cost of running a scrubber. That cost reflects daily operating costs, such as reagent, power consumption and labor, but not those associated with recovering capital investment. In fact, for many potential sellers of allowances, the cost of continuing to generate excess allowances is zero.

Consider companies that achieved compliance earlier than Phase I because of increasingly lower costs of delivering western low-sulfur coal to mid-western power plants (due to falling rail rates), or because of the need to comply with more stringent state regulations. For these sellers, the price question is not what the allowances cost, but what they are worth to others, or to themselves for future internal use.

In 1995, it became apparent that overcompliance had been substantial: emissions of the 445 units affected by Phase I of Title IV totaled only 5.3 million tons of SO2 relative to a cap in 1995 of 8.7 million tons. %n8%n The actual amount of banking, 3.4 million tons, exceeded earlier estimates by as much as 1.5 million tons. (The number will decline by about 1 million tons in 1997 due to the drop in bonus allowances awarded for the first two years of scrubbing.) The fact that the excess allowances could be saved for a future day when the cap will be more binding is