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Capping Emissions: How Low Should We Go?

Investigating where environmental efficiency and good public policy intersect.
Fortnightly Magazine - December 2002

finding that the NO x and SO 2 caps for all of the legislative proposals appear justified when comparing benefits and costs.

Further, it is important to stress that there are qualitative differences between the efficient policy that we model and the current proposals, and among the proposals as well. These qualitative differences have important implications for the efficiency of the policy, and the distribution of benefits and costs. For example, the bills differ in their treatment of technology-based standards in the Clean Air Act known as new source review (NSR). By requiring certain pollution control equipment on new facilities and old facilities that receive substantial investment, NSR creates a perverse incentive to maintain older, dirtier power plants. The Jeffords bill eventually would eliminate this distinction by requiring that, when they are 40 years old, all existing plants must come into compliance with new source performance standards. However, this would not reduce aggregate pollution (which is already set by the cap), but instead merely reduce the efficiency gains from permit trading. Over time, this technology-based standard may even become more binding than the emissions caps, effectively eliminating the trading program. In contrast, the Clear Skies proposal has been linked to a phase-out of the technology-based standards already present in NSR. The Carper bill also would weaken NSR, and would repeal emission offset requirements for new electricity generators in non-attainment areas.

Another area where the bills differ substantially is in their approaches to allocating emission allowances. Under the Jeffords bill, over 60 percent of the allowances are allocated to households in the first year, effectively giving them the proceeds of an allowance auction, with this fraction eventually growing to nearly 100 percent. In contrast, the Clear Skies proposal allocates the vast majority of the allowances to existing firms, and gradually phases in an auction of allowances over 50 years. The Carper bill continues the approach used in allocating allowances in Title IV for SO 2, but it adopts an output-based allocation approach for NO x, mercury, and CO 2. Under this approach, allowances are allocated to generators based on their share of total generation from covered facilities in recent years, thereby providing an incentive for low or non-emitting facilities to increase their generation.

As noted previously, our model allocates permits through an auction. This allocation is substantially more cost-effective from a societal perspective than grandfathering or an output-based approach. However, allocation of allowances does have important distributional consequences. In past research with carbon allowances, we found that virtually all existing firms prefer the grandfathering approach to the other two approaches, while consumers feel the opposite. However, existing firms prefer the auction, in turn, to output-based allocations, as it generally does a better job of preserving their asset values. As noted previously, a compromise approach of grandfathering a fraction of the allowances would be sufficient to protect the valuation of existing firms.

Finally, our analysis suggested that a national cap-and-trade program for both NO x and SO 2 might be more efficient if it differentiated emissions according to where they originate.