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Significant obstacles stand in the way of achieving cost savings that should accrue to market-based emissions trading policies.
Fortnightly Magazine - June 15 2003

Significant obstacles stand in the way of achieving cost savings that should accrue to market-based emissions trading policies.

Should the U.S. emissions allowance market grow from the current level of $2.5 billion to $20 billion, this would suggest that the United States was successfully reducing emissions of SO 2, NO X, mercury, and CO 2 at a substantial savings (see sidebar, p. 36). However, there are a number of major challenges confronting the U.S. Environmental Protection Agency (EPA) and market participants that must be successfully managed before the full measure of cost savings can be realized.

The most immediate challenge for maximizing the cost savings from emissions trading is the financial crisis gripping the energy industry. As a result of the Enron debacle and related fallout, many energy companies have ceased to engage in speculative trading. According to a recent article in the Wall Street Journal, Aquila, CMS, Dynegy, El Paso, Reliant, and Williams have exited the power and gas trading market, and presumably have reduced their speculative trading in emissions markets. 1 Thus, the financial crisis has led to a less liquid and more volatile emissions allowance market. As a result, inter-company emissions trading declined by about 40 percent in 2002, and remained about 40 percent below 2001 levels in the first three months of 2003. 2

A second challenge facing the emissions trading markets is that progress toward electric market restructuring has ground to a halt. To date, more than 20 states have adopted retail restructuring legislation. However, the Enron debacle and the California electric market crisis have stopped electric market restructuring in its tracks. In fact, in states like California and Virginia, efforts are under way to put the deregulation genie back into the bottle. At the federal level, opposition from low-cost northwestern and southeastern states has essentially derailed the Federal Energy Regulatory Commission (FERC) proposal on standard market design. In addition, the energy bills currently working their way through Congress do not contain language mandating national electric market restructuring.

This collapse of momentum toward electric market restructuring affects emissions trading markets in two ways. First, it increases the risk that the fear of deregulation and market-based approaches will spread to emissions trading. One indicator of this risk is that the RECLAIM emissions trading market in the South Coast Air Quality Management District has been identified as one of the contributors to the rapid run-up in prices in California. Secondly, it is more difficult to achieve the full efficiency gains of a market-based approach to emissions trading in regulated electric markets as they are currently regulated.

As a result of the collapse in electric market restructuring, market-based emissions trading programs must try to function within a patchwork quilt, with some states operating under traditional cost-of-service regulation and some states operating in a restructured competitive retail market. In many states, cost-of-service regulation biases utilities towards capital-intensive compliance strategies while discouraging the use of emissions trading.

Douglas Bohi and Dallas Burtraw at Resources for the Future have addressed the bias toward capital-intensive strategies resulting from cost-of-service regulation during Phase