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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

I of the SO 2 allowance trading program. 3 They concluded that many states had implemented cost-of-service regulations that favored scrubbing and fuel switching over emissions trading. The bias towards capital-intensive compliance strategies exists in regulated states because power companies are guaranteed a rate of return on prudent capital investments. Bohi and Burtraw observed that at the same time that cost-of-service regulation biased compliance strategies toward capital-intensive solutions, these same regulations discouraged reliance on emissions trading to achieve compliance. For example, in some states, regulations removed the upside potential from trading excess allowances at prices higher than the cost of acquisition, because the revenue gain from such a trade was treated as a reduction in cost-of-service. In addition, in some states buying or selling allowances could have led to a prudence audit if and when allowance prices subsequently moved in an adverse direction relative to the earlier trade. Furthermore, power companies in some states had disincentives to locking in allowances ahead of time because they may not have been able to pass on costs, as they could with fuel costs, until the acquired allowances were actually used. Bohi and Burtraw reported that all of the generating units that installed scrubbers during Phase I of the SO 2 program were located in states with a regulatory bias towards capital-intensive compliance strategies.

Today, some states have improved their treatment of allowance trading. For example, some allow power companies to retain a portion of the profits from trading. However, the inherent bias in cost-of-service regulation toward capital-intensive compliance strategies remains. In a time when there is a glut of generation capacity in many power markets and much of the new generation capacity is owned by others, one of the largest components of capital investment, and therefore profit, is capital expenditures on pollution control equipment.

Over the past several years, ICF Consulting has discussed compliance strategies for the NO X SIP Call regulations with many companies in the eastern United States. We recommend developing a balanced compliance strategy that minimizes impacts on near-term earnings and stock price, while preserving flexibility to respond to the uncertainties associated with the outcome of the current multi-pollutant debate. Our approach to developing a NO X strategy examines the full range of compliance options including the following:

  • Lower capital cost, and less effective pollution control equipment, such as selective non-catalytic reduction;
  • Constructing clean hedges by placing allowance market put and/or call options to manage the risk associated with pursuing a lower capital cost strategy;
  • Constructing dirty hedges by taking positions in the electric and fuel markets to balance a company's allowance market exposure.

We have found that there is a very different response to our recommended balanced approach to compliance strategy in regulated versus deregulated states. While there are notable exceptions, in general, power companies in regulated states have taken a more narrow pollution-control approach to achieving compliance, with little or no consideration given to using allowance market options, or gas and power market hedges. We have found a similar capital-intensive bias in some power companies in deregulated states where the