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 SO2, NOX, mercury, and CO2 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 I of the SO2 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 SO2 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 NOX 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 NOX 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 old regulated mentality lingers.
In contrast, we have found our focus on minimizing near-term earnings impacts resonates well with many power companies in deregulated states. This has become increasingly true as the financial crisis has deepened. In the current market, the cost of borrowing for heavily leveraged companies to finance pollution control investments has become prohibitively expensive.
A further challenge to achieving the cost savings from emissions trading comes from the ongoing balkanization of the emissions trading markets resulting from individual states implementing their own restrictive emissions trading regulations. Emissions trading yields the most cost savings in large markets with a diverse population of affected units. But nine states have implemented their own multi-pollutant regulations, and other states are moving in the same direction, thus subdividing the large national and regional emission allowance markets that exist today-and as proposed in all of the multi-pollutant bills in Congress-into much smaller markets. Indeed, in some states like New York, the emissions regulations place restrictions on trading allowances to downwind states, or require importing two or three allowances to gain one ton of credit within the state. These state-based emission markets limit the cost savings that can accrue to larger regional and national markets.
In conclusion, the United States is at a critical juncture in terms of air emissions regulations. New multi-pollutant legislation has been proposed that could deliver a comprehensive, integrated, low-cost solution to the major air pollution problems facing the country. These proposals rely on emissions trading to achieve these air quality goals in a cost-effective efficient manner. However, there are several obstacles standing in the way of obtaining these emissions trading benefits.
Chief among these obstacles is the continued regulation of the power markets that favors capital-intensive air compliant strategies. There is a critical need for leadership from Washington to finalize national multi-pollutant legislation and prevent further balkanization of emissions markets, and for national electric market legislation that ensures that the cost savings from emissions trading.
- Wall Street Journal, May 1, 2003, p. A14.
- Environmental Data Services, Allowanceresource.com.
- Douglas R. Bohi, and Dallas Burtraw, "SO2 Allowance Trading: How Experience and Expectations Measure Up," Resources for the Future, Discussion Paper 92-24, February, 1997.
Market-Based Pollution Regulation: A History
The EPA has relied on market-based approaches for achieving environmental objectives, dating back to the phase-out of leaded gasoline in the 1970s. The rationale for relying on market-based approaches for regulating pollution is that they will harness the efficiency of the market place to reduce the overall costs of achieving air quality goals. The first national foray into market-based air emission approaches was the SO2 emissions cap and trade program, which was first established by the Clean Air Act Amendments of 1990. Resources for the Future has estimated that this market-based SO2 allowance trading program has lowered the costs of addressing the U.S. acid rain problem by 43 percent relative to an enlightened command and control approach.1 The EPA has also worked with states in the eastern United States to create the NOx SIP Call program, which began in May of this year.
As illustrated in Figure 1, allowance markets have a huge potential for growth. The current SO2 and NOX allowance markets have a value conservatively estimated at $2.5 billion.2 The Bush administration has proposed multi-pollutant legislation, the Clear Skies Act, which would further reduce SO2 emissions, expand the current NOX emissions regulation from an eastern regional summer-only trading regime into a national annual program, and for the first time introduce an emissions trading program for mercury emissions from electric generation sources. Should Clear Skies be enacted, the emissions trading program in the United States would expand to a $10 billion dollar market.
A competing multi-pollutant proposal in Congress, sponsored by Sens. Thomas Carper, D-Del., Lincoln Chafee, R-R.I., John Breaux, D-La., and Max Baucas, D-Mont., would add carbon dioxide as a fourth emittant from power generation to be regulated. The Carper bill calls for a reduction in carbon dioxide emissions from electric generation sources down to 2001 levels by 2013. This is less stringent than the economy-wide reduction called for in the Kyoto Protocol, which would have reduced carbon dioxide emissions to 1990 levels by 2008, and the reductions called for in competing legislation sponsored by Sens. John McCain, R-Ariz., and Joe Lieberman, D-Conn. A market-based carbon dioxide emissions cap and trade program such as that called for in the Carper bill could further expand the total emissions market in the United States by an additional $10 billion. -J.B.
- Curtis Carlson, Dallas Burtraw, Maureen Crooper, and Karen Palmer, "Sulfur Dioxide Control by Electric Utilities: What Are the Gains From Trade," Resources for the Future, Discussion Paper 98-44-REV, April 2000.
- The market values provided in this article are conservative estimates based on the assumptions that inter-company trading will be approximately equal to the total emissions cap and current market prices. These estimates are conservative because, while the volume of inter-company trades reported to the EPA was approximately equal to the total emissions cap in 2002, it was nearly double the cap level in earlier years. In addition, these total volume estimates do not include options transactions, which would increase the size of the market.
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