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Evaluation of Phase II Compliance with Title IV of the 1990 Clean Air Act Amendments

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Description
This research will conduct a detailed, ex-post evaluation of abatement responses and allowance market performance through the first few years of the Phase II under Title IV of the 1990 Clean Air Act Amendments, better known as the U.S. acid rain program. Particular emphasis will be placed on ascertaining abatement costs, determining the cost savings when compared to plausible "command and control" alternatives, and, more generally, analyzing the extent to which agents respond rationally to market incentives that reflect environmental goals. This grant extends the investigators' earlier research on Phase I of the acid rain program (Markets for Clean Air: the U.S. Acid Rain Program).

Objectives/Hypothesis:
Numerous studies have asserted that market mechanisms and incentives are superior to non-market alternatives, yet few empirical studies exist to verify this theoretical finding, in part because market mechanisms have been so little used. SO2 emissions trading now provides an unparalleled opportunity to test this finding. Accordingly, the objective of the research conducted under this grant will be to gauge the extent to which the relatively unfettered use of market mechanisms has met these theoretical expectations and more generally to understand how firms react when relatively well-defined property rights to the use of the environment are made available to them.

Approach:
The research plan consists of three main components. The first is a survey of operators of Phase II affected electric generating units concerning abatement cost, compliance strategies, and reliance on market mechanisms in 2000, the first year of Phase II. The second is the econometric estimation of how much Title IV has actually reduced emissions, given electricity generation in 2000 and ongoing trends in generation, fuel use, and SO2 emissions. The third element integrates this information on the cost and quantity of abatement with readily available emissions and allowance data to analyze how firms have responded to the market-based incentives in Title IV. Due attention will be given in this final integrating task to upstream responses by fuel suppliers.

Expected Results:
As was the case with the Phase I research by these investigators, this project will result in a number of publications, first as working papers by MIT's Center for Energy and Environmental Policy Research, and later as articles primarily but not exclusively in peer-reviewed academic journals. In addition, all of the investigators frequently speak and make presentations on emissions trading to a wide variety of audiences, and they will continue to do so using the results of this research. We expect that the end result of the research funded by this grant and of efforts to disseminate these research findings will be a better understanding on the part of policy-makers, regulators, researchers, and other interested parties of the potential for market mechanisms and incentives in managing environmental problems. This will lead to a more cost-effective allocation of federal and state environmental protection resources and an improved understanding of the cost of abatement in evaluating actions to address health risks and other environmental concerns.
Supplemental Key Words: air emissions, acid deposition, tradable permits, cap and trade systems, environmental property rights, cost effectivenes

Metadata

EPA/NSF ID:
R828630
Principal Investigators:
Ellerman, A. Denny
Joskow, Paul L.
Schmalensee, Richard
Montero, Juan Pablo
Technical Liaison:
Research Organization:
Massachusetts Institute of Technology
Funding Agency/Program:
EPA/ORD/Incentives
Grant Year:
2000
Project Period:
October 1, 2000 to March 31, 2003
Cost to Funding Agency:
$289,477
Project Status Reports:
For the Year 2001

Objective:
The principal achievements during this first year of the grant are: (1) completion of a firm-level database integrating allowance transactions and abatement behavior; (2) analysis of the year 2000 compliance data; and (3) development of a model to analyze allowance banking behavior under Title IV. These achievements support the overall purpose of the research under this grant, which is "to provide a detailed, ex post evaluation of the abatement responses of emissions sources covered by Phase II and of the further development of the emissions permit markets."

Three specific tasks are to be performed as outlined in the original proposal and later modified by the memorandum to the Environmental Protection Agency (EPA) dated August 1, 2000: (1) a survey of costs and market behavior; (2) a re-estimation of counterfactual emissions; and (3) integration of emissions and allowance data. The work conducted this year falls under the third of these tasks. The cost survey has been delayed until the second year and the estimation of counterfactual emissions will be undertaken after 2001 data are available.

Progress Summary:

Overall, research under the grant is on schedule. The integrated database that will allow a more micro-level analysis of compliance behavior was debugged and now is being used for analysis; the larger amount of data concerning emissions and compliance data in 2000 has been successfully incorporated into our ongoing analysis. Several presentations concerning these data have been made, and papers are in varying stages of completion. Most of the research conducted during this first year concerned two topics: 2000 compliance and banking behavior. Several important points have emerged out of the analysis of the year 2000 data:


    1. Prices, not allowance allocations in individual years, have the greatest effect on abatement.
    The year 2000 is the sixth year under Title IV. The significant reduction in allowances for Phase I units had relatively little impact on emissions. This would be predicted by economic theory on the assumption that the cumulative allocation of allowances over the banking period determines prices and abatement, not the allocation in any particular year. Units first becoming subject to Title IV in 2000 undertook a significant reduction in emissions, as did the Phase I units in 1995.

    2. Not receiving an allowance endowment does not appear to impede the entry of new units.
    About 12 percent of the units first subject to Title IV in 2000 did not receive an allocation of allowances. These units were located in 36 of the 48 states and they included both coal and natural gas fired units. This suggests that failing to receive an initial endowment does not create a barrier to entry.

    3. Emission reductions under Title IV are located in the Midwestern region, which is the source of acid rain precursor emissions transported to the Northeast.
    With fossil-fired generating units subject to Title IV for the first time in 2000, a complete picture of the geographical distribution of emission reductions under Title IV can be made. In 11 Midwestern and Southeastern states, 83 percent total emission reduction occurred. This includes all eight Midwestern states that are the main source of acid rain precursor emissions in the Northeast.


Surprisingly, our analysis of banking indicates that utilities have engaged in optimal behavior. This conclusion challenges conventional wisdom (including some of our own) to the effect that too much banking has occurred in Title IV. This conclusion depends on the appropriate discount rate to be applied to banked allowances. Our research finds no correlation between the returns from holding allowances and those from investing in a broad index of stocks. Lack of correlation implies that all risk associated with allowances is specific to this asset, and therefore capable of being diversified, and that the appropriate discount rate for holding allowances is the risk-free rate.

These results are significant in providing further support for the view that participants respond rationally to the incentives provided by tradable permits, and market-based mechanisms are effective in achieving environmental goals at least cost.

Future Activities: The main focus during 2002 will be the writing and publication of four papers. The analysis of aggregate banking behavior, which was largely conducted in 2001, will provide the material for a first paper assessing the optimality of banking under Title IV. The now operational firm-level, integrated database will provide the research basis for two further papers that are being started as of the time of this report. One concerns the effect of ownership changes, such as from regulated to unregulated status, on emissions abatement and the use of allowances; the other explores patterns of trading and allowance use at the firm level. The fourth paper concerns the costs of further SO2 emission abatement and the relative roles of scrubbing and natural gas.

During this year, the survey will be designed and sent out and the 2001 data will be incorporated into databases and our analysis. We expect to begin the counterfactual estimation by the end of the second year and to start another paper describing compliance in the first 2 years of Phase II.

Supplemental Keywords: air emissions, acid deposition, tradable permits, cap systems, trade systems, environmental property rights, cost effectiveness.

Project Reports:

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