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United States Experience with Economic Incentives for Pollution Control

Crocker and Dales generally are credited with first proposing that marketable emission permits be used as an incentive mechanism for achieving environmental goals. The basic approach outlined by Crocker and Dales and later refined by Dewees and Harrison is that the environmental authority can issue a fixed number of marketable permits to release emissions. Through trading, low-cost sources will sell some of their permits and abate more than they would under a traditional regulatory approach, while high-cost sources will buy permits and abate less. The end result, according to the academic design, is the same amount of pollution reduction that would be achieved through traditional regulatory approaches, but it is achieved at lower cost.

EPA first applied the concept of marketable emission permits in the mid-1970s as a means for new sources of emissions to locate in non-attainment areas without causing air quality to worsen. New sources and existing sources that wanted to expand their facilities were required to offset their emissions by acquiring emission reduction credits from existing sources. This important but modest beginning was based on an interpretation of the Clean Air Act, rather than on a specific statutory authority. EPA’s Offset Policy was included in the 1977 amendments to the Clean Air Act statute. In 1980, then-Administrator Hawkins signed a memo that allowed emission averaging between can-coating lines.[ 45 FR 80824. Dec. 8, 1980]

On August 7, 1980, EPA promulgated New Source Review (NSR) and Prevention of Significant Deterioration (PSD) rules that allowed netting, a means for sources to avoid PSD and NSR requirements for emission increases due to facility expansion, if emissions were decreased contemporaneously elsewhere at the facility. (45 FR 52676). Under the PSD mandate, this rule included facilities within a plant as a source of emissions as well as an entire plant as a source of emissions, in what was termed a “dual-source definition.” Chevron and others challenged this rule, claiming it made modernization too difficult. Eventually the U.S. Supreme Court agreed that states did not need to include the dual-source definition in their non-attainment rules. This opened the door to many of the emission trading programs that exist today.

The 1990 Clean Air Act Amendments authorized a variety of emission trading systems. While similar statutory authority to establish effluent permit trading systems does not exist, EPA believes that the Clean Water Act allows effluent trading. Programs of this sort have been operational for several years without legal controversy. Pollution permit trading systems now come in a wide variety of forms, and they apply to a large and growing number of sources of pollution that affect the quality of air, water, and land.

Insofar as trading between economic entities is concerned, two main forms of trading systems are observed: (1) uncapped emission (or effluent) reductions credit (ERC) systems, and (2) capped allowance systems (also referred to as cap-and-trade systems). In the case of uncapped systems, pollution limits are rate-based (e.g., grams per mile for motor vehicles), and sources earn credits by releasing less pollution than their legal limit or other defined baseline. Under these systems, emissions can increase with economic growth. By contrast, with capped systems, total emissions are limited by an overall ceiling that is designed to achieve health or environmental goals, and allowances are allocated to sources in quantities consistent with this ceiling. The formula for making such allocations will vary from one situation to the next.

A number of the programs described in this chapter involve the right to average emission characteristics of a slate of similar products that are manufactured by one economic entity. Emission averaging is an important mechanism for improving the cost effectiveness of environmental regulation. It can be characterized as intra-firm trading across the product lines where it is allowed.

Trading systems, properly designed and applied in appropriate circumstances, can cut compliance costs, encourage technological development, and create incentives for achieving environmental benefits beyond minimum requirements. For trading systems to function well, a number of requirements must be satisfied. There should be several potential participants in trades if a functioning market is to be created. Exactly how small a universe of potential participants there can be and still have a functioning market is difficult to say, but simulation experiments suggest that 8-10 participants is a reasonable estimate. (Hahn and Noll. 1982). If sources are dispersed geographically, trading ratios other than one-to-one might have to be imposed to account for wind direction or the distance between sources to ensure no degradation in environmental quality.

Some pollutants are seasonal in their impact, implying that trades might be allowed only during a portion of the year. Trading might be limited because of a desire to avoid “hot spots” where pollution concentrations increase. Trading requires that pollution control agencies have the ability to monitor emissions (or measure a surrogate to those emissions) reasonably well. The need to ensure accountability of trades must not pose unacceptably high transaction costs. The commodity to be traded needs to be defined. In general, a well-defined commodity requires a baseline from which to calculate the emission reduction credits (or allowances) that may be traded. Establishing baselines is likely to require good historic data on emissions, input use, etc. In the case of allowance systems, the political will must exist to achieve an allocation of allowances among competing interests.

Cap-and-trade systems to date have allocated most or all of the allowable emissions under the cap to existing sources, providing allowance set-asides for new sources or using auctions as a safeguard to ensure access to allowances. Initially, environmentalists opposed marketable permit trading because the existence of trading was evidence that sources could make greater reductions in pollution than were being achieved. In addition, there has been a lingering concern that trading could result in localized “hot spots” that had undesirably high levels of pollution. With the success of the Regional Clean Air Incentives Market (RECLAIM) and the Acid Rain Program described later in this chapter, marketable permit trading has become more accepted as a cost-effective means of achieving many environmental goals.

On the other hand, attempts to establish new trading programs often encounter controversy. For example, some citizen groups have opposed trading programs for ozone-forming volatile organic compounds (VOCs). They based their opposition on two basic concerns: (1) the possibility of localized toxic pollution “hot spots,” or (2) the ability of the source (or EPA for that matter) to reliably measure emissions to ensure that participants would be held accountable. EPA, in consultation with environmental justice groups and other stakeholders, is working on guidance for addressing these environmental justice concerns with trading.

The scope of trading systems is considerable. An emission trading proposal is a centerpiece of the Kyoto Protocol for controlling greenhouse gas emissions. Certain Colorado communities have created programs to trade the right to own and operate a wood burning stove or fireplace. For a number of years, there was an active program under which refiners could trade lead that was used as an additive in gasoline. Heavy-duty truck manufacturers can meet engine emission standards by averaging together the emissions performance of all the engines they produce. Programs to trade effluents are operating in selected locations. These particular programs are likely to be expanded significantly in coming years as a result of a new EPA initiative to improve water quality in polluted rivers and lakes. Developers whose activities would cause the loss of wetlands can satisfy mitigation requirements in some areas by purchasing credits from a wetland mitigation bank.

These and other trading systems for air, water, and land are described in this chapter. The discussion begins with a review of trading programs in air emissions, followed by sections on water effluent trading, land development, and, finally, international trading programs in which the United States is involved.

A few basic parameters may be used to characterize trading systems:

1. Scope. Is trading restricted to averaging within a single facility, allowed among facilities owned by the same firm, or allowed among firms or facilities under different ownership?

2. Cap. Is there a limit on total emissions or on effluents?

3. Commodity Being Traded. How will the commodity be defined: As allowances for future pollution, as credits for quantifiable reductions in pollution, as emission characteristics of products, as rights to own and operate products themselves, or as some other definition?

4. Distribution of Tradable Permits. Are the tradable certificates auctioned to the highest bidder, or are they grandfathered to existing sources?

5. Trading Ratio. Is the required trading ratio 1:1 or some greater ratio? Does the trading ratio depend on the respective location of the sources, season of the year, or other factors?

6. Banking. Can tradable certificates be banked or otherwise reserved for future use?

7. Monitoring. How is credit generation and trading monitored?

8. Environmental Benefit. Is a “set-aside” for the benefit of the environment built into the trading system? For example, each trade could be debited by 10% to yield an environmental benefit.

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