Q.      Do you have any opening comments?

A.      Yes, first I would like to thank the Committee for inviting me to come and share my comments and insights regarding the usefulness of market based environmental trading systems. Over the course of my career I have been involved in environmental regulation of utilities from several different perspectives--as a utility planning engineer, as the Director of Regulated Utility Planning for the State of Vermont, as a senior scientist at the Tellus Institute for Resource and Environmental Strategies and, currently, as the Managing Director of Cantor Fitzgerald Environmental Brokerage Services.

Q.      What is your direct experience with market based emission programs?

A.      My first exposure to market based programs was during my tenure as Senior Scientist at the Tellus Institute. A significant part of my work focused on how best to incorporate environmental impacts into utility resource planning. In that capacity I provided expert testimony on this issue in a variety of jurisdictions.

      My analysis of Title IV of the Clean Air Act Amendments of 1990 (the Acid Rain Program) led me to conclude that the tradable emissions system are a highly efficient and effective approach to this contentious problem. Economically, tradable emission rights¹ can readily be incorporated into resource planning and operations promoting economic efficiency. Environmentally, the fixed quantity of emission rights guarantees permanent reductions in the emission of the pollutant from the regulated sources. I would like to emphasis guarantee and permanence compared to other types of environmental regulation.

      My enthusiasm for these programs led to my present position at Cantor Fitzgerald. I joined Cantor Fitzgerald in 1992 and created Environmental Brokerage Services (CF-EBS) to service the secondary market for Emission Allowances used in Title IV of the Clean Air Act Amendments of 1990. CF-EBS subsequently has expanded to serve the secondary market for RECLAIM Trading Credits, and the various state programs for Emission reduction Credits. CF-EBS currently has a staff of eight broking all active environmental trading programs in the United States, and the fledgling market for Greenhouse Gas Offsets.

      Since establishing CF-EBS, I have been immersed in developing services and programs to extract value from these markets for my clients.

Q.      Given your experience, do you believe that market based tradable emission programs are a successful method of implementing environmental policy?

A.      Absolutely. The interface between economics and environmental responsibility has always been one of the most problematic issues faced in resource planning for electric utilities and other businesses that create significant environmental impacts. Tradable emissions programs address the pertinent public policy issue, i.e., containment of environmental insults, head on, while leaving the marketplace to reveal the path to obtaining that goal.

Q.      Please elaborate on your last point by contrasting tradable emissions programs to other modes of implementing environmental policy.

A.      There are three basic types of environmental regulation: Command and Control; Tradable Emission Rights; and Emission Taxes. Each types balances environmental and economic impacts of environmental restrictions using a different economic paradigm.

      Command and Control, the traditional approach to environmental regulation n the US, uses a central planning perspective. Command and Control focuses on technology prescribing specifically the environmental control technological approach a business must use comply with the regulation.

      The economic penalties of this system are severe. Command and Control is rigid, does not readily adapt to changing economic conditions, and therefor, does not embrace new technological solutions.

      In the short-term on an operational level, industry has an extremely limited ability to adjust its compliance strategies to changing business conditions. This can result in both economic and environmental sacrifice.

      In the long term on a strategic level, the cast in concrete nature of Command and Control regulations stifles innovation. Entrepreneurs are discouraged from exploring better ways to meet environmental constraints knowing they must not only build a better mouse trap, but before they can sell it, they must also get regulatory approval. The process of getting such approvals is unwieldy, bureaucratic, and fraught with vested interests for maintaining the status quo.

      Emission taxes, by contrast, focus on environmental objectives indirectly. Emission taxes offer no direct connection to the level of true emissions. They attempt to control pollution through economic surrogates.

      Controlling emissions through taxation can result in an endless game of chasing one's tail. Such taxes are in turn either environmentally ineffective or economically punitive depending on the state of the economy. During strong economic periods, emission taxes are likely to be sufficiently high to constrain excess emissions resulting from increased industrial activity. During weak economic periods, taxes are an unnecessary burden on businesses operating within acceptable emission limits.

      Finally, and perhaps most significantly, emission taxes place environmental and economic objectives in diametric opposition. Emission taxes pose the perpetual threat that environmental policy will become hostage to fiscal policy.

      Tradable emissions programs correctly and directly recognize that the key public policy issue is the containment of a particular environmental insult. Pollution is a reality of today's society. Environmental policy must balance the negative impacts of pollution against the benefits of industrialization. The creation of a limited quantity of tradable emission rights transforms the right to pollute into a scarce resource.² This is exactly the way it should be viewed.

      By limiting the amount of emissions available to a particular category of regulated businesses, the environmental goals are guaranteed. And most importantly, they are guaranteed through time. Emissions are constrained through the short-term rise and fall of the business cycle and in the long-term as industry reinvents itself.

      Economically, today's market economy is well positioned to continually reallocate this scarce resource to the highest valued users ensuring the efficient allocation of this new commodity. In addition, the economic burden on industry is self-regulating. An emissions trading system adjusts the economic burdens in correlation with the economic cycle. During periods of economic slow down the demand for emission rights decreases resulting in a lower prices and costs to industry. During economic expansion, demand increases driving prices up, promoting rational investment strategies in alternative processes that reduce emissions at a time when industry can best afford it.

Q.      From a practical view point, what is your overall impression with the actual experience with the implementation of tradable emission programs?

A.      Existing programs have been very successful, which is very impressive given the novelty of these early programs. In particular, the success of the Acid Rain Program³ is widely held. The GAO⁴ conservatively estimated that the utility industry will save at minimum of $1.4 billion per year compared to traditional Command and Control regulation.

      While I agree that the Acid Rain Program has been highly successful, I have a somewhat different view on the revealed successes and weaknesses of the program than the mainstream interpretations. Some of the criticisms leveled at the program, are really success stories. Conversely, some of the attributed successes I believe reveal modest failures in the programs design.

Q. Please elaborate.

A.      The Acid Rain program came under criticism after the program revealed the true cost of emissions reductions to be well below the estimates prevailing at the time the program was being developed. It was argued that the low costs demonstrated that the environmental community had failed to capture sufficient reductions. Others argue the low prices did not result from the use of tradable rights, but rather from the unforeseen impact of railroad regulation.

      Both of these interpretations are in error. First, the primary environmental benefit of tradable permit programs is achieved when the cap is established The cost savings resulting from the use of emission allowances (EAs) versus traditional command and control regulation is a very important secondary benefit, as well as the major economic benefit. The operative question from the environmental perspective is whether or not the agreed upon emissions cap is sufficient, not whether it could have been lower simply because the goal was less expensive to achieve than anticipated. The environmental goal was to achieve a specific quantity of emission reductions, not to spend a specific sum of money.

      Second, it is interesting that some parties denigrate the value of the tradable rights programs by teasing out the technological basis of the savings. Tradable rights programs in and of themselves do not reduce emissions. Instead, they provide the vehicle that permits the affected parties to seek out and exploit such opportunities.

Q.      Isn't the point of that criticism that the saving would have been obtainable through traditional methods without the use of a tradable rights program?

A.      Theoretically, the saving would be obtainable under Command and Control; however, we can never know whether or not the saving would have been captured without a tradable program. My guess is that they probable would not have been.

      There are several factors underlying this opinion. One is the reluctance by a regulated entity to modify an approved environmental compliance strategy. This is particularly true, if such a modification requires regulatory, or public, review. The Acid Rain Program grants utilities the right to take advantage of temporary reduction opportunities without lengthy review, and, of equal importance, to revert to their original strategy if conditions change back.

      I have an antidote, which illustrates this point. Before the market price of EAs was well established, it was routine to explore a client's cost of emission reductions to determine if they should be buying or selling EAs. One utility fuel trader was reluctant to reveal the cost of emission reductions on his system. Eventually, he revealed that the company was actually saving money buying lower sulfur fuel. This opportunity had been available for some time, so prior to fuel switching the company had been polluting at a loss.

      This seemingly illogical behavior was actually quite rational. Under the pre-EA system, if the utility had started to buy lower sulfur fuel, they would have been subject to a de facto downward ratcheting of their allowed emissions. This company was afraid that should the price of low versus higher sulfur fuel should later reverse itself, it would not be politically feasible to increase emissions back to earlier levels. Economically, the added cost of the higher sulfur fuel was the cost to maintain the option to continue emitting at previously allowed levels.

Q.      You mentioned earlier that some claims of success for this program you viewed as partial failures. What did you mean?

A.      The EA program has resulted it a vast over compliance by the affected utilities in the early years of the program. The EPA reports that Phase I affect units over controlled emissions by 6.3 million tons, or 38% below allowable levels.⁵ While this is unarguably good for the environment from a Acid Rain abatement standpoint, it reveals one of the weakness of the specific implementation of the Acid Rain Program.

      While some early excess reduction was expected, the actual excess reductions were two or three times that anticipated level. For the most part this resulted from investments by utilities in emission reductions, which in retrospect, were not economic efficient.

      Part of the blame is attributable to unavoidable vagaries of planning for the future. With regard to the Acid Rain Program, rail deregulation had the unanticipated impact of expanding the economic penetration of low sulfur coal from the Powder River Basin into new markets.

      A second factor was the failure of both utilities and their regulators to embrace the freedom offered by the new system. In too many cases, the immediate reaction was to reduce system emissions before without consideration of trading opportunities.

      Third, the last minute bifurcation of the program into Phase I and Phase II. This compounded both of the aforementioned faults and contributed an additional dimension. Phase I embraced the 110 'big dirty' utility stations requiring them to enter the tradable EA program in 1995. Phase II embraces all plants beginning in the year 2000. Economies of scale indicate that the biggest emitters are likely to have the lowest average cost of emission reductions. Consequently, they are among the natural sellers. Conversely, the natural EA buyers would be found among the Phase 2 units. The bifurcation of the program inserted a five year separation between the decision making points between the natural buyers and sellers.

      Efficient markets rely upon the constant give and take between buyers and sellers. A five year gulf breaks the communication between these groups depriving the potential Phase I sellers of important feedback regarding the value of their reductions; i.e., what the market would pay for those reductions. As a result, the Phase I utilities made large investment decisions based upon early, untested estimates of the value of emission reductions.

Q.      Were any of these factors unavoidable?

A.      All three of these factors contributed largely to the over investment in reductions. Of them the first case was largely unavoidable. Plans will always be revealed to be better or worse than anticipated in the cold light of the future revealed. If we had perfect foresight we wouldn't need markets, we would have a perfectly efficient centrally planned economy. With markets and planning comes mistakes, and conversely, the occasional windfall.

      Corporate cultures will always take time to embrace radically new tools, the adaptation period growing geometrically with the level of regulation. To embrace these new tools utilities had to build consensus both within their company and with their regulators that trading was an appropriate course of action. Often secondary factors weighed into the debate, such as effects on local employment. In addition, both utilities and regulators lack many of the required skill sets to fully recognize and exploit the new opportunities available to them. In the future, this problem will be lessened as new programs embrace players already operating under existing programs due to program overlap; and as new players review the errors of earlier program hopefully avoiding those mistakes. Additionally, new programs will benefit greatly from the existing framework of brokers, traders, and trade organizations developed to service the EA market.

      The bifurcation of the program was the only issue which was unavoidable. Future program design should refrain from inserting unavoidable complications into the system. Markets work best; i.e., when they are simplest and unencumbered.

Q.      Is there a greater lesson to be derived from your last point?

A.      Market forces are excellent at anticipating and correcting for uncertainty. However, dealing with this uncertainty inflicts a price on the overall efficiency of the system. Consequently, in the promotion of efficiency, it is best to keep the programs as simple as possible. One important aspect of simplicity is to apply the program uniformly to all participants. Any subdivision of program participants into sub-groups creates different economic impacts among the groups resulting in a different equilibrium price for each group. While markets thrive on exploiting the differences among participants the creation of artificial differentials should be avoided.

      The apparently simple act of the Phase I and II bifurcation greatly complicated the implementing regulations, reporting and monitoring. A very large portion of the implementing regulations addressed issues related to the bifurcation, and a large part of the implementation and monitoring ensures that participants do not unduly shift emissions from Phase I to Phase II units.

      The resulting complexity of the regulations eventually led to legal challenges of the regulations.

Q.      Isn't it important to build in regulations to protect against environmental 'hot spots'?

A.      Yes it is, but fortunately most of the protections are already available through existing laws. Each facility is still governed by an individual air emissions permit. If there is a specific need to further control a particular source, it can be done on a case by case basis. This was done at the Navaho coal-fired power station, which was required to reduce its sulfur dioxide emissions below that allowed under the Acid Rain Program to address haze problems at the Grand Canyon.

      I would caution that any such adjustments must be made selectively and only after the program has had an opportunity to work. New programs already contain a reassessment period providing a safety net against programmatic failure. If the program is not on track to accomplishing its emission goals, the emissions cap can adjusted downward. Because the reassessment process and time frame is known, and the assessment will be public, the market for those particular emission rights should have an amble opportunity to assimilate the potential for changes to the cap and make adjustments to the price for those rights accordingly.

Q.      Isn't it important to build in regulations protect against a party cornering the market?

A.      Hypothetically, it might be possible for a party to corner the market. However, in practice it would be very difficult and unlikely to be an attractive investment. First, no party can corner the market without first purchasing the credits in the open market. This would require out bidding the other potential purchasers. Second, as the prices rise due to the speculators activities, it would become attractive for parties not to utilize any credits they already held and to execute emission control strategies instead with the intention of selling their now unneeded credits. The combined effect of these two factors makes it unlikely that a speculator would find the risk reward relationship attractive.

Q.      Does this concept of program simplicity extends to other aspects of the implementation of tradable right programs?

A.      Yes it does. In general, the simpler the program the more efficient the market for the commodity can become in its continual reallocation of emissions to the highest value uses. Ironically, one complicating factor can be the attempt of a regulating body to facilitate market development.

      When a marketable product is created a support services (e.g., brokers, trade organizations, information providers, etc.) develop in proportion to the economic value of the portion of the product expected to trade. I am directly involved developing these services for tradable emissions rights.

      New markets create a tremendous level of anxiety among the market's participants. The level of anxiety is inversely proportionate to the level of their experience with markets. As a result, arguments undoubtedly arise for regulators to create programs or institutions to "encourage" market development. In many cases, such programs create an unanticipated obstacle to the development of an efficient market.

Q.      Please explain how a program designed to enhance market development can create such an obstacle.

A.      We turn to markets in the belief that overall efficiency is achieved through the constant give and take of parties with different knowledge, ideas and objectives. This applies the sector servicing the market, as well as, the flow of the market good itself. If the government dictates a program or market activity, it is de facto preventing the give and take used by the market to find the best solution. This creates at least two problems.

      First, it virtually eliminates the competition among ideas. Potential service providers will not spend the resources to offer alternative solutions. Second, if the injected solution proves to be ill designed, or even slightly off target, corrections are hard to make. Where competitive pressures constantly cause the market service industry to refine its products to better serve market participants, legislated or regulatory programs must be corrected through political, not economic feedback.

Q.      Can you offer any examples of how programs were designed to encourage market development proved to be hindrances?

A.      Yes. In particular, I point to the annual auction held by the EPA each year as mandated by the Clean Air Act Amendments. Each year the EPA withholds and auctions 2.8% of the allocated emission allowances. The original premise was to ensure that non-utility generators, which did not receive an original allocation, had access to emission allowances at a 'market price'.

      The results have proven to be quite different than original expected. Almost none of the auctioned emission allowances have been purchased by the groups that sought these protection. The structure of the auction (i.e., once a year for two vintages only) was not useful service this sector. Instead these parties found they were much better serviced by through unregulated over the counter markets in which they could tailor deals to their specific requirements.

      Unfortunately, the auction has proven to be worse than simply superfluous. Because the allowances are auction with no minimum price, bidding naturally starts below the prevailing market price. This depresses prices, and penalizes sellers.

Q.      Does this mean there is no role for government in enhancing market development?

A.      Not at all. Government has a vital role in the development of all emission trading market. Without regulation there simply is no market. However, that role should be sharply focused enforcement of the underlying environmental objectives, not on developing the market itself.

      Nonetheless, I am certain that political pressures will result in future interventions. In these cases, I would strongly advocate that any such intervention have a short and well defined time limit. Any market "enhancement" programs, e.g., auctions, direct sales, etc., should have a fixed expiration date. Extension of a program after that date should require affirmative action, i.e., a demonstration that the effort is having a positive affect and is worth extending. Such a blue sky provision will help ensure that only worthwhile programs get extended.

Q.      What factors should the government effort be focused?

A.      It is the government's twin duties to write the rules and enforce them.

Q.      Are there other important factors in establishing a viable trading program?.

A.      As I discussed earlier, the simpler the program the more readily it will be embraced by it participants, and the less opportunity for game playing will exist. An often overlooked aspect of establishing the program is funding. Emission trading programs are heavily loaded with front end costs. Establishing the rules, setting up the reporting and recordation systems, and making initial allocations is time consuming and expensive. These up-front cost will be well repaid by a well functioning program. The EPA estimates that the EA program is responsible for 40% of the reduction resulting from the Clean Air Act Amendments of 1990 while utilizing approximately 2% of the staff and other resources.⁶

      Early on, the Acid Rain program suffered from the slow establishment of the Allowance Tracking System. The ATS is the computer database in which all Allowances exist. It is essentially the title system for EAs. The creation of the database was delayed for a year in part due to lack of funding. With millions of dollars involved in a medium size transaction, it is easy to understand why the ability to transfer title of the purchased allowances is important. While the lack of transfer capability did not prevent trading in its entirety, it greatly hampers the development of the most efficient market forms

Q.      Please elaborate on you thoughts regarding enforcement.

A.      There is no 'natural benefit' for owning a tradable emissions right. Their only value is compliance with the law. Consequently, there must be a fate worse than trading if trading is to succeed. Accordingly, penalties for non-compliance must severe when compared to the costs of trading (including the time and effort to execute the trades). And, just as importantly, penalties must be enforced.

Q.      Do you have any observations you would like to make regarding the future of tradable emission programs?

A.      Yes. Tradable programs are expanding to embrace more and more types of environmental commodities. In addition to expanding to include new pollutants, I expect the programs will also expand to embrace an ever growing number of emitters in each program. Tradable programs initially encompass the largest emitters, consequently an expansion of the program will absorb lower level emitters. Nonetheless, the total quantity of emissions controlled by the program would grow. For such an expansion to occur the cost of participating in the programs must decrease. This may require a loosening of monitoring standards.

      For example, the Acid Rain program has a provision to allow industrial sources to opt-in and join the program. Unfortunately, the cost of the required monitoring equipment is so great as to prohibit all but the largest emitting facilitates from joining the program. As a result, facilities that might otherwise join and clean-up are excluded. This is unfortunate.

      To facilitate the next generation of programs, we should loosen monitoring standards, but not enforcement standards This is a natural progression in the development of the emissions trading paradigm. Trading programs already exchanged the certainty that each and every trade is in the public good for the knowledge that the aggregate trading program is in the public good.

      I believe the level of monitoring and enforcement can be similarly loosened on the individual entity so that we can embrace an ever greater portion of active polluters. Loosening monitoring may result in the occasional cheat or accidental emitter escaping detection; but the gains from embracing larger population of polluters and getting them to reduce emissions at a lower cost should more than off-set such leakage.

Q.      What is your opinion of a greenhouse gas trading program?

A.      I believe that if the US is going to contain it emissions of greenhouse gases (by reduction and offset), a trading program is by far the best means available. I believe the free market will quickly demonstrate that the is a large quantity of relatively inexpensive greenhouse gas reductions and offsets available domestically, as well as internationally. In fact, I am already marketing a large portfolio of high quality projects at a fraction of the cost below those commonly used when discussing the issue.

Q.      Do you believe that an international greenhouse gas trading program is possible?

A.      In the long-term yes, but I do not believe it the best way to inaugurate trading. I believe the US could establish a domestic trading program to fulfill any commitment to contain domestic emissions of greenhouse gases. A domestic program could incorporate a cap and trade system, similar to the Acid Rain Program, for the allowable level of emissions, and could also permit the creation of greenhouse gas credits through offsets (e.g., methane abatement, carbon sinks, etc.). Offset credits would be approved by a certifying entity, perhaps similar to that establish for Joint Implementation Projects.

      A domestic trading program would result in the establishment of a hard price for greenhouse gas offsets. It is my believe that if hard currency were available for parties selling credits to the US market, an international market would quickly develop. This would likely lead to other countries willing to live by the same rules desiring to join the program . Eventually the for the importation of credits from other countries could be allowed provided they meet a criteria at least as strict that used to certify US offsets as credits.

      As with other emission programs, we would soon discover that the cost of the solution was well below our expectations.

Q.      Does this conclude you testimony?

A.            Yes, it does.

Endnotes

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