My name is Daniel J. Dudek and I am a senior economist with the Environmental Defense Fund, a national not-for-profit environmental organization with over 300,000 members. EDF's mission is to solve environmental problems by combining science, law, and economics. EDF, among all environmental organizations, has particularly focused on the development of market-based policies. I am here today to testify as an unabashed advocate of market-based environmental policies. EDF believes such policy tools:
We believe that the nation has accumulated significant experience with several forms of market-based environmental policies, particularly that class of market tools known as emissions trading. Emissions trading was initially implemented in the late 70's to address concerns about rigid Clean Air Act compliance deadlines and the need to encourage local economic growth for employment. Since that time, emissions trading and banking has been applied to heavy duty engine nitrogen oxide and particulate emissions, the lead phase down in gasoline by refiners, the reduction of production of stratospheric ozone destroying chlorofluorocarbons, cutting acid rain, retiring high emitting vehicles, creating incentives for alternative vehicle fuels, and for the reduction of pollution discharges to rivers and lakes.
Conceptually, emissions trading is quite simple, no more complex than addition and subtraction. In fact, EDF has frequently analogized the acid rain program to the opening and management of a checkbook. Within a category of sources each of which has an emissions limitation requirement, any one source may reduce its emissions more than required and find its emissions below its emissions limitation. That source in effect can transfer or assign the extra increment of emissions reduction to a second source; the second source can emit above its required limitation up to the amount of the first source's extra reductions and both sources' combined emissions still equal the same quantity that would have been emitted had both been emitting at their initial required levels. The key is defining what constitutes an extra reduction and quantifying it. The key to the success of these programs has been empowering business to determine the most effective strategy to produce pollution reductions.
During the '80's emissions trading initiatives created a mixed record, at best. Since emissions trading was grafted onto existing command-and-control programs which suffered basic flaws, it often had the effect of amplifying those flaws. As a result, many environmentalists worried that including emissions trading in programs that did not control total pollution well in the first place would only aggravate existing command-and-control programs' considerable barriers to achieving the intended levels of emissions reductions (Hinds, 1996). At the same time, the inherent difficulty of converting command-and-control requirements into tradable emissions reductions made transactions cumbersome and costly. However mixed, these experiences provided invaluable learning for the development of more market-oriented emissions trading programs.
With the enactment of the acid rain emissions trading program in the Clean Air Act Amendments of 1990, this decade has seen a steady expansion of emissions trading programs that have brought, or are poised to bring, exactly the benefits the original proponents of emissions trading promised. For the most part, these programs have succeeded by integrating the design of businesses' compliance requirements with the design of the emissions trading tool. In many cases, this design integration has forged a new paradigm for pollution control that offers superior environmental performance, lower cost and a ramping back of otherwise intrusive relationships between regulators and business.
If one of the often debilitating flaws of command-and-control programs was their failure to make any party accountable for achieving specific levels of reductions in actual emissions, and if, for this reason, such programs made emissions trading environmentally risky and economically cumbersome, then the distinctive genius of the acid rain program's design -- which has been instrumental in encouraging the widened use of emissions trading in the past several years -- was in taking these problems on directly.
In so doing, the acid rain program introduced the paradigm-shifting notion of making sources explicitly obligated for meeting a limitation on their actual emissions. This has the effect of guaranteeing that the intended emissions reductions in fact will be achieved and of capping total emissions at the aggregate reduction level. To the great benefit of emissions trading, this approach also means that any emissions reductions below a source's required emissions limitation level are, by definition, surplus and therefore tradable. As a result, sources can create, bank, sell and/or buy, the tradable emissions reduction currency without the need of regulatory intervention with respect to any transaction. Uncertainty and overall transactions costs which dominated emissions trading in the 1980's are radically reduced, if not eliminated.
All of this is made especially easy and understandable by the mechanics of the acid rain program. Every year, the EPA allocates a fixed total of marketable permits, called emissions allowances, to the group of sources with emissions limitations. These allocations were explicitly established by Congress as an integral part of the Clean Air Act Amendments of 1990. In fact, the distribution of these allowances to affected sources was key to reducing industry's opposition to the program and ameliorating impacts among states. Sources can buy, sell or bank these allowances however they wish provided that at the end of each year each source holds allowances equal in number to its actual emissions. As a result, even the regulator's role is fundamentally streamlined.
Aside from its many inherent virtues, the acid rain program has provided an instant textbook example of how emissions trading can work and how the problems associated with emissions trading in the past can be escaped or solved. Congress' work in designing the program restored both environmental and economic credibility to the concept of emissions trading and offered a variety of environmental policy-makers and interested parties teaching-by-example. It is in response to this teaching, that environmental regulators from Southern California to the Northeast have developed and deployed emissions trading to combat air pollution throughout this decade.
EDF had long been convinced of the importance of integrating environmental programs into economic decision-making. Put simply, the vast bulk of the money spent on environmental problems comes from the private sector. Given our market economy's ability to grind down costs through competition and innovation, why shouldn't we harness entrepreneurial energy in solving pollution problems? If we did, we would have more investment choices, new products and markets, fewer resources spent, and, perhaps most important for the environment, more progress faster. However, for many years, EDF was largely alone in this belief. Emissions trading was and is controversial even in the Environmental Protection Agency. It took the spectacular results of the acid rain allowance trading program to demonstrate the power of market forces to produce environmental benefits.
As the figure below indicates, one of the most dramatic results from the Clean Air Act acid rain program has been the degree of overcontrol, i.e. the number of extra reductions that utility sources have made in response to the opportunity to produce and "bank" extra reductions for future use. In 1995, the first year of the program, utility emissions were 39% below allowable levels and in 1996, the program's second year, they were 35% below allowable emission levels (EPA, 1997). This is 3.44 and 2.86 million tons respectively. What other environmental program can show such dramatic performance in so short a time? This performance is especially salient when viewed from the perspective of the environmental problem we are attempting to solve.
In part, acid rain as it affects ecosystems is a cumulative emissions problem which acts over time to leach the buffering capacities from the soils sustaining forests and surrounding lakes. As this buffering capacity is depleted, the process of lake acidification and forest decline are accelerated. By reducing emissions sooner rather than later, the program provides relief to these acid-stressed ecosystems exactly when they need it most. In economist's terms, the marginal benefits, i.e. avoided damages, associated with these extra reductions are highest when we first begin to reduce emission levels. The typical command-and-control regulatory program, on the other hand, phases reductions in slowly and provides no motivation for companies to reduce any more than they are required by the regulation.
In effect, emissions trading turns traditional environmental incentives on their head. Companies are challenged and rewarded by a flexible compliance program and market opportunities to go beyond government minimums. Environmental management becomes part of the strategic business plan.
Recently, EDF was able to participate directly with a company in which this very dynamic was unfolding. On May 14, EDF and British Petroleum struck an agreement to design a greenhouse gas emissions trading program and to test design options with demonstration transactions (Los Angeles Times, 1997). BP's action reflects exactly this strategic understanding, an understanding engendered whenever markets for emissions reductions are created. Furthermore, it reflects another critical change induced by the spread of the emissions trading paradigm – the switch from reactive to proactive policy involvement by business.
In addition to accelerating emissions reductions and realigning the incentives of private firms, emissions trading programs, especially those exemplified by the acid rain program, bring other environmental benefits. The simple notion that making sources explicitly accountable for their actual emissions can simultaneously serve as the cornerstone for an emissions trading system has helped air regulators confronting a variety of pollutants and environmental problems see that they can design programs that impose explicit caps on total emissions and thus ensure achievement of intended emissions reductions. This insight has helped win over many previously skeptical environmentalists and regulators.
However, the ability of well designed cap and trade programs to guarantee emissions reductions and the lowest achievable costs led to another more critical insight – that we could afford more environmental protection if policy makers could be guaranteed that costs would be as low as possible. It was this insight that led President Bush to adopt a 10 million ton reduction in sulfur dioxide emissions for the Administration's acid rain program proposal to Congress, a goal long advocated by environmentalists. Assured of the lowest costs to the economy by the flexible market orientation of the program's design, President Bush was able to eliminate the usual tension between environmental and economic performance.
How has the program performed in economic terms? The chart below shows the unexpected history of allowance prices. The economic models employed to assess the potential costs of compliance with the acid rain program predicted substantially higher costs and allowance values (Ellerman, et al., 1997). This performance is especially dramatic when considered in the context of the Direct Sale Subaccount established under Sec. 416 which sets aside 50,000 tons per year for direct sale at $1500 per ton adjusted by the Consumer Price Index.
Some critics have argued that there is "not enough" trading in the acid rain program. They miss two points. First, the purpose of the acid rain program is not to promote trading.1 Rather, it is to reduce acid deposition at the lowest cost. All evidence points to the fact that the program is succeeding triumphantly. The allowance values reflected in the figure above are far below the marginal cost of compliance projected for the program when it was enacted.
Second, the allowance-trading market may be effective in reducing costs because it fosters implicit or "latent" emissions trading as well as active trading. Put another way, emissions trading places all compliance options in direct competition with each other. Of course, any program that permits flexibility in compliance choices does this. Because of emissions trading, however, that competition is geometrically expanded in the acid rain program. Different compliance options do not compete with each other only at any one facility. Because emissions trading allows a facility operator to choose to apply a compliance option at its own site or, in effect, at any other affected facility that can make surplus allowances available, the facility operator's range of choices are much broader, the competition among them much more intense, and the capacity of that competition to lower costs much, much greater.
To date, the dramatic spread of emissions trading in the 1990's has been carried by three programs that were more or less patterned on the acid rain "cap and allowance" or "cap and trade" model. The Northeast states' Ozone Transport Commission (OTC) adopted a nearly identical system for controlling oxides of nitrogen (NOx) in the 12-state region as an important measure for reaching the groundlevel ozone standard in cities throughout the region. In Los Angeles, the South Coast Air Quality Management District adopted a similar cap and trade program to reduce NOx and sulfur dioxide emissions in the L.A. basin. Finally, the Illinois Environmental Protection Agency (IEPA) developed a cap and trade program for reducing volatile organic compounds in Chicago.2
EDF participated in the "design team" effort convened by the IEPA. Initially, the design team assumed that the characteristics of VOC emissions, their atmospheric behavior in ozone formation and difficulties quantifying them militated against the use of a cap and trade approach. In trying to develop an emissions trading design that ensured environmental integrity and economic viability, however, the design team discovered the superior features of a cap and trade program actually made it easier to address these issues. In contrast, it was alternative designs that did not include caps or that did not proceed from the cornerstone of defining compliance in terms of actual emissions that proved to be the least likely to achieve success.
On the basis of this experience, as well as on its participation in the OTC's design efforts for its NOx program, EDF has concluded that cap and trade programs should be the template of first resort that policy-makers use when designing air pollution programs. To be sure, there are a variety of models and approaches to emissions trading that policy-makers can use in designing specific programs. None has the inherent environmental and economic advantages of the cap and trade model. As a result, in EDF's view, the variety of emissions trading models should be understood to occupy a hierarchy at whose top is the cap and trade approach. For this reason, in assessing alternatives, program designers should begin by determining whether the cap and trade model can be applied to managing the pollutant(s) for which they may be creating a program. Only if they conclude that such an approach is impracticable, should they examine alternative tools.
In fact, notwithstanding its strong preference for cap-based programs, EDF itself has advocated for the use of emissions trading approaches that do not follow the cap and trade template in a number or circumstances, particularly in its work on emissions and emissions trading in the mobile source sector (EDF and GM, 1992). Such approaches are demanded for sources that cannot be subject to a total emissions cap or are not being subject to mandatory regulation. Even sources with these characteristics, however, can play a beneficial role in an emissions trading program, just as emissions trading can dramatically improve the performance of programs for controlling emissions from these sources. In fact, the market forces unleashed by cap and trade programs can be focused on the search for untraditional, but cost-effective emissions reductions such as accelerated vehicle retirement.
In working with such programs, EDF has concluded that a second maxim, of equal importance to the ultimate preference for cap and trade models, should guide the work of policy designers: in fashioning emissions trading programs, regulators must develop program features that are highly specific to the pollutants being managed and the environmental problem being addressed. Attempts to promulgate generic emissions trading rules that purport to be applicable to a variety of sources or a range of programs almost inevitably will result in failure. One need only look at the U.S. EPA's ill-fated proposal in 1995 of an Open Market Trading Rule (OMTR) for a demonstration of the importance of this maxim.
EDF was deeply critical of the OMTR and vigorously opposed its final promulgation. To be sure, we offered the agency detailed criticism of a number of its features. In our view, however, its flaws stemmed from the fact that EPA had set itself an impossible task in attempting to propound a rule with generic application. For example, in its attempt to craft the OMTR for use across the full range of existing command-and-control programs, the EPA was unable to fashion a method for establishing that emissions reductions were surplus and tradable in a way that both guaranteed the environmental integrity of the underlying emissions control program while ensuring that open market trading was economically practical. More critically, the EPA failed to provide guidance for the integration of this proposed program with existing emission reduction credit trading programs or with emerging state-based cap and trade programs.
From EDF's perspective, there is no reason to reject open market trading out of hand. Instead, open market trading must be understood to sit far below cap and trade approaches on the emissions trading hierarchy and the application of open market trading should be attempted, as is the case of all trading approaches, only when it can be carefully integrated into the overall design of a specific emissions control program.
However great the superiority of cap and trade programs relative to other trading approaches, even cap and trade is not a magic bullet. The importance of fashioning emissions trading programs by integrating them into overall pollution management programs cannot be overstated.
In crafting pollution control programs, policy designers must pay attention to several fundamentals, however, if their efforts are to succeed:
1. Environmental integrity is paramount. A pollution control program is virtually certain to fail if sources are permitted to trade emissions reductions that are not truly surplus relative to the emissions limitation target of the overall program or, at least, of the category of sources being regulated. The cap and trade approach succeeds because it makes traded reductions surplus virtually by definition. The open market approach, in contrast, must struggle to assure that traded reductions are surplus.
It is imperative for the success of emissions trading programs that the clear and unequivocal message be sent that emissions trades are fully equivalent as compliance options to on-site controls.3 The performance of most emissions trading markets has been characterized by significant sources of supply, but effective demand has been much slower to develop. Frequently, this pattern has been due to regulatory uncertainty introduced by either environmental or economic regulators. In this regard, public education is a key component to success. Critics can easily misrepresent emissions trading as "selling licenses to pollute". Demonstration transactions, preferably with environmental partners, are an important tool in allaying suspicion about the environmental effectiveness of such programs.4
2. Market fundamentals apply to emissions trading markets. An insufficient number of participants will doom an emissions trading market. For example, the U.S. established an production quota trading system to implement the Montreal Protocol and eliminate chloroflourocarbons, which deplete stratospheric ozone. Because there were so few producers, the quota-trading market saw little, if any, activity. Similarly, an early water effluent trading program was established by the state of Wisconsin to reduce pollution in the Fox river. The program was designed, however, in a way that featured extensive regulatory oversight of transactions. As a result, anticipated uncertainty and high transactions costs inhibited participation.
3. High transactions costs may be good for brokers and other intermediaries, but not for buyers and sellers. The design of the acid rain program was highly conducive to minimizing transactions costs: regulatory approval was eliminated and transparency was maximized. Critics have repeated the mantra that there is "not enough trading".5 These have tended to be market intermediaries, who have missed the point – the program's purpose is to achieve the required reductions at the lowest cost, regardless of how much or little work or profit there is for brokers. Indeed, those firms, like Cantor Fitzgerald, whose low-cost intermediary services have been specifically designed to streamline transactions costs have done the best at surviving, while those that sought to emphasize their own role have left the market. A key institutional innovation was establishing the legal ability for any person to own or hold such allowances. This has allowed options, swaps, forward and futures contracts to be developed.6
In contrast, the OMTR seemed to be designed to maximize uncertainty and related transactions costs. While the proposed rule suggested that emissions trading brokers could provide the tools for hedging or absorbing those costs for buyers and sellers, it would appear that brokers would have to play a featured role – and charge the market accordingly.
4. Banking has important environmental and economic benefits, but must be carefully designed. If sources can keep excess emissions reductions in one year and use them in future years, then an emissions trading system gives them an incentive to make additional surplus reductions early. In virtually every case, early reductions yield additional environmental benefits, as exemplified by acid rain. At the same time, banking can be critical to market formation. In the early years of many markets, potential supply-side investors may have reason to doubt whether demand exists for extra emissions reductions they may create. If they know, however, that reductions made even in the early years of a program can be used in later years, when the market can be expected to mature, the value of that expectation will justify making early reductions. In many cases, investments in early reductions involve investments in aggressive and innovative control technologies, thus helping to stimulate the deployment of environmental innovation.
Of course, for many environmental problems, acute exposure to pollutants is more serious than cumulative exposure. In these cases, later emissions increases are not environmentally offset by earlier excess reductions. It falls to program designers then to find approaches to balance the benefits of banking with its potential problems. For example, the designers of the OTC's NOx cap and trade program permitted unlimited banking but included a "flow control" requirement limiting the use of banked emissions reductions in certain circumstances.7 The designers of the IEPA VOC program, in contrast, included a device to limit, ultimately, the number of emissions reductions that could be banked.
5. Regulators cannot be market-makers, but they can give markets the tools to build the institutions to facilitate market activity. A key to markets, of course, is information. Program designers can ensure this by maintaining a transparent system for accounting for sources' emissions and tracking trades. In addition, auctioning a small portion of emissions credits or allowances can jump-start price discovery.8 Of course, private intermediaries are instrumental to facilitating market activity. For this reason, emissions trading markets should be designed to let any person, not just sources, hold and transact allowances or credits.
The practical experience with emissions trading is significant and growing. However, some real barriers to the realization of its full potential remain. First, not enough has been to educate the public about the importance of these environmental reforms. They have reduced costs and provided more environmental protection sooner. This is the kind of good news that is all too rare in environmental policy making. This good news needs to be shared with our colleagues and trading partners throughout the world as well. As we review our experience with the Commission on Environmental Cooperation established under the North American free Trade Agreement, we should extend NAFTA's mandate to free trade in environmental commodities.9 NAFTA is an excellent laboratory for the extension of emissions trading outside the U.S. Our trading partners among the OECD nations need to understand more of the positive experience with emissions trading in the U.S. At the present time, negotiations aimed at the development of a market-based international protocol for the control of greenhouse gas emissions is threatened by misunderstanding of emissions trading (Dudek and Goffman, 1997).
Secondly, the remaining artifacts of the old command-and-control system continue to inhibit effective application of emissions trading. Nowhere is this more evident than in the difficulties of cooperatively managing interstate flows of ozone and its precursors. Last year, EDF was involved in the first interstate emissions trade of NOx emissions reduction credits. The trade was between facilities of two companies straddling the borders of New Jersey and Pennsylvania. Most aspects of the negotiations between the two companies involved were a relatively straightforward business transaction. However, the negotiations between the two states and the two regional EPA offices were protracted. Since such a transaction had never before been consummated, each state had to under the other's program in order to adjust for the transfer. In the end, the resolution of critical details concerning emissions inventories had to be punted to the US EPA since the strategies each state was pursuing differed so radically. These differences existed and persisted despite the fact that each state program was developed under the US EPA's Final Emissions Trading Guidance of 1986. We will continue to have high compliance costs and poor environmental protection if we don't address these key interstate comparability issues.
Lastly, we need to extend the development of emissions trading both in the emissions and sources covered. EDF's strategic vision is of a complete set of environmental commodity markets as companions to the normal markets for goods and services. This comprehensive approach would extend the environmental and economic effectiveness of these programs more widely throughout the economy. Emissions trading programs have been very effective in controlling costs for producers. They have also acted to reveal and identify and bring to market emissions reductions options not previously contemplated by regulators. The remaining challenge is how to tap consumer energy to amplify the economic rewards to producers' environmental decision making. Creating market incentives for companies to reveal the emissions consequences of their products in competition for consumer purchases, for example in the case of energy or vehicles, would be a significant step to creating markets for environmental commodities that engaged all Americans.
2 Illinois uses the term "volatile organic materials" or VOM to describe its program.
3 Of course, the pollution controlled whether through on-site controls or emissions trades must meet all applicable health-based limitations such as the National Ambient Air Quality Standards.
Dudek, Daniel J., Joseph Goffman, Dean Drake, and Tom Walton, "Mobile Emission Reduction Crediting: A Clean Air Act Economic Incentive Policy Proposal for Retiring High-Emitting Vehicles", Environmental Defense Fund and General Motors Corporation, October 1992, 18 pp.
Dudek, Daniel J. and Jonathan Baert Wiener, "Joint Implementation, Transaction Costs, and Climate Change", Organization for Economic Cooperation and Development, OCDE/GD(96)173, Paris, 1996, 69 pp.
Dudek, Daniel J. and Joseph Goffman, "Emissions Budgets: Building an Effective International Greenhouse Gas Control System", Environmental Defense Fund, February 1997, 32 pp.
Ellerman, A. Denny, Richard Schmalensee, Paul L. Joskow, Juan Pablo Montero, and Elizabeth Bailey, "Sulphur Dioxide Emissions Trading Under Title IV of the 1990 Clean Air Act Amendments: Evaluation of Compliance Costs and Allowance Market Performance", Center for Energy and Environmental Policy Research, Massachusetts Institute of Technology, Cambridge, MA, Draft May 1997.
Emissions Exchange Corporation, "SO2 Allowance Values", 8101 W. Flamingo Road, Las Vegas, Nevada, 1997.
Hinds, Michael deCourcy, "Environmental Protection: A Challenge Bigger than All Outdoors", National Issues Forum Institute and Public Agenda, New York, New York, 1996, 29 pp.
Los Angeles Times, "British Petroleum CEO John Browne Delivers Speech on Global Climate Change at Stanford University", Business and Technology Section, Monday, May 19, 1997.
Stavins, Robert N., "Transaction Costs and the Performance of Markets for Pollution Control", Environment and Natural Resources Discussion Paper G-93-02, John F. Kennedy School of Government, Harvard University, Cambridge, MA, May 1993.
U.S. Environmental Protection Agency, 1996 Compliance Report: Acid Rain Program, Office of Air and Radiation, EPA 430-R-97-025, June 1997, 19 pp.
Endnotes
1 Nonetheless, trading activity increased in 1994 and has continued in 1996. Trading between distinct entities doubled between 1995 and 1996 from 1.9 million tons in 1995 to 4.4 million tons in 1996 (EPA, 1997). At the same time, it is important to recognize that transfers even between units with the same owner can produced very substantial cost savings when compared with more inflexible regulatory programs. These internal transfer economies are a critical consideration for transboundary pollution problems such as acid rain, ozone, and greenhouse gases.
References
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