Thank you for inviting me to testify today on emissions trading. Before I discuss EPA's experience with emissions trading, let me first point out that this country has made substantial progress toward clean air since passage of the Clean Air Act.
Since 1970, the underlying drivers of air quality problems in the U.S. have gone up -- U. S. population has grown by 28%, real Gross Domestic Product has grown by 99%, and the number of miles traveled by on-road vehicles (VMT) has increased by 116%. Behind these statistics are more factories, more production, more commerce, more power generation, and more cars. However, as a result of efforts marshaled under the Clean Air Act, during this same time period we have achieved a 29% reduction in air pollution -- that's not emissions -- but actual, monitored air pollution.1
In other words, as a Nation we have not just held our own, we have been able to substantially improve air quality across the country, even as the sources of air pollution have increased and the economy has grown. As a result, our air is generally cleaner and healthier today than at any time since EPA began measuring air quality. These pollution reductions are preventing tens of thousands of respiratory illnesses and deaths every year.
But the job is not done. We must continue to make progress in cleaning up our Nation's air. And we must be open to new tools, such as emissions trading, to progress faster, less expensively and more effectively toward that goal. We have experience in using market incentives, including emissions trading -- we know that it works, and we plan to expand its use.
The air pollution reduction programs in the U.S. have historically been based on traditional forms of environmental regulation: source-specific emissions standards (e.g., Reasonably Available Control Technology) set on a uniform basis for categories of similar sources. Even though set as performance standards, these regulations have a tendency to treat all sources within a category the same and to be oriented either toward the average or typical source at an average cost of control, or toward the more difficult sources to control. Such standards simultaneously miss substantial opportunities for inexpensive reductions by sources with lower than average control costs, and impose a disproportionately high cost (per ton of pollutant reduced) on other sources. State and federal governments frequently lack information on undemonstrated but cost-effective control options, and sources have no incentive to be forthcoming. Governments also tend to overlook smaller or unconventional sources.
Recognizing some of these shortcomings with traditional regulation, EPA has developed policies since the late 1970's permitting trading approaches for an increasing variety of emissions. Emissions trading is based on the simple concept of allowing sources, through market-based mechanisms, to seek the least costly solution to meeting pollution control requirements. Sources with relatively low costs of control are able to create extra reductions that are used by sources with relatively high costs of control. When these sources trade emission control obligations, the area experiences the same level of emissions reductions, but at a lower overall cost.
Over the last twenty years, EPA has learned that market-based programs and other uses of economic incentives can dramatically cut costs compared to other approaches. The lead and chloroflorocarbon (CFC) phase-out plans and the Acid Rain program are all examples of the ability of market-based programs to provide environmental protection at lower cost. EPA analyses have suggested that for the gasoline lead phaseout program, the trading and banking provisions resulted in 20 percent lower costs. The cost of reduction in the CFC phaseout program, which used an emissions allowance trading system, was at least 30 percent less than it would have been without trading. According to GAO's analysis of the sulfur dioxide (SO2) allowance program published in December 1994, the projected compliance costs for full implementation with trading should be less than half the costs without trading, i.e., $2.0 billion per year versus $4.9 billion per year.
In this era of heightened competitive pressures, EPA recognizes that it is essential to ensure that industry is getting the greatest pollution reduction for its money. Emissions trading is one way to do this.
Emissions trading is beneficial because:
EPA would like to see all of the above benefits realized wherever possible. It must be remembered, however, that trading is only a tool and does not replace the need for setting and achieving an environmental objective, which can be implemented through a cap on total emissions, or the setting of emissions rates on all relevant facilities sufficient to achieve the specified air quality goal. The degree of flexibility afforded by trading must be matched with the appropriate accountability, i.e., the more accountable individual sources are with respect to their emissions, and the more accountable the overall program is to the environmental objective, the more flexible the program can be with regard to how, where, and when emissions are reduced.
From our experience, we have found several factors important to consider before choosing to employ emissions trading.
Nature of the Problem
First, the decision to utilize trading depends on the nature of the problem to be solved. If the pollutant of concern is transported far from its source and dispersed broadly, such as SO2 and to a lesser degree oxides of nitrogen (NOx), then where it is reduced may be less important than reducing total loadings in general. Also, if the primary concern is total annual loadings, such as SO2, then when during the year emissions are reduced is less important. If the concern is ambient ozone concentrations, NOx and volatile organic compounds (VOC), reductions need to be made in the summer months and a trading system would have to be based on this. Human induced atmospheric carbon loading, which takes place over decades and is caused by emissions of greenhouse gases from multiple sources in many countries around the world, is especially well suited for trading.
On the other hand, pollutants that need to be reduced in a specific location for health or environmental reasons might not be appropriate for trading over a broad region -- for example, acutely toxic pollutants. Also, sources emitting pollutants whose impacts are localized would not be good candidates for purchasing emission allowances in lieu of controlling on site. However, such sources could still benefit from being part of a trading regime by selling their reductions to others and recovering some of their compliance costs.
Number of Sources with Differing Control Costs
Second, for trading to be utilized and cost savings realized, an adequate number of sources with differing levels of control costs is necessary. Also necessary is a balance between enough sources to make trading viable, but not too many that the program becomes unworkable. For instance, it may not be practical if every car owner were a participant in a mobile source trading program.
Ability to Quantify Emissions
Third, EPA believes that accurate quantification of emissions ensures that the environmental objective is being achieved, and that it gives participants in the market necessary information about the commodity they are trading. Quantification also allows the more effective establishment and enforcement of emissions, budgets or caps.
Institutional Capabilities
Fourth, though trading programs can give sources increased flexibility to choose from multiple compliance options, as with any market, they require appropriate ground rules and proper management. Essential safeguards such as accurate measuring and reporting of emissions, effective and automatic enforcement tools, and certified trading commodities insure the integrity of the trading program and achievement of the environmental objective.
Finally, it should be pointed out that air pollution control programs implemented through State Implementation Plans (SIPs) have unique challenges when developing or implementing interstate trading programs to address multi-state nonattainment situations.
Throughout the country there are many efforts under way to use emissions trading. The RECLAIM program in the Los Angeles area, for example, has been used by the South Coast Air Quality Management District since 1993 to assist the area in coming into attainment with the ozone and SO2 standards. It is a cap and trade program applied to stationary sources of NOx and SO2 and is credited with reducing emissions at substantial cost savings. Today, however, I would like to focus on those emissions trading efforts with which EPA is directly involved.
Sulfur Dioxide (SO2) Emissions
The leading cause of acidification of our lakes and streams is long-term total loadings of sulfur compounds, and the primary source of these compounds is emissions of SO2 from hundreds of coal-burning power plants. The Acid Rain Program sets a cap on the total amount of SO2 emissions from power plants, allocates those emissions in the form of tradeable allowances, and lets the plants trade allowances freely on a national basis. Confidence that allowances accurately represent emissions is assured by state of the art emissions monitoring equipment required on most emission stacks and by automatic penalties for exceedances. The Acid Rain Program has proven to be highly successful in reducing both SO2 emissions and compliance costs.
In 1995, the first year of the program, we saw the largest one-year drop in SO2 emissions since 1970. The 110 power plants required to be in this first phase of the program reduced emissions by more than 50% below their levels in 1980 and 40% below the levels required by law. In 1996, these impressive results were nearly repeated with emissions 35% below required levels [see Figure 1]. These emissions reductions resulted in a decrease of 10 to 25% in wet sulfur deposition (acid rain) over large areas of the eastern U.S. in 1995 [see Figure 2]. Ambient concentrations of sulfur dioxide also declined by 17% between 1994 and 1995.2 By the year 2010, the reduction in fine sulfate particulate matter is expected to provide health benefits of $12 to 40 billion per year3 and visibility benefits of $3.5 billion per year.4
Data from the SO2 Allowance Tracking System (ATS) is showing that utilities are taking advantage of the market flexibilities and cost saving opportunities afforded by the program. More than 2,400 allowance transfers moving approximately 38 million allowances (where one allowance is an authorization to emit one ton of SO2) were recorded by EPA between early 1994 and the end of the first quarter of 1997 [see Figure 3]. More than 50% of Phase I affected utilities have engaged in trades with others outside of their company such as other utilities and brokers. Though the number of brokers and traders involved in the market has remained relatively stable since 1995 (there are seven companies that identify themselves as brokers or traders in the ATS), their level of involvement has increased significantly. From 1995 to 1996, the flow of allowances from brokers/traders to utilities increased six-fold and the stream from utilities to brokers increased three-fold. The price of allowances has fallen from early estimates of $400 - $1000 to less than $100 for an allowance [see Figure 4]. These results prove that a legitimate trading market in SO2 emission allowances exists and is thriving.
Nitrogen Oxides (NOx) Emissions
Using a cap and trade approach to limit NOx emissions and reduce transported levels of NOx and ozone which in turn can assist states in attaining and maintaining the ozone standard and mitigate acidification and eutrophication is also appropriate. As the Ozone Transport Assessment Group (OTAG)5 modeling has shown, NOx is emitted by multiple sources and transported across state boundaries. EPA is in fact preparing to manage a regional NOx trading program for 12 Northeastern states represented by the Ozone Transport Commission (OTC) , which will begin in 1999. The OTC program will include electric power generators and industrial boilers, and will allow emissions trading throughout the 12-state region. Before embarking on the trading program, the OTC reviewed analyses indicating that multi-state trading would not be harmful to ozone attainment and would reduce compliance costs by 30% compared to the same scenario without trading. Since electric utilities contribute about 30% of total NOx emissions and are already monitoring and reporting NOx emissions under the Acid Rain Program and participating in the SO2 allowance trading program, the administrative framework associated with their participation in a regional NOx trading program is relatively straightforward.
Greenhouse Gas Emissions
Scientists agree that the balance of evidence supports the view that there is a discernible human influence on global climate due to the significant increase in greenhouse gas emissions (principally carbon dioxide, methane, nitrous oxides, chloroflourocarbons). This global environmental problem is especially well suited to be addressed through emissions trading because the problem is caused by cumulative emissions well mixed in the atmosphere, residing for long periods of time, and originating from multiple sources all over the world. The international community is interested in finding cost-effective policies for slowing and eventually halting global climate change as evidenced by the adoption of the UN Framework Convention on Climate Change. Recently, there has been a growing interest in applying an emissions trading paradigm to the climate problem as indicated by the recent report prepared by the Organization for Economic Cooperation and Development, Working Paper 9, titled "Policies and Measures for Common Action" on the subject of International Greenhouse Gas Emission Trading. That paper concludes -- and we strongly agree -- that an international emissions trading system founded upon accurate, verifiable emissions measurement and reporting can send the right market signals to create investment in cost-effective technologies to reduce greenhouse gas emissions.
In January, the U.S. put forth a climate protocol proposal based on legally binding greenhouse gas emissions budgets that offered Parties the option of using emissions trading to achieve needed reductions in greenhouse gas emissions in the most cost-effective manner possible.
The key to lowering costs is to allow maximum flexibility in reducing emissions, while ensuring the strict accountability of all Parties involved. Allowing trading between nations with low and high marginal costs of abatement could reduce the costs of achieving emission reductions significantly. The ultimate effectiveness of a trading system in lowering the costs of reducing emissions will depend on its ability to keep transaction costs low, and its success in creating and maintaining the credibility of the commodity being traded.
Creating an international emissions trading system requires three initial conditions: a legally binding allocation of emissions authorizations (or starting emissions budgets); a standardized and verifiable system of measurement and reporting that enables actual emissions to be matched to authorized amounts; and an effective legal mechanism to ensure that all Parties are complying with their obligations.
To sum up, EPA has now had 20 years of experience with emissions trading programs. Where appropriate to the problem and when properly designed and implemented, we have found emissions trading to be an extremely helpful tool in lowering compliances costs, promoting innovation, and achieving environmental goals.
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