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3.2.3. Acid Rain Allowance Trading

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Savings from Economic Incentives

An early solution to mitigate local air pollution caused by sulfur dioxide (SO2) and nitrogen oxide (NOX) emissions from power plants was to build tall stacks to disperse pollutants away from populated areas. This strategy led to large increases in regional pollution concentrations and concerns about potential ecological damage. Coal-burning electric generating units built after 1970 were limited to 1.2 pounds of SO2 per million Btu, and by 1977 new plants were forced to meet a percent reduction requirement in addition to the 1.2 pound limit. However, older coal-burning units continued to emit pollutants at much higher rates--up to 7 pounds of SO2 per million Btu--and to operate far beyond their original design lives because of the high cost of building new units.

By the 1980s, studies began to demonstrate probable harm to lakes and forests, agricultural crops, materials, and visibility from the long-range transport of SO2 and nitrogen oxide emissions. Studies also revealed that acidification of soils and waters could release heavy metals and aluminum previously bound in soils, posing a risk to human health.

Though great scientific uncertainty surrounded almost every aspect of the acid rain issue, legislators in states affected by acid rain were understandably interested in implementing a national pollution control program for older plants. In Title IV of the Clean Air Act Amendments of 1990, Congress created such a program to cut total national SO2 emissions by approximately 50 percent at an estimated cost of about $5 billion per year. At that time, quantifiable economic benefits were believed to be lower--in the range of $1 billion per year (Portney, 1990).

The program set a cap of 8.95 million tons of SO2 per year, to be achieved in two phases. During Phase I, which runs from 1995 through 1999, the 110 highest emitting coal-fired power plants (with a total of 263 coal burning units) must reduce emissions to satisfy a tonnage cap. These so-called “Table A” units were targeted for the first phase because their emissions exceeded 2.5 pounds of SO2 per million Btu and their capacity exceeded 100 MW. Phase I will yield a nationwide reduction in emissions of approximately 3.5 million tons of SO2. In the second phase, which begins in 2000, all power plants producing more than 25 megawatts and all new facilities must meet a lower emission cap. Phase II reductions will total an additional 5 million tons and will reach the overall 8.95 million ton cap.

A major innovation of the program is the acceptance of emissions trading as a means of achieving compliance. Prior to the drafting of this title of the Clean Air Act, a number of studies had identified potential cost savings of up to $1 billion per year through emissions trading due to significant differences among utility sources in the marginal cost of abatement (ICF Resources Inc. 1989).


The emission caps are enforced through a system of tradable emission allowances. Title IV specifies fixed numbers of allowances, each of which is good for one ton of SO2, to be given each year to each of the affected units. Political considerations dictated that allowances be given rather than auctioned. SO2 allowances may be used for 30 years, meaning allowances issued in one year may be “banked” for use in subsequent years. This provision gives utilities the flexibility to develop compliance approaches during their regular planning cycles. The basic formula for computing Phase I allowances is 2.5 pounds of SO2 per million Btu multiplied by each unit’s average 1985-1987 Btu consumption; for Phase II, 1.2 pounds of SO2 per million Btu multiplied by each unit’s 1985-1987 Btu consumption. There are a number of departures from the basic formula, particularly in Phase II. Sources that fail to meet these limits are subject to a penalty for each ton of excess emissions. Initially set at $2,000 per ton, the penalty is indexed for inflation and reached $2,454 per ton in 1996. In practice no utility pays the penalty because compliance with the program is far less costly.

Table A units receive 5.55 million allowances every year of Phase I. Several other provisions of Title IV also create allowances. Owners of “extension” units that propose to reduce emissions with flue gas desulfurization (FGD)/scrubbing, receive allowances, as do owners of “substitution” and “compensation” units. The substitution provision allows owners of Table A units to substitute cheaper reductions from other units, for reductions required of Table A units. The compensation provision lets a utility reduce electricity generation of a Table A unit below its baseline level provided the source of any compensating generation is designated. If the compensating unit emits SO2, an allocation of allowances is made to that unit so that the compensating unit in essence becomes part of Table I. Phase I initially included 263 units; an additional 182 combustion units joined Phase I as compensation or substitution units, raising the total of Phase I units to 445.

Beginning 1 January 1995, the USEPA could allocate up to 300,000 bonus allowances from its Conservation and Renewable Energy Reserve to utilities that undertake energy efficiency and renewable energy measures. The full accounting of provisions for allocating 1997 allowances are identified in the Table 3-1.

Sources of 1997 Allowable Emissions

Type of Allowance
Number of Allowance
Explanation of Allocation
    Initial allocation
    Granted to units based on baseline Btu output and emission rates, as specified in Clean Air Act Amendments of 1990
    Phase I extension
    Given to Phase I units that reduce emissions by 90 % or reassign obligations to units that reduce emissions by 90% (i.e., scrubbers)
    Substitution allocation
    These are the initial allocations of Phase II units that enter Phase I as substitution units
    Provided in CAAA in a Special Allowance Reserve when initial allocations were made
    Compensation allocation
    These are the initial allocations of Phase II units that enter Phase I as compensating units
    Opt-in allowances
    Provided to units that enter the program voluntarily
    Small diesel allowances
    Allocated to small diesel refineries that produce and desulfurized diesel fuel the previous year
    Conservation allowances
    Awarded to utilities that undertake efficiency and renewable energy measures before their first compliance year
Total (1997)
    CAAA = Clean Air Act Amendment

In order to maintain the emissions cap, new sources receive no allowances. Rather they must buy them from existing allowance holders or in USEPA auctions.

In March 1995, USEPA expanded the acid rain program to include industrial facilities that burn fossil fuels (USEPA, 1995). The rule establishes an “opt-in” program that allows industrial and other sources to participate in the existing SO2 program that previously included only utilities. Industrial sources that participate in the program will have an allocation of allowances that they can use for compliance, sell or trade to other sources. These provisions allowing industrial sources to opt-in were little used because of high transactions costs (Atkeson, 1997). Title IV also sets allowable limits on NOX emissions from utility boilers. An owner of two or more power plants may comply with the NOX requirement by averaging emissions across all its power plants, a rudimentary form of emission trading.

Monitoring and Compliance

Utilities whose units are included in Phase I and Phase II must install continuous emission monitoring systems to verify compliance with emission limits, and file quarterly reports of their hourly emissions data with USEPA. Initially sources mailed these data to USEPA on disks, but most sources now transmit the information over the Internet. Continuous emission monitoring (CEM) systems, the accepted industry standard for measuring SO2, NOX, and CO2, provide an accurate accounting of emissions, assuring those buying and selling allowances that the commodity they are trading is real and assuring USEPA that emission limits have been met.

CEMs have an initial capital cost of just over $700,000 and annual operating costs of just under $50,000. On an annualized basis that spreads the capital costs over a capital recovery period, the cost of operating a CEM is approximately $125,000 each year. This is equivalent to about $0.16 per kilowatt of installed capacity. (Ellerman, et al., 1997).

The cost of monitoring in the program is quite substantial. The projected savings from the overall flexible design of the program are about $2.5 billion per year. The savings that can be attributed to allowance trading have not been estimated directly; however, the literature suggests that the contribution of allowance trading is less important than some other features. (e.g., see Burtraw) When the acid rain program is fully implemented, it will include 2,000 units, each of which must install a CEM. The total cost of CEMs will be about $250 million annually, a sum that could approach the savings attributable to ET. For applications of ET in DMCs, it would be desirable to find acceptable but less costly means of measuring emissions.

At the end of each quarter, USEPA receives more than 1,700 reports containing hourly emissions data and heat input for affected units. More than 90 percent of this data is received electronically. Using these data and the allowance record for each unit, USEPA tracks compliance. Across the industry, 1995 emissions measured with CEMs averaged 7 percent higher than emissions calculated with formulas based on technology and fuel use that had been used to determine compliance with environmental regulations.

Under the authority of Title IV, USEPA developed an allowance tracking system that serves as the official record of ownership and transfers. The system currently requires a paper form that is signed by both the buyer and seller of the allowances, but plans are underway to enable utilities to submit allowance transfers electronically with just the signature (or its electronic equivalent) of the seller. With just two staff members, USEPA processes most allowance transactions within one day of receipt.

Allowance Auction

In addition to private transactions in allowances, Title IV directed USEPA to offer at an annual auction, beginning in 1993, allowances equivalent to about 2.8 percent of total allowances to assure that some allowances would be available for utilities that planned on complying with their emission limits by purchasing allowances. Private parties may also offer allowances at the auction. Each offer involves both a quantity offered and a minimum acceptable price. So far, the auctions have involved only allowances for relatively nearby years.

Economists have criticized the mechanics of the auction, suggesting that it may also contribute to lower prices than otherwise would occur (Cason, 1995). The Act requires a discriminating price auction, which ranks bids from highest to lowest. USEPA has interpreted this as requiring that each seller receive the bid price of a specific buyer. The auction first awards allowances offered by the seller with the lowest asking price to the bidder with the highest bid price. Incrementally, the allocation mechanism moves up the supply list and moves down the bid list until no bidder is willing to offer what the remaining sellers are asking. The idea of having a discriminating price auction came from House staff who were convinced that such an auction maximized revenue to sellers (Hausker, 1992).

This unusual auction mechanism may cause sellers to misrepresent and under-reveal their true costs of emission control (Cason, 1995). By lowering the reservation price, a seller increases the probability of sale and the expected price if buyers are offering different prices. Therefore, sellers would set lower reservation prices in such a discriminating price auction than in a single price auction. Joskow, et al. (1998) conclude that after the first two auctions--which provided useful indications early on that allowance prices would be lower than first anticipated--USEPA auctions have become a sideshow to the much larger private market. The evidence from a detailed analysis of the auction records is that private sellers in the USEPA auction have tended to set prices above market clearing levels rather than too low, as initially hypothesized by Cason and others.

Transactions Costs

The allowance market operates on a very narrow bid-ask spread. Recently this spread has been less than $2 per ton, or about 1 percent of allowance prices. The requirement for CEMs may be viewed as another cost of the program; at an annualized cost of $125,000 each, the CEMs required for 2,000 units included in Phase II will cost $250 million each year. This represents 11 percent of the projected costs of the program in Phase II. Another element of transaction cost is the burden on USEPA. Through the first five years of the program, USEPA reported spending a total approximately $44 million.


From 1995 through 1997 the Acid Rain Program has exceeded expectations, with firms over-achieving the reduction target at less than one-half the forecast cost. These results follow from the very flexible structure of the program, one component of which was the trading provision. In 1997 utilities exchanged 7.9 million allowances and purchased an additional allowances through the annual auction. This total excludes intra-firm transfers. This activity represents a significant increase over prior years: 0.9 million allowances traded in 1994; 1.9 million in 1995; and 4.4 million in 1996.

In searching for explanations for the relatively low level of initial activity, analysts have cited relatively high transactions costs at first, the behavior of public utility commissions, and legislation in some states that promoted the use of locally produced coal (Burtraw ).

The price of allowances has been far below initial forecasts, an issue that has attracted considerable attention. Prior to passage of the Clean Air Act Amendments of 1990, industry estimates of abatement costs were $1,000 per ton and USEPA forecast allowance prices were in the $750 per ton range. As an ultimate backstop for compliance, Congress authorized direct allowance sales by the USEPA at a price of $1,500 per ton.

Some early allowance transactions occurred at prices as high as $300 per ton in 1992. By 1993, the price had fallen to a range of $150 to $200 per ton. Allowance prices (from the USEPA auctions, transactions through the Emissions Exchange, and through brokers) gradually fell through mid-1995 to a low of $66 per ton and generally remained below $120 per ton through 1997. In 1998, allowance prices began to increase and approached $200 per ton by the end of the year.

Lower than forecast allowance prices have several explanations. Prices for virtually every form of compliance are well below anticipated levels. The price of low-sulfur western coal delivered to mid-west and eastern markets has declined due to productivity improvements in extraction, and transport and deregulation of rail rates. Engineers have found ways to blend low-sulfur coal with high sulfur coal to meet emission limits. Innovations in the scrubber market have cut the cost of scrubbing by approximately one-half. Many utilities committed themselves to scrubbers and other relatively expensive control measures based on early engineering cost studies. If they had better anticipated SO2 control costs, utilities would have ordered fewer scrubbers. The consequence of greater than expected compliance cause a downward pressure on allowance prices in Phase I.

Analysts debate the role that allowance trading plays in stimulating cost-effectiveness in SO2 control for coal-fired power plants. There is no doubt that SO2 control has experienced tremendous technological and productivity improvement over a very short period of time, leading to lower allowance prices than had been anticipated. The issue is the extent to which allowance trading is necessary to achieve these gains. Burtraw (1995) concluded that it is the flexible, performance-based design of the program that has stimulated the development of low cost compliance measures seen in Phase I, and that within that framework allowance trading played an incremental, positive role.

Phase II of the Acid Rain program is likely to see much greater reliance on allowance trading. Phase II will involve 700 additional sources, many of which are likely to select scrubbing as their method of compliance. Because more scrubbing should result in greater variation in the marginal costs of control across sources, there should be greater incentives to trade allowances to achieve compliance in Phase II.

A recent USEPA assessment of the Acid Rain program put the costs at $1.2 billion annually in Phase I and $2.2 billion annually in Phase II (USEPA 1995). The same USEPA report estimated the mean value of annual health benefits at $10.6 billion in Phase I and $40 billion in Phase II. Interestingly, health benefits were not a major concern in the design of acid rain control legislation, yet they now appear to be the dominant benefit component, dwarfing earlier estimates of environmental effects. Recall that early estimates of the costs of acid rain control put the costs at $4.5 to $6 billion annually with a command and control approach and benefits at $1-2 billion. An independent assessment reached a similar conclusion–that benefits will be much greater than costs (Burtraw, et al, 1998).

To estimate the savings attributable to tradable allowances, Carlson, Burtraw, Cropper and Palmer estimated marginal abatement cost functions for thermal power plants affected by Title IV. For plants that use low sulfur coal as a means of compliance, they found that the main sources of cost reductions are technological improvements and the fall in low sulfur coal prices, not allowance trading. Over the long run, the authors estimate that allowance trading could result in savings of $700 to $800 million per year relative to an "enlightened" command and control approach with a uniform emission standard.

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