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3.2.2. Chlorofluorocarbon Taxes and Allowance Trading

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Savings from Economic Incentives

The 1987 Montreal Protocol on Substances that Deplete the Ozone Layer called for a cap on chlorofluorocarbon (CFC) and halon consumption at 1986 levels, with reductions scheduled for 1993 and 1998. This agreement was ratified by the United States and 22 other countries in September, 1987. At a second meeting in 1990, the parties to the Montreal Protocol agreed to a full phaseout of the already-regulated CFCs and halons, as well as a phaseout of "other CFCs," by 2000.

In accordance with the terms of the Montreal Protocol and subsequent amendments, production of ozone-depleting chemicals such as chlorofluorocarbons for most uses in the United States was phased out by January 1, 1996. Unless otherwise stated, the term "CFCs" refers throughout this section to a variety of ozone-depleting chemicals, including halons and methyl chloroform. To facilitate the phaseout, the United States imposed a tax on selected CFCs on January 1, 1990 and expanded the tax to other CFCs the following year. EPA has a web page that describes the science and consequences of ozone depletion and activities to protect stratospheric ozone.

1. Trading of CFC Production Rights Iternationally

The Montreal Protocol created a system for the international trading of ODS. This trading took place between parties to the agreement or legal entities designated by parties. These entities included many large industrial producers. Parties to the Protocol had the responsibility for keeping their consumption of ODS within allowed levels. To assure parties were in compliance the MP created an Implementation Committee with special powers.

The 2nd Meeting of the Parties (MOP) of the Montreal Protocol in 1990 established procedures and an interim committee to deal with issues of non-compliance: to identify instances of non-compliance
to recommend treatment for Parties found to be in non-compliance
to recommend potential solutions During the formative years of the Implementation Committee (IC) between 1990 and 1993, a several principles guided its operation: keep things simple
try not be confrontational or judgmental
keep activities transparent
remain under the authority of the MOP Responsibilities of the Implementation Committee include evaluation of performance and general monitoring. Initially, the IC reviewed compliance with obligations to report data. The IC began work slowly to establish a common understanding of its responsibilities. The IC respected fully the authority of the MOP and maintained full transparency of its activities. Members in the IC are representatives of specific parties, rather than named individuals. Geographic and regional balance in the selection of members and institutional links to other elements of the MP committee structure have been instrumental to the success of the IC. When necessary the IC may establish links to the Funding Mechanism, to the Technical and Economic Advisory Panel, and to agencies that implement the MP (i.e. UNEP, UNDP, and the World Bank). The Implementation Committee identifies innovative solutions to improve performance of Parties to the MP. The Committee tries to avoid disputes by emphasizing solutions and methods for achieving compliance under the MP. The small size of the IC has allowed it to function more efficiently than if it had representatives from more parties. Linkage to financial mechanisms is provides a powerful incentive for parties to cooperate with the IC since the IC can help to make financial assistance available to facilitate compliance by a non-complying party.

2. Domestic CFC Allowance Trading

Parties to the Protocol (signatory nations) could establish mechanisms to assure that they were in compliance. As a party to the convention and the largest producer of these substances, the US established a parallel system for domestic trading of ODS. The Montreal Protocol defined consumption as production plus imports, minus exports. Consequently, in implementing the agreement, The US Environmental Protection Agency (USEPA) distributed allowances to companies that produced or imported CFCs and halons. Based on 1986 market shares, USEPA distributed allowances to 5 CFC producers, 3 halon producers, 14 CFC importers, and 6 halon importers.

The marketable permit system for producers and importers resulted in a number of savings relative to a program that directly controlled end uses. EPA needed just 4 staffers to oversee the program, rather than the 33 staffers and $23 million in administrative costs it anticipated would be required to regulate end uses. Industry estimated that a command and control approach to end uses would cost more than $300 million for record keeping and reporting, versus only $2.4 million for the allowance trading approach. CFC Regulatory Impact Analysis

Title VI of the Clean Air Act Amendments of 1990 modified the trading system to allow producers and importers to trade allowances within groups of regulated chemicals segregated by their ozone depleting potential. Canada, Mexico and Singapore also implemented trading programs in CFCs. In late 1991 EPA issued a temporary final rule that apportions baseline allowances, provides a schedule for reducing the allowances, and allows for trading of allowances among firms. In the rule EPA assigned producers and importers allowances for five types of CFCs (CFC-11, CFC-12, CFC-113, CFC-114, and CFC-115). Producers and importers could trade allowances within this group. For example, 14 million kilograms of CFC-11 and CFC-113 were traded for CFC-12 in 1992 as air conditioner makers and foam producers reduced use of these substances, while CFC-12 users maintained their demand. By 1994, the quantity of CFC-11 and CFC-113 swapped for CFC-12 grew to 26 million kilograms. EPA rules implementing Title VI specify that each time a production allowance is traded, one percent of the allocation is "retired" to assure further improvement in the environment.

Nearly 600 million kilograms of CFCs were apportioned among producers in the EPA rule. Allowing trading among producers helps to assure that as CFC production is phased out production becomes concentrated with at the most efficient facilities. The market price of most of the CFCs is well in excess of $1 per pound. With the phaseout their market value is expected to rise significantly, indicating that trading provisions potentially have a large value to producers. However, CFCs also are subject to a windfall profits tax that begins at $1.37 per pound in 1990, rising to $3.10 per pound by 1995, and increasing at $0.45 per pound per year thereafter. In the context of windfall profits taxes, trading provisions have a value if the substances continue to be competitive in the marketplace (which they are). As production is phased out, trading is likely to become more valuable per pound. EPA estimated the cost savings from halving CFC use was $1.05 per kg in 1992 (about $1.00 per pound). By 1996 production was restricted sharply and the savings probably amounted to $2 per pound. This would indicate that trading provisions might have saved about $250 million in 1992 and perhaps twice as much in 1996. By the year 2000, CFC phaseout will be complete so there will be no savings from trading beyond that date.

Like the United States and Canada, Mexico and Singapore sought to ease the phaseout of CFCs through tradable production quotas. In Singapore, CFC use permits were allocated quarterly, half on the basis of historical use and half through sealed bids. In registering to participate in the bidding, users and importers specified the quantity of CFCs they wanted and their offer price. The lowest winning bid price served as the price for all allocations, including those based on historical use. This system gave firms a strong incentive to substitute other products for CFCs or adopt other measures to limit CFC use.

3. CFC Excise Taxes

The marketable allowance trading system was accompanied by excise taxes on CFC production in the US. The rationale for the excise taxes was that the restrictions on the quantity of CFCs and halons offered on the market would lead to rapidly escalating prices that potentially would reduce incentives to develop subsititutes in a timely fashion. The excise taxes were designed to capture "windfall profits," whereas the allowance trading system was designed to assure that production and import of the substances was efficient (concentrated at the lowest cost producers, who then produced the most valued CFCs).

The magnitude of the tax was determined by multiplying a base rate per pound by an ozone depletion factor that varied according to the type of chemical. Initially set at $1.37 per pound, the base tax amount increased to $3.35 in 1993, $4.35 per pound in 1994, and $5.35 in 1995. The ozone depletion factors, which are intended to indicate each chemical's damage to the ozone layer, were set by the Montreal Protocol. For example, methyl chloroform had a factor of 0.1, whereas Halon-1301 had a factor of 10.0. The tax was imposed on the production and importation of these chemicals as well as the importation of products which contained them or used them in their production processes. Barthold (1994), pp. 137-138.

Unlike most product charges, this tax is widely credited with a significant incentive impact. CFC consumption (expressed in CFC-11 equivalents) fell from 318,000 metric tons in 1989 to 200,000 metric tons in 1990, the year the tax was introduced. (Cook (1996), p. 5) A Congressional Research Service (CRS) study concluded, "the CFC tax has clearly accelerated the rate at which CFC uses are being substituted for and the rate at which CFCs are being recovered for reuse." CRS adds that the tax was also intended to raise revenue for the federal government and to capture CFC producers' windfall revenues resulting from a tightening supply situation. Congressional Research Service (1994), pp. 72-75.

According to Cook, the tax raised $2.9 billion in its first five years. Further, the phaseout cost less than EPA's original projection. In 1988, EPA predicted that the average cost of halving CFC use would be $3.50 per kg. In 1992, the predicted cost was only $2.45 per kilogram.

Although the tax is believed to have contributed significantly to the reduction in CFC use, other factors also had an impact, including a CFC trading system (it is described next in this report), well-publicized CFC phaseout intentions, and EPA's work with the private sector on CFC recycling and substitutes. As a result of the multiplicity of policy measures, it is difficult to isolate the effects of the CFC tax.

Whether CFC taxes resulted in compliance cost savings is unclear. While taxes themselves may be costs to the taxpayer, CFC producers in this case, they are simply transfers not costs within the economy. The relevant costs are those associated with manufacturing CFCs and CFC substitutes. These costs likely rose as a result of the program, since higher-cost substitutes were introduced more rapidly than they otherwise would have been. Presumed benefits also rose, as environmentally-damaging CFCs were phased out. Thus CFC production taxes result in a market equilibrium with more costs as well as more benefits. While the CFC tax approach is likely to be more cost-effective than a command and control alternative that would yield the same environmental benefit, there appears to be no basis for estimating the magnitude of reduced compliance costs since the command and control alternative does not exist and would at best be difficult to characterize. Hence, cost savings from this program, while quite possibly substantial, cannot be determined.

4. Lessons

The Montreal Protocol offers several lessons for the establishment of international trading regimes in substances that pollute the environment. First, there was a strong scientific consensus that environmental problems caused by ozone depleting substances were very serious. Second, producers of ODS were confident that substitutes could be developed (albeit with higher production costs) within a few years. Third, the Multilateral Fund, to which developed nations contributed (in proportion to their United Nations dues), created a reserve to help developing countries with the cost of formulating substitutes. The comparisons with the Kyoto Protocol are striking. First, the scientific consensus for global warming is relatively strong but the severity of environmental effects is still debated. While some nations are convinced they face serious threats, other nations anticipate benefits from warming trends. Second, the cost of reducing greenhouse gas emissions enough to have a significant impact on the rate at which the Earth warms or to eliminate warming altogether is likely to be quite high. Third, developing nations might be forgoing opportunities to bring their economies to developed nation standards were they to agree now to limit greenhouse gas emissions.

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