Markets for Clean AirThe U.S. Acid Rain Program

A. DENNY ELLERMAN PAUL L. JOSKOWMassachusetts Institute of Massachusetts Institute of Technology Technology

RICHARD SCHMALENSEE JUAN-PABLO Massachusetts Institute of MONTEROTechnology Catholic University of Chile

ELIZABETH M. BAILEYNational Economic Research Associates, Inc.

published by the press syndicate of the university of cambridgeThe Pitt Building, Trumpington Street, Cambridge, United Kingdom

cambridge university pressThe Edinburgh Building, Cambridge CB2 2RU, UK http://www.cup.cam.ac.uk40 West 20th Street, New York, NY 10011-4211, USA http://www.cup.org10 Stamford Road, Oakleigh, Melbourne 3166, AustraliaRuiz de Alarcón 13, 28014 Madrid, Spain

© Center for Energy and Environmental Policy Research,Massachusetts Institute of Technology 2000

This book is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements,no reproduction of any part may take place without the written permission of Cambridge University Press.

First published 2000

Printed in the United States of America

Typeface Times Roman 10.5/13pt. System QuarkXPress [BTS]

A catalog record for this book is available from the British Library.

Library of Congress Cataloging in Publication data

Markets for clean air : the U.S. acid rain program / A. Denny Ellerman . . .[et al.].

p. cm.Includes bibliographical references and index.ISBN 0-521-66083-1 (alk. paper)1. Emissions trading – United States. 2. Air quality management –

Government policy – United States. 3. Acid rain – Environmental aspects – Government policy – United States. I. Ellerman, A. Denny.HC110.A4M37 2000363.738¢7 – dc21 99-16913

ISBN 0 521 66083 1 hardback

Contents

List of Illustrations page xiList of Tables xiiiPreface xviiAcknowledgments xxi

Part I. Background 11 A Market-Based Experiment 3

A Star Is Born (?) 3The U.S. Acid Rain Program 5Overview of the Book 9

2 A Political History of Federal Acid Rain Legislation 13Early History of Federal Regulation of SO2

Emissions 13Legislative History of the 1990 Acid Rain

Program 21

3 The Political Economy of Allowance Allocations 31Competing Theories of Distributive Politics 31The Allowance “Pie” 36Phase I Allowance Allocations 39Phase II Allowances 43Alternative Phase II Allocation Rules 48

vii

Gainers and Losers from Alternative Phase II Allocation Rules 53

Hypothetical Votes on Phase II Allocations 61Estimating Political Determinants of Allowance

Allocations 64A Majoritarian Equilibrium 75

4 The Pre-1995 Trend in SO2 Emissions 77Expected versus Actual SO2 Emissions 77The Economics of Coal Choice 80Historical Patterns in Rail and Coal Prices 82Econometric Analysis 89Rail-rate Deregulation Reduces SO2 Emissions 104

Part II. Compliance and Trading 1075 Title IV Compliance and Emission Reductions,

1995–97 109Perfect Compliance and Significant Emission

Reductions 109Counterfactual Emissions 110Emissions Reductions Resulting from Title IV 118

6 Emissions Trading: The Effect on Abatement Behavior 141Unit-level Emissions Trading 141Some Classifications and Definitions 143Overcompliance 149Excess Allowances 151Current Demand for Allowances 154Banking of Allowances 161From Internal to External Trading 165

7 Emissions Trading: Development of the Allowance Market 167Annual EPA Auctions 169Emergence of the Private Allowance Market 172Influence of State Electric Utility Regulation on

Allowance Trading 190The Allowance Market Works 195

8 Title IV’s Voluntary Compliance Program 197Patterns of Voluntary Compliance 198

viii Contents

The Decision to Volunteer 203Effects on the SO2 Market 213Implications for Program Design 215Adverse Selection Is a Problem 219

9 Cost of Compliance with Title IV in Phase I 221Confusion about Control Costs 221Assumptions and Data Sources 223Estimates of Phase I Costs of Compliance 228The Cost of Abatement by Scrubbing 235The Cost of Abatement by Switching to

Lower-Sulfur Coal 242Monitoring Costs 248

Part III. Questions and Implications 25110 Cost Savings from Emissions Trading 253

Cost Savings Is the Goal 253Evidence of Cost Savings 254Basic Analytic Framework 260Positioning the Title IV Cost Curves 270Cost-Saving Estimates 280Substantial and Real Cost Savings 294

11 Errors, Imperfections, and Allowance Prices 297Unexpected Behavior at Allowance Prices 297Some Unconvincing Hypotheses 299Expectation Errors and Overinvestment 302Puzzles and Future Price Trends 309A Better Alternative Policy? 312

12 Concluding Observations 314Trading Can Work 315Politics Don’t Matter 316Markets Can Develop 317Trading Handles Surprises 319Opt-in Provisions Are Tricky 320Extrapolate with Care 321

Appendix: Effect of Title IV on SO2 Emissions and Heat Input by Susanne M. Schennach 323Introduction 323

Contents ix

Data 324Specification of the Model 324Results 329Effect of Title IV on Utilization 334Conclusion 341

Bibliography 343Index 353

x Contents

Illustrations

4.1. Mine-mouth prices for coals competing in the Midwest, 1987–98 page 85

4.2. Power plants burning Powder River Basin coal,1985–93 87

4.3. Simulated effect of PRB coal expansion on SO2

emission rates 1005.1. Estimated Phase I effect on heat input (coal

units, non-PRB zone) 1195.2. Title IV in historical perspective 1215.3. Emissions, Title IV and PRB abatement

according to econometrically estimated counterfactual, 1993–97 122

5.4. Distribution of SO2 emissions reductions, by unit,1997 124

5.5. Distribution of emission-rate reductions, by unit,1997 125

5.6. Distribution of 401 continuously affected units,by emission-rate category, 1985–97 126

5.7. Title IV emissions reductions, by abatement technique 127

5.8. Title IV emissions reductions, by state and year 1315.9. Comparison of 1997 Title IV emissions

reductions with pre–Title IV emissions reductions, by state 132

5.10. Effect of emissions trading on emissions reductions, by state, 1997 134

xi

5.11. 1997 emissions reductions, by state and abatement technique 135

6.1. Unit-level emissions trading, 1997 1426.2. Sources of supply for emissions trading, 1995–97 1476.3. Sources of demand for emissions trading, 1995–97 1486.4. Sources of overcompliance, 1995–97 1506.5. Sources of excess allowances, 1995–97 1536.6. Emissions at units acquiring extra allowances, 1995–97 1556.7. Annual banking of allowances, by utility 1647.1. Allowance prices, 1992–98 (1995 or current vintage) 1737.2. Evolution of bids and offers at EPA spot auctions,

1993–98 1807.3. Term structure of allowance prices 1887.4. Convenience yields for SO2 allowances 1898.1. Costs and benefits from voluntary compliance 2169.1. Long-run “marginal” cost for Phase I units 2309.2. Estimates of Phase I cost, predicted vs. actual 2349.3. The fixed costs of scrubbing 23710.1. Allowance value vs. coal-sulfur premium, central

Appalachia, 12,500 Btu/lb, 1.5 to 2.0 lb/mmBtu 25710.2. Distribution of changes in emission rates, 1995–97 25910.3. Illustrative two-period cost-savings diagram 26210.4. Optimal emissions and allowance price paths 26810.5. The Phase I cost curves 27810.6. The cost-savings framework fitted to Title IV 28010.7. The effect of overinvestment 28310.8. Effect of assumptions on cost ratio between the CAC

alternative and Title IV 28911.1. Allowance prices, 1992–98 (1995 or current vintage) 29811.2. Mandatory and banking components of 1995–97

reduction 306A. 1. Title IV abatement, by unit type 332A. 2. Actual, predicted, and counterfactual emissions, for units

subject to Phase I in at least one year 333A. 3. Relative magnitudes of Title IV abatement and PRB

abatement by coal-fired Phase I units located between 600 and 1,200 miles from the PRB 335

A. 4. Transfers of heat input from unscrubbed Phase I units 340

xii Illustrations

Tables

2.1. Per capita and aggregate baseline SO2 emissions,by state page 19

3.1. Phase I allowance allocations by state 413.2. Incidence of selected special Phase II (2000–09)

provisions 453.3. Alternative Phase II allowance allocation rules 493.4. Effect of alternative Phase II allowance

allocations on cost 523.5. Baseline emissions and effect of Phase II

allowance allocation rules, by unit type 553.6. States with largest gains and losses from Phase II

allowance allocation changes 573.7. States with largest Phase II gains and losses vs.

average benchmark allowance allocation 593.8. Results of simulated votes on Phase II allowance

allocation changes 633.9. Variables employed in Phase II regression

analysis 663.10. Phase II regression results 714.1. SO2 emissions by U.S. power plants, 1985–93 794.2. Rail rates of coal shipments to the Midwest,

1979–93 844.3. Delivered cost of PRB coal to the Midwest, 1987

and 1993 854.4. Coal price comparisons for plants switching to

PRB coal 864.5. Sample statistics (1,039 units) 92

xiii

4.6. OLS results for years 1989–93 974.7. Causes of change in SO2 emissions, 1985–93 1015.1. Title IV emission reduction, 1993–97 1195.2. Title IV SO2 compliance statistics, 1995–97 1205.3. SO2 emission reductions from fuel switching, 1995 1285.4. Voluntarily affected units, 1995–97 1375.5. Characteristics of 1995–97 voluntarily affected units 1386.1. Classification of Phase I units 1446.2. Principal sources of overcompliance, 1995–97 1506.3. Units acquiring additional allowances, 1995–97 1556.4. Phase I affected utilities ranked by 1997 internal

trading ratio 1576.5. Current external demand for allowances, 1995–97 1606.6. Sources and uses of retained allowances, 1995–97 1626.7. Sources and uses of allowances by utility, 1995–97 1637.1. Allowances sold in EPA auctions and in the private

market 1767.2. Percentage differences between average winning bids

and lowest winning bids in EPA auctions 1827.3. Allowances privately offered for sale in EPA auctions 1847.4. States with PUC guidelines or generic orders 1938.1. Statistics of Table A, substitution, and eligible units for

selected years 2028.2. Summary statistics for “eligible” and “reduced” samples

for 1995 2088.3. ML logit estimates for participation in the substitution

provision equation 2098.4. Estimated impacts of statistically significant coefficients

on opting-in probability 2128.5. Accounting for allowances from the voluntary

compliance program 2149.1. 1995 cost of compliance with Title IV 2299.2. Estimates of Phase I compliance costs 2329.3. Expected and actual cost and performance data for

Phase I scrubbers 2369.4. Changes in abatement at Phase I units, 1996 and 1997 2469.5. Cost of CEMS 250

10.1. Data for average Phase I year 27110.2. Data for average Phase II year 27210.3. Data for positioning CACC 27710.4. Abatement cost and cost savings from emissions

trading 282

xiv Tables

10.5. Alternative estimates of abatement cost and cost savings from emissions trading 284

10.6. Effect of banking periods on abatement cost and cost savings from emissions trading 287

10.7. Effect of Phase II CACC on abatement cost and cost savings from emissions trading 289

10.8. Estimates of Title IV cost savings 292A. 1. Estimated coefficients of Equation (A.1) 330A. 2. SO2 abatement (in thousands of tons), for each type of

Phase I unit 331A. 3. Actual, predicted, and counterfactual emissions

(in thousands of tons), for units subject to Phase I in at least one year 332

A. 4. 95% confidence interval of Title IV abatement (in thousands of tons) 334

A. 5. PRB abatement by coal-fired Phase I units located between 600 and 1,200 miles from the PRB (in thousands of tons); total Title IV abatement also shown 335

A.6. Estimated coefficients of Equation (A.2) 339A.7. Changes in emissions at Phase I and Phase II units

(in thousands of tons) resulting from a heat-input transfer from Phase I to Phase II units 341

Tables xv

1. Notable works in this tradition include Montgomery (1972), Tietenberg (1985), andBaumol and Oates (1988).

2. For discussions of other environmental programs employing various forms of emissionstrading, see Tietenberg (1985), Hahn and Hester (1989), and National EconomicResearch Associates, Inc. (1994, Chapt. 2). Noll (1989, p. 1275) discusses some of thepolitical reasons such programs are rare; see also Stavins (1998).

1 A Market-Based Experiment

3

A STAR IS BORN (?)

More than thirty years ago, Dales (1968) demonstrated that, in theory,an emissions-trading system,in which rights to emit pollution are avail-able in fixed and limited aggregate amount and are freely tradable,would induce rational firms to reduce pollution at the least possiblecost.This basic theoretical argument has been refined and elaboratedmany times since.1 Over this same period, the alternative command-and-control approach to environmental policy, in which the design orperformance of individual pollution sources is specified, has beenapplied to a wide variety of problems and has generally performedpoorly, with excessive costs and, often, failure to achieve environmen-tal objectives. Nonetheless, until quite recently, emissions trading andrelated approaches (such as emission taxes) attracted little but hostil-ity from noneconomists and were rarely employed in practice.2

Then, with relatively little fanfare, Title IV of the 1990 Clean AirAct Amendments (1990 CAAA, Public Law 101–549), the U.S. AcidRain Program, passed by the U.S. Congress and signed by PresidentGeorge Bush in 1990, established the first large-scale, long-term U.S.environmental program to rely on tradable emission permits (called

“allowances” in the legislation) to control emissions. Its target waselectric utility emissions of sulfur dioxide (SO2), the major precursorof acid rain.

Since 1990, policymakers’ interest in emissions trading has grownrapidly. This growth accelerated in 1995, when Title IV came intoeffect. Most observers quickly judged the program to be a greatsuccess, largely because the price of emission rights (allowances) waswell below expectations.3 Subsequently, the United States has movedtoward implementation of a regional trading program for rights toemit oxides of nitrogen (generally called NOx, which are importantcontributors to ozone pollution), and the international communityhas endorsed, at least in principle, the use of international emissionstrading to deal with the threat of global climate change.4 There seemsto be a conference on emissions trading somewhere in the worldevery day, each accompanied by a raft of papers from universities,think tanks, and government agencies. In less than a decade, emis-sions trading has gone from being a pariah among policymakers tobeing a star – everybody’s favorite way to deal with pollution prob-lems. As always, when widespread public acclaim for a new approachto an important public policy issue comes so fast and is based on frag-ments of evidence about performance, at least some will wonderwhether such acclaim is truly deserved.

This book provides a comprehensive description, analysis, andevaluation of the source of this widespread public acclaim: the SO2

emissions-trading program created by Title IV of the 1990 Clean AirAct Amendments. This work is based on the first few years of expe-rience with the program. Our goal is both to deepen understandingof this program in its own right and to make it possible to use expe-rience with Title IV to inform both decisions about the use of emis-sions trading to control pollution and the design of emissions-tradingsystems more broadly. We concentrate on political economy, compli-ance behavior, and abatement cost; an inquiry into the benefits ofreduced emissions is beyond the scope of this study.5 We find that, on

4 Background

3. Ironically, as we show in Chapter 11, the very low allowance prices in 1995 and 1996reflected the Acid Rain Program’s (perhaps inevitable) imperfections more than itsvirtues.

4. On these and related developments see, for instance, U.S. Council of Economic Advisers (1998, pp. 156–80).

5. NAPAP (1998) provides a discussion of the effects and benefits of the reduction of SO2

emissions effected so far by Title IV. In general, the pertinent sections state that a

balance, Title IV has indeed performed well and has thereby proventhat emissions trading has considerable potential in practice, as wellas in theory. But, as we hope subsequent chapters will demonstrate,there is much more to be learned from careful analysis of thiscomplex and important policy experiment than can be inferred froma cursory examination of allowance price levels.

We turn first to a brief description of the structure of the SO2

allowance-trading program set up by Title IV and of how it wasdesigned to operate. (More details are given in subsequent chaptersas needed.) The final section of this chapter provides an overview ofthe rest of this book.

THE U.S. ACID RAIN PROGRAM

Acid rain (or, more properly, acid deposition) occurs when sulfurdioxide (SO2) and nitrogen oxides (NOx) react in the atmosphere toform sulfuric and nitric acids, respectively.6 These acids then fall toearth, sometimes hundreds of miles downwind from their source, ineither wet or dry form. In North America, acid rain is a concernmainly in the northeastern United States, particularly in the Adiron-dacks and New England, and in southeastern Canada. The motiva-tion for regulatory policies to reduce acid rain is the argument thatin this region, acid rain damages aquatic life and harms trees in sen-sitive forest areas. The dominant precursor of acid rain in the UnitedStates is SO2 from coal-fired and, to a much smaller extent, oil-firedpower plants. These emissions are the focus of Title IV of the 1990Clean Air Act Amendments.7

A Market-Based Experiment 5

statistically significant reduction in sulfur deposition was observed in 1995 by monitorslocated in the Northeast and the Ohio River Valley, but similarly significant changes inthe acidity of waters or other indicia of ecosystem response have not been observed,because of the longer response times of these complex processes.

6. NAPAP (1991).7. Electric utilities accounted for about 70% of 1985 U.S. SO2 emissions: Coal-fired

units accounted for 96% of this total, and oil-fired units accounted for the remainder(EPA, 1994). The other 30% of emissions is accounted for by a wide variety of industrial, commercial, and residential boilers and process sources (including smeltersand paper facilities), as well as by the use of diesel fuel for transportation. Aside fromcertain voluntary opt-in provisions contained in Title IV, including these other sourcesin the allowance program was not given serious consideration. These sources are generally individually much smaller than utility sources and are much more diverse.Moreover, there were no systematic baseline emissions data available for these sources

Title IV represents a fundamental change in the regulatory frame-work governing air pollution in the US. Previous air pollution regu-lations controlled the emissions rates of individual pollution sources(measured in, for instance, pounds of pollutant per unit of fuelburned) or required that individual sources employ designatedcontrol technologies. Aggregate emissions (measured in, for instance,tons of pollutant) were not directly controlled. In contrast, the 1990acid rain law focuses directly on aggregate SO2 emissions rather thanon emissions by individual sources, their emission rates, or the tech-niques they use to control emissions. It does so by placing an aggre-gate cap on SO2 emissions and gives polluters extensive flexibility tochoose whether and how to reduce emissions at specific sources. Theintroduction of emissions trading goes well beyond trading amongutilities. Equally importantly, the 1990 law gives utilities with multi-ple fossil-fired generating units enormous and unprecedented flexi-bility in complying with emission limits even if they trade noallowances at all with each other.

Title IV was advertised as requiring a 10-million-tons-per-yearreduction in SO2 emissions from 1980 levels by the year 2000. Toachieve this goal, the law created a cap on SO2 emissions from elec-tric generating plants of roughly 9 million tons per year, effective inthe year 2000 and beyond. This emissions cap was to be achieved intwo phases. During Phase I (1995–1999), the 263 dirtiest large gen-erating units (located in 110 generating plants and accounting for 88GWe of electric generating capacity) were required to reduce theiremissions by roughly 3.5 million tons per year, beginning in 1995. InPhase II (2000 and beyond), virtually all fossil-fueled electric gener-ating plants become subject to the national cap on aggregate annualSO2 emissions. (All states had Phase II units except Alaska andHawaii, which were simply omitted from the program, and Idaho,which had no fossil-fueled generating units.)

The Phase I reductions and Phase II cap are enforced through theannual issuance of tradable emission allowances, each of whichpermits its holder to emit one ton of SO2 in a particular year or anysubsequent year.8 Each unit has thirty days after the end of each year

6 Background

to provide a basis for allocating allowances to incumbents. On this issue, see Kete (1993,pp. 217–21).

8. In fact, these allowances are like checking account deposits, in that they exist only asrecords in the EPA’s computer-based allowance-tracking system. The system, which contains accounts for all affected generating units and for any other parties that wantto hold allowances, can be used to transfer allowances from one account to another.

to deliver to the U.S. Environmental Protection Agency (EPA) validallowances sufficient to cover its emissions during the year. At thattime, the EPA cancels the allowances needed to cover emissions.Failure to produce the necessary allowances subjects a utility to sub-stantial financial penalties and requirements to make additionalfuture emission reductions.

Allowances good in any particular year but not needed to cover SO2

emissions in that year may be “banked” for future use, but allowancescan never be borrowed from the future. (As we shall see, this hasturned out to be an absolutely critical feature of the program.) Ownersof individual units are free to decide what mix of emission reductionsand allowance transactions they will employ to meet each year’sallowance constraint, and essentially no restrictions are placed onemission reduction techniques. There is also no restriction on who may buy or sell allowances. Brokers have acquired some in hopes offuture price increases, for instance, and environmentalists haveacquired some in order to reduce emissions more than the lawrequires.

Phase I (1995–99)

The basic allowance-allocation formula for each unit required toreduce emissions in Phase I (called “Table A units” because they are listed in Table A in the statute) multiplies an emission rate (ER)of 2.5 pounds of SO2 per million Btus of heat input (2.5 lb/mmBtu, forshort) by baseline heat input (generally the unit’s 1985–87 average).As discussed in Chapter 3, however, the final bill included significantdepartures from this formula. The most important of these wasdesigned to favor the use of eastern high-sulfur coal by providingbonus allowances to Phase I units (“extension units”) that opted tocomply with Title IV via flue-gas desulfurization. This involvesinstalling a relatively expensive facility, generally called a “scrubber,”that removes sulfur from the flue gas. The main alternative approachto emission reduction is to switch to coal with a lower sulfur content,which is historically more expensive than high-sulfur coal.

Title IV also contains provisions designed to give utilities additionalflexibility in complying with Phase I emission-reduction obligations:

• The “substitution” provision permits utilities to substitute otherunits for Table A units. Non-Table A units that have been sub-

A Market-Based Experiment 7

stituted for Table A units then receive allocations of allowancesapproximately equal to their historic emissions and, for allintents and purposes, are treated as Table A units.

• The “compensation” provision allows utilities to reduce genera-tion in Table A units in a way that does not simply involve shift-ing electricity production and the associated SO2 emissions froma Phase I unit to units not affected by Phase I.

Collectively, these provisions are often referred to as the “voluntarycompliance program.” As we discuss in Chapter 8, the substitutionprovision has been much more important than anyone had antici-pated, while the compensation provision has been little used.9

Phase II (2000 and Beyond)

During Phase II, each fossil-fuel-based generating unit exceeding 25MWe generating capacity is allocated a specific number of SO2

allowances per year, and additional reductions in aggregate emissionsare required. The Phase II allocation rules for the years 2000–09,which we analyze in detail in Chapter 3, are specified in about thirtystatutory provisions. The provisions for 2010 and subsequent yearsare only slightly less complex. As in Phase I, utilities can cover theiremissions with the allowances they were allocated, and buy, sell, orbank allowances for future use. Any individual or firm is free to buyand sell allowances, as well.

Annual EPA Auctions

In addition to allocating allowances to each generating unit, the EPAhas been required by Title IV to conduct small annual revenue-neutral allowance auctions since 1993. Auctioned allowances areacquired by the EPA’s holding back approximately 2.8% of theallowances issued to each unit; each unit in turn receives a pro ratashare of the auction proceeds. The auction is “revenue neutral” in thesense that the EPA takes allowances from each affected source (i.e.,each generating unit that must use allowances to cover its emissions)and then pays the source for these allowances based on the market

8 Background

9. Title IV also established a voluntary program applicable to industrial sources thatallowed such sources to “opt in” to the program. However, like the compensation provisions, the voluntary industry-source program has also been little used.

value they fetch at auction. The auction provision was a response toconcerns expressed by independent power producers and rapidlygrowing utilities that an active market for allowances would notemerge, concerns strengthened by assertions during debates on the1990 Clean Air Act Amendments that utilities would hoard theirinitial allocations and refuse to sell at any price.10

Measuring Emissions

Any effective “cap and trade” system such as that embodied in TitleIV requires an accurate method for measuring emissions and track-ing allowances. Title IV requires utilities to install continuous emis-sion monitoring (CEM) equipment, and EPA regulations containpowerful financial incentives to ensure that these monitors are oper-ationally accurate. In addition, the EPA created a comprehensivecomputer database that allows owners of affected units, as well as the EPA and third parties, to track the number of allowances in each unit’s “account” at a particular point in time. The system also allows each unit’s authorized representative to record transfersof allowances between generating units under common ownership aswell as between generating units with different owners. While theterms and conditions of allowance market transactions are notreported to the EPA, any allowances that are bought and sold musteventually appear in the EPA’s allowance-tracking system if they areto be used for compliance purposes.

OVERVIEW OF THE BOOK

Like it or not, environmental policies are outputs of politicalprocesses. Understanding the political process that drove the designand enactment of Title IV can inform thinking about future uses ofemissions trading. Chapter 2 describes the evolution of acid raincontrol policy in the United States over the last three decades, andthe long political process that culminated in the passage of Title IV

A Market-Based Experiment 9

10. For several years, some allowances were also held back each year for sale at a fixedprice (which turned out to be well above market prices); any excess supply was auc-tioned the following year. Hausker (1992) discusses the political economy of these insti-tutions; see also Joskow, Schmalensee, and Bailey (1998) and Chapter 7 of this book.

in 1990. Since allowances to emit SO2 are valuable, it should be nosurprise that interest groups affected by the program desired to gaintitle to as many allowances as possible. Moreover, the economicimpact on key actors – utilities, coal-mine owners, coal miners, andelectricity consumers – of a program designed to reduce SO2 emis-sions significantly varied widely from one region of the country toanother. There was similar variation in the political influence of the groups affected in each region and of their legislative represen-tatives. In Chapter 3, we examine Congress’s ultimate allocation ofSO2 allowances among electric generating units located in differentregions of the United States from a political economy perspective,focusing on the role of key interest groups and their supporters inCongress.

With this background, we then turn to a multidimensional analy-sis of the effects of Title IV on SO2 emissions, of compliance strate-gies adopted by the owners of affected generating units, of thebehavior and performance of allowance markets, and of the costsincurred by emission sources to comply with the program’s require-ments. Chapter 4 examines the historical patterns of SO2 emissionsbefore Title IV took effect in 1995. This is important because SO2

emissions were declining even before Title IV became effective, dueto changes in coal and transportation markets, as well as earlier emis-sion-control regulations aimed at other adverse environmentaleffects of SO2 emissions. Chapter 5 presents “counterfactual” esti-mates of what SO2 emissions would have been, had there been noTitle IV restrictions on them. The level of “counterfactual” emissionsthen becomes a baseline from which the reduction in emissionsattributable to Title IV in the years 1995–97 can be determined. Thischapter also discusses abatement techniques used to accomplish thatreduction and the way the emission reduction was distributed geo-graphically and among units. In particular, we provide an analysis ofwhy “hot spots” have not appeared. In Chapter 6, we present ananalysis of the extent to which operators of Phase I units have madeuse of the flexibility provided by Title IV to reassign and trade emis-sion rights among units and over time.

Chapter 7 turns to a detailed analysis and evaluation of the devel-opment and performance of markets for SO2 allowances. This analy-sis examines both the annual EPA auctions as well as the much larger

10 Background

and more complex private markets for allowances and allowancederivatives that have developed in the last few years and the influenceof state regulatory commissions. Chapter 8 analyzes why the volun-tary compliance program was so heavily utilized and contributed solittle to the overall reduction of emissions. In particular, we elucidatean important potential “adverse selection” problem that must be con-sidered in the design of voluntary features of any future emissions-trading program. This problem may be especially important in thedesign of international CO2 emissions-trading programs, since in theabsence of a world government, all participation is necessarily vol-untary. In Chapter 9, we develop estimates of the costs incurred byutilities to comply with Phase I of the program. Some have arguedthat the low allowance prices observed early in Phase I indicate thatthe allowance-trading system made large SO2 emission reductionspossible at a small fraction of the anticipated cost. Our estimate ofthe actual costs of complying with Phase I of Title IV is developedand compared to earlier predictions of the cost to comply with Title IV.

This book concludes with three chapters that identify and discussa number of questions raised by the experience with the SO2 tradingprogram. As just noted, Chapter 9 provides an estimate of the cost ofcomplying with Phase I. Of equal interest is the question of how thisestimated compliance cost compares with the costs that would havebeen incurred if a reasonable “command-and-control” system hadbeen employed instead of a cap-and-trade system. That is, how muchwas saved by turning to a cap-and-trade system instead of an alter-native command-and-control system? Chapter 10 provides an esti-mate of the cost savings achieved by Title IV’s emissions-tradingprovisions when compared to a plausible alternative form of SO2

emission regulation that would achieve the same aggregate reductionin emissions but would not allow for trading of emission rights.Having focused on the benefits resulting from the flexible trading fea-tures of Title IV, we turn in Chapter 11 to a discussion of imperfec-tions in certain aspects of emissions trading. We also address theinevitable “errors” (i.e., decisions that 20/20 hindsight reveals to havebeen suboptimal) made in a world of uncertainty. This discussion necessarily involves an interpretation of the behavior of allowanceprices, which have been anything but smoothly rising, as textbook

A Market-Based Experiment 11

presentations (which generally assume away uncertainty) wouldsuggest. Chapter 12 offers concluding observations and presentssome thoughts on the implications of the experience with the SO2

trading program for the application of similar market-based emission-control approaches to other pollutants, such as air emissionsthat are thought to contribute to global warming.

12 Background