January -March Issue


Reducing Sulfur Dioxide Emissions
Through Market-Based Regulation

n 1995, the acid rain provisions of the 1990 Clean Air Act Amendments (CAAA) went into effect. By year's end, electric utilities had reduced emissions of sulfur dioxide (SO₂) far more than required by the new law. According to an Energy Laboratory analysis, the reduction was largely the result of a novel regulatory scheme that turned the right to emit SO₂ into a valuable commodity that could be bought and sold. Under the new law, utilities were issued a limited number of fully tradable permits to emit SO₂. Some utilities faced high costs to reduce emissions, so they bought permits from utilities whose costs were lower. Other utilities reduced emissions below their allowable levels, thereby freeing up permits to sell or to save for meeting tighter emissions restrictions in the future. The result was an unprecedented emissions reduction at a lower-than-expected cost. Judging by the success of this first large-scale experiment, "market-based" environmental regulation could be an effective means of controlling other pollutants, among them worldwide emissions of CO₂.

Title IV of the CAAA requires that electric utilities in the United States reduce their emissions of SO₂ to roughly half the 1980 level, or 8.9 million tons per year--a level at which acid rain would cease to be a problem. Traditional "command-and-control" regulations would force that emissions reduction by making all electric utilities achieve a set percent reduction or meet some uniform standard and by requiring that at least some electricity-generating units install SO₂-removing scrubbers. If past experience is any guide, the reduction of emissions would be costly, bureaucracy and litigation would abound, and complete compliance would be far from assured.

Title IV takes a dramatically different approach to achieving the mandated reduction in SO₂ emissions. Instead of imposing a specific reduction requirement on every unit, it creates and distributes emission permits, or "allowances." Each allowance gives the holder the right to emit 1 ton of SO₂. The number of allowances allocated to a particular unit in a given year is determined by the product of the average amount of fuel burned between 1985 and 1987 (the "baseline") and a legislatively specified level of allowed emissions per unit of burned fuel. In Phase I, starting in 1995, 445 large units with relatively high emissions received allowances equal to 2.5 pounds of SO₂ per million Btu's of fuel burned during the baseline. In Phase II, starting in the year 2000, all units in the United States over 25 MWe will be issued allowances equal to 1.2 pounds per million Btu. Total emissions under all permits nationwide will equal the goal of 8.9 million tons. Under this novel regulatory arrangement, utilities must monitor SO₂ emissions continuously and report their measurements to the US Environmental Protection Agency (EPA). At the end of each year, utilities must turn in enough allowances to "permit" the past year's reported emissions, or face heavy fines.

For many units, the new annual emissions "budgets" are substantially below past emissions levels. To make the necessary cuts, utilities can install scrubbers, switch to lower-sulfur fuel, increase the use of non-sulfur-emitting generators, or undertake conservation measures. The approach selected is, of course, based on the relative costs of the various options. If the costs of all the options are high, a utility can continue to emit above its emissions budget by buying extra allowances from another utility. If the costs are low, a utility can cut its emissions more than required and either sell its unused allowances or "bank" them for use in the future, when standards will become more stringent and the cost of meeting them will be higher.

When Title IV was adopted in 1990, critics accused the government of granting the utilities "permission to pollute." They argued that total "compliance costs" would not be reduced because the (usually conservative) utilities would not buy and sell allowances but would simply make the necessary reductions, even at high cost. However, data from 1995--the first year in which Title IV took effect--suggest that the skeptics were wrong. Not only were compliance costs less than predicted in the affected units but the reduction in SO₂ emissions was dramatically more than required by law--an outcome unprecedented in the history of environmental regulation. And much of the reduction occurred at the highest-emitting plants, especially those in the heavy coal-burning states of the Midwest. The outcome has been so compelling that some people are advocating the use of "tradable allowances" for reducing other pollutants.

For the past year, Energy Laboratory researchers in the Center for Energy and Environmental Policy Research (CEEPR) have been examining the cost of complying with Title IV, the development of allowance markets, and the use of emissions trading. The research team includes A. Denny Ellerman, senior lecturer at the Sloan School of Management and executive director of the CEEPR; Richard L. Schmalensee, Gordon Y. Billard Professor of Management and Economics and director of the CEEPR; Paul L. Joskow, Mitsui Professor of Economics and Management; Juan Pablo Montero, PhD candidate in the Technology and Policy Program; and Elizabeth M. Bailey, PhD candidate in the Department of Economics.

To unravel the causes and costs of changing SO₂ emissions, the researchers used publicly available data on 1995 emissions, fuel deliveries, and investments at the 445 units affected by Phase I of Title IV in 1995. The researchers also surveyed individual utilities, soliciting information on compliance actions, costs, and allowance trading in 1995.

The figure below presents information on SO₂ emissions from the 445 Phase I units. The solid line with data points shows the actual aggregate emissions from those units between 1985 and 1995. The dashed line shows total emissions from those units in the absence of Title IV, as predicted by the EPA in 1990. The stepwise solid line starting in 1995 shows total emissions as mandated by Title IV. The step down in 1997 occurs because extra allowances were issued in 1995 and 1996 to encourage utilities to install scrubbers.

The decline in emissions prior to 1995--thus before the implementation of Title IV--proved to have a straightforward explanation: between 1985 and 1993, some utilities switched to lower-sulfur coal to save money. The deregulation of railroads in the 1980s drastically cut the cost of shipping low-sulfur coal from the Powder River Basin (PRB) in Wyoming. Attracted by lower prices, utilities farther east began to buy and use PRB coal, and sulfur emissions dropped. Thus, most of the reduction in emissions prior to 1993 would have occurred without Title IV.

By 1994, aggregate SO₂ emissions from Phase I units were already at or below the mandated cap. Nevertheless, during 1995 emissions plummeted almost 4 million tons. The researchers' analysis shows that continuing pre-1995 trends explain some of the decrease. But most of the decrease was due to Title IV. According to their calculations, fully 3.2 million tons of the decrease was the result of utilities banking allowances, that is, reducing emissions and stockpiling their allowances for future use. Of course, utilities will ultimately use those stockpiled allowances, probably after the year 2000, when more stringent emissions reductions are required.

What about the financial cost of complying with Title IV? Using data from the literature and from their survey, the MIT researchers calculated the cost of compliance, including both initial capital expenditures and annually recurring operating costs. They concluded that the 4-million-ton cut in SO₂ emissions observed in 1995 cost about $720 million--an estimate slightly below researchers' pre-1995 forecasts, which ranged from $800 million to $1.3 billion.

Why was the cost of reducing emissions lower than expected? About half of the reduction was achieved by using scrubbers, about half by switching to lower-sulfur fuel. The cost of switching fuels was about as anticipated. (Most utilities that switched to PRB coal did so prior to 1995.) Scrubbing costs, on the other hand, were about 40% lower than expected due to reduced operating and maintenance costs and more intensive use of the scrubbed units.

A review of the data shows that trading was more prevalent than the skeptics had predicted. Of the 8.69 million allowances issued, about 5 million were used by the utilities that received them to cover their own emissions. But about a half million were moved from an assigned unit to a different unit that would be cheaper to clean up. And 3.2 million were banked in order to reduce costs over the long term.

The MIT team observes that one of the most remarkable outcomes of Title IV has been the rapid evolution of a market for trading allowances. Some trading has taken place at a small annual auction administered by the EPA. But most of the trading to date has occurred privately. Because allowance trading is not hindered by government restrictions or subject to prior approvals, an effective market has developed, complete with brokers, futures, and other features typical of traditional financial markets. Thus far, allowance prices have been much lower than expected, largely because of the low cost of buying clean coal and of using already-installed scrubbers. While prices are likely to rise, utilities will almost surely continue to seek money-saving trades on the new allowance market.

The researchers note that everyone likes some aspect of Title IV. The utilities are free to make business decisions concerning technologies, fuels, and even their allocated allowances without direction from the federal government. Government regulators are delighted because Title IV is easy to implement and the affected utilities are complying fully. (The fine for noncompliance is $2000 plus a possible jail sentence. With allowances selling at $100 or less, the choice is clear.) And environmentalists are pleased with the complete compliance and greater-than-expected reduction in SO₂ emissions. Indeed, under Title IV environmentalists can influence emissions directly: they can buy allowances from utilities and "retire" them. And some groups are doing just that. At last year's annual allowance auction, a sixth-grade class from Glens Falls, New York, received an award for organizing a fund-raiser to collect money to retire SO₂ allowances. Their efforts raised $20,000--at the going rate, enough money to keep more than 200 tons of SO₂ from entering the environment next year.

This research was supported by the National Acid Precipitation Assessment Program and the US Environmental Protection Agency. Further information can be found in references.