Saturday, 29 June 2013

Evaluation of Cap and Trade in the Context of the EPA Acid Rain program

In many countries Cap and Trade policies are seen as revolutionary. These types of programs have actually been in existence for decades in different forms and we can learn much from the outcomes.

Title IV of the Clean Air Act amendments of 1990, the Acid Rain Program (Title IV) was the world’s first, and is still the foremost example of a Cap-and-Trade program. As such, the program was highly anticipated and has been a benchmark for subsequent policy responses to environmental issues. This report identifies the issues that Title IV sought to resolve, develops an understanding of the economic principles that are involved in the policy, and ultimately explores whether this was, in fact, good policy

Title IV sought to address concerns around health and environmental impacts of Sulfur Dioxide (SO2). Policy makers are particularly concerned when SO2 in the environment is absorbed by vegetation or soil, is dissolved into water (Albeta Environment, 2003) or when SO2 reacts with other compounds to form small particles which penetrate the lungs of animals including humans. These particles can lead to respiratory disease, heart disease and premature death (EPA, 2012). The impacts on wild-life are often indirect and caused by changes to an animal’s ecosystem, such as impact on levels of selenium in plants (WHO, 2000).
The purpose of a policy instrument that seeks to manage environmental impact is to balance environmental improvements with the most economically efficient abatement measures which have the most positive social impacts. In addition, the aim is improve products and processes (Common, 2005). As a market mechanism it should also strive to provide certainty, liquidity (Chan, 2012), flexibility, distributional efficiency (geographic and temporal) and have reasonable transaction fees (Sovacool, 2011). In this case the key polluters were power stations, and as such mechanisms needed to be designed specifically to manage the Marginal Abatement Costs (MAC) and Marginal Damage Function (MDF)associated with these assets.

Cap-and-Trade is essentially a market response to an environmental problem. As such the mechanism is grounded in economic theory. Many perceive the benefits of Cap-and-Trade mechanism are that it combines the positive attributes of command and control, in the setting of absolute targets, with the efficiency of a market instrument. The policy also seeks to manage the following key requirements.

Calculating the target
When this policy came into being there was no way to clearly model the Marginal Damage Function (MDF) and the Marginal Abatement Cost Function (MAC). Rather the target was based on what was seen as being abatement that could be achieved cost effectively, and above which costs would climb exponentially (Schmalensee, 2013).
An initial cap was set at 9.97 (m) tons SO2e on 263 of the most polluting power stations. It then was to reduce to 8.95 (m) tons SO2e in year 2000 on approx 3,200 generating units (Chan, 2012), which is a reduction of 50% from 1980 levels.

Determination of least cost abatement
The key benefit of Cap-and-Trade is that it should, in theory, drive the lowest market wide cost of abatement. By allowing trading in allowances, the program enables the market to identify those individual firms with the least cost abatement opportunities and then these firms trade their allowances with firms with higher cost of abatement.
Originally pundits evaluated the success of the scheme by comparing ex-ante estimates of abatement costs in a theoretical least cost solution. To build a realistic evaluation of success you need to employ scenario modeling that accounts for the impact of variables such as technological change and fuel price movements (Carlson, 2000) and then discount value of compliance costs over time. Other economic concepts that feed into this equation include decisions around labor, capital investment, fuel costs (high and low sulfur content fuel), cost of production, emission rate, rate of retirement of existing capital and time period (Carlson, 2000). As factors outside of the program influence the MAC the benefits of allowances and trading change to the positive or negative..
It is also important to differentiate between compliance costs (which are relatively easy to measure) and true economic costs (which are often missed in evaluations). Economic costs are the value of goods and services lost due to regulation. For example increased product prices will effectively lower real wages and therefore decrease consumption. (Burtraw, 1998)

Managing temporal issues – banking, auctions and futures markets

Economic concepts are also employed to manage “inter-temporal arbitrage” (Burtraw, 1998). There have been two tools employed in Title IV to manage this phenomenon – banking of credits and futures trading in allowances. Both allow industry to determine when the MAC will be minimized given changes in capital, labor, fuel and other costs.
Managing geographic issues
Perhaps one of the most keenly debated economic features of this type of policy is the management of dispersion.  It is typically assumed that command and control policies are beneficial where issues are location specific, and Cap-and-Trade is more appropriate where they are dispersed. SO2 has characteristics of both which made dispersion a more complex issue and resulted in b-spoke solutions that often pitted the Cap-and-Trade scheme against existing local regulations and schemes (Chan, 2012).

What are the potential outcomes of the policy (from an “inter-disciplinary” perspective")?
Is this ‘good’ policy?

Many articles, both past and more recent, laud the success of this scheme. The report by Harvard Business review outlined that the schemes was “ a success by all measures” (Chan, 2012, p. 5). To fulfill this promise it should (according to definitions) maximise environmental benefit at the least social cost. 

A common figure for the health benefits of the program was $142 B, which is a significant saving as against the costs outlined by (Burtraw, Cost Savings, Market Performance, and economic benefits of the U.S Acid Rain program, 1998). A particular success was the flexibility of the scheme, as industry adopted unexpectedly wide range of mitigation strategies to minimize their MAC (Sovacool, 2011). Another positive surprise were the incredibly high compliance rates of  99.9% (Napolitano, 2007). And there were many other benefits such as the fact that emissions did not rise with economic prosperity, the scheme was seen as transparent, liquidity did emerge after a point, and banking of credits reduced uncertainty.
The core argument from detractors of the scheme is not as to whether there were environmental benefits, but rather whether these benefits were based on the scheme driving the lowest costs of abatement. As identified above, the actual MAC is based on changing technologies, fuel prices and changes to other inputs to power generation (such as transport costs (Schmalensee, 2013)). Many argue that positive movements in these factors drove reductions in SO2 rather than the cap. By reducing the MAC it is easier to achieve the cap and reduction in spatial differences, (including transport costs), have made cost curves more homogenous. Both of these developments have lowered the benefits of trading allowances (Carlson, 2000).

Other issues that have emerged in this policy include: generating units were able to pass costs onto consumers; a monopoly developed in the market futures contracts (Jaffe, 2009); there were market distortions caused by over-compliance in early years (Burtraw, 1999); the initial allocation of allowances was often based on lobbying rather than economic principle; the sum of the market value of allowances exceeded the total abatement costs due to the cap being too high (Chan, 2012); there were some challenges with the equity of pollution, as emitters that bought permits continued to pollute in some areas and the impacts of pass-through pricing hit lower income earners disproportionately; there are challenges assessing the true cost at the margin if energy generated by coal is not the most expensive form of generation (Carlson, 2000); in 2005 the price of allowances initially inflated and then dropped to near zero as insurmountable conflicts emerged between this market based and traditional policy measures (Chan, 2012).

Perhaps the most burning social and environmental questions arise from the potential inappropriateness of discounting environmental damage, and the initial basis for determination of the cap; which were the perceived acceptable costs of mitigation, rather than the benefits that could have been accrued based on the related opportunity costs of the damage. This raises serious questions around the ongoing perception of the marginal damage caused and therefore the real (i.e discounted) opportunity cost of Acid Rain.

Title IV was a groundbreaking policy initiative that was pushed by neo-liberal politicians as a market response to the increasing impacts of Acid Rain. While many questions remain regarding whether this was the least cost method of abatement on a systemic basis, and whether it really avoided appropriate levels of marginal damage, this was brave policy and enabled future policy makers and environmentalists to better understand the mechanics of a Cap-and-Trade response. For this alone it was good policy.

Albeta Environment. (2003). Sulphur Dioxide: Environmental Effects, Fate and Behaviour. Alberta: Science and Standards Branch Alberta Environment.
Burtraw, D. (1998). Cost Savings, Market Performance, and economic benefits of the U.S Acid Rain program. Washington: Resources for the Future.
Burtraw, D. (1999). The Effects of Trading and Banking in the SO2 Allowance Market. Washington: Resources for the Future.
Carlson, C. (2000). Sulfur Dioxide Control by Electric Utilities:What Are the Gains from Trade? Washington: Resources for the Future.
Chan, G. e. (2012). The SO2 Allowance Trading System and the Clean Air Act Amendments of 1990. Cambridge: Harvard Environmental Economics Program.
Common, M. a. (2005). Environmental Policy Instruments. In M. a. Common, Ecological Economics: An Introduction (pp. 402-438). Cambridge: Cambridge University Press.
EPA. (2012, August 24). Sulphur Dioxide. Retrieved May 3, 2013, from EPA:
Hahn, R. (2010). The effect of allowance allocations on Cap-and-Trade system performance. Cambridge: National Beuro of economic research.
Jaffe, S. (2009, March 27). SO2 Allowances Price Drop : Is there a lesson here? Retrieved May 5, 2013, from Law and the Environment:
Napolitano, S. (2007). The U.S. Acid Rain Program:Key Insights from the Design,Operation and assessment of a Cap-and-Trade System. The Electricity Journal , 47-58.
Schmalensee, R. (2013). The SO2 Allowance Trading System: The ironic history of a grand policy experiment. Journal of Economic Perspectives , 103-122.
Sovacool, B. K. (2011). The policy challenges of tradable credits: A critical review of eight markets. Energy Policy , 575–585.
Stern, N. (2006). Policy responses for mitigation IV; harnessing markets for mitigation - the role of taxation and trading. Canberra: Stern Review.
WHO. (2000). Effects of sulfur dioxide on vegetation: crititcal levels. Copenhagen,: WHO Regional Office for Europe.

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