The Pitfalls of Pollution Allowance Trading

Managing POWER magazine

By Kennedy Maize
Although Congress killed the Obama administration's plans for a cap-and-trade program for controlling power plant emissions of carbon dioxide, many advocates of that policy approach, …continue to push for allowance trading. The argument is that trading mechanisms are more efficient than conventional command-and-control. But a new policy analysis from the environmental think tank Resources for the Future (RFF) highlights the problems cap-and-trade programs have faced in regulating emissions of sulfur dioxide and oxides of nitrogen. According to the analysis, changes in just one program—the sulfur dioxide rules—have wiped out some $3 billion in the value of utility-held emissions allowances.

Image via Wikipedia…[Says] the RFF analysis—"Banking on Allowances: The EPA's Mixed Record in Managing Emissions Market Transitions" —cap-and-trade programs have suffered from declining credibility and market support. Say Arthur Fraas and Nathan Richardson, "…[Changes] by regulators in the rules governing the use of allowances can significantly affect the certainty and credibility of the emissions-trading programs and the value of allowances. Such changes may lead to undesirable market behavior, including an emissions increase as sources use up or dump their banked allowances."

… The prototype trading programs for SO₂ and NO_x have all allowed utilities to bank excess pollution reductions, giving the allowance owners flexibility in timing and financing their reductions. But all of the programs changed substantially as time passed—particularly as the Environmental Protection Agency (EPA) has sought to tighten caps over the years. ...

Image via Wikipedia"Because emissions allowances convey certain rights," says the RFF discussion paper, "it is important that emissions-trading programs maintain clear and consistent rules of the use of allowances in order to limit uncertainty and assure a smoothly functioning market." But that has not been the case, …

Pushed by internal and external policy and political dynamics, the EPA has repeatedly ratcheted down emissions targets, or caps. …[Says] the RFF discussion, "If banked allowances are used in the new, stricter program, emissions will be greater than desired in the short term until those banked allowances are drawn down. … [This] delay before the new caps 'bite' will be perceived as problematic and will create pressure to reduce or eliminate these 'excess' allowances."
"Striking the right balance" between the need for greater reductions and the value of banked allowances "is not easy," says the RFF paper, … "Though the problems have been consistent, the EPA's response has not” …
The damage to cost-effective reductions can be significant, says the analysis. … In the policy tug-of-war over new emissions reductions, environmental groups and their allies have pushed to eliminate the use of banked allowances, while business interests have argued for preservation of the value of the emissions.

Image via WikipediaPart of the problem is that the government has specifically avoided treating banked allowances as property; … Both Congress and the EPA have insisted through the law and implementing regulations that an allowance "does not constitute a property right." The RFF paper says the best way to understand the emissions allowances is to see them as "carrying some (but not all) of the rights in the property bundle. For example, holders can exclude others from using allowances they hold. But the statutory provisions and government agency decisions that create allowances limit allowance holders' rights." One of the problems in the property "bundle" is "the extent to which banked emissions allowances hold value as emissions caps decline and new programs are created."

… Although the EPA historically has sought to preserve the value of banked allowances during program shifts, most recently the agency proposed to wipe out banked allowances from the CAIR program to apply its successor "Transport Rule" regulatory regime. This EPA move, says the RFF paper, "represents a shift" in the EPA's traditional approach "that can only be detrimental to the overall efficiency of the EPA's cap-and-trade programs." …
—Kennedy Maize is MANAGING POWER's executive editor.