Cap & Trade: A Market Approach to Reduce Pollution Brian McLean, Director Office of Atmospheric Programs U.S. Environmental Protection Agency The Sixth Mansfield Pacific Retreat Unleashing Market Forces to Protect the Environment

Traditional Environmental Regulation u Established what needed to be done u Prescribed how and when each source was to do it u Designed to address local impacts u Assured compliance through equipment installations and performance tests, not usually by measuring total emissions u Referred to as “command and control”

Bubbles, Offsets and Credits u Assumed command and control infrastructure u Provided some flexibility in how a source could comply, i.e. by getting reductions from another source u Required government approval to prevent: ã “paper credits” ã “anyway tons” ã unacceptable air quality impacts

Cap & Trade – A New Experiment u Sets a maximum allowable emission level u Provides incentives for innovation u Refocuses government’s role ã Emphasizes emission reduction and measurement ã Enforces cap (holding sufficient allowances), avoids dictating how sources are to comply ã Reduces administrative burden and cost while promoting greater environmental certainty u Changes government-industry relationship

Flexible Approach u Cap & trade provides sources with flexibility to determine appropriate strategy ã How to make reductions ã Where to make reductions ã When to make reductions u For some problems, flexibility may not adequately address problem ã Does it matter where reductions are made? ã Does it matter when reductions are made? u Cap & trade can work with source-specific controls or emission levies

Setting the Emission Level u Environmental needs ã Public health ã Lakes, streams and forests ã Buildings and cultural resources u Technical and economic feasibility

Allocating Allowances 1990 SO 2 Emissions

Operating the Program: U.S. EPA u Collect and verify emission data and make available to public via Internet u Audit and enforce monitoring requirements u Record official allowance transfers and make available to public via Internet u Determine compliance: reconcile annual emissions and allowance holdings u Enforce automatic emission offsets and financial penalties

Program Requirements: Sources u Develop compliance strategy u Monitor and report all emissions ã Install and maintain monitors (coal, oil & gas) ã Conduct performance tests ã Report hourly emission data and performance test results u Hold sufficient allowances to cover emissions

Acid Rain Program Results u Reductions began on time and on target u Compliance is high (over 99%) u Compliance costs are low (75% below estimate) u Government role is focused u Transaction costs are low u Incentives for innovation are continuous u Health benefits exceed costs by more than 50:1 u Relationship with industry is positive

Wet Sulfate Deposition Decreased

SO 2 Concentrations Decreased

NOx Budget Programs u Emission budgets (caps) set for each state by OTC or USEPA u States determine allowance allocations u USEPA (in consultation with States) establishes trading and monitoring rules u USEPA operates allowance and emission tracking systems u States enforce monitoring and allowance holding requirements

Benefits of Cap & Trade u More certainty that a specific level of emissions will be achieved and maintained (even with economic growth) u More regulatory certainty for sources u More compliance flexibility and lower compliance costs for sources u Lower transaction costs for trading u Better emission data u Fewer administrative resources needed by industry and government

Keys to Successful Cap & Trade u Cap ã Protects the environment ã Provides predictability to market participants u Accountability ã Accurate, complete emission measurement ã Transparent emission and allowance data ã Predictable consequences for noncompliance ã Complete and consistent enforcement u Simplicity of design and operation ã Minimal, but effective government role ã Facilitates market and maximizes cost savings

Infrastructure: Measurement u Accurate, consistent measurement methods are essential ã Ensure environmental integrity u Government verification is important ã Ensure environmental integrity ã Encourage equity ã Promote public acceptance

Infrastructure: Data Systems u Emission and allowance data must be managed ã Collect data from sources ã QA/QC emission data ã Maintain data ã Disseminate information u Computerized tracking systems provide benefits ã Increase accuracy and consistency ã Reduce time, effort and costs ã Simplify data storage, maintenance, and retrieval ã Improve access to relevant information

Infrastructure: Enforcement u Resources for auditing emission measurements and equipment u Resources for determining compliance u Strong enforcement institutions ã Political and institutional support ã Authority to assess and collect penalties

For More Information u Visit the clean air markets web site to view ã Emission data and allowance information ã Information on cap and trade programs ã Program rules and guidelines ã Studies and reports ã Information about international cooperation

SO 2 Emissions in the U.S. Million Short Tons Great Depression WW II CAA Without the CAA Acid Rain Program

SO 2 Emissions Decreased

Health Benefits Significant Health Benefits in 2010 $50 billion in annual health benefits 10,000 premature deaths avoided

Annual Compliance Costs are Low u Reasons for low cost ã Competition across emission reduction options ã Continuous incentive for innovation ã Banking provides timing flexibility ã Allowance price provides benchmark for decision making ã Trading not restricted 2010 Predicted Costs Enactment4 Yrs Later8 Yrs Later

Active Allowance Market u Since 1994, over 150 million SO 2 allowances have been transferred. u On-line transfers initiated in By end of 2002, 80% of transactions conducted on-line. u Approximately 45% of all SO 2 allowances have been transferred between different companies. u In 1990, EPA estimated allowance prices for 2000 at $625* (actual price about $150). * in 2000 dollars

Limited Supply of allowances (cap) Economic value for allowances Economic incentives to reduce emissions Demand for allowances Why Cap & Trade Works u Emission Cap ã Limits emissions and maintains reductions ã Provides market value and certainty ã Allows trading without government approval u Trading ã Allows companies to choose compliance options ã Minimizes costs through compliance flexibility

RECLAIM u The RECLAIM program is a cap-and trade program that began in 1994 and was expected to be fully implemented in 2003: ã NOx emissions were to be reduced from 105 to 27 tons/day ã SOx emissions were to be reduced from 26 to 10.5 tons/day u Caps all facilities emitting 4 tons or more/year of NOx and/or SOx: ã Initially affected 364 facilities l Included electric utilities, refineries and “other” emitters (cement kilns, diesel engines, process heaters, dryers, etc…,) ã Excluded certain essential public services.

Source: White Paper on Stabilization of NOx RTC Prices, SCAQMD Emissions and Credit Supply

Cycle 1 Credits Cycle 2 Credits Cycle 1 StartsCycle 2 StartsCycle 1 Ends/Starts Cycle 2 Ends Cycle 1 Credits Trading Under RECLAIM u Two annual cycles: ã Cycle 1: January 1 - December 31, Cycle 2: July 1 - June 30 u Free trading among facilities in different cycles u There is no banking, however, facilities can use another cycle’s credits to offset emissions during the first six months of their cycle.

Market Reaction SO 2 and NOx RTC (Compliance Year) Market Price Index Source: Cantor Fitzger ald, EBS NOx Trading continued throughout 2000 despite high prices

Reaction to the Price Increase u In response, RECLAIM officials proposed to isolate utilities >50MWe from the NOx market. ã Instead, utilities would pay into an “air quality investment program” $7.50/lb of NOx emitted beyond their initial allocation. u In compliance with abatement orders, 37 air pollution control projects are underway and 29 more are planned ã 17 utility boilers are in the process of installing SCR u Effectively removed utilities from the market

Why did NOx RTC prices increase? u Demand increased faster than expected and sources did not reduce their emissions enough to account for the demand increase. u Sources planned to rely on the market for compliance and did not install control technologies that could meet or go beyond the more stringent cap. ã Low RTC prices before 2000, on average < $2000/ton; ã A limited economic incentive to reduce emissions below the required level, ã Absence of banking in the trading program

Banking u Banking encourages sources to reduce their emissions sooner and below required levels, ã Allows sources to make extra reductions where and when it is cost-effective to do so; ã Ensures that all reductions will have an economic value in the long-term even if the short term gain is small. u Each banked ton represents a future ton of emissions ã Tradeoff between the short and the long term; ã RECLAIM decided the risk of variability in emissions due to the withdrawal of banked emissions was too great to allow banking.

Banking (cont’d) u Other programs resolved the tradeoff differently: ã The Acid Rain Program allows for unlimited, unrestricted banking. ã The OTC NOx Budget Program allows unlimited banking but places an economic disincentive on the use of banked allowances for compliance purposes; l Limits the variability associated the the withdrawal of banked allowances; l Mutes the incentive to generate excess reductions.

Implications for future cap-and- trade programs u Program design impacts sources’ ability to meet the cap. ã In RECLAIM, not allowing banking resulted in only a limited incentive for sources to generate excess reductions. ã When demand increased, sources could not reduce their emissions enough to account for the increase ã RECLAIM also has an annually declining cap that (in combination with no banking) may have declined too rapidly given the options and costs for controls. u Need to be aware of the tradeoffs when designing a program