The Colby Reader

Tradable Permit Approaches to Pollution Control


Introduction

Using the market to protect the environment is clearly an idea whose time has come. And the particular form of market-based approaches that I shall discuss in this article, the use of a transferable permits approach to air
pollution control, is in some ways the most visible of these approaches.

Not everyone is cheering this shift in direction. In less enthusiastic circles using the market to protect the environment is treated as roughly akin to showing up with the Devil for communion. Since the market is seen
by deep ecologists and others as the source of most environmental problems, using the market to solve them seems to them to be a form of ideological suicide.

I think both groups are wrong. Market-based approaches are useful in some, but not all circumstances. They should neither be vilified nor put on a pedestal.

Market based-approaches are in the midst of what has become known in public policy circles as the "pendulum effect". I used to spend much of my time trying to convince reluctant policy makers that market-based approaches had merit. I now spend much of my time convincing (in many cases the same!)legislators that these approaches are not panaceas that will solve all environmental problems with little or no sacrifice.

But I get ahead of myself. Let's begin the journey and let the story unfold.

Traditional Policy
To understand the new approach it is important first to understand the policy environment that gave rise to it. U. S. air pollution policy was, and is, designed to assure that people and ecosystems are protected from harmful levels of pollution. It does that by promulgating ambient air quality standards, which specify the permissible legal thresholds for concentrations of pollutants in the ambient air, and by establishing a process for reaching those standards.
The traditional approach for improving air quality so as to bring it into conformance with the ambient standards involved a three-step process:
ß picking desirable control technologies,
ß using those technologies to specify permission emission limits, and
ß forcing sources to live within those limits.
All of these roles were performed by the government authority. They picked the ambient standards and selected the way to allocate the responsibility for meeting those standards among the various emissions sources.
In the early 1970's a group of academics (I was among them) suggested that
it might be possible to improve upon this system by allowing firms to trade
control responsibility among themselves by means of a transferable permit
system. In this way firms which could control relatively cheaply could
voluntarily control more, selling the excess control to those that, for
economic reasons, wanted to control less. Our analysis suggested that this
increased degree of flexibility would lower control costs substantially
while assuring that the environmental target was met. The huge potential
cost savings seemed to us, naively as it turned out, to be sufficient
motivation for a rather large reform in environmental policy to take place.
Out ideas were met with complete silence. No one, it seemed, had the
slightest interest. As long as the status quo is "working", changing the
way things are done is very difficult.
The Offset Policy: The Problem Becomes the Solution
That all changed in 1976. By 1976 it had become clear that a number of
regions, designated "nonattainment" regions by the Clean Air Act, would
fail to attain the ambient air quality standards by the deadlines mandated
in the Act. The statute mandated improvements in air quality in
nonattainment regions. Since further economic growth appeared to make the
air quality worse in these regions, economic growth seemed contrary to the
intent of the statute.
To improve air quality, therefore, EPA was faced with the unpleasant
prospect of prohibiting many new businesses (those which would emit any of
the pollutants responsible for nonattainment in that region) from entering
these regions until the air quality came within the standards.
Prohibiting economic growth as the means of resolving air quality problems
was politically very unpopular among governors, mayors, and many members of
Congress. As it attempted to follow statutory mandates, EPA found that it
had a potential revolution on its hands. At this point, of necessity, they
began to consider alternatives. Was it possible to solve the air quality
problem while allowing further economic growth?
It was possible as it turns out and the means for achieving these
apparently incompatible objectives involved the creation of a transferable
permit system. Sources of the pollution that were already located in the
nonattainment area were encouraged to voluntarily reduce their emission
levels below their current legal requirements. These excess reductions
could then be certified by the EPA as "emission reduction credits". Once
certified by the control authority these credits then become transferable
to new sources that wished to enter the area.
New sources were allowed to enter nonattainment regions providing they
acquired sufficient emission reduction credits (representing excess
reductions) from other facilities in the region that total regional
emissions would be lower (not the same!) after entry than before. (This
was accomplished by requiring new sources to secure credits for 120% of the
emissions they would add; the extra 20% would be retired as an improvement
in air quality.) Known as the "offset policy," this approach not only
allowed economic growth while improving air quality, the original
objective, it made economic growth the vehicle for improving the air. It
turned the deteriorating air quality problem on its head and made the
problem part of the solution. The reform that could not be brought about by
academic cost saving demonstrations became a reality once the status quo
became difficult to maintain.
Getting the Lead Out: The Lead Phaseout Program
Following the path blazed by the offset program, the government began
applying the tradable permit approach more widely. One prominent use
involved facilitating the regulatory process for getting lead out of
gasoline.
In the mid-1980's prior to the issuance of new, more stringent regulations
on lead in gasoline, EPA announced the results of a cost/benefit analysis
of their expected impact. The analysis concluded that the proposed .01
grams per leaded gallon (gplg) standard would result in $36 billion ($1983)
in benefits (from reduced adverse health effects) at an estimated cost to
the refining industry of $2.6 billion. (Notice that benefits are over 12
times costs.)
Although the regulation was unquestionably justified on efficiency grounds,
EPA wanted to allow flexibility in how the deadlines were met without
increasing the amount of lead used. While some refiners could meet early
deadlines with ease, others could do so only with a significant increase in
cost. Recognizing that meeting the goal did not require every refiner to
meet every deadline, EPA initiated an artificial market in the rights to
use lead in gasoline to provide additional flexibility in meeting the
regulations.
Under this program a fixed amount of lead rights (authorizing the use of a
fixed amount of lead over the transition period) were allocated to the
various refiners. Refiners who did not need their full share of authorized
rights (due to early compliance) could sell their rights to other refiners.
Refiners had an incentive to eliminate the lead quickly because early
reductions freed up valuable rights for sale. Acquiring these rights made
it possible for other refiners to comply with the deadlines, even in the
face of equipment failures or Acts of God; fighting the deadlines in court,
the traditional response, was unnecessary. Designed purely as a means of
facilitating the transition to this new regime, the lead banking program
ended as scheduled on December 31, 1987.
Before moving on I want to call your attention to a couple of noteworthy
features of this program.
First, it resulted in a much earlier phase out of lead than would have
traditionally be possible because of the inter-refinery flexibility it
offered. The traditional approach, setting the deadline late enough to
allow the refinery facing the most difficult compliance problems to meet
it, would have resulted in a great deal more lead being injected into the
air. And, as the benefit/cost analysis persuasively demonstrated, the
health consequences of ambient lead were severe, particularly on children.
Second, this program was designed to eliminate a pollutant, not merely
place an upper limit on its annual use. That is a rather different policy
setting than the typical pollution control problem.
Tackling Acid Rain: The Sulfur Allowance Program
The most sophisticated version of the use of tradable permits for pollution
control to date has been it use for achieving further reductions in those
U. S. electric utility emissions contributing to acid rain. Under this
innovative approach authorized emissions will be severely reduced over two
phases to assure a reduction of 10 million tons in emissions from 1980
levels by the year 2010.
Perhaps the most interesting political aspect of this particular
application was its role in the passage of the acid rain bill. Though
reductions of acid rain precursors had been sought with a succession of
bills over the two decades of Clean Air Act legislation, none had been able
to become law. With the inclusion of a tradable permits program for sulfur
in the bill, the compliance cost was reduced sufficiently to make passage
politically possible.
Sulfur allowances form the heart of this tradable permit program. The total
number of sulfur allowances is limited and is ultimately reduced to achieve
the 10 million ton reduction in Phase II. The allowances are allocated to
specific utilities on the basis of an allocation formula.
Each allowance, which provides a limited authorization to emit one ton of
sulfur, is defined for a specific calendar year, but unused allowances can
be carried forward into the next year. They are transferable among the
affected sources. Any plants reducing emissions more than required by the
allowances are allowed to transfer the unused allowances to other plants.
Emissions may not legally exceed the levels permitted by the allowances
(allocated plus acquired). An annual year-end audit balances emissions with
allowances. Utilities that emit more than authorized by their holdings of
allowances must pay a $2000 a ton penalty and are required to forfeit an
equivalent number of tons in the following year.
This program has several innovative features, but to conserve time I will
mention only two. The first important innovation in this program was
assuring the availability of allowances by instituting an auction market.
These allowances can either be transferred by private sale or in the annual
auction. Historically the problem with the private sale route was that
prices were confidential so buyers and sellers were operating in the dark.
Transactions costs were high so the market did not work very well.
EPA wanted to solve this problem by instituting an auction market run by
the Chicago Board of Trade. Utilities fought the idea of a standard auction
because they knew it would raise their costs significantly. Whereas under
the traditional policy they would be given the allowances free of charge,
under a standard auction they would have to buy these allowances at the
full market price.
To gain the advantages an auction offers for improving the efficiency of
the market while not imposing a rather large financial burden on utilities,
EPA established what has now become known as a zero revenue auction.
Here is how it works. Each year the EPA withholds somewhat less than 3% of
the allocated allowances and puts them up for bid in the auction. These
withheld allowances are allocated to the highest bidders with successful
buyers paying their bid price. The proceeds are refunded on a proportional
basis to the utilities from whom the allowances were withheld.
Private allowance holders may also offer allowances for sale at these
auctions. Potential sellers specify minimum acceptable prices. Once the
withheld allowances have been disbursed EPA then matches the highest
remaining bids with the lowest minimum acceptable prices on the private
offerings and matches buyers and sellers until all remaining bids are less
than the remaining minimum acceptable prices. This auction design
unfortunately is not particularly efficient because it provides incentives
for inefficient strategic behavior.
A second innovation in this program is that it allows anyone to purchase
allowances. This means environmental groups or private citizens can buy
them for the purpose of retiring them. Since retired allowances represent
authorized emissions that are never emitted, they result in cleaner air.
Many of my students have purchased allowances on the internet to give to
their parents for Christmas or birthdays.
I want to close the discussion of this particular program with a story that
occurred this past January. I think the story illustrates just how far our
mindset has come in this endeavor.
A colleague was giving an excellent paper at the American Economics
Association meetings in New York. In it he revealed that the sulfur
allowance program cost savings had amounted to only 43% of the costs that
could have been expected in the absence of the program. His discussant,
Dick Morgenstern, a former Assistant Administrator at EPA, suggested that
the characterization of cost savings as "only" 43% was remarkable. He
suggested that most program managers would leap at the opportunity to get
cost savings of that magnitude.
RECLAIM: The States Take the Initiative
All of the previous programs were initiated by the federal government. The
states were primarily involved as the enforcers of the federal programs. In
1994 that changed.
Faced with the need to reduce ozone concentrations considerably in order to
come into compliance with the ozone ambient standard, states have chosen to
use trading programs as a means of facilitating rather drastic reductions
in precursor pollutants. One of the most ambitious of these programs, and
the one I will discuss this morning, is California's Regional Clean Air
Incentives Market (RECLAIM) established by the South Coast Air Quality
Management District, the distinct responsible for the greater Los Angeles
area. Under RECLAIM each of the almost 400 participating industrial
polluters are allocated an annual pollution limit for nitrogen oxides and
sulfur that will decrease by 5% to 8% each year for the next decade.
Polluters are allowed great flexibility in meeting these limits, including
purchasing credits from other firms which have controlled more than their
legal requirements.
In an importance sense the RECLAIM program has changed the nature of the
regulatory process. The burden of identifying the appropriate control
strategies has been shifted from the control authority to the polluter. In
part this shift was a necessity (traditional processes were incapable of
identifying enough appropriate technologies to produce sufficiently
stringent reductions) and in part it was motivated by a desire to make the
process as flexible as possible.
As a result of the flexibility which become possible from this shift in the
burden of choosing appropriate responses, many new control strategies are
emerging. Instead of the traditional focus on end-of-pipe control
technologies, pollution prevention has been given an economic underpinning
by this program. All possible pollution reduction strategies can, for the
first time, compete on a level playing field.
Problem Areas
Tradable permits have made a positive impact, but they also have their
share of problems. As I mentioned earlier, they are not panaceas.
Let me just mention some of the more important problems here. I shall begin
with two problems that in my opinion are more apparent than real, but I
shall follow with a discussion of two more problems that I believe to be
more substantial.
The first concern is market power. If a few entities can control the market
by buying most of the permits, this will undermine most of the desirable
properties. While in principle this concern is absolutely valid, in
practice, to my knowledge, market power has not been a factor in any active
air pollution tradable permits market. The reason is simple. In a typical
market a large number of buyers and sellers are present. The conditions for
market power to be exercised are rarely present.
A second concern involves the ability to save permits not used in an
earlier year for use in subsequent years. If enough polluters took
advantage of that provision, wouldn't it be possible to end up with
emissions clustered in some future year? And aren't clustered emissions
more harmful in general that diffused emissions? Again in principle this
can be a problem in the right circumstances. In practice it has not been a
problem in any actual market I am aware of for the simple reason that
economic incentives to use or to save allowances over time are balanced.
Let's now turn to problems that I think are more substantial. Transferable
permits seem to have worked particularly well in certain circumstances. Two
such cases are:
ß trades involving uniformly mixed pollutants (those for which only the
level of emissions matters) and
ß for trades of nonuniformly mixed pollutants (those for which emission
location also matters) involving contiguous discharge points (implying that
they have essentially the same location so, once again, the policy can
focus solely on the level of emissions).
But how about when emission location matters and trades involve spatially
separated sources? When emission location matters, the dominance of
economic instruments over traditional command-and-control strategies is
less clear cut in practice than it might appear from theory.

To illustrate the point consider a complaint filed in California during
June 1997 by the Los Angeles-based Communities for a Better Environment.
This complaint contends that RECLAIM is allowing the continued existence of
toxic "hot spots"(high pollutant concentration areas) in low-income
communities.

Under RECLAIM rules Los Angeles-area manufacturers can buy and scrap old,
high-polluting cars to create emissions-reduction credits. (The rationale
for this is that a disproportionately large amount of pollution comes from
a relatively few high polluting vehicles. Hence getting those vehicles off
the road makes environmental sense.) These credits can be used to reduce
the required reductions from their own operations. Under RECLAIM most
California refineries have installed equipment that eliminates 95% of the
fumes, but the terminals in question reduced less because the companies
scrapped more than 7,400 old cars and received mobile source emission
reduction credits which they credited toward their reduction requirements.

The complaint notes that whereas motor vehicle emission reductions are
dispersed throughout the region, the offsetting increases at the refineries
are concentrated in low-income neighborhoods. On a technicality, in Los
Angeles on March 30,1998 a federal judge dismissed the lawsuit. While this
action disposes of the lawsuit, it does not dispose of the issues that gave
rise to it.
And finally my major personal disappointment with the tradable permit
approach is that it has not yet spurred truly large changes in polluting
behavior. In principle tradable permit systems should encourage new
approaches to pollution control such creating less pollution in the first
place rather than simply capturing residuals before they exit the source.
In practice most of the chosen compliance options are rather
traditional--installing end-of-pipe equipment or engaging in fuel switching.
Why? The optimist in me believes that it is simply too early for us to
observe these more dramatic effects. Clearly the cheapest, most familiar
options are chosen first. And in both the sulfur allowance and RECLAIM
program the really stiff requirements have not yet begun to bite. When they
do, will we see much more innovative responses? Only time will tell.
What does a thorough understanding of the problems tell us? My assessment
is that none of the problems are insurmountable, but they do suggest
caution in accepting the simple idea of tradable permits as a panacea. It
is a valuable, but not necessarily dominant, aspect of pollution control
policy.
Characterizing The Evolution
What general conclusions can we draw from this experience? How has the
original idea been transformed by experience?
o Whereas the early programs complemented traditional regulation by
making it more flexible, later programs represent a more radical departure
from traditional regulation. They are beginning to substitute for
traditional regulation, though they will never completely replace it.
o The earliest transferable permit programs were designed in
Washington by "policy geeks" rather than by those in the EPA program
offices who had the operational responsibility for implementing traditional
policy. Resistance to this approach from regulators (at both the federal
and state levels) was initially very high. Business leaders were also
skeptical. Now the atmosphere has changed. Regulators have been actively
involved in the design of the newest programs. They have come to see this
approach as allowing them to do a better job of protecting environmental
quality. Many business leaders and environmental groups have also signed
on, recognizing that lower compliance costs result in both enhanced
competitiveness and enhanced air quality.
o While the earlier programs were designed purely to reduce the costs
of compliance while holding air quality constant, later programs have
attempted to produce better air quality and lower cost. This has made the
cost savings lower than they otherwise would have been, but it has also
meant that environmental groups have been transformed from opponents of
this idea to supporters.
o Establishing these markets has turned out to be much harder than we
originally thought. After the offset policy and before the sulfur allowance
program, trading was sporadic. Active markets did not exist. Some permits
were hoarded as a reaction to the thinness and unreliability of these
markets. We learned that you don't take the effectiveness of these
artificial markets for granted, but that it is possible to design the
systems in such a way as to promote effective markets.
Diffusion of the Concept
I would like to close by sharing with you two of the latest applications of
this concept with which I have been involved.
Global Warming. The first example involves enlisting market-based
approaches in the international effort to control climate change.
The principle accomplishment of the December, 1997 Conference of Parties in
Kyoto, Japan was the establishment of fixed quantitative reductions in
greenhouse gases for 38 nations and the European Community. The
reductions, which are relative to 1990 emission levels, are to be achieved
by 2012 and expected to produce a global reduction of 5.2% from 1990 levels
or, for the United States, approximately 30% from levels that would have
been expected by 2010.

The Kyoto Protocol offers the opportunity for four rather different types
of emissions trading, but two are particularly important. Article 17
authorizes emissions trading of "assigned amounts" (AAs) among the Annex B
nations and clearly offers the greatest potential to take advantage of the
benefits of a trading program. Article 12, known as the Clean Development
Mechanism, authorizes the case by case creation of certified emission
reductions (CERs) by non-Annex I (developing) countries respectively.

I was asked to head a team that was responsible for producing a report to
facilitate the process of implementing Article 17. We presented our report
at the Buenos Aires meeting. I can't begin to share the results of that
report here (it is over 80 pages), but perhaps I can share a couple of
insights. If you are interested in more details the report can be
downloaded in its entirety from my web site.
(
http://www.colby.edu/personal/thtieten/.

While I believe the trading regime may both facilitate participation in the
agreement and encourage the development of more environmentally benign
technologies, the road to success is littered with potholes. Furthermore
while we can now extract a number of useful lessons from domestic trading
programs that have clearly worked, their transfer to the international
setting is not obvious. Let me name just a few reasons.

ß Monitoring. Some of the six designated gases are relatively easy to
monitor, while others are not. How should this differential capability be
handled by the trading system?
ß Compliance. Enforcement in a domestic setting is difficult, but in an
international setting is even more difficult. How can the obligations be
enforced?
ß Accountability. Delegates at Buenos Aires were very concerned that
countries might not fulfill their obligations. How can they be held
accountable?

Can these problems be solved? I think we are making headway, but it is too
early to know the answer to that question.

Fisheries. The second application involves the use of this approach to
control fisheries. It currently is used around the world including four
fisheries in the United States. I had the good fortune to be a member of a
National Research Council committee a couple of years ago that was formed
to study this management regime. We spent a year holding hearings around
the country to assess the implementation experience with this and
alternative management regimes.

Let me begin with some history, using the Pacific Northwest to illustrate
the point. As pressure on fisheries increased, it became clear that some
regulatory action was needed.

Regulators responded by setting a Total Allowable Catch for each species.
Once the season started fishers would report their catch. Once the
aggregate catch reached the limit imposed by the Total Allowable Catch
(TAC), the fishery would be closed. This approach produced a number of
problems.

ß The season length, which may have been six months in the beginning,
diminished over time as the race for fish brought more and more fish to
market earlier. In one dramatic case it was reduced to a matter of hours!
ß To get as many fish as possible people began adding boats to the fleet
and increasing the size of existing boats until the fleet was
overcapitalized.
ß Death rates for fishing went up as fishers were forced to venture out in
all kinds of weather.

Finally the regulators implemented a transferable permit system. First the
total allowable catch was defined and then fishers were allocated shares of
the TAC (usually on the basis of historic catch). This changed the entire
dynamic of the fishery.

ß Death rates went down as fishers could exploit good weather and stay home
during storms
ß Overcapitalization started to decline in both the fishing and the
processing sector. Having the capacity to be first was no longer important.
ß Fish were sold in the fresh fish market for higher prices. (Previously
since they were all harvested in the same time period most had to be
frozen.)
ß Whereas the TAC was commonly exceeded prior to transferable permits, the
TAC been met every year since transferable permits were introduced.

In Closing
In thinking back over the two decades of experience with transferable
permits, it is clear that transferable permits have come a long way from
the initial abstract conception that found its way into academic journals.
In some ways we were a bit naive in our assumptions about how easy
implementation would be and how completely these systems would produce cost
savings and/or improvements in environmental quality.
On the other hand we underestimated the impact they ultimately would have
both in terms of the number of possible applications and the degree to
which they would transform the regulatory system. To be sure the program is
far from perfect, but the flaws should be kept in perspective. Although
transferable permits lose their utopian luster upon closer inspection, they
have, nonetheless, made a lasting contribution to environmental policy.


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