Presented at Instituto de Ingeneria Electrica Universidad de la Republica del Oriental Uruguay

1. An Overview of the Organization, Properties, and Issue of Markets for Tradable Permits for Emissions of Air Pollutants Presented at Instituto de Ingeneria Electrica Universidad de la Republica del Oriental Uruguay 4 November, 2004 Paul M. Sotkiewicz Director, Energy Studies Public Utility Research Center University of Florida

2. Why Tradable Permit Markets for Emissions Control? • In theory, these markets lead to the least-cost solution to the emissions control problem. • Poor experience with writing legislation for, and the implementation of command and control (CAC) policies in the 1970’s and1980’s. • Political compromises that exempted many polluting resources. • Markets recognize the use of the environment as an input…or conversely recognizing emissions as an output (“bad”) that has a negative price. • Markets offer flexibility in meeting emissions obligations with a minimal amount of information required by the government agency implementing the program. • May induce innovation in technologies • In US scrubber costs have been reduced by more than 50% for SO2.

3. Origins of Pollution Markets • Ronald Coase (1960) in his discourse on property rights recognizes that all externalities (consequences of market activities that are not recognized immediately by markets) can be internalized by defining property rights. • J.H. Dales (1968), a political scientist, floats the idea of pollution markets in Pollution, Property, and Prices. • For all intents and purposes, emissions permits are property rights: The allow the holder the right to emit x units of pollution into the air (or water, etc.) • In practice, and by law in the US, permits (they are called allowances in the US) they are not property rights in the strict sense, but act as such.

4. Tradable Permit Market Fallacy and Fact • Fallacy: Many environmental groups to this day object to tradable emissions permit markets in the mistaken belief that firms can simply buy all the permits they want and this will lead to unbounded amounts of pollution. • Opinion: Trading pollution permits is “immoral” and should not be allowed. • Fact: Tradable permit markets are “cap-and-trade” markets. That is, the aggregate amount of emissions is capped at a predetermined level, and then firms can trade among each other for the scarce “right to pollute”

5. Firm 1 Unabated emissions, E1=24,000 tons Cost of abatement function: C1(E1 – e1)=(E1 – e1)2 where e1 represents emissions after abatement. Firm 2 Unabated emissions, E2=30,000 tons Cost of abatement function C2(E2 – e2) = 0.5(E2 – e2)2 where e2 represents emissions after abatement. Two Firm Example:Emissions Capped at A*=18,000 tons

6. Minimizing Cost of Emissions Abatement Mine1,e2 C1(E1 – e1) + C2(E2 – e2) s.t. e1 + e2≤ A* The solution to this problem is characterized by the marginal costs of abatement being equal. ∂C1/∂e1= ∂C2/∂e2=λ where λ is the Lagrange multiplier on the emissions constraint and is the shadow price of emissions. And the emissions constraint being satisfied e1 + e2≤ A* These conditions will hold true for emissions permit market!

7. Two Firm Example:Cost Minimizing Emissions • Firm 1: e1=12,000 tons with ∂C1/∂e1=24,000 and C1= 144,000,000. • Firm 2: e2=6,000 tons with ∂C2/∂e2=24,000 and C2=288,000,000 • In total 66.6% or 36,000 tons were abated from the unrestricted levels. • The total cost is 432,000,000.

8. Defining the Emissions Market Problem • Let Xi be the permits/allowances allocated to firm i and xi be the permit/allowance position of firm i. • Xi < 0 →firm i is a seller of permits/allowances. • Xi > 0 →firm i is a buyer of permits/allowance is. • Let P be the price of permits/allowances. • Each firm solves the following problem to minimize its costs. Minei,xi Ci (Ei – ei) + Pxi s.t. ei≤ Xi + xi The solution to the firm problem is characterized by the marginal costs of abatement being equal. ∂Ci/∂ei= λi = P where λ is the Lagrange multiplier on the emissions constraint and is the shadow price of emissions. • Note that P serves as the “shadow price” much like λ of the previous problem!

9. Defining the Emissions Market Equilibrium • An equilibrium for the emissions market is a price P*, emissions levels ei* for all i and permits/allowance levels xi*for all i such that ei* and xi* solve for each i Minei,xi Ci (Ei – ei) + P*xi s.t. ei ≤ Xi + xi And the emissions constraint is satisfied Σiei ≤ Σi Xi And the market clears Σi xi ≤ 0

10. Firm 1 Unabated emissions, E1=24,000 tons Allocated permits X1=9,000 tons Cost of abatement function: C1(E1 – e1)=(E1 – e1)2 where e1 represents emissions after abatement. Firm 2 Unabated emissions, E2=30,000 tons Allocated permits X2=9,000 tons Cost of abatement function C2(E2 – e2) = 0.5(E2 – e2)2 where e2 represents emissions after abatement. Two Firm Market Example:Emissions Capped at Σi Xi=18,000 tons

11. Two Firm Example:Market Equilibrium Outcome • Market Price = 24,000 and volume is 3,000 tons. • In total 66.6% or 36,000 tons were abated from the unrestricted levels. • Firm 1: e1=12,000 tons and x1=3,000 tons • Firm 1: ∂C1/∂e1=24,000 and C1= 144,000,000 + 72,000,000. • Firm 2: e2=6,000 tons and x2=-3,000 tons • Firm 2: ∂C2/∂e2=24,000 and C2=288,000,000 – 72,000,000 • The total cost is 432,000,000, but it is divided differently! Note how permit transaction cancel each other out when getting total costs for the market!

12. Firm 1 Unabated emissions, E1=24,000 tons Allocated permits X1=9,000 tons Cost of abatement function: C1(E1 – e1)=(E1 – e1)2 where e1 represents emissions after abatement. Firm 2 Unabated emissions, E2=30,000 tons Allocated permits X2=9,000 tons Cost of abatement function C2(E2 – e2) = 0.5(E2 – e2)2 where e2 represents emissions after abatement. Two Firm Command and Control Example:Emissions Capped at Xi=9,000=ei tons for each i

13. Two Firm Example:CAC Outcome • In total 66.6% or 36,000 tons were abated from the unrestricted levels. • Firm 1: e1=9,000 tons • Firm 1: ∂C1/∂e1=30,000 and C1= 225,000,000. • Firm 2: e2=9,000 tons • Firm 2: ∂C2/∂e2=21,000 and C2=220,500,000 • The total cost is 445,500,000 which is greater than the 432,000,000 in the least-cost solution. Firm 1 abates too much pollution, Firm 2 abates too little pollution.

14. Firm 1 Unabated emissions, E1=24,000 tons Cost of abatement function: C1(E1 – e1)=(E1 – e1)2 where e1 represents emissions after abatement. Firm 2 Unabated emissions, E2=30,000 tons Cost of abatement function C2(E2 – e2) = 0.5(E2 – e2)2 where e2 represents emissions after abatement. Two Firm Emissions Tax Example:Emissions taxed at $20,000/ton

15. Defining the Emissions Tax Problem • Let T be the tax on emissions. • Each firm solves the following problem to minimize its costs. Minei,xi Ci (Ei – ei) + Tei The solution to the firm problem is characterized by the marginal costs of abatement being equal to the tax. ∂Ci/∂ei= T • Note that T serves as the price of emissions to the firm.

16. Two Firm Example:Tax Outcome • 30,000 tons were abated from the unrestricted levels missing the target of 36,000 tons. • Firm 1: e1=14,000 tons • Firm 1: ∂C1/∂e1=20,000 and C1= 100,000,000. • Firm 2: e2=10,000 tons • Firm 2: ∂C2/∂e2=20,000 and C2=200,000,000 • The total cost is 300,000,000 which is less than the 432,000,000 in the least-cost solution, however the target is not met and a higher tax must be announced. This creates a consistency problem if the tax is constantly being changed.

17. Designing a Tradable Emissions Permit Market • There are several elements and issues to consider: • Choice of Emissions Cap • Abatement Options and Their Relative Cost • Allowance (Permit) Allocation • Allowance (Permit) Banking and Inter-temporal Trading • Spatial Trading Rules and Pollution “Hot Spots” • Monitoring, Measurement, and Record Keeping • Market “Distortions”

18. Choice of Emissions Cap • The cap can be based on a political decision of the “optimal emissions level”. • This was done in the US. The cap was in effect for only the largest emitters in the first few years of the SO2 program, and allocations were based on less stringent standards. • After 5 years, the allocations applied to all emitters over 25MW, and were based on more stringent requirements. • The cap could be based on “science” with economists and epidemiologists working together. • Setting the cap where marginal cost equals marginal benefit. • Coincidentally, it appears that the Bush Administration Clear Skies proposal is close to that in its full implementation.

19. Abatement Options and Their Relative Cost • Allowance (Permit) buying or selling. • Fuel switching • High sulfur to low sulfur coal • Oil to natural gas • Post-combustion controls • FGD (scrubbers) for SO2 or Hg • SCR, SNCR, low NOx burners for NOx • Underground storage for CO2 • Unit repowering • Alter dispatch to be more emissions friendly • Improve system efficiency • Loss reductions • Heat rate improvements

20. Allowance (Permit) Allocation Scheme • Gratis allocations to units: • Based on historical heat input • Based on historical output • Based on future expectation of input or output • Allocation by auction: • Forces emitters to buy all allowance needs at the start • Puts the money in the hands of government as opposed to polluters • Combination of gratis and auction • Set-asides for units that do not yet exist? • Opt-in provisions for non-required units? • “Bonus” allocation for environmentally friendly actions?

21. Allowance (Permit) Banking and Inter-temporal Trading • Must allowances be used up in the year issued or can they be carried over into future years. • Allowing trading between years allows emitters to smooth out costs and emissions over time as emissions requirements become tighter and tighter. • This smoothing out helps lead to cost savings over the life of the market. • Some markets do not allow banking (RECLAIM in S. Cal.) or limited banking (OTC NOx) market. • Banking may not be a good idea if the pollutant has a slow decay rate. • Large emissions levels in one year could be very dangerous in this case.

22. Spatial Trading Rules and Pollution “Hot Spots” • A concern among environmentalists is that large trading areas can create spots where emissions deposition are greater due to transport and concentration of sources. • This has not happened in the nationwide trading of SO2 in the US. • This is a concern in the trading scheme proposed for Hg in the US under the Bush Administration as Hg deposition is close to the source and hot spots could be very dangerous. • In RECLAIM, there are two trading zones, and a 2 for 1 trading ratio between east and west to make sure the LA basin is not adversely affected.

23. Monitoring, Measurement, and Record Keeping • Emissions can be monitored at the stack by a continuous emissions monitoring system (CEMS) • Or by estimation using chemical composition of fuel and combustion technology. • Data on chemical composition of fuel, combustion technology, heat input are all kept as a check on emissions monitors. • If a source does not have permits to cover emissions, it must pay heavy penalties (far greater than the allowance price) • All allowance transactions are public record except for the price. • Price indices are kept by traders and brokers in the market.

24. Market “Distortions” • Economic regulation and treatment of abatement options for ratemaking purposes. • Fuel content requirements from local sources. • Overlapping environmental rules between the federal market policy, and a state policy that is more stringent. • State rules forbidding trades. • No harmony in policy within the federal agency administering the market. • EPA/DOJ lawsuits in US requiring certain abatement technologies for some emitters. • Transaction costs. • Regulatory uncertainty as to future policy • Existing fuel contracts. • Non-convexities in abatement technology choices.

25. Experience in US and Concluding Remarks • Pollution markets have existed in the US for over 10 years. • Emitters have taken advantage of the flexibility offered and costs have been much lower than technology based command and control. • However, emitters have not taken full advantage of cost savings through trading. • This could be due to some of the problems listed in the previous slide. • The costs of the market policy have been lower than predicted, but this could be due, in part, to other factors.