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ESSAYS O N ISSUES T H E FEDERAL RESERVE BANK O F C H IC A G O MAY 1992 N U M B E R 57 Chicago Fed Letter A m arket based approach to cleaner air Several new programs aimed at pro tecting the environment and human health have been initiated under the 1990 Amendments to the Clean Air Act (CAA). According to official esti mates, the annual direct costs of these regulatory programs will be around $20 billion but other estimates are much higher. In addition to the direct costs of abatement, the economy will undergo difficult adjustments to changes in prices and wages. Some of these costs of pollution control will be mitigated by the recent adoption of a different approach to environmental regulation. The new Title IV of the 1990 CAA Ajmendments has intro duced the market based approach for controlling sulfur dioxide (S09) emis sions instead of continuing to rely on the so-called “command and control” approach which had been proposed in the 1980s for acid rain control. Title IV can potentially serve as a model for future market based pollution control programs, but this Title has unique features. The Chicago Fed Letter de scribes the market based approach to pollution control and assesses the new acid rain legislation as a prototype. Market based versus command and control Using the command and control ap proach, regulators have often required that industry apply the best available pollution control technologies to their industrial processes as a means of achieving the lowest levels of air toxic emissions or effluent water discharge. The obvious costs of this system are the large regulatory management systems which are needed to determine the best technology and to monitor and administer the flow of regulations and permits. In addition, this approach can be very costly by not allowing firms the flexibility to discover and apply the least cost methods of lower ing pollution. Such regulation may discourage the development of pro cesses which lower pollution further; industry would be reluctant to develop such technologies for fear that, re gardless of their cost, the new technol ogies would be mandated for their operations. Indeed, new technology mandates could be especially costly in those instances when the new technol ogy must displace a firm’s very recent investment in equipment. In an effort to offset some of the finan cial burden on existing industry, com mand and control regulations are often applied only to new sources of emissions. However, new source per formance standards (NSPS) have often been cited as encouraging the continued use of existing industrial equipment beyond the point at which it would otherwise have been econom ic to replace or update the equipment. Hence, NSPS regulations may lower investment in otherwise promising ventures. In contrast, market incentive systems begin with an overall level or goal for emissions or discharge. Optimally, such a goal is determined by consider ing the costs of abatement in relation to the potential benefits to society. Subsequently, incentives are put into place to achieve the overall environ mental goal in the least costly fashion. Under market incentive programs, firms are awarded the rights or allow ances to pollute, with the distribution of allowances following some fair or equitable considerations. The owners of allowances are then free to use the allowances as a pollution permit or, alternatively, to reduce their rate of pollution while selling their excess rights to pollute to other parties. In this way, those firms that can control their emissions at least cost have the (profit) incentive to do so, while those firms who would otherwise find it unduly burdensome to restrict emis sions can purchase the right to pollute. Market incentive systems have better long run properties as well; they en courage the development of more cost effective control technology and in vestment in cleaner processes and bring forth competitive suppliers in the marketplace. Acid rain control o f coal-fired electric utilities The three major pollutants regulated under Title IV on acid deposition control, as well as under Title I on nonattainment areas and other CAA regulations, are nitrogen oxides (NO ), volatile organic compounds (VOC), and sulfur dioxide (S09). The Midwest’s share of the nation’s total emissions approximately mirrors its share of economic activity with the exception of S 0 9. The region emits sulfur dioxide at a rate two-thirds high er than its share of economic activity largely because its electric utilities tend to heavily rely on high sulfur coal which is locally mined (see Table 1). Title IV creates a market incentive system based on S 0 9 “emission allow ances.” An allowance must be ob tained and expended for each ton of S 0 2emitted. Once allocated by the U.S. EPA, the allowances can also be traded among companies rather than expended for emissions. In addition, allowances are tradable between years, a concept called “emission banking” whereby allowances can be retained as a reserve for future use as a hedge 1.1985 Midwest emissions and GSP Pollutant or economic activity Share in Midwest by sector (%) All Utility Transpor tation Industrial and other $30,000—$10,000 for A and $20,000 for B—rather than the $40,000 cost under the uniform rollback policy. Under Title IV, allowances are issued gratis to existing pollut 24.2 3 0.9 17.6 MO 2 2 .6 ing utility units based on their VOC 21.6 22.2 2 1 .6 2 1.6 “baseline” fuel use as measured by the annual average of 1985Gross state product (GSP) 21.5 87 Btu consumption. Emis sions are ratcheted down over time by issuing allowances over against higher future emission allow two different phases of increasing strin gency with Phase I running from 1995 ance prices or even for purely specula to the year 2000 (see Table 2). tive purposes. so2 3 7.3 42.9 16.4 25.1 Emissions trading and banking provide cost savings over mandatory technolo gies in achieving long run environmen tal goals. These gains are achieved be cause, rather than adopting mandatory control technology or abandoning pro duction altogether, firms gain the flexi bility to reduce pollution by choosing from among the cheapest technologies, alternative fuels, and alternative time schedules in lowering emissions. Fac tors which will affect the least cost choice are a plant’s design suitability for retrofit, land availability, economies of scale in abatement technology, access to alternative fuels including differences in competition in transportation to power plants at different locations, and alterna tive local air quality requirements. Gains from trade can be illustrated with a simple example. Suppose 100 tons of emission reduction are needed to meet the environmental objective. Suppose plant A has a marginal abatement cost (MAC) of $300 per ton and plant B has a MAC of $500 per ton. Under a uni form rollback policy each plant would reduce emissions 50 tons at a total cost of $40,000. However, suppose each plant is issued 50 tons of tradable emis sion allowances. Then plant A, which has a lower MAC, can sell its allowances to plant B for, say, $400 per ton. Plant A then reduces emissions 100 tons for $30,000, and gains $20,000 in revenue from the sale of allowances. Thus, the net cost to A of the reduction in emis sion is $10,000. Plant B’s $20,000 cost of purchasing allowances is less than the $25,000 it would have had to pay to reduce emissions by 50 tons. The total cost of the 100 ton emission reduction is particular, some states have already moved to circumvent the choice pro cess of utilities in various ways. For example, the state legislature in Illi nois has mandated the use of smoke stack “scrubbers,” which remove impu rities caused by the burning of high sulfur coal, thereby eliminating the option of using low sulfur coal for two generating plants. Fortunately, the aforementioned im pediments to market decision making are unlikely to dominate. Partly owing to the rising costs of utility services in recent decades, public scrutiny and opposition have made utility rate hikes The market price of allowances is cur far from automatic. For this reason, rently expected to be low in the early utilities do have incentives to engage in cost efficiency measures so as to 1990s and to rise steadily over the course of Phase I and II through the ensure their shareholders a good rate middle of the next decade because an of return on investment. States with excess stock of allowances is expected high sulfur coal mining interests are to be held at the outset. The actual likely to continue to provide a base time path of prices will depend not only market for their coal products by man on several uncertainties such as fuel dating the use of scrubbers at some switching costs and the growth of elec utility plants. However, cost consider tricity demand, but also on the motiva ations will dictate that the plants cho tions of market participants. Utility risk sen are those where the costs of the aversion provides a motive to bank scrubbing option are well within rea allowances, thereby increasing the cur son. And the fact that states without rent price of allowances. Forward con mining interests may choose other tracts and futures markets for S 0 2allow options means that the price of high ances, such as those proposed by the sulfur coal would be bid down relative Chicago Board of Trade, may also influ to the price of low sulfur coal, making ence allowance prices by facilitating the scrubbing a cost efficient choice for entry of speculators who are willing to some fraction of the utility market bear some of the risks of risk averse in any case. utilities. By lowering costs and risks everyone can gain, including rate pay Nevertheless, certain provisions of the ers and utility shareholders alike. Clean Air Act itself may be working against the market based approach introduced in Title IV. Title V of the Will the market be allowed to work? 1990 Amendments legislates a new Some skeptics question whether the comprehensive permitting program benefits envisioned by market propo authorizing specific compliance strate nents will materialize. Much of the gies such as those found in a com efficiency gain is envisioned to come mand and control system. The inter about as profit motivated firms choose action among competing regulations the least cost compliance strategy. under the CAA, resulting from the fact However, the firms in question are that SC) , NO , and VOC are con largely state regulated public utilities. trolled under two or more major Ti To the extent that utilities are guaran tles, caused the EPA to seek the com teed a fair rate of return on their invest prehensive permitting program so that ed capital, it is alleged that utilities may one permit will be issued for each have a diminished incentive to engage industrial source. However, reopen in least cost planning. There are also ing the permitting process for existing conflicts between least cost choices and industrial facilities also provides an the preservation of mining jobs in those opportunity for intervention by such regions that mine high sulfur coal. In parties as the National Park Service, o f SO,, emission reduction requirements Phase 1 affected units1 U.S. M idwest3 Phase II2 U.S. Midwest % o f U.S. % o f U.S. Number of generating units 261 137 52 1107 443 40 81 39 48 294 97 33 8.3 4.5 55 15.1 7.1 47 5.6 2.6 46 8.9 2.5 28 33 43 41 65 Capacity (thousand m egaw atts) S02 emissions (m illion tons) S 02 allowances (m illio n tons) Reduction needed to meet allowances (percent)* able control technology or MACT); 2) subsequent risk/benefit studies to evaluate whether a second round of controls beyond MACT may be re quired; and 3) special regulations to prevent accidental releases of very toxic chemicals. The last type of envi ronmental concern, which has a very low probability but high potential damage from a discharge, may repre sent a type of situation where technol ogy based regulations are the best approach to protect health and envi ronment. Conclusions 1Phase I affected units are listed by name in Table A of the 1990 Amendments; these are the larger, higher emitting units in the country. 2A few small units are not included. Illino is, Michigan, Wisconsin, Indiana, Ohio, Minnesota, Iowa, and Missouri. 4Required reduction based on no net trading of allowances outside the region. SOURCE: Argonne Utility Simulation Model for 1989. environmental interest groups, and others in the same state or neighbor ing states to argue for more stringent emission controls to protect “air quali ty related values” such as visibility in cities and national parks. As the state and federal governments undertake this massive permitting process of industrial sources, delays and uncer tainties are to be expected, and once a permit is issued, plant facilities will lose flexibility in adapting to changes in product demands or adjusting their manufacturing processes for competi tive reasons. The consequences of this loss of flexi bility are as yet poorly understood. Certainly, the potential gain under the S 0 2 trading system comes into ques tion. More generally, Title V is only one of several within the overall CAA whose structure and nature reflects the command and control approach to emissions control rather than a market based approach.1 New directions and exceptions Despite the conflicting approaches to emission control within the CAA, Title IV may stand as a turning point be yond which environmental regulation will never return. Policymakers are extending the scope of the market based approach to new areas. For example, urban ozone nonattainment is typically a regional airshed problem, e.g., the south coast area of California around Los Angeles or the vicinity of Chicago and Milwaukee metropolitan areas which have been designated as “extreme” and “severe” (respectively) nonattainment areas under Title I of the CAA. The South Coast Air Quality Management District of California is moving rapidly ahead toward a pro gram of tradable emission permits in reactive organic compounds which contribute to ozone formation and smog. In contrast to acid rain controls, which focus on relatively few, large sources nationally, the urban smog program addresses individual vehicles, dry cleaners, and household and firm use of surface coatings, solvents and cleaning fluids. Other potential market based programs include allowing firms to buy and dispose of “old clunker” cars as a way to reduce urban emissions, and limiting motor vehicle trips into congested cities while allowing the trading of vehicle trip permits. While a market based approach holds many potential advantages over com mand and control, some situations may be inappropriate for the trading of permits. Regarding the control of industrial hazardous air pollutants (i.e., air toxics) the 1990 Amendments call for a three-pronged program: 1) technology requirements for a list of 189 chemicals (called maximum achiev Prior to the CAA, market based ap proaches to reducing pollutants had been widely discussed but largely un tried. Certainly, the acid rain Title IV amendments will provide a major testing ground for many of the institu tional features of the market based approach including the trading and banking of emission allowances. Should this approach prove to be successful, we can expect to see it wide ly applied to other areas such as the regulation of water, toxic sites, and urban air pollutants. —Donald A. Hanson and William A. Testa *See Donald A. Hanson, “The 1990 Clean Air Act: a tougher regulatory challenge facing Midwest industry,” Economic Perspec tives, May/June 1992, pp. 2-18. Karl A. S cheld, S en io r Vice P re sid en t a n d D irecto r o f R esearch; David R. A llardice, Vice P re sid en t a n d A ssistant D irecto r o f R esearch; C arolyn M cM ullen, E ditor. Chicago Fed Letter is p u b lish ed m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views ex p ressed are th e a u th o rs ’ a n d are n o t necessarily th o se o f th e F ederal Reserve B ank o f C hicago o r th e F ed eral Reserve System. A rticles m ay be re p rin te d if th e source is c re d ite d a n d th e R esearch D e p a rtm e n t is pro v id ed with copies o f th e rep rin ts. Chicago Fed Letter is available w ith o u t ch arg e from th e P ublic In fo rm atio n C e n te r, F ederal Reserve B ank o f C hicago, P.O. Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Midwest manufacturing activity ended 1991 on a sour note, as the MMI declined 0.6% in December, continuing a downward slide that began at mid-year. Much of the recent weakness has come from the transportation sector. However, that sector scored a respectable gain (up 1.1%) in December. With auto production plans over the first quarter of 1992 showing a steady rise, the sector should con tinue to make a positive contribution to the MMI in the early part of 1992. The December decline in the MMI also marked one of the few times in recent years that the region has underperformed manufacturing activity nationwide for a full quarter. The region’s weakness underscores the importance of its trans portation sector to its overall performance. N O TE: T h e MMI a n d th e USMI are co m p o site indexes o f 17 m a n u fa c tu rin g in d u stries a n d are d erived from e c o n o m e tric m odels th a t estim ate o u tp u t fro m m o n th ly h o u rs w orked a n d kilow att h o u rs data. For a discussion o f th e m ethodology, see “R eco n sid erin g th e R egional M a n u fac tu rin g In d ex es,” Economic Perspectives, F ederal Reserve B ank o f C hicago, Vol. XIII, N o. 4, Ju ly /A u g u st 1989. 1119-SSg (H£) F£80_06909 s!o u HlI ‘o ^ D iq o F£8 x o 9 O d J 3 1 U 3 3 U O p e tU J O J U I 3 1 ^ 0 ^ O O V O IH O T O X N V 9 T A ^ T S T ^ I T V T IT d T T JTlprI pqj oSiDiq/)
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