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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO AUGUST 1997 NUMBER 120 Chicago Fed Letter What can the Midwest learn from California about emissions trading? For more than 30 years, economists have advocated the use of marketbased environmental regulations to improve the efficiency of regulatory programs designed to clean up the environment. Emission taxes and tradable emission permit markets have been proposed to supplant traditional regulatory methods by which regulators prescribe specific technology-based standards. One market-based program that received considerable attention began in 1994, when the South Coast Air Quality Management District (SCAQMD) introduced the Regional Clean Air Incentives Market (RECLAIM) in the Los Angeles basin. RECLAIM is a regional market designed to improve air quality through the reduction of two pollutants, oxides of nitrogen (NOx) and oxides of sulfur (SOx). RECLAIM introduced a regulatory strategy for meeting a particularly severe regional environmental problem, and it aims to meet stringent federal and state requirements with greater flexibility and less economic disruption to the regional economy than a command and control approach. The potential benefits of environmental markets are increasingly being recognized in the Midwest. The Illinois Environmental Protection Agency (Illinois EPA) will soon launch the Emissions Reduction Market System (ERMS) to help address the ground-level ozone problems facing the Chicago area. This Fed Letter reviews the California RECLAIM experience in the first two years of market activity, focusing on the NOx market, the larger of the two emissions trading programs.1 It then describes the basic features of the Illinois ERMS program and attempts to relate the lessons from the RECLAIM market to the proposed Illinois program. Basics of the RECLAIM market In 1994, the L.A. basin had the dubious distinction of being the only area in the nation classified as a “severe non-attainment area” for not meeting the current ozone standard. The combination of geography and high levels of ozone precursors made the region fall short of meeting the ambient air standards established under the 1990 Clean Air Act Amendments. Since the precursors to ozone had been subject to regulation for some time, SCAQMD decided to use environmental markets to reduce the economic dislocation and regulatory burden that would result from the imposition of increasingly stringent emission standards. At the outset it was determined that stationary facilities emitting four tons of NOx or more per year would be included in the RECLAIM program. This criterion encompassed 390 facilities, representing roughly 65% of the permitted stationary NOx emissions in the L.A. basin.2 The program is designed to be facilityspecific, with each facility being given an allocation of credits to cover all its emission sources, such as furnaces and boilers. Each facility then can choose how to achieve the required overall reduction in emissions, rather than having to force changes on specific pieces of equipment. This flexibility can result in significant cost savings at the facility level by allowing firms to shift emissions reductions among sources within a facility. RECLAIM establishes what is commonly referred to as a “cap and trade” market. It sets an area-wide emissions budget that declines over time and specifies an emissions reduction schedule for each facility in the program to the year 2003. The average NOx reduction required by the original 390 facilities was on the order of 75% of starting emissions levels. One of the most contentious issues in the RECLAIM program was the establishment of the initial emissions allocation level for each facility. Regulators wanted to make sure that it reflected average production levels for each facility and was not being distorted by special conditions, such as a recession leading to reduced production levels. However, to gain individual firm acceptance of the RECLAIM program, SCAQMD let firms pick their baseline level on the basis of actual emissions during one of four years between 1989 and 1992. As a result, the total allocation at the beginning of the program was somewhat above actual 1993 emissions levels. Other issues included reducing potential volatility in the trading market (this was accomplished by creating two partially overlapping trading cycles); easing the transition to an emissions trading environment by allowing firms a reconciliation period to purchase additional emission credits prior to imposing noncompliance penalties; and establishing two different geographic zones for trading to reflect the pollution patterns of the L.A. basin. Finally, the marketbased approach was coupled with a performance-based standard that encouraged accurate monitoring and reporting of actual emissions. which until recently, had been affected by the 1990–91 recession. With firms in the region operating below normal capacity, it is likely that the allocation of RECLAIM credits was generous enough for firms to easily meet the required emissions reductions during the first two years of the market. 1. Price data for NOx RTCs price, dollars per pound 1.25 1.00 High price Weighted average Low price 0.75 0.50 0.25 0.00 1994 ’96 ’98 2000 ’02 ’04 ’06 ’08 ’10 Source: Compiled by authors from Cantor Fitzgerald “Clean air auction announcement,” Los Angeles, CA, January 11, 1996, and from a press release, Cantor Fitzgerald, “The fourth clean air auction,” Los Angeles, CA, February 19, 1996. RECLAIM performance There are many metrics that can be used to assess the performance of the RECLAIM market to date. One question that can be asked is to what extent firms are trading credits in the market and whether the regulators’ expectations are being met. Based on trades of RECLAIM trading credits (RTCs) that expired in 1995, the market participation rate was around 50%. Given the new market and regulatory structure, this can be considered a good start. Yet, this seems low considering that RECLAIM does not allow banking of credits. Alternatively, one can attempt to assess the cost savings attributable to RECLAIM. Figure 1 shows the price trends that emerged from the first four auctions held by Cantor Fitzgerald, one of the larger brokers active in the market. The price of RTCs is found to be rising with their vintage. Because of the shrinking emissions cap and rising marginal costs of control, this pattern had been expected. However, the prices reported in figure 1 also fall well below SCAQMD’s projections prior to trading.3 This suggests that the additional flexibility in compliance provided by RECLAIM has reduced the cost of controlling for NOx. An additional factor to be taken into consideration in assessing the early activity of the RECLAIM market is the economy of southern California, Lessons in market design In general, RECLAIM is a well-designed environmental market. Transactions costs have been kept to a minimum.4 Trades are easy to execute, information is accessible via an electronic bulletin board, and the regulator provides useful data on market activity. In addition, brokers have entered the market and appear to be serving an important intermediary role in helping to sell and buy credits. However, the market approach represents a new regulatory structure and, as such, firms need to become familiar with it. Various uncertainties associated with the start-up of the program, such as the clearing of titles to RTCs and the imposition of fees associated with using RTCs, as well as uncertainties regarding future emission levels, have influenced facilities’ decisions during the first two years of the market. We found that many facilities traded only a small amount of RTCs and did not engage in long-term strategic trades. However, once firms adjust to the new regulatory structure, trading volume and participation are likely to increase. Finally, information collected by SCAQMD allows some inferences about facilities’ motivation to participate in the market. Figure 2 lists the main ways the traded RTCs were generated by RECLAIM facilities, brokers, and other parties. The most frequent response reported by sellers of RTCs was a decrease in production, which suggests an influence of the business cycle on trading behavior. Implications for Chicago In order to comply with Clean Air Act requirements, the Chicago area needs to reduce emissions of ozone precursors. More than five years ago, the Illinois EPA began to develop a regional emissions trading program for the Chicago area. At first it considered a NOx trading program, similar to RECLAIM. Later, regional air quality modeling found that the first priority for controlling ozone in Northwest Illinois was not local reductions in NOx, but reductions in volatile organic material (VOM) emissions. The modeling showed that, unlike Los Angeles, the Chicago area would experience an increase in ozone concentrations if local sources reduced emissions of NOx. In response, the Illinois EPA developed what will be the nation’s first VOM emissions trading program, which it expects to be finalized by the fall of 1997. While ERMS and RECLAIM were both designed to reduce regional ozone concentrations, the meteorological, economic, and regulatory differences between the two regions have resulted in two unique programs. The sources and types of companies that emit VOM are different from those that emit NOx. NOx emissions generally come from the combustion of fuels at electric utilities and other industrial facilities. In contrast, over 250 different chemicals are categorized as VOM, and they are emitted by steel mills and large chemical plants as well as other types of facilities. Figure 3 shows the different composition of high-emission industries for both programs. Another difference relates to the meteorology and air quality chemistry in the two regions: ERMS is a seasonal program while RECLAIM is a year-round program. This is because the weather conditions conducive to ozone formation only occur in the warm weather months in Chicago. Also, ERMS has only one geographic trading area, unlike the two trading zones in the California system. under RECLAIM. Facilities are allowed to average two of the number of transactions before 10/3/95 three seasons from 0 50 100 150 1994 to 1996. If a facilDecrease in production resulting in a decrease in emissions ity can demonstrate Bought from RECLAIM that these three years facility for resale Process change resulting are not representative, in lower emissions it may substitute years New or additional control equipment to reduce emissions from 1990 to 1997. Extra RTCs from an Once the ERMS baseequipment or facility shutdown Facility acquisition from line is set, initial reducchange in ownership tion requirements will Other be issued in 1999 in one step, with each facility receiving seaSource: Authors’ calculations based on South Coast Air Quality Management District, RECLAIM Annual Report, 1994–95 , Los Angeles, CA, 1996. sonal allotments that represent a 12% across the board reduction from its historical Another important difference is that baseline. Under RECLAIM, the ERMS allows limited banking of credits, amounts of required emission reducwhile RECLAIM does not. State tion vary from facility to facility, requirements in California did not based on the command and control allow SCAQMD to include banking requirements for each source, and in its design of RECLAIM. Under increase annually through 2003. ERMS, most trading units have a two-year lifetime.5 Furthermore, a special account to be managed by the Conclusion Illinois EPA will serve as an alternative Both theory and practice have demsource of trading units in case facilionstrated that market-based environties are unable to obtain them in the mental programs can be significantly private market. more cost effective than traditional The emissions baseline determinacommand and control regulations. tion under ERMS is similar to that Our analysis of the regional emissions trading market in California suggests that its performance so far 3. Top 4 high emission industries has been promising. Industry and residents in the Midwest now stand ERMS—VOM ready to enjoy the regulatory flexibility and compliance that will be providPaper, allied products ed by Illinois’s new emissions trading Chemicals, allied products program. While both RECLAIM and Petroleum, coal products Fabricated metals ERMS are designed to reduce local air pollution problems, they vary Percent of total emissions 52.8 according to regional conditions, Percent of total facilities 37.7 such as local weather patterns, industrial structure, and political environRECLAIM—NOx ments. Common to both programs’ Electricity, gas, and sanitary success, however, will be efforts to Petroleum, coal products keep transaction costs low and to Stone, clay, and glass minimize uncertainty associated with Oil and gas extraction the start of a new regulatory approach. 2. Generation of NOx RTCs sold Percent of total emissions Percent of total facilities 84.3 38.0 Sources: Compiled by Illinois EPA from preliminary baseline estimates, 1997; and Thomas Klier and Richard Mattoon, “To trade or not to trade: Who participates in RECLAIM,” Federal Reserve Bank of Chicago, working paper, No. WP-1994/11, 1994. —Thomas H. Klier and Richard H. Mattoon, Federal Reserve Bank of Chicago —Michael A. Prager, Illinois EPA6 1 For a more detailed analysis, see Thomas H. Klier, Richard H. Mattoon, and Michael A. Prager, “A mixed bag: Assessment of market performance and firm behavior in the NOx RECLAIM program,” Journal of Environmental Planning and Management, forthcoming. 2 The 390 facilities included at the outset of RECLAIM represented just over 11% of total NOx emissions in the L.A. basin. By the end of 1995, the number of facilities had decreased to 353, mainly as a result of a reevaluation of emissions estimates by SCAQMD staff. 3 Before RECLAIM began, one estimate from SCAQMD economists suggested that the prices for NOx credits would fall around $0.29 a pound in 1994 and rise to possibly $5.50 a pound by 1999. See Scott Lee Johnson and David M. Pekelney, “Economic assessment of regional clean air incentive market: A new emissions trading program for Los Angeles,” Land Economics, Vol. 27, No. 3, 1996, pp. 277–297. 4 The literature suggests that high transactions costs, including overly burdensome regulatory structures, have been responsible for the poor performance of some environmental markets. 5 Banking, which is allowed under the Acid Rain trading program, has encouraged early emission reductions and may have reduced the uncertainty of participants in the program; see Dallas Burtraw, “The SO2 emission trading program: Cost savings without allowance trades,” Contemporary Economic Policy, Vol. 14, April 1996, pp. 79–94. 6 Michael A. Prager is an environmental policy analyst with the Illinois EPA. The views expressed herein are the authors’ and not necessarily those of the Illinois EPA. Michael H. Moskow, President; William C. Hunter, Senior Vice President and Director of Research; Douglas Evanoff, Assistant Vice President, financial studies; Charles Evans, Assistant Vice President, macroeconomic policy research; Daniel Sullivan, Assistant Vice President, microeconomic policy research; William Testa, Assistant Vice President, regional programs; Helen O’D. Koshy, Editor. Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Articles may be reprinted if the source is credited and the Research Department is provided with copies of the reprints. Chicago Fed Letter is available without charge from the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690-0834, tel. 312-322-5111 or fax 312-322-5515. Chicago Fed Letter is also available on the World Wide Web at http:// www.frbchi.org. ISSN 0895-0164 Tracking Midwest manufacturing activity Manufacturing output indexes, 1992=100 126 Manufacturing output indexes (1992=100) CFMMI IP May Month ago Year ago 121.6 121.4 121.6 116.0 115.7 120.8 CFMMI IP 118 Motor vehicle production (millions, seasonally adj. annual rate) June Month ago Year ago 5.8 5.8 6.7 Light trucks 5.8 5.4 5.4 Cars 110 Purchasing managers’ surveys: net % reporting production growth June Month ago Year ago MW 54.5 56.6 60.6 U.S. 56.0 57.0 54.6 102 Motor vehicle production (seasonally adjusted annual rate) for June increased from 5.4 to 5.8 million units for light trucks and remained constant at 5.8 million units for cars. The U.S. purchasing manager’s survey for production declined in June from 57.0% to 56.0%. The Midwest purchasing manager’s survey also declined in June from 56.6% to 54.5%. 1997 Sources: The Chicago Fed Midwest Manufacturing Index (CFMMI) is a composite index of 16 industries, based on monthly hours worked and kilowatt hours. IP represents the Federal Reserve Board’s Industrial Production Index for the U.S. manufacturing sector. Autos and light trucks are measured in annualized units, using seasonal adjustments developed by the Board. The purchasing managers’ survey data for the Midwest are weighted averages of the seasonally adjusted production components from the Chicago, Detroit, and Milwaukee Purchasing Managers’ Association surveys, with assistance from Bishop Associates, Comerica, and the University of Wisconsin–Milwaukee. Chicago Fed Letter The Chicago Fed Midwest Manufacturing Index (CFMMI) decreased 0.1% from April to May, the first decline in seven months. By comparison, the Federal Reserve Board’s Industrial Production Index (IP) for manufacturing increased 0.5% in May. This is the first time in a year and a half that every sector in the region had slower growth from the prior month than its national counterpart. 1996 FEDERAL RESERVE BANK OF CHICAGO 1995 Public Information Center P.O. Box 834 Chicago, Illinois 60690-0834 (312) 322-5111 1994 PRESORTED FIRST-CLASS MAIL ZIP + 4 BARCODED U.S. POSTAGE PAID CHICAGO, ILLINOIS PERMIT NO. 1942
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