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REGIONAL ECONOMIC ISSUES Working Paper Series To Trade or N ot to Trade: W ho Participates in R ECLA IM ? Thomas H K and Richard H Mattoon . lier . FEDERAL RESERVE BANK OF CHICAGO WP- 1994/ 1 1 T o T ra d e o r N o t to T ra d e : W h o P a rtic ip a te s in R E C L A IM ? Thomas H. Klier Richard H. Mattoon I. Introduction In the l s decade the t e r t c l p o e at h o e i a r p rties of incentive-based approaches t o environmental regulation have received widespread a t n i n i the f e d of teto n il environmental economics ( e f r example Cropper and Oates 1992) A As a se o r s l of t a discussion, t e Clean Air Act Amendments (CAAA) of 1990 eut ht h incorporated market-based approaches as a way t achieve compliance with o f d r l clean a r requirements. Recently, the focus has s i t d t evaluating eea i hfe o e i t n programs as well as designing f ture programs on the basis of cost xsig u e ffectiveness and improvement of environmental q a i y ( Hahn and Hester u l t see 1989, Hahn 1989b, Carlson and Sholtz 1994, Hahn and Foster 1994). The i i i l regulatory response t t e l g s a i e requirements f r cleaner a r nta o h eiltv o i had been to specify technological sol t o s by means of a so-called command uin and control approach. However, i has become increasingly apparent t a t ht regulation based on tec n c l standards i i e f c e t and therefore unlikely t hia s nfiin, o make s g i i a t progress towards meeting the ozone standard i severe infcn n nonattainment a e s which i one of the pr n i l objectives of the Clean Air ra, s icpe Act Amendments ( f r example Hahn and Stavins 1992, Hahn and Hester see o 1989).^ The r egulators generally lack the wealth of technological knowledge and experience of i d s r , yet they s e l out d t i e requirements f rcontrol nuty pl eald o technology. At the same time mandatory investments i s e i i technology n pcfc are found t s i l innovative e f r s by firms t f r h r reduce t e r o tfe fot o ute hi emissions. " a i i i s facing s b t n i l pen l i s fo noncompliance have Fclte usata ate r every reason t meet mandatory emissions r d ctions, and because of market o eu competition, every economic reason not t go below those standards" o (Carlson and Sholtz 1994, p.16).^ In a d t o , command-and-control diin regulation does not consider differences i abatement costs among the n regulated sources. I i t erefore necessary t come up with a regulatory t s h o system t a promotes g ht reater f e i i i y for i lxblt ndividual firms and, by doing s , o lowers aggregate compliance c s s while sil making s g i i a t progress ot, tl infcn towards attainment ofthe ozone s a d r . tnad The recent l t r t r analyzing the e f c s of expanding the use of inc n i e ieaue fet etv- 1 FRB CHICAGO Working Paper August 1994, WP-1994-11 WA K v based approaches t environmental regulation addresses various dimensions o of such s r t g e ranging from the s e i i f a u e of emissions markets taeis pcfc etrs (Carlson and Sholtz 1994) t the p t n i l e f c s of f e i l regulation on o oeta fet lxbe regional economic s r c u e and growth (Robinson, 1993).^ This paper tutr introduces a d f e e t focus by examining what f c o s motivate the f r ' ifrn atr ims decision t trade when p r i i a i g i a market-based emissions trading o atcptn n program. In t i c s , th market-based t hs a e e rading program i the Regional s Clean Air Incentives Market (RECLAIM) located i the Los Angeles basin i n n southern C l f r i . Firms were placed in the RECLAIM program based on aiona c r a n emission thresholds fo oxides of nitrogen and s l u t a have been eti r ufr ht proven t be contributors t the formation of high ozone concentrations. o o Beginning on January 1 1994, these firms have had the opportunity t t ade , o r emission c e i s as a means of complying with the a r q rdt i uality standards established fo the b s n This paper argues t a one needs to look at the r ai. ht f r ' perspective i order t make inferences about e f c s of such a program ims n o fet on the economic s r c u e of a re i n For example, i e t f c t o of firmtutr go. dniiain l v l c a a t r s i s i of c u i l importance t s r out the various arguments ee hrceitc s rca o ot about possible e f c s of such programs on forcing technology improvements fet (see for example Downing and White 1984, Malueg 1989, and Milliman and Prince 1989).' Does t rading encourage the adoption of new and innovative production technology and provide b n f t t technologically sophisticated eeis o i d s r e ? An answer t t a question might enable analysts to shed some nutis o ht l g t on the hypothesized connection between innovation i abatement ih n technology and die competitiveness offirms or a r g o ' economy. The main eins challenge i to find f r s i m level c a a t r s i s t a can explain observed firm hrceitc ht behavior with respect t pollution abatement. Assuming p o i maximization, o rft what e f c have f c o s such as the age of the source, type and s z of f r , fet atr ie im degree of exposure t the l c l market on the f r ' decisions? o oa ims As a state-based e f r t comply with the 1990 Clean Air Act Amendment fot o ozone standards RECLAIM represents a f r t attempt a regional emissions is t t a i g Experience gained i the RECLAIM program i expected t o f r rdn. n s o fe valuable lessons t other regions having t comply with the C A A A standards. o o Given the h s o i and continued importance of manufacturing t is region, itrc o t the Midwest, defined as the s a e i the Seventh Federal Reserve D s r c — tts n itit I l n i , Indiana, Iowa, Michigan and Wisconsin - has r l t v l high lios eaiey emissions r t s and therefore a pressing need t devise c s - f e t v ae o otefcie mechanisms f r meeting clean a r standards i order t preserve the health of o i n o the regional economy. In recognition of t i , s h s everal Midwest s a e have tts already begun c a t n t e r own emissions trading programs. For example, rf i g hi I l n i developed a complete proposal for a Chicago area NOx emissions lios FRB CHICAGO Working Paper August i m , WP-1994-11 2 ta r ding program and Wisconsin has an o f e emissions trading system i fst n p a e The c r f l y constructed I l n i program was placed on hiatus a the lc. aeul lios t end of l s year when airshed modeling suggested t a v l t l organic at ht oaie compound (VOC) c n r l would be more b n f c a i preventing ozone oto eeiil n exceedences than reducing NOx l v l i the Chicago a e . Currently, e f r s ees n ra fot are underway both i t e Los Angeles Basin and i I l n i t develop a n h n lios o market f rVOC emissions. o In t a context RECLAIM can be seen as a policy laboratory f r the Midwest ht o s a e . I already has provided valuable experience about the design of tts t markets f r emission c e i s and about important s r c u a design f a u e o rdt tutrl etrs such as e t b i h n f r - p c f c emissions baselines and the implications of salsig imseii economic phenomena on t a i g a t v t . C a a t r s i s of t r d n ciiy h r c e i t c rading a t v t ciiy taking place may provide i s g tas t which i d s r e benefit from emissions nih o nutis t a i g That could be very h rdn. elpful i fashioning trading systems t a f c o n ht atr i c a a t r s i s of t e Midwest economy. n hrceitc h The remainder of t i paper i organized as fol o s Section two reviews the hs s lw. relevant c a a t r s i s of th RECLAIM tr d n program. Section th e hrceitc e aig re discusses t e f r ' i c ntives t tr d by identi y n f r - pecific h ims ne o ae fig ims c a a t r s i s t a may influence trading a t v t . The concluding s hrceitc ht ciiy ection discusses the outlook f r empirically t s i g th e f c of these variables i o etn e fet n influencing t a i g behavior. rdn H. W hy RECLAIM? The problem of ozone attainment i not new. The Clean Air Act was passed s i 1963 and has since been amended s n everal t m s most recently i 1990. An ie, n important aspect of t e 1990 amendments i the requirement t reduce h s o p l u a t contributing t t e formation ofdamaging ozone. Ozone i created oltns o h s by the i t r c i n of sun i h and v l t l organic compound (VOC) emissions neato lgt oaie as well as nitrogen oxide (NOx) emissions. In order t comply with the o n tional ambient ozone standard of 0.12 p r s per m l i n s a e are required a at ilo, tts t submit a plan of control measures t be approved by the EPA. The 1990 o o C A A A d s i g i h f v d f e e t nonattainment c t g r e , each of which i itnus ie ifrn aeois s given a d f e e tamount of time t reach the t r e a rqu l t s ifrn o a g t i a i y tandards. FRB CHICAGO Working Paper August 1994, WP-1994-11 3 T b e 1 Ozonen n t a n e tc t g r e al o a t i m n aeois compliance deadline (from 11/15/90) Marginal 3 years Moderate 6 years Serious 9 years Severe [two subcategories] 15 or 17 years Extreme 20 years A. A new way ofresponding to the air quality problem in the L.A. basin In Southern C l f r i , a r q a i o n a i uality i a p r i u a problem since climate and s atclr geographic f a u e i the region combine t produce stati n r weather etrs n o oay f o t and sunshine year round. They i t r c with high NOx l v l to give rns neat ees the area the worst ozone r t n i the n t o . The Los Angeles area therefore aig n ain has the dubious d s i c i n of being the only area i the nation under the itnto n Clean Air Act t receive the r t n of extreme non-compliance. In 1970 the o aig area exceeded the fe e a ozone standard on over 150 days and despite being drl regulated for over 20 y a s the region sil had 40 exceedences i 1993. er, tl n Because of t i severe problem, regulations f r NOx emissions i the basin hs o n have been issued since the mid-1970s, but even these ea l regulations have ry not been s f i i n t c u f c e t o orrect the ozone problem. RECLAIM represents an innovative approach by th South Coast Air Quality e Management D s r c (SCAQMD) t use market incentives t reduce the itit o o presence of oxides of Nitrogen (NOx) and oxides of Sulfur (SOx) i the Los n Angeles b s n I s l g l basis i the California s a e implementation plan ai. t ea s tt (SIP) which i even more s r n e t than the C A A requirements. The s tign RECLAIM program i receiving national a t n i n as a p tential model f r s teto o o e tablishing other l c land regional markets fo trading emission c e i s * s oa r rdt.* F c l t e included i RECLAIM receive trading c e i s (RTCs) — aiiis n rdt denominated i one pound per year - equal t t e r emission caps. I a n o hi f s e i i source reduces emissions below the targeted l v l i can s l is pcfc ee, t el t c e i s t any i t r s e p r y e g another source where emissions reductions rdt o n e e t d a t , .. are impractical or more c s l . oty FRB CHICAGO Working Paper August 1994, WP-1994-11 4 According t SCAQMD e t m t s RECLAIM would reduce the average o siae, annual co t f r targeted source emissions by 42% t $80.8 m l i n In ss o o ilo. a d t o , the new program i expected t lead t fewer job l sses and lower diin s o o o consumer cost inc e s s ^ rae. B. Specifics of the NOx trading program This paper focuses on the RECLAIM NOx trading program.** NOx i a s problem emission f r many urban areas because ispresence, when combined o t with s nlight and other f c o s helps form damaging ozone. In order t u atr, o achieve the desired o e a l emissions reductions i was decided t a each vrl t ht source with NOx emissions of gre t r than four tons per year needed t be ae o included i the RECLAIM program. n The NOx trad n program encompasses 390 sources, representing roughly ig 65% of permitted NOx emissions i t e Basing Some exemptions were made n h for c r a n industry groups such as dry c e n r , restau a t and public eti laes rns treatment f c l t e ; they are not included i t e RECLAIM program. F r t a aiiis n h is, cap was established f r the t t l emissions from a l sources included i the o oa l n program. This aggregate l v l was then allocated i the form of allowable ee n emissions t each of the sou c s Consequently each source was provided o re. with s e i i annual r t s of emissions reductions out t the year 2003. The pcfc ae o goal of the program i t reduce o e a l emissions by 80 tons of NOx per day s o vrl by t e . Within a framework of declining f c l t emission caps i i no hn aiiy t s longer necessary f r t e regulator t specify p r i u a abatement o h o atclr technologies. As t b e 2 shows, th average NOx reduction required by these 390 sources al e w l be on th order of 75 percent of s a t n emission l v l .^ Table 2 also il e trig ees shows the mix of i d s r e and the number of f c l t e included i the nutis aiiis n RECLAIM program a well as the d s r b t o of the NOx emission l v l s itiuin ees from beginning t end of t e program. As t e t b e i d c t s the vast bulk of o h h al niae, the NOx emissions are generated by roughly 38% of the f c l t e which aiiis reside i t e following four industry groups: SIC 1300: o l and gas e t a t o , n h i xrcin SIC 3200: s o e clay and g a s SIC 2900: petroleum and coal products, and tn, ls, SIC 4900: e e t i i y gas and s n t r s r i e . These four industry groups lcrct, aiay evcs represent 148 f c l t e (38% of 390), emitting s i h l over 84% of the t t l aiiis lgty oa s a t n emissions i th RECLAIM NOx program. Even by the end of the trig n e program, i the year 2003, they w l emit 78% of the t t l NOx emissions of n il oa sources i the program. n FRB CHICAGO Working Paper August 1994, WP-1994-11 5 The trading operations of RECLAIM have s everal s e i i f a ures worth pcfc et n oting. F r t the annual allotment of t is rading c e i s t a each firm receives rdt ht has been established within staggered trading c c e . Firms are assigned t yls o one of two c c e , t e rannual RTC allotmentbeing valid from e t e January yl s hi ihr 1 t t December 31st ( ycl 1 or July 1 tthrough June 30th (cycle 2 . The s o c e ) s ) presence of two cycles i intended t smooth trading behavior. Simulations s o had found t a when firms were a lplaced on th same c c e trading tended ht l e yl, t occur a the very t i end of the cycle creating extreme v l t l t in the o t al oaiiy market. This was seen as a p t n i l obstacle to the market operating oeta e f c e t y Also a r c n i i t o period has been established a the end of the fiinl. eoclain t f r ' annual compliance deadline i which i can review i s emissions ims n t t performance and take measures t ensure i i meeting is compliance cap o t s t before pen l i s are imposed. F n l y the a t RECLAIM market has been ate ial, c ual established with 2 geographic zones--inland and c a t l Trading occurs osa. between firms located within t e r designated zone; in a d t o , coastal firms hi diin can trade with inland f r s but not vice v r a In the case of the Los Angeles im, es. Basin, the more severe a r problem occurs i the inland zone. RECLAIM i n designers wanted to e t b i h 2 t sals rading zones t insure t a trading did not o ht s i t a r qu l t problems t the c a t Actual t a by e i i l firms ( . . hf i a i y o os. r des lgbe eg cycle 1 films) could begin on January 1,1994. 1 facility-wide permits . RECLAIM i a f c l t - p c f c program. Each f c l t i given a single s aiiyseii aiiy s permit which covers a l of i s NOx emissions. This replaces the approach l t taken under command and control where permits were generally t e t id o individual types ofproduction equipment.^ The advantage of a facili y w d t-ie permit i t a i allows each f c l t t e f e i i i y t choose where and how i s ht t aiiy h lxblt o t wants to achieve emissions reductions in order t meet the required overall o reduction r t a her than forcing i t make changes on s e i i pieces of t o pcfc equipment which may not represent the most cost e f c i e way of reducing fetv emissions. In terms of being able to plan ahead, a f c l t permit w l c e r y aiiy il lal e t b i h what the annual r t of emissions reduction i going t be for a sals ae s o p r i u a f c l t . I provides c r a n y t the regulated establishments fo the a t c l r aiiy t etit o r next 10 years i terms ofannual control requirements.^ n 2 baseline allocation . One of the most contentious i sues i the RECLAIM program was the s n establishment of the l v l of i i i l emissions a l c t o s for each f c l t .^ ee nta loain aiiy One p r i u a problem f r RECLAIM designers was to ensure t a the atclr o ht emission a l c t o s r f e t d t p c l t a i r c s i n n u r l production l o a i n e l c e yia, ht s e e s o - e t a , a t v t a each f c l t . C l f r i ' recent recession had caused many ciiy t aiiy aionas FRB CHICAGO Working Paper August 1994, WP-1994-11 6 f c l t e t operate a below average production l v l which i t r , meant aiiis o t ees n un t a th most recent emission l v l would r f e t reductions r l t d t a ht e ees elc eae o c c i a lowering of production r t e than reductions through improved ylcl ahr technology. In order t gain individual firm acceptance of RECLAIM, o designers allowed firms t s t t e r i i i l baselines on th basis of act a o e h i nta e ul emissions i one of the four years 1989 t 1992. This enabled firms to s l c n o eet a baseline year t a r f e t d what the firm f l was a reasonable, recessionht elce et n u r l production y a . Each f c l t ' emission l v l was adjusted for by eta er aiiys ee using emission f c o s s e i i t the s a t n and ending l v l as well as atr pcfc o trig ees throughput l v l f r each process and equipment category. F n l y t i was ees o i a l , hs adjusted by requiring t a th s a t n and ending a l c t o s r f e t e ht e trig l o a i n e l c xisting control s a d r s A s t of environmental standards has been established by tnad. e regul t r i order t r f e t the types of technological s l aos n o elc o utions t a are ht cr u rently available and are the most e f c i e a reducing emissions. They are fetv t r f rred t as BACT because they u i i e th Best Available Control ee o tlz e Technology. 3 monitoring and reporting . RECLAIM requires the submission of periodic emissions r eports and c r i i d etfe qa u rterly compliance s a ements. I imposes s b t n i l p nalties f r tt t usata e o noncompliance. The f c l t permit i RECLAIM i based on actual aiiy n s emissions and not thepermitted emissions of s e i i types of equipment used pcfc i previous c n ontrol programs.^ Other key elements of t e program concern emissions r p r i g In exchange h eotn. fo t e freedom t devise t e rown emissions reduction program, f c l t e i r h o hi aiiis n RECLAIM must provide r g l t r with b t e and more accurate information euaos etr on a t a emissions l v l . The RECLAIM program distinguishes three t e s cul ees ir f r emissions r p r i g Major s u ces, f r example a 400 M W b i e , are o eotn. or o olr required t report emissions l v l on a da l b s s Large sources are o ees i y ai. required t report on a monthly b s s and minor sources are required t report o ai o on a q arterly b s s While the i i i l monitoring c u ai. nta osts fo RECLAIM r f c l t e can range from $1,500 f r minor sources t $200,000 fo large aiiis o o r sources, much of t i can be recovered through lower ov r l f c l t hs e a l aiiy compliance c s s ^ ot. FRB CHICAGO Working Paper August 1994, WP-1994-11 7 D L A firm's incentive to trade D A. Framework As was alluded t e r i r from t f r ' perspective the a t a t o of a o ale, he i m s trcin market-based t rading program i the provision of greater f e i i i y i s lxblt n abatement-related decision making. Whereas under a command and control regulatory framework a firm needed to comply with s e i i technological pcfc requirements, i i now able t apply i scost minimization calculus t the area ts o t o of environmental compliance. S a t n with a known amount of required trig emission reduction, the question a i e as t how t best - . . least-costrss o o ie achieve i, whether t a be through process switching, technology t ht enhancement or purchasing of c e i s The a a l b l t of marketable permits rdt. viaiiy provides an incentive f r the firm t lower emissions by more than what i o o s required so t a i can s l the c e i s r s l i g from th additional emissions ht t el rdt eutn e reduction. The f r ' decision w l be based on a comparison of the marginal ims il cost of abatement (..i t r a pollution reduction) and the cost of purchasing ie n e n l permits to comply with t e requirement. However, as Carlson and Sholtz h (1994) argue, i seems s f i i n for a firm t base is decision t trade on t ufcet o t o knowledge of i s own abatement c s . The significance of t i i t a firms t ot hs s h t w l each have an i t r a reservation price a which they w be willing t il nenl t ill o t a e Essentially t e firm can place a c l order t buy a s tamount of c e i s rd. h al o e rdt a a price t a i lower than the i t r a abatement c s . Trading behavior wi l t ht s nenl ot l be based on t a f r - p c f c price offer r t e than the general equilibrium ht imseii ahr price s ti the RECLAIM market e n For our analysis the question of i t r s i which f c o s can explain the neet s atr decision t trade RTCs. We s a twith the s t a i n of a cost-minimizing firm o tr iuto t a i included i the RECLAIM program ( e f g r 1 . Suppose the firm i ht s n se iue ) s currently controlling emissions a l v l Q , M C represents ismarginal cost of t ee ' t abatement and Q designates i s new emission cap. In order t meet the t o required emission reduction t r e , i w l choose t t a e RTCs i t a action agt t i l o rd f ht r s l s i lower compliance costs compared t straightforward technology eut n o enhancement or other forms of compliance. A firm i trading e t e because i s ihr t i cheaper to buy permits r ther than i s a l new control technology, or s a ntl because i can p o i t r f tably overcontrol for NOx by s l i g the r sulting c e i s eln e rdt u t lthe marginal costs ofpollution abatement are equal t the market price of ni o a permit Since the firm i c rrently controlling emissions a a l v l of Q , i s u t ee ' t needs t reduce emissions f r h r i order t meet the new cap. I the price o ute n o f for emission c e i s equals pj, t a firm w l control emissions a is f c l t rdt ht il t t aiiy FRB CHICAGO Working Paper August 1994. WP-1994-11 8 up t point A, and buy emission c e i s f r t e remaining abatement of AQ. o rdt o h A t r a i e y i th p l e n t v l , f e rice of permits i equal t P2 i s e d the firm w l s o nta, il overcontrol NOx a lthe way t an abatement l v l of B and s l c e i s f r the l o ee el r d t o quantity QB. Leaving aside the issue of u c r a n y the determinants of th netit, e abatement cost function need t be f r h r analyzed The following section o ute presents such an a nalysis as well as the expected respective e f c s of the fet various determinants on t e likelihood of a t a e occurring. h rd B. Determinants of abatement cost Best Available Control Technology (BACT) i th most s r n e t type of s e tign control technology prescribed by r g lators and each f r ' r l t v adherence eu ims eaie t t i standard i l k l t influence is t a i g behavior. Firms currently o hs s iey o t rdn meeting BACT standard w l not have t make emissions reductions from il o t e r c rrently s t l v l u t l the year 2000 ( e f g r 1. At the very l a t hi u e e e s ni se iue ) es, th closer a f c l t i t operating a BACT l v l , th l s severe isannual e aiiy s o t ees e es t r t of emissions reductions w l be Figure 2 demonstrates the e f c t a a ae il . fet ht f c l t ' e i t n l v l of control technology has on isrequirements t reduce aiiys x s i g e e t o emissions. The fi u e shows th e f c l t e i t e same industry (SIC 1311) gr r e aiiis n h with roughly comparable s a t n emissions l v l . Even though the Shell trig ees Western f c l t i contributing the same l v l of emissions t the aiiy s ee o environment as the Exxon f c l t , t e Shell f c l t does not have t make aiiy h aiiy o f r h r emission red c i n , a is current l v l of production, because i ute utos t t ee t already i a "clean" (.. BACT) f c l t . Both the Brietbum and th Exxon s ie aiiy e f c l t e must make f r h r reductions i emissions t be operating a a aiiis ute n o t si i a environmental st n a d given t e r l v l of production. This mlr adr, hi ees demonstrates how t e individual firm baselines were s t given f r h e, i m-specific c i e i . I also shows t a declines i the l v l of aggregate emissions i the rtra t ht n ee n RECLAIM program w l be more binding on c r a n f r s even within the il eti im, same industry group. The variable "co t o technology" i d c t s the extent nrl niae t which a firm has invested i BACT c n r l technology. Since BACT o n oto represents a very co t y regulatory requirement, t i control technology i sl hs s expected t correspond t high marginal c of abatement ( e figure 1 o o ost se , m c BACT)- BACT f c l t e are t e e o e expected t be more l k l aiiis hrfr o iey p r i i a t i the market f r emission c e i s than non-BACT firms since atcpns n o rdt they have already exhausted low-cost technology-based emission reduction otos pin. Even within t e same industry the magnitude of required emission reductions h v r e widely across firms ( i u e 2 . Some f c l t e are already cleaner than ais fgr ) aiiis o h r , and the firms t a must reduce t e r emission l v l most aggressively tes ht hi ees FRB CHICAGO Working Paper August 1994, WP-1994-11 9 are going t need t take d a t c st p t ensure compliance. I emission o o rsi es o f reductions can be accomplished by i s i u i g a reasonable low-cost ntttn technological s l t o , these firms may end up generating surplus c e i s t a ouin rdt ht can be t a e . The revenue generated through the s l of these c e i s could rdd ae rdt be used f r f r h rabatement e f r s On the other hand, i reductions through o ute fot. f technology are too c s l , firms with heavily polluting f c l t e may end up oty aiiis needing t purchase c e i s i order t meet annual reduction l v l . The o rdt n o ees variable " i m s reduction" measures a f r ' average percentage reduction i fr' ims n baseline emission req i e . I i expected t be pos t v l r l urd t s o i i e y e ated t the o likelihood of t a e occurring. rds A sm i ilar argument applies a the industry l v l As shown i Table 2 NOx t ee. n , emissions are heavily concentrated i c r a n i d s r e . I i expected t a n eti nutis t s ht firms i these i d s r e w l be a tive p r i i a t i the market since they n nutis il c atcpns n need t generate the g e t s quantity of reductions. The variable "industry" o raet dummies the heaviestpollu i g industries.^ tn Investments i pollution abatement, e g continuous emissions monitoring n .. systems or continual process monitoring systems, can involve s b t n i l usata amounts of money and resources. I seems reasonable t assume t a l r e t o ht agr firms have e s e access t research s a f regulatory engineers, and c p t l air o tf, aia than smaller f r s Market-based programs, l k RECLAIM may successfully im. ie lower compliance c osts and yet f i t reduce those scale and scope al o requirements t a pose the g e t s obstacles t small firm compliance ht raet o (Robinson 1993, pp. 17 ) From t a perspective one would expect la g r 9. ht re firms t be more l k l t t o i e y o rade since they are more l k l t be able t i vest iey o o n i advanced abatement technology. We measure "firm s z " by employment. n ie The choice of compliance methods, and therefore p r i i a i n i the market atcpto n for RTC w l a depend on the a i i y of the firm t reduce emissions by i l lso blt o trading emission c e i s between is own f c l t e i the RECLAIM a e . rdt t aiiis n ra This s -called i t r a trading can be p r i u a l a t a t v since the firm o nenl atclry trcie does not have t disclose the same degree of information, which could o possibly reveal production c a a t r s i s t competitors or the public i hrceitc o n g n ral, as i would i the case of an external t a e ^ As the number of a ee t n rd. firm’ f c l t e i the RECLAIM area i c e s s the options f r i t r a s aiiis n nrae, o nenl trading increase as w l . Since we expect these i t r a t a not t be el n e n l r des o FRB CHICAGO Working Paper August 1994, WP-1994-11 10 repor e , an increase i t a v riable would lead t a reduction i t e td n ht a o n h likelihood i observed t a e . n rds IV. Outlook Unfortunately, very few t a e have been recorded i th RECLAIM NOx rds n e market t d t . That has prevented us from t s i g our model. Once actual o ae etn t a e w l have occurred i s f i i n numbers, we w l be able t empirically rds il n ufcet il o analyze t e data s t of the 390 p r i i a i g establishments within a limited h e atcptn dependent var a l framework. One datapoint w l represent a sin l trade by ibe il ge ap r i u a f r . atclr im The following e f c s have been mentioned i connection with the slow s a t fet n tr of the t rading of NOx RTCs a t e outset ofRECLAIM. The r s l e c of th t h eiine e recession i southern California i essence means t a the current actual n n ht production l v l are low enough f r many firms so t a the required ees o ht reduction i permitted emissions i not yet a binding c n t a n .^ n s osrit The RTCs, representing a source-specific endowment of pollution c e i s are rdt, allocated f e of charge. A t r a i e y they could have been auctioned o f re lentvl, f. That " r e a l c t o might well reduce th willingness of sources t s l fe" loain e o el t e rc e i s as the opportunity cost of holding them seems very sma l Also, hi rdt, l. firms probably want t gather more information on the workings of the o market, esp c a l a the beginning of a new regulatory regime, such as eily t RECLAIM. F n l y a s e i l s a t u e f c i provided by the f a u e of two overlapping ial, pca tr-p fet s etr trading c c e . I w l not be u t lJuly ’ t a t e e t r a l c t o of permits yls t il ni 94 h t h n i e l o a i n w l be t a e b e il rdal. Judgements on the ultimate success of market-based programs such a s RECLAIM w l depend upon the vantage point t k n From our point of il ae. view, i i i t e i t r s of the individual firm t have the option of a markett s n h neet o based s l t o . That allows i t minimize compliance cost r l t v t other ouin to eaie o forms of r g l t o . I firms are able t make t e r choice of regulatory euain f o hi compliance p r of t e rproduction decision r t e than having t t e t i as an a t hi ahr o ra t add on t production considerations, they w l be able t develop s e i i o il o pcfc p a s based on t e rdet i e knowledge of production options and associated ln, hi ald c s s i order t meet t e rcompliance requirements. ot, n o hi FRB CHICAGO Working Paper August 1994, WP-1994-11 11 Empirical research on the determinants of i ndividual f r s decisions t t a e im' o rd emission c e i s w l be important t evaluate the ac u l workings of the rdt il o ta market-based approach as well as t possibly i e t f c i e i t consider as o d n i y rtra o these new regulatory approaches are being more widely developed and implemented. FRB CHICAGO Working Paper August 1 994,WP-1994-11 12 Figure 1 Cost minimizing control of pollution with permit trading $ui /nt FRB CHICAGO Working Paper August 1994, WP-1994-11 Figure 2 Start-interim-end NOx allocations for three SIC 1311 facilities tons of NOx emissions Source: SCAQMD, "RECLAIM", vol. 1 & 2. Final, 1993. FRB CHICAGO Working Paper August 1994, WP-1994-11 Table 2 RECLAIM data-SIC sorted by size of initial NOx allocations Start SIC Misc. Manufacturing Pipeline excl. natural gas Apparel, other textile Misc. repair Administration o f environment Furniture, fixtures Motor freight Government excl. finance W holesale trade, nondurable Food store Mining, non-metallic excl. fuels Lumber, wood Administration o f economic programs Heavy construction excl. buildings Instruments Personal services Engineering, accounting professional Unclassified Industrial machinery Rubber, misc. plastics Electronics Depository institutions Hotels, lodging Business services Wholesale trade, durahle Construction, specialty trade Printing, publishing Textile, m ill products Transportation, air Food, kindred products Amusement Transportation equipment Fabricated metals Chemicals, allied products National security Primary metals Paper allied products Oil, gas extraction Stone, d ay, glass Petroleum, coal products Electricity, gas, sanitary TOTALS 3900 4600 2300 7600 9500 2500 4200 9100 5100 5400 1400 2400 9600 1600 3800 7200 8700 3500 3000 3600 6000 7000 7300 5000 1700 2700 2200 4500 2000 7900 3700 3400 2800 9700 3300 2600 1300 3200 2900 4900 Allocation percent % of start % o f end Allocation reduction # facilities End allocation allocation 3.5 3.7 3.9 4.3 6.0 9.3 10.8 11.2 13.5 18.4 18.6 19.3 21.3 24.5 28.2 30.3 32.4 34.5 36.6 42.0 44.9 45.0 51.3 53.6 56.4 71.1 119.9 129.8 207.8 242.4 271.7 342.6 521.0 557.5 632.4 893.4 1290.4 2762.7 4543.7 12013.7 12311.5 1.5 2.6 2.1 0.9 0.4 3.2 4.1 0.8 9.3 8.3 0.9 0.9 1.1 1.2 6.8 9.9 23.4 18.6 19.0 19.8 21.2 16.0 6.7 38.7 10.8 7.2 57.7 72.1 22.8 130.1 158.0 144.9 130.4 314.4 128.8 321.5 348.6 389.9 993.3 3471.1 2443.8 57.1 27.8 47.8 78.7 92.8 65.3 61.6 92.8 30.7 55.1 95.2 95.2 94.9 95.1 75.9 67.2 27.7 46.0 48.1 52.8 52.7 64.4 86.9 27.8 80.9 89.9 51.9 44.4 89.0 46.3 41.9 57.7 75.0 43.6 79.6 64.0 73.0 85.9 78.1 71.1 80.2 37528.5 9359.1 75.1 1 1 1 1 1 1 1 1 4 4 2 1 2 1 3 5 1 3 6 10 6 2 3 1 5 3 4 19 3 30 2 20 22 22 7 27 16 34 33 37 44 388 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.2 0.2 0.3 0.3 0.6 0.6 0.7 0.9 1.4 1.5 1.7 2.4 3.4 7.4 12.1 32.0 32.8 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.1 0.0 0.0 0.0 0.0 0.1 0.1 0.3 0.2 0.2 0.2 0.2 0.2 0.1 0.4 0.1 0.1 0.6 0.8 0.2 1.4 1.7 1.5 1.4 3.4 1.4 3.4 3.7 4.2 10.6 37.1 26.1 100.0 100.0 Source: SCAQMD, "RECLAIM", Vol. 1 & 2, Final, 1993. FRB CHICAGO Working Paper August 1994, WP-1994-11 15 Table 3 Expected effects of explanatory variables independent variable effect on the likelihood of trade occurring control technology [% of BACT facilities per firm] + firm's reduction [avg. %reduction in baseline emissions reqd.] + firm size [employment] + industry ["dirty" SIC dummy] + # of facilities in basin FRB CHICAGO Working Paper August 1994, WP-1994-11 16 F o o tn o te s *Generally two categories of incentive-based policies are distinguished: marketable permits and emission charges (see e.g. Hahn 1989a). Both o f these differ from the command and control approach which specifies the technology a firm has to use in order to comply with regulations. ^Nonattainment areas are defined as areas that do not meet the federally mandated national ambient standards ^A good example o f this was recently shown at the Amoco refinery in Yorktown, Virginia. A pilot study, undertaken jointly by Amoco and EPA, reached the conclusion that relatively low-cost reductions in emissions could be made by altering the fuel loading procedures and technology at the facility. But due to existing command and control regulation Amoco was forced to pursue more expensive reductions on specific regulated equipment It was not in Am oco’s interest to either pursue or even reveal the existence o f these potential low cost reductions since it would be likely to bring additional regulation (Solomon 1993). ^Related research on the subject also includes the effects of transactions costs on em issions markets (Stavins 1994); as well as an examination of the effect o f markets on aggregate compliance costs and environmental quality (SCAQMD 1993) and o f the political feasibility of using market based tools as part o f a regulatory scheme (Hahn 1989b). ^"In the long run, the effect of public policies on technological change may be among the most important determinants of success in environmental protection". (Hahn and Stavins 1992, p. 466). ^Similar proposals are under consideration in Massachusetts, Illinois, Wisconsin, Texas, Ontario, and British Columbia (see Carlson and Sholtz 1994, p. 15). 7SCAQMD 1993; Carlson and Sholtz 1994, p. 18. ®It went into operation Januaiy 1 1994. Currently rules are being written on how to deal with reducing the VOC emissions. ^However, permitted stationary sources account for only 17 percent o f the inventory of NOx emissions in the Basin. The largest category contributing to NOx emissions are mobile and o ff road mobile sources (Carlson and Sholtz 1994, p. 17). l^That represents an average 8.3% annual reduction per source. * *That could easily lead to 30 or 40 permits per facility. ^ U n d er command and control regulation, each year between 15 and 20 new rules were issued. It needs to be mentioned that the RECLAIM program has a built in backstop provision that requires a change in the regulatory procedure if the required emission reduction targets are not met. l^Hahn and Hester (1989) point out the importance of a proper emissions baseline. "If the baseline involves a large amount o f permitted emissions that are not actually produced (at a particular point in time), then the potential for an adverse environmental impact is significant; if the baseline reflects a realistic assessment of actual emissions, then the potential for environmental harm is slight" (p. 151). ^W ithin the command and control framework, permits were issued with reference to a technology standard. They were based on potential emissions to be expected from that particular piece of equipment; however, the regulators often had no idea what the actual em issions were. l^A. Ganguli, Senior Manager SCAQMD; presentation at 2nd Regional Emissions Trading Conference, January 27-28 1994, Chicago IL. FRB CHICAGO Working Paper August 1994, WP-1994-11 17 *^The actual modelling will depend on the number of observations available; with sufficient data one could differentiate between industries at a more disaggregate level. ^ A n external trade refers to a trade with a different company. IBr TC s were allocated on basis o f a baseline that itself was based on a recession-neutral emission level. Given the historical volatility o f the Midwest economy this influence too will have to be considered in its effect on trading activity in that region. FRB CHICAGO Working Paper August 1994, WP-1994-11 18 R e fe re n c e s Carlson, Dale A.; Anne M. Sholtz. 1994. RECLAIM: Lessons from Southern California for Environmental Markets. Journal of Environmental Law and Practice 1(4): 15-26. Cropper, Maureen L. Wallace E. Oates. 1992. Environmental Economics: a survey. Journal of Economic Literature XXX:675-740. Downing, Paul B., Lawrence J. White. 1986. Innovation in Pollution Control. Journal of Environmental Economics and Management 13:18-29. Foster, Vivien; Robert Hahn. 1994. ET in L.A.: Looking Back to the Future. ENRP Project 88/Round II Project Report P-94-01, Kennedy School of Government, Harvard University. Hahn, Robert W. 1989a. Economic prescriptions for environmental problems: how the patient followed the doctor's orders. Journal of Economic Perspectives 3(2):95-114. Hahn, Robert W. 1989b. A Primer on Environmental Policy Design. Harwood: New York. Hahn, Robert W.; Gordon L. Hester. 1989. Where did all the markets go? An analysis of EPA's emissions trading program. The Yale Journal on Regulation 6:109-153. Hahn, Robert W., Robert N. Stavins. 1992. Economic Incentives for Environmental Protection: integrating theory and practice. American Economic Review 82(2):446- 468. Malueg, David A. 1989. Emission credit trading and the incentive to adopt new pollution abatement technology. Journal of Environmental Economics and Management 16:52-57.111 Milliman, Sott R., Raymond Prince. 1989. Firm incentives to promote technological change in pollution control. Journal of Environmental Economics and Management 17:247- 265. Robinson, Kelly. 1993. The regional economic impacts of marketable permit programs: the case of Los Angeles; in: Richard F. Kosobud, William A. Testa, Donald A. Hanson (editors) Cost Effective Control of Urban Smog; Federal Reserve Bank of Chicago. Solomon, Caleb. 1993. Cleaning the air. Wall Street Journal. March 29 1993, p. A l. FRB CHICAGO Working Paper August 1994, WP-1994-11 19 South Coast Air Quality Management District. RECLAIM. Vol. 1-2. October, 1993. Stavins, Robert N. 1994. Transaction costs and the performance of markets for pollution control. Paper presented at the American Economics Association Meeting, Boston, MA, January 1994. FRB CHICAGO Working Paper August 1994, WP-1994-11 20 Working Paper Series A series of research studies on regional economic issues relating to the Seventh Federal Reserve District, and on financial and economic topics. REGIONAL ECONOMIC ISSUES Estimating Monthly Regional Value Added by Combining Regional Input With National Production Data WP-92-8 Philip R. Israilevich and Kenneth N. Kuttner Local Impact of Foreign Trade Zone WP-92-9 D a vid D . W eiss Trends and Prospects for Rural Manufacturing WP-92-12 W illiam A. Testa State and Local Government Spending-The Balance Between Investment and Consumption WP-92-14 R ichard H. M attoon Forecasting with Regional Input-Output Tables WP-92-20 PJZ. Israilevich, R. M ahidhara, and G J D . H ewings A Primer on Global Auto Markets WP-93-1 P aul D . B allew and R obert H. Schnorbus Industry Approaches to Environmental Policy in the Great Lakes Region WP-93-8 D a vid R. A llardice, R ichard H . M attoon and William A. Testa The Midwest Stock Price Index-Leading Indicator of Regional Economic Activity WP-93-9 William A. Strauss Lean Manufacturing and the Decision to Vertically Integrate Some Empirical Evidence From the U.S. Automobile Industry WP-94-1 Thomas H. K lier Domestic Consumption Patterns and the Midwest Economy WP-94-4 R obert Schnorbus and Paul B allew 1 W alking paper series continued To Trade or Not ot Trade: Who Participates in RECLAIM? WP-94-11 Thomas H. K lier and R ich ard H. M attoon ISSUES IN FINANCIAL REGULATION Incentive Conflict in Deposit-Institution Regulation: Evidence from Australia WP-92-5 E dw ard /. K ane and G eorge G. Kaufman Capital Adequacy and the Growth of U.S. Banks WP-92-11 H erbert B aer and John M cE lravey Bank Contagion: Theory and Evidence WP-92-13 G eorge G. Kaufman Trading Activity, Progarm Trading and the Volatility of Stock Returns WP-92-16 Jam es T. M oser Preferred Sources of Market Discipline: Depositors vs. Subordinated Debt Holders WP-92-21 D ou glas D . E vanoff An Investigation of Returns Conditional on Trading Performance WP-92-24 Jam es T. M oser and Jacky C. So The Effect of Capital on Portfolio Risk at Life Insurance Companies WP-92-29 E lijah B rew er III , Thomas H . M ondschean, and P hilip E. Strahan A Framework for Estimating the Value and Interest Rate Risk of Retail Bank Deposits D a v id E. Hutchison , G eorge G. Pennacchi WP-92-30 Capital Shocks and Bank Growth-1973 to 1991 WP-92-31 H erbert L. B aer and John N. M cE lravey The Impact of S&L Failures and Regulatory Changes on the CD Market 1987-1991 WP-92-33 Elijah B rew er a nd Thomas H. M ondschean 2 Working paper series continued Junk Bond Holdings, Premium Tax Offsets, and Risk Exposure at Life Insurance Companies WP-93-3 Elijah B rew er III and Thomas H. M ondschean Stock Margins and the Conditional Probability of Price Reversals WP-93-5 P aul Kojm an and Jam es T. M oser Is There Lif(f)e After DTB? Competitive Aspects of Cross Listed Futures Contracts on Synchronous Markets WP-93-11 P aul Kojm an, Tony Bouwman and Jam es T. M oser Opportunity Cost and Prudentiality: A RepresentativeAgent Model of Futures Clearinghouse Behavior WP-93-18 H erbert L. B aer, Virginia G. France and Jam es T. M oser The Ownership Structure of Japanese Financial Institutions WP-93-19 H esna Genay Origins of the Modem Exchange Clearinghouse: A History of Early Clearing and Settlement Methods at Futures Exchanges WP-94-3 Jam es T. M oser The Effect of Bank-Held Derivatives on Credit Accessibility WP-94-5 Elijah B rew er III, B ernadette A. M inton and Jam es T. M oser Small Business Investment Companies: Financial Characteristics and Investments WP-94-10 Elijah B rew er III and H esna Genay MACROECONOMIC ISSUES An Examination of Change in Energy Dependence and Efficiency in the Six Largest Energy Using Countries-1970-1988 WP-92-2 J a ck L . H ervey Does the Federal Reserve Affect Asset Prices? WP-92-3 Vefa Tarhan Investment and Market Imperfections in the U.S. Manufacturing Sector WP-9 2-4 P aula R. Worthington 3 Working paper series continued Business Cycle Durations and Postwar Stabilization of the U.S. Economy WP-92-6 M ark W. Watson A Procedure for Predicting Recessions with Leading Indicators: Econometric Issues and Recent Performance WP-92-7 Jam es H. Stock and M ark W. Watson Production and Inventory Control at the General Motors Corporation During the 1920s and 1930s WP-92-10 A nil K . Kashyap and D a v id W. W ilcox Liquidity Effects, Monetary Policy and the Business Cycle WP-92-15 L aw rence J. Christiano and M artin Eichenbaum Monetary Policy and External Finance: Interpreting the Behavior of Financial Flows and Interest Rate Spreads WP-92-17 Kenneth N. Kuttner Testing Long Run Neutrality WP-92-18 R obert G. King and M ark W. Watson A Policymaker’s Guide to Indicators of Economic Activity C harles E vans , Steven Strongin, and Francesca Eugeni WP-92-19 Barriers to Trade and Union Wage Dynamics WP-92-22 Ellen R. Rissman Wage Growth and Sectoral Shifts: Phillips Curve Redux WP-92-23 Ellen R. Rissman Excess Volatility and The Smoothing of Interest Rates: An Application Using Money Announcements WP-92-25 Steven Strongin Market Structure, Technology and the Cyclicality of Output WP-92-26 Bruce Petersen and Steven Strongin The Identification of Monetary Policy Disturbances: Explaining the Liquidity Puzzle WP-92-27 Steven Strongin 4 Working paper series continued Earnings Losses and Displaced Workers WP-92-28 Louis S. Jacobson , R obert J. LaLonde, and D aniel G. Sullivan Some Empirical Evidence of the Effects on Monetary Policy Shocks on Exchange Rates WP-92-32 M artin Eichenbaum and C harles Evans An Unobserved-Components Model of Constant-Inflation Potential Output WP-93-2 Kenneth N. Kuttner Investment, Cash Flow, and Sunk Costs WP-93-4 Paula R. Worthington Lessons from the Japanese Main Bank System for Financial System Reform in Poland WP-93-6 Takeo Hoshi, Anil K ashyap, and G ary Loveman Credit Conditions and the Cyclical Behavior of Inventories WP-93-7 Anil K . K ash yap , O wen A. Lam ont and Jerem y C . Stein Labor Productivity During the Great Depression WP-93-10 M ichael D . Bordo and C harles L. Evans Monetary Policy Shocks and Productivity Measures in the G-7 Countries WP-93-12 Charles L. Evans and Fernando Santos Consumer Confidence and Economic Fluctuations WP-93-13 John G. M atsusaka a n d A rg ia M. Sbordone Vector Autoregressions and Cointegration WP-93-14 M ark W. Watson Testing for Cointegration When Some of the Cointegrating Vectors Are Known WP-93-15 M ichael T. K . Horvath and M ark W. Watson Technical Change, Diffusion, and Productivity WP-93-16 Jeffrey R. Cam pbell 5 Walking paper series continued Economic Activity and the Short-Term Credit Markets: An Analysis of Prices and Quantities WP-93-17 Benjamin M. Friedman and Kenneth N. Kuttner Cyclical Productivity in a Model of Labor Hoarding WP-93-20 A rgia M. Sbordone The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds /. C hristiano , M artin Eichenbaum and Charles Evans WP-94-2 Algorithms for Solving Dynamic Models with Occasionally Binding Constraints WP-94-6 Law rence Law rence J. Christiano and Jonas D M . Fisher Identification and the Effects of Monetary Policy Shocks WP-94-7 L aw rence J. C hristiano , M artin Eichenbaum and Charles L. E vans Small Sample Bias in GMM Estimation of Covariance Structures WP-94-8 Joseph G. Altonji an d L ew is M . Segal Interpreting the Procyclical Productivity of Manufacturing Sectors: External Effects of Labor Hoarding? WP-94-9 A rgia M . Sbordone Small Sample Properties of Generalized Method of Moments Based Wald Tests WP-94-12 C raig Burnside and M artin Eichenbaum 6
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