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How Cap-and-Trade Markets Work for Acid Rain and Smog
Eric De Place, 27 Nov 09

The evidence from US air pollution markets.

image_mini.png Contrary to claims that cap and trade is untested or uproven, there are a half dozen or so operational cap-and-trade programs already functioning in the United States. Of these, the most significant are the Acid Rain Program and the NOx Budget Trading Program. Both have large vibrant trading markets, both have been extremely successful in achieving environmental aims, and neither has evidenced manipulation or gaming.

The Acid Rain Program has been administered by the US Environmental Protection Agency since 1995. It includes a cap-and-trade program for sulfur dioxide (SO2) -- and all evidence suggests that the program has functioned exceedingly well. In fact, the program achieved steep emissions reductions at lower-than-expected costs.

The lion's share of the success in SO2 reduction can be attributed to the market-based cap-and-trade program. According to a 2007 article in Electricity Journal:

As part of its compliance strategy a regulated source may engage in allowance trading—buying or selling surplus allowances. Because of the cap, there is no need for EPA to review each transaction thereby reducing the time, transaction costs, and administrative costs to trade allowances. Parties to a trade can enter the transactions online using EPA’s information system, allowing trades to be processed in less than one day; competition and market liquidity have driven down the costs of private transactions to less than 0.1 percent of the cost of an allowance, and administering transactions of millions of allowances each year requires less than one full-time employee at EPA.

In other words, cap and trade was able to deliver environmental improvement at a low cost. And it did so quickly.

The EPA also runs the NOx Budget Trading Program, a cap-and-trade system designed to reduce the nitrogen oxides (NOx) emissions that contribute to ground-level ozone, which is the primary component of smog. (This NOx program is sometimes lumped together with the Acid Rain Program, which treats both SO2 and NOx, but they are different programs; the Acid Rain Program's treatment of NOx is more similar to a traditional regulatory approach.) The NOx trading program has been working since 1999, operating first as a multi-state agreement known as the Ozone Transport Commission and folded into a larger federal system in 2003.

The World Resources Institute (WRI) has an exceptionally smart 2005 white paper, "Greenhouse Gas Emissions Trading in the U.S. States," that takes a close look at the allowance markets under the NOx Budget Trading Program. It hasn't been entirely seamless, but neither has it been seamy. In fact, at the highest level, the program has been a smashing success:

The OTC NOx Budget Program proved to be effective on economic, environmental, and administrative grounds. From 1999 to 2002, annual emissions were significantly reduced and consistently fell below the emissions cap. Compliance with the program was nearly perfect, and it appears that there was little if any leakage, or the displacement of emissions and/or economic activity, from the OTC region to other regions. The cost of reducing emissions was considerably lower than the initial forecasts...

All of which is encouraging.

That said, the NOx allowance market did experience a few hiccups, including some price volatility near the beginning of the program and then again in 2003 when the program shifted into federal hands. But WRI's analysis of the market reveals that the volatility was largely the result of uncertainty and lack of information on the part of market participants. Indeed, as the program continued and the market matured, it demonstrated its ability to adapt to relatively complex regulatory changes.

A recent in-depth analysis by the US EPA -- in the form of an April 2009 white paper examining the biggest price changes in the SO2 and NOx markets -- comes to substantially similar conclusions. The SO2 market experienced a couple instances of temporary price spiking, but a closer look reveals that these short-lived spikes can be largely attributed to changes in the governing regulatory framework that, basically, tightened the cap and set off a scramble for allowances. (Interestingly, the EPA found that some firms made money on trading allowances with no untoward consequences for market stability. Indeed, in my judgment, money-making opportunities for traders may have actually increased liquidity and thereby helped stabilize the market.)

The EPA's findings for the NOx market were roughly parallel to WRI's. The short-term price volatility can mostly be attributed to information gaps and uncertainty about various factors, including when specific kinds of pollution-reduction technology would come online. Price volatility isn't, generally speaking, a good thing but neither is it terrible. Indeed, as the EPA paper concludes:

Market observers should not confuse temporary high prices in the transition to new market dynamics as volatility. We have demonstrated in both programs that a relatively large portion of the increase is a natural adjustment to a new control level, while some portion is related to early market jitters and tends to self-correct relatively quickly... We have also explained how the concerns of undue volatility in the SO2 allowance market are misplaced outside of a transition to aggressive new regulations: EPA found that generally speaking, allowance market volatility is no more or less than volatilities of other related energy prices and stock prices of energy-related companies.

But maybe what's most important for those of us who like draw analogies to carbon markets is what's missing: evidence of fraud, gaming, or market manipulation. That's because no one belives that either the SO2 or NOx market have been distorted by bad actors. To the contrary, despite a few bumps in the road, they accomplished what markets are best at: they quickly delivered the least expensive benefits from around the economy.

This piece originally appeared on Sightline Daily.

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