Selling Air Pollution

The politics go in before the market goes on.

Brian Doherty from the May 1996 issue

(Page 4 of 4)

That might explain unexpectedly low prices, but not a lack of trades that seem economically sensible. The trading program has other problems that tend to either discourage trading, confuse the market, or drive down the apparent price of the allowances.

One problem is the set-up of the auction where the EPA offers new credits for sale and lets utilities sell allowances to each other. The auction isn't like the familiar New York Stock Exchange, where all trades occur at one market-clearing price.

In the EPA auction, every buyer pays what he bids, but sellers with the lowest asking price get the highest bid. As Timothy Cason, an economics professor at the University of Southern California, explained in a Journal of Environmental Economics and Management article, that system encourages people to "under-reveal their true cost of emission control...because lower asking prices increase the probability that a seller trades with high-bidding buyers." This curious system was written into the act by Congress, emulating the structure of Treasury auctions. But unlike the Treasury bills market, the emissions market has more than one seller, which leaves room for unnaturally low sale prices.

Another problem is the trading program's two-phase structure. To ease in the burdens on utilities, the most polluting plants were thrown in first in Phase I. Other things being equal, those plants should have the lowest reduction costs, and thus be the most likely sellers of allowances. But the higher-cost reducers don't have to worry about the program until Phase II begins in the year 2000. The system thus separates likely sellers from likely buyers--and trading is less intense than it might be.

Good old-fashioned bad press also helps dampen public allowance trades. Many utility analysts and industry insiders say that public numbers about trades are severe lowballs, because many trades are done through private contracts or intrautility (where a utility trades credits among different stacks, all of which it owns). One reason for this is that when the first public allowance sale--between Wisconsin Power and Light and the Tennessee Valley Authority--was announced, the companies involved caught hell from the press for "buying the right to pollute." The TVA's executive vice president William Malec then griped to The Energy Daily that the sale "created an impression in the media that nothing less than a cabal of utility executives had conspired to pollute the environment for fun and profit," and that such bad press would have a chilling effect on utilities, which are forced to operate at the public's forbearance under layers of regulation.

Thus, many utilities just use one of the many private dealmakers, such as Clean Air Capital Markets and Cantor Fitzgerald, that have arisen to broker the private sales of allowances. The utilities and brokers involved tend to be close-mouthed about deals. Unlike the EPA's public auctions, no one need know the specific details of the costs involved in such trades, and most utilities are happy to play it close to the vest. Thus, emphasis on public trades as a measure of the market's success is overrated, both because full information on private trades isn't known and because even intrautility trading can save a lot of money for utilities with more than one stack.

Problems with the sulfur allowance trading program aren't just a matter of sunk costs in an existing program. Despite the collapse of L.A.'s planned VOC RECLAIM, more allowance trading programs loom ahead, both locally and regionally. Chicago has a VOC trading program nearing completion. Maryland, Michigan, and Colorado have emissions trading plans of various sorts on the drawing board.

More ambitiously, the EPA is developing a potentially national program for trading in ozone precursors--nitrogen oxides and VOCs. The planned program, known as the "open-market trading system," differs from the sulfur program in important ways. While each individual emitter will have a cap, the program envisions no universal cap on total emissions, leaving room for new entrants.

The open-market trading system is a buyer-beware market. Unlike with the sulfur program, where you start with allowances that can be used as currency, any would-be seller of credits needs to assert to the EPA that he has reduced his own emissions, which the agency acknowledges but doesn't verify. Only then can the credit be sold. The buyer is responsible for verifying that the credits he bought were any good. "If you need to verify each trade, no one will trade," insists Boyden Gray, an architect of the sulfur dioxide program and critic of the open-market trading system. The system also has a built-in tax to effect reductions--for every 10 credits you buy, you can only use nine. The system is so filled with transactions costs for brokers to handle, such as verification, that one emission-trading insider says it will never satisfy anyone but those brokers. The program is still in the rule-making and comment stage at the EPA, but might go into effect before the year is over. Any state would have the option of joining the program to help meet its EPA-imposed ambient air quality standards, so the program's final scope, if passed, is still a question mark.

Whatever the future of emissions trading, pollution-rights markets can't work exactly like real markets. They are delivering at least some of the economists' dreams of cost-saving efficiencies. But the nature of air pollution makes it hard for each of us to choose in a market how much clean air is worth to us. And the nature of the political conflict over pollution--environmentalists married at least rhetorically to the notion that any pollution is intolerable vs. polluting industries and their customers concerned about costs--guarantees that managed markets in air pollution credits won't take the politics out of an inherently political system.

So what's a polluting industry to do? Dale Botts, an environmental engineer with Southern California's Steelcase, which makes and coats furniture, was one of the aggrieved parties at November's SCAQMD meeting. "Lots of people disagree with the whole concept [of emission-trading programs]," he shrugs. "But I guess you have to offer up another solution if you disagree. And I don't have any new proposal to offer."