Selling Air Pollution

The politics go in before the market goes on.

Markets are about freely buying and selling, not arguing with bureaucrats. Markets for the right to pollute--a still unusual but growing phenomenon--are different. Witness the drama in the main conference hall of Southern California's South Coast Air Quality Management District's Diamond Bar headquarters on a warm, slightly smoggy November morning.

SCAQMD specialists rise one by one to the podium, facing a dense crowd. They hype their new "technology review"--a study of how local businesses could comply with the SCAQMD's proposed new demands to reduce volatile organic compound, or VOC, emissions in Southern California. Those demands are part of a planned extension of Southern California's RECLAIM (Regional Clean Air Incentives Market) program, one of the new breed of emissions-rights-trading programs. RECLAIM covers sulfur dioxide and nitrogen oxide emissions in Los Angeles, Riverside, Orange, and San Bernardino counties, and affects about 300 polluters. The program orders gradual emissions reductions until the year 2003--but with a twist: Instead of just reducing as commanded, polluters have the option to buy and sell the right to emit the pollutants.

When the bureaucrats finish their spiel, dozens of frustrated representatives of various small and large Southern California businesses stride up to the microphone--men and women, young and old, in business dress and flannel. They're independent consultants, small printers, employees of huge companies like Northrup Grumman, members of task forces and think tanks. All of them work in some way with paints and coatings--an unsexy subject, but the prime industrial sources of VOCs. All of them feel their livelihoods threatened by the SCAQMD's conclusions.

They explain--some patiently, some not--to the SCAQMD bureaucrats lined up before them that those bureaucrats are talking through their hat. Market or no market, no way, no how, can SCAQMD's proposed standards be met. When the meeting ends, most of them hang around, milling about and chatting. These people know each other well through the multi-year battle over what a VOC RECLAIM program might look like. I talk to some of them later.

Robert Wyman is a young lawyer representing the Regulatory Flexibility Group, a coalition of aerospace, chemical, entertainment, and automotive companies coping with air-quality regulatory hassles. He's a local point man on the issue, the man most likely to get buzzed by the Los Angeles Times for a quote on industry's position when a story on air-quality regs breaks. People underestimate the importance of the …stuff…at issue with VOC reductions, Wyman says: paints, lacquers, and coatings for boats, planes, and furniture. Those substances are of more than cosmetic interest, especially in aerospace, one of California's biggest industries. "Coatings are the front line against corroding of metal," says Wyman. "They also include bonding primers that help parts stay together, so these substances affect the strength of the structure."

The SCAQMD assured its audience that plenty of low-VOC coating substances and methods are plausible; achieving the proposed reductions would be no problem. Wyman, like everyone else who spoke after the SCAQMD presentation, disagrees. "There are product performance requirements, sets of qualifications, salt spray tests, all these tests to make sure we can use these products and that they do what they need to do. We've found that no more than 50 percent of what's promised actually performs. Maybe even 20 percent. It's a sad performance rate. We have 20 years of experience trying to develop coatings to solve these problems, and we don't think it can be done. You can't replace 40 years of solvent technology in a day."

Millie Yamata, a prim, well-composed woman representing military aircraft maker Northrup Grumman at the meeting, agrees. Before her company can use a new coating, she says, "We need lots of lab development time. The whole process from a manufacturer's lab sample to the day we put it on a plane can be seven to eight years." The SCAQMD wants them in place in a couple of years.

Ed Laird was especially incensed with the SCAQMD's review. He runs a coating development company and also chairs the Small Business Coalition of California. He's been lobbying on this issue for five years, and fears it was all wasted time. While he's listed as a data source in the technology review, he insists SCAQMD never talked to him. SCAQMD is playing a dangerous game with the economic health of Southern California, he insists. "No company that uses any sort of paint, cleaner, solvent, or adhesive will come into this four-county area. It just wouldn't be wise."

And for all of the brouhaha, the proposed program, which would hit only those emitting over four tons of VOCs a year, would have affected only around 5 percent of the VOCs emitted in Southern California. A lot of the pollution comes from numerous tiny stationary sources. And much of it comes from cars.

Unfortunately, as L.A. environmental consultant John Bellheimer notes, people in California "don't like to realize that Pollution-R-Us. They like to think it's factories. They always say no when someone tries to curtail free driving. Pollution cutting is very dear to the public's heart as long as it doesn't hit home."

For now, those with grievances at that November meeting have won. In early January, SCAQMD announced it was abandoning its plans to extend RECLAIM to VOCs.

Business lobbying bureaucrats? Looks more like politics than markets. But this jockeying for advantage is a necessary prelude to any venture into "market" solutions to air pollution problems. Despite years of experience, no one's figured out how to take the politics out of the market in pollution allowance trading.

It wasn't supposed to be that way. Since the federal Clean Air Act of 1970 was passed (as much because of polluting industries' desire to make an end run around state regulation as from growing environmental consciousness), air-quality control mostly has worked through "command-and-control"--government telling polluters how to do things as well as what to do. Command-and-control has large bureaucratic costs, can stifle innovations, and doesn't encourage anyone to do any better than the law demands.

Efficiency-minded economists had been toying for years with what might be a better way: pollution-rights markets. Instead of ordering how, the government could just command how much and allow businesses to cut compliance costs--and potentially to profit--by trading licenses to pollute. Those ivory tower ideas have gotten some trial runs in the real world. The Environmental Protection Agency allowed trading in lead credits while phasing out lead from gasoline in the '80s. The EPA also allowed small-scale trading of emission rights for an assortment of pollutants--including sulfur dioxide, carbon monoxide, and nitrogen oxides--beginning in the mid-'70s. Because of the complicated bureaucratic nature of the program, those markets showed little life. Economist Robert Hahn, now of the American Enterprise Institute, concluded that the early programs caused negligible additional harm to the environment while still saving billions of dollars in total permitting and emission-control costs.

Emission-rights trading scored its biggest national success when Title IV of the Clean Air Act Amendments of 1990 created the largest-ever national pollution market. The market was among electric utilities, and the commodity was sulfur dioxide--targeted for its alleged role in causing acid rain.

But before the market gets to work in government-created pollution markets, the overall allowed level of pollution gets decided politically. Markets aren't allowed to answer the question, How much pollution do we want? Perhaps none could. So pollution baselines get set by bureaucratic ukase. And since different parties want different baselines, that means political fights.

Southern California's proposed VOC RECLAIM program was scuttled over those fights. Environmentalists thought the proposed baseline was too high. Because of a local business recession, industry had been emitting less pollution than the initial maximum under VOC RECLAIM. Environmentalists bristled at a pollution-control program that started off allowing more emissions than the year before. Businesses argued that the glide path doesn't matter if the end result is the same; enviros complained that the end result means nothing to the people stuck breathing bad air now. SCAQMD couldn't split the difference and gave up.

For the national sulfur dioxide trading program, the designers had to steer a path between environmentalists' mistrust of trading the right to pollute and the business community's mistrust of tough reduction goals. "What we had to do was throw everyone in a room for however many weeks and not let them out till they had a baseline," remembers Boyden Gray, then a White House official who fought hard for the sulfur trading program. His role was such that one emissions-trading insider swears, admiringly and ironically, that Gray "command-and-controlled emissions trading on the utility industry."

Utilities fought for the earliest baselines they could get, Gray explains, so they could benefit from reductions they'd already done. Environmentalists wanted later baselines to make sure reductions started from the lowest possible level. The eventual compromise cut national sulfur dioxide emissions from their 1980 level by 10 million tons a year, on a glide path ratcheting down year by year until 2010.

Electric utilities were given yearly allowances to pollute, largely based on what emissions were from 1985-87. Each allowance gives the right to emit one ton of sulfur dioxide. At the end of the year, each utility must prove to the feds that it holds at least as many allowances as it emitted tons of sulfur dioxide that year, as measured by devices called continuous emission monitors at the end of stacks. If it doesn't, it's fined $2,000 per extra ton emitted and faces an equal reduction in its allowance baseline for next year. Within those parameters, utilities have room to maneuver--and to buy and sell.

Here's where the theoretic glories of emissions-trading schemes come in. If one utility can reduce emissions below the number of allowances it holds for that year, it can make money selling extra allowances to a utility that couldn't reduce enough. This gives reason to beat the regulation: If you do better than the regs demand, you can profit by selling excess allowances to others.

In theory, this system also allows everyone to reduce pollution as cheaply as anyone can. If another utility can cut emissions more cheaply than your utility can, you can reap the benefits of their know-how by buying their extra allowances. Economists' models hold out sugar-plum promises of huge efficiency gains and cost savings if the market in allowances is robust--possibly billions every year.

Have those economists' dreams come true? It's still early in the game for sulfur dioxide trading. While trading began in 1992, the actual commands for emission reductions began only in 1995--and then only for 110 of the most highly polluting utilities. The second phase begins in the year 2000, when every sulfur-dioxide-emitting utility becomes part of the market--another 700 or so potential buyers or sellers.

Some apparent magic has already appeared. Sulfur dioxide emissions are falling far ahead of the EPA's schedule. A General Accounting Office study of the allowance trading program finds that by 1997 annual sulfur dioxide emissions will be 30 percent lower than expected. Utilities are doing better than the EPA demands.

Also, prices for the two main reduction options--switching to lower-sulfur coals and installing scrubbers to eliminate sulfur at the end of your stacks--are falling. Here's where the real benefits of the program come in, some analysts say. "The purpose of this program isn't to trade allowances," says Dallas Burtraw of Resources for the Future, a Washington-based environmental think tank. "It's to give firms flexibility to comply in the least-cost manner. And the program has thrown input markets into direct competition with each other and set loose forces that have created innovation."

Falling prices are hitting every industry that allows utilities to reduce emissions: rail transport, coal markets, scrubber markets. Rail transport prices from the West, where much lower-sulfur coal is, to Eastern and Midwestern users have fallen 50 percent, Burtraw says. When the Clean Air Act Amendments of 1990 were first passed, low-sulfur coal was projected to cost $40 a ton in 1995. Instead, the price hovers around $25 a ton. Scrubber prices have also fallen by around 20 percent. Other forces undoubtedly contributed to these trends. But competition among different potential compliance mechanisms is clearly helping push costs down.

The price for complying by buying emissions allowances is also lower than expected. The EPA has held an annual allowance auction in March since 1993, selling off 2.8 percent of the total yearly allowance allocation and distributing the proceeds back to the utilities. Allowances at this auction, conducted by the Chicago Board of Trade, are going at fire-sale prices.

At the first auction in 1993, the average price for a spot allowance was $156. By 1995, it had plummeted to $132, about half the EPA's forecasts. Private brokers condemn the EPA auction as no indication of the real market--most utilities are doing private trades outside the auction's auspices--but in the outside market, allowance prices in late 1995 had fallen as low as $120.

Another positive side effect of allowance trading has been the rise of environmental charities that strike at the guts of the stated goal of environmental activism: cleaning the environment. For less than $150, an eager environmentalist can make sure that a whole ton of crud never enters the air. A Cleveland-based environmental charity called INHALE (National Healthy Air License Exchange) has spent about $120,000 buying allowances since the program started, and acts as broker for individuals (and in some cases, schools) that want to put their environmental dollars to direct use. Some utilities have been giving away allowances to charity; Northeast Utilities of Connecticut, for instance, donated 10,000 to the American Lung Association in 1993.

Despite some benefits, all is not rosy with emissions-trading markets. For one, the sulfur program's national structure sticks in many people's craws. Free marketeers like Fred Smith at the Competitive Enterprise Institute, a Washington think tank emphasizing free market environmentalism, condemn the program as "market socialism" because the government set the sulfur reduction goals--goals based on the assumption that sulfur-dioxide-generated acid rain was a severe crisis, killing forests and lakes across the nation. That crisis view isn't supported by the National Acid Precipitation Assessment Program, the government's own study on acid rain. "The sulfur trading market diverts attention from what to do to how to do it. We shouldn't fall back on instruments to avoid discussing goals," Smith says.

Environmental activists also have problems with the program's national scale. National reductions in overall sulfur emissions are all well and good, but regional desires can conflict with the national standards. New York state was unhappy that a state utility could profit from selling emission allowances that might end up in the hands of a Midwestern utility--whose extra emissions might rain back down on the Adirondacks. The New York Assembly has twice passed bills banning such sales, but the bills haven't gotten through the Senate.

The Adirondack Council, an Albany-based environmental group, and the Natural Resources Defense Council are suing the EPA to set standards dictating how much sulfur dioxide can fall on specific regions, not just a cap for the whole nation. "The EPA's rules have a catchall prohibiting states from taking actions that interfere with allowance trading. We're trying to challenge that provision," says David Hawkins, an NRDC lawyer pursuing the case.

California's Citizens for a Better Environment is also suing about emissions trading, over Southern California's RECLAIM program. A provision of California's Clean Air Act requires any new pollution-control program to be at least as good as the program it replaces. Because initial allocations under RECLAIM are higher than the recession-created trough that industrial activity in the Los Angeles area is crawling out of, CBE says RECLAIM fails that test.

CBE is also concerned with localized problems versus widespread trading. "If groups in a certain area buy enough credits, they can pollute as much as they want," says CBE staff attorney Richard Drury. "And from our limited data, they seem to center in poor areas. It's economically efficient to dump things on poor people. Hot-spot problems and environmental justice can't be addressed with trading schemes, only with command-and-control."

If New York state or California's CBE are able to squash participation in allowance markets in ways they don't like, or if every trading decision has to be vetted for its possible effects on specific regions or localities, national trading programs, or even multi-county ones like RECLAIM, would be severely hampered.

Many partisans of the sulfur trading program are disturbed at how sluggish the market is. Despite low, low prices, hardly anyone seems to want to buy the darn things--even, the General Accounting Office reports, when it costs a utility more to reduce emissions than to buy allowances. The GAO calculates that if utilities traded more, by 2002 they could be saving $1.2 billion more a year than by intrautility trading alone. But something is holding utilities back--perhaps many things.

To begin with, the utility industry is uniquely unsuited for a brave new experiment in applying market forces. Utilities are among the most highly regulated businesses in the country, watchdogged closely by multiple levels of government. Local air-quality districts, state public utility commissions, the Federal Energy Regulatory Commission, and the EPA can all have a say on a utility's every move.

Utilities don't charge customers what the market will bear. Every pricing decision, and every cost decision, needs to be justified in "prudence reviews" before regulatory boards, either before or after the fact. The utility industry has never been one where bold, independent action was welcome, and that corporate culture won't change instantly with a wave of the EPA's magic market wand. Utilities crave answers from their public utility commissions before they act.

But most state regulators haven't made the important decisions the emissions market requires. For example, how will the value of the emissions--or the profits made by trading them--be treated in the ratemaking process? Without knowing beforehand what the end results of allowance trading might be, and without knowing if they'll be able to reap the profits of any smart trading decisions, utility executives tend to err on the side of caution. The result: no trading.

"If utilities are going to take the risk inherent in purchasing and selling allowances, you need a commensurate reward," says James Evans, the director of environmental activities with the Edison Electric Institute, which represents investor-owned utilities. "They need to know whether there will be an equitable split between ratepayers and shareholders. It could end up being heads I win, tails you lose. If you make a good deal, the benefits go to the ratepayers. But if in retrospect it appears that had you done something differently it would have been a better deal, then your shareholder bears the burden. In that scenario, which is not unlikely, there's no incentive at all to take that risk."

Public utility regulators are now debating how to handle emissions deals in prudence reviews and ratemaking. But so far only four states involved in Phase I of the sulfur dioxide market have yet made rigorous, detailed regulatory decisions fully covering their treatment of allowances, says Ken Rose of the National Regulatory Research Institute.

Unfortunately, now isn't the best time for utilities to adjust to the vagaries of allowance markets. The industry is facing enormous regulatory changes. On the horizon are the possibilities of selling off federal power administrations, breaking up vertically integrated utilities, and placing all power in the system in power pools where energy flows in and out on a pure bid system. In the midst of great uncertainty, skittish utilities are neglecting the needs of this strange new market system that they weren't really prepared for in the first place.

Besides the inherent problems of national goals vs. local standards and the nature of the utility industry, the 1990 trading program also suffers from design peculiarities that stymie the market.

The pollution-trading market lacks something that most regular markets have: more-or-less dependable property rights. To leave regulatory wiggle room, and to protect the EPA from possible future Fifth Amendment "takings" problems, the Clean Air Act explicitly states that allowances are not real property rights. The government can change the rules of its market game at any time. New regulatory notions are always on the EPA's agenda, so making drastic changes in your operations expecting the regulatory regime to stay the same seems foolish.

James Johnston, a former senior economist with Amoco Corp., says this lack of firm property rights is the key to the market's inactivity. "The government's like Lucy holding out the football to Charlie Brown," says Johnston, who is now with the Heartland Institute, a Chicago-based free market think tank. "You never know when they'll pull it [allowance rights] away." Allowance prices are so low for a simple reason, Johnston maintains: No one values them highly because their security as property can't be trusted.

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."