Topic Area: Air Pollution
Geographic Area: United States
Focal Question: How have economic incentives been applied to the regulation of sulfur dioxide emissions in the United States?
(1) Internet Site -
(2) Kete, N. (1992). The U.S. Acid Rain Control Allowance Trading System. Climate Change: Designing a Tradable Permit System. T. Jones and J. Corfee-Morlot. Paris, Organization for Economic Co-operation and Development Publication: 78-108
Reviewer: Nicholas B. Lambert, Colby College '96

The environmental impact of acid rain is the acidification of water sources, which is harmful to wildlife, and damage to trees at high elevations. The pollutants which comprise acid rain decrease visibility and are damaging to human health, primarily causing respiratory disease. In addition it accelerates the decay of man-made structures such as buildings and monuments.

The Clean Air Act Amendments of 1990 were signed into law on November 15 of that year. Title IV of this legislation was directed at acid rain. Specifically, it set a goal of reducing sulfur dioxide emissions to 10 million tons below 1980 levels and set a permanent ceiling on allowable sulfur dioxide emissions per year.

The Acid Rain Program was designed to be implemented in two phases. Phase I began on January 1, 1995 and affected 110 electric utilities, the majority of which being coal-burners, which have historically had high emission levels. Phase II is scheduled for January 1, 2000, and will both lower allowed emission levels for Phase I plants and include smaller, cleaner plants which had previously not been covered by the program. Each phase is expected to lower total emissions by 5 million tons relative to 1980 levels.

The key feature of the Acid Rain Program is the use of economic incentives through the SO2 allowance system. Each allowance authorizes the emission of one ton of SO2. Once allocated, allowances become marketable commodities and may be bought, sold, or traded. At the end of each year, units included in the program must hold a quantity of allowances equal to or greater than its annual emissions.

The Program creates a great deal of flexibility in regulation compliance. The allowance system allows the least costly units to reduce emissions to a greater extent than the higher cost units. An individual source could switch fuels, shift production from dirtier units to cleaner ones, reduce electricity demand through conservation programs, and so on, depending which would incur the least cost.

Phase I allocation is based on an emission rate of 2.5 pounds of SO2/mmBtu (million British thermal units) of heat input multiplied by the unit's baseline mmBtu (the average fossil fuel consumed from 1985 to 1987). Phase II lowers allocation to 1.2 pounds of SO2/mmBtu of heat input multiplied by the unit's baseline and sets a cap on the total number of allowances issued at 8.95 million. Only units in operation before 1996 are eligible for allowance allocation; others will be required to purchase them through the market system. To supplement the original allocations, there are several alternative sources of additional allowances. As incentives for reduced emissions, the EPA offers allowances to units which install new technology, implement customer-oriented conservation measures, or invest in renewable energy generation. Additionally, annual auctions and direct sales are sponsored by the EPA, which help to send the market price signals.

In an effort to minimize cost in reaching its emissions goals, the EPA established an opt-in provision to the allowance program. Sources emitting SO2 which are not included in the program have the option to participate on a voluntary basis. By reducing their emissions at a relatively low cost, their gained allowances may be transferred to higher cost sources. The industry minimizes compliance costs, while the voluntary entrant profits as long as revenue from allowances exceeds emissions reduction and participation costs.

In addition to the annual allocation and collection of allowances, the EPA is responsible for recording all transfers which take place. This is done through the Allowance Tracking System (ATS). All parties holding allowances must register them in an account with the EPA. To accompany the recording of allowances is the Continuous Emission Monitoring (CEM) system, which provides a standardized method of measuring and reporting emission levels to the EPA, which in turn maintains an Emission Tracking System (ETS) to serve as a repository for emissions data for the industry. Through these control measures, the program gains credibility and the EPA is able to both monitor the progress of emission reductions and enforce compliance. Units found to be emitting in excess of their allowances are fined 2,000 dollars per ton of SO2 and are forced to supply offsetting allowances, either through reduced allocation or a emission reduction proposal.

While Phase I officially began in 1995, the EPA implemented a trial program to cover 1994, including 263 utility units in 21 states. The objective was to discover any potential problems and facilitate the transition of large companies into the program.

Each unit began monitoring emissions and submitted the measurements for CEM certification. The data collected proved to be very reliable. With a few exceptions which required estimated figures to replace errors in monitoring, the 1994 data was accurate enough to provide a credible basis for measurement and error detection for the Phase I systems.

The most important result of the trial program, however, was a decrease in SO2 emission. Over the course of the year, national SO2 emissions dropped to an estimated level of 7.4 million tons, well below the 1980 baseline level of 9.4 million tons, and was nearly low enough to meet the 1995 allowance target level. The decrease was attributed to units switching fuel sources and implementing control measures early in preparation for the 1995 emission limits. Furthermore, the decrease was spread evenly across the country, with almost all states experiencing proportional declines from their 1980 baseline levels.

As the trial program ran its course, and especially as Phase I was implemented over 1995, use of the allowance system increased dramatically. By the end of 1994, private allowance transfers had reached an estimated 15 million, and EPA/market transfers 7 million. Private transfers are those within the industry, while EPA/market transfers are through auction, direct sale, substitutions, etc. In the first quarter of Phase I, private and EPA/market transfers increased to an estimated 29 and 9 million, respectively, and by the fourth quarter were at a level of 36 and 11 million. Of the total trades within 1994 and 1995, 77.6 percent were inter-utility, that is, between separate companies. This reflects the willingness of the industry as a whole to accept the program and take advantage of cost minimizing opportunities. The remainder of the trades were primarily intra-utility and broker to utility. A limited number of allowances were bought by environmental groups who "retired" them.

The potential success of the sulfur allowance program is due to its utilization of market forces through economic incentives. As demonstrated by the significant volume of trading which has taken place thus far in the program, use of a command and control approach in this situation would have placed far greater economic burden on some units than others, increasing the overall cost imposed upon the industry. By allowing certain units to reduce emissions to a greater extent than others and not specifying the method by which these reductions would come about, the regulations provide a great deal of flexibility in compliance and cost minimization. Accompanying the lower costs of the industry are lower regulation and enforcement costs faced by the EPA. The burden of emissions measurement and the development of the technology to reach the emissions limit is placed on the industry, not the EPA. This is an additional cost to the industry, but is insignificant in comparison to the savings. The EPA has the responsibility to organize and periodically check the emission data and must allocate and track the allowances, but again the overall costs are greatly reduced when compared to a command and control approach.

The ability of the allowance program to reach the set goal of a 10 million ton emissions reduction is a benefit compared to the probability that many sources would not be able to fully comply with an across-the-board limit. It appears that in this case, the use of economic incentives can benefit all parties involved.

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