Clean Air Act of 1990 ; Environmental protection

Michael A. Prager

Richard H. Mattoon

Thomas H. Klier

English

Research Papers in Economics

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK AUGUST 1997
OF CHICAGO NUMBER 120
Chicago Fed Letter
What can the Midwest
learn from California
about emissions trading?
For more than 30 years, economists
have advocated the use of market-
based environmental regulations to
improve the efficiency of regulatory
programs designed to clean up the
environment. Emission taxes and
tradable emission permit markets
have been proposed to supplant tra-
ditional regulatory methods by which
regulators prescribe specific technol-
ogy-based standards. One market-based
program that received considerable
attention began in 1994, when the
South Coast Air Quality Management
District (SCAQMD) introduced the
Regional Clean Air Incentives Market
(RECLAIM) in the Los Angeles basin.
RECLAIM is a regional market de-
signed to improve air quality through
the reduction of two pollutants, oxides
of nitrogen (NOx) and oxides of
sulfur (SOx).
RECLAIM introduced a regulatory
strategy for meeting a particularly
severe regional environmental prob-
lem, and it aims to meet stringent
federal and state requirements with
greater flexibility and less economic
disruption to the regional economy
than a command and control ap-
proach. The potential benefits of
environmental markets are increas-
ingly being recognized in the Midwest.
The Illinois Environmental Protection
Agency (Illinois EPA) will soon launch
the Emissions Reduction Market
System (ERMS) to help address the
ground-level ozone problems facing
the Chicago area.
This Fed Letter reviews the California
RECLAIM experience in the first two
years of market activity, focusing on
the NOx market, the larger of the
two emissions trading programs.1 It
then describes the basic features of
the Illinois ERMS program and at-
tempts to relate the lessons from the
RECLAIM market to the proposed
Illinois program.
Basics of the RECLAIM market
In 1994, the L.A. basin had the dubi-
ous distinction of being the only area
in the nation classified as a “severe
non-attainment area” for not meet-
ing the current ozone standard. The
combination of geography and high
levels of ozone precursors made the
region fall short of meeting the ambi-
ent air standards established under
the 1990 Clean Air Act Amendments.
Since the precursors to ozone had
been subject to regulation for some
time, SCAQMD decided to use envi-
ronmental markets to reduce the
economic dislocation and regulatory
burden that would result from the
imposition of increasingly stringent
emission standards.
At the outset it was determined that
stationary facilities emitting four
tons of NOx or more per year would
be included in the RECLAIM pro-
gram. This criterion encompassed
390 facilities, representing roughly
65% of the permitted stationary
NOx emissions in the L.A. basin.2
The program is designed to be facility-
specific, with each facility being given
an allocation of credits to cover all
its emission sources, such as furnaces
and boilers. Each facility then can
choose how to achieve the required
overall reduction in emissions, rather
than having to force changes on spe-
cific pieces of equipment. This flexi-
bility can result in significant cost
savings at the facility level by allowing
firms to shift emissions reductions
among sources within a facility.
RECLAIM establishes what is com-
monly referred to as a “cap and trade”
market. It sets an area-wide emissions
budget that declines over time and
specifies an emissions reduction
schedule for each facility in the pro-
gram to the year 2003. The average
NOx reduction required by the origi-
nal 390 facilities was on the order of
75% of starting emissions levels.
One of the most contentious issues
in the RECLAIM program was the
establishment of the initial emissions
allocation level for each facility. Reg-
ulators wanted to make sure that it
reflected average production levels
for each facility and was not being
distorted by special conditions, such
as a recession leading to reduced
production levels. However, to gain
individual firm acceptance of the
RECLAIM program, SCAQMD let
firms pick their baseline level on the
basis of actual emissions during one
of four years between 1989 and 1992.
As a result, the total allocation at the
beginning of the program was some-
what above actual 1993 emissions levels.
Other issues included reducing poten-
tial volatility in the trading market
(this was accomplished by creating
two partially overlapping trading
cycles); easing the transition to an
emissions trading environment by
allowing firms a reconciliation period
to purchase additional emission
credits prior to imposing noncompli-
ance penalties; and establishing two
different geographic zones for trading
to reflect the pollution patterns of
the L.A. basin. Finally, the market-
based approach was coupled with
a performance-based standard that
encouraged accurate monitoring
and reporting of actual emissions.RECLAIM performance
There are many metrics that can be
used to assess the performance of
the RECLAIM market to date. One
question that can be asked is to what
extent firms are trading credits in the
market and whether the regulators’
expectations are being met. Based on
trades of RECLAIM trading credits
(RTCs) that expired in 1995, the
market participation rate was around
50%. Given the new market and reg-
ulatory structure, this can be consid-
ered a good start. Yet, this seems low
considering that RECLAIM does not
allow banking of credits. Alternative-
ly, one can attempt to assess the cost
savings attributable to RECLAIM.
Figure 1 shows the price trends that
emerged from the first four auctions
held by Cantor Fitzgerald, one of the
larger brokers active in the market.
The price of RTCs is found to be ris-
ing with their vintage. Because of the
shrinking emissions cap and rising
marginal costs of control, this pattern
had been expected. However, the
prices reported in figure 1 also fall well
below SCAQMD’s projections prior to
trading.3 This suggests that the addi-
tional flexibility in compliance provided
by RECLAIM has reduced the cost of
controlling for NOx.
An additional factor to be taken into
consideration in assessing the early
activity of the RECLAIM market is
the economy of southern California,
which until recently,
had been affected by
the 1990–91 recession.
With firms in the re-
gion operating below
normal capacity, it is
likely that the alloca-
tion of RECLAIM
credits was generous
enough for firms to
easily meet the re-
quired emissions
reductions during
the first two years of
the market.
Lessons in market
design
In general, RECLAIM
is a well-designed environmental mar-
ket. Transactions costs have been kept
to a minimum.4 Trades are easy to ex-
ecute, information is accessible via
an electronic bulletin board, and the
regulator provides useful data on mar-
ket activity. In addition, brokers have
entered the market and appear to be
serving an important intermediary
role in helping to sell and buy credits.
However, the market approach rep-
resents a new regulatory structure
and, as such, firms need to become
familiar with it. Various uncertainties
associated with the start-up of the pro-
gram, such as the clearing of titles to
RTCs and the imposition of fees asso-
ciated with using RTCs, as well as un-
certainties regarding future emission
levels, have influenced facilities’ deci-
sions during the first two years of the
market. We found that many facilities
traded only a small amount of RTCs
and did not engage in long-term
strategic trades. However, once firms
adjust to the new regulatory structure,
trading volume and participation are
likely to increase.
Finally, information collected by
SCAQMD allows some inferences
about facilities’ motivation to partici-
pate in the market. Figure 2 lists the
main ways the traded RTCs were gen-
erated by RECLAIM facilities, brokers,
and other parties. The most frequent
response reported by sellers of RTCs
was a decrease in production, which
suggests an influence of the business
cycle on trading behavior.
Implications for Chicago
In order to comply with Clean Air
Act requirements, the Chicago area
needs to reduce emissions of ozone
precursors. More than five years ago,
the Illinois EPA began to develop a
regional emissions trading program
for the Chicago area. At first it con-
sidered a NOx trading program, sim-
ilar to RECLAIM. Later, regional
air quality modeling found that the
first priority for controlling ozone
in Northwest Illinois was not local
reductions in NOx, but reductions
in volatile organic material (VOM)
emissions. The modeling showed that,
unlike Los Angeles, the Chicago area
would experience an increase in ozone
concentrations if local sources reduced
emissions of NOx. In response, the
Illinois EPA developed what will be
the nation’s first VOM emissions trad-
ing program, which it expects to be
finalized by the fall of 1997.
While ERMS and RECLAIM were both
designed to reduce regional ozone
concentrations, the meteorological,
economic, and regulatory differences
between the two regions have resulted
in two unique programs. The sources
and types of companies that emit VOM
are different from those that emit
NOx. NOx emissions generally come
from the combustion of fuels at elec-
tric utilities and other industrial facil-
ities. In contrast, over 250 different
chemicals are categorized as VOM,
and they are emitted by steel mills
and large chemical plants as well as
other types of facilities. Figure 3
shows the different composition of
high-emission industries for both
programs. Another difference relates
to the meteorology and air quality
chemistry in the two regions: ERMS is
a seasonal program while RECLAIM is
a year-round program. This is because
the weather conditions conducive to
ozone formation only occur in the
warm weather months in Chicago.
Also, ERMS has only one geographic
trading area, unlike the two trading
zones in the California system.
0.00
0.25
0.50
0.75
1.00
1.25
1994 ’96 ’98 2000 ’02 ’04 ’06 ’08 ’10
price, dollars per pound
High price
Weighted
average
Low price
Source: Compiled by authors from Cantor Fitzgerald “Clean air auction
announcement,” Los Angeles, CA, January 11, 1996, and from a press
release, Cantor Fitzgerald, “The fourth clean air auction,” Los Angeles,
CA, February 19, 1996.
1. Price data for NOx RTCsMichael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research;
Douglas Evanoff, Assistant Vice President, financial
studies; Charles Evans, Assistant Vice President,
macroeconomic policy research; Daniel Sullivan,
Assistant Vice President, microeconomic policy research;
William Testa, Assistant Vice President, regional
programs; Helen O’D. Koshy, Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago.  The views expressed are
the authors’ and are not necessarily those of
the Federal Reserve Bank of Chicago or the
Federal Reserve System.  Articles may be
reprinted if the source is credited and the
Research Department is provided with copies
of the reprints.
Chicago Fed Letter is available without charge
from the Public Information Center, Federal
Reserve Bank of Chicago, P.O. Box 834,
Chicago, Illinois 60690-0834, tel. 312-322-5111
or fax 312-322-5515.  Chicago Fed Letter is also
available on the World Wide Web at http:/ /
www.frbchi.org.
ISSN 0895-0164
05 0 1 0 0 1 5 0
Other
Facility acquisition from
change in ownership
Extra RTCs from an
equipment or facility shutdown
New or additional control
equipment to reduce emissions
Process change resulting
in lower emissions
Bought from RECLAIM
facility for resale
Decrease in production resulting
in a decrease in emissions
number of transactions before 10/3/95
Source: Authors’ calculations based on South Coast Air Quality Manage-
ment District, RECLAIM Annual Report, 1994–95, Los Angeles, CA, 1996.
2. Generation of NOx RTCs sold
Another important difference is that
ERMS allows limited banking of credits,
while RECLAIM does not. State
requirements in California did not
allow SCAQMD to include banking
in its design of RECLAIM. Under
ERMS, most trading units have a
two-year lifetime.5 Furthermore, a
special account to be managed by the
Illinois EPA will serve as an alternative
source of trading units in case facili-
ties are unable to obtain them in the
private market.
The emissions baseline determina-
tion under ERMS is similar to that
under RECLAIM. Fa-
cilities are allowed to
average two of the
three seasons from
1994 to 1996. If a facil-
ity can demonstrate
that these three years
are not representative,
it may substitute years
from 1990 to 1997.
Once the ERMS base-
line is set, initial reduc-
tion requirements will
be issued in 1999 in
one step, with each
facility receiving sea-
sonal allotments that
represent a 12% across
the board reduction from its historical
baseline. Under RECLAIM, the
amounts of required emission reduc-
tion vary from facility to facility,
based on the command and control
requirements for each source, and
increase annually through 2003.
Conclusion
Both theory and practice have dem-
onstrated that market-based environ-
mental programs can be significantly
more cost effective than traditional
command and control regulations.
Our analysis of the regional emis-
sions trading market in California
suggests that its performance so far
has been promising. Industry and
residents in the Midwest now stand
ready to enjoy the regulatory flexibili-
ty and compliance that will be provid-
ed by Illinois’s new emissions trading
program. While both RECLAIM and
ERMS are designed to reduce local
air pollution problems, they vary
according to regional conditions,
such as local weather patterns, indus-
trial structure, and political environ-
ments. Common to both programs’
success, however, will be efforts to
keep transaction costs low and to
minimize uncertainty associated with
the start of a new regulatory approach.
—Thomas H. Klier and
Richard H. Mattoon,
 Federal Reserve Bank of Chicago
—Michael A. Prager,
Illinois EPA6
ERMS—VOM
Paper, allied products
Chemicals, allied products
Petroleum, coal products
Fabricated metals
Percent of total emissions 52.8
Percent of total facilities 37.7
RECLAIM—NOx
Electricity, gas, and sanitary
Petroleum, coal products
Stone, clay, and glass
Oil and gas extraction
Percent of total emissions 84.3
Percent of total facilities 38.0
Sources: Compiled by Illinois EPA from
preliminary baseline estimates, 1997; and
Thomas Klier and Richard Mattoon, “To trade
or not to trade: Who participates in RECLAIM,”
Federal Reserve Bank of Chicago, working paper,
No. WP-1994/11, 1994.
3. Top 4 high emission industries
1For a more detailed analysis, see Thomas H.
Klier, Richard H. Mattoon, and Michael A.
Prager, “A mixed bag: Assessment of market
performance and firm behavior in the NOx
RECLAIM program,” Journal of Environmental
Planning and Management, forthcoming.
2The 390 facilities included at the outset of
RECLAIM represented just over 11% of total
NOx emissions in the L.A. basin. By the end
of 1995, the number of facilities had decreased
to 353, mainly as a result of a reevaluation of
emissions estimates by SCAQMD staff.
3Before RECLAIM began, one estimate from
SCAQMD economists suggested that the
prices for NOx credits would fall around
$0.29 a pound in 1994 and rise to possibly
$5.50 a pound by 1999. See Scott Lee Johnson
and David M. Pekelney, “Economic assessment
of regional clean air incentive market: A new
emissions trading program for Los Angeles,”
Land Economics, Vol. 27, No. 3, 1996, pp.
277–297.
4The literature suggests that high transactions
costs, including overly burdensome regulatory
structures, have been responsible for the poor
performance of some environmental markets.
5Banking, which is allowed under the Acid
Rain trading program, has encouraged early
emission reductions and may have reduced
the uncertainty of participants in the pro-
gram; see Dallas Burtraw, “The SO2 emission
trading program: Cost savings without allow-
ance trades,” Contemporary Economic Policy, Vol.
14, April 1996, pp. 79–94.
6Michael A. Prager is an environmental policy
analyst with the Illinois EPA. The views ex-
pressed herein are the authors’ and not
necessarily those of the Illinois EPA.P
R
E
S
O
R
T
E
D
F
I
R
S
T
-
C
L
A
S
S
 
M
A
I
L
Z
I
P
 
+
 
4
 
B
A
R
C
O
D
E
D
U
.
S
.
 
P
O
S
T
A
G
E
 
P
A
I
D
C
H
I
C
A
G
O
,
 
I
L
L
I
N
O
I
S
P
E
R
M
I
T
 
N
O
.
 
1
9
4
2
P
u
b
l
i
c
 
I
n
f
o
r
m
a
t
i
o
n
 
C
e
n
t
e
r
P
.
O
.
 
B
o
x
 
8
3
4
C
h
i
c
a
g
o
,
 
I
l
l
i
n
o
i
s
 
 
6
0
6
9
0
-
0
8
3
4
(
3
1
2
)
 
3
2
2
-
5
1
1
1
F
E
D
E
R
A
L
 
R
E
S
E
R
V
E
 
B
A
N
K
 
O
F
 
C
H
I
C
A
G
O
C
h
i
c
a
g
o
 
F
e
d
 
L
e
t
t
e
r
102
110
118
126
1994 1995 1996 1997
Manufacturing output indexes, 1992=100
CFMMI
IP
Motor vehicle production
(millions, seasonally adj. annual rate)
June Month ago Year ago
Cars 5.8 5.8 6.7
5.4 5.4 5.8 Light trucks
Manufacturing output indexes
(1992=100)
May Month ago Year ago
CFMMI 121.6 121.6 116.0
115.7 120.8 121.4 IP
Purchasing managers’ surveys:
net % reporting production growth
June Month ago Year ago
MW 54.5 56.6 60.6
54.6 57.0 56.0 U.S.
Tracking Midwest manufacturing activity
Sources: The Chicago Fed Midwest Manufacturing
Index (CFMMI) is a composite index of 16 industries,
based on monthly hours worked and kilowatt hours.
IP represents the Federal Reserve Board’s Indus-
trial Production Index for the U.S. manufacturing
sector. Autos and light trucks are measured in an-
nualized units, using seasonal adjustments devel-
oped by the Board. The purchasing managers’
survey data for the Midwest are weighted averages
of the seasonally adjusted production components
from the Chicago, Detroit, and Milwaukee Purchas-
ing Managers’ Association surveys, with assistance
from Bishop Associates, Comerica, and the Uni-
versity of Wisconsin–Milwaukee.
The Chicago Fed Midwest Manufacturing Index (CFMMI) decreased 0.1%
from April to May, the first decline in seven months. By comparison, the
Federal Reserve Board’s Industrial Production Index (IP) for manufacturing
increased 0.5% in May. This is the first time in a year and a half that every
sector in the region had slower growth from the prior month than its national
counterpart.
Motor vehicle production (seasonally adjusted annual rate) for June increased
from 5.4 to 5.8 million units for light trucks and remained constant at 5.8
million units for cars. The U.S. purchasing manager’s survey for production
declined in June from 57.0% to 56.0%. The Midwest purchasing manager’s
survey also declined in June from 56.6% to 54.5%.

What can the Midwest learn from California about emissions trading?

http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter/1997/cflaug97.pdf

What can the Midwest learn from California about emissions trading?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics