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									    To: HEMTLAND
               TEST                 Frrim:The Harrtlrnd Inotitut,

               TRADING IN LA
                               James L. Johnston

               Outhcrn California is the home of the            similiar phenomena), L.A+‘s meteorology and
       S       defense industry, movle-studioa, relIgioua
               cults, Disneyland, Muscle Beach, race
       riots, brush fires, earthquakes, floods, and
                                                               topography am unique among North American
                                                               cities, which Largely explains why air pollution
                                                               over that city is mm severe than smog over
       celebxjty murder trials. It is perhaps best lUIowJ&     even heavier industrialized cities such as New
       however, for its everpresent smog.                      York+ Chicago, and Hnllston.
            Despite popular perceptions, the major                    Southern California is well known as a
       cause of air pollution in Los Angeles is not            national incubator for &turd          and political

       industrial activity or a w-obsessed population
             is instead the meteorology and topography
       of the region. The L.A. Basin is ringed by moun.
                                                               tmnda, and that ~etirly      holds true for LA’S
                                                               war on air pollution. As both etiro~ntalists
                                                               and mark0t economists grow increasingly disil-
       t&n ranges that trap the precursor emissions            lusioned with the h&h cost and low affective-

       (volatile organic compoun&i and nitrogen oxide)
              together are the main ingredients of low-
       level ozone, or smog. The air stagnation that
                                                               ness ofadditional command and control rcgula-
                                                               tory edicts, interest has turned toward a mon
                                                               market-oriented approach. Rmi&on aoumes are
       results typically lasts up to two weeks or more in      allowed the freedom to use whatever abatement
       duration. When coupled with the high tempera-           techniques a&eve the required environmental
       tures of Southern California (about 90 days a           ends, Although interrn&antly       attempted on a
       year above 90 degrees fahrenheit), an ideal envi-       small scale for de4e.s {with, it must be noted,
       ronment exists for the fnrmation of smog.               disappointing results), market-oriented regula-
       Akhnugh L.A. is not unique in this drnvnstance          ticm made the national big-time during the 1990
       (Mexico City and San Paula, Brazil. experiemx.          Amendments to the Clean Air Act, where sul-
                                                               phur dioxide emiesians (the alleged cause of
                                                               acid rain} will be regulated starting in 1995
                                                               under a “allowance trading” program for elect&
                                                               utilities, Heady from their political Tory at ?he
                                                               federal level, the proponents of allowance Wad-
                                                               ing turned theit attention to &x&em Cakfcmk
            TEST                                         From:The Harrtlrnd Inrtitutb                                    Mm 21 1336 l&42 PST Page 3125

      ..:,r..   , . ,,*     , ,,‘jY.Y.~“,,:UU...r                                  ,    _   ,


                           where regulators &em were axxk~ to attempt
                           an tvm more ambiW         q@kution of this new                         Table1
                           policy trend,
                                Thus on October 15, 1993, the South Coast
                           Air Quality Management District (SCAQMD)
                           adopted by a vote of 11 to 1 the Regional Clean
                           Air Incentives Market (RECLAIM), a measure                             YEAR.              N4(s4t
                           designed to allow point sources of certain air                                                        .-.---.-_-__
                           pollutants to buy and sell permits issued by the
                           SCAQMD. But not everyone is totally happy
                          with the plan. Some of the largest emission
                           sources such as southern Catifornia’s refiners
                           a&y dutitly       hvt gone along while‘ environ-
                          mentalists are generally opposed to RECLAIM
                          not necessary because of the trading regime
                          itself but because of the delayed clean up
                          requirements      of the plan. However, Henry
                          Wedaa, a Yorba Linda city councilman who
                          chairs the SCAQMD Board, spoke for many                               coxn.mon with respect to source (fuel combue-
                          diverse inkrests when he declared that “this is a                     tion), reactive organic compounds wme from
                          very complex program, but it’s going to work. , .                     other murcas such as coating and solvent opet~
                          RECLAIM will enable us to have clean air and a                        tiO2E.i.
                          healthy economy.”                                                         The &x-native to REUAIM is a “command
                               Whether RECLAIM can actually live up to                          and control” approach where abatement is
                          its advanced billing or wiLI simply pmve to be a                      specified in meticulous technical detail. The
                          myopic example of Gorbochevian market plan-                           SCAQMD st& has forecast the cost of a eom-
                          ning is addressed below.                                              mand and control plan based upon a list of
                                                                                                cqtipment and process changes that m&ht have
                          RECMM                     E@aineFd                                    been ordered under the regulations. They have

                           The RECLAIM program covers 390 stationzuy
                          emission sources of nitrogen oxides and 41
                          emitters of sulfur dioxide. The target reductions                        The system c&ala with just 17 percent of
                          closely parallel those in a.n a,tternative cornmgnd                      the total NO,emirsions     in the bath
                          and control plan drafted by the SCAQMD. Table                            Coast Air B&n and 31 pemt         of the
                           I demonstrates the dramatic naturz of the NOX                           total $0, edssions.
                          and SOX reductions that RECWkl is designed
                                 Although it wouid appear that RECLAIM is
                          bound to have a significant effect on the coneen-                     also cstirnatccl the cost of RTKLJUM based upon
                          trstiotl   Of air pcbliutants kl. Southern California,                three main calculations: the anticipated prices
                          the plan covers only stationary sources of those                      of the RECLAIM Trading Credits (RTCs); the
                          two compxlnd6 that emit more than 4 tans per                          record keeping and measurement costs for trad-
                          par. Consequently, the system deals with just                         ing; and a conjecture about the “opportunity
                          17 percent of the total NO, emissions in the                          costU of the initial endowment of the credits.
                          South Coast Air Basin and 31 percent of the                           The primary determinate of the cost savings
                          total SO, emissions.                                                  supposedly delivered by the RECLAIM program,
                                 The district is considering the possibility,                   hawever, is the trading process itself and that
                          howevtr, of establishing a market-based ptp-                          process is in turn largely dcpmdent upon the
                          gram for reactive organic campauncla 88 well.                         estimated market clearing prices for the
                          &sent&b           L$ such a plan to the district’s gov-               BtlXLAIM tradhg wedire. The prices for those
                          eming board is anticipated sometime in 1994.                          RTCs, as e&mated by the SCAQMD, arc shown
                          Unlike N4, and SO,, which hue a great deaf in                         in Table 2.
                                                                                                                      21 1996 13:42 PST PIgo 4/25
                 TEST                    Fmn: Thr Hmrtlrnd   Inrtitutr                                         #r


               l%blsr2                                                      Table3

                       hnmge Pricesfor RTCs                                        CpanmCf SavingsEstfmmtw
                       (1987doltampwm)                                             (mfflfona of 1987 dollan)

                YEAR                                                        YUR             ClLCP   RECLAIM         Eiavlnga
                                N%              94(                         ~-.-

                                                                            1994             49          10         38
               lW4              ST7              577                        1395            t12          14         88
               WD6                              1631                        lS@#            123         78          47
               1998             szl             a46                         1837            127         94          38
                1997            8151            3062                        1RW                         125
                1338            8877            2870                        18W             E           185         ii
                1333           1'1257          2682                         AVS.            139         71          68

              Table 3 summarizes the cost estimates for                  allocation of trading credits. The imposition of a
         the command and control plan drafted by the                     fee on top of that effort, will be the cmp de grace
         SCAQMB and the RECLAIM alternative. AIso                        fm many firms in the basin.
         included are the differences Wween the two,                          Theasacr&nontbepartofthcdi&ictistkat
         which are the notional ‘savings” from adopting                  the RECLAIM emiasim alkxrdtion fee & a snaight-
         RECLAIM. If Table 3 can be believed, the cmis-                  fimwud rephct?ment for the annual emission fee
         sions trading    scheme contained      in the                   that exists in the SCAQMD. That may welI be.
         RECLAIM plan promises substantial savings                       However, it raises a serious qucation-why have
         over the comand-and-control altermtiva                          b&a~tnhmitemi&onsandasystemof
                                                                         fees on emissions a~ well? Momcn~, ctbx.dRying8n
                                                                         bring about an ad&tment in the schedule of emis-
           Most fknu will have to struggle to meet                       sion-
           the Implied reduction k emissions rep-                             The existence of a fee also raises another
           resented by the initial allocation of trad-                   question. An emission fee is often viewed as an
           ing credits.                                                  alternative to command and control and other
                                                                         policies to reduce pollution. A fee has the impor-
                                                                         tant advantage of neutrality with respect to
                                                                         abatement choiem, On the other hand a fee poli-
                                                                         cy requires a stable relationship between the fee
         surcharge credimlnpliatitlg                   the               and the improvement in environmental quality,
         Prddem                                                               That complication, it is interesting to note,
                                                                         has been resolved already in the RECLAIM
          In the middle ages, it was a custom for the con-               effort. As reported above, a set of equilibrium
         demned to tip the executioner so that he would                  prices has been assembled that achieves the
         swing the axe effectively and bring death quick-                desired emission reduction. If there is any vahd-
         ly. The district has resurracted thii quaint tradi-             ity to that Exercise, then fJl the economic condi- by charging a fete on the lUXX4.M credits                  tions are in place for designing a viable fee-
         allocated to facilities as though the credits are a             based system of emission reduction.
         gift 6am the district It should be remembered                        There is a drawback that a fee system shams
         that the initial alhxation of trading credit.9 rep              with the command and control alternative,
         resents the reduced level of emissions. Thus, in                When emission reduction occurs as a result of
         a very real. sense, the allocatkn already xxpre-                shutting down a statiorutry source, then k ILO
         sents a taking from the emission source. Most                   be&it from acquiring that source by a firm that
         firms wju have tu struggle to meet the implied                  continues operations in the basin. Such a firm
         reduction in emissions represented by the initial               will still have to pay the fee on its emissions
           TEST                From: The Harrtland Inrtitutlr                                 hr 21 1996 13:43 PST Page 5/25

            without obtaining credit from acquiring and            them in mserye until the end of the year in case
            closing down other sources.                            emissions grow larger than were originally
                 The ostensible purpose of the fee system,         expected. The unsold credits are like insurance
            whether it is command and control                or    and consequently part of a fi&s risk manage-
            Reclaim, is to finance the district’s operations.      ment plrlan.
            This is a questionable arrangement. It is like the           The RECLAIM credit, and therefore the
           IRS deciding its own CFASZS. design casts               option component, is cxcrciaable only on a spe-
           doubt on the expectation that the regulatory            cific date. That means that the opdon is a so-
           decisions will be free of financial conflicts of        called European, as opposed to an Ametican,
            interest.                                              type. The fair value of such options has been
                 There is something to be. said for ccmform-       successfully modeled by economist Fischer
           ing the RECLAAIM fees to the existing district          Black, The model is very robust and is used
           plan-it    leaves the institutional    conditions       extensively    by arbitragers   in commodity
           U&W@.         But the economy and the emissions         exchanges. The table below presents the C&X&P
           ia the Basin will ~unzly be evolviag (one hopes         tions of option premiums for several times to
           for the better). That suggests going to a more          expirations, along with the associated assump-
           neutral fee, such as a lump sum levy which does         tions about interest rates and expected voIatili-
           not a&z the firm% max@nal cost. Slice the fee.          ties.
           arrangement is not yet settled. the district
           should consider cleaning up its act with respect
           to fees.
                                                                     W use of the w~cd “hoarding” puts a
            Hoarding and Risk Management                             peqjorath   spin on a perfectly reason-
                                                                     ably risk management strategy-there      is
            Another complication of the RECLAIM prom                 nothing wroxkg with setting aside pre-
            is the fact that RTCs are limited to a term of one       caud4mary st4xks in advance of a crisis.
           year. The reason offered in the RECWM docu-
           mentation for limiting the term of rhe credits is
            to reduce the chances of hoarding. The district
            is ostensibly trying to avoid the problem                   Three of the four expected volatiliries are
            in-d         by the lack of expiration date on the     taken from the recent trading of natural gas
            SO2 allowances in the federal 1990 Cle3,n Air          opticms on the New York Mercantile FLxchange,
           Act. The effect of the latter is to allow “banking      Natural gas is the fuel of choice for reducing
           of allowances to caver future volatility          and   SO2 and NO, and therefore its implied volatility
           uncertainty.     Since there are two phade+~ laid out   L a relevant indicator for the RECLAIM tiing
           in the Clea Air Act {the kstter phase contains          credits. Ihe expected volatility for the ten-year
           more stringent requirements), the effect of the         option is an extrapolation. The interest rate8 are
           nonexpiring allowance is to stimuIate the early         taken from the Treasury yield curve. The times
           reduction of em&ions. In that way Ed electric           to expiration arc tho$c r&vant to the RECLAIM
           utility gains mure flexibility In its future opera-     tiding credit, The three, six, and twelve month
           tions. It is prepared, for example, for an unusu-       periods are three points in the life of the
           ally wanm summer when the surge in demand               RECWM credit. The ten-year p&xl coincides
           for electricity is especially great. The utility can    withtheC.asewherethewrpdrationistheendof
           increase gmemion and handle the O&UC-                   the RECLAIM program in 2003.
           tion of emissions by drawing from its ‘%a&”                  A couple of conclusions can be drawn l%orn
                  In a very real reuse, the allawance in the       the calculations. First, while the ten-year premi-
           Clean Air Act is like a futures contract with a         ums add 21 percent ta the value of a reclaim
           linked option. And because of this, the utility         credit, the lesser prunium~ for the shorter peri-
           has an txtm tool in its risk management efforts.        ods are still bubbtantial. They are, nevertheless,
                   While the R.ECI,AuI credit has only a one-      sufficiently large to generate what some would
           year life, it is also a combined futures and            cdl hoarding;. Of course, the use af the word
           option contract. An emission source with extm           “hoarding” puts a pejomtiw     spin on a perfectly
           RECLAIM credits can either sell them or hold            reasonably risk mrtnagement strategy-there is
                                      From:The Hasrtlmd Inttitutrr                                        br   21 139613:44 PST Pago 6/25
I              TEST

                                                                                           ecmmic theories of Nobel
                                                                                           prize winning economist
                                                                                           Ronald Coase. Philip R.
                                                                                           O’Connor, the chair of the
                                                                                           EPA’s Allowance Tracking
                                                                                           and Trading Subcommittee
                   REClAIMOpti~nsAsst~mptiorw and Premium                                  of the Acid Rain Cwunittee,
                                                                                           for example, asserts that
                           9montha           8months          12 month         10 yews     “allowances are consistent
             --.                                                                           with     economic       theory
             Vchtilii       -45                A0              36               a0         (Cease).” O’Connor and oth-
             lnter85t%     3.1               3.3             3.5               5.7         ers seem to believe that their
             Premium        8%               11%              14%              21%         emissions trading model is
                                                                                           exactly the kind of market
                                                                                           exchange that Comaehad in
                                                                                           mind in his classic essay
                                                                                           “The Problem of Social
                                                                                           Cost .II Cease       is better
          nothing wrong with setting aside precautionary              known, however, for stressing the impom            of
          stocks in advarlce of a Gristi.                            well-detied property rights in promoting effi-
               Another fmplicetim of the options in-                 ciency in the allocation of resources.
          tionisthatalongerlifefort.heRECLAIMcredit                       As is often the case with Nobel laureates,
          wlllddisposeQfthefiflusxyQffatye~                           Coast is more honored in ceremony than in
          when information is Ie.s reIiabk and price volatili-       practice. The allowances fn the Clean Air Act
          tyisgIT&.f!r.It~htbe        mtllattbisw#                   that O’Connor believes are consistent with
          thentionalsfor8~eREcLAIM                    contract. A     Cease’s emphasis on well defined property
          longwtforthccreditcQuldalsobawsimpli-                      rights arc in fact denied property rights status.
          fled the mduction schedule and-provided an incen~          EasentiaUy, the federal &ovemment did not want
         tivetoac&Xatetha~~ofeanissions.                             to be reqti       by the Fifth AmCndment to the
                   stru#uhng a plant% open&ions, it is e8sier 03 Constitution to be responsible for actions that
         Lte               a single etwkonmental event than a        might affect the ~lua of allowances,
          series of annUalreduction targets.                              The situation is similar for RECLAIM.
                Finally, incorporation of the option premi-          FUKUIM credits which are to be traded are
         ums in the pricing of the trading credits raises            explicitly denied property-right       status. Rule
         the net cost of RECLiUM. In the context of the              2007(b)(3) says “An RTC [RECLAIM Trading
         revised estimates prescntcd above, the option               Credit] shall not constitute a security or other
         premium would further raise the anticipated                 form of pruperty ...”
         cost dif%rence between RECLAIM and the corn-                     The mistake is cxnnpcqmded in the next sec-
         mand and cuntml alternative.                                tion (4) which says
               Regrettably, it is not now possible to change              Nothing in District n&s shall be con-
         the ten-n of the RECLAIM credit. V&& can be                      strued to limit the District’s authority to
         done, however, is to avoid misrepresenting the                   condition, limit, suspend OT terminate
         genuine effects of the one-year term and to                      any RTCS or the authorization to emit
         adjust further the estimated costs of the                       which is represented by a Facility
         RlXLAlM program, and once again, to adjust                      Permit.
         those Costs UpWards        of CVtn the rcvirsd Qures            As with the fedeti Clean Air Act, the district           ’
         prexnttd in Table 4.                                        in Rule 2007 ia insisting on being exempt from                   I
                                                                     responsibility for its actions. At the same time
                                                                     the district is demanding that all other parties
                                                                     be strictly liable for their mistakca, includllng
                                                                     penalty fee5 for exceeding emission Eaps.
         Proponents of emissions trading often &fend                     The lack of property rights for RTCs haa sev-
         their artificial market by associating it w3th the          eral rather important           implications      for

         48   k3SGvWmON,   KWNUMEES.
                                FPDIII:The Harrtlrnd Inttitut,                                 Par 21 199613:45 PST Page 1125

                RECLAIM participants.       With all the
               uncertainties of a new system and rhe
               prospect that any mistakes by the dis-
               trict will be imposed on ttZeparticipants,
               investment will more likely be diverted
               outside the Basin, The shxnative is a
                dubious gamble on the consistency and
               predictability    of SCAQMD regulators
               who will undoubtedly be tempted to
               revamp and fine-tune the permit levels
               as the grand RECLARbt experiment
               begins to yield (either poor or good)
                     Emission     sources that plan to
              remain in the Basin, (albeit at a reduced
              level of operations) will acquire the
              assets of emission sources that axe
              departing the area rather than installing
               the costly abatsment measures. By
              doing this, the acquit-& firm gains bet-
              ter defined property r-i&s in the emis-
              sion reductions from the shut down
              installation     than would be obtained
              from the RECLAIM trading credits
              alone. The scquisition is equivalent to
              an averaging of emissions over a larger
              number of sources, alI of which an new
              within the corporate brxmdaries.
                     There are other ways to average emissions      inventory, financial insbum45nt5, pzxkperty used
              and “game” the new RECLAIM system. One                in trade or business, materials and suppIics.
              method is a joint venture of fh15      that stay in   ordinary and necessary busiaess expense, or
              the sJreawhich purchases assets of the dcparkg        costs of producing inventory. Olxzrv-ers feel that
              sources. The joint venture would allocate the
              elinkated emissions among its equity partners
              by a contract that could be subsequently
              enforced through the courts. This; legal form           The lack of ptpptrty rights for RTti has
              exitts in many operations, notably among                several rather important implications
              pipelinea.                                              for lmixA&l    paMcipanta.
                     Another way of aggregating over emission
              sources is for the local electric or gas utility to
              purchase the assets of the departing firms. The
              utilities could then repackage the reductions          the most likely arrangement to he approved by
              with their ordinary energy services, for which         the IRS for purchasers of cmdits f.s korxrtv ”
                                                                                                              a .
             property tights are well d&n&. Of course, such          used in trade‘or ln16iness,”
             an action would have to pass muster with the                Without property status, however, it is not
             state utility commission, It would also have to        clear that the tax treatment of allcwauces can be
             sulvivc legal scrutiny on antihust grounds, and        successfuily reconciled with the body of tax law
             both are sizable hurclles.                             that is based an the zssu.tnption that an assti is
                    Also problematic for the district is the tax    indeed property. Thus, firms that trade credits
             treatment of credits, There are myriad wrirys to       wiu not be certain of their future tax liability.
             characterize purchased credits, all of which           That is, except for the standard assumption   that
             have unique tax and fiscal implications, The           the IRS has a tendency to decide ambiguous
             Internal Revenue Service may treat RTCs as             issues in its favor.
I   To: HEMTMNDTEST                  From:The Hcrrtirnd   Institutr                                        kr 21 199613:46 PST Paw 8125

              All of the above factors tend to Iessen open             in the LA Basin with the expectntios that they
         trading of emission credits. This in turn will                will sell their physical assets, including the em&
         make it more difficult f?tr the district to monitor           sion reduCt.iOnS,  to firms that plan to Stay in the
         activities and will dramatically complicate the               area. Thus, tding disappem from the orgpm-
         assessment of the RECLAIM trading system.                     ized RECLAIM credit market and reappears
              Halfway thmugh the f& year of RECLAIM,                   later as an internal transfers within the new
         the tzading has been modest, to put it charfta-               larger corporate structure of the firms that stay
         bly. The auction designed to handle high txading              intheama.
         volume has twice been postponed for lack of
         demand. As of the end OCJune 1994, there has                  Failing the Coat-Benefit Test
         been only one substantial trade. Unlba Carbide’s
         Tofiance plant sold $1.2 million wo&~ of &its                  The rationale       for reducing emissions in
         covering 1,700 tons of NO, to Anchor Glass                     Southern California is ostensibly to improve
                                                                        public healtb in the South Co& Air Basin. The
                                                                        RECLAIM report asserts that the system “has
                                                                       been designed to achieve equivalent or better
            Halfway   through     the first year of                    pollution reductions necessary to protect public
            RECLMM, the trading has been modest,                        health as would have been attained under the
            to put it charitably.     The auction                      cumnt regulatory program”
            deeed    to handle high trading volume                           Yet 0th than detailing the state ad f&ml
            haa twice been postponed for lack of                       standat& that apply to emissions, there is no
                                                                       cpautificath     of the benefits ta be derived from
            cIeJmd.                                                    implementing a program that drains $200 mil-
                                                                       lion or so from the economy of Southern
                                                                       California, Are the benefits from “polIution
          Container Co~ration.        That is an average price         reductions necessary to protect public health”
          of $700 per ton, which is larger than the $577               worth the costs? The RECLAIM rqrort does not
          price predicted        in the fbal draft of the              address that question, except to describe how
          RECLAIM report.. Is is also 4.5 percent of the               the command and control alternative          and the
          total number of 37,511 credits that makesup the              RECLAIM system both satisfy the legal man-
           1994 stakdng allocation+                                    dates of state and federal statutes. In a very
               citiif.ens for a Better Etlwimnment claims ill          revealing admission. the RECLAIM report
          a lawsuit that the lack of moxe substantial trad-            ackn0wIedgcs that
          ing is due to too many c&its being issued, leav-                   Over the last decade and a half, there
          ing a glut on this tiew market, Yet if an ov~up-                  has been significant improvunent in air
         ply of crediti exists, the actual price would be                   quality in the district. . , +In 1992, there
         Iower than predicted, not bigher,                                  wcn no nzzorded excec&nces of either
              One might believe that instead of trading,                    the state or federal SO2 standards.
         each firm is actLlally plan&g to install Rir pol-                 Annual average concentrations of NO2
         lution czu-&ol equipment. But if this were true,                  decreased over the, period 1976-3992, By
         the equipment business would be booming. The                       1992, there were no monitored
         reality is that it is not. One firm, Wahlco                       exceedances of the federal N02 stan-
         Environmental Systems of Santa AM, took a                         dard. Los Angeles County was the last
         $56 million pre-tax loss in the second quarter of                 area in the United States to meet the fecl-
          1994 because the market frrx air pollution con-                  et-al standard, The state NO2 standard
         trol prrJducts has f&d to meet expected levels.                   was, however, still exceeded in 1992 at
              One expla~dQn that is consistent with the                    three of the?distrkt locations in which it
         pattern of early trading is that the market is                    was monitored. The highest one-hour
         being affected by the credits being denied prop-                  average concentration ia 1992 was 20
         erty-right status. It might well be the case that                 percent above the stame    standard.
         firms are adopting a more defensive strategy.                     Although NOX is a contributing factor to
         That is, many firms faced with high costs of                 low-level ozone, it is generally agreed that
         abatement are planning to shut down operations               v&idle organic c~rnpounds play a much greater
                             From: Thr Harrtlrnd Iwtituts                                   br 21 1116 1346 PST Pwr 9125

           role in smog formation in LA. &an does NO,
           Moreover, L.A. has experienced a dramatic                                   Figure 1
           decline of days in which if has exceeded the fed-         .-
            eral ozone standard over the past decade, a~
            Figure 1 demonstmtw
                If there Is any relationship between emission
           standards and the effect of emissions w public
           health, it would seem that de additiodal post-
            1994 improvements in the South Coast Air
           &sin’s public health from either SCAQm plan
            sured and that may be the reason the district did
           not iacludc them in the RECLUM repoti
                The omission of this salient consideration
           brin8s to mind the contribution of Ronald Cease
           which was part of the basis for his Nobel prize.
           He discusses the reciprocal nature of pollution,
           The tl?ditianal e~~nmcntal        pL-Qblem,he says,     the Clinton Administration        in April 1993
            is commonly thought of as one in which A               reversed U.S. policy and L expected to press for
           in&ts harm on B and what has to be decided              the addition of substantive protocols to the
           Is: how should we restrain A? But this is WZYIII&       Framework Convention on Climate Chane.
           We are dealing with a problem of a reciprocal               The science behind the supposed threat
           nature. To avoid the harm to B would inflict            polPed by SO, k also less than one would pry
           harm on A. The reaI question has to be decided          sumc. The major problem in connection with
           is: should A be allowed to hatm B or should B           502 is acid rain, An authoritative study of the
           be allowed to harm. A? The problem is to avoid          acidity of lakes and soil. was conducted in the
           the more serious lxxm.                                  late 1980s as a part of the National Acid
                h o&r to do this, it is necessary to evriluate     Precipitation Assessment Projjrarn. It was found
           not only the co9t of &atfxnent but also the cat
           of not reducing emissions. In other words, a
           proper environmental impact analysis must
           include a condrGn8 reassessment of the bene-              There ln no quantlficadon   of the bene-
           fits from improving the air quality. FaUure to do         fits to be derived fnom implementing B
           this risks a loss in public support for pollution         pgram      that drains $200 million or a0
           abatement,                                                from     the economy      of Southern
                An example of the kind of n&take that can            Cdiforda.
           take place is the policy problem af global warm-
           ing, in which NO, plays a role. In 1988, the
           Intergovernmental       Penel on Climate Change
           was established, and in a I990 report it predict-       that there was little correlation between SO2
           ed a possible inc=se in average temperatures            emissions and the acid condition of lakes and
           of irom one to five degrees celsius, Two years          soil in the nmtheasm United States, Moreover,
           later that same IPCC reported that over the last        even if there were a connection, there are less
           century global mean temperatures have ristin            costly ways of reversing acidity than to reduce
           only 0.3 to 0.6 degrees Celsius. Moreov~~, the          SO2 emissions h-am electric power generation.
           1992 npmt concluded that no definite associa-           In any ease, “acid r;aina is en eastern-and pti-
           tion can be made between wrumlng and human              rnarily northeastern-phenomemn.       and is sim-
           activity, nor will scienXists be able to verifjr such   ply not a problem on either the Pacific Coast or
           a hypothesis         for a decade or more.              in the mountain states+
           Notwithstanding this revised opinion about the               The need for NO, ar SO, emissions rcduc-
           threat &global warming and the estimate of the          tions under RECLAIM or the command and
           longterm cost of reducing global c&on emis-             control alternative has simply not been proven.
           sions on the order of four perrent of world GDP,        It is certainly questionable whether or not
                                                                                                 Mm 21 199613:47 PST PWJB
To: HEMTLMDTEST                 From:The Harrtl~nd Institutlr

       improving reducing those emissions is worth                in the Basin, Most refineries there have been
       hundreds of millions of dollars per year under            given up to a S-percent increase in NOx emis-
       either plan.                                               sions if they commit to producing reformulated
                                                                  gasoline. It is unlikely that this is a sufficient
       Trading-Up the L42vetof Pollution?                        incentive for refiners in the Basin to generate
                                                                 reformulated gasoline to comply with federal
        The task Of reducing emissions is a difficult and        clean fuel requirements and the G&for&           Air
       costly  one. If it were not, the problem urould            Resources Board’s Pha.~eTI regulations for hel,
       have been solved long ago. One of the oomplica-            Several smaller refiners have suggested that a 2O
       tions from &e ef%rt to reduce emissions is that           percent allowance would better facilitate the
       the process itself creates emissions and stunts           production of reformuked gaSolin With just a
       industial competition.                                    5-percent allowance, production of this environ-
           Two examples have already arisen under                mentally superior gasoline wilf take p&e largely
       RECLGl;M. One iti the process that reduces the            outside Of the Bash Oil companies with refiner-
       discharge of reactive organic compounds at sta-           ies both inside and outside the Basin will be
                                                                 able to handIe the regulation better than those
                                                                 with a single refinery in the Basin. That may
                                                                 have repercussions on competition among refin-
           One of the complications from the effcn-t             em in the Southern California.
           to mduce tsnissfons is that the process                    There was a last minute change in the
           itself creates emissions    and stunts                RECLAIM regulations for refiners that produce
           industr&l competitioa                                 reformulate# &asoIine.
                                                                       [A) refinery may not exceed flv~ percent
                                                                      of any refiner total starting Allocation,
                                                                      unless any facility emits less than 0.0135
       tionary sources. The other is the making of                    tons of NO, per thousand barrels of
      xxcfannulated gasdine whfch has the potcntiaI of                crude processed, in which case the
      reducing emissiona from mobile sour~cs. in                      AIlocation increases shall not exceed
      both of these casts, NO, emissions are                          twenty percent. This provision was
      incnased somewhat in o&r to achieve more                        inc.Il.lded so as not to pmvide a competi-
       substantial reduceions in reactfve organic corn-               tive disadvantage among refinexs.
      prrunds.                                                        Complicated last minute changes provoke
           The R,R. DonneIley plant in Torrance is the          skepticism, ~especfally when the rationale is the
      first case. In testimony on October 15, 1993,             promotion of competition. The question that
       Dale Colina of RR Donnelley described how the            arises is which refiners are rdhcted and which
      increase in NO, emissions at the plant is a               arc not. To answer that question, the 1994 start-
      direct result of the mandated mducdons in reac-           ing allocations for ND, were &kctcd from the
      tive organic compounds. The prOHem was                    RECLAIM documentation. and the 1993 crude
      aggravated because the abatement equipment                oil mrw were taken fnom the Oil B Gus JotdmaI.
      was installed after the base period. Thb effec-           The data and the rough calculation fnr the tons
      tively lowers the starting allocation in the reduc-       of NO, emissions per barrel of crude oil -pa&-
      tion schedule and makes it more difficult for             ty at the refineries are shown 3n the following
      Donnelley to remain in the Basin. RECLAIM                 table.
      does not offer even a Spercent allowance in                     From these rough calculations, it can be
      cages like these. The District’s response is for          seen which refiners w likely to qusf;fy for the
      such firms to purchase credits from other                 #)-percent reformulated gasoline allowance.
      sOll2Ces. Clearly, activities like printing can be        The first six refiners (ranked by NO, tons per
      done outside the Basin and shipped into the               barrel of crude oiI capacity) are small by indu~
      market. Thus, the NO victcvy wti force many               try sU&arcls and without the capability to pro-
      such firms out of the tas-ln and may also result          duce reformulated gas&ne in competition with
      in an increase in mobile emissions.                       lefineas Outside the Basin. Of the larger refiner-
           The other case of pollution       interaction        ies, none are within striking distance of the
      inv01~ the prOductiOn of reformulated gasoline            RECLALM threshold with the sole exception of
To: HEARTLAND                    From:The Harrtlrnd   Inotitutr                                 Mm 21    199613:48 PST PB~B

            the ARC0 refinery located in Carson. One can-
            eludes therefore rhat the last minute exception          Tabb6
            inserted in the RECLAIM regulations applies
            only to the ARC0 refinery and hardly qualifies
            a5 a provision that ptumotes competition as is

            Emisstoae Tiaditlg     and Auto scrapping                Chsmuil               t1      22       o.t)014
                                                                     Edgingfon            26       42       O.OD17
            Proponents of emissions tmding schemes often             Hunnvay               a       6        MD57
            acknowledge    the nature of the problems                Ultramar             327      68       0.0132
            addressd  above but still maintain that there are        Fletcher                      30       0.0147
            plenty of examples of such schemes actually              PPWWIt               E        40       0*0166
            working and that REW         is designed to build       ARGO                 1863      237      (1.0214
             upon those demonstrable successess. RECLAIM            Powsrina                                0.0207
                                                                    Chevron              izi       z        a.0342
            proponents often suggest that their program is          UNOCAt               1618      11s      omw
             modeled after one such example often billed as         Mobl                 l%KJ      127      o.o#%
            perhaps the mast striking “emissions trading”           Texaco               1499      es       0.04s2
            success-the automobile scrzapping progra
            undertaken by Unocal Corporation. In fact, in                                                            --
             1992 the Preaiclent’smedal for innoration in the
            environment and conservation was awarded t0
            the Unoeal, and the President’s Council on                 The scrapping program, however, is not
            Environmental Quality deemed the program               without its critics. During the hearings in
                  an unprecedented effuti to improve dr            September and October 1993, the most vocal
                  quality in the Los Angeles Air Basin by          were the collectors of alder vehicles and the
                  scrapping heavily polluting pre- 197 1           mechanics that maintain them, who found tize
                  cars. ha f&r moeths, the oompany pur.            mainstay of their business nmoved from the
                  chased and cmhed for recycling 8,376             marketplace. Their major point was that older
                  old cam. SCRAP reduced air pollutants            cars are not necessarily the largest polluters.
                  by 13 million pounds per year at a cost          That tracks with the work of Donald Stedman, a
                  of SOcents per pound.                            professor at the University of Colorado, who has
                  RFELAIM contains a specific rule governing       actually sampled emissions from vehicles as
            the siapping of old vehicles. Actually the rute        they tit expsways.
            predates RECLAIM, having been adopted in                   The preiude to a possible eompmmise arose
            January 1993, And the program itself p&&s              during the hearings on October 15, 1993,
            the adoption of the tie, M0reover, another oil         Chevron offered a 5-day period between the
            refiner, Chevron, has also begun a scrapping           $700 acquisition of aa oId vehicle and the acnral
            exercise.                                              scrapping. During this 5-day period, old car
                 There appears to be an important le.$son in       enthusiasts would be free to cannibalize the
            this experience. While s~rappillg of old vehicles      vehicles for spare parts. At least one old car
            is the one demonstrable trading success, it            enthusiast expressed approval of the plan
            involves a trading partner that is outside the         offered by Chevron. It should be noted that the
            main RECLAIM market.                                   potential deal resulted from direct uxnmunice-
                 Note also that it is a variation 0x1the type of   tions between principals, not through mediation
            trading discussed above. One souse buys and            by the &strictt. Indeed, the district’s last minute
            then eliminates another source, in this case a         reaction was to cap the overall annual number
            mobile source. Since the buying institution            of ecrappings to 30,000 mmI$,
            acquires a wfder array of emission sources. the
            emission trading takes place totally within the
            institution’s corporate structure and thereby
            finesses the problem of ill-defined property           The Regional Clean Air Incentives          Market is
            K-i&s.                                                 substantialIy flawed. The small reductions in

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