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					  An Overview of the Organization,
 Properties, and Issue of Markets for
Tradable Permits for Emissions of Air
              Pollutants
                       Presented at
             Instituto de Ingeneria Electrica
    Universidad de la Republica del Oriental Uruguay
                    4 November, 2004

                  Paul M. Sotkiewicz
               Director, Energy Studies
             Public Utility Research Center
                  University of Florida
Why Tradable Permit Markets for Emissions
               Control?
• In theory, these markets lead to the least-cost solution to the
  emissions control problem.
• Poor experience with writing legislation for, and the implementation
  of command and control (CAC) policies in the 1970’s and1980’s.
    – Political compromises that exempted many polluting resources.
• Markets recognize the use of the environment as an input…or
  conversely recognizing emissions as an output (“bad”) that has a
  negative price.
• Markets offer flexibility in meeting emissions obligations with a
  minimal amount of information required by the government agency
  implementing the program.
• May induce innovation in technologies
    – In US scrubber costs have been reduced by more than 50% for SO2.
         Origins of Pollution Markets
• Ronald Coase (1960) in his discourse on property rights
  recognizes that all externalities (consequences of market
  activities that are not recognized immediately by
  markets) can be internalized by defining property rights.
• J.H. Dales (1968), a political scientist, floats the idea of
  pollution markets in Pollution, Property, and Prices.

• For all intents and purposes, emissions permits are
  property rights: The allow the holder the right to emit x
  units of pollution into the air (or water, etc.)
• In practice, and by law in the US, permits (they are
  called allowances in the US) they are not property rights
  in the strict sense, but act as such.
  Tradable Permit Market Fallacy and Fact

• Fallacy: Many environmental groups to this day object to
  tradable emissions permit markets in the mistaken belief
  that firms can simply buy all the permits they want and
  this will lead to unbounded amounts of pollution.

• Opinion: Trading pollution permits is “immoral” and
  should not be allowed.

• Fact: Tradable permit markets are “cap-and-trade”
  markets. That is, the aggregate amount of emissions is
  capped at a predetermined level, and then firms can
  trade among each other for the scarce “right to pollute”
              Two Firm Example:
       Emissions Capped at A*=18,000 tons

• Firm 1                  • Firm 2
• Unabated emissions,     • Unabated emissions,
  E1=24,000 tons            E2=30,000 tons
• Cost of abatement       • Cost of abatement
  function:                 function
C1(E1 – e1)= (E1 – e1)2    C2(E2 – e2) = 0.5(E2 – e2)2
where e1 represents       where e2 represents
  emissions after           emissions after
  abatement.                abatement.
  Minimizing Cost of Emissions Abatement

           Mine1,e2 C1(E1 – e1) + C2(E2 – e2)
                     s.t. e1 + e2 ≤ A*
The solution to this problem is characterized by the
  marginal costs of abatement being equal.
                 ∂C1/∂e1= ∂C2/∂e2=λ
   where λ is the Lagrange multiplier on the emissions
      constraint and is the shadow price of emissions.
And the emissions constraint being satisfied
                       e 1 + e 2 ≤ A*
These conditions will hold true for emissions permit market!
            Two Firm Example:
         Cost Minimizing Emissions
• Firm 1: e1=12,000 tons with ∂C1/∂e1=24,000 and C1=
  144,000,000.
• Firm 2: e2=6,000 tons with ∂C2/∂e2=24,000 and
  C2=288,000,000

• In total 66.6% or 36,000 tons were abated from the
  unrestricted levels.
• The total cost is 432,000,000.
Defining the Emissions Market Problem
• Let Xi be the permits/allowances allocated to firm i and xi be the
  permit/allowance position of firm i.
    – Xi < 0 → firm i is a seller of permits/allowances.
    – Xi > 0 → firm i is a buyer of permits/allowance is.
• Let P be the price of permits/allowances.
• Each firm solves the following problem to minimize its costs.
                       Minei,xi Ci (Ei – ei) + Pxi
                             s.t. ei ≤ Xi + xi
The solution to the firm problem is characterized by the marginal costs
  of abatement being equal.
                             ∂Ci/∂ei= λi = P
 where λ is the Lagrange multiplier on the emissions constraint and is
                     the shadow price of emissions.
• Note that P serves as the “shadow price” much like λ of
  the previous problem!
 Defining the Emissions Market Equilibrium

• An equilibrium for the emissions market is a price P*,
  emissions levels ei* for all i and permits/allowance levels
  xi* for all i such that ei* and xi* solve for each i
                      Minei,xi Ci (Ei – ei) + P*xi
                           s.t. ei ≤ Xi + xi
            And the emissions constraint is satisfied
                        Σi ei   ≤ Σi Xi
                   And the market clears
                          Σi xi ≤ 0
         Two Firm Market Example:
     Emissions Capped at Σi Xi =18,000 tons

• Firm 1                  • Firm 2
• Unabated emissions,     • Unabated emissions,
  E1=24,000 tons            E2=30,000 tons
• Allocated permits       • Allocated permits
  X1=9,000 tons             X2=9,000 tons
• Cost of abatement       • Cost of abatement
  function:                 function
C1(E1 – e1)= (E1 – e1)2    C2(E2 – e2) = 0.5(E2 – e2)2
where e1 represents       where e2 represents
  emissions after           emissions after
  abatement.                abatement.
             Two Firm Example:
         Market Equilibrium Outcome
• Market Price = 24,000 and volume is 3,000 tons.
• In total 66.6% or 36,000 tons were abated from the
  unrestricted levels.
• Firm 1: e1=12,000 tons and x1=3,000 tons
• Firm 1: ∂C1/∂e1=24,000 and C1= 144,000,000 +
  72,000,000.
• Firm 2: e2=6,000 tons and x2=-3,000 tons
• Firm 2: ∂C2/∂e2=24,000 and C2=288,000,000 –
  72,000,000
• The total cost is 432,000,000, but it is divided differently!
  Note how permit transaction cancel each other out when
  getting total costs for the market!
     Two Firm Command and Control
               Example:
Emissions Capped at Xi =9,000=ei tons for each i
• Firm 1                  • Firm 2
• Unabated emissions,     • Unabated emissions,
  E1=24,000 tons            E2=30,000 tons
• Allocated permits       • Allocated permits
  X1=9,000 tons             X2=9,000 tons
• Cost of abatement       • Cost of abatement
  function:                 function
C1(E1 – e1)= (E1 – e1)2    C2(E2 – e2) = 0.5(E2 – e2)2
where e1 represents       where e2 represents
  emissions after           emissions after
  abatement.                abatement.
              Two Firm Example:
                CAC Outcome
• In total 66.6% or 36,000 tons were abated from
  the unrestricted levels.
• Firm 1: e1=9,000 tons
•   Firm 1: ∂C1/∂e1=30,000 and C1= 225,000,000.
•   Firm 2: e2=9,000 tons
•   Firm 2: ∂C2/∂e2=21,000 and C2=220,500,000
•   The total cost is 445,500,000 which is greater
    than the 432,000,000 in the least-cost solution.
    Firm 1 abates too much pollution, Firm 2 abates
    too little pollution.
   Two Firm Emissions Tax Example:
           Emissions taxed at $20,000/ton

• Firm 1                   • Firm 2
• Unabated emissions,      • Unabated emissions,
  E1=24,000 tons             E2=30,000 tons
• Cost of abatement        • Cost of abatement
  function:                  function
C1(E1 – e1)= (E1 – e1)2     C2(E2 – e2) = 0.5(E2 – e2)2
where e1 represents        where e2 represents
  emissions after            emissions after
  abatement.                 abatement.
  Defining the Emissions Tax Problem
• Let T be the tax on emissions.
• Each firm solves the following problem to
  minimize its costs.
             Minei,xi Ci (Ei – ei) + Tei

The solution to the firm problem is characterized
  by the marginal costs of abatement being equal
  to the tax.
                   ∂Ci/∂ei= T
• Note that T serves as the price of
  emissions to the firm.
              Two Firm Example:
                Tax Outcome
• 30,000 tons were abated from the unrestricted levels
  missing the target of 36,000 tons.
• Firm 1: e1=14,000 tons

• Firm 1: ∂C1/∂e1=20,000 and C1= 100,000,000.
• Firm 2: e2=10,000 tons
• Firm 2: ∂C2/∂e2=20,000 and C2=200,000,000
• The total cost is 300,000,000 which is less than the
  432,000,000 in the least-cost solution, however the
  target is not met and a higher tax must be announced.
  This creates a consistency problem if the tax is
  constantly being changed.
  Designing a Tradable Emissions Permit
                 Market
• There are several elements and issues to
  consider:
  – Choice of Emissions Cap
  – Abatement Options and Their Relative Cost
  – Allowance (Permit) Allocation
  – Allowance (Permit) Banking and Inter-temporal
    Trading
  – Spatial Trading Rules and Pollution “Hot Spots”
  – Monitoring, Measurement, and Record Keeping
  – Market “Distortions”
            Choice of Emissions Cap

• The cap can be based on a political decision of the
  “optimal emissions level”.
   – This was done in the US. The cap was in effect for only the
     largest emitters in the first few years of the SO2 program, and
     allocations were based on less stringent standards.
   – After 5 years, the allocations applied to all emitters over 25MW,
     and were based on more stringent requirements.
• The cap could be based on “science” with economists
  and epidemiologists working together.
   – Setting the cap where marginal cost equals marginal benefit.
   – Coincidentally, it appears that the Bush Administration Clear
     Skies proposal is close to that in its full implementation.
 Abatement Options and Their Relative
                Cost
• Allowance (Permit) buying or selling.
• Fuel switching
   – High sulfur to low sulfur coal
   – Oil to natural gas
• Post-combustion controls
   – FGD (scrubbers) for SO2 or Hg
   – SCR, SNCR, low NOx burners for NOx
   – Underground storage for CO2
• Unit repowering
• Alter dispatch to be more emissions friendly
• Improve system efficiency
   – Loss reductions
   – Heat rate improvements
    Allowance (Permit) Allocation Scheme
• Gratis allocations to units:
     – Based on historical heat input
     – Based on historical output
     – Based on future expectation of input or output
• Allocation by auction:
     – Forces emitters to buy all allowance needs at the start
     – Puts the money in the hands of government as opposed to
       polluters
•   Combination of gratis and auction
•   Set-asides for units that do not yet exist?
•   Opt-in provisions for non-required units?
•   “Bonus” allocation for environmentally friendly actions?
 Allowance (Permit) Banking and Inter-
          temporal Trading
• Must allowances be used up in the year issued or can
  they be carried over into future years.
• Allowing trading between years allows emitters to
  smooth out costs and emissions over time as emissions
  requirements become tighter and tighter.
• This smoothing out helps lead to cost savings over the
  life of the market.
• Some markets do not allow banking (RECLAIM in S.
  Cal.) or limited banking (OTC NOx) market.
• Banking may not be a good idea if the pollutant has a
  slow decay rate.
   – Large emissions levels in one year could be very dangerous in
     this case.
   Spatial Trading Rules and Pollution
               “Hot Spots”
• A concern among environmentalists is that large trading
  areas can create spots where emissions deposition are
  greater due to transport and concentration of sources.
• This has not happened in the nationwide trading of SO2
  in the US.
• This is a concern in the trading scheme proposed for Hg
  in the US under the Bush Administration as Hg
  deposition is close to the source and hot spots could be
  very dangerous.
• In RECLAIM, there are two trading zones, and a 2 for 1
  trading ratio between east and west to make sure the LA
  basin is not adversely affected.
Monitoring, Measurement, and Record
              Keeping
• Emissions can be monitored at the stack by a continuous
  emissions monitoring system (CEMS)
• Or by estimation using chemical composition of fuel and
  combustion technology.
• Data on chemical composition of fuel, combustion
  technology, heat input are all kept as a check on
  emissions monitors.
• If a source does not have permits to cover emissions, it
  must pay heavy penalties (far greater than the allowance
  price)
• All allowance transactions are public record except for
  the price.
• Price indices are kept by traders and brokers in the
  market.
                 Market “Distortions”
• Economic regulation and treatment of abatement options
  for ratemaking purposes.
• Fuel content requirements from local sources.
• Overlapping environmental rules between the federal
  market policy, and a state policy that is more stringent.
• State rules forbidding trades.
• No harmony in policy within the federal agency
  administering the market.
    – EPA/DOJ lawsuits in US requiring certain abatement
      technologies for some emitters.
•   Transaction costs.
•   Regulatory uncertainty as to future policy
•   Existing fuel contracts.
•   Non-convexities in abatement technology choices.
    Experience in US and Concluding
                Remarks
• Pollution markets have existed in the US for over 10
  years.
• Emitters have taken advantage of the flexibility offered
  and costs have been much lower than technology based
  command and control.
• However, emitters have not taken full advantage of cost
  savings through trading.
• This could be due to some of the problems listed in the
  previous slide.
• The costs of the market policy have been lower than
  predicted, but this could be due, in part, to other factors.

				
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