Monday, October 25, 2010

Is the SO2 Trading Program Dying or Only Napping?

Recent posts on this blog (here) and at the Environmental Economics blogs (e.g., here), reported on a conference presentation by Richard Woodward on "The End of the SO2 Trading Program." Since then, I have been trying to unravel, historically and analytically, the apparent collapse of the SO2 market, as illustrated in Woodward's graph below:

Thanks to information provided by Professor Woodward and two EPA economists, Al McGartland (Director of the National Center for Environmental Economics at EPA) and David Evans, at least some pieces of the puzzle are beginning to fall into place.

First, the 2005 Clean Air Interstate Rule (CAIR) affected the preexisting acid rain program in two ways: it reduced overall SO2 caps and it differentiated between sources in upwind and downwind states, imposing more stringent requirements on SO2 emissions from upwind states in order to prevent them from contributing to nonattainment of national ambient air quality standards (NAAQSs) in downwind states. The relevant air quality standards here are not those for SO2 itself, but for PM and O3 (ozone), to which SO2 emissions contribute.

Both of CAIR's effects on the acid rain program, according to Karen Palmer and David Evans (here) should have improved the acid rain trading program, increasing net social benefits. Moreover, CAIR should have increased allowance scarcity and thereby raised prices, assuming no offsetting shift in demand and no new restraints on trading.

However, in July 2008 the DC Circuit Court of Appeals vacated CAIR in large part because it did not control trading of SO2 emissions to ensure that emissions from upwind states could not contribute significantly to nonattainment (of PM and Ozone standards) in downwind states. In effect, the court called into question the continued existence of the SO2 trading program. This ruling may have had a chilling effect on trading, depressing SO2 allowance prices. However, the court allowed CAIR to remain in effect while EPA worked on a replacement policy that would satisfy the court's concerns.

In July of this year, the EPA proposed a new "transport rule" (see fact sheet here, overview presentation here,  and the full proposed rule here) to replace the vacated CAIR rule. This proposed rule would not terminate the SO2 trading program completely, but would limit it substantially and in complicated ways to prevent emissions from upwind states from contributing to nonattainment in downwind states. By limiting and increasing the complexity of trading, the rule would limit demand for SO2 allowances and, therefore, depress prices (all else remaining equal). The apparent market reaction - reduced demand, leading to lower prices and reduced volume of trading - could reflect uncertainty over whether the SO2 trading market remains viable given the new and complex geographical trading restrictions the transport rule would impose. At the very least, the proposed rule would significantly raise the transaction costs of participating in the SO2 market. On the other hand, the new transport rule could reinvigorate the SO2 market if caps are set so as to ensure sufficient scarcity of allowances, even after adjusting for geographical limitations on transferability.

Another potentially important piece of the puzzle, though one that remains pretty obscure, is the possible impact (perhaps already factored into the market) of the not-yet-completed "Utility MACT" (Maximum Achievable Control Technology) rule. It is possible, but not certain, that the Utility MACT will use SO2, a non-hazardous air pollutant, as a surrogate for various acids that are hazardous air pollutants (under sec. 112 of the Clean Air Act). If that happens, then we really could be back in a situation where all (or virtually all) SO2 emissions are scrubbed, and the acid rain trading regime is rendered obsolete.

Also, as I observed in my earlier posting on this issue (here) the graph from Richard Woodward's presentation (above) indicates that trading volume and the price of SO2 allowances were both declining well before the DC Circuit vacated the CAIR rule. This does not necessarily mean that the trading market was dying. But even if it was, we need to bear in mind that the trading market itself is not an end in itself, but simply a means of minimizing the costs of complying with an exogenously set environmental protection goal. It could be that the SO2 trading program has served its purpose and is now ready to be superseded by new programs with somewhat different aims, which (for reasons relating to NAAQS compliance in downwind states) are not amenable to widespread emissions trading.

If, and it remains a big if, SO2 emissions trading is winding down, what are the implications for the theory of emissions trading generally, and for trading programs relating to other pollutants, such as carbon dioxide? One obvious lesson seems to be that, in the context of the Clean Air Act, large-scale emissions trading may not easily co-exist with statutory air quality goals.  These and other policy issues raised by Professor Woodward's graph are immensely interesting. I just wish I had time to deal with them right now.

UPDATE: In response to the first question of my final paragraph, Tim Haab writes (here):
My opinion? The theory is sound.  The real question is whether the theory is so sound that the practical implementation resulted in suicide for Cap'n Trade, or whether Cap'n Trade is a theoretical construct, similar to Hotelling's rule, which, while nice on paper, is confounded when put into practice by the annoying nuisances of the political, legal and economic systems.
 By raising the implications for theory, I did not mean to suggest that emissions trading does not work as John Dales and others said it would: It certainly does reduce the compliance costs of achieving exogenously set environmental protection goals. What I wonder about is, as a matter of instrument-choice, whether emissions trading regimes have only short-term instrumental value, and whether they are compatible with other regulatory regimes. In this case, for example, a clear conflict has arisen between the SO2 allowance market and the preeminent goal of the Clean Air Act. This might well count as an "annoying nuisance[] of the political, legal and economic systems."


  1. How does the economic downturn figure into the demand for allowances?

  2. It must have some effect, but I haven't seen any data. No one I've spoken with seems to think it's among the most significant contributing problems.


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