A cap-and-trade climate policy success

The US SO2 cap-and-trade program has been hailed a triumph in almost all areas. And its success suggests cap-and-trade could be applied more widely in climate policy.

VoxEU.org

The sulphur dioxide allowance-trading program established under Title IV of the 1990 Clean Air Act Amendments was the world’s first large-scale pollutant cap-and-trade system. ('Allowance trading' and 'cap-and-trade' are synonymous.) The stated purpose of the Acid Rain Program was to reduce total annual SO2 emissions in the US by 10 million tonnes relative to 1980, when total US emissions were about 26 million tonnes.

In a departure from conventional environmental regulation, the legislation did not prescribe how power plants would reduce their SO2 emissions. Instead, with a phase-in beginning in 1995 and culminating in 2000, the statute capped aggregate SO2 emissions at the nation’s 3,200 coal plants and created a market for firms to buy and sell government-issued allowances to emit SO2. By 2007, annual emissions had declined below the program’s nine million tonne goal (a 43 per cent reduction from 1990 levels), despite electricity generation from coal-fired power plants increasing more than 26 per cent from 1990-2007 (EPA 2012; EIA 2011).

In economic theory, a cap-and-trade scheme can be cost effective, meaning the aggregate costs of pollution reduction are minimised. Because each company (or facility) has flexibility to choose the course of action that costs it the least to achieve environmental compliance (broadly speaking, either reduce its own emissions or buy more allowances to cover its emissions), investment flows to where it is least costly to abate. The marginal cost of pollution abatement becomes equalised across all regulated entities, and, in aggregate, the mandated environmental target is achieved at lowest cost.

Although compliance costs of the acid rain program – as implemented – may have exceeded those associated with the cost-effective ideal, they were significantly below estimates generated by government and industry analysts in the debate leading up to the CAAA. In 1989, before the program went into force, the US Environmental Protection Agency estimated the total cost of implementing the Acid Rain Program at $6.1 billion. Eight years into the program, in 1998, the Electric Power Research Institute, an industry organisation, and Resources for the Future, an independent think tank, estimated that total implementation costs would be between $1.1 billion and $1.7 billion.

Several factors – some exogenous to the program, which we will not discuss here – explain the large gap between initial programmatic-cost expectations for the SO2 allowance trading system and later assessments of actual costs. One might have been the failure of early analysts to fully recognise the fundamental cost-effectiveness of such a market-based approach. In addition, early estimates surely failed to incorporate adequately the incentive provided by the price set on SO2 emissions for technological innovation in both scrubbers and power-plant operation, which reduced costs over the period.

What made the Acid Rain Program work?

To a close approximation, regulated entities in a cap-and-trade system will face the same incentives to reduce emissions, regardless of the how allowances are initially allocated and, specifically, how many allowances a given firm holds at the outset. What matters with regard to firms’ decisions to trade or abate are marginal abatement costs, and these are generally unaffected by the initial allocation of allowances.

Indeed, members of Congress fought intensely to increase the share of freely allocated allowances that would go to utilities in their home districts, in part as a means to sell the Acid Rain Program to constituents. In the end, the distribution of free allowances to individual firms was largely based on historic rates of emissions ('grandfathering'), but allowed for considerable political horse-trading at the margin – awarding a few more allowances to a particular plant in a particular district – to win support for the overall policy. The literature on the SO2 allowance trading system identifies the free allocation of allowances to the economic 'losers' in the SO2 allowance-trading program – high-sulphur-coal-intensive power companies in the Midwest – as an essential factor in the program’s enactment.

Unlike most earlier pieces of landmark environmental legislation, the CAAA of 1990 was not precipitated by a ‘crisis moment’ (the most memorable was the Cuyahoga River catching on fire, leading to the Clean Water Act), which may have given policymakers greater latitude to implement a flexible and entrepreneurial policy, rather than resorting to a more rigid traditional approach.

In many observers’ views, the Acid Rain Program flew ‘under the radar’, in terms of the attention it received both from the public and environmental advocacy groups, most of which were more concerned about changes to other portions of the Act, unrelated to the SO2 trading program.

What can the Acid Rain Program teach us about climate policy?

The Acid Rain Program, while not without flaws, is viewed as a success by almost all measures. Certainly it demonstrated that broad-based cap-and-trade systems can be used to achieve significant emissions reductions that firms can navigate and regulators can enforce the compliance requirements of such systems, and that giving the private sector flexibility to pursue a range of abatement options can simultaneously protect the environment, stimulate innovation and diffusion, and reduce aggregate costs.

The recent climate debate has taken place in a political context that is much different than that of the CAAA of 1990. Deep ideological division dominates today’s dialogue; the two major political parties were much less ideologically polarised in 1990. The large bipartisan majorities of 1990 appear much less likely today.

Recent hostility toward cap and trade in US climate legislation may reflect the broader political environment of the climate debate more than it reflects the substantive merits (or demerits) of market-based regulation. In other words, congressional hostility toward greenhouse-gas cap and trade appears to have been collateral damage in a wider set of policy and ideological battles.

Ironically, the cap-and-trade model seems especially well suited to addressing the problem of climate change, in that emitted greenhouse gases are evenly distributed throughout the world’s atmosphere. Emissions reductions anywhere make identical contributions to helping alleviate the problem, and there are no pollutant concentration hot-spots.

The sheer number and variety of greenhouse gas-emissions sources heightens the practical difficulty of developing a comprehensive and effective command-and-control approach, and magnifies the cost savings that could be achieved by enlisting the market to find the least costly abatement options.

The stakes for a broad-based GHG policy – economic, political, and environmental – are much higher than they were for SO2 policy in 1990. While the debate over federal policy to address climate change is currently in hiatus, the lessons of the SO2 allowance-trading programme will prove useful and relevant to future deliberations about climate change policy when the time arrives for serious reflection and action.

This column summarises the Harvard Environmental Economics Program policy brief “The SO2 Allowance Trading System and the Clean Air Act Amendments of 1990: Reflections on Twenty Years of Policy Innovation”, published in revised form as Chan et al. (2012).

Originally published on www.VoxEU.org. Reproduced with permission.

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