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&EPA
United States
Environmental Protection Air and Radiation EPA/400/1 -91/007 A
Agency (ANR-445) April 1991
Acid Rain Advisory
Committee Meeting:
February 20-22,1991
Allowance Trading
Issue Papers
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HEADQUARTERS LIBRARY
ENVIRONMENTAL PROTECTION AGENCY
WASHINGTON, D.C. 20460
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CODE
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ALLOWANCE TRADING SUBCOMMITTEE
v< PAPERS FOR FEBRUARY 20-22, 1991
Ajenda for Allowance .Trading .Subcommittee
Minutes from January 28,1991 Subcommittee Meeting
A16
AS -
A9 - K
S
A17 -
A18 -
A7 -
A19 -
A20 -
A21 -
isignated Representative Discussion Paper (EPA)
Lscussion Paper on Grace Period (Tim Method)
Pooling of Allowances and Book Closing Period
(rilliam A. Badger)
-The Book-Closing Period Under Title IV (UARG)
isue Paper on Multi-Unit Allowance Pooling for
'impliance (EPA)
(reprinted from January subcommittee packet)
>y Issues on Opt-In Provisions, Title IV
tction 410.(Ann D. Murtlow)
•printed from January subcommittee packet)
Marketable Trading Allowances for SO,:Issues
Concerning Information Provision (Robert Hahn
»«<* Al McGartland)
^PA)**in AUowanc* Tracki«9 System Accounts
Tfce Allowance Transfer System (EPA)
(zeprinted from January subcommittee paeXatt)
e Tax Treatment of Emission Allowance*
onald W. Klefer)
Idantification of Emission Allowances
(Commonwealth Edison)
Dei
of
Loitte ft Touch* letter discussing serialization
emission allowances (Charles D. Muha)
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2
12
17
19
28
39
47
50
63
75
86
87
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Februarv 20th
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S — 10:15 aa
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11:4!> - 1:00 pa
1:OC - 2:;
2:3C
2:42
4:45
9300
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* 4:45 pa
irv 21st
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ALLOWANCE TRADING SUBCOMMITTEE
DRAFT AGENDA
•*»
Raaada Renaissance Hotel
Washington Dulles
13869 Park Center Road
Hemdon, Virginia
Announcements; Review Agenda
Designated Representative
(Paper A13)
Grace Period; Allowance Pooling
(Paper* A14, A1S, A16, AS)
LUNCH
Election Sources
(Paper A9)
Trading: Panel
—Chicago Board of Trade
—Goldman Sachs
—Abt Associates (Paper A17)
- 5:00 pa Summary
O'Connor
EPA
Goodman
Method
Badger
Sant,
Murtlov
0*Connor
Announcements; Review Agenda
Allowance Trading Scheme
—Coming to closure on basic
trading scheme
(Papers A17, A18, A19, A20, A21, A22)
O'Connor
EPA
Allowance Trading Scheme continued
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Notes from the
Acid Rain Advisory Committee
Allowance Trading Subcommittee Meeting
January1 28, 1991
Preaentation of Auctions and Sales
Liada Reidt Criteafield, BPA Office of Air and
Radiation, Office of Atmospheric and Indoor
Air Programs
Allowance Auction
EPA opened the meeting by reporting on two decisions that were
made since the last ARAC subcommittee meeting. First, the auction
will be structured as a discriminating price auction. When asked
if the statute required a such an auction, the Office of General
Counsel (OGC) noted that the more natural interpretation of the
statute does imply a discriminating price auction.
Second, the private allowance auction will be tagged onto the
end of the EPA allowance auction. In response to a question, EPA
established that private sellers will .not have the option to
reconsider their minimum price after the EPA auction is completed.
fefe*
EPA proposed that the names and bids of all auction
participants be published at the conclusion of each auction. Many
participants agreed that because EPA and the purchaser were
partners in a "recorded, transfer," the names and bid prices of
successful bidders would have to be disclosed. However, there was
no consensus over whether the names of losing bidders should be
published. Participants were presented with four options on. this
matter: disclosing all losing names and bids; publishing names
only; publishing bids only; or publishing moms and a distribution
of bid prices. Several aspects of this issue were discussed.
• OGC pointed to a Department of Interior auction which sets a
precedent for this proposal. After the Interior Department
conducts a coal lease auction, all bidding parties* names and
bid prices are disclosed.
_. ^ft^^^ft^b ^m^^^^^m^^^^^ ^^^*^m £ ^^»V^»^« ^M^* ^^^b^^V 4 ^k
•~ 3DBB cossiencorSf mcifUQing yuunc
felt that all aspects of the auction should be open, and that
EPA must have a compelling reason not to disclose all of the
•'"*'*'»•'•*•*'*" It lias.. OGC noted that there is no
confidentiality clause in the legislation, and suggested that
if disclosure might be required anyway < perhaps through the
Freedom of Information Act) EPA should publish everything
right from the beginning.
- Publishing the names of losing bidders would aid regulators
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in determining whether utilities were,.. making reasonable
; efforts to buy allowances.^ •;.£?£•.*..*£" '"• !;"" cl"
.- one participant .suggested t&at'irp&i^ti^se ofrthe'^auction
is "jump start" the private market, then EPA should publish
as much information as possible. ..However, .another, commentor
was more cautious, noting that IT*"the names ofv Bidders in a
single price auction are published, it increases the potential
for gaming (strategic bidding, etc.). Information from such
an auction 'would not provide an accurate* picture of the
market. He suggested that EPA consider what kinds of
information it and other agencies want from the auction
results, and determine whether publishing the names of losing
bidders would alter the effectiveness of .these results. There
was no response to an EPA query as to whether publishing the
names of the losing bidders would change the behavior of
bidders.
• One commentor suggested that publishing bid prices would be
beneficial by letting potential actors in the market know what
prices others were offering to pay. But another participant
stated that this "asymmetric disclosure" of information
.benefitted the sellers only, and would tend to drive the price
of allowances up.
- Still others felt that this was not an important issue,
suggesting that if the losing bidders did not want their
identities known, they could simply use a street name or
broker's name on the bid form. EPA would allow this practice.
* Finally, EPA noted that it would be possible to design a
system which would intentionally avoid collecting the names
of losing bidders. '• There was no discussion on this proposal.
of tlM
auction could be held early or late in the calendar year.
An early auction would facilitate planning (utilities would know
in the flxst ^mx^MP oC Ultt yw Dow wvf allowances they need to
buy in the private market) and would proceed the direct sale. With
a later auction, the direct sales program would take place early
in the year. However, if the direct sale is discontinued (if less
than 20% ot the allowances are sold 2 consecutive years in a row)
unsuccessful bidders .would have no place of last resort to buy
al.l0MSA0es}« AsflajHUews sf V&SA ££• auction takes olace^ any
withheld allowances that are not sold are returned at the end of
the year.
The general conclusion o? 15ie discussion "was tjieft fm
auction would be better than a later auction because this would
stimulate the private market for allowances and facilitate
planning.
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• '- • •».*:.' ' ' •• '•' '4
Payment fog Allowances
EPA proposed that certified or cashiers checks be submitted
with the auction bids to pay for allowances. One commentor
expressed concern that if certified checks..were indeed required,
the bidder*s funds would be tied up fps-ran extended amount of time.
He suggested that alternative guarantees such as letters of credit
be accepted as well. EPA, however,.. noted that accepting letters
of credit does not advance EPA's objectives -for requiring payment
in advance: to immediately verify that the money to pay for
allowances is actually available, and to limit the time such funds
remain outstanding. If EPA accepted. letters of credit another
bureaucratic step (verifying the legitimacy -of the guaranteeing
bank) would be created. EPA also expressed concern for the forced
sellers of allowances. Although the statute allows EPA has 90 days
to return to proceeds of the auction to sellers, it would like to
complete that transaction without delay. Requiring certified
checks enables EPA to finalize the transfer as soon as possible.
One commentor was concerned that IPP's who wish to participate
in the auction may not have access to the required funds before
they come on line.
. The subcommittee was interested in pursuing possible
electronic means of securing the money for the bids (in lieu of
actual checks), so that no interest would be lost on these funds.
EPA proposed that advanced allowances also be peid for at the
time of the auction. There are several advantages to such an
approach: it prevents defaults, facilitates trading, and eases the
administrative tasks. There was no discussion on this issue.
the Mietlon
EPA requested that the committee make recommendations on which
organization (s) EPA might contract with to conduct the auction.
Administrative costs would be paid by EPA, not by auction fees.
EPA verified that the Department of the Treasury is not willing to
administer the auction. The Chicago Board of Trade representative
expressed interest in conducting the auction.
In order to obtain a written guarantee for allowances,
must meet the definition of an ZPP and must demonstrate that it
meets the criteria outlined in the statute. In response to
^aammit i *"»^ gp^ ^•ahaM^^Ad fc^££ ****^ U£4££fi9 J*1"tM**^ff^^'E J-» j? f OXCB
for the entire life of the project. In addition,' the IPP may
reserve streams of allowances. Several addition matters were
discussed regarding the guarantees.
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The group appeared .to agree that fche application-requirements
are detailed enough to prevent frivolous applications.
The discussion focused on whether EPA-should take measures to
prevent ZPPs from reserving more allowances than they need. ^
EPA suggested that it could require a non-refundable deposit^B
from IPPs^uras jts--done in the direct tsalesj-y program, one^^
commentor suggested that a deposit -or • downpayment would
discriminate between ZPPs. that^had immediate access to funds
and those that didn't, and felt requiring a deposit could set
a "threshold of participation." Another participant agreed,
adding that it might not be appropriate to apply one aspect
of the direct sales program but not another.
One commentor noted that EPA could evaluate the reasonableness
of an ZPP's request for allowances by making a simple
computation using information from the application. The size
of the plant is limited by the PSA and the emissions per mmBtu
are limited by the statute. Multiplying these figures
provides a general indication of the number of allowances the
utility might need. And, if EPA felt it were necessary, the
number of reserved allowances could be subsequently adjusted
when the permit is granted.
One participant proposed that the allowances reserved by ZPP
written guarantees be credited against the direct sale spot
allowances first and then, if necessary, against advance
allowances. This would leave advance allowances to be sold
in the direct sale. Another participant suggested that the
guaranteed allowances be credited against spot and advance
allowances evenly, reasoning that since spot sales can be
banked, this method would give utilities greater flexibility.
EPA proposed that there be no cot off date for applications
to the written guarantee program, even if the direct sales
program is terminated. This would provide a source of last
resort to IPPs that had made aiiaiiuementa for allowances in
the private market, should such negotiations fail.
EPA proposed that the direct sales program begin soon after
the auction has taken place. Under this program, applicants will
be sold allowances for $1500. Applications for allowances must be
approved, and a 30% deposit paid at tiie time of application. The
remaining 50% of sale price must be paid within tf months of
approval. Should requests for allowances exceed availability,
completely paid for within six months would be sold to the next
applicant oa the list. Should an application be approved within
6 months of the date when the yearly sale is scheduled to end, the
purchaser must pay the remainder due before the sale ends. No
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comments were received on this issue.
• ••«• •-" ..*v • -'..I-.
- jy .
"allowance Tranafeg
Speaker* Xeaoa smith}*i;PA Office of*Air mad' ';i ' ' '
Radiation, Office of Atmospheric* and Indoor
Air Programs
»
This presentation, based on paper A-7, was Intended to cat
iwa« diacuajion on the mechanic* of the allowance transfer system.
f« «» W»< bu^does
lasio laformatioa on Tradiag
Trades can be aade among designated representatives and
P«son (altnoiiga initially only affSted uni& w^d Ia7e
systea accounts, any person could open an account.
market participants would be free to work any dS
anyone they want.^0nly wh«> trading parties waS?
be officially recorded would they need to notify EPA,
Hotifying EPA or its agent could conceivably be done in
writing or electronically. .For written notification, ZFA would
develop a form for reporting, the •allowance transfer form". This
fora would need to contain certain minimum information (which EPA
would need for recordatlon purposes). The seller would need to
fill out one section and the buyer another section (if the buyer
does not already have an account: in the tracking system, he would
also need to provide a new account form). For electronic
notification, the form would be put in a computerized format with
personal identification numbers (PXVs) substituting for signatures.
Sither way, once EPA receives notification a data entry team
would; make sure the form is correctly filled out, the information
is complete, and the seller has sufficient allowances to cover the
transfer. If there is a problem and EPA cannot record the
transfer, then both parties would be notified as to the problem.
Assuming no problems, recordation would take place by debiting the
trading parties would toow i
on
Some members of the subcommittee commented that:
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Commercial transactions need to be reported in advance of vhen
,. trading t partis may otherwisev, choosfir£o nc;tify:-EPA of .the
transfer., X.EPA should require transfet^^seportlhg as. soon as
an agreement is reached (the point" where the seller is
committed).
EPA should require full disclosure of ^information pertaining
to the transaction including price information.
Brokers and other "non-emitters" should *^e licensed or
certified to provide assurances to the market.
'<•:.'
• • • • ' . . *~ j_j. - .'
Presentation of "H*tion«l Allowance Trmeklncr
Speakert Alex Salpeter, BPA Office of mix and
&*41atioa, Office of Atmo«pfeeri« aad Indoor
The system, as envisioned, will be an information clearing
house for buyers and sellers of sulfur dioxide air pollution
allowances. The system tracks allowance transactions and
balances of holders, but does not actively match sellers and
buyers. The system's information will be available
electronically to the public and is intended to facilitate)
allowance trading. Mr. Salpeter demonstrated a few of the
primary menu options. The final version of the system will
reflect the EPA1 a regulatory requirements. This version is one
possibility.
view Option
(1) Shows total allowances held toy every
ailerons* holder
(2) For each allowance hr*****? (users aad broker*
alike), shows initial allowance allocation,
data on each transaction including name ot
transaction partner, and current allowance
balance
Add/Edit Optioa
<1) Allow imese to list of alloMsaaa teldac* -
information fields included name, address,
ID*
(2) Allows access to list of transactions -
information fields included number of
allowances traded, names of buyer and seller,
allowance balances of both
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(3) Shows 'mass balance1 across holders, i.e.
total-allowances of all holders- •-•--• c*> • •
•'• .? • •
Questions , ,
i . • . ; .,• i • • - .! : ' " •' > • •. ?
Is there a way to identify date or year that an allowance
was allocated or traded? A: This capability will be added to the
final version of the system.
Does the system accoaaodate trading of partial allowances?
A: Ho, only whole allowances.
Does, the system .track .individual allowances? A: No. While
individual transactions are recorded, there is no information on
the identity of individual allowances.
Speaker * s additional comments
Allowances are allocated to individual "affected units*1, not
to integrated groups or pools. There are approximately 2400
"affected units".
The system also trades users' actual emissions (reported
quarterly) and shows allowance tnlan^t^ net of these emissions*
The system would allow buyers to look for potential
allowance sellers.
Emissions data is expected to be updated on a quarterly
basis, while trading information will be updated in "real time"
(i.e., as each trade is recorded).
Ideally the system will be eveilebl« electronically.
Audience comments
toBR&iftsy function could be "atscoplisJted by carrying
a holder's allowance balance forward from one year to the next.
It does not seem that a separate banking system would be needed.
Systems participants might want to restrict transaction
price information, revealing only auction prices. Revealing
decrease market competition.
The system does not communicate market basis^, i.e. whether a
user will need more or xewer allowances TIJQR qudr uiu caoTi tx, TC&
last quarter. (Confirmed by speaker)
Use of a 1-900 (fee based) phone number might be appropriate
for system access.
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Year-end allowance-emissions account settlement should not
be automatic. There should be an interactive period after the
year-end*a^pwance-emissipn, .aecoqqgL.flr*.. 4tftta& *o,-tha,t,.u,sers,, .
can appeal discrepancies be-fore final EPA action. £s~takeo7. (This
comment constituted a lobbying effort from an industry rep and
was sott directly relevant ..to the d^ussJ^jpf ..the ay stamps ,^
capabilities*) .,.,,. ,.u,- .„.,.*,- locat fcr" iciir" "~V.
•'I . « r.. .
* -Add a bulletin board to the system ;toafacilif;ata . ..,.T ...
communication and exchange of other pertinent; information. "
*" ' v of> c . •• • .
Allowance Veoliaa
• Joe Goffaan of the EPA. initiated an audience/speaker
discussion of the implications of • pooling* or the practice of
sharing emissions allocations between users. In aggregate, pools
of users balance their total emissions against their total
allowances and agree to trade allowances to meet EPA regulations
on a disaggregated basis. EPA's preference is not to regulate.
pools of users in aggregate; it would prefer each individual
member of a pool to meet EPA regulations.
The Mr. Goffman indicated that the systea may need to .,
address an option to represent pools as aggregate units. Pools'
ideally would want to trade allocations as a group and would
theiefuie have a need to be represented in the eystea as a one
unit. The systea might accommodate a pool or its designated
representative via one account which would list the allowances of
all the pool members. The pool would appear oa the systea as one
user with one balance. At year-end, the 'account would
disaggregate the balance of allowances so that regulators could
check individual allowances against individual emissions.
An alternative would be to require pool members to be
represented on the systea individually. Trading activity with
users outside the pool would have to be executed through
individual pool member accounts and trading between pool members
to comply with emission regulations would require individual
records.
Two issues) were raised regarding pooled representation on
the systea. The first was that some steps would be needed to
insure disaggregation to members of compliance and fine
liabilities) and of annual allowance allocations. The second
questioned whether pooled representation wwUd allav auditors
track individual member allowance balances and transactions.
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Reulatory -
'Speakers* Bradford L. 7«rgu»on, Hopkins' i gutter
Philip R. O'Connor, Palmer Bellvue
Corporation
'Patrick J. Condon, Arthur Anderses, -national
Diraotor of the Baergy Management Group
Mr. Condon and Mr. Ferguson, presented their thoughts
concerning potential accounting and tax treatment of allowances
under the acid rain title.
An allowance is an intangible property right and is treated
as a separate right for tax purposes. A "potential problem lies
in the fact that the right is subject to immediate transaction
but is useful generally only at some point in the future.
Therefor* tiara will £• tax asymmetries between buyers and
sailers.
Legislatively allocated allowances would have, as issued,
zero cost basis for accounting and tax purposes. Even after
emissions have been released, or saved via control mechanisms
(e.g. scrubbers) , there would be no accounting or tax basis, the
east of control mechanisms notwithstanding.-
The accounting and tax bases would be different for
transferred allowances (those traded on a secondary .market) . The
speakers dealt with a number of issues, first from the
perspective of an allowance purchaser, t&ea from the pezspecliTB
of an allowance seller.
The accounting and tax bases for an allowance purehaaad for
cash would equal the cost of the allowance. This cost would be
tax deductible when the allowance is used and would be a debit to
the expense account, a credit to the cash account.
There would be no accounting or tax basis for an allowance
purchased through a forward or opflnn centrist ™»*41 tb* contract
is executed. (Both are contracts for cash payment at a later
time for future allowances.) At the tiae of execution th« bases
would be the sam« as for a cash transaction. However, the price
of the option would constitute the accounting and tax bases for
the initial option transaction.
The accounting and tax bases for an allowance sold for cash
would equal the resulting gain or loss, as income. A loss might
be thought of as a capitol loss or a normal loss.
There would be no accounting or tax basis for an allowance
sold through a forward or option contract until the contract is
executed. At the time of execution the bases would be the same
as for a cash transaction. However, the gain or loss on the
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price of the option would constitute an accounting and tax bases
for the initial option transaction.
Finally, seller and buyer face the sane accounting and tax
bases in some circumstances:
(1) A futures contract that is marked to market: the
basis would be equal to the appreciation or
depreciation of the contract.
(2) Bartered allowances would typically face zero
basis.
(3) If they are bundled with other goods, allowances
would be valued either at the market or as the
_. ----------- residual between the transaction price and the
market value of the other goods. The allowance
part of the transaction would be treated as a cash
sale for accounting and tax purposes. See above.
(4) There are no expected consequences when the
allowance is recorded with the EPA.
The speakers commented on the recognition of use of
allowances under different allowance portfolio conditions. When
a portfolio of allowances consists solely of legislatively
allocated allowances, the accounting and tax bases for the use of
the allowances would be zero. When a portfolio consists of
allocated and yuxuliased vllowices tvhich implies diwm
individual bases) it is unclear what basis should be used for
accounting and tax purposes. Average cost, straight line
composite depreciation/ amortization and individual identification
(either Last-Xn-Pirst-Out or First-In-First-Out) all have merits.
Xn concluding comments the speakers mentioned that
accounting and tax bases were subject to the public utility
commissions* treatment of allowance related gains or losses.
regiilifory tedla* wmtU &* XUEaly te ielley their
In terms of tax and accounting issue* , the one question for
EPA to address is whether serialization of allowances is good for
the market*
10
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ISSUE PAPER ON THE DESIGNATED REPRESENTATIVE
Several provisions in^ Title W? particularly those governing
the management of allowances and the permitting process, require
that the owners or operators of an affected unit act through a
"designated representative" in connection with such transactions.
This paper will enumerate the eleaents or mechanics of establishing
the designated representative for each affected unit, and will
outline the representative's responsibilities. This paper will not
address any issues involving legal interpretation nor will it
address issues involving the liability of the designated
representative or individual owners for a unit's non-compliance.
Rather, it will simply discuss the meet effective way of
implementing the facial requirements of the statutory language.
Z. Statutory Provisions
Section 402(25) defines "designated representative" as:
•a responsible person or official authorized by the owner or
operator of a unit to represent the owner or operator in matters
pertaining to the holding, transfer or disposition of allowances
allocated to a unit, and the submission of and compliance with
permits, permit applications, and compliance plans for the unit."
As a prerequisite to the issuance of a permit, section 408 (i)
requires that the designated representative of the owners/operators
of the unit file a "certificate of representation with regard to
matters under this title, including the holding and distribution of
allowances and tfie ^proceedm of 'trvssactdLozts iuvolving allowances."
Zn the case of "multiple owners", the certificate must state: "(1)
that allowances and the proceeds of transactions involving
allowances will be deemed to be held or distributed in proportion
to each holder's legal, equitable, leasehold or contractual
reservation or entitlement, or (2) if such multiple holders have
expressly provided for a different distribution of allowances by
contract, that allowances and the proceeds of transactions
involving allowances will be deemed to be held or distributed in
Finally, section 4O4
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- a- -
person for the purposes of the allowance tracking system and the
permitting" process. Second, it 'provides - certain projection for
minority-share owners of multiply-owned facilities.
Such protection lies in the fact that all the ownes* of a-unit
must come to a; decision as to the identity eof- the* designated
representative and as to the holding *nd/ or distribution of .-fehe
allowances allocated for the jointly owned unit. Only after .those
decisions have been made, can the designated representative. make
the required certification and can th« permit be issued for the
unit. In practical terms, any individual co-owner can prevent such
decisions from being reached until the owner is satisfied with the
terms of the decisions. At the same time, since it is in every co-
owner's interest to secure an operating permit for the unit, all
owners will have a strong incentive to reach agreement so that the
certification may be submitted, leaving disputes to be resolved
outside the ambit of the acid rain program itself.
The regulations implementing these provisions should be
designed to reflect these objectives. To insure
the credibility of these incentives (as well as of the allowance
tracking system itself) , the regulations should make clear that
allowances will not be permitted to be transfered to or from a
unit** account in the absence of a designated representative.
Accordingly, the designated representative for each unit must
submit a statement identifying him- or herself as such. Such self-
identification must also include a certification that
specifies the allowance holding/ distribution arrangements made by
and among the unit owners. The designated representative must
submit a list Identifying each person with an ownership interest in
the unit, as defined by applicable commercial or corporate law
(where not otherwise specified in the title) , and certify the
existence of: 1) an agreement legally binding on such persons
reflecting their decision nominating the designated representa-tive
and 2) an agreement legally binding on the owners reflecting their
decision as to the arrangement of the holding and/ or
distribution of the allowances allocated for the unit.
Sinc« the legal and economic relationship between and among
co-owners of units are already in place almost by definition, any
more specific regulations, such as those prescribing the methods by
vftien ma enmei a*el*leA* «* mad*, ongoing r**p«r*iMli^i*s between
and among co-owners or procedures for private dispute resolution,
would be unwarranted. In addition, more prescriptive mandates
would be superfluous. Siaplv requiring that co-owners undertake a
decision-making process that concludes with a legally binding
nomination of a dee ignited representative and with a resolution as
to the holding and/ or distribution of allowances captures the
dynamic of mutual restraint and cooperation established by the
statutory language. Further requirements would not seem to add
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.
appreciably to the protection/given minority-share owners, but
could unduly interfere with private transactions among co-owners.
III. Certification Review and Dispute Resolution
The apparent objective of section 408 (i) and the intent of the
certification discussed above are to rely on the decision-making
process among co-owners to give certain procedural protection to
minority-share owners. Conversely, both the statute and the need
to insure that the allowance allocation and permitting processes
proceed expeditiously so that all units* allowances will be
available to the market suggest that EPA should play no role in
resolving disputes.between owners, and should be able to rely on
the facial adequacy of the certification and supporting
tt inn*
To minimize the likelihood of unresolved dispute* persisting
into the EPA certification process and to allow the Agency or
permitting authority to rely on the certification, the regulations
should specify that before the representative is designated, the
would-be representative must notify by mail and by publication
those with ownership interest in the unit. The regulations should
specify a minimum period for objections to be raised with the
designated representative and the co-owners following public
notice. As part of the documentation submitted for certification,
the designated representative would have to include certified mail
receipts and copies of the publications in which notice was made.
This requirement would assure a high degree of likelihood that the
decision-making procedures implied by the other documentation
requirements — i.e., legally binding nomination of the
representative and disposition of the allowances — had in fact
Finally, the regulations should state that the EPA will not
take a position on any claim or objection presented in connection
vita th* designated r«pr«seatafcive cert
prescribed procedures were followed in the designation process. In
the event of any objection, the EPA simply will not accept the
representative's designation; as a result allowances will not be
permitted «to be* transfered to or from the unit's account, permit
applications will not be accepted or approved and permits will, not
be issued,, until the parties resolve the dispute and the objection
is lifted. Again, this comports with the statute's approach of
establishing procedural protection rather than substantive ones for
minority-share owners, and of requiring the parties themselves,
that involves invoking commercial law and/ or litigation) .
IV. Functions of the Designated Representative
Section 408 (i) uses the phrase "certificate of representation
with regard to matters under this title" and also requires the
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- 4 -
b
certification of a designated representative even for units with a,
•ingle owner. Together with the apparent objective of protecting
the interests of all co-owners by creating among them a dynamic of
mutual restraint and cooperation, this reinforces the conclusion
that all transactions, beginning with allocation of allowances to
a unit's account, that involve directly engaging the allowance
allocation process, the allowance tracking and transfer system and
the permitting process must be undertaken by the same individual —
the designated representative — for each unit. Requiring the same
person to be responsible for each of a unit's transactions with
regard to these aspects of the program can only make the allowance
system more efficient and reliable.
At the same time, since accounts can be created by any person,
non-designated-repreaentative co-owners who happen to have separate
access to allowances or who hold allowances as a result of a
distribution among co-owners, can create their own separate
accounts .to manage such allowances. To avoid ambiguities, the
allowance tracking and compliance systems will require that any
allowances to be used to meet a unit's emissions requirements must
be transferee to the unit's account; allowances held in a co-
owner's account would not be applied to the unit's emissions unless
they were transferred into the unit's account.
Below is a preliminary list of transactions related to the
allowance system or permitting process which should be carried out
by the designated representative of a nnit. As noted above, this
list does not necessarily reflect conclusive interpretation of
ambiguous language nor does it include provisions involving issues
of liability. In addition, it is assumed that well before December
31, 1992, when the penultimate list of Phase II allowance
allocations is to be published* as required by section 4 03 (a), the
designated representative for each unit will be established and
will be able to present changes to the preliminary list to be
published at the end of 1991, as required by section 403 (a) , and to
Fractions or TBS DESIGNATED REPRESENTATIVE
1. Hold/distribute allowances allocated for each unit.
2. Transfer allowances).
3. Establish allowance) pools.
S. Held (in unit account) allowances to cover unit emissions.
6. Submit binding compliance plan and permit application on timely
basis and certify in compliance plan that unit account will hold
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; • ' ,K **.. '••*'. «/' *-r
allowances to cover unit emissions or specify alternative method of
compliance (including reduced Utilization of Phase I unit).
7. Hold unit permit issued pursuant to approved compliance plan.
. ' " ~ • • • »* •
8. Make designated representative and allowance distribution
certifications described above.
9. Petition for adjustments to unit's baseline for allocation
purposes.
10. Make substitution application for Phase X units or application
for qualifying Phase I technology compliance extension.
11. Petition the permitting authority for an alternative NOx
emission limitation in its permit.
12. Petition the permitting authority for NOx emissions averaging
over the units in question.
These functions would not preclude a unit's owners/operator
from liability for m unit's non-compliance.
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BXJ
fraca pariod would Allow utilitiaa pU
oconoaio condition*, allowance
malfunction* near taa oad of a calandir yoar *oaa additional tiaa to
sad by unplanned outage*, bad
irkat failure*, or pollution control
adc
aalSAion* vita ownad allovancaa. Tai* fraca pariod would ba aa
uity to Avoid iapoaitioa of taa Act'* azca** eai**ioa panalty and
offjae proviJion* if A unit*a eai**i0na 'exceeded taa eai**ica
raauiraaeat* during taa calandar yoar.
f* •
It U
uafa
of
tsat A gxAca pariod i* aaialy to account for
circaaataacaa or ta daal vita minor diffaraacaa
illowaacaa at taa aad of taa yoar. A fraca paai<
a unit'*
or
•mi**io»s
ia no« tao
Many horo inciirproted ta* Coaf orone« CoaMitto* Joint StAt
iatane to Allow A.poriod of fiao Afto« tao and of tao
indie«t«
loBrtag y«ar
fax Affactad unit* to parcaaaa praviou* yoar or aarliar allovancaa to acaiova
taa loojiAlativa lanouaga and taa Conforaaoi
aloa ba iasarpracad ta oaly allow Affactad uaita ta
traaafara aad for I9A ta rocord allowaaca traaafara aftar taa aad of a
ir. All cradaai would teva ta occur baf ora taa aad of taa calanaar
(Bidaigat OAirawDar 31). tni* papa* doa* nee irtrtrata taa laaal iaauaa and
taat taa act caa ba iatarpratod to allow a raaaoaaala pariod of tiaa
aftar a calandar yoa* aa A fraoa pariod.
A diJCuAAion of aavaral ijauaa aaaaciatad with any fraca pariod follow:
•d of tha
providad by tfta Conf aranca Raport
off
10 day* « Aiaea) 9«ctioa 411 (bl roqoiroa aa affactad unit to
, propaawd plaa ta taa OA and tao Staea to aeaiov« ta« roquirad
witaia aixcy daya of taa and of taa calendar yaar.
•* ^aiAaa ^A Aa>
ta raviav iea aaiaaioaa data and to aogociaea salaa of allowaacaa
AUbait tradaa to OA for racordacioa.
and
13 ta 30 daya to rawiaw sabolttad CEM and
oeaar aaijaioaa data (aaauaad aubaittad within 30 daya aftar aad of
citonrfAr yaar) » ta raeard araco poriod traajf ora, aad to dataraiaa which
affactad unit* auae aubait propo^od piano for axcara amiaaion of faata and
waica unit* aaac pay axcaja aviosioa panaltiaa.
A fTAea poriod of 30 dtyo ia A raaaonabla pariod of tlaa. It would not
joopardira EPA or taa Stataa ability to of faetivoly aaforea taa axcoaa
offaae proTiAioa jtartiao; (0 days aftar taa and of taa calandar yaar.
-------
i.
wt» A oucs rsatzoof
A cnssil nmnj-,,to..provide eertain-^aetifluaatdcmssetotiCd Be" included ~£n Che ';">
compliance plan of any unit which would like to have the option of using a
trace period to -true up" aftoe.,.th« and: of tbe.,(d),(f), Section 409* Section 410 etc.}, may have detailed .
compliance plans. It found not to comply with the specific provisions of
their compliance plan* a grace period may not be appropriate. The finding of
anmnnmpl iaaqsj by «f* «* ^ft» 9t*t* could then negate any transfers of
allowances after the end of the calendar year for the purposes of
for that given year.
Per Section 40S> the use of any je^mamsm acLec e* earn ^emc tvt «i£*a it is
allcatsjd is prohibited, therefore, allowance transfers involving previous
year
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Paper A15
DRAFT DISCUSSION PAPER
ACID RAIN ADVISORY COMMITTEE
ALLOWANCE TRADING SUBCOMMITTEE
POOLING OF ALLOWANCES AND
BOOK CLOSING PERIOD
Maryland Public Service Commission
231 East Baltimore Street
Baltimore, Maryland 21202
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. DRAFT DISCUSSION PAPER
POOLING OF ALLOWANCES AND
BOOK CLOSING PERIOD
•' • •<.(. : |ntrodtictiQti ;" • .
Congress had three main objectives in enacting the sulfur dioxide emission
reduction requirements of Title IV of the Gean Air Act Amendments of 1990. First,
Congress wanted to achieve a reduction of sulfur dioxide emissions of 10 million tons from
1980 levels. Second, Congress wanted to achieve the •**j««*"n reduction goal in the most
* . •
economically efficient way possible. Finally, Congress wanted to ensure that achieving the
emission reduction goal would not jeopardize the reliability of the nation's supply and
distribution of electricity.
To accomplish these objectives. Congress established an emission allowance
trading approach that relies primarily on private marked mechanisms to bring buyers and
seflen together. The allowance trading system is supposed to encourage the development
of a THTJf™! market in allowances that wffl not only ensure frnffrfpp reductions, but
»-
The major objective of the amendmrntt is to achieve the mandated reduction
in acid deposition precursors at the lowest possible overall cost consistent with doing the
least harm to the ecfmomtet of the states served white assuring continuation of the adequate
and reliable service that oiflity customers expect. A large past of the reason reliable service
has'been maintained through many unforeseen events such as tornadoes, ice storms, heat
waves, fuel supply interruptions, and equipment Mures is that the eastern interconnection
has had a program of mutual assistance hi place for many years - with a high degree of
notice, WWxnrt this flcjril^, to same k^ of reliability
high price through higher levels of installed generating reserves.
Looking to the future, the difficulty of coping with contingencies will be
compounded due to the stringent new emission regulations. In other words, if something
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\-"T'~ 'r'rimJ^V^jiriii' Nf^V^£-»
goes wrong, the generating units needed to.overcom^.the con*$agency wflj not only have to
able to operate, but wffl need *aIIowa^cesM,-,
-------
commodities or services. The regulatory mechanism is already in place and working
effectively to insure that no such abuses occur.
The market for emission allowances should be nationwide to insure the widest
••i '."•"'• * ' •
possible market and thereby preclude the ibflity of any one participant to manipulate the
market Further, broken and dealers as well as futures and options markets are necessary
to allocate risk to those most willing to take it and to reduce transaction costs. Initially, to
insure the proper functioning of this mnrtri, EPA should allow at least a 90 day true-up
period at year end and thereby avoid hoarding as a hedge against an unplanned outage.
T3us «dU insure compliance At tte Joweat cost
In order that the nrriuinni trading market cm be a viable tool for -utility use
and dean Air Ao compliance, that market must be allowed to develop with as lew
constraints as possible.. Regulatory constraints should not be imposed upon emissions
trading within a pcmwpcc^ holding company or region. The market would thus be allowed
to develop in whatever manner was most efficient Pooling of allowances within and
ffld TBK?! *"•"****"! «JIffaM be
If the emission allowance market is permitted to develop freely, utilities will
be able to purchase necessary allowances economically whether trading within an allowance
pod or purdiaiiiigfrnma nationwide narket Power pool rales and guidelines win continue
igmg power and allowances where necessary. This may
necessitate modification* to easting rules or guidelines. However, power pools have been
able, in the past, to modify or change their rales to insure efficient operations. The self-
a
attend change, including the introduction of emissions trading. Thus, a market mechanism
w3 Tjeit rationalize the eSects of compliances pofide* on the emissions trading market
whether within a power pool or an individual utility.
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"ALLOWANCE POOLING* AND "BOOK-CLOSING"
UKPgR TITLE IV QFT *
.•••». •.!!• • •••»*•
*13l '
m** M '. * *f '_3B» 9 ^ * * • *"i "*.*•?• * LR _^?*» .«. -"•-**- «*** ' it
'Allowance pooling^ Is contemplated by sectftin 403(d)(2) of the Act, which
i ,
provides that ."the total tonnage .of emisiifgu in any.:calendariy^ar («?/piiatf^ at the
Thcrmf) fram nil imfri fn.,. a-mffity rjitrrn, powrrpoot or lUlbwnnrr pnofiifrccmciiti ilull
not exceed the total allowances to such units tor tha calendar year concerned." A "book-
F ' ' *«f • ""
doaing period" If contemplated by the joint statement of the Hbuselsenate conference
rwttca ^r1"*™ the tegWatrve intent that an W^^tfii unit or us •ffrfted source
not be pmnffrrd for emitting solfor dfoBde in aocea of its allowances for a given calendar
ytsz*mtil that year hat ended and aQ transfisn of aOowmnces applkable to that year have
been completed within a reaiongble tfmg after tha e^^ Q| ^^ y^y* (cmphasa added).
Hie fbUowing two sections ducma the bane policy issuet raised by "allowance
pooling* and book*o»pccliwribair7<«bcra
pleted among any fndMduaJ affincted units or aOowence pools within a reasonable
approach gives effect to the language of 4Q3(d)(2) on allowance
pooling. Section 403(dV2^ toeciflcaOv statea that EPA*s refnlariom "ihri^ act prehibit...
temporary increases or decreases... within utlm> systems, power pools, or mOities entering
allowance pool agreements... and such temporary emmon increases and decreases shall
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not require transfer of allowances among units nor shall it require recordation* (emphasis
, * , . . _f •' i - • • t »'.••-- •
added). Section 403(d)(2) only provides that the "total tonnage of emissions... from all
units in such a utility system, power pool, or allowance pool agreements shall not exceed the
/•,,.» : •
total allowances tat such units for the calendar year congfrnftd.*
:. i . •
Through allowance pooling and the use of a "reasonable time" after year-end
to complete iaflowance trades, the need for each affected unit to hold a substantial number
of allowances In reserve to accommodate unanticipated electric generation requirements
.: . ' • » i " *" • •
would be greatly diminished. Affected units would be able to jug allowances in the year for
which they were allocated. With flexible allowance pooling and a reasonable book-dosing
period, the Act's endssian reduction objective would be achieved in fun, at substantial cost
savings for utilities and their residential, commercial, industrial, and institutional customers,
and with far greater ability on the part of utilities to plan compHanfe strategies to ensure a
reliable supply of electricity at a reasonable cost
This approach therefore would recognize that the allowance pooling concept
is critical 10 fulfiDmem of CoogreM'
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•c- -if. .- •> . . ..- .«".«;• o •'••"a on • -t"5 *•-.• .-jis.. .
not eve effect to the above-cited language of 403(d)(2) on allowance' pooling and the
^ „ .>•.'..«• • -. -... . . .' • .-, I*. «.-i.o>C ."'.jit. sift ,ics,t .*• ;•'• ..t'2.."'
flexibility needed by utilities to meet the objectives ofthe Act= .,„-.
3 While lection 403(d)(2) ^provides thar-the allowance calculation tor pooling
agreement* is to be made "at the end" of the calendar year \Lt^ once the~year is over), this
*^ •• • .. _. . ;.ju. , «;-.; - -•?
does not dictate that aft accounting be *rttffrl**f^ before midnjght^n December 31. Indeed,
it would be impossible to complete necessary accounting transactions before year-end,
because it is only alter the year is over that one witt know what allowances are needed for
that year. Requiring allowances calculations based on projected emission before year end
therefore would seem inconsistent with the language of 4Q3(d)(2). Moreover, it wodd
give no effect to the conferees' statement that EPA must allow a "reasonable time" for
completing allowance transactions after the end of the calendar year.
2. Implementation Issues -Imlementing "Poolin" and
nf
* -
EPA Tt«ff and omen ht¥e suggested that a system ander which ihe Agency
and states are required to assess affected units* compliance on a pooled basis could present
i
a series of practical problems. EPA staff has suggested that the Title IV permitting and
enforcement scheme b based oa the assumption that each individual affected unit tor
affected source) wfll submit a permit application tnd recche a permit, that compliance
status wifl be judged based oa a comparison of an individual affected unit's emissions wifh Its
allowances, and that - m the event of noncompBance - penalties, emission offsets, and
allowance deductions wfll be imposed on a uaft-by*unh basis.
Toe first and most Important tfl*-*™ OK aooretsmg mttc eoccens is to
recognize that neither the language of 4OJ nor the conferees' e^lanatkm of the allowance
system contemplates a final accounting of umt-byumt allowance allocations before year
end. As the joint statement of the House-Senate conference committee explains, a final
accounting for purposes of a unit's (or a poofr) allowances should not be made "until that
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year has ended and all transfers of allowances applicable to that year have been completed
* . . ;. ..•.•-.' .i- - •'-* . i -.• •' •
within a reasonable time after the end of thai year." This approach .recognizes, that the
monitoring information necessary to determine the need for and availability of allowances
for the calendar year concerned win not be available until the year has ended
A ninety day period at year end la appropriate tor a variety of reasons. It
should provide sufficient time to review and quality assure necessary continuous emission
monitoring data, and to complete necessary accounting transactions for the calendar year in
QfllUtVVVpMHI . _
ID addition, ninety days is needed so that there is sufficient time after the
determination of annual emissions levels for the allowance market to operate in an efficient
and orderly manner. If ninety days were not permitted, affected sources would have to
make trading deciiinm in an atmosphere of considerable uncertainty. The vagaries of
weather and forced outages could eaten pressure oa the allowance market and cause
dramatic and unpredictable swings in allowance prices. Ninety days is a sufficient time
period lor affected sources to obtain knowledge of their actual requirements, complete
necessary transactions, and tout refrain from speculative trading based on projections.
After there is some indication that the allowance market indeed operates efficiently, the
ninety day book-period dosing could be reduced to stay or thirty days based on the
experience of the actual amount of time necessary to insure the proper functioning of the
market . .
At suggested above, any TWe IV rules should also give effect to the language
of 4Q3(d)(2) authorizing automatic transfer of allowances among utilities in a utility
system, power pool, or pooling agreement Implementing this provision wffl give utility
systems or pooh) the flexibility to respond to unanticipated changes in operations and/or
emernncy conditions without engaging in formal allowance transactions. Even for
companies in a utility system or pool, however, a reasonable book-dosing period at year end
will be critical to allow the designated representative of the pool to complete
-------
tramactions with other utilities or utility pods. In addition, if wcwaiy,
, •* , < - .ii:. IT, pS?BWlteH^.ftiSfiFS*»;'«
whatever arrangements the'pool partic^tTniVe'inaai^ong'meratoh^^^^
addresi any of the ^EPA itaff implementatioa concern reganfing th need
luowaooB information.
, ' •**• m * • ***
In fonx the approach outlined above wfQ giye effect to the book^loaag and
allowuce pooling concepts described fa Title IV and the joint conference statement, by
•flowing for unfettered trading among utilities fa a system or a pool during the year and for
redistribution of allowances during a reasonable book
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Paper A16
February 11, 1991
utility Air Regulatory aroup
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period, own«rf and operators of affected^uaits would be.Tallowed
to trad* allowance*, applicable to emissions,.in the^year just
ended, after the units' annual emissions have been determined. A
book-closing,,period is contemplated by the,House-Senate :g_
conference report in its discussion of the allowance trading
program.
This paper addresses issues that hay*,arisen during
discussions of the) book*closing period and makes recommendations
for consideration by the Allowance Trading Subcommittee.._
Should EPA provide for a book-e losing period in ita nilaa?
POSITTOH:
SPA should provide for a book-closing period. As explained
above, it is impossible to know before the end of the year how
much sulfur dioxide was emitted during the year. Emissions can
be known only after a reasonable time after the end of the year.
One member of the Acid Rain Advisory Committee) has suggested
that the owners or operators of an affected unit should be
subject to the penalties of the Act if, at midnight on
Peeember 31. they or their designated representative do not hold
allowances in an amount sufficient to cover the unit's emissions
for the entire year, trp through midnight en Oeiejibej. 31. This
suggested approach to implementing the Act would require
utilities to complete their transactions in allowances for the
year at some time before the end of the year, based only on
estimates or projections of annual emissions. In other words,
utilities* allowance transactions would be based on projected
emissions), while its compliance or noncompliance (and its
liability for penalties} would be based on actual emissions.
Under this approach, any unit whose projection of annual
^m^j^mt.gu^^ ,/»««fl £bA*tA£a*tM*. J&A AI>.A4£g£^£B ^* £^A0UMBCS)
requirements) turns out to bs too low would be penalized.
This risk could be mitigated to the extent that the unit
holds allowances in reserve for uss in the event that, for
. 2 -
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whatever reason, projected emissions turn out to-be lower than
actual emissions. But requiring units to hold allowances in
reserve would, in many cases, prevent the best use of the total
pool of allowances ~ indeed, would prevent the use of allowances
for the year for which they were allocated — and would force
emission reductions- that are not part of the statutory objective
of an annual reduction of 10 million tons. Emission reductions
are costly, and additional marginal reductions in emissions are
particularly costly. Requiring utilities to hold excess^reserves
of allowances would add costs to the Title IV program that are
not needed to achieve a 10-million-ton-reduction. Because of the
potentially enormous costs associated with excess reserves, and
because of the uncertainty to which utility planning would be
subjected in the absence of a book-closing period, an approach
that relies only on reserve allowances would jeopardize the
reliability of the supply of electricity to satisfy the demands
of the nation's r***»j*p*-t»i f jp^My»7»^«i, commercial, and
institutional consumers.
£KCSS* reserve* could be particularly large because of the
risk that actual emissions could vary substantially from
projected emissions due to unforeseeable events. Weather, the
economy, and capacity conditions at other plants may greatly
affect any given rail's
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For example,. A review of, JJecember. *990 &*£& OD -units and plants- -
in. the. Southern £oapany Astern r%veale4; JSfcat -qftvara.1 ^£ them .:
experienced enormous differences between projected generation and
actual generation for that month. The differences between
projected and actual generation ranged between 100 percent less
and 204 percent more-. Most, units.^pr pLanfis experienced at least
a 10 percent variation between projected and actual generation.
Because emission levels are tied closely-to generation levels,
emissions lUcsly experienced similarly large variations, between
projected and actual levels.
Variations between projected and actual emissions from
fossil fual fired power plants can ba magnified by events such as
a significant period of unexpectedly cold weather at or near, the
end of the year (such as the period of extremely cold weather
that occurred in many parts of the East in December 1989), or an
unanticipated requirement that a nuclear power plant — with its
enormous generating capacity — be shut down for safety
inspections. Because many events that can cause great changes in
emission levels cannot be predicted, even the most sophisticated
projections of those) levels are, at best, imprecise) guides to
determining the number of allowances needed to cover actual
emissions.
Although it may be possible to adjust anticipated allowance
requirements periodically to reflect actual emissions as they are
determined for the early months of tna year, doing so -would not
closing period, would compel the establishment by affected units
of unnecessarily large allowance reserves. Verification of
emission data takes time, and during that time emissions may
Unless ZPA's regulations allow for a booJc~closing period,
the number of allowances available for use in any year would be
reduced by the size of the reserves that would be necessary to
accommodate emission variability. Although these allowances
could be carried forward, comparable reserves would be required
- 4 -
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for the next year and all subsequent years. In affect, total
allowances would be permanently reduced, by, at a minimum, one
•_•'*•.»•• • •'- * • • '
year's aggregate reserve requirement for each unit, resulting in
the unnecessary reaoval froa the market of an extraordinarily
.••:••••.«* V * * -
large number of allowances. ,. ... 4 .
Utilities should not be required to spend scarce econoaic
resources to control eaissions beyond the objectives set forth in
the statute. A book-closing period allows the aost efficient use
of allowances, thereby preserving the cost-benefit trade-off
embodied in the Act's 10-aillion-ton-reduction objective. Given
.the opportunity to make up any allowance shortfalls after
] actual eaissions for the year/ owners and operators
of affected units would not be forced to hold allowances back
froa the market. Tnose units whose eaissions turn out to be
higher than expected could buy allowances, during the book-
closing period, froa those units whose eaissions turn out to be
lower than expected. Moreover, it would be possible for
sources • • including, for exssple, JOUILSV in inter connec ted
systems — to enter into allowance insurance arrangements under
which *re»«rre* allowances would be allocated after the end of
*
the year to whichever participating units experience unexpectedly
high emissions. ^
la short, EPA should allow for a book-closing period because
it would minimize the number of allowances that would have to be
held in reserve, and the cost* associated with excess reserves,
vitteut permitting »™» increase in total sulfur dioxide emissions
above the level intended by Congress.
See the discussion of allowance pooling below.
- 5 -
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What role can allowance pooling play in mitigating problems
associated with variability between projected and actual
emissions and g 11 owane a requirements?
Allowance pooling of various forms can and will take place
as a part of any coordinated program to achieve aggregate
emission levels. These pooling relationships have no
implications for EPA's regulatory program except in cases where
"collective compliance" by a pool is contemplated.
Independent of the question whether certain pools can be
recognized for "collective, compliance,* allowance pools of
various forms will be critically important to achieving
compliance in an efficient and cost-effective way. When pooled,
emissions and allowance requirements are likely to vary much less
from projected levels than is the case with an individual unit's
emissions and allowance requirements. Just as diversification of
an investment portfolio reduces the risk of dramatic reductions
from expected performance levels, "diversification11 of a group of
affected units through the mechanism of an allowance pool would
reduce the risk of dramatic variations froa projected emission
levels. Moreover, by referring to "allowance pool agreements1* in
the Act, Congress recognized that allowance pooling .is a
legitimate compliance tool.*'
EPA staff .has Indicated that allowance pooling that would be
recognized for collective eenpliane* ewald piaseat permitting and
enforcement problems* ZPA staf£ have suggested that, in the
event of noncompliance, penalties, emission offsets, and
allowances deductions should be imposed on an individual affected
unit
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ownership or control), but not on an allowance, pool. EPA also
has noted that in Phase II of the sulfur dioxide emission
reduction program, states are likely to assume permitting
responsibilities for affected units, a fact that raises the
specter of disputes among states about bow to apply allowance
requirements to interstate allowance pools that would want to
show compliance on a collective basis.*/
Given these concerns* collective compliance for allowance
pools other than intrastate pools could be difficult to
implement, but one promising way of avoiding the potential
problems suggested by EPA staff would be implementation of a
reasonable book-closing period. During the book-closing period,
interstate and inter-utility pools (e.g., reserve pools among
utilities with different mixes of generation and different peak
demand conditions) would be able to ."redistribute" allowances to
individual affected units in accordance with their pooling
without a book-closing period* it would be impossible to
rat* any •redistribution* provisions in an allowance pool.
Pool participants will need to know the amount of total actual
emissions in the year — a fact that can be known only after
year-end — to determine which allowances can be transferred to
which units.
Ho 2PA regulatory requirements are appropriate for allowance
pools that are maintained for the purpose of redistribution of
allowances to individual units. These arrangements are only one
of a wide variety of private arrangements that will be made among
participants in the allowance market. As discussed below,
regardless: of any disputes that might arise among pool members,
Section 403 (f) of the Clean Air Act provides that nothing
40&* which ooverns the allowance ^program, "shall be
construed as modifying'the Federal Power Act or as affecting the
authority of the Federal Snergy Regulatory Commission £FERCJ
under that Act." This paper does not address any questions
concerning the scope of FERC's authority or the applicability of
the Federal Power Act to interstate allowance pools.
- 7 -
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if an.affscted unit does, not bo-ld.iall^wagaca^^ua,! tA or . greater.
than £ts ^annual .emissions at: the endj'af t«ie boWc-cics-ifcg period,
th« unit would bs'in noncomplfanca. ' Disputes regarding
distribution of allowances are the affected units* problem, not
EPA's problem, and would not affect EP.A's enforcement. program.
• - r ' ' • *;'"• ^w>»* ,j.-3«-. _ v.'-f,
* •• «• .. • . ii •
How long would a book-closing period have -to befl - -
Zf allowance requirements are to be determined on the basis
of actual, not projected, emissions, enough time must be allowed
after year-end to determine the magnitude of those actual
emissions. The time that will be necessary for determining
emission amounts depends in large part on the nature of the
measures that are necessary to collect, and to verify the
• • *
accuracy of, emission data. Because EPA has not determined what
rules will govern collection, reporting, and verification of
emission data for Title IV compliance purposes, it is impossible
to say now exactly how much time will be needed.
Unless EPA imposes unduly burdensome data requirements,
however, 30 days may well be an adequate period for utilities to
collect and verify emission data in most cases. For example,
EPA's "Subpart OaN rules for new source performance standards for
electric utility steaa generating units require units to submit
quarterly monitoring reports within 30 days after the end of each
calendar guartsr.4/ Moreover, a 30-day period may well be the
minimum period of time for utilities to complete data reporting
in cases in which alternative monitoring systems, such as fuel
sampling and analysis, are used, and in cases in which monitoring
equipment is not operational during the final days of the year.
For these) reasons, 30 days is the shortest period of time that
should be budgeted for emission data reporting requirements under
40 C.P.R. S 60.49a(i) (1990).
- 8 -
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. • : .•.' *•:;•• ... , , H '
Following collection and verification of emission data,'
additional time will be necessary for affected units to conduct
and complete transactions in allowances to satisfy allowance
requirements. Once utilities have complete and verified 'emission
data in hand, they must line up a seller (or sellers) of
allowances; negotiate, prepare, and execute one or more contracts
to purchase the requisite number of allowances; and send a
certification of the transfer to EPA. Depending on the
requirements of EPA's allowance trading rules, it is possible
that other steps would be necessary as well. A period of is
days, after completion of emission data collection and
verification, would DSJ th« minimum that should be permitted for
conducting and. completing these transactions.
Thus, assuming that EPA does not impose unreasonably
burdensome emission data reporting or allowance trading rules, a
45-day hook-closing period (i.e. , from January 1 to February 15
of each year) is likely to bm adequate. Forty-five days is the
period that should be allowed for completion of the
steps necessary to comply with allowance requirements. 3/
Zn addition, a 43-day book-closing period appears to be
consistent with section 411 (b) of the Act, which provides that
the owner or operator of a source that has been determined to
have emitted sulfur diexid* in «xc*»s of allowances held must
submit a proposed plan for achieving required excess emission
offsets "within sixty days after the end of the year in which the
excess emissions occurred.11 Presumably, excess emitters need to
be identified in at least a preliminary way before the end of
that 60-day period so they know whether this requirement could
apply to them. A requirement that by February 15, affected units
hold adequate allowances Cor the previous year's emissions would
w suen a 43-day iDocx-ciosing period appears
consistent with industry practice in completing energy purchase
and transfer transactions. These transactions are often
accomplished in a six-to-eight-week timeframe following the end
of a calendar period.
- 9 -
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of s
How vatild a book-eloaina period affaet emissio
- ~"
ons?
. TTg"
TOMTOM:
A book-closing period would not increase the level of'total
allowable sulfur dioxide emissions. Permitting affected units to
cover unanticipated allowance shortfalls by obtaining allowances
after the end of the calendar year would not alter the
requirement that an allowance cannot be used prior to the year
for which it is allocated. Under the book-closing approach, an
allowance obtained after the end of the year could be used to
, cover emissions during that year only if the allowance vaa
allocated far fehat vaar (or carried forward to that year from* the
previous year). A book-closing period therefore would not
increase the number of allowances eligible for use in any given
year. The emission reduction objective and the cap .on total
allowable emissions set by Congress would therefore be preserved.
How would a book-closing period affect enforcement of
aniaaion lin
A book-closing period would not tAd«rmilM eftfMesamt ot the
required emission reductions. The ability to conduct post-year
allowance trading during a limited period under conditions of
certainty regarding allowance requirements would in no way
ifMtila^e dBCMra eart *•*»*•**'**» £ram th4 flhl Jgitiflil to pfrf yj1*
^bAV^^^BBV^M^^^B ^^^^P^^^^^^ ^V ^^^^^^B ^^^^^^^^^^ff^^^^^m^f ^••^••^•^W 4B^^^^ ^f^^f^^^^f^f^^ ^*^^^r^^ ^r-^ m ^ m
enough allowance* to cover emissions. Any unit holding an
insufficient number of allowances as of the date for
reconciliation (i.e., the last day of the book-closing period)
would remain fully liable for applicable excess emission
penalties and for offsetting excess emissions.
- 10 -
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How would a book-closing period affect the allowance trading
program? - . - — - : -
A boolc-closing period would promote an orderly and efficient
allowance market. If an affected unit were required at midnight
on December 31 of each year to hold allowances sufficient to
cover all of its emissions for that year, the market for
allowances could be subject to significant distortions,
particularly in the final weeks of the year. As discussed above,
affected units would have to make allowance trading decisions in
the face of uncertainty about their allowance requirements.
Circumstances beyond an owner or operator's control, such as
unusually cold weather or unplanned outages, requiring increased
utilization of affected units late in the year, could exert
pressure on the allowance market, causing unpredictable and
perhaps drastic increases in allowance prices. Smaller companies
and systems — including public power systems and rural
cooperatives — would be disproportionately impacted.
Market pressures would be fewer and. less severs with a book-
closing period. Ones actual allowance requirements are known,
" excess" allowances could be identified with certainty and would
be more readily supplied to the market, and only those sources
with actual allowance shortfalls would remain in the "spot"
market as buyers. Horeover, because they could •maks final
allowance trading decisions wttn Knowledge o< their actual
allowance requirements, many unit owners and operators could be
expected to refrain from last-minute speculative transactions
based on projections of allowance requirements.
- 11 -
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A-8 • Paper A8
ISSUE PAPER ON MULTI-UNIT ALLOWANCE POOLING FOR COMPLIANCE
I. Background . .-.,,.
Son* utilities "pool" electricity production across several
units, within a pool electric generation is treated as fungible so
that generation demand is dispatched to a given unit within the
pool based on a variety of economic and other efficiency factors.
The scope of such pools varies, sometimes involving only a single
operating company, sometimes including units froa aore than one
holding coapany. Title IV treats sulfur dioxide eaissions and
allowances as fungible as veil since allowances are freely
transferable among units and a unit siaply has to hold allowances
in an amount equal to its eaissions in order to Beet compliance.
The language of the Senate Committee report suggests that one
of the purposes of creating a system of fungible allowances/
eaissions was to allow power pools to continue to operate as such
and to integrate emissions/allowance dispatching into their overall
dispatching protocol.
II. Statutory Language
This paper will nafi address the legality of permitting pool-
based compliance in lieu of unit-by-unit compliance. Instead, it
will focus on the practical and policy consequences of the two
different approaches. Clearly, though, the statute includes
provisions that, to a small extent, open the question of whether
pool-wide compliance is permissible.
Section 403(g) states:
"It shall be unlawful for any affected unit to emit sulfur
dioxide in excess of the number of allowance* held for ta*t
unit for that year by the owner or operator of the unit."
Section 403 (d) (2) provides:
"la order to insure electric reliability, such regulations
shall not prohibit or affect temporary increases and decreases
eaissions within utility system*, power pools or utilities
b^KMB^ ^K^M J ^K^M.^K _. * * .— ._ __ ._. -_ _j_ _ _ _ «• _ _ _. __ •_•_•_ A .. .a
— — — — f — £ •»• •» • • f ^ -^ -^ -^^m ^m-^-^^m^^ -^^m ^m^m^B^m^m ^^v^p^v
entering into allowance pooi iTmnrnff. that rasull: frosi
their operations, including emergencies and central dispatch,
and such temporary eaissions increases and decreases shall not
require transfer of allowances among units nor shall it
* •^•*ss YvS3vo5r%l€ik. ^nv Qvnmrs or operators of such units
shall act through a designated representative. Notwithstand-
ing the preceding sentence, the total tonnage of eaissions in
any calendar year (calculated at the end thereof) froa all
-------
unit! in luch a utility system, power pool? or* allowance DOOI
agreements shall not exceed the total allowances for auch
units for the calendar year concerned."
III. Impact.of Unit-by-Onit compliance W Power?Allowance Pool!
, *. w *.'• * -tev
It appears that even under a unit-Based -compliance • regime
utility systems and power pools will still be able to use pooling
strategies in meeting both their emissions limitation and dispatch
requirements.
Logically* each utility system and power pool will probably
choose to pool the allowances allocated to each of its units and
integrate its dispatch and emissions control strategies so that at
the end of each year total emissions from all of the system's or
pool's units will not exceed the number ot pooled allowances. Even
under a pool-wide compliance regime, to effectuate this strategy,
the system's managing authority would have to cull and SUB
emissions data from each unit in the system in order to determine
total, pool-wide emissions. Permitting pool-wide compliance'
demonstrations would simplify .the management authority's task,
however, once total emissions were determined, this total would
merely have to be matched to the total number of allowances In the
pool.
At the same time, though, requiring the allowance pool to
demonstrate compliance tm m mit-toy unit-basis deem not impose an
appreciable burden. Under such a regime, the pool could still
operate on the basis of aggregated emissions and allowances. To
reconcile such operations with the unit-based compliance regime,
the pool's management authority would only have to draw from the
allowance pool under the authority's central the number of
allowances needed to cover a unit** emissions and assign or
transfer those allowances to the unit in question, on a mechanical
level, such a procedure might entail the manager*s erecting in
EPA'.s allowance tnrTir? sys&em am illnManoe account into which ail
the allowances held for each unit in the pool would, be transferred.
At the end of the year, following the Agency's standard allowance
transfer procedures, the pool manager would transfer from the pool
account into each unit's individual account the number of allowanc-
es needed to cover each unit's emissions for that year. This
method — transferring individual unit allowances into a single
pool-wide account and then transferring allowances from the account
back to the individual units in amounts needed to cover emissions
— would not: only replicate pooling but also allow the pool aanager
transferring allowances to and from individual, units. other,
similar options could be crafted. Thus, the additional step
imposed oa the pool manager by a unit-based compliance regime would
consist of simply sorting each unit's emissions and allowances by
-------
means of the EPA's allowance account and transfer systea without
intsrferring with, ths ability of .the pool to -operate as such in
actual practice. '
>;,•• * • .»••.* • , , •
Because allowances «nd eaissions are fungible and because all
units arc included .in Phase II, no special regulatory provisions
would be required in order to allow pools to function in this way
within a unit-based compliance framework. In Phase I, however,
soae pools may find theaselves with some units that are affected
and seas that are not. Zn these cases, the statute peraits
affected units to subait substitution plans to include unaffected
units in a coapliance prograa. Accordingly, a power pool that
included SOB* phase Z units could subait a substitution plan
bringing all of its units into Phase Z. The statutory provisions
governing substitution plans appear to conteaplate only unit-by-
unit substitution, but this only means that EPA would aceoaaodate
pools as if all the units were operating in the Phase II systea
(but with emissions limits and allowance; allocations appropriate to
Phase Z reduction requireaents). Pursuant to the requireaents of
the substitution plan provisions and the specifications of each
plan, the Agency would establish allowance accounts for each
substitution unit and perait transfer of allowances into a pool
account and then out to each unit's account as needed to cover its
XV. Zffact of Pool-Based Coapliance on compliance
The compliance, permitting and enforcement scheme of the title
appears clearly to rest on the individual unit or plant. Hot only
are the statutory eaissiona limitation- requireaents expressed
exclusively in terms of the individual unit, but the functional
eleaents of the title — the permits, the eaissions monitoring
requireaents and the imposition of liability for excess eaissions -
- depend on a unit-based approach. Under such an approach, the
regulatory authority need look only at a unit4* perait, allowance
account and eaissions data to determine whether a unit is in
compliance or to demonstrate; that a unit Is liable for wress
eaissions feea and offsets as a result of being out of coapliance.
Under a pool-wide compliance regime, the basic compliance
elemmnta could perhaps be fashioned to capture an aggregation of
units. Eaissions monitoring requirements would be imposed on each
individual plant and the total eaissiona limitation requirement for
the pool as well aa the total allowance allocation would be equal
to the SOB of those for sacfe iadividiial omit, ia t&a peel. la all
likelihood tha permit* .issued to individual units in the pool weald
hsva to be linked to an overall perait issued to the pool as a
whole.
Most difficult, though, would be preserving the self-executing
eleaents of the excess eaissiona requirements of the title. Zn the
case of the $2,000 per ton fee, the pool's permit would have to
-------
sake the pool's management authority directly and autoaatically
liable for payment, with no account taken, for liability purposes,
of questions of apportionment of tha payment aaong the units within
tha pool. Such quastion* would be diapoaad of by privata arrange-
ment anong tha pool "members (avan in a unit-by-unit ragiaa with
individual unit owners and operators paying tha faa, tha pool
arrangaaant would moat liJcaly provide for a defraying of auch
axpanaae aaong the pool aeabera)•
The aelf-executing alaaent of the of feet requirement night be
nearly iapoaaibla to replicate. The statute requires that where a
unit'a eaissions exceed its allowances, the Agency is to reduce the
unit's subsequent allocations to offset the axcess. Zn the context
of a pool, the Agency would be required to withold allowances ao
that the pool's subsequent aggregate allocations would be reduced
in the aaount necessary to offset the pool's excess eaissions. The
statutory allowance allocation provisions are based on individual
units. Thus, the only plausible way to affarfnare a reduction in
the pool's aggregate allowances would be to include in each unit's
perait a stataaent making the unit liable for a reduction in its
allowance allocation equal to its pro rate share of any aaissioas
of which tha pool ae a whole may be guilty, While this is
not impossible, it does suggest how complex a systea of permits
would be required to subject the units in a pool to precisely those
emissions/allowance coapliance requirements imposed in the title.
Za Phase IT, where the program will rely en state authorities.
for permitting and compliance, pool-based coapliance could present
practical problems especially if multi-state pools are involved.
A pool, liable for excess fees and offsets as a result of aggregate
eaissions exceeding aggregate allowances, could frustrate a atate
enforcement authority or citizens group by basing a challenge to
liability on data or factors pertinent to plants outside the
authority'a geographical jurisdiction.
Zn addition, atate authorities could have a formidable burden
to bear in approving coapliance plena and issuing permits for
multi-state pools and in ensuring enforcement and liability across
several jurisdictions. 2&ls, aa well as the general need ta vmrav*
liability for the pool as a legal entity, could result in the
compliance planning and permitting ptucess presenting significant
burdens for the units in the power pool itself. This becomes
especially clear if contrasted with tha option of submitting
individual unit plans stating a commitment to hold allowances equal
to emissions) and aiaply engaging tha mechanics of tnnsfarriag
allowances among units in the pool at tha end of each year*
Finally, any enforcement authority's burden would be signifi-
---*^ £ss$i±e£t£A ur.isr a »•»!•• ta •uiQ. uuayiimnce and liability
was pool-based. Instead of being able to bring an enforcement
action in a context in which the inquiry was confined to the
eaissions data of one plant, an enforcement action against a pool
-------
4i'put*»"«" -*-*•-
f «
-------
r
MULTI-UNIT POOLING EXAMPLE
Pool ABC consists of 5 plants and 10 units.
allocation-of allowancas, by unit ara:
Its original
i
2
3
4
5
6
7
8
9
10
TOTAL
1,000
1,000
1,000
1,000
1,000
1,000
2,000
2,000
2,000
2,000
14,000
POQE-WTPg COMPLIANCE .
In Casa 1, tha total aaissions of tha pool art lass than tha
total allowances bald by tha pool (14,ooo allowances held;
•missions of 13,650). Undar a unit-by-unit coaplianca raquiraaant,
Units 4, 5 and 7 would hava baan out of compliance.
In Casa 2, aaissions ara highar than-in Case 1 for Units 1, 2
and 3. Emissions for tha pool axcaad tha allowancas hald (14,250
vs. 14,000). Tha pool would ba out of complianca as a whola, with
5 units (1, 3, 4, 5, and 7) whara Missions axcaadad avaiiabla
allowancas.
Allowancas hald
1
2
3
4
3
6
7
8
10
TOTAL
CASK 1
In-Coaplianca
1,000
1,000
1,000
1,000
900
950
950
1,100
CASE 2
Out of Coaplianca
Eaiaaiana
1,200
1,000
1,300
1,100
1,000
2,000
2,000
2,000
14,000
900
2,100
2,000
1,800
1,900
13,650
900
2,100
2^000
1,800
1,900
14,250
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Unit by Unit Compliance *•-••'
In CM* l, the pool ii able to make inter-pool allowance
transfers to cover thm potential excess Missions in Units 4, S and
* i aaintain a carry-oviir balance pf 330 allowances into
In Case 2 , tae pool cannot COM into compliance bv
conducting trades jrith-in the pool-an overall, poolwidl
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-------
KEY TSSUES ON QPT.W
TITLE IV. SECTION i]Q
Prepared by
Ann D. Muitiow
the ACS Corporation
Do industrial boilers fall under the category of process sources in
Section 410 (d>?
The term "process source" is not defined in the Amendments. Rather
it appears that Section 410 (d) gives the Administrator authority to
define this by regulation, as well as to define the requirements that
such a source must meet in order to opt-in and receive allowances.
It does appear, however, that an industrial boiler, by definition, was not
intended to be included under 410 (d), as a process source, but rather
under 410 (a) as a "unit that is not nor will become, an affected unit
under Section 403 (e), 404, or 405*. By definition in Section 402 (24) an
industrial source includes "units" (defined as a fossil fueled combustion
device) that do not serve a generator that produces electricity,
nonutility units and process sources. The differentiation between units
and process sources indicates that Industrial boilers are separate from
the definition of process sources.
If an industrial unit opts-in under Section 410, what emission rate is
used to calculate its allowances?
S«ctton-410 (c) indicates that a non-affected unit (which for the
purposes of this paper will not indude process sources) that opt-in
will be issued allowances based on the lesser of the unit's 1985 actual or
allowable emission rate. If the unit did not operate in 1985, the lesser
of the actual or allowable emission rate from a later year, as determined
by the Administrator, will be used. This implies that full credit will be
given to these units even if the emission rate is greater than the Phase
1 and Phase 2 emission limitations of 15 Ib/MMBru and 12 Ib/MMBtu,
respectively. At the December 1990 Allowance Trading Subcommittee
Meeting, joe Goffman confirmed that this was the legislature's intent.
He indicated that the unit's allowances would be part of the industrial
source inventory used by EPA to track and quantify emissions from these
sources.
-------
wnat procedure will be,used to determine eligibility under the opt-in
provisions? How long will this process take?
Section.410 (a) indicates that "An election shall be submitted to the
Administrator for approval, along with a permit application and
proposed compliance plan". EPA has indicated that a standard
application form would be created for affected units. This type
of standardized form would also be useful for streamlining opt-tns.
It also appears, given the discussion in bullet *2 above, that the
submittal of compliance plans will only be applicable to process units
which need to clean up to reach the emission limitation determined to
be acceptable by the Administrator under Section 410 (d). this
emission limitation would then be used to calculate the number of
allowances to be issued. The length of the election process is also of
concern since the creation of allowances under Section 410 may become
a tool to support financing ot UT projects before the allowance market
fully matures.
Can a unit clean up sometime after the date of enactment but before
promulgation of the regulations and soil receive allowances for the
interim period provided that opt-in requirements are met?
A non-affected unit (as defined above) may reduce its SOz emissions
after date ot' enactment but prior to promulgation of the opt-in and
permitting regulations. If, subsequently, this unit applies for opt-in
and meets the requirements set forth in the regulations, it will
receive allowances based on the formulas in Sections 410 (b) and (c).
If 1985 data is not available, some prg-date of enactment data-should
be used in order to ensure full credit to the unit. If the unit has
reduced emissions in order to create saleable allowances under the
opt-in provisions, will it receive allowances for the operating period
between date of enactment and official opt-in? This seems fair given
that the benefit is also realized during this period.
WIH units opting in under Section 410 be subject to the NOx reduction
Section 407, through omission, excludes units opting in under Section
410 from regulation as affected units with respect to NOx reduction.
This seems logical since it is unlikely that a unit would opt-in if it is
subjected to the cost associated with both NOx and SO2 reduction costs
While it may seem unfair to give opt-in units the benefit of
-------
allowance issuance without the downside of NO* reduction, the
legislature has intentionally offset this through the provisions in
Section 410 (f). This section prohibits opt-in units from banking or
transferring allowances produced as a result of reduced utilization or
shutdown, a limitation which is not placed on other affected units. This
ensures fair treatment under the Amendments and full environmental
benefit
-------
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PAPER A17
PRELIMINARY DRAFT
DISCUSSION PAPER
MARKETABLE TRADING ALLOWANCES FOR SO,:
ISSUES CONCERNING INFORMATION PROVISION
Prepared for Allowance System Branch
Acid Rain Division
U.S. Environmental Protection Agency
Prepared by: Robert W. Hahn and Al McGanland1
L Introdnctfon and Executive Summary
A. Introduction
The 1990 dean Air Act Amendments call for the reduction of 10 million tons of
SO2 emissions by the year 2000. This reduction is to be achieved through a system of
marketable emission permits or allowances, which limits emissions while at the same time
providing firms with a great deal of flexibility in the methods they use to comply with
the law. A comparison of the allowance market with more traditional "command-and-
controi" approaches to regulation suggests that the market has the potential to result in
cost savings of as much as $2 to 3 billion annually. Whether this potential will be
realized depends on the how the allowance market is designed and implemented.
Both EPA and state regulatory agencies will play a crucial role in affecting the
efficiency of the allowance market The purpose of this paper is to identify and
highlight major issues concerning the information the allowance market will need in order
to function efficiently, and who is the best provider of that information. This paper is
intended to serve as a catalyst for further discussion leading to resolution of these issues.
1Mr. Hahn is a resident scholar at the American Enterprise Institute and an adjunct
professor of economics at Carnegie Mellon. Mr. McGartland is a senior economist at
Abt Associates, Inc. This paper has benefited from discussions with several people in
the Allowance Systems Branch of the Acid Rain Division at EPA as well as
representatives of industry and academia. The views in this paper are those of the
authors and do not necessarily reflect the views of the institutions with which the authors
are affiliated.
-------
PRELIMINARY DRAFT
ISSIMI Examined In This Paper
At the last ARAC meeting, a lively discussion of infonnation issues indicated there
was little agreement over several important questions. These include:
(1) What kind of transaction infonnation should traders be required to submit to
EPA?
(2) Should EPA require traders to submit information immediately upon concluding
a commercial transaction but before an allowance transfer is made?
(3) Should serial numbers and an EPA tracking system be implemented to trace
specific permits through the market?
(4) Should brokers and other traders be licensed?
(5) Should .the EPA provide a computer-based bulletin board where potential offers
to buy or sell could be posted for public inspection?
This paper explores how different resolutions to these issues will affect the
performance of the allowance market We do not discuss other criteria that EPA and
ARAC may want to incorporate when developing final recommendations and regulations.2
The purpose is to help frame the discussion for future meetings and analysis.
^For example, EPA may wish to obtain information to evaluate the performance of
the allowance market Such information could be used both for improving the workings
of the allowance market as well as for improving the design of new market-based
environmental initiatives. In general, more information is required to do a
comprehensive program evaluation than for the purpose of helping to ensure that the
allowance market functions efficiently.
-------
PRELIMINARY DRAFT
C Summary of Our Findings
Given the large uncertainties in bow state regulatory agencies will treat allowances,
we »M«fc it is likely that a large proportion of trading in the next few years will be based
on bilateral trades that do not use an exchange. In the long run, however, it is
conceivable that a homogeneous allowance will evolve/ However, it is impossible to
predict with certainty how this market will operate in the future.9
This finding has implications for the best design of an allowance trading market
Looking to markets that do trade a homogeneous commodity (e.&, securities or
commodities markets) to develop an EPA trading system may not be appropriate.
Rather, the EPA should design a system that accommodates the private market's ability
to innovate and develop a variety of trading approaches, yet be flexible enough so that
regardless of how allowance markets evolve, a well-functioning market is fostered.
In general, this goal is best achieved by relying on the private market to bring
buyers and sellers together. While trades will not be effective until recorded by EPA,
our preliminary analysis suggests that EPA's role should be minimized and private traders
should retain tiMMriftmm flexibility. ' . "
This paper assumes a fair amount of familiarity with the allowance trading system
called for in the Gean Air Act and the institutions that are relevant to analyze different
trading systems. Section n provides a framework for designing an efficient allowance
market and identifies key participants. Section m briefly discusses the objective functions
and operating constraints of market participants. Based on these observations, we
establish that in the short run, a homogeneous commodity will not be traded. Section
IV grammes the issue of 'forced* recordation and what information should EPA require
and make publicly available. Section V explores whether allowances should be numbered
and tracked through the system. In section VI, we ask whether EPA should license
^Throughout this paper, we define exchange very broadly. In addition to the
organized exchanges (e.g4 Chicago Board of Trade) we also include broken who offer
to buy or sell to all parties at quoted prices.
*A homogeneous allowance is defined as one where the potential buyer is indifferent
about who the seller is-the allowance has the same value and characteristics regardless
of the identity of the seller and how the seller is "producing" excess allowances (e.g..
overcontrol technology, shut down etc.).
^Similarly, at the time of the deregulation of airlines, no analyst envisioned the
development of the hub and spoke system now commonplace today. This innovation has
fostered efficient use of landing rights and airline resources resulting in large benefits to
society.
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brokers or other non^mitting traders holding an account on the EPA allowance tracking
system. Finally, in section Vn, we address the benefits and costs of implementing an
EPA bulletin board. :
IL A Framework for Analyzing the Allowance Market
Intelligent design of the allowance market requires an understanding of the
objectives of the market as well as a.knowledge of the key actors. Here, it is assumed
that the objective of the market is to minimha' the cost of achieving a 10 million ton
reduction in SO, subject to legislative and regulatory constraints.
A* Conditions for Mar*** Efficiency
There are three basic conditions for ensuring that a market in allowance trading
will achieve high levels of efficiency. First, allowances need! to be given the status of
property rights. While EPA cannot officially define allowances as property rights, its
regulatory actions will have a dramatic impact on whether firms perceive that the
allowances are property rights. Second, transactions costs associated with trading
allowances must be low enough that firms have an incentive to trade. EPA, FERC and
state regulatory agencies will all play a critical role in affecting transactions costs. Earlier
attempts to implement environmental markets have, for the most part, tended to impose
high transactions costs with the result that trading has been quite limited. The third
critical feature for market efficiency is that firms face appropriate incentives, to use an
efficient combination of inputs such as fuel, allowances, and hardware, in meeting.their
emissions targets. This problem is a particular challenge for the allowance market
because utilities, which are heavily regulated, are expected to be the major participants.
Different regulators will be able to exert influence over different features of the
market For example, EPA will play a central role in defining allowances. State
regulatory agencies, most notable public utility commissions (PUCs) will play an
important role in defining the incentives faced by utilities in selecting an abatement
strategy. Both the state and federal agencies will jointly play a critical role in
determining the transactions cost associated with trading. Our focus in this paper will
be on the role that EPA can play in helping to minimi** these transactions costs.
B. Kfly Acton
The success of the market will depend on the interaction of a large number of
diverse interests. We believe there will be, at least at the outset, six critical groups that
could have a dramatic impact on the performance of the allowance market.
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1. Electric Utilities. Utilities will have to develop a compliance strategy that shows
how they intend to undertake the necessary abatement activity and allowance
trading to comply with the Acid Rain provisions of the Clean Air Act Note that
this strategy,,and all abatement costs, allowance purchases, and sales will have to
be approved by the local Public Utility Commission (PUC). Utilities will want
information necessary to weigh the relative costs of pursuing various compliance
strategies. This includes cost and uncertainties associated with allowance prices
and abatement equipment, and the reaction of the PUC to various compliance
strategies.
2. The PUCs. The PUCs approve rate increases and cost "pass-through's", based on
the utility's operations. In deciding how a particular expense is passed on to the
consumer (if at all) the PUC balances risks and expected costs to the consumer.
Obviously, the regulated utility will act to get the most favorable ruling from the
PUC If the PUC punishes risk taking (in an attempt to lower costs) a utility will
proceed accordingly. PUCs will want information on the consequences of their
decisions in terms of utility behavior and costs.
3. Non-utility Generators, The non-utility generators. (NUGs), which include
independent power producers (IPPs) are unregulated power producers who sell
electricity to the "grid" at market prices. These producers are expected to play
a more important role in electric power generation over the coming decade. Their
level of production may be dramatically affected by how the market in allowances
is designed
4. Brokers. Brokers are defined as those specializing in bringing buyers and sellers
together by crafting contracts (transactions) that are mutually advantageous.
S. US. Environmental Protection Agency (EPA). The EPA is responsible for
keeping, the official records of allowance balances and recording each transaction.
They also enforce the penalties for those sources emitting more than their
allowance holdings permit
6. Environmental Groups. For the allowance program to succeed, it may need the
support of environmental interest groups. They can be instrumental in convincing
the public of the merits of buying and selling "rights to pollute." Something that,
on the surface, sounds objectionable.
This list is not meant to be exhaustive. Other regulators, such as FERC, may play
an important role in trading. Moreover, if the market works well, industrial emitters of
SO2 may choose to take an active role in the market
.-«•>- *i,-«W,-;-..
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HI. The Nature of the Allowance Market
In a market with no transactions costs or regulatory distortions, once allowances
are distributed to existing power producers we would expect trading to commence until
all the gains from trade are exhausted. That is, at the margin, all allowance holders
value the marginal allowance by the same amount In this way, markets will minimize
the cost of achieving a given environmental objective.
However, in the real world, there are numerous distortions and transactions costs
that guarantee that a socially cost-effective solution will not be achieved The most
obvious one is that most allowance holders are natural monopolies regulated by a variety
of laws and institutions.
. This section does not investigate these types of distortions. Rather, we quickly
describe how different market participants will value allowances, according to the
regulatory, accounting, and tax institutions in place. Based on these crude descriptions
of value determination, we conclude that there is a tremendous amount of uncertainty
over the net benefits of allowance trading, Until this uncertainty is reduced, trading is
likely to involve fairly sophisticated brokers 'tfarghfr*g for mechanisms to reduce
uncertainty and ff»^*imif-f gains from trade. Further, the uncertainty will probably give
rise to specialized offers to buy and sell, inhibiting the immediate development of the
concept of an offer to buy or sell a "homogeneous" allowance. These dynamics are
illustrated with simple *Mitiplef of possible trading situations.
Example L A trade Pctnuji Two Utilities
Public utility commissions, based on the costs of the utility, approve all rates
charged by the utility. Therefore, a trade between two utilities probably would be
conditional upon the approval of two different PUCs. The value to each party can only
be determined once each PUC approves a transaction. Therefore, it is conceivable that
depending on the PUCs decision, a utility may not know whether buying or selling
allowances will enhance profits. In the early stages of the market, the PUC decisions
will not be able to be predicted with enough certainty to justify trading prior to PUC
approval. Therefore, both utilities would want to make each transaction conditional upon
satisfactory PUC treatment.
Note thai; in principle, this problem does not rule out a homogeneous commodity.
In this example, the value of the allowance to the buyer did not depend on the actions
of the seller. However, the risk aversion induced by different approaches of state utility
regulation may lead to even more complicated offers to buy or sell For example, both
parties may agree that the PUCs would look favorably on a financing arrangement in
which the buyer of allowances pays for the pollution control equipment of the seller. If,
in tact, the utilities believe that this creative financing of an allowance trade has a better
chance of increasing the "rate base" then brokers and trading partners will pursue such
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arrangements. In this case, a homogeneous allowance is not traded. .Each party is taking
advantage of a unique situation introduced by differing regulatory treatment and
unresolved regulatory uncertainties in the treatment of allowances.
A Trade Between an IPP and a Utility
Given the structure of the electricity market, an independent power producer (IFF)
is likely to be more risk adverse than a utility. While continuing to satisfy a given load
demand, a utility in need of allowances can buy power from the grid or use its own
lower-emitting units more intensely. An IPP must have sufficient allowances to cover its
emissions, (as defined in an approved compliance plan). Otherwise it faces forced
shutdown (or other EPA enforcement action). Therefore, when developing a compliance
plan, an IPP may be unwilling to wait for the seller's PUC approval Instead, the IPP
will go elsewhere for a more certain supplier. At a mintmtimt an IPP will discount
heaviry an offer from a utility conditional upon satisfactory PUC approval Accordingly,
an IPP may be willing to pay a great deal more for an unconditional offer.
In this example, there are at least two different commodities evolving from
allowance trading: (a) an offer to sell (or buy) conditional upon PUC approval; and (b)
an offer to sell (or buy) without any conditions.
Example 3. Toe Tax Treatment of the Seller Affects the Tax Treatment of the
Buyer
Tax and accounting procedures may result in further uncertainties and
complications. For example, a seller of allowances may be in a position to defer
recognition of income, thereby preventing the buyer from writing off the expense of the
allowance in the current period (for tax purposes).
*
This issue is more common for real estate and other commercial transactions but
it could be relevant for allowance trading as well dearly, the value of the allowance
to the buyer could be a function of the tax treatment of the seller. Exchange trading
would not be able to take advantage of this situation-a homogeneous allowance is not
traded.
Example
Utilities Develop Compliance Plans Simultaneously
When developing compliance plans, a utility can pursue several options. These
include: (1) buy allowances in the short term and plan for the installation of abatement
equipment in the intermediate future; (2) install abatement equipment immediately; (3)
enter into a low-sulfur fuel contract; or (4) buy a perpetual allowance allocation from
other utilities that are retiring uncontrolled units. Each of these options are associated
with a different allowance demand or supply profile over time.
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The utilities will also place a premium on certainty. A compliance plan that relies
on purchasing allowances "as needed" may be unacceptable to PUCs and therefore
discouraged by unfavorable cost recovery rulings. Alternatively, a compliance plan that
identifies allowance trading partners, financing mechanisms, and a reasonable degree of
compliance certainty may be viewed as mMmmn^ risks to rate payers and therefore
receive favorable rulings.
To reduce the uncertainty over costs and compliance, utilities will place a premium
on finding buyers or sellers of allowances, consistent with the other components of a
compliance strategy. For example, those planning to install abatement equipment in
the year 2000 wfll need to buy allowances in the short run. Others will want allowances
bundled for longer time periods. Rather than waiting to see bow a market develops, net
buyers of allowances will want to enter into contracts to secure reliable sources of
allowances now.
Exchange trading has shown a remarkable ability to "bundle" commodities
according to the needs of buyers and sellers.9 However, it is unlikely that an exchange
will be able to develop quickly enough to meet the utilities' demand for a certain supply
-of allowances. Hie- regulatory uncertainties introduced by the PUC regulatory
environment probably will result in bilateral trading with creative financing arrangements.
The conclusions drawn from these four illustrations is that, in the primary market,
the uncertainty and risk aversion that will exist when the allowance market begins will*
create a need for creative and unique trading arrangements-exchange trading will take
some time to evolve.7
dearly, the lack of an immediate central market suggests that there is a seed for
widespread market information dissemination. However, the same reasons that rule out
immediate exchange trading also make it difficult to report a reasonable set of economic
characteristics that would inform the market* Much like tax lawyers, real estate
consultants and accountants, allowance specialists in the private sector are in the.best
position to communicate this complex information most effectively. Further, private
sector specialists (broken) have an incentive to change the information set in response
there are stock Index futures and options that allow traders to buy
and sell bundles of stocks. The commodity markets deal with contracts for a given
commodity wftn a range of different "delivery" dates.
'Similarly, the commodity exchanges of today developed over time as traders
developed different specifications to define various trading instruments.
*As a illustrative parallel, it is equally difficult to summarize economic characteristics
of commercial real estate transactions in light of tax considerations, financing schemes
etc. The price per acre or per square foot is a poor proxy for all considerations.
8
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to market innovations and evolution. In the process of supplying this information, private
market specialists can also perform a brokering role to help reduce transactions costs
further. :
The only other actor in a position to supply this information is the EPA. This
organization would be a poor substitute for private brokers. First, EPA specialists have
no profit incentive to stay informed of what information the market needs over time.
Second, it is unlikely that, without considerable expense, EPA could assemble a team of
analysts, lawyers, accountants etc, that could determine what the appropriate information
to communicate should be. Finally, EPA brokering and information-providing may
dampen interest in private sector brokering.9
A. The Secondary Market
It is impossible to say what the secondary market, (loosely defined as those
transactions carried on by speculators/brokers on their own accounts), will look like over
time. These secondary acton could serve to reduce much of the uncertainty created by
the PUC rate making process. For example, if there is a premium for unconditional
offers to buy and seU, a broker could fill a very useful role by accepting conditional
offers themselves but offering unconditional offers to others.
The prospects for a secondary market operating on an exchange are hard to
assess.10 dearly, the chances improve if PUCs can converge on a standardized treatment
of revenues and expenses arising from the sale and purchase of allowances. More work
is needed on this issue, including an analysis of how PUCs may treat allowance
It may be possible to conclude that the primary market will always need to be
flexible and creative to overcome the uncertainty and to take advantage of the unique
positions of some buyers and sellers. On the other hand, promoting a homogeneous
market can have tremendous payoff in terms of lower transactions costs, more organized
antitrust enforcement efforts, and a forcing mechanism to trigger uniform PUC treatment
of allowance revenues and expense. Although it is impossible to know what the final
outcome will be, EPA regulations should allow for a great deal of private market
flexibility and creativity when designing the allowance market
In light of mis need for flexibility, we review specific information .issues in the
"While EPA's information gathering is financed with tax revenues, a private sector
broker would have to charge a fee.
TOWe define exchange to include both formal exchanges (e.&» Chicago Board of
Trade) and off-exchange exchanges where brokers make a market in a commodity by
accepting orders to buy or sell a commodity at quoted prices.
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remainder of thfc paper.
IV. Recoidatfcra and Publicly Available Information
The presentation of the computer-bawd allowance trading system at the January
ARAC meeting suggested that a great deal of trading information could be collected and
made available to the public In the demonstration model, the names of those
participating in a transaction and the quantity of allowances traded would be recorded
and made available to the public. Price information was not treated as required
information in the demonstration. We believe that the issues oft (1) what information
on transactions should be required; (2) when that information should be supplied and;
(3) who should have access to that information are important issues that are not easily
resolved. This section provides a preliminary analysis of these issues.
A, What Information Should Be Recorded and Made Available to the Public
The Allowance Trading System demonstration program presented at the January
ARAC meeting included the identity of the buyers and sellers in a transaction, along with
the quantity traded as information that would be recorded and readily available to the
public Note that the information was presented for each transaction and summarized
so that the balance of allowances for each market participant is easily determined. In
thif analysis* we jtiKwnw flint thi« is the rnin«nMni amount of information that must be
collected and made available to the public11 As a matter of law and EPA policy, all
information provided to EPA would be made available to the public as welL 2
While there are benefits associated with public disclosure of this information,
there are potential concerns. First, a public record of each transaction, with names of
those undertaking trades, could make it easier for a subset of brokers to enforce a
cartel The cartel wfll have an official record of any member cheating on the cartel.
Second, publishing names associated with each transaction may lead to market
inefficiencies. In a competitive electric power market, utilities and IPPs will need to plan
for production expansions. Siting a new plant wfllinvolve numerous contingencies.
Public disclosure of an allowance sale may signal an IPPs intention to build a new plant.
As a result, other sellers of plant sites, etc may inflate their asking prices. Rather, the
polluter may decide that although purchasing abatement equipment is probably more
1\Dbvionlyt EPA must require that parties to a transaction be identified for
accounting reasons. Otherwise it would not know who to debit and credit, and thus,
would not be able to effectively monitor and enforce trades.
taThe dean Air Act does not provide for confidential business information in the
. Acid Rain provisions. Under the Freedom of Information Act, anyone could, therefore,
request information collected by EPA on each transaction.
10
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expensive, it is a less risky, preferred alternative.19 Finally, there are public relations
consequences to buying allowances. A utility may not want to acquire a reputation of
a firm that actively buys allowances (and therefore increases pollution) instead of
investing in pollution control equipment
Note that these arguments are not relevant if allowance holders can use third
parties to transact trades on their behalf in order to avoid public disclosure.
Should Price In/bmtatioa B« Recorded and Made Public?
Many as the last ARAC meeting suggested that EPA should require and disclose
price information in addition to the quantity bought and sold when finalising a
transaction. In general, price information is important to fostering competitive markets.
The real issue is whether this information is best provided by EPA or the private sector.
There are several points to consider when evaluating this issue:
1. If allowances are not homogeneous, price information may provide as much
misinformation as helpful information.. The market is really buying and selling
unique commodities. A price observation on a unique commodity is only of
limited use valuing a "similar* but different commodity.
2. Other regulated markets do not require each business enterprise to disclose the
terms of individual transactions. The reason is probably that this disclosure will
discourage participation. For example, one broker may have invested heavily in
search costs to locate and develop the best possible financing and buying
arrangements. If price information from *n»f transaction is made available, other
competing brokers may gain valuable information. As a result, brokers may be
unwilling to invest in business development.
3. To the extent that pools can trade internally without reporting this information,
> such onerous requirements only serve to keep trading within pools.
4. Some price information will be available through other channels, along with other
details about trading. For example, a great deal of information will be available
EPA auction results. Further, some information will be presented at PUG
5. What does EPA do if a party does not want to supply the information? Does
EPA have the enforcement authority to deny the trade?
1*This is not an issue if the buyer of allowances has the ability to withhold the
information from EPA until the appropriate time. The timing of reporting transactions
is treated in the next section.
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6. There is reason to believe that private markets will supply useful price and
quantity information through broken and/or centralized information networks.
Data resource companies may collect the information. Details on trades would
probably be reported in newspapers and trade magazines.
B. Forced Recordation Immediately Upon Concluding Transaction
Should EPA require parties to immediately report successful transactions to the
allowance ^trading system? EPA, in turn, would inform others in the trading community
and the public. This requirement is motivated out of concern for the public's right to
know utilities1 use of these allowances.14 Further, forced recordation will provide market
transaction information sooner to potential market participants and EPA. If every sale
were recorded quickly, EPA would have up-to-the-minute allowance holdings. If any
single group tried to manipulate the' market, EPA could more easily detect it.15
However, a rigid rule forcing recordation would impose unnecessary costs. First,
it is likely that the vast majority of trades will be recorded soon after a commercial
transaction. Buyers of permits have a strong incentive to report trades immediately, since
it "legitimizes" a trade. Buyers will want to insure that the allowances are there to trade
and that EPA makes the transfer to their account They may even want to withhold
some or all of the payment until EPA records the exchange. Legitimate sellers should
be indifferent However, there may be special circumstances that demand the flexibility
of not recording trades immediately.
Specifically, Federal and state initiatives have been aimed at encouraging
competition for the generation of power. Requiring immediate public disclosure of an
allowance sale or purchase may signal the intentions of one or a group of IFPs to
compete in this market As in other industries; these firms need the ability to plan in
private; otherwise the incentive to take risks and undertake market research are reduced.
Given that the situation described above is likely to arise, what would EPA do if
two parties did not report the transaction immediately. Would EPA have the authority
to deny the trade? Would denying the trade be good policy?
'^Obviously, a transfer wfll have to be recorded before any increase in emissions
takes place.
Possible market concentration is a concern and related to issues associated with
pooling of allowances. In particular, if pools can act as single buyers or sellers, can the
exert too much influence on the market?
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V. Serialization of Allowances
This issue was also discussed at the last ARAC meeting. There are three basic
options:
(1) Label (serialize) each allowance, but do not have EPA record or track each
allowance
(2) Label each allowance and develop an allowance trading system that tracks each
allowance
(3) Do not label or track each allowance, but carefully account for the net purchases
and sales by each allowance holder.
Our preliminary examination suggests to us that serial numbers and tracking will
not enhance the performance of the market The most obvious parallel is the common
checking account The balance in an account are not serialized Banks feel no need to
do so. The only requirement banks impose is that they know the actor requesting a
transaction is a legitimate depositor. Notably, brokers in many commodity and financial
markets keep only a balance for each client A client can instantaneously close out a
position (long or short) by instructing the broker to do so. Keeping detailed accounting
of each instrument is not necessary. Similarly, EPA need not worry about specific
allowances. Rather, the balance in each account is what is important The system has
no need for the information.
Some may believe that a detailed tracking system may make it easier to recreate
trades and correct possible recording errors by EPA. This is a concern that needs
additional examination. If this is a concern, there are alternative ways to deal with this
problem,'*
Finally, there may be accounting or tax concerns with serialization. Nothing in the
presentation at the last ARAC meeting demonstrated the need for serialization and
tracking. If EPA serialized each allowance, (but did not track them) firms may acquire
the flexibility of establishing the cost basis of various allowance transactions using specific
valuation rules (e.g* UFO, FIFO) or averaging procedures as in the case for other
fungible assets If a case is to be made, those with expertise in this field need to spell
out dearly why a detailed tracking system, and the corresponding EPA supporting budget,
are needed.
example, a third party could be responsible for maintaining the allowance
tracking system, under dose EPA supervision and auditing. This third party would be
liable for any recording errors that could not be corrected easily. Perhaps a performance
bond would be required. If EPA were solely responsible for recording, the cost of
mistakes that can not be corrected will more likely be borne by all allowance holders.
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VL IJffi****! ud Bonding of Broken and Other Market Participants
This section explores the arguments for licensing market participants designated
"nonemitters.* Clearly, unless there is a way for buyers to insure that the allowances are
legitimate, they will be reluctant to enter into a transaction. Further, sellers will need
assurances that the buyer has the ability to pay the price for each allowance.
One option that is often proposed is for EPA to require the bonding and licensing
of nonemitters. Given these guarantees, market participants can proceed with confidence.
While this is true there are costs to taking these steps. Further, there are more
straightforward ways to provide assurances to market participants.
1. Buyers of allowances always have the option to withhold payment until EPA
officially records the transaction.
2. If the market demands assurances, brokers will find in their own interest to
become bonded.
3. In general, bonding and licensing can be handled at the state level if fraud
ft
While commodity brokers must be registered with the Commodity Futures Trading
Commission, licensing or h^wting is performed by the exchanges.
VIL EPA Bulletia Board
Another issue suggested at the ARAC meeting is the possibility of EPA sponsoring
a bulletin board where potential buyers and sellers could post requests for proposals,
expressions of interest or raise questions. While this would be relatively inexpensive to
operate, the design and cnrnimn'ng adaptation of such an institution is probably best
handled by the private sector. —
We base this assertion on two considerations. First, we believe the private sector
will supply this service. We sense that the number and sophistication of potential
allowance broken are increasing. Second, allowances will not be homogeneous
commodities Therefore, a successful bulletin board will need to convey important
information as yet unidentified. Brokers close to the trading action will be in the best
position to identify what this information is and modify the bulletin board systems
accordingly.
14
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Paper
ACID RAIN ALLOWANCE TRACKING SYSTEM ACCOUNTS
Discussion Paper
I. Introduction
Th« allowance tracking system (ATS) will be the official
record of who holds allowances at any point in time. All the
information in ATS accounts would be open to public viewing via
computer connection, while the statute allocates allowances "for
units" it permits transfers among designated representatives and
anv person. ...This means that any person not initially allocated
allowances that purchases and holds allowances would need an
account in the ATS. Since there are no limitations concerning who
can hold allowances, EPA must develop procedures to set up a new
account in the ATS for anyone who wants one.
Not all accounts in the tracking system would be the same.
For instance, the information EPA would require for an emitting
source would be different from that required for a non-emitter.
This paper is intended to identify different types of ATS accounts
and to examine the potential requirements for setting up each
account type.
II. Account Types and Requirements
For the purposes of this paper, account types are divided into
two categories, 1) emitting sources and 2) non-emitters. The
initial information EPA would require for emitting sources will be
generated for EPA in the allowance allocation and permitting
processes, while non-emitters would be required to submit a new
account form to EPA.
A. Emitting Sources
for all emitting sources, EPA would need to require certain
minimum information to establish an ATS account. Below is a list
of the required information.
Plant Nane
Plant Address
Unit Nam* or Number
Designated Representative
Designated Representative Phone Number (and Fax Number)
Designated Representative Hailing Address
Emitting sources must also go through the required permitting
procedures. This includes the appointment of a designated
representative by the owners or operators of each unit. once
certified, the designated representative will be responsible for
the emitting source's account (allowance transactions, emissions
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reporting, and compliance). For the purpose of discussion, the
emitting source category is separated into three types of units-
(listed below).
i. Existing Phase I or II Affected Units
Under the Act, these units will be allocated sulfur dioxide'1
emission allowances. Phase X allowance allocations are listed in
Title XV of the Act, and Phase XI allowance allocations will be
calculated by EPA. Beginning in 1995 for Phase I units and in 2000
for Phase XX units, allowances will be issued annually.
Since these units will be allocated allowances, . allowance
tracking system accounts will be set up for then automatically.
As a result of calculating Phase XX allocations, EPA already has
the required plant and unit information necessary to set-up this
type of account. The rest of the information, concerning the
designated representative, will be provided for the unit during the
permitting process .
ii. New Phase XX Affected Units
From the ATS perspective, these units will be treated the same
as existing Phase XX affected units, except they will not be
allocated allowances. Instead, they will be required to purchase
enough allowances to offset their emissions. As with the existing
units, these new units would have an account set up for them prior
to commencing commercial operation.
For new units, all the information EPA needs to set up an
account will be provided by the unit as part of the permitting
process. Possibly, as part of the permitting process (perhaps
along with the permit application), EPA would require the unit to
submit a new account form. Xf the unit already has an account in
the tracking system originating from a prior purchase of allowances
(either through the auction, the sale, or trading), then the new
account form would not be necessary, but a designated
representative certification would be required for the account (if
not already present)2*
1 Affected units wishing to transfer allowances prior to
applying for their permit may be required to appoint their
designated representatives before EPA would record the transfer.
2 It is useful to note that the unit would be required to
have a designated representative to receive its permit, but could
have a broker or anyone else hold allowances for it prior to being
permitted.
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iii. Election Source (Opt-in) Units
Sine* election sources will receive an allowance allocation
most likely through the permitting process, EPA will have the plant
and unit information required for opening an account. As in the
case of other emitting source units, the designated representative
information will also be provided during the permitting process.
Election source units would have an account set up for them when
they become an affected unit under the acid rain title.
Requirements for the election source program will be discussed
elsewhere; however, because elect-in units can not transfer or bank
allowances produced as a result of reduced utilization or shutdown,
election source accounts will be subject to certain limitations,
reflected in the mechanics of transfers from such accounts .
B. Non-Emitters
. Emitting sources would be required to have a designated
representative, who would be responsible for their accounts (i.e.
allowance transactions, permitting, and compliance). Non-emitters,
who would not be subject to emissions limitation or permit
requirements, would nfi£ be required to have a designated
representative. Since EPA would simply not record transfers in
which the seller had insufficient allowances to cover the transfer
and these accounts would not be tied to emissions data, non-
emitter accounts would not be subject to overdraft penalties,
offset requirements, or to any of the emissions related penalties
set forth in Title IV. This means there are fewer requirements and
less information needed to set up an ATS account for non-emitters.
For non-emitters, only the new account form would be required to
open an ATS account. Below is a list of the minimum information
that would be required on the new account form.
Name and Official Title of Account Holder
Telephone (and Pax) Number
Mailing Address of Account Holder
Organization or Company Name (if relevant)
Type of Organization (if relevant)
Signature and Oat* Signed
Again, for the purpose of discussion the non-emitters category is
separated into two types of accounts (listed below).
i. Individual or Broker Account
This would be a very simple account, since such a person would
Por further discussion of the mechanics of opt-in source
allowance transfers, please see discussion paper A-7, "The
Allowance Transfer System1*, Section III. B. Special Considerations
for Opt-in Source Allowances.
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be representing herself and acting on her own account. In this
case EPA: would simply require the new account form.
ii. Allowance Pool Account
A group of affected units may find it in their interest to
pool their allowances by setting up a single non-emitting account.
The allowances would be held in such an account until the end of
the year, at which time the allowances would be transferred back
to the affected units' accounts for compliance purposes. As with
the individual or broker account, opening an allowance pool account
would simply require a new account form. EPA would not need to
know what private arrangements are made among the affected units
that constitute the allowance pool. This is simply a non-emitting
account, since allowances are not tied to individual units.
Other affected units (perhaps an existing power pooling
arrangement) may find it easier to appoint the same designated
representative for each unit in the pool. This designated
representative would be responsible for the pool's allowance
transactions, permitting, and compliance. This type of arrangement
would allow the designated representative .to make only one group
of transfers among the units at the end of the year, and could
provide an alternative to having an allowance pool account in the
ATS. Allowance pool accounts could also address end of year issues
by allowing for pre-designated transfers to pool members in cases
where the unit(s) would be subject to the excess emissions
requirements.
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A-7 Paper A7
THE ALLOWANCE TRANSFER SYSTEM
Discussion Paper
I. Background
*
Developing regulations and procedures will involve using a
core workgroup of relevant offices in EPA. The core workgroup will
address the options and issues involved with promulgating the
allowance tracking system, allowance transfer system regulations
(trading and banking), and the auctions and sales regulations. The
workgroup's analyses and issues will be presented to the acid rain
advisory. committee (ARAC) for review. In some cases, this will
involve developing a strawman proposal, and in other cases it may
involve presenting'an options paper. This paper examinee some of
the issues surrounding the allowance transfer system; how the
allowance transfer system could be designed, EPA's role in
receiving and recording allowance transfers, and considerations for
allowances allocated to "opt-in" sources.
IX. Introduction
EPA must promulgate a regulation to establish the allowance
system by Kay 15, 1992. Under The Clean Air Act amendments of 1990
(The Act), the allowance system shall include, but net be limited
to, requirements for the allocation, transfer, and use of
allowances. Regarding transfers. The Act states that, "Transfers
of allowances shall not be effective until written oertifioatiom
of the transfer, signed by a responsible official of eech party to
the transfer, is r«e«iv«d and rmcor^mA by the Administrator."
Additionally, the Act requires EPA's regulations to permit the
transfer of allowances prior to the issuance of such allowances.
Such recorded pre-issuance transfers will be deducted from the
number of allowances which would otherwise be allocated to the
transferor and added to those allowances issued to the transferee.
In addition, EPA mist establish an allowance tracking system (for
issuing, recording, and tracking allowances), which specifies all
necessary requirements for an orderly and competitive functioning
of the allowance system. - . ~
The Act provides the general framework for the allowance
transfer system. It does not, however, specify how the system is
to be designed. Designing a simple and- efficient transfer system
is crucial to the success of the acid rain program. EPA's role in
receiving and recording allowance transfers is also important for
ensuring an efficient market for allowance trading. For the
purposes of discussion, this paper presents one possible aodel
for the allowance transfer system and EPA's role in receiving and
recording transfers. This paper is divided into three parts: i)
Basic Transfers, 2) The Notification Process, and 3) Special
Considerations for Opt-in Source Allowances.
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IZZ. ISSUes
A; Basic Transfers — One Possible Model
Under the Act, affected units will be allocated sulfur dioxide
emission allowances. Phase I allowance allocations are listed in
Title XV of the Act, and Phase IZ allowance allocations will be
calculated by EPA. Beginning in 1999 for Phase Z units and in 2000
for Phase II units, allowances will be issued annually. While
allowances will be issued annually, affected units may transfer
future year allowances to which they are. entitled based on the
statutory allocation formulas. While the statute allocate*
allowances "for units* it permits transfers among dmmlan****
r«pr«a«ntagiv«« and any nmrma*. This means that any person not
initially allocated allowances that purchases and holds allowance*
would need a separate account in the allowance tracking system.
Thus, EPA will need to develop procedures for establishing new
accounts.
i. Allowance Transactions
EPA's role in allowance trading is to receive and record
allowance transfers. Streamlining the mechanics of receiving and
recording allowance transfers is vital for facilitating market
transactions. Zn order to foster an effective trading program, the
process should entail the minimum involvement of EPA consistent
with the statutory requirements.
Utilities as well as non-utility participants vill generally
be free to work out any transfer they want. When two parties agree
to a transfer, they must notify EPA to make it "official*, once
EPA records the transfer (by debiting the seller's account and
crediting the buyer's account) in the allowance tracking system it
becomes, official.
At the risk of oversimplification, a transfer could be made
the same) way a bank cheek is written. The eeller can write the
"allowance check* and give it to the buyer. The buyer can then
endorse it and camh it in by sending it to EPA for recordation or
could chooee to endorse it, but instead of notifying EPA and
triggering the account debiting and crediting mechanism, simply
sell th« allowance "check* to someone else. Za this case the check
could rnanejej hands many times before a buyer decides to endorse it
and send it to EPA for recordation (i.e. debiting the account of
the initial seller and crediting the account of the lamt buyer).
The "check* will need to contain certain information on both
parties, in order for EPA to record the transfer. Below is a
potential list of the minimum information EPA would need from both
parties to record a transfer.
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The seller would need to include:
Unit and designated representative system . identification
numbers
Man* and telephone number of designated representative
Signature (and date of signature) of the designated
representative
Amounts and use dates of allowances being transferred
(earliest date each allowance can be used)
The buyer would need to include:
Unit and designated representative system identification
numbers
Kane and telephone number of designated representative
Signature (and date of signature) of the designated
representative
A saaple transfer night work as follows. Unit A enters into
an agreement and sells allowances to a broker by writing him a
"check1* (Kote: unit A could either make the "check" out to the
broker or not). The broker intend* to hold the "check* for several
months (thinking allowance prices may rise) and then to sell these
allowances to another unit that needs them for compliance purposes-.
Because he's planning to sell the "check", he does not fill in his
information and only endorses the "check* if made out to him.
Several months later when the broker finally sells the allowances
to unit B, unit B would fill ia its information, endorse the
"check* and notify EPA so the allowances can be officially
transferred to its account. Xf all the procedures are followed
correctly, EPA would record the transfer to make it official by
debiting unit A's account and crediting unit B's. Consistent with
the statutory requirements, the notification (the check) must be
signed by responsible officials of both parties to the transfer,
in this case the designated representatives of unit A and unit B.
In this instance, the broker never officially held the allowancee
since, whether endorsed or not, the cheek was never presented to
EPA for the purposes of crediting the allowances to the broker's
account. They were officially held by unit A, even though the
broker bought them, until EPA recorded the transfer to unit B.
ii. notification Process
Therer weald be two possible methods for notifying (i.e.
cashing the> "cheek*) EPA (or its agent) of allowance transfers; i)
electronic reporting and 2) written reporting. Electronic
reporting would be similar to electronic funds transfers currently
used in the banking industry. EPA could produce a standardized
electronic format that would be completed by the party that
endorses the cheek and sent to EPA vie computer. In this case,
Personal Identification Numbers (Plus) would be used in place of
signatures. For written notification EPA could produce an
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"allowance chack* which would ba a standardized fora to help
facilitata tranafar reporting. Utilities choosing to send written
notification could aitbsr fax tha information to EPA at the
tracking cantar (whara data antry taJcaa placa) for quick
recordation, or aail (cart if lad?) it to EPA at the tracking eantar.
Faxing tha information is only poaaibla if EPA does not need'
original signatures of the designated representatives.
Onca EPA has racaivad tha transfer notification (tha "check"),
tha data antry teaa would need to make aura tha fora ia corractly
fIliad out, tha information ia coapleta, and that tha aallar haa
anough currant or futura allowancaa to covar tha trad*. Thia would
includa: 1) confirming that both parties hava accounts in tha
allowance systaa (adding an account for any party that ia not
alraady in that systaa), 2) checking tha number and dataa of
allowancaa, and 3) aaking aura tha fora is signed and datad by both
raaponaibla officials (also known as dasignatad representatives)
or that tha PIN nuabars ara corract in thai casa of alactronic
reporting*
If tha tranafar information is eoaplats and tha aallar holds
or vill hold anough allowancaa, EPA (data antry) would racord tha
tranafar by entering it in tha tracking systaa (dab it ing tha
sailer's account and crediting tha buyar's account). Cartaihly,
utilitiaa vill ba fra« to trada futura allowancas to which thay ara
ant it lad. Howavar, EPA would not allow a unit to trada aora
allowancaa than it had or would ba antitlad to in the futura. For
axaapla, if unit A haa a Pnaaa ZZ allocation of 10,000 allowancas,
it would ba abla to tranafar up to 10,000 allowancaa aach yaar.
If unit A wrota a "chack" for 11,000 yaar 2010 allowancas, EPA
would not racord tha tranafar and would notify both tha buyar and
aallar of tha chack that unit A haa insufficient ailowancas to
covar tha transaction1.
onca SPA racorda tha tranafar it is official. Tha transfar
participants would know it's official whan tha transaction appaars
in thair account in tha allowanca tracking systaa (showing tha
transfers which took placa and thair naw balance)*. Ho parait
1 Allowing affected sources to trada allowancaa thay ara not
entitled to coold erode emissions reductions by implicitly
permit-tin* otherwise unauthorized "borrowing" of allowancaa. To
prevent thia, tha mechanics or protocol of tha allowanca tranafar
aystaa moat block transfers of allowances not held by the
transferor. .
1 Siailar to a monthly bank stataaent, tracking systaa account
stataaaata might hava to ba issued on a regular basis throughout
tha yaar. These statements could show tha account holder's
beginning balance, all transfers which took placa, and ending
balance.
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review would be necessary or required for sources that simply
transfer allowances. If the information is incomplete or the
sallar doaa not hava enough allowances to covar the trade, then
EPA would not raeord such tranafara and vould notify both partiaa
aa to why tha trada vaa not racordad. At tha and of the year, EPA
would do tha accounting procaduraa and sand out a final notice3.
Diaeuaaion Questions;
Zs thia "checking account" modal appropriata for tha allowance
trading ayatea (taking into account potantial tax and
accounting implicationa)?
Conaiatant with tha Uniform Comaarcial Coda, doaa tha
"allowance check" naad to ba racordad within a givan amount
of tima (six montha for example) or alaa bacoma invalid?
whila alactronic or faxad tranafar notifications would ba
anough for purposes, should EPA raquira a writtan copy
(par hap a tha original) of tha tranafar form for EPA'a intarnal
racordXaaping?
Similar to a monthly bank statement, should EPA sand out
periodic account balance statements to ail account holders?
. How often?
After EPA records a transfer, should EPA send each account
holder a notica showing the transaction which took place?
»
Zf tha information is incomplete or the seller doea not have
enough allowances to caver the trade, how should EPA notify
the trading parties that tha tranafar can not be recorded?
B. Special Considerations for Opt*in Source Allowances
The preceding discussion covers the allowance system in
general. However, allowances allocated to sources that elect-in
to the allowance system are subject to certain additional
limitations that will affect how these allowances are treeted.
Specifically, any unit that elects-in to the allowance system ah«n
utiii»««:i«Mi ae shutdown. this has implications for both tha
allowance* transfer and tracking systems.
THe< "opt-in" allowances would be aubject to the same
requirements as other allowancae, except when an opt-in source
shuts-down or reduces its utilization. Zn such cases, the excess
allowances (e.g. produced through shut-down) would stay with the
1 End-of-year procedures will need to be developed.
5
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source to which they were allocated. Then, at the end of the year
these allowances would disappear because they could not be banked
or carried over. The mechanics of handling these- "opt-in"
allowances must be consistent with the larger allowance systea such
that recordation would not occur until the year in which allowances^
becoae useful — even for future allowance transfers consummated^^
and recorded with EPA several years in advance. Whenever a
transfer of allowances from an opt-in source is sent to EPA for
recordation, the actual physical debiting and crediting could not
take place until the end of the year. Recordation would take place
only after the determination that the source was in full operation
throughout the year and that no allowances were aade available as
a result of reduced utilization or shut-down. During the course of
the calendar year, the number of allowancee in accounts that have
pending opt-in allowance transfers would not reflect the debit and
credit associated with recordation, but would contain a note that
the sourcee had notified EPA of an allowance transfer and that tha
transfer is pending4.
This posee a risk to purchasers of "opt-in* allowancee. For
exaaple, assume an industrial unit has elected-in to the aystea and
is allocated 5,000 allowances per yeer starting in the year 2000.
The industrial unit immediately sells 2,500 allowancee for each
year froa 2000 to 2010 to an independent power producer (XPP). The
industrial unit writes an "allowance cheek" and gives it to tha
XPP, who endorsee it and sends it to EPA for recordation. Both the
industrial unit's and XPP's accounts would now contain a note that
such allowance transfers are pending* After the end of the year
2000, EPA determines that the industrial source was in full
operation throughout the yeer 2000 and subsequently records the
first transfer of 2,500 allowances (by debiting the industrial
source's account and crediting tne XPP's account). On March 31,
2001, the industrial unit shuts down permanently. At this point,
the. XPP will have received only the 2,500 allowances for the year
2000. The remaining 2,500 allowances each year from 2001 to 2010
would not be transferred to the XPP's account or carried over in
the industrial sources account. Therefore, these allowancee would
never be made available for use to offset emissions. Clearly, this
presents a problem for the XPP, who was planning on these
allowancee in order to comply. The buyer must bear the risks
involved with purchasing "opt-in" allowances.
4 This would only apply to opt-in sources, not to existing
utility units.
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Paper A19
The Tax Treatment of Emission Allowances
Donald W. Kiefer
Senior Specialist in Economic Policy
Congressional Research Service
Library of Congress
January 30,1991
[Not*: Th« vi«wt in this paper art thoM of th« author and do not Mcmahly r*fl«ct the vj««* of
:h« Congnaaioiul Rmarch S«rvic* or ch« Library of CongrMa.]
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The Tax Treatment of Emission Allowances
As I thought of what I ought to say in the introduction to this presentation.
an extended good news, bad news joke ran through my mind.
}
The good news~at least it would be good news to many audiences-is that
I am not a lawyer. The bad news-again, at least it would be to many
audiences-is that I am an economist. The worse news is that to adequately
address the topic I have been asked to speak on today, I probably should be a
lawyer.
The good news is that since Doug Jones asked me to do this presentation
I have had time to ponder some of the intriguing tax issues raised by the
emission allowance system in title IV of the 1990 Clean Air Act Amendments.
Hopefully, the results of this rumination will be of some use to you. The bad
news is that ! won't provide definitive answers regarding any of these issues.
As already mentioned, I'm an economist, not a lawyer, so perhaps that is not
surprising. On the other hand, the lawyers I know who practice in this area
don't claim to know the answers on ail of these issues either.1
The good news for me as an economist is that the emission allowance
trading system in title IV "raises a large number of very .interesting
microeconomic and market structure issues on which one could write, and no
doubt people will write, volumes. The bad news, at least for me, is that's not
what I have been asked to address in this paper. I have been asked to discuss
the tax implications, which, fortunately, are also interesting. So I will restrain
my considerable temptation to comment on the emission allowance market now
aborning and limit my discussion to issues regarding tax treatment.
The discussion below is organized around the primary events involving the
emission allowances that require a determination of tax treatment: receipt of the
emission allowances, sale or exchange of the allowances, and purchase and cost
recovery of. the allowances. The final section considers inter-period tax
accounting issues.
Receipt of Emission Allowances
The first issue is whether receipt of emission allowances should be regarded
as a taxable event. It may seem intuitively that receipt of the allowances should
not be regarded as taxable income, but the issue is not as straightforward as it
may initially seem. Section 61 of the Internal Revenue Code (tax code) defines
gross income as 'all income from whatever source derived." The allowances
received by utilities will obviously have value. Estimates of the vigor of private
trading differ, but the allowances are expected to be traded and to have a
market-based price. Furthermore, allowances will be auctioned and sold by the
1 Some of these lawyer*, who would probably rather not a* named. have been kind trough to
consult with me during preparation of this paper, for which I am grateful Hence, the discussion
is not completely devoid of legal input.
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Environmental Protection Administration (EPA). One possible interpretation
would be that the "allowances received should be regarded as income to the
utilities equal to the number of allowances received multiplied by their market
price.
A case can be made, however, that this would not be the proper
interpretation. To sharpen the argument, it may be useful initially to focus on
a simplified and stylized version of the emission allowances system; the
implications of other characteristics of the program can be considered
subsequently. Assume that emission allowances are to be issued to utilities
based solely on their baseline fuel use, that utilities are obligated to have
emission allowances equal to their emissions, and that in ail cases the number
of allowances to be received by a utility is lest than or equal to current
emissions.
One approach to the question is to ask whether receipt of the emission
allowances meets a standard definition of income. The well-know Haig-Simons
definition is probably the most widely cited; it holds that income during a period
is equal to the sum of consumption plus the change in net worth.2 If the
allowances received by a .utility exactly equal its current level of emissions, the
allowances leave net worth unchanged.9 If the allowances received are less than
the current level of emissions, then the utility's net worth is reduced because
the firm has imposed on it a liability equal to the lesser of I) the cost of
obtaining sufficient additional allowances, or 2) the coat of reducing emissions
to the level permitted by the allowances. In this case, receipt of the allowances
does not provide income; the allowance system, in effect, imposes a tax.
A second approach to the issue is to appeal to the principle of taxation
which holds that the form of a transaction should not determine its tax,
consequence. That is, if the substantive effect* of a transaction could be
duplicated by an alternative transaction taking a different form, the two
transactions should have the same tax consequence. Ignoring for the moment
the opportunity to trade emission allowances, the granting of the allowances is
a means of restricting the level of air pollution. The Senate committee report
makes this explicit; in identifying the primary objectives of the- allowance
system, it states, Tint, allowances are a regulatory implement for ensuring that
the aggregate emission limitation requirements set forth in new title IV of the
Act are mat."4 Thia function of the emission allowances could have been
achieved, alternatively, by imposing on each utility, through a command system.
2 Sea: ILM. Hai£ The Concept of Income: Economic and Legal Aspects, in R.M. Haig < ed. >,
Federal Income Tax, Columbia University Proa, New York. 1921; Henry C Simons. Personal
Income Taxation, University of Chicago Press. Chicago. 193S; and Henry C Simons. Federal Tax
Reform, University of Chicago Press, Chicago, 1950.
3 la this caat. the 'asset value" of the allowances is exactly offset by the "liability" requiring
the utility to obtain and hold allowances equal to current emissions.
4 Clean Air Act Amendment* of 1S89, Report to Accompany S. 1630, Committee on
Environment and Public Works. U.S. Senate. Report 101-228. 101M Congress. I"4 Session.
December 20, 1989. p. 320.
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a stated limit on emissions. It is unlikely that receipt by a utility of a notice
that it must restrain its emissions to some stated level would raise the issue of
whether it had thereby received taxable income. Note that this point does not
depend on the assumption that the allowances are less than or equal to the
utility's current level of emissions.
This approach can be extended to consider the tax consequences of the
tradability of excess allowances. Clearly, if a company receives more allowances
. than required to cover its own emissions, and these excess allowances can be
sold, then the company receives income by the Haig-Simons definition (the net
worth of the company is increased). The precise amount of that income may not
be determinate at the time of receipt of the allowances (and, therefore, the tax
code may not recognize the income at that time), but it is relatively certain, at
least in an economic sense, that income has been received.
Here again, however, the program could take an alternative structure, and
this alternative structure is instructive in thinking about the tax consequences.
Rather than granting tradeable allowances equal to the total amount of
permitted emissions, tradeable allowances could have been defined as the
permitted level of emissions minus the actual level (if positive). Indeed, this is
the approach that is used in EPA's air emissions'trading program which was
begun in 1979. It is also the approach that was used in EPA's lead trading
program which existed from 1982 through 1987 aa pan of the effort to reduce
the lead content of gasoline.
In the case of the current air emissions trading program, the right to
produce a certain quantity of emissions is created when a State regulatory
agency issues a-permit to an emission source. This right, however, is not
regarded aa producing tradeable allowances. The tradeable allowances, called
emission reduction credit* or ERCs, are created by generating less emissions
than permitted by regulation. These CRCs can be saved (banked) and used by
the firm at a later data or sold to another firm.4 Since tradeable allowances are
not created at the time the emission permit is issued, the question of tax
treatment does not arise at that time. The number of ERCs created is not
known until the end of the period. At that time, if the ERCs have been sold, the
proceeds would, of course, be taxable (further discussion of the tax treatment of
sales proceeds ia provided below). If, on the other hand, the ERCs have been
banked to be saved for future use or sale, they .would be more in the nature of
inventory, their tax treatment to be determined in the future when they are
used or sold
An analogous approach was used in EPA's program of lead rights trading.
EPA set the allowable lead content in terms of grams of lead per gallon of
* For further information on the air emissions trading program see, Anderson, Robert C, Lisa
A. Hofmaon, and Michael Rusin. The Us* of Economic Inemavt Htehanitm* in Environmental
Management, Rattarch Paptr 4*051. Anitnean Petroleum Institute. June 1990. p. 15-20; and
Hahn. Robert W. and Gordon L Hwttr. Afar*«rao/r Ptrmitt: Letsont for Theory and Practice.
Discussion Paper, School of Urban and Public Attain. Carnegie Mellon University, January 15.
1988. p. 8-17. -
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T /
gasoline refined or imported. Here again, the total allowable lead content was
not regarded as tradeable lead rights. Rather, lead rights were created by
refining or importing gasoline with less lead than allowed.. From 1932 through
1984', lead rights expired at the end of the quarter in which they were
generated; hence, they had to be either used or sold to generate any value.
Beginning in 1985, the lead rights could be banked for use in a future period.
The program ended at the end of 1987.* The tax consequences would seem to
be similar to those of the air emissions trading program. Issuing a regulation
specifying an allowed lead content of gasoline does not raise the issue of
whether taxable income has been received by refiners as a consequence of the
regulation. If a refiner generated and sold lead rights during a year, the
proceeds of the sale would be taxable. If a refiner generated and banked lead
rights, the treatment of the banked rights would be determined at the time of
their future use.
Since the emission allowance trading program under title IV of the 1990
Clean Air Act Amendments is designed to achieve the same effects as these
programs, a case can be made that the tax treatment should also be the same.
This would suggest that the receipt of emission allowances should not be
regarded as a taxable event, and that the tax treatment of excess allowances
should be determined when they are used or sold.7
The discussion so far applies only to the emission allowances to be received
by utilities as a means of imposing the basic emissions tonnage limitations, that
is, those allowances determined by multiplying the allowable emissions rate by
the utility unit's baseline fuel consumption.* But extra allowances will be given
8 For further detail* see, Anderson, et. ai, op. ac, p. 24*31; «nd Hahn and Hester, op. at., p.
17-24.
7 Support for this paattiaa am be found in I.R.3. General Counsel's Memorandum (GCM)
39606. winch srlrtrssaes. the) MM treatment of airport landing and takeoff "slots' that can be traded.
•old, purchased, and otherwise- eirhsnged by airline*. Th* memorandum sue*. "the initial
acquisition of a aloe from the federal government....]* not an event that mult* in the realization
of gross income.* The memorandum further states. This ia true even chough, in some cam, these
right! are transfersbk, have aa sscertainable fair market value, and were acquired at no cost or
for a negligible fee,' In addition, the GCM notes. The same reault waa reached in vanou* court
eaaea alao daaiaif with TV or radio broadcasting licenaea or permits, cotton acreage allotments.
city liquor BOSOM* cattle grazing privileges, ttc. The intangible aaaeta considered in theee cases
and ruliap ahare with airport landing rights the characteristic of having been conferred by a
governmental body ia furtherance of government regulatory policiea in allocating a limited
resource.* See the eummary of the GCM in. Doily To* Report, The Bureau of National Affairs.
March 11, 1987. p. H-4 to K4. tt thould be noted thai GCMs cannot be reiied on as precedent.
* The allowances withheld for the Administrator's reserve do not necessarily raise any special
issues. There should be no tax consequence at the time they are withheld. If they are returned
in the form of allowances to the companies from which they are withheld, there should be no tax
consequence at that time either: If they are returned as income from their sale, that income
would in most circumstances be taxable. One discussion of (he issue, however, suggests the
possibility that if a utility must purchase allowances to replace those withheld for the
Administrator's reserve, the cost of the purchased allowances may be netted against the proceeds
of the sale of the withheld allowances under the tax code's involuntary conversion rules. See, The
Clean Air Act of 1990, Public Utility Executive Bneft. D«loitte & Touche, January 11, 1991. p. 11
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to some utilities under several special provisions of sections 404 and 405 of the
Amendments, which spell out the phase I and phase H sulfur dioxide
requirements. The tax treatment of these extra allowances may be more
problematic.
Under phase I, utilities in Illinois, Indiana, and Ohio are to receive pro rata
share* of a pool of 200,000 extra allowances annually. So-called phase I
extension units can receive incentive emission allowances for installing 90*
percent-removal scrubbers by 1995 (additionally, they can qualify for a two-year
extension of the emission limitations if they commit to installation of such
scrubbers). Extra allowances are to be given to certain utilities for early
emission reductions (prior to 1995). Extra allowances are also to be given for
emissions avoided through energy conservation programs and use of renewable
energy sources.
Under phase E, there is a pool of 50,000 extra allowances annually to be
shared on a pro rata basis by utilities in 10 states, including the three states
sharing the special pool under phase L There is a special pool of 125,000 bonus
allowances annually to be divided among utilities with fossil fuel fired steam
generation units in low-emission states. There is also a larger pool of bonus
allowances available for allocation to utilities in certain "high growth" States/
How should receipt of these bonus allowances be treated for tax purposes?
They could be treated as a selective means of relaxing the generally stated
emission limitations. Alternatively, they could be treated as subsidies.
la some cases, for example the allowances received by the Midwestern
utilities from the special pools, the bonus allowances may be used currently by
the recipients as a means of relaxing the emission limitation requirements. In
other cases in which the recipient utility currently meets or exceeds the emission
requirements, the bonus allowances will not be used to relax the current
limitation. The bonus allowances could, however, be banked and used to relax
the more stringent requirements under phase II or used in a future year when
the utility has new or expanded generation capacity.
Many regulatory programs have relaxed requirements for some categories
of the entities falling under their jurisdiction. Small businesses, for example,
are frequently treated more favorably than larger businesses. This more
favorable) treatment, while beneficial to the recipients, is not regarded as giving
rise to rsrrahle income;. If the bonus emission allowances were similarly regarded
as serving primarily to relax the emission limitations for certain categories of
firms, they presumably would also not be regarded as taxable income.
Alternatively, the bonus allowances could, in an economic sense, be
regarded as the means of providing subsidies to some categories of firms to help
defray extraordinary pollution control costs, to induce extra pollution control
efforts, and to piece together the political coalition necessary to pass the Clean
Air Act Amendments. If they are viewed as subsidies, their receipt would be
* This list of special allowance provision* is not comprehensive.
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regarded as income equal to their fair market value at the time of receipt.
Absent a specific exclusion in the tax law, which does not currently exist; this
income would be taxable.10*" ;
i
The final issue regarding tax treatment of emission allowances received is
the treatment of industrial or process plants that elect to become affected units
under section 410 to earn allowances to sell to utilities. This issue is of less
immediacy to this audience since these firms are not regulated utilities
(although units smaller than 25 megawatts can also make such an election).
The emission allowances received by these firms will probably be regarded as
taxable income. Since these sources are not subject to the emission limitations,
the sole purpose of the emission allowances is apparently to provide a subsidy
to these firms for their emission reductions, and they are likely to be taxed as
such. This tax treatment is probably of little consequence in this case since
these allowances are likely to be sold quickly; hence, their value will be taxed
currently under any circumstances.
Sale) or Exchange of Emission Allowances
The tax treatment of the sate of emission allowances may be the least'
controversial (though still not certain) tax issue. The allowances sold are likely '
to be regarded as capital assets under section 1221 of the tax code.12 If so, the
sales proceeds in excess of basis would be taxed as capital gain; any excess of
basis over the sales proceeds would be a capital lose.19
The basis of the allowances would be 0 for those allowances received as an
initial distribution from the Administrator if receipt of the allowances is not
regarded as taxable income. If receipt of the allowances is. taxed, then the basis
of the allowances would be the imputed (pre-tax) value of the allowances at the
time of receipt. The basis of purchased allowances would be their cost.
10 Internal Revenue Cod* section 126 provide* rrrlniuna for certain specifically lisud
subsidies, including payment* received under 'Any program of a Star*. poseeetion of the United
State*, a political subdivision of the foregoing, or the District of Columbia under which payments
*r* made to individual* primarily for the purpose of conserving soil, protecting or restoring the
muuimmmt, improving forest*, or providing a habitat for wildlife, (emphasis added) This
would not apply to emission allowance* under title IV of the Clean Air Act
1' Alternatively, for those bonus allowance* that subsidize investment in specific assets such
a* scrubbers, the ban* of the aaset* could be required to be reduced by the value of the allowances
13 Th* allowance* can be regarded a* property for tax purpose* even though the 1990 Clean
Air Act Amendments specifically state that they do not constitute a property right (section 403(0
of the Act); see I.R.S. General Counsel's Memorandum 39606 (cited in footnote 7).
1-1 It should be noted that under current !jw c-ipiul gams are taxed at the same rate a.«
ordinary income. Also, capital IOSM* are deductible only to the extent of capital gains; excess
capital losses may be earned back three years or carried forward five years.
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It is possible that certain trades of emission allowances-far example,
allowances useable in different years-may qualify as "like-kind exchanges" under
section 1031(a) of the tax code. If so, no gain or loss would be recognized as a
result of these exchanges. Allowances received in such a trade would assume the
basis of those traded (carryover basis).
The necessity of determining the basis of allowances sold requires a method
of inventorying the allowances held by a taxpayer. It is likely that EPA
regulations will require reporting the vintages of allowances used during a year,
since allowances cannot be used prior to the year for which they are allocated.
Because one of the goals of the allowance system is to maximize the flexibility
permitted in responding to the environmental restraints, however, EPA may not
have an interest in imposing more specific inventory rules.
The most favorable inventory system from the company's point of view
would be to allow firms to specify, without restraint, which allowances from
within their holdings are deemed to have been used or sold during the tax
period. This approach would parallel the rules for determining the basis of
securities that investors sell. Investors are allowed to direct their brokers to sell
specific securities from their portfolio-for example, those purchased on a
particular date-and thereby determine the basis of the securities even though,
in fact, the sold securities may be indistinguishable from other similar securities
in the investor's portfolio.
Alternatively, the LSLS. may require firms for tax purposes to use a
recognized inventory procedure such as first in, first out (FIFO) or some type
of averaging approach14 to identify those allowances used or sold from among
those eligible for use in the tax year. While FIFO may be the most conceptually
appealing of the procedures," the tax code allows use of last in, first out (UFO)
and certain other methods for product inventories so long as the same system
is used in the firm's financial reports.
Purchase and Coat Recovery of Emiaaioa Allowance*
The primary tax issue at the time of purchase of the emission allowances
is what kind of asset the allowances are to the purchaser, which determines the
method of cost recovery. Unfortunately, the emission allowances do not fit
neatly into any asset category currently in the tax code, which results in some
uncertainty regarding their treatment.
To measure' income properly, the cost of emission allowances should be
deducted against the income they are used to produce. This would require
deducting the cost of the allowances on an as-used basis. The view seems widely
14 On* accounting firm with in extensive public utility practice advocate* use of an "average
cost method;* see, Delottt* A Touch* (cited in footnote 8) p. 10.
14 FIFO is th« default procedure tar investors who Mil securities if the specific share* sold are
not or cannot be identified.
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held that this is the treatment likely to be afforded emission allowances, but
there is uncertainty regarding how this result will be derived under the tax code.
One possibility is that the allowances may be viewed as assets like
inventory, or, alternatively, as deferred expenses (see tax code section 461(h»,
to be deducted as ordinary and necessary business expenses (under code section
162) in the year in which they are used. Another possibility is that the
allowances might be regarded as intangible assets with no fixed life; in this case
they would be written off upon exhaustion, that is, in the year they are used.
These approaches would require a method of inventorying the allowances, as
discussed above.
A lest likely treatment is that allowances could be viewed as intangible
assets to be amortized over some average assumed useful life (which could be
determined with reference to the average period over which allowances are
expected to be banked before use) or, where applicable, over a specific period
determined by a rate order or contractual arrangement. This approach,
however, would not seem to result in the correct measurement of income.
Inter-period Tax Accounting Issue* -
Whether the emission allowances give rise to any inter-period tax
accounting issues depends, of course, on both the tax and ratemaking treatments
of the allowances, which, at this moment, are uncertain. Nonetheless, it is
possible to suggest area* when such issues might arise.
While regulatory commissions recognize some items as income before they
are matched by cash flows (AFUDC, for example), it seems unlikely that they
will recognize emission allowances as income when received (including bonus
allowances). If this is the case, then the only potential inter-period tax
accounting issue regarding receipt of the allowances would arise if some
allowances are taxed as income upon receipt. This would result in a tax
prepayment from the ratemaking: perspective and should be treated as a negative
tax deferral.
The sale of allowances probably will not result in significant differences
between tax and ratemaking accounting; Sales proceeds presumably will be
recognized a* income for both tax and ratemaking purposes. The method of
inventorying allowances probably will be required to be the same for tax and
ratemaking purposes. While some differences could result from the details of
specific sales-for example, when income is recognized from an installment sale-
the differences probably will be relatively minor.
Regarding the purchase of allowances, some regulatory commissions may
be inclined to allow recovery (or partial recovery; of allowances purchased and
banked for use in the future in connection with new or expanded generation
capacity. Advance recovery of the cost of allowances would be somewhat
analogous to allowing CWIP in the rate base. This treatment would result in
a negative deferred tax. A negative deferred tax would also arise if allowances
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.V1
are required to be amortized for tax purposes but regulators allow deduction of
the cost of allowances in the year they are used
The normalization requirements in the tax code do not apply directly to the
ratemalring treatment of emission allowances; they apply only to the deferred
tax resulting from accelerated depreciation (including the "excess deferred taxes"
resulting from the tax rate decrease in the Tax Reform Act of 1986) and deferred
investment tax credits. The IRS, however, could issue regulations on whether
any negative tax deferrals resulting from emission allowances violate the
required normalization procedures for these items, just as it has recently issued
proposed regulations regarding the effects of the tax benefits from consolidated
returns."
There are many other differences between tax and ratemaking accounting
that could arise depending on the regulatory response to the overall emission
reduction strategy adopted by a utility. If, for example, a utility decided to over-
control to create excess allowances to sell in the market, and the PUC decided
not to allow rate base treatment for the over-control investment, an obvious
difference between tax and regulatory accounting would be created. The precise
nature of this difference and the implications of the current normalization
requirements would vary from case to case depending on the ratemaking
* treatment. It is impossible at this time to anticipate all of the possible
permutations, but the tax implications of alternative regulatory approaches will-
have to be evaluated carefully.
Conclusions]
In this presentation I have made five main points:
1) The receipt of the basic emission allowances from the Administrator is
not likely to be regarded as taxable income. The receipt of bonus allowances,
however, may be.
2) Proceeds from the sale of emission allowances will probably be treated
as income from the sale of a capital asset, resulting in either a capital gain or
toss depending on the relationship of the proceeds to the basts of the allowances.
The necessity of determining basis will require a method of inventorying
allo*
3) IBs) cost of allowances probably will be deductible on an as-used basis,
although the precise interpretation under the tax code to arrive at this result
is uncertain at this time. A less likely possibility is that the cost of allowances
might be required to be amortized over some stated period.
" See: Internal Revenue Service Notice of Proposed Rulemakiiif (PS* 10748). on Extant to
Which Certain Ratemaking Procedures and Adjustments that art Baaed oa Tax Savings that art
Attributable to Filing of a Consolidated Return will be Treated aa Inconsistent with Normalization
Requirements of Sections 167(1) and 16Aix9>. Filed Nov 20.1990. reproduced in Daily To* Report.
The Bureau of National Attain, November 21. 1990. p H to L-13.
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10
4) If the tax and ratemaking treatments of the allowances differ, inter-
period tax accounting issues will arise. The I.R.S. may rule on the compatibility
of the ratemaking treatment of emission allowances with the existing
normalization requirements for accelerated depreciation and the investment tax
credit.
5) The tax implications of the regulatory response to a utility's overall
emission reduction strategy will have to be evaluated carefully.
With the exception of number 5, I am not certain of any of these
conclusions.
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Identification of
Emission AUoMActs
Provided by TftVt IV
Paper A20
Tho purpost of this analysis Is to evaluate the need, from an Income
tax point of view, to Identify specific emission allowances provided by Title
IV of tho 1990 Clean Air AMAdMflt.
For Income tax purposes, the genera! rule for establishing the Income
tax basis of any asset Is to determine the amount paid or Incurred to acquire
the asset. Internal Revenue Service Code Section 1012 provides: 'The basis
of property snail bo the cost of such property . . . .• Section f. 1012-1 (a).
of the IncoM Tax Regulations provides: "In general, the basis of property Is
the cost thereof.' Income Tax Regulation Section 1.1012-Kc) provides in
exception to the general rule for determining the Income tax basis of stock
certificates. That exception provides: 'If shares of stock In a corporation
are sold or transferred by a taxpayer who purchased or acquired lots of stodc
on different dates or at different prices, and tho lot free) which tho stock
was sold or transferred cannot bo adequately Identified, the stock sold or
transferred shall bo charged against the earliest of such lots purchased or
acquired In- order to determine tho cost or other basis of such stock and 1n
order to determine the holding period of such stock . . . .*
- *
Thus, for IncoM tax purposes, the taxpayer has the burden of
Identifying the Income tax basis of Its property. The Inference from the
cited authorities 1s that If a taxpayer cannot identify tho Income tax basis
of Its property then tho Internal Revenue Service could Insist that tho basis
of tho property bo zero or tho Internal Revenuo Service could mako a
determination of tho Income tax basis of tho property on behalf of tho
taxpayer* Of courso, neither of thoso alternatives are acceptable to tar
practloners.
Kith respect to tho emission allowances provided by Title IV of the
1990 Clean Air Amendment, a taxpayer could have ownership of allowances for
which the taxpayer has Incurred either no cost or varying costs. Thus, the
income tax basis of tho multiple emlsstom allowances owned by a taxpayer can
bo different. * Accordingly, frost a* Income tax point of view (and probably
frosi a financial accounting point of view), a taxpayer will need to accurately
report tho Income tax basis of emission allowances used or disposed of during
a taxable year. Failure to bo able to Identify tho Income tax basis of an
Mission allowance that a taxpayer uses or disposes of probably will create a
point of controversy between tho taxpayer and the Internal Revenue Service.
frost am Income tax point of view, each emission allowance
should be> givem am Identification number so that taxpayers can readily
Identify am* determine tho Income tax basis of each emission allowance It uses
or disposes of. Mitt specific Identification of the emission allowances,
taxpayers cam arrange thoir transactions for emission allowances with
certainty of tho Income tax*assigned cost of such allowances, and thereby
determine any gain or toss that may result frost the use or disposition of the
certificate, furthermore, wit* specific identification of emission
allowances, taxpayers will avoid an alternative 'Imputed" or assigned cost
basis of the allowances which may be Imposed by Internal Revenuo Service, such
as those that are Imposed on stock certificates for which the specific cost is
not able to be determined.
281
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tr
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Paper A21
1001
OC 2000*2864
1-
•4
«r. Inilip 1. O'Connor
president
111 wast Weaning*
Suits 134?
Illinois
St.
<0«02
Phil:
flunks for your call alerting us to the upcoming seating on the
allowance "»ariaii«ation" issue. wt> off«r th* foiloving eonMnta
for year and th* «ubcoa^Ltt*«l» consideration.
Whll* toJcaovlodfiAg th« aignif ioaat «d»litlatrmtiv* bordoa t&at th«
•••riallMtioa* of «llovaaea« will plac* oa th« tovlrona«ntal
protaotloa Aq*neyr «• iMllovta tttat tiui allowaneos should o«
••rialliod in »o»a aazmar. yurtu«r, va JMllovw tbat taar* «houid
b« coao avidanc* of oimarmUlp, aoota u a eartlfleato. «• b«liav«
ara at laa*t tturaa priiaiy baaafita to marlaliiation.
Daloitta tt
•** may aotod tax aacpartv^ laeludlAg tftoaa at
Toucho, baliava that If tiara la any poaaUaility of
panaaa aaaoclatad vitfe prccbaaad allovaneaa whan uaad
on a tpacific idantlficatlon ba«iaf tftay mat ba aarlalixad. Thia
ia not to say tnat auoD a aathod will bo aaoaytabla> only to point
out tnait without it, it would not appear to bo poaalbla.
*• On* of ta« eoneara« taat va as auditors hava ia the
aasats and tte ooaplatana*s of tranaaotions. ma
aarlaJLUvtioo of allowanaas will aid in oonf Iraing tno aacistanca of
asset* an* in tracking transfars* Further, we believe tbet
tarialliatloo viU enable utilities (and »A as well) to design
oost affectiva internal control systexs*
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Philip O'Connor
February 11, 19tl
Page Two
afe
in
— W« b«li«V« that Serialisation vill *as«
»*r)c*tpl*c* aad ia*ur« th« integrity of th*
Phil,
ty u
trading
t&anka again for tha opportunity to giva our via*a on this
i i«sua. If you hava any guaation* or eomanta, do not
to call Bob Hafana or aa.
5.W-
Cbarla* 0. Muha
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