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
              WASHINGTON, D.C. 20460


 A12 -
     - D
- D
              v<   PAPERS FOR FEBRUARY  20-22,  1991
  Ajenda for Allowance .Trading .Subcommittee
  Minutes from January 28,1991 Subcommittee Meeting
 AS  -
 A9 -  K

 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)
    Loitte ft Touch* letter discussing serialization
    emission allowances  (Charles D. Muha)










  Februarv 20th
     ) -  9:15 am

     S — 10:15 aa

     ! - 11:45 an
11:4!> -  1:00 pa

 1:OC -  2:;



     :30 pa

-  2:45 pa

*  4:45 pa
      irv 21st
     -  9:15

     - 10345
     - 11:00

     - 12:00

                            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)

                     Election Sources
                     (Paper A9)
                               Trading: Panel
                     —Chicago Board of Trade
                     —Goldman Sachs
                     —Abt Associates (Paper A17)
      -   5:00 pa    Summary

              Announcements;  Review Agenda

              Allowance Trading Scheme
              —Coming  to  closure on basic
               trading scheme
              (Papers A17, A18,  A19,  A20,  A21, A22)

                    Allowance Trading Scheme continued


                          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.

     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

     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

  •  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

      • '-  •     •».*:.'     ' '  ••  '•' '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.

     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

 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
Some members of the subcommittee commented that:

      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

      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

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

Add/Edit Optioa

     <1)  Allow  imese to  list  of alloMsaaa teldac* -
           information fields included name,  address,

     (2)  Allows  access to  list  of transactions -
          information fields  included number of
          allowances  traded,  names of buyer and seller,
          allowance balances  of  both

     (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.

     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

     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.

             Reulatory -
'Speakers*  Bradford L.  7«rgu»on,  Hopkins' i gutter
           Philip R. O'Connor,  Palmer Bellvue
          '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

      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

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

      (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*

      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
                               - 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


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

                              - 4 -
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

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

                         ; • ' ,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

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.


  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
        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
   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'*
                                                             ia no« tao
Many horo inciirproted ta* Coaf orone« CoaMitto* Joint StAt
          iatane to Allow A.poriod of fiao Afto« tao and of tao
                                                                  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
             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.
                           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.

                                      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
                                   Paper A15
    Maryland Public Service Commission
        231 East Baltimore Street
       Baltimore, Maryland 21202


                       .    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

                                                                          \-"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-
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.

                   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

 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'
 •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
                                                   * -
             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
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

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
                                                      Paper A16
                                                February 11, 1991
               utility Air Regulatory aroup 
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
     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?
     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 -

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 
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
     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 -

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  -

     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
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 -

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  -

         . •     : .•.'      *•:;••    ...   , ,    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 -

                                                           of  s
How vatild a book-eloaina period affaet emissio
   -                               ~"
                                                    . TTg"

      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  -

     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 -


A-8      •                                            Paper A8


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

     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

     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

     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 «


Pool  ABC consists  of  5  plants  and 10  units.
allocation-of allowancas, by unit ara:
                                                                Its  original


            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 hald


                                 CASK 1
    CASE 2
Out of Coaplianca





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

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


                                                        PAPER  A17

                                           PRELIMINARY DRAFT

                              DISCUSSION PAPER
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

(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

                                           PRELIMINARY DRAFT

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.

                                                        PRELIMINARY DRAFT

            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

            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,-;-..

                                            PRELIMINARY DRAFT

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

                                           PRELIMINARY DRAFT

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

      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
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.

                                            PRELIMINARY DRAFT

       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.


                                            PRELIMINARY DRAFT

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.

                                            PRELIMINARY DRAFT

 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.


                                            PRELIMINARY DRAFT

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.


                                            PRELIMINARY DRAFT

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?


                                            PRELIMINARY DRAFT

V.     Serialization of Allowances

       This issue was also discussed at the last ARAC meeting.  There are three basic

(1)    Label  (serialize)  each allowance, but  do not have EPA record or track each

(2)    Label  each allowance and develop an allowance trading system that tracks each

(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

       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.


                                            PRELIMINARY DRAFT

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
      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


                         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

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

     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.

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

A-7                                                   Paper A7
                         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.


 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

      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.

The seller would  need  to  include:

     Unit and  designated  representative  system . identification
     Man* and telephone number of designated  representative
     Signature   (and  date  of  signature)   of  the   designated
     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
     Kane and telephone number of designated  representative
     Signature   (and  date  of  signature)   of  the   designated

     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

"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

     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

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

     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.


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.

                                                                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.]


              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

     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.

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

    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

    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.

 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.                         -

                                                                                         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.

   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

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

     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.

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*"                                     ;
     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.

     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.

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

 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

     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.

                       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
                       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.


    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

    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

                               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

         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.



                                                               Paper A21
                                                   OC 2000*2864
          «r. Inilip 1. O'Connor
          111 wast Weaning*
          Suits 134?

          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*

Philip O'Connor
February 11, 19tl
Page Two
                   —  W«  b«li«V« that  Serialisation  vill *as«
                      »*r)c*tpl*c* aad ia*ur« th« integrity of th*
       ty u

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.
Cbarla* 0. Muha